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Analysis: Repositioning Aaron Brothers as in-store concept makes sense

Michaels’ results are flattered by an additional week of trading which helped sales to expand by a very robust 8%. Even so, taking out the revenue of this extra week leaves growth of 3.5% -- a good outcome, which is underpinned by some strong same-store uplifts.

Admittedly, the same-store sales growth comes off the back of a weak performance during the prior year when comparables dipped by 1.0%. Even so, it is pleasing that sales momentum has strengthened consistently across this fiscal year. In our view, this indicates that Michaels has taken the right steps to improve the business.

Sales are just one half of the equation; the other half is the bottom line. Here Michael's performance looks solid enough, with operating income increasing by 5.3% and net income by 3.9%. However, when the extra week of trading is removed, the numbers look less healthy. On this basis, operating income declined by 2.8% and net income dipped by 9.9%.

The source of such deterioration does not come from missteps with the assortment. Indeed, as a percentage of net sales, gross profit increased 70 basis points to 41.0%. This was mostly thanks to a better merchandising mix, less discounting, and an inventory adjustment in the prior year. However, a one-off higher tax charge, slightly higher interest payments, more pre-store opening expense, and a modest jump in operating costs, all eroded the gross profit gains.

Fortunately, we believe that Michaels can get most of these cost items under control as it moves into its new fiscal year. The benefits from tax reform will also allow the company to make investments in the business without too much burden to the bottom line. These include building capacity to bring e-commerce fulfillment in-house and some store reformats.

The bad news for the upcoming fiscal year is the weak forecast for sales. Management has penciled in a 0 to 1.5% rise in comparables. While this takes account of the stronger growth across the course of the year just gone, we would point out that while underlying sales improved, the numbers were still somewhat anemic. Indeed, for most of the year, same-store growth was below 1%; and during the first quarter, comparables shrank by 1.2%.

Against this soft backdrop, we believe that Michaels should be aiming higher -- especially since management has been keen to point out the improvements to ranges and the omnichannel proposition. In short, if guidance is not exceeded, Michaels will be losing share from its existing stores and its position in the market will be going backward.

Away from the primary business, the firm has decided to shutter 94 full-size Aaron Brothers stores. The chain, which focuses on custom and ready-made picture frames and wall art, along with some art supplies, represents a relatively small part of the overall business.

We also believe it has been suffering from the rise of online framing services, which has reduced its profitability. In any case, it makes no real sense for Michaels to invest time and effort into a brand that has little potential as a stand-alone entity. In our view, having the concept as a shop-in-shop within Michaels stores and as an online service is both operationally and fiscally sound.

Overall, we believe that Michaels has made good progress over the last year. It should also now see some gains from the failure of Toys “R” Us. However, we are concerned with the soft sales guidance. This either reflects a lack of confidence or knowledge of potential issues. Either way, it means there is some doubt as to whether Michaels will continue to move forward over the next 12 months.
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