THE MICHAELS COMPANIES, INC. The following discussion and analysis of our financial condition, results of operations and liquidity generally discusses fiscal 2020 compared to fiscal 2019. For a discussion of our financial condition, results of operations and liquidity for fiscal 2019 compared to fiscal 2018, see "Part II, Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations" in our Annual Report on Form 10-K for the fiscal year endedFebruary 1, 2020 , filed with theSecurities and Exchange Commission onMarch 17, 2020 . We report on the basis of a 52-week or 53-week fiscal year, which ends on the Saturday closest toJanuary 31 . All references to fiscal year mean the year in which that fiscal year began. References to "fiscal 2020" relate to the 52 weeks endedJanuary 30, 2021 , references to "fiscal 2019" relate to the 52 weeks endedFebruary 1, 2020 and references to "fiscal 2018" relate to the 53 weeks endedFebruary 2, 2019 .
Pending Acquisition by
OnMarch 2, 2021 , the Company entered into an Agreement and Plan of Merger ("Merger Agreement") with certain affiliates of Apollo Global Management (such affiliates, "Apollo"), pursuant to whichApollo will acquire the Company. Under the Merger Agreement, and upon the terms and subject to the conditions thereof,Apollo will commence a tender offer to acquire all outstanding shares of Michaels for$22.00 per share in cash. If certain conditions are satisfied and the offer closes,Apollo will acquire all remaining shares not tendered in the tender offer through a second-step merger at the same price. The tender offer will initially remain open for twenty business days, subject to possible extension on the terms set forth in the Merger Agreement. The parties currently expect the acquisition to be completed during the first half of fiscal 2021.Apollo's obligations to complete the acquisition are subject to certain customary closing conditions, including a majority of the outstanding shares of Michaels common stock having been tendered and not validly withdrawn, the expiration of a twenty-five day go-shop period, compliance with certain antitrust requirements inthe United States andCanada , and the completion of a specified marketing period forApollo's debt financing of the offer price. The Merger Agreement also provides that the acquisition agreement may be terminated by us orApollo under certain circumstances, and in certain specified circumstances upon termination of the Merger Agreement we will be required to payApollo a termination fee of up to$104 million . The anticipated acquisition of the Company byApollo is described more fully in our Current Report on Form 8-K filed with theSEC onMarch 3, 2021 . This summary of the Merger Agreement does not purport to be complete and is qualified in its entirety by reference to the full text of the Merger Agreement filed as Exhibit 2.1 to this Annual Report. Fiscal 2020 Overview
With$5,271.1 million in net sales in fiscal 2020, we are the largest arts and crafts specialty retailer inNorth America (based on store count) providing materials, project ideas and education for creative activities, primarily under the Michaels retail brand. We also operate a market-leading vertically-intergrated custom framing business under the Artistree brand name. AtJanuary 30, 2021 , we operated 1,252 Michaels stores.
Financial highlights for fiscal 2020 include the following:
? Net sales increased to
primarily due to a 4.8% increase in comparable store sales. InMay 2020 , we adopted a plan to close our Darice wholesale operations
("Darice"). As a result of the closure, we recorded a charge totaling
million in fiscal 2020, consisting primarily of a
? profit related to the liquidation of inventory and
selling, general and administrative associated with the write-off of
indefinite-lived intangible assets and employee-related expenses. The closure
of Darice was completed in the fourth quarter of fiscal 2020.
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We recorded impairment charges totaling
million related to the closure of 13 underperforming stores and
? primarily related to the relocation of our corporate offices in
The impairment charges include
and$6.0 million related to leasehold improvements and inventory.
We reported operating income of
? prior year and net income of
year.
Adjusted EBITDA, a non-GAAP measure that is a required calculation in our debt
? agreements, increased by 13.2%, from
million in fiscal 2020 (see "Management Discussion and Analysis of Financial
Condition and Results of Operations - Non-GAAP Measures").
We issued
We used the proceeds from the issuance of these notes, together with cash on
? hand, to voluntarily pay down
credit facility and extended the due date for our term loan credit facility to
October 1, 2027 .
