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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 Nine Months Ended November 1, 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 nine months ended November 1, 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 third quarter of fiscal 2003” and “the first nine months of fiscal 2003” relate to the 13 and 39 weeks ended November 1, 2003, respectively, and all references to “the third quarter of fiscal 2002” and “the first nine months of fiscal 2002” relate to the 13 and 39 weeks ended November 2, 2002, respectively.

      During the third quarter of fiscal 2003, we resolved certain tax issues pending with the Internal Revenue Service. As a result, our effective tax rate for fiscal 2003 is expected to be 38.25%. In the first two quarters of fiscal 2003, we recorded our tax liability at an effective tax rate of 41%. In the third quarter of fiscal 2003, we recorded our tax liability at an effective tax rate of 34.7%, which adjusted the effective tax rate for the first nine months of fiscal 2003 to 38.25%. Our effective tax rate for the third quarter and first nine months of fiscal 2002 was 41%.

      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

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For the Nine Months Ended November 1, 2003

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 third quarter and first nine 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 third quarter and first nine months of fiscal 2002 was reduced by $645,000 and $2.8 million, respectively.

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

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For the Nine Months Ended November 1, 2003

      Our purchase and subsequent retirement of 1.0 million and 264,900 shares of our Common Stock in the first and third quarters of fiscal 2003, respectively, reduced the number of weighted average shares outstanding by 1.1 million and 829,000 shares for the third quarter and first nine 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.

      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 nine 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.

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For the Nine Months Ended November 1, 2003

      Effective May 1, 2001, we signed a $200 million unsecured revolving bank credit facility with Fleet National Bank and other lending institutions. 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 November 1, 2003 or at any time during the first nine months of fiscal 2003. Borrowings outstanding under the Credit Agreement were $90.0 million as of November 2, 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 November 1, 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 failed 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

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For the Nine Months Ended November 1, 2003

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 September 11, 2003, Leo J. Dutil filed a purported stockholder derivative action, which is pending in the United States District Court for the Northern District of Texas, Dallas Division. The lawsuit names certain former and current officers and 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 stockholder class actions and the Fathergill derivative lawsuit described above. The plaintiff asserts claims against the individual defendants for breach of fiduciary duty, misappropriation of confidential information, and contribution and indemnification. 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 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 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

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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 third quarter of fiscal 2003” and “the first nine months of fiscal 2003” relate to the 13 and 39 weeks ended November 1, 2003, respectively, and all references to “the third quarter of fiscal 2002” and “the first nine months of fiscal 2002” relate to the 13 and 39 weeks ended November 2, 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 third quarter and first nine months of fiscal 2002. There was no change in the comparable store sales increase percentage for the third quarter and first nine 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

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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 November 1, 2003 Compared to the Quarter Ended November 2, 2002

      Net sales for the third quarter of fiscal 2003 increased $50.6 million, or 7%, over the third quarter of fiscal 2002. At the end of the third quarter of fiscal 2003, we operated 798 Michaels, 158 Aaron Brothers, 11 Village Crafts by Michaels, two ReCollections, and two Star Wholesale stores. The results for the third quarter of fiscal 2003 included sales from 47 Michaels, 11 Aaron Brothers, eight Village Crafts by Michaels, two ReCollections, and one Star Wholesale store that were opened during the 12-month period ended November 1, 2003, more than offsetting lost sales from the closure of five Michaels and one Aaron Brothers store. Sales at the new stores (net of closures) during the third quarter of fiscal 2003 accounted for $38.7 million of the increase in net sales. Comparable store sales increased 2% in the third quarter of fiscal 2003 compared to the third quarter of fiscal 2002, which contributed $11.9 million to the net sales increase. Comparable store sales growth was strongest in our apparel crafts, seasonal, framing, kids’ crafts, and art categories. Customer traffic was essentially flat in the third quarter of fiscal 2003 compared to the third quarter of fiscal 2002. Average ticket increased approximately 2%, driven primarily by favorable pricing /product mix trends and a strengthening of the Canadian dollar (contributing 66 basis points), partially offset by higher clearance sales levels. 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-

