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UNITED STATES

FORM 10-Q

Commission file number 001-09338

MICHAELS STORES, INC.

8000 Bent Branch Drive

(972) 409-1300

      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 x          No o

      Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).     Yes x          No o

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

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MICHAELS STORES, INC.

Part I—FINANCIAL INFORMATION

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MICHAELS STORES, INC.

MICHAELS STORES, INC.

See accompanying notes to consolidated financial statements.

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MICHAELS STORES, INC.

See accompanying notes to consolidated financial statements.

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MICHAELS STORES, INC.

See accompanying notes to consolidated financial statements.

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MICHAELS STORES, INC.

For the Six Months Ended August 2, 2003

      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 2, 2003 are not indicative of the results to be expected for the entire year.

      The balance sheet at February 1, 2003 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 1, 2003.

      All references herein to “fiscal 2003” relate to the 52 weeks ending January 31, 2004 and all references to “fiscal 2002” relate to the 52 weeks ended February 1, 2003. In addition, all references herein to “the second quarter of fiscal 2003” and “the first six months of fiscal 2003” relate to the 13 and 26 weeks ended August 2, 2003, respectively, and all references 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.

      In November 2002, the EITF reached consensus on Issue 02-16, Accounting by a Customer (Including a Reseller) for Cash Consideration Received from a Vendor. Issue 02-16 addresses the accounting for cash consideration received by a customer from a vendor (e.g., slotting fees, cooperative advertising payments, buydowns) and rebates or refunds from a vendor that are payable only if the customer completes a specified cumulative level of purchases or remains a customer for a specified time period. Issue 02-16 became effective for new arrangements or modifications to existing arrangements entered into after December 31, 2002, although early adoption was permitted. We elected to adopt early, effective February 3, 2002, the provisions of Issue 02-16 in the preparation of our Annual Report on Form 10-K for the fiscal year ended February 1, 2003. Accordingly, in fiscal 2002, we recorded a cumulative effect of accounting change of $12.6 million, $7.4 million net of income tax, for the impact of this adoption on prior fiscal years. The adoption of the provisions of Issue 02-16 resulted in the ongoing deferral of our cooperative advertising allowances into inventory, with the allowances being recognized as the associated inventory is sold. This adoption also resulted in the reclassification of our cooperative advertising payments earned in fiscal 2002 from selling, general, and administrative expense to cost of sales and occupancy expense retroactively as of the beginning of fiscal 2002. Results for the second quarter and first six months of fiscal 2002 have been restated to reflect our new accounting policy for cooperative advertising allowances and, as a result, income before cumulative effect of accounting change for the second quarter and first six months of fiscal 2002 was reduced by $358,000 and $2.1 million, respectively.

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For the Six Months Ended August 2, 2003

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

      Our purchase and subsequent retirement of 1.0 million shares of our Common Stock in the first quarter of fiscal 2003 reduced the number of weighted average shares outstanding by 1.0 million and 704,166 shares for the second quarter and first six months of fiscal 2003, respectively.

      We have elected to follow Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and related guidance in accounting for our employee stock options. The exercise price of our employee stock options equals the market price of the underlying stock on the date of grant and, as a result, we do not recognize compensation expense for stock option grants.

      Pro forma information regarding net income and earnings per common share, as required by the provisions of Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation, and SFAS No. 148, Accounting for Stock-Based Compensation—Transition and Disclosure, has been determined as if we had accounted for our employee stock options under the fair value method.

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For the Six Months Ended August 2, 2003

      For purposes of pro forma disclosures, the estimated fair value of the options is amortized over the options’ vesting periods. Our pro forma information is as follows:

(1)	The net income amount for the first six months of fiscal 2002 includes the cumulative effect of the change in accounting principle, net of income tax, related to cooperative advertising allowances. See Note 2.

      Effective May 1, 2001, we signed a $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 21, 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. No borrowings were outstanding under the Credit Agreement as of August 2, 2003 or at any time during the first six months of fiscal 2003. Borrowings outstanding under the Credit Agreement were $20.4 million as of August 3, 2002. Borrowings available under the Credit Agreement are reduced by the aggregate amount of letters of credit outstanding under the Credit Agreement ($26.2 million as of August 2, 2003).