? We repurchased 7.2 million shares for an aggregate amount of
In fiscal 2020, we continued to make progress implementing our strategic initiatives, including:
? expanding our Michaels Rewards loyalty program by enabling customers to earn
rewards on purchases that can be redeemed for discounts on future purchases;
expanding our assortment to include more bulk merchandise for customers who
? create items to sell and altering our assortments, including technology, craft
storage and fine art, to better align with our customer's needs;
pivoting to a more customer centric selling model by initiating improvements in
? our supply chain to allow better store labor efficiency, enabling a more
customer service culture;
? growing our overall e-commerce business, including the roll-out of curbside
pick-up and same-day-delivery, and improving its profitability;
? enhancing our pricing and promotion programs by leveraging data to define
optimal pricing levels and promotional offers to drive profitability;
continuing to maximize our marketing productivity by shifting to more
? productive media options, including digital and targeted television
advertising;
focusing on our customer relationship management ("CRM") strategy through the
? use of personalized customer emails to improve customer engagement and drive
incremental trips to our stores and website; and
? generating meaningful cost savings through our ongoing sourcing efforts.
Fiscal 2021 Outlook
In fiscal 2021, we intend to continue to expand our industry leadership through innovation and strategic initiatives such as:
? leveraging our improved category management process to ensure the mix within
each category is appropriate and aligned with the needs of our customer;
further strengthening our CRM capabilities by continuing to develop a more
? personalized e-commerce experience including, among other enhancements,
targeted promotional offerings;
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? continuing to expand better performing assortments, including technology, craft
storage and fine art, to drive sustainable growth for our business;
improving our supply chain, including adding two seasonal distribution centers,
? to support omnichannel sales growth and to increase the speed and agility of
getting merchandise to our stores to improve the overall customer experience;
and
continuing to expand virtual content and develop our communities, laying the
? foundation for future strategic initiatives that will connect content,
commerce, and community. Comparable Store Sales Comparable store sales represents the change in net sales for stores open the same number of months in the comparable period of the previous year, including stores that were relocated or expanded during either period, as well as e-commerce sales. A store is deemed to become comparable in its 14th month of operation in order to eliminate grand opening sales distortions. A store temporarily closed more than two weeks is not considered comparable during the month it is closed. If a store is closed longer than two weeks but less than three months, it becomes comparable in the month in which it reopens, subject to a mid-month convention. A store closed longer than three months becomes comparable in its 14th month of operation after its reopening. The Company temporarily closed a significant number of stores during the first half of fiscal 2020 to comply with state and local regulations associated with the COVID-19 pandemic. All stores that were temporarily closed due to the pandemic have continued to be included in the computation of comparable store sales. COVID-19
InMarch 2020 , theWorld Health Organization declared the current COVID-19 outbreak to be a global pandemic. In response to the pandemic, many state and local jurisdictions ordered non-essential businesses closed and executed extensive stay-at-home orders. These orders resulted in the temporary closure of over 900 of our 1,252 stores which had a material adverse impact on our results of operations during the first quarter of fiscal 2020. During the second quarter of fiscal 2020, we reopened all of our stores and experienced a significant improvement in our business as net sales increased 12.4% during the preceding nine month period endingJanuary 30, 2021 compared to the same period in the prior year. Our liquidity position, which includes cash on hand and amounts available under our senior secured asset-based revolving credit facility ("Amended Revolving Credit Facility"), increased from$1.2 billion as ofFebruary 1, 2020 to$1.7 billion as ofJanuary 30, 2021 . However, there remains significant uncertainty surrounding the future impact of the COVID-19 pandemic on our results of operations, and future waves of the pandemic could require us to close stores again if certain restrictions are reinstated by state and local authorities. We intend to continue to manage our liquidity position closely and invest in our omnichannel capabilities to meet the growing customer demand for a seamless omnichannel experience. Tariffs Certain products that we import fromChina have been impacted by tariffs. We have taken steps to mitigate a portion of the financial impact of these tariffs, including, among other things, selectively increasing prices on certain of our products, sourcing products from alternative countries and negotiating lower prices with our suppliers inChina . If additional tariffs are implemented, we cannot provide any assurances that our mitigation efforts will be successful and, as a result, such tariffs could have a material impact on our business. 28 Table of Contents Results of Operations
The following table sets forth the percentage relationship to net sales of line
items in our consolidated statements of comprehensive income. This table should
be read in conjunction with the following discussion and with our consolidated
financial statements, including the related notes.