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      Cost of sales and occupancy expense, as a percentage of net sales, for the third quarter of fiscal 2003 was 63.5%, an increase of 1.6% compared to the third quarter of fiscal 2002. This increase was primarily attributable to lower merchandise margins as a result of accelerated markdowns in the third quarter of fiscal 2003 on fall and Halloween seasonal products as well as specific products in categories that will be discontinued in connection with our fiscal 2004 planogram resets. In addition, distribution costs recognized in the third quarter of fiscal 2003 were higher, as a percentage of net sales, than in the third quarter of fiscal 2002 as a result of the timing of merchandise receipts and shipments within our distribution network. These increases were partially offset by a decrease in store occupancy costs as a percentage of net sales.

      Selling, general, and administrative expense was $208.5 million, or 27.6% of net sales, in the third quarter of fiscal 2003 compared with $204.5 million, or 29.0% of net sales, in the third quarter of fiscal 2002. This decrease, as a percentage of net sales, was primarily the result of lower store compensation costs and a leveraging of corporate general and administrative costs.

      We expense all store pre-opening costs as incurred. Store pre-opening costs were $3.7 million, or 0.5% of net sales, in the third quarter of fiscal 2003 compared to $3.5 million, or 0.5% of net sales, in the third quarter of fiscal 2002. In the third quarter of fiscal 2003, we opened or relocated 32 Michaels, one Aaron Brothers, three Village Crafts by Michaels, one ReCollections, and one Star Wholesale store compared to 37 Michaels, two Aaron Brothers, and two Village Crafts by Michaels stores opened or relocated in the third quarter of fiscal 2002.

      Operating income increased 5% to $63.6 million, or 8.4% of net sales, in the third quarter of fiscal 2003 from $60.6 million, or 8.6% of net sales, in the third quarter of fiscal 2002.

      Interest expense was $5.0 million, or 0.6% of net sales, in the third quarter of fiscal 2003 and $5.7 million, or 0.8% of net sales in the third quarter of fiscal 2002. This decrease was primarily due to decreased interest expense on borrowings under the Credit Agreement. There were no borrowings outstanding under the Credit Agreement at any time during the third quarter of fiscal 2003 compared with average borrowings of $93.5 million outstanding for the entire third quarter of fiscal 2002.

      The effective tax rate was 34.7% for the third quarter of fiscal 2003 and 41% for the third quarter of fiscal 2002. The effective tax rate was reduced from 41% to 34.7% in the third quarter of fiscal 2003 due to the resolution of certain tax issues pending with the Internal Revenue Service. The effective tax rate for fiscal 2003 is expected to be 38.25%.

      Net income for the third quarter of fiscal 2003 was $38.2 million, or $0.54 per diluted share, compared to $32.3 million, or $0.46 per diluted share, for the third quarter of fiscal 2002.

First Nine Months Ended November 1, 2003 Compared to the First Nine Months Ended November 2, 2002

      Net sales for the first nine months of fiscal 2003 increased $143.7 million, or 8%, over the first nine months of fiscal 2002. Sales at the new stores (net of closures) during the first nine months of fiscal 2003 accounted for $111.9 million of the increase in net sales. Comparable store sales increased 2% in the first nine months of fiscal 2003 compared to the first nine months of fiscal 2002, which contributed $31.8 million to the net sales increase. Comparable store sales growth was strongest in our seasonal, general crafts, ribbon, kids’ crafts, and framing categories. Customer traffic increased approximately 1% in the first nine months of fiscal 2003 compared to the first nine months of fiscal 2002. Average ticket increased approximately 1%, driven by favorable pricing/product mix trends and a strengthening of the Canadian dollar (contributing 47 basis points), partially offset by higher clearance sales levels.

      Cost of sales and occupancy expense, as a percentage of net sales, for the first nine months of fiscal 2003 was 63.3%, an increase of 0.3% compared to the first nine months of fiscal 2002. This increase was

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