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Michaels (MIK) Q1 Earnings Meet, Tariff Woes Hurt Stock

Zacks Equity Research

The Michaels Companies, Inc. MIK reported a dismal first-quarter fiscal 2019. Earnings in the quarter were in line with estimates but sales missed the same. Moreover, its top and bottom lines declined year over year. With this, the company delivered in-line earnings after four positive earnings surprises while sales lagged after two consecutive beats.

Further, management trimmed its earnings guidance for fiscal 2019 due to impacts of the increase in tariffs on List 3 goods from 10% to 25% and expectations of additional tariffs on List 4 goods. Backed by the soft quarter and disappointing guidance, shares of this Texas-based company declined as much as 12.4% on May 6.

In the past three months, shares of this Zacks Rank #3 (Hold) company have declined 35.2% against the industry’s 6% growth.

 



Q1 Numbers

Michaels’ adjusted earnings of 31 per share were in line with the Zacks Consensus Estimate but declined 20.5% from the prior-year quarter. This decline mainly resulted from soft sales as well as lower gross margin.

The Michaels Companies, Inc. Price, Consensus and EPS Surprise

 

The Michaels Companies, Inc. Price, Consensus and EPS Surprise

The Michaels Companies, Inc. price-consensus-eps-surprise-chart | The Michaels Companies, Inc. Quote

Net sales of this arts and crafts specialty retailer fell 5.3% year over year to $1,093.7 million and missed the Zacks Consensus Estimate of $1,105 million. Sales lag in the quarter resulted from the timing differences of plan-o-gram changes this year, which led to lower levels of clearance products in stores as well as unfavorable winter weather at the start of the quarter, which impacted traffic and sale of seasonal products.

The decline in net sales is also attributed to the closure of Pat Catan’s and Aaron Brothers outlets in fiscal 2018, and soft comparable store sales (comps). This was somewhat offset by sales from the operation of 17 additional flagship stores (net of closures) in the fiscal first quarter.

Comps fell 2.9% in the reported quarter, attributable to a decline in customer transactions, partly compensated with rise in average ticket. However, the company delivered strong e-commerce sales again in this quarter, driven by increased traffic and higher conversion rates.

Gross profit declined 8.5% year over year to $417.6 million while gross margin contracted 130 basis points (bps) to 38.2%. The contraction in gross margin resulted from rise in distribution-related costs, occupancy cost deleverages and an adverse sales mix, resulting from strong sales of lower margin categories like technology and storage. Further, the company had to endure the impact of tariffs on cost of goods sold during the quarter. This downside was partly offset by gains from the ongoing sourcing endeavors and lower promotional activity.

SG&A expenses, including pre-opening costs, decreased roughly 2.5% to $321.8 million on lower expenses associated with the closure of Pat Catan’s and Aaron Brothers’ stores, and lower payroll expenses. This decline was partly offset by costs associated with the departure of the company’s former CEO. As a percentage of sales, SG&A expenses, including pre-opening costs, increased 80 bps to 29.4%.

Adjusted operating income dropped nearly 19.6% to $101.4 million, backed by lower gross profit, partly offset by a decline in SG&A expenses.

Stores Update

During the fiscal first quarter, the company inaugurated four Michaels stores alongside closing two and relocating seven stores. As of May 4, 2019, it operated 1,260 Michaels stores.

For fiscal 2019, the company intends to open 20 Michaels outlets, which include nearly 12 Pat Catan’s stores that it plans to rebrand. Also, it expects to relocate 13 Michaels stores. In the second quarter of fiscal 2019, the company plans to open three and relocate two Michaels stores.

Financial Position

Michaels had cash and equivalents of $246.7 million, long-term debt of $2,675.6 million, and total stockholders’ deficit of $1,587.4 million as of May 4, 2019. Total merchandise inventory fell 1.8% to $1,101.7 million at the end of the fiscal first quarter. However, average Michaels inventory per store, inclusive of distribution centers, inventory in-transit and inventory for its e-commerce site, grew 1%. This included a 70-bps negative impact of 10% incremental duties incurred on List 3 tariff products.

Management incurred capital expenditure of $25.1 million in first-quarter fiscal 2019 mainly related to investments in technology projects, including investments for e-commerce and digital platforms as well as store-growth efforts. For fiscal 2019, Michaels expects to incur capital expenditure of about $135 million.

Guidance

The company remains confident about its strategic initiatives. It is poised to gain by improving its current sales trends, executing against the 2019 priorities to build momentum in the second half and refreshing its long-term growth strategy. These apart, the company remains focused on integrating its e-commerce and in-store operations to enhance the omni-channel experience.

However, Michaels is concerned about the recent increase in tariff on List 3 goods from 10% to 25%. Further, the potential imposition of List 4 China tariffs is likely to worsen the situation, putting significant cost pressure on the company. Though it reiterated its sales view for fiscal 2019, it lowered its margins and earnings per share guidance to reflect the recent increase in tariffs.

For fiscal 2019, net sales are still estimated to be $5.19-$5.24 billion compared with $5.27 billion generated in fiscal 2018. Comps are likely to be flat to up 1%.

Adjusted operating income is now estimated to be $625-$650 million versus the previously mentioned $640-$665 million. This is mainly due to the aforementioned increase in tariff on List 3 goods to 25%. It expects about $400 million of product costs to be subject to higher duties in fiscal 2019. The company is relentlessly working to lower impacts of tariffs through sourcing actions, vendor negotiation, product reengineering and selective price increases. However, the imposition of List 4 tariffs may further impact the company’s bottom line and margins. Nonetheless, it notes that the pending tariffs on products from Mexico will not pose material impacts  as it sources only limited goods from Mexico.

Driven by the additional duties, the company expects gross margin for fiscal 2019 to be slightly below the fiscal 2018 levels. Apart from impacts of tariffs, it expects gross margin to gain from ongoing sourcing initiatives and improved management of promotions, offset by ongoing transportation headwinds, occupancy costs deleverage and strong e-commerce growth. Further, the company expects SG&A expense leverage in fiscal 2019 compared with fiscal 2018 due to the absence of restructuring charges and investment spending of $15 million that was incurred in fiscal 2018.

Interest expenses are expected to be about $153 million due to expectations of no additional tax increases this year. The effective tax rate for the fiscal year is expected between 23% and 24%.

Driven by the aforementioned tariff impacts and other changes, adjusted earnings per share for fiscal 2019 are now envisioned to be $2.29-$2.41 compared with $2.34-$2.46 stated earlier.

For the fiscal second quarter, comps are projected to be flat to down 1.5%. Adjusted operating income is estimated to be $65-$75 million, driven by expectations of flat gross margin compared with the second quarter of fiscal 2018. Gross margin is likely to reflect higher distribution-related costs, occupancy deleverage and the impact of tariffs, compensated with sourcing benefits and discount management. Further, adjusted earnings per share are envisioned to be 13-16 cents.

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