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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549

FORM 10-Q

(Mark One)

For the quarterly period ended August 3, 2002

OR

For the transition period from                              to                             

Commission file number 001-09338

MICHAELS STORES, INC.
(Exact name of registrant as specified in its charter)

8000 Bent Branch Drive
Irving, Texas 75063
P.O. Box 619566
DFW, Texas 75261-9566
(Address of principal executive offices, including zip code)

(972) 409-1300
(Registrant's telephone number, including area code)

        Indicate by check mark whether the Registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ý    No o

        Indicate the number of shares outstanding of each of the Registrant's classes of Common Stock, as of the latest practicable date.

MICHAELS STORES, INC.
FORM 10-Q

Part I—FINANCIAL INFORMATION

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MICHAELS STORES, INC.

Part I—FINANCIAL INFORMATION

Item 1. Financial Statements.

MICHAELS STORES, INC.

CONSOLIDATED BALANCE SHEETS

(In thousands, except share data)

See accompanying notes to consolidated financial statements.

3

MICHAELS STORES, INC.

CONSOLIDATED STATEMENTS OF INCOME

(In thousands, except per share data)

(Unaudited)

See accompanying notes to consolidated financial statements.

4

MICHAELS STORES, INC.

CONSOLIDATED STATEMENTS OF INCOME

(In thousands, except per share data)

(Unaudited)

See accompanying notes to consolidated financial statements.

5

MICHAELS STORES, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

See accompanying notes to consolidated financial statements.

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MICHAELS STORES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

For the Six Months Ended August 3, 2002

(Unaudited)

Note 1. Basis of Presentation

        The consolidated financial statements include the accounts of Michaels Stores, Inc. and our wholly-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated. All expressions of "us," "we," "our," and all similar expressions are references to Michaels Stores, Inc. and our consolidated wholly-owned subsidiaries, unless otherwise expressly stated or the context otherwise requires.

        The accompanying unaudited consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and notes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals and other items, as disclosed) considered necessary for a fair presentation have been included. Because of the seasonal nature of our business, the results of operations for the quarter and six months ended August 3, 2002 are not indicative of the results to be expected for the entire year.

        The balance sheet at February 2, 2002 has been derived from the audited financial statements at that date but does not include all of the information and notes required by generally accepted accounting principles for complete financial statements. For further information, refer to the consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the fiscal year ended February 2, 2002.

        All references herein to "fiscal 2002" relate to the 52 weeks ending February 1, 2003 and all references to "fiscal 2001" relate to the 52 weeks ended February 2, 2002. In addition, all references herein to "the second quarter of fiscal 2002" and "the first six months of fiscal 2002" relate to the 13 and 26 weeks ended August 3, 2002, respectively, and all references to "the second quarter of fiscal 2001" and "the first six months of fiscal 2001" relate to the 13 and 26 weeks ended August 4, 2001, respectively.

Note 2. Common Stock and Earnings per Share

        On October 31, 2001, our Board of Directors declared a two-for-one common stock split effected in the form of a stock dividend to stockholders of record as of the close of business on November 12, 2001, payable on November 26, 2001. An amount equal to the par value of shares issued in the split has been transferred from paid-in capital to the common stock account. All references to the number of shares of Common Stock (except for shares authorized), per share prices, and earnings per share amounts in the consolidated financial statements and accompanying notes included in this Quarterly Report on Form 10-Q have been adjusted to reflect the split on a retroactive basis.

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        The following table sets forth the computation of basic and diluted earnings per common share:

        Our purchase and subsequent retirement of 392,100 shares of our Common Stock in the second quarter of fiscal 2002 reduced the number of weighted average shares outstanding by 24,330 shares for the second quarter of fiscal 2002 and 12,165 shares for the first six months of fiscal 2002.

Note 3. Senior Notes

        In July 2001, we issued $200 million in principal amount of 9¹/4% Senior Notes due July 1, 2009 in a private placement under Securities and Exchange Commission Rule 144A to a limited number of qualified institutional buyers. The Senior Notes due 2009 are unsecured and interest thereon is payable semi-annually on each January 1 and July 1, beginning on January 1, 2002. In August 2001, as required by the contract with the purchasers of the Senior Notes due 2009, we made an offer to exchange all of the privately placed Senior Notes due 2009 for an equal principal amount of Senior Notes due 2009 having substantially identical terms, the sale of which was registered under the Securities Act of 1933. As of October 1, 2001, all of the privately placed Senior Notes due 2009 were exchanged for the Senior Notes due 2009 having substantially identical terms.