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For the Six Months Ended August 2, 2003

      On April 17, 2003, Donald Brown, Thomas Lamour, and Sau Yeung, acting on behalf of themselves and the general public, filed a putative class action in the Superior Court of California for the County of Los Angeles against a number of employers, including Aaron Brothers, Inc., a wholly-owned subsidiary of Michaels Stores, Inc. The lawsuit alleges that the defendants violated California Labor Code provisions that prohibit employers from requesting job applicants to disclose prior criminal convictions for specified marijuana-related infractions or participation in certain criminal diversionary programs. We believe these claims are without merit and will vigorously contest them.

      On various dates between February 4, 2003 and March 25, 2003, 10 purported class action lawsuits were filed in the United States District Court for the Northern District of Texas, Dallas Division, against Michaels Stores, Inc. and certain of the current and former directors and officers of Michaels. All of these lawsuits have been consolidated. The suits assert various claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 related to actions prior to Michaels’ announcement on November 7, 2002, that, among other things, it had revised its outlook for the fourth fiscal quarter of 2002, adjusting downward its guidance for annual earnings per diluted share. The complaints charge that, prior to that announcement, Michaels and certain of the other defendants made misrepresentations and omitted to disclose negative information about the financial condition of Michaels while the individual defendants were selling shares of Michaels common stock. We believe these claims are without merit and will vigorously contest them.

      On March 21, 2003, Julie Fathergill filed a purported stockholder derivative action, which is pending in the 192nd District Court for Dallas County, Texas. The lawsuit names certain former and current officers and directors, including all of Michaels current directors, as individual defendants and Michaels as a nominal defendant. In this derivative action, the plaintiff makes allegations of fact similar to those made in the purported securities class actions described above. The plaintiff asserts claims against the individual defendants for breach of fiduciary duties, abuse of control, gross mismanagement, waste of corporate assets, and unjust enrichment. All of these claims are asserted derivatively on behalf of Michaels. We believe this claim is also without merit and will vigorously oppose it.

      On April 8, 2003, the Chairman of the Board of Michaels received a demand letter on behalf of Chris Frith, a purported Michaels stockholder, requesting that the Board commence an action against certain former and current officers and directors. The demand letter threatens to file a derivative lawsuit if an action is not commenced within a reasonable time. The purported bases of the demand are similar to those made in the purported stockholder class actions and stockholder derivative lawsuit described above.

      On December 20, 2002, James Cotton, a former store manager of Michaels of Canada, ULC, our wholly-owned subsidiary, and Suzette Kennedy, a former assistant manager of Michaels of Canada, commenced a proposed class proceeding against Michaels of Canada and Michaels Stores, Inc. on behalf of themselves and current and former employees employed in Canada. The Cotton claim was filed in the

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For the Six Months Ended August 2, 2003

Ontario Superior Court of Justice and alleges that the defendants violated employment standards legislation in Ontario and other provinces and territories of Canada by failing to pay overtime compensation as required by that legislation. The Cotton claim also alleges that this conduct was in breach of the contracts of employment of those individuals. The Cotton claim seeks a declaration that the defendants have acted in breach of applicable legislation, payment to current and former employees for overtime, damages for breach of contract, punitive, aggravated and exemplary damages, interest, and costs. We believe we have certain meritorious defenses and intend to defend this lawsuit vigorously.

      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. There can be no assurance that future costs of such litigation would not be material to our financial position or results of operations.

      In May 2003, the Financial Accounting Standards Board issued SFAS No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities, which amends and clarifies the accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under SFAS No. 133. SFAS No. 149 is effective for contracts entered into or modified after June 30, 2003. The adoption of the provisions of SFAS No. 149 had no material impact on our operating results or financial position.

      In December 2002, the FASB issued SFAS No. 148, Accounting for Stock-Based Compensation— Transition and Disclosure, as an amendment to SFAS No. 123 and to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, SFAS No. 148 amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. Our policy is to account for stock-based employee compensation using the intrinsic value method in accordance with APB Opinion No. 25. Prior to the adoption of the disclosure provisions of SFAS No. 148, we reported the pro forma effect of the fair value method of accounting for stock-based employee compensation under the provisions of SFAS No. 123. We adopted the disclosure provisions of SFAS No. 148 in the preparation of our Annual Report on Form 10-K for the fiscal year ended February 1, 2003. While this adoption does not change our policy of accounting for stock-based employee compensation using the intrinsic value method, we have disclosed our stock-based employee compensation in Note 4 and have revised our presentation format of the pro forma effect of the fair value method of accounting.

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      The following discussion should be read in conjunction with our consolidated financial statements and related notes included elsewhere in this Quarterly Report on Form 10-Q. The following discussion, as well as other portions of this Quarterly Report on Form 10-Q, contains forward-looking statements that reflect our plans, estimates, and beliefs. Any statements contained herein (including, but not limited to, statements to the effect that Michaels or its management “anticipates,” “plans,” “estimates,” “expects,” “believes,” and other similar expressions) that are not statements of historical fact should be considered forward-looking statements and should be read in conjunction with our consolidated financial statements and related notes in our Annual Report on Form 10-K for the fiscal year ended February 1, 2003. Specific examples of forward-looking statements include, but are not limited to, statements regarding our future cash dividend policy, forecasts of capital expenditures, working capital requirements, and stock repurchases. Our actual results could materially differ from those discussed in these forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in our Annual Report on Form 10-K for the fiscal year ended February 1, 2003, and particularly in “Risk Factors,” and in our other 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.

General

      All references herein to “fiscal 2003” relate to the 52 weeks ending January 31, 2004 and all references to “fiscal 2002” relate to the 52 weeks ended February 1, 2003. In addition, all references herein to “the second quarter of fiscal 2003” and “the first six months of fiscal 2003” relate to the 13 and 26 weeks ended August 2, 2003, respectively, and all references 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.

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

(1)	Average inventory per Michaels store calculation includes Michaels and Village Crafts by Michaels stores, but excludes Aaron Brothers, ReCollections, and Star Wholesale stores.
(2)	Comparable store sales increase represents the increase in net sales for stores open the same number of months in the indicated period and the comparable period of the previous year, including stores that were relocated or expanded during either period. A store is deemed to become comparable in its 14th full month of operation in order to eliminate grand opening sales distortions. Beginning in fiscal 2003, we began including 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 in our comparable store sales calculation. As a result, we have retroactively applied the custom frame sales deferral to our comparable store sales increase for the second quarter and first six months of fiscal 2002. There was no change in the comparable store sales increase percentage for the second quarter and first six months of fiscal 2002 from the amount previously reported as a result of this adjustment.

Change in Accounting Principle

      In November 2002, the EITF reached consensus on Issue 02-16, Accounting by a Customer (Including a Reseller) for Cash Consideration Received from a Vendor. Issue 02-16 addresses the accounting for cash consideration received by a customer from a vendor (e.g., slotting fees, cooperative advertising payments, buydowns) and rebates or refunds from a vendor that are payable only if the customer completes a specified cumulative level of purchases or remains a customer for a specified time period. Issue 02-16 became effective for new arrangements or modifications to existing arrangements entered into after December 31, 2002, although early adoption was permitted. We elected to adopt early, effective February 3, 2002, the provisions of Issue 02-16 in the preparation of our Annual Report on Form 10-K for the fiscal year ended February 1, 2003. Accordingly, in fiscal 2002, we recorded a cumulative effect of accounting change of $12.6 million, $7.4 million net of income tax, for the impact of this adoption on prior fiscal years. The adoption of the provisions of Issue 02-16 resulted in the ongoing deferral of our cooperative advertising allowances into inventory, with the allowances being recognized as

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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.

Quarter Ended August 2, 2003 Compared to the Quarter Ended August 3, 2002

      Net sales for the second quarter of fiscal 2003 increased $39.9 million, or 7%, over the second quarter of fiscal 2002. At the end of the second quarter of fiscal 2003, we operated 773 Michaels, 157 Aaron Brothers, eight Village Crafts by Michaels, and one ReCollections retail store. The results for the second quarter of fiscal 2003 included sales from 50 Michaels, 12 Aaron Brothers, and seven Village Crafts by Michaels, and one ReCollections retail stores that were opened during the 12-month period ended August 2, 2003, more than offsetting lost sales from the closure of five Michaels and two Aaron Brothers stores. Sales at the new stores (net of closures) during the second quarter of fiscal 2003 accounted for $33.4 million of the increase in net sales. Comparable store sales increased 1% in the second quarter of fiscal 2003 compared to the second quarter of fiscal 2002, which contributed $6.5 million to the net sales increase. The improvement in comparable store sales was due to a strong performance in our core categories of Summer seasonal, general crafts, books, ribbon, and kids’ crafts. 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 merchandise to our stores, to be successful in our sales promotion efforts, to anticipate customer demand and trends in the arts and crafts industry, and to respond to competitors’ activities.

      Cost of sales and occupancy expense, as a percentage of net sales, for the second quarter of fiscal 2003 was 62.1%, a decrease of 0.3% compared to the second quarter of fiscal 2003. This decrease was primarily attributable to improved merchandise margins, partially offset by increased store occupancy costs.

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      Selling, general, and administrative expense was $186.7 million, or 30.3% of net sales, in the second quarter of fiscal 2003 compared with $174.3 million, or 30.2% of net sales, in the second quarter of fiscal 2002. This increase, as a percentage of net sales, was primarily the result of higher store employee benefits and workers compensation costs. In addition, inventory counting service fees increased from the second quarter of fiscal 2002 to the second quarter of fiscal 2003 in connection with the rollout of our perpetual inventory and automated merchandise replenishment systems. These increases were largely offset by leveraging in advertising, store compensation, corporate general and administrative, and depreciation expenses as a result of higher net sales in the second quarter of fiscal 2003 compared to the second quarter of fiscal 2002.

      We expense all store pre-opening costs as incurred. Store pre-opening costs were $1.6 million, or 0.2% of net sales, in the second quarter of fiscal 2003 compared to $2.1 million, or 0.4% of net sales, in the second quarter of fiscal 2002. In the second quarter of fiscal 2003, we opened or relocated 12 Michaels, four Aaron Brothers, one Village Crafts by Michaels, and one ReCollections store compared to 19 Michaels and eight Aaron Brothers stores opened or relocated in the second quarter of fiscal 2002.

      Operating income increased 12% to $45.5 million, or 7.4% of net sales, in the second quarter of fiscal 2003 from $40.5 million, or 7.0% of net sales, in the second quarter of fiscal 2002.

      Interest expense was $5.1 million, or 0.8% of net sales, in the second quarter of fiscal 2003 and $5.1 million, or 0.9% of net sales in the second quarter of fiscal 2002. This decrease, as a percentage of net sales, was primarily due to the leveraging of interest expense on higher net sales in the second quarter of fiscal 2003 compared to the second quarter of fiscal 2002.

      The effective tax rate was 41% for both the second quarter of fiscal 2003 and the second quarter of fiscal 2002.

      Net income for the second quarter of fiscal 2003 was $24.3 million, or $0.35 per diluted share, compared to $21.1 million, or $0.30 per diluted share, for the second quarter of fiscal 2002.

First Six Months Ended August 2, 2003 Compared to the First Six Months Ended August 3, 2002

      Net sales for the first six months of fiscal 2003 increased $93.1 million, or 8%, over the first six months of fiscal 2002. Sales at the new stores (net of closures) during the first six months of fiscal 2003 accounted for $73.3 million of the increase in net sales. Comparable store sales increased 2% in the first six months of fiscal 2003 compared to the first six months of fiscal 2002, which contributed $19.8 million to the net sales increase. The improvement in comparable store sales was due to a strong performance in our core categories of Summer and Spring seasonal, general crafts, ribbon, custom framing, and kids’ crafts.

      Cost of sales and occupancy expense, as a percentage of net sales, for the first six months of fiscal 2003 was 63.1%, a decrease of 0.6% compared to the first six months of fiscal 2002. This decrease was primarily attributable to improved merchandise margins, partially offset by increased store occupancy costs.

      Selling, general, and administrative expense was $381.3 million, or 30.0% of net sales, in the first six months of fiscal 2003 compared with $347.5 million, or 29.5% of net sales, in the first six months of fiscal 2002. This increase, as a percentage of net sales, was primarily the result of higher store employee benefits, workers compensation, and advertising costs. In addition, inventory counting service fees increased from the first six months of fiscal 2002 to the first six months of fiscal 2003 in connection with the rollout of our perpetual inventory and automated merchandise replenishment systems. These fees will also be higher in the fourth quarter of fiscal 2003 compared to fiscal 2002 as we complete this chain-wide rollout. These increases were partially offset by decreases in store compensation and corporate general and administrative costs as a percentage of net sales from the first six months of fiscal 2002 to the first six months of fiscal 2003.

      Store pre-opening costs were $3.3 million, or 0.2% of net sales, in the first six months of fiscal 2003 compared to $3.8 million, or 0.3% of net sales, in the first six months of fiscal 2002. In the first six months

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      Operating income increased 11% to $85.0 million, or 6.7% of net sales, in the first six months of fiscal 2003 from $76.7 million, or 6.5% of net sales, in the first six months of fiscal 2002.

      Interest expense was $10.1 million, or 0.8% of net sales, in the first six months of fiscal 2003 and $10.2 million, or 0.9% of net sales in the first six months of fiscal 2002. This decrease, as a percentage of net sales, was primarily due to the leveraging of interest expense on higher net sales in the first six months of fiscal 2003 compared to the first six months of fiscal 2002.

      The effective tax rate was 41% for both the first six months of fiscal 2003 and the first six months of fiscal 2002.

      In the fourth quarter of fiscal 2002, in connection with the adoption of the provisions of EITF Issue 02-16, we changed our accounting policy with respect to recording cooperative advertising allowances effective retroactively as of the beginning of fiscal 2002. As a result, we recorded a non-cash charge of $7.4 million, net of income tax, in the first quarter of fiscal 2002 for the cumulative effect of the change on fiscal years prior to fiscal 2002.

      Net income for the first six months of fiscal 2003 was $45.1 million, or $0.65 per diluted share, compared to $32.6 million, or $0.46 per diluted share, for the first six months of fiscal 2002. Income before cumulative effect of accounting change for the first six months of fiscal 2002 was $40.0 million, or $0.57 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 2003 was $13.9 million compared to $124.9 million during the first six months of fiscal 2002. The decrease in cash used in operating activities of $111.0 million in the first six months of fiscal 2003 compared to the first six months of fiscal 2002 was primarily attributable to a decrease in the net change in merchandise inventories and accounts payable of $95.5 million and a decrease in the change in income taxes payable and accrued liabilities of $22.4 million. These decreases were primarily a result of the timing of inventory purchases and related payments and the payment of income taxes and other obligations. Inventories per Michaels store decreased 2.5% from August 3, 2002 to August 2, 2003. We anticipate average inventory per Michaels store at the end of fiscal 2003 will remain consistent with average inventory per Michaels store of $1.018 million we reported at the end of fiscal 2002.

      Cash flow used in investing activities in the first six months of fiscal 2003 was $40.9 million compared to $71.3 million in the first six months of fiscal 2002. In the first six months of fiscal 2003, we incurred capital expenditures related to the construction of our new Illinois distribution center, the opening of 22 Michaels, nine Aaron Brothers, five Village Crafts by Michaels, and one ReCollections store and the relocation of nine Michaels stores. In the first six months of fiscal 2002, we incurred capital expenditures related to the completion of our Hazleton, Pennsylvania distribution center, the expansion of our Lancaster, California distribution center, the opening of 36 Michaels, 10 Aaron Brothers, and one Village Crafts by Michaels store, and the relocation of nine Michaels stores.

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      The following table sets forth capital expenditures for the first six months of fiscal 2003 and the first six months of fiscal 2002 (unaudited):