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Can Michaels (MIK) Withstand Tariff & Margin-Related Woes?

Zacks Equity Research

The Michaels Companies, Inc. MIK displays a dismal run on the brochures, thanks to its soft margins trend as well as disappointing first-quarter fiscal 2019 results. Moreover, the company’s trimmed margins and earnings per share view for fiscal 2019, in response to the recent increase in tariffs on List 3 goods from 10% to 25% and expectations of additional tariff on List 4 goods, has been hurting investor sentiments.

Consequently, this Zacks Rank #4 (Sell) stock has declined as much as 32.8% in the year-to-date period against the industry’s growth of 24.3%.

 



Recent Results Indicate Soft Trends

Michaels has been witnessing a soft margins trend for the past several quarters, owing to elevated costs, which persisted in first-quarter fiscal 2019. This marked the company’s fifth straight quarter of gross margin decline and the sixth consecutive quarter of operating margin contraction. In the fiscal first quarter, gross margin contracted 130 basis points (bps) due to rise in distribution-related costs and occupancy cost deleverages. Moreover, an adverse sales mix, resulting from strong sales of lower margin categories like technology and storage, hurt gross margin. Further, the company had to endure the impact of tariffs on cost of goods sold during the quarter.

Meanwhile, adjusted operating income dropped nearly 19.6%, backed by lower gross profit, partly offset by a decline in SG&A expenses. Adjusted operating margin fell 160 bps to 9.3%, owing to an 80-bps increase in SG&A expenses as a percentage of sales as well as the aforementioned decline in gross margin.

Moreover, the company delivered in-line earnings after four positive earnings surprises while sales lagged after two consecutive beats. Earnings decline mainly resulted from soft sales as well as lower gross margin. Soft sales 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 the 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 comps.

Tariff Costs to Hinder Growth

After a dismal fiscal first quarter, Michaels reiterated sales view for fiscal 2019 while it lowered margin and earnings per share guidance. This was mainly due to the recent increase in tariffs for List 3 goods and expectations of additional tariffs on List 4 goods. Management 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.

Driven by the aforementioned increase in tariff on List 3 goods to 25%, adjusted operating income is now estimated to be $625-$650 million versus the previously mentioned $640-$665 million. The company expects about $400 million of product costs to be subject to higher duties in fiscal 2019.

Notably, Michaels 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.

Backed by the additional duties, as well as the ongoing transportation headwinds, occupancy costs deleverage and strong e-commerce growth, the company expects gross margin for fiscal 2019 to be slightly below the fiscal 2018 level. Adjusted earnings per share for fiscal 2019 are now envisioned to be $2.29-$2.41 compared with $2.34-$2.46 stated earlier.

Wrapping Up

Clearly, like many others in the retail sector, Michaels is likely to remain in rough waters over the near term, owing to the impacts of tariffs. However, the company seems to be keen on reviving its sales performance in the quarters ahead, which is a silver lining. It plans to focus on three areas — improving current sales trends, executing against the 2019 priorities and refreshing long-term growth strategy — to aid growth in the second half of fiscal 2019. Moreover, its robust omni-channel initiatives bode well.

While the backdrop remains disheartening, we would wait for the company’s efforts to reflect in its results before we become optimistic about the stock.

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