Note 4. Credit Agreement

        Effective May 1, 2001, we signed a new $200 million unsecured revolving bank credit facility with Fleet National Bank and other lending institutions, which replaced the previous $100 million unsecured revolving bank credit facility. The Credit Agreement had an original term of three years (with a maturity extension for one additional year available under certain conditions) and contains a

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$25 million competitive bid feature and a $70 million letter of credit sub-facility. Effective May 24, 2002, pursuant to the terms of the Credit Agreement, our lenders agreed to extend the term of the Credit Agreement from April 30, 2004 to April 30, 2005.

        We are in compliance with all terms and conditions of the Credit Agreement. Borrowings outstanding under the Credit Agreement were $20.4 million as of August 3, 2002 with no borrowings outstanding as of August 4, 2001. Borrowings available under the Credit Agreement are reduced by the aggregate amount of letters of credit outstanding under the Credit Agreement ($16.7 million as of August 3, 2002). In the first six months of fiscal 2002, borrowings under the Credit Agreement were outstanding for five days, with average outstanding borrowings of $16.4 million and a weighted average interest rate of 4.75%.

Note 5. Legal Proceedings

Raniwala Proceeding

        On May 2, 2000, Taiyeb Raniwala, a former assistant manager of a Michaels store, filed a purported class action complaint against us, on behalf of Michaels stores' former and current assistant store managers. The Raniwala Complaint was filed in the Alameda County Superior Court, California and alleged that we violated various California laws by erroneously treating Michaels stores' assistant store managers as "exempt" employees who were not entitled to overtime compensation. Based on these allegations, the Raniwala Complaint asserted that we: (1) violated various California Wage Orders; (2) violated Section 17200 of the California Business and Professions Code; and (3) engaged in conversion. The Raniwala Complaint sought back wages, interest, penalties, and attorneys' fees.

        On June 6, 2001, we negotiated a tentative settlement of the purported class action with Raniwala. As a result, we recorded a litigation settlement charge of $3.2 million in the first quarter of fiscal 2001, covering all claims, attorneys' fees, and estimated payroll taxes. The settlement, in exchange for a full release of claims, received final approval from the Alameda County Superior Court on November 20, 2001, and as a result, the case against us was dismissed effective November 20, 2001. The distribution of the settlement proceeds was made on January 19, 2002.

Collins Proceeding

        On April 16, 1999, Suzanne Collins, a former assistant manager of our subsidiary, Aaron Brothers, Inc., filed a class action complaint against Aaron Brothers on behalf of Aaron Brothers' former store managers, assistant store managers, and managers-in-training. The Collins Complaint was filed in the Los Angeles County Superior Court, California and alleged that Aaron Brothers violated various California laws by erroneously treating its store managers, assistant store managers, and managers-in-training as "exempt" employees who were not entitled to overtime compensation. Based on these allegations, the Collins Complaint asserted that Aaron Brothers: (1) violated various California Labor Codes; (2) violated Section 17200 of the California Business and Professions Code; and (3) engaged in conversion. The Collins Complaint sought back wages, interest, penalties, punitive damages, and attorneys' fees.

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        On March 15, 2002, Aaron Brothers negotiated a definitive settlement of the purported class action with Collins, subject to final court approval. The Court granted preliminary approval of the settlement on March 29, 2002. As a result, Aaron Brothers recorded a litigation settlement charge of $5.0 million in the fourth quarter of fiscal 2001, covering all claims, attorneys' fees, and estimated payroll taxes. On June 12, 2002, the Court approved the settlement and the judgment was entered. The appeal period expired on August 12, 2002. No appeals were filed with the Court. The settlement payments were delivered to the settlement administrator on August 16, 2002 for distribution.

General

        We are a defendant from time to time in lawsuits incidental to our business. Based on currently available information, we believe that resolution of all known contingencies is uncertain, and there can be no assurance that future costs of such litigation would not be material to our financial position or results of operations.

Note 6. Recent Accounting Pronouncements

        In October 2001, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. SFAS No. 144 addresses the accounting and reporting for the impairment or disposal of long-lived assets and supersedes SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed of, and Accounting Principles Board Opinion No. 30, Reporting the Results of Operations—Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions. SFAS No. 144 establishes a single accounting model for long-lived assets to be disposed of by sale and resolves implementation issues related to SFAS No. 121. SFAS No. 144 is effective for financial statements issued for fiscal years beginning after December 15, 2001. In the first quarter of fiscal 2002, we adopted the provisions of SFAS No. 144, and they had no material impact on our consolidated operating results or financial position.

        In June 2001, the FASB issued SFAS No. 141, Business Combinations, and No. 142, Goodwill and Other Intangible Assets, effective for fiscal years beginning after December 15, 2001. Under the provisions of SFAS No. 141 and No. 142, goodwill and intangible assets deemed to have indefinite lives will no longer be amortized but will be subject to annual impairment tests. Other intangible assets with finite useful lives will continue to be amortized over their useful lives. We adopted these provisions in the first quarter of fiscal 2002. During the first quarter of fiscal 2002, we performed the first of the required impairment tests of goodwill and indefinite lived intangible assets, and the tests did not result in an impairment charge.

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        The following pro forma financial information reflects net income and diluted earnings per common share as if goodwill were not subject to amortization in the second quarter and first six months of fiscal 2001:

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Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.

        Certain statements contained in this discussion and analysis (or elsewhere in this Quarterly Report on Form 10-Q), which are not historical facts, are forward-looking statements that reflect our plans, estimates, and beliefs. Words such as "anticipates," "plans," "expects," "believes," and similar expressions often identify forward-looking statements. Our actual results could materially differ from those discussed in these forward-looking statements, which involve risks and uncertainties, including, but not limited to, customer demand and trends in the arts and crafts industry, impact of competitors' locations, pricing, and products, related inventory risks due to shifts in customer demand, impact of economic conditions, the availability of acceptable locations for new stores, difficulties in implementing information system technologies, supply constraints, results of financing efforts, effectiveness of advertising strategies, and other risks detailed in our Securities and Exchange Commission filings.

        All expressions of "us," "we," "our," and all similar expressions are references to Michaels Stores, Inc. and its consolidated wholly-owned subsidiaries, unless otherwise expressly stated or the context otherwise requires.

        Discussions relating to our Common Stock reflect the effects of the two-for-one Common Stock split effected in the form of a stock dividend to stockholders of record as of the close of business on November 12, 2001.

General

        All references herein to "fiscal 2002" relate to the 52 weeks ending February 1, 2003 and all references to "fiscal 2001" relate to the 52 weeks ended February 2, 2002. In addition, all references herein to "the second quarter of fiscal 2002" and "the first six months of fiscal 2002" relate to the 13 and 26 weeks ended August 3, 2002, respectively, and all references to "the second quarter of fiscal 2001" and "the first six months of fiscal 2001" relate to the 13 and 26 weeks ended August 4, 2001, respectively.

        The following table sets forth certain of our unaudited operating data (dollar amounts in thousands):

---

(Notes on following page)

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(Notes from table on preceding page)

(1)

EBITDA is calculated as income before income taxes plus interest, depreciation, and amortization. EBITDA is presented because it is a widely accepted financial indicator of a company's ability to incur and service debt, but is not a financial measurement recognized by generally accepted accounting principles, and therefore, may not be comparable to similarly titled measures used by other entities. EBITDA should not be considered by an investor as an alternative to net income, as an indicator of our operating performance, or as an alternative to cash flow as a measure of liquidity.

(2)

Adjusted EBITDA is calculated as income before income taxes plus interest, depreciation, amortization, and unusual, non-recurring charges. Adjusted EBITDA for the second quarter of fiscal 2001 excludes a $347,000 adjustment to reduce the one-time charge recorded in the first quarter of fiscal 2001 related to senior executive severance. Adjusted EBITDA for the first six months of fiscal 2001 excludes costs of approximately $1.0 million related to senior executive severance and a litigation settlement charge of $3.2 million.

(3)

Comparable store sales increase represents the increase in net sales for stores open the same number of months in the indicated and comparable period of the previous year, including stores that were relocated or expanded during either period, adjusted for unusual circumstances year over year such as inclement weather and natural disasters. A store is deemed to become comparable in its 14^th full month of operation in order to eliminate grand opening sales distortions. The calculation of comparable store sales increases excludes the effect of deferring the recognition of custom frame sales for orders that have not been picked up by the customer at the end of the period.

Results of Operations

        The following table sets forth the percentage relationship to net sales of each line item of our unaudited consolidated statements of income. This table should be read in conjunction with the following discussion and with our consolidated financial statements, including the related notes, contained herein.

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Quarter Ended August 3, 2002 Compared to the Quarter Ended August 4, 2001

        Net sales for the second quarter of fiscal 2002 increased $90.5 million, or 19%, over the second quarter of fiscal 2001. At the end of the second quarter of fiscal 2002, we operated 729 Michaels and 147 Aaron Brothers retail stores. The results for the second quarter of fiscal 2002 included sales from 83 Michaels and 21 Aaron Brothers retail stores that were opened during the 12-month period ended August 3, 2002, more than offsetting lost sales from the closure of 11 Michaels and two Aaron Brothers stores. Sales at the new stores (net of closures) during the second quarter of fiscal 2002 accounted for $47.9 million of the increase in net sales. Comparable store sales increased 9% in the second quarter of fiscal 2002 compared to the second quarter of fiscal 2001, which contributed $40.9 million to the net sales increase. The improvement in comparable store sales was due to a strong performance in our core categories of books, general crafts, ribbon, apparel crafts, art supplies, seasonal, kids crafts, and party. Going forward, we expect to achieve comparable store sales increases for the remainder of fiscal 2002, taken as a whole. Our ability to continue to generate comparable store sales increases is dependent, in part, on our ability to continue to maintain store in-stock positions on the top-selling items, to properly allocate seasonal merchandise to our stores, and to be successful in our sales promotion efforts.

        Cost of sales and occupancy expense, as a percentage of net sales, for the second quarter of fiscal 2002 was 63.9%, a decrease of 3.3% compared to the second quarter of fiscal 2001. This decrease was primarily attributable to improved merchandise margins and a leveraging of store occupancy expense on higher average net sales per store compared to the second quarter of fiscal 2001.

        In addition, in the second quarter of fiscal 2002, we fully utilized the $14.8 million markdown reserve originally recorded in the fourth quarter of fiscal 2001 to offset the liquidation of certain merchandise that did not conform to each store's specific plan-o-gram SKU program.

        Selling, general, and administrative expense was $165.0 million, or 28.6% of net sales, in the second quarter of fiscal 2002 compared with $143.9 million, or 29.6% of net sales, in the second quarter of fiscal 2001, which includes an adjustment of $347,000 to reduce the one-time charge recorded in the first quarter of fiscal 2001 related to senior executive severance. Excluding this severance adjustment, selling, general, and administrative expense was $144.2 million, or 29.7% of net sales, in the second quarter of fiscal 2001. The decrease as a percentage of net sales to 28.6% in the second quarter of fiscal 2002 from 29.7% in the second quarter of fiscal 2001 was due in part to a decrease in store payroll and related expenses, on a percentage of net sales basis, resulting from higher average net sales per store in the second quarter of fiscal 2002 compared with the second quarter of fiscal 2001. In addition, net advertising expense decreased, as a percentage of net sales, in the second quarter of fiscal 2002 as a result of a leveraging of advertising expense on higher average net sales per store and higher co-op advertising income compared to the second quarter of fiscal 2001. Furthermore, as a result of our adoption of the provisions of SFAS No. 142 in the first quarter of fiscal 2002, amortization expense decreased $921,000 in the second quarter of fiscal 2002 compared with the second quarter of fiscal 2001.

        Store pre-opening costs remained relatively constant at 0.4% of net sales for both the second quarter of fiscal 2002 and the second quarter of fiscal 2001. In the second quarter of fiscal 2002, we opened or relocated 19 Michaels and eight Aaron Brothers stores compared to 16 Michaels and five Aaron Brothers stores opened or relocated in the second quarter of fiscal 2001.

        Operating income increased 203% to $41.1 million, or 7.1% of net sales, in the second quarter of fiscal 2002 from $13.5 million, or 2.8% of net sales, in the second quarter of fiscal 2001. Operating income for the second quarter of fiscal 2001 includes a $347,000 adjustment related to senior executive severance. Excluding the effects of the severance adjustment in the second quarter of fiscal 2001, operating income increased 211% from $13.2 million, or 2.7% of net sales, in the second quarter of fiscal 2001.

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        Interest expense (net of interest income) decreased to $4.8 million, or 0.8% of net sales, in the second quarter of fiscal 2002 from $5.6 million, or 1.1% of net sales, in the second quarter of fiscal 2001, due in part to lower interest expense in the second quarter of fiscal 2002 on outstanding borrowings against the Credit Agreement. Borrowings were outstanding under the Credit Agreement for five days in the second quarter of fiscal 2002 compared to 61 days in the second quarter of fiscal 2001. In addition, interest expense for the second quarter of fiscal 2001 includes non-recurring incremental interest expense of $1.5 million incurred while the Senior Notes due 2009 and the Senior Notes due 2006 were both outstanding for a 29-day period during the second quarter of fiscal 2001.

        The effective tax rate was 41% for both the second quarter of fiscal 2002 and the second quarter of fiscal 2001.

        Net income for the second quarter of fiscal 2002 was $21.5 million, or $0.30 per diluted share, compared to $4.7 million, or $0.07 per diluted share, for the second quarter of fiscal 2001. Excluding the effects of the severance adjustment and the incremental interest expense, net income for the second quarter of fiscal 2001 was $5.4 million, or $0.08 per diluted share.

First Six Months Ended August 3, 2002 Compared to the First Six Months Ended August 4, 2001

        Net sales for the first six months of fiscal 2002 increased $169.0 million, or 17%, over the first six months of fiscal 2001. Sales at the new stores (net of closures) during the first six months of fiscal 2002 accounted for $99.2 million of the increase in net sales. Comparable store sales increased 7% in the first six months of fiscal 2002 compared to the first six months of fiscal 2001, which contributed $66.9 million to the net sales increase. The improvement in comparable store sales was due to a strong performance in our core categories of books, apparel crafts, art supplies, ribbon, general crafts, kids crafts, and party.

        Cost of sales and occupancy expense, as a percentage of net sales, for the first six months of fiscal 2002 was 64.9%, a decrease of 1.8% compared to the first six months of fiscal 2001. This decrease was primarily attributable to improved merchandise margins and a leveraging of store occupancy expense on higher average net sales per store compared to the first six months of fiscal 2001.

        In addition, in the second quarter of fiscal 2002, we fully utilized the $14.8 million markdown reserve originally recorded in the fourth quarter of fiscal 2001 to offset the liquidation of certain merchandise that did not conform to each store's specific plan-o-gram SKU program.

        Selling, general, and administrative expense was $330.4 million, or 28.0% of net sales, in the first six months of fiscal 2002 compared with $300.3 million, or 29.7% of net sales, in the first six months of fiscal 2001, which includes one-time costs of approximately $1.0 million related to senior executive severance. Excluding this one-time severance charge, selling, general, and administrative expense was $299.3 million, or 29.6% of net sales, in the first six months of fiscal 2001. The decrease as a percentage of net sales to 28.0% in the first six months of fiscal 2002 from 29.6% in the first six months of fiscal 2001 was due in part to a decrease in store and corporate payroll and related expenses, on a percentage of net sales basis, resulting from higher average net sales per store in the first six months of fiscal 2002 compared with the first six months of fiscal 2001. In addition, net advertising expense decreased, as a percentage of net sales, in the first six months of fiscal 2002 as a result of a leveraging of advertising expense on higher average net sales per store and higher co-op advertising income compared to the first six months of fiscal 2001. Furthermore, as a result of our adoption of the provisions of SFAS No. 142 in the first quarter of fiscal 2002, amortization expense decreased $1.8 million in the first six months of fiscal 2002 compared with the first six months of fiscal 2001.

        Store pre-opening costs remained relatively constant as a percentage of net sales for both the first six months of fiscal 2002 and the first six months of fiscal 2001. In the first six months of fiscal 2002,

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we opened or relocated 46 Michaels and 11 Aaron Brothers stores compared to 36 Michaels and nine Aaron Brothers stores opened or relocated in the first six months of fiscal 2001.

        On June 6, 2001, we negotiated a tentative settlement of the purported class action with one of our former assistant managers, Taiyeb Raniwala. As a result, we recorded a litigation settlement charge of $3.2 million in the first quarter of fiscal 2001, covering all claims, attorneys' fees, and estimated payroll taxes. The settlement, in exchange for a full release of claims, received final approval from the court on November 20, 2001, and distribution of the settlement proceeds was made on January 19, 2002.

        Operating income increased 171% to $80.4 million, or 6.8% of net sales, in the first six months of fiscal 2002 from $29.6 million, or 2.9% of net sales, in the first six months of fiscal 2001. Operating income for the first six months of fiscal 2001 was negatively impacted by one-time severance costs of $1.0 million and the litigation settlement charge of $3.2 million. Excluding the effects of the one-time severance charge and the litigation settlement charge in the first six months of fiscal 2001, operating income increased 138% from $33.8 million, or 3.3% of net sales, in the first six months of fiscal 2001.

        Interest expense (net of interest income) decreased to $9.0 million, or 0.8% of net sales, in the first six months of fiscal 2002 from $9.2 million, or 0.9% of net sales, in the first six months of fiscal 2001 due in part to lower interest expense in the first six months of fiscal 2002 on outstanding borrowings against the Credit Agreement. Borrowings were outstanding under the Credit Agreement for five days in the first six months of fiscal 2002 compared to 140 days in the first six months of fiscal 2001. In addition, interest income was higher in the first six months of fiscal 2002 as a result of larger invested cash balances compared to the first six months of fiscal 2001. These decreases were partially offset by higher interest expense on the $200 million of 9¹/4% Senior Notes due July 1, 2009, which were issued in July 2001, compared to the $125 million of 10⁷/8% Senior Notes due 2006, which were redeemed in August 2001.

        The effective tax rate was 41% for both the first six months of fiscal 2002 and the first six months of fiscal 2001.

        Net income for the first six months of fiscal 2002 was $42.1 million, or $0.60 per diluted share, compared to $12.0 million, or $0.18 per diluted share, for the first six months of fiscal 2001. Excluding the effects of the one-time severance charge, the litigation settlement charge, and the incremental interest expense, net income for the first six months of fiscal 2001 was $15.3 million, or $0.23 per diluted share.

Liquidity and Capital Resources

Changes in Cash and Equivalents

        Cash flow used in operating activities during the first six months of fiscal 2002 was $124.9 million, compared to $101.5 million during the first six months of fiscal 2001. The increase in cash used in operating activities of $23.4 million in the first six months of fiscal 2002 compared to the first six months of fiscal 2001 was primarily attributable to an increase in the change in merchandise inventories net of the change in accounts payable of $17.5 million and an increase in the change in income taxes payable and accrued liabilities of $45.1 million, partially offset by an increase in net income of $30.2 million. Inventories per Michaels store of $1.262 million at August 3, 2002 increased 8.4% from $1.164 million at August 4, 2001. We anticipate average inventory per Michaels store to increase 5% to 7% by the end of fiscal 2002.

        Cash flow used in investing activities in the first six months of fiscal 2002 was $71.3 million compared to $20.7 million in the first six months of fiscal 2001. Cash flow used in investing activities in the first six months of fiscal 2002 was due in part to capital expenditures related to the completion of our new Hazleton, Pennsylvania distribution center, the expansion of our Lancaster, California

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distribution center, and the opening of 37 Michaels and 10 Aaron Brothers stores and the relocation of nine Michaels stores and one Aaron Brothers store in the first six months of fiscal 2002.

        The following table sets forth capital expenditures for the first six months of fiscal 2002 and the first six months of fiscal 2001 (unaudited):

        We anticipate capital expenditures for fiscal 2002 to total approximately $147.0 million. In fiscal 2002, we plan to open approximately 65 Michaels and 13 Aaron Brothers stores.

        Cash flow provided by financing activities in the first six months of fiscal 2002 was $19.7 million compared to $207.8 million in the first six months of fiscal 2001. The decrease in cash provided by financing activities was primarily due to the issuance of the 9¹/4% Senior Notes due 2009 in the second quarter of fiscal 2001 totaling $194.5 million, net of expenses, compared to the repurchase and subsequent retirement of 392,100 shares of our Common Stock totaling $12.8 million in the second quarter of fiscal 2002. This decrease in cash provided by financing activities was partially offset by borrowings under the Credit Agreement in the first six months of fiscal 2002 totaling $20.4 million. Proceeds from the exercise of stock options were $11.6 million for approximately 751,000 shares of our Common Stock in the first six months of fiscal 2002 and $13.2 million for approximately 1.1 million shares of our Common Stock in the first six months of fiscal 2001.

Bank Credit Facility

        Effective May 1, 2001, we signed a new $200 million unsecured revolving bank credit facility with Fleet National Bank and other lending institutions, which replaced the previous $100 million unsecured revolving bank credit facility. The Credit Agreement had an original term of three years (with a maturity extension for one additional year available under certain conditions) and contains a $25 million competitive bid feature and a $70 million letter of credit sub-facility. Effective May 24, 2002, pursuant to the terms of the Credit Agreement, our lenders agreed to extend the term of the Credit Agreement from April 30, 2004 to April 30, 2005.

        We are in compliance with all terms and conditions of the Credit Agreement. Borrowings outstanding under the Credit Agreement were $20.4 million as of August 3, 2002, with no borrowings outstanding as of August 4, 2001. Borrowings available under the Credit Agreement are reduced by the aggregate amount of letters of credit outstanding under the Credit Agreement ($16.7 million as of August 3, 2002). In the first six months of fiscal 2002, borrowings under the Credit Agreement were outstanding for five days, with average outstanding borrowings of $16.4 million and a weighted average interest rate of 4.75%.

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General

        On October 31, 2001, our Board of Directors declared a two-for-one common stock split effected in the form of a stock dividend to stockholders of record as of the close of business on November 12, 2001, payable on November 26, 2001. An amount equal to the par value of shares issued in the split has been transferred from paid-in capital to the common stock account.

        In July 2001, we issued $200 million in principal amount of the 9¹/4% Senior Notes due 2009 in a private placement under Securities and Exchange Commission Rule 144A to a limited number of qualified institutional buyers. The Senior Notes due 2009 are unsecured and interest thereon is payable semi-annually on each January 1 and July 1, beginning on January 1, 2002. In August 2001, as required by the contract with the purchasers of the Senior Notes due 2009, we made an offer to exchange all of the privately placed Senior Notes due 2009 for an equal principal amount of Senior Notes due 2009 having substantially identical terms, the sale of which was registered under the Securities Act of 1933. As of October 1, 2001, all of the privately placed Senior Notes due 2009 were exchanged for the Senior Notes due 2009 having substantially identical terms.

        On December 5, 2000, our Board of Directors authorized the repurchase of 2.0 million shares of our outstanding Common Stock. On September 11, 2002, our Board of Directors approved the repurchase of up to an additional 1.0 million shares of our outstanding Common Stock. During the second quarter of fiscal 2002, we repurchased and subsequently retired 392,100 shares of our Common Stock. As of August 3, 2002, we have repurchased and retired 1.44 million shares under this plan at an average cost of $20.79 per share. As of September 11, 2002, we have approximately 1.56 million shares of our Common Stock available for repurchase. The repurchase plan also provides that the proceeds of the exercise of options under our 2001 General Stock Option Plan may be used to repurchase shares under the repurchase plan and that the maximum number of shares authorized to be repurchased under the repurchase plan will be increased to the extent necessary, if any, to so use the proceeds from such option exercises. Under the agreements governing our outstanding indebtedness, we can only repurchase shares of our Common Stock if we maintain or comply with specified financial ratios and other covenants. We may also be restricted by regulations of the Securities and Exchange Commission from making future repurchases during certain time periods.

        We believe that our available cash, funds generated by operating activities, funds available under the Credit Agreement, net proceeds from the Senior Notes due 2009, and proceeds from the exercise of stock options will be sufficient to fund anticipated capital expenditures, working capital requirements, and any stock repurchases for the foreseeable future.

Item 3. Quantitative and Qualitative Disclosures About Market Risk.

        We have market risk exposure arising from changes in interest rates. The interest rates on the Credit Agreement are repriced frequently, at market prices, which would result in carrying amounts that approximate fair value. We had borrowings outstanding of $20.4 million under the Credit Agreement at August 3, 2002. In July 2001, we issued $200 million of the Senior Notes due 2009 with a fixed interest rate of 9¹/4%. In August 2001, we used a portion of the proceeds from the Senior Notes due 2009 to redeem the Senior Notes due 2006. Generally, the fair market value of our fixed interest rate long-term debt will increase as interest rates fall and decrease as interest rates rise. Our market risk is described in more detail in our Annual Report on Form 10-K for the fiscal year ended February 2, 2002.

Item 4. Controls and Procedures

        In the second quarter of fiscal 2002, there were no significant changes in internal controls or in other factors that could significantly affect these controls.

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MICHAELS STORES, INC.

Part II—OTHER INFORMATION

Item 1. Legal Proceedings.

        Reference is made to Part I, Item 3. Legal Proceedings, of our Annual Report on Form 10-K for the fiscal year ended February 2, 2002, filed on April 12, 2002, and Part II, Item 1. Legal Proceedings, of our Quarterly Report on Form 10-Q for the period ended May 4, 2002, filed on June 18, 2002, which reported during the fiscal year the legal proceedings referenced below.

Collins Proceeding

        On April 16, 1999, Suzanne Collins, a former assistant manager of our subsidiary, Aaron Brothers, Inc., filed a class action complaint against Aaron Brothers on behalf of Aaron Brothers' former store managers, assistant store managers, and managers-in-training. The Collins Complaint was filed in the Los Angeles County Superior Court, California and alleged that Aaron Brothers violated various California laws by erroneously treating its store managers, assistant store managers, and managers-in-training as "exempt" employees who were not entitled to overtime compensation. Based on these allegations, the Collins Complaint asserted that Aaron Brothers: (1) violated various California Labor Codes; (2) violated Section 17200 of the California Business and Professions Code; and (3) engaged in conversion. The Collins Complaint sought back wages, interest, penalties, punitive damages, and attorneys' fees.

        On March 15, 2002, Aaron Brothers negotiated a definitive settlement of the purported class action with Collins, subject to final court approval. The Court granted preliminary approval of the settlement on March 29, 2002. As a result, Aaron Brothers recorded a litigation settlement charge of $5.0 million in the fourth quarter of fiscal 2001, covering all claims, attorneys' fees, and estimated payroll taxes. On June 12, 2002, the Court approved the settlement and the judgment was entered. The appeal period expired on August 12, 2002. No appeals were filed with the Court. The settlement payments were delivered to the settlement administrator on August 16, 2002 for distribution.

General

        We are a defendant from time to time in lawsuits incidental to our business. Based on currently available information, we believe that resolution of all known contingencies is uncertain, and there can be no assurance that future costs of such litigation would not be material to our financial position or results of operations.

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Item 4. Submission of Matters to a Vote of Security Holders

        Our 2002 Annual Meeting of Stockholders was held on June 20, 2002. The following item of business, as proposed in the Proxy Statement dated May 6, 2002, was presented to the stockholders:

Election of Directors

        The six director nominees, information with respect to which was set forth in the Proxy Statement under the caption titled "Proposal for Election of Directors," were elected. The vote with respect to the election of these directors was as follows:

        Each elected director will serve until the next annual meeting of stockholders and until his or her successor is duly elected and qualified or until the earlier of his or her resignation, death, or removal.

Item 6. Exhibits and Reports on Form 8-K.

(a)

Exhibits:

10.1

Amendment to Employment Agreement between Michaels Stores, Inc. and R. Michael Rouleau, dated July 16, 2002 (filed herewith).

10.2

Agreement between Michaels Stores, Inc. and Bryan M. DeCordova, dated effective as of June 7, 2002 (filed herewith).

10.3

Amendment to Agreement among Michaels Stores, Inc., Michaels Management Services, LP, and Bryan M. DeCordova, dated effective as of August 2, 2002 (filed herewith).

10.4

Michaels Stores, Inc. Amended and Restated 2001 Employee Stock Option Plan (previously filed as Exhibit 99.1 to Form 8-K, filed by Registrant on July 29, 2002, SEC File No. 001-09338).

99.1

Certification pursuant to 18 U.S.C. §1350, as adopted pursuant to §906 of the Sarbanes-Oxley Act of 2002 (filed herewith).

(b)

Reports on Form 8-K:

1.

Report on Form 8-K, dated June 20, 2002 and filed with the Securities and Exchange Commission on July 29, 2002, reporting Items 5 and 7.

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MICHAELS STORES, INC.

SIGNATURES

        Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

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CERTIFICATIONS

        I, R. Michael Rouleau, certify that:

1.

I have reviewed this quarterly report on Form 10-Q of Michaels Stores, Inc.;



2.

Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; and



3.

Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report.

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CERTIFICATIONS

        I, Bryan M. DeCordova, certify that:

1.

I have reviewed this quarterly report on Form 10-Q of Michaels Stores, Inc.;



2.

Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; and



3.

Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report.

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INDEX TO EXHIBITS