Fiscal Year
2020 2019 2018
Net sales 100.0 % 100.0 % 100.0 %Cost of sales and occupancy expense 62.9 63.1
61.6
Gross profit 37.1 36.9
38.4
Selling, general and administrative 26.4 25.7
25.6
Restructure and impairment charges 0.5 1.0
2.0
Store pre-opening costs 0.1 0.1 0.1
Operating income 10.1 10.2 10.7
Interest expense 2.9 3.0 2.8
Losses on early extinguishments of debt and
refinancing costs 0.4 - -
Other (income) expense, net - - -
Income before income taxes 6.8 7.1 7.9
Income taxes 1.2 1.7 1.8
Net income 5.6 % 5.4 % 6.1 %
Fiscal 2020 Compared to Fiscal 2019
Net Sales . Net sales increased$199.1 million in fiscal 2020, or 3.9%, to$5,271.1 million compared to fiscal 2019. The increase in net sales was due to a$238.6 million increase in comparable store sales. The increase was partially offset by a$37.3 million decrease in wholesale revenue as a result of our decision to close Darice. E-commerce sales, which are included in comparable store sales, increased$447.1 million in fiscal 2020, or 184.4%, to$689.6 million compared to the same period in the prior year. Comparable store sales increased 4.8% due to an increase in average ticket, partially offset by a decrease in customer transactions. Gross Profit. Gross profit was 37.1% of net sales in fiscal 2020 compared to 36.9% in fiscal 2019. The increase was due to a decrease in promotional activity and benefits from our ongoing sourcing initiatives. The increase was partially offset by a$37.3 million charge related to the closure of our wholesale business, an increase in distribution costs primarily related to higher e-commerce sales, a change in sales mix and the impact of tariffs on inventory we purchase fromChina . Gross profit also includes$3.6 million of incremental COVID-19 related costs, including hazard pay for our distribution center team members and certain supply costs. Selling, General and Administrative. Selling, general and administrative ("SG&A") was 26.4% of net sales in fiscal 2020 compared to 25.7% in fiscal 2019. SG&A increased$86.3 million to$1,390.6 million in fiscal 2020. The increase includes$72.7 million in performance-based compensation, a$24.0 million increase in expenses associated with strategic initiatives to improve profitability,$16.2 million of incremental COVID-19 related costs, including hazard pay for store team members and sanitation supplies, and a$7.9 million charge related to the closure of Darice. The increase was partially offset by a$12.0 million decrease in marketing costs, an$8.2 million decrease in payroll-related costs as a result of furloughed team members and$8.0 million of wage subsidies resulting from COVID-19 relief legislation. Restructure and Impairment Charges. In fiscal 2020, we recorded$28.8 million of impairment charges, consisting of$19.4 million related to the closure of 13 underperforming stores and$9.4 million primarily related to the relocation of our corporate offices inIrving, Texas . The impairment charges include$22.8 million related to operating lease assets and$6.0 million related to leasehold improvements and inventory. In fiscal 2019, we recorded impairment charges of$40.1 million as a result of lower than expected operating performance in our wholesale business and a restructure charge of$8.2 million related to the closure of ourPat Catan's stores during fiscal 2018. Interest Expense. Interest expense decreased$1.6 million to$152.4 million in fiscal 2020 compared to fiscal 2019. The decrease was primarily due to savings of$26.7 million as a result of a lower interest rate and lower principal related to our amended term loan facility. The decrease was partially offset by$11.6 million related to settlement payments associated with our cash flow hedges,$6.0 million related to our senior secured notes issued in October
2020,$2.8 million 29 Table of Contents related to increased borrowings on our revolving credit facility,$2.5 million related to a higher interest rate associated with our senior notes issued inJuly 2019 and$1.4 million of interest related to deferred tax payments. Losses on Early Extinguishments of Debt and Refinancing Costs. We recorded a loss on the early extinguishment of debt of$22.0 million during fiscal 2020 related to the refinancing of our term loan credit facility. We recorded a loss on the early extinguishment of debt of$1.3 million during fiscal 2019 related to the redemption of our senior subordinated notes and the refinancing of our senior secured asset-based revolving credit facility. Other (Income) Expense, net. Other (income) expense, net increased$2.8 million in fiscal 2020 compared to fiscal 2019. The increase was primarily due to a$5.0 million charge related to the write-off of an investment in a liquidated business during fiscal 2019. Income Taxes. Income tax expense decreased$20.1 million in fiscal 2020 to$65.7 million compared to the same period in the prior year. The decrease was due to a$18.4 million income tax benefit recorded in fiscal 2020 in connection with the Coronavirus Aid, Relief, and Economic Security Act ("CARES Act"), including certain provisions related to net operating loss carrybacks.
Liquidity and Capital Resources
We require cash principally for day-to-day operations, to finance capital investments, purchase inventory, service our outstanding debt and for seasonal working capital needs. We expect that our available cash, cash flow generated from operating activities and funds available under our Amended Revolving Credit Facility will be sufficient to fund planned capital expenditures, working capital requirements, debt repayments, debt service requirements and anticipated growth for the foreseeable future. We may also opportunistically pursue acquisitions and other inorganic growth opportunities, and our future capital investments may include expenditures for these transactions. Our ability to satisfy our liquidity needs and continue to refinance or reduce debt could be adversely affected by the occurrence of any of the events described under "Item 1A. Risk Factors" or our failure to meet our debt covenants as described below. Our Amended Revolving Credit Facility provides senior secured financing of up to$850 million , subject to a borrowing base. As ofJanuary 30, 2021 , the borrowing base was$624.1 million , of which we had no outstanding borrowings,$87.3 million of outstanding standby letters of credit and$536.8 million of unused borrowing capacity. Our cash and cash equivalents totaled$1,194.4 million atJanuary 30, 2021 . InMarch 2020 , theWorld Health Organization declared the current COVID-19 outbreak to be a global pandemic. In response to the pandemic, many state and local jurisdictions ordered non-essential businesses closed and executed extensive stay-at-home orders. These orders resulted in the temporary closure of over 900 of our 1,252 stores which had a material adverse impact on our results of operations during the first quarter of fiscal 2020. During the second quarter of fiscal 2020, we reopened all of our stores and experienced a significant improvement in our business as net sales increased 12.4% during the preceding nine month period endingJanuary 30, 2021 compared to the same period in the prior year. Our liquidity position, which includes cash on hand and amounts available under our Amended Revolving Credit Facility, increased from$1.2 billion as ofFebruary 1, 2020 to$1.7 billion as ofJanuary 30, 2021 . However, there remains significant uncertainty surrounding the future impact of the COVID-19 pandemic on our results of operations, and future waves of the pandemic could require us to close stores again if certain restrictions are reinstated by state and local authorities. We intend to continue to manage our liquidity position closely and invest in our omnichannel capabilities to meet the growing customer demand for a seamless omnichannel experience. InMay 2020 , the Company adopted a plan to close our Darice wholesale operations. As a result of the closure, we recorded a charge totaling$45.2 million in fiscal 2020, consisting primarily of a$37.3 million charge in gross profit related to the liquidation of inventory and$7.9 million included in selling, general and administrative associated with the write-off of indefinite-lived intangible assets and employee-related expenses. The closure of Darice was completed in the fourth quarter of fiscal 2020. In fiscal 2020 and fiscal 2019, Darice's net sales totaled$37.6 million and$79.9 million , respectively. Excluding the charges, Darice did not have a material impact on the Company's operating income in the periods presented. InSeptember 2018 , the Board of Directors authorized a share repurchase program for the Company to purchase$500 million of the Company's common stock on the open market or through accelerated share repurchase transactions. The share repurchase program does not have an expiration date, and the timing and number of repurchase transactions 30
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under the program will depend on market conditions, corporate considerations, debt agreements and regulatory requirements. Shares repurchased under the program are held as treasury shares until retired. During the year endedJanuary 30, 2021 , we repurchased 7.2 million shares for an aggregate amount of$87.2 million . As ofJanuary 30, 2021 , we had$206.4 million of availability remaining under our current share repurchase program. We had total outstanding debt of$2,536.7 million atJanuary 30, 2021 , of which$1,661.7 million was subject to variable interest rates and$875.0 million was subject to fixed interest rates. InApril 2018 , we executed two interest rate swaps with an aggregate notional value of$1 billion associated with our outstanding Amended Term Loan Credit Facility (as defined below). The swaps replaced the one-month LIBOR with a fixed interest rate of 2.7765% and expire inApril 2021 . InApril 2020 , we executed two interest rate cap agreements with an aggregate notional value of$2 billion associated with our outstanding Amended Term Loan Credit Facility. The interest rate caps have an effective date ofSeptember 30, 2020 andApril 30, 2021 , respectively. During the third quarter of fiscal 2020, we amended theSeptember 30, 2020 interest rate cap agreement and reduced the notional value from$1 billion to$300 million . The interest rate caps have a maturity date ofApril 30, 2025 and were executed for risk management and are not held for trading purposes. The interest rate caps will effectively cap our LIBOR exposure on a portion of our Amended Term Loan Credit Facility at 1%. OnMarch 2, 2021 , we entered into a Merger Agreement withApollo . The Merger Agreement contains limitations on actions that the Company may take between signing and closing without the consent ofApollo , including certain limitations on our borrowing. Our substantial indebtedness could adversely affect our ability to raise additional capital, limit our ability to react to changes in the economy or our industry, expose us to interest rate risk and prevent us from meeting our obligations. Management reacts strategically to changes in economic conditions, including those created by the COVID-19 pandemic, and monitors compliance with debt covenants to seek to mitigate any potential material impacts to our financial condition and flexibility. We may use excess operating cash flows to repurchase outstanding shares and repay portions of our indebtedness, depending on prevailing market conditions, liquidity requirements, existing economic conditions, contractual restrictions and other factors. As such, we and our subsidiaries, affiliates and significant shareholders may, from time to time, seek to retire or purchase our outstanding debt (including publicly issued debt) through cash purchases and/or exchanges, in open market purchases, privately negotiated transactions, by tender offer or otherwise. If we use our excess cash flows to repay our debt, it will reduce the amount of cash available for additional capital expenditures.
Cash Flow from Operating Activities
Cash flows provided by operating activities were$1,222.4 million in fiscal 2020, an increase of$729.3 million from fiscal 2019. The increase was primarily due to the timing of inventory receipts following higher than expected sales, renegotiating payment terms with our vendors and landlords and the timing of federal tax payments. Inventory decreased 8.2% to$1,007.0 million atJanuary 30, 2021 , from$1,097.1 million atFebruary 1, 2020 . The decrease in inventory was primarily due to the timing of inventory receipts following higher than expected sales, a reduction in inventory associated with the operation of 22 fewer Michaels stores (net of openings) sinceFebruary 1, 2020 and the closure of Darice. Average inventory per Michaels store (inclusive of distribution centers, in-transit and inventory for the Company's e-commerce site) decreased 2.0% to$800,000 atJanuary 30, 2021 , from$816,000 atFebruary 1, 2020 . 31 Table of Contents
Cash Flow from Investing Activities
The following table includes capital expenditures paid during the periods
presented (in thousands):
Fiscal Year
2020 2019 2018
New and relocated stores (including stores not
yet opened) (1) $ 10,083 $ 11,110 $ 32,153
Existing stores 39,868 34,998 39,524
Information systems 50,919 54,222 54,794
Corporate and other 61,134 20,215 18,916
$ 162,004 $ 120,545 $ 145,387 (1) In fiscal 2020, we incurred capital expenditures related to the opening of 14
Michaels stores, including the relocation of eight stores. In fiscal 2019, we
incurred capital expenditures related to the opening of 34 Michaels stores,
including the relocation of 13 stores. In fiscal 2018, we incurred capital
expenditures related to the opening of 45 Michaels stores, including the
relocation of 21 stores.
In fiscal 2021, we plan to invest in the infrastructure necessary to support the
further development of our business, including the buildout of our new
distribution centers in New Jersey and California , investments in information
technology related to our e-commerce business, enhancing our digital platforms
and tools, and improving our data analytical capabilities to gain additional
customer insights. In addition, we will continue to invest in new store openings
and store remodels. In fiscal 2021, we plan to open approximately 33 Michaels
stores, including approximately 10 relocations.
Term Loan Credit Facility
On May 23, 2018 , MSI entered into an amendment with JPMorgan Chase Bank, N.A .
("JPMorgan"), as successor administrative agent and successor collateral agent,
and other lenders to amend and restate our then-existing term loan credit
facility. The amended and restated credit agreement, together with the related
security, guarantee and other agreements, is referred to as the "Amended and
Restated Term Loan Credit Facility".
On October 1, 2020 , MSI entered into an amendment with JPMorgan and other
lenders to our term loan credit facility. The amended credit agreement, together
with the related security, guarantee and other agreements, are referred to as
the "Amended Term Loan Credit Facility". In connection with this amendment, MSI
voluntarily prepaid $500.1 million in principal of the then outstanding term
loan credit facility.
Borrowings under the Amended Term Loan Credit Facility were issued at 98.5% of face value and bear interest at a rate per annum, at MSI's option, of either (a) a margin of 2.50% plus a base rate defined as the highest of (1) the prime rate published by The Wall Street Journal, (2) the greater of the federal funds effective rate and the overnight bank funding rate determined by theFederal Reserve Bank of New York , plus 0.5%, and (3) the one-month London Interbank Offered Rate ("LIBOR") plus 1%, in each case, subject to a 1.75% floor, or (b) a margin of 3.50% plus the applicable LIBOR, subject to a 0.75% floor. The Amended Term Loan Credit Facility matures onOctober 1, 2027 subject to a springing maturity date ofApril 15, 2027 if certain other indebtedness, including MSI's 8% senior notes maturing in 2027, exceeds$100 million as of such earlier date.
As ofJanuary 30, 2021 , the Amended Term Loan Credit Facility provides for senior secured financing of$1,661.7 million . MSI has the right to request additional term loans in an aggregate amount of up to the sum of (a) the greater of$650 million and 100% of Adjusted EBITDA (as defined in the Amended Term Loan Credit Facility) for the most recently ended four fiscal quarters, plus (b) the aggregate amount of voluntary prepayments of certain indebtedness, plus (c) at MSI's election, an amount of additional indebtedness if the consolidated secured debt ratio (as defined in the Amended Term Loan Credit Facility) is no more than 3.25 to 1.00 on a pro forma basis as of the last day of the most recently ended four fiscal quarters, subject to certain adjustments. The lenders will not be under any obligation to provide any such additional term loans and the incurrence of any additional term loans is subject to customary conditions precedent. There are no limitations on dividends and certain other restricted payments so long as (a) no event of default shall have occurred and be continuing and (b) immediately after giving pro forma effect to such restricted payment(s) and the application of proceeds therefrom, the consolidated total leverage ratio is less than or equal to 3.75 to 1.00. 32 Table of Contents MSI must offer to prepay outstanding term loans at 100% of the principal amount, plus any unpaid interest, with the proceeds of certain asset sales or casualty events under certain circumstances. MSI may voluntarily prepay outstanding loans under the Amended Term Loan Credit Facility at any time, subject to payment of customary breakage costs with respect to LIBOR loans. The Amended Term Loan Credit Facility provides for a 1.0% soft call premium in connection with certain Repricing Transactions (as defined in the Amended Term Loan Credit Facility) occurring on or prior toApril 1, 2021 . MSI is required to make scheduled quarterly payments equal to 0.25% of the original principal amount of the term loans (subject to adjustments relating to the incurrence of additional term loans) for the first six years of the Amended Term Loan Credit Facility, with the balance to be paid onOctober 1, 2027 . All obligations under the Amended Term Loan Credit Facility are unconditionally guaranteed, jointly and severally, byMichaels Funding, Inc. ("Holdings") and all of MSI's existing domestic material subsidiaries and are required to be guaranteed by certain of MSI's future domestic wholly-owned material subsidiaries (the "Subsidiary Guarantors"). All obligations under the Amended Term Loan Credit Facility, and the guarantees of those obligations, are secured, subject to certain exceptions, by substantially all of the assets of Holdings, MSI and the Subsidiary Guarantors, including:
a first-priority pledge of MSI's capital stock and all of the capital stock
held directly by MSI and the Subsidiary Guarantors (which pledge, in the case
? of any foreign subsidiary or foreign subsidiary holding company, is limited to
65% of the voting stock of such foreign subsidiary or foreign subsidiary holding company and 100% of the non-voting stock of such subsidiary);
a first-priority security interest in, and mortgages on, substantially all
other tangible and intangible assets of Holdings, MSI and each Subsidiary
? Guarantor, including substantially all of MSI's and the Subsidiary Guarantors
owned real property and equipment, but excluding, among other things, the
collateral described below; and a second-priority security interest in personal property consisting of
inventory and related accounts, cash, deposit accounts, all payments received
? by Holdings, MSI or the Subsidiary Guarantors from credit card clearinghouses
and processors or otherwise in respect of all credit card charges and debit
card charges for sales of inventory by Holdings, MSI and the Subsidiary Guarantors, and certain related assets and proceeds of the foregoing.
The Amended Term Loan Credit Facility contains a number of negative covenants
that are substantially similar to, but more restrictive in certain respects
than, those governing the Senior Notes and Senior Secured Notes (as defined
below), as well as certain other customary representations and warranties,
affirmative and negative covenants and events of default. As of
Interest Rate Swaps InApril 2018 , we executed two interest rate swaps with an aggregate notional value of$1 billion associated with our outstanding Amended and Restated Term Loan Credit Facility. The interest rate swaps have a maturity date ofApril 30, 2021 and were executed for risk management and are not held for trading purposes. The objective of the interest rate swaps is to hedge the variability of cash flows resulting from fluctuations in the one-month LIBOR. The swaps replaced the one-month LIBOR with a fixed interest rate of 2.7765% and payments are settled monthly. The swaps qualify as cash flow hedges and changes in the fair values are recorded in accumulated other comprehensive income in the consolidated balance sheet. The changes in fair value are reclassified from accumulated other comprehensive income to interest expense in the same period that the hedged items affect earnings.
Interest Rate Caps
InApril 2020 , we executed two interest rate cap agreements with an aggregate notional value of$2 billion associated with our outstanding Amended Term Loan Credit Facility. The interest rate caps have an effective date ofSeptember 30, 2020 andApril 30, 2021 , respectively. During the third quarter of fiscal 2020, we amended theSeptember 30, 2020 interest rate cap agreement and reduced the notional value from$1 billion to$300 million . The interest rate caps have a maturity date ofApril 30, 2025 and were executed for risk management and are not held for trading purposes. The interest rate caps will effectively cap our LIBOR exposure on a portion of our Amended Term Loan Credit Facility at 1%. 33
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The interest rate caps qualify as cash flow hedges and changes in the fair values are recorded in accumulated other comprehensive income in the consolidated balance sheet. The changes in fair value are reclassified from accumulated other comprehensive income to interest expense in the same period that the hedged items affect earnings.
Senior Notes
OnJuly 8, 2019 , MSI issued$500 million in principal amount of senior notes maturing in 2027 ("Senior Notes"). The Senior Notes were issued pursuant to an indenture among MSI, certain subsidiaries of MSI, as guarantors, andU.S. Bank National Association , as trustee (the "Senior Notes Indenture"). The Senior Notes mature onJuly 15, 2027 and bear interest at a rate of 8% per year, with interest payable semi-annually onJanuary 15 andJuly 15 of each year, beginning onJanuary 15, 2020 . The net proceeds from the offering and sale of the Senior Notes, together with cash on hand, were used to redeem MSI's outstanding 2020 Senior Subordinated Notes (as defined below).
The Senior Notes are fully and unconditionally guaranteed, jointly and severally, on a senior unsecured basis by each of MSI's subsidiaries that guarantee indebtedness under the Amended Revolving Credit Facility and the Amended Term Loan Credit Facility (collectively defined as the "Senior Secured Credit Facilities").
The Senior Notes are general, unsecured obligations of MSI, and the guarantees of the Senior Notes are general, unsecured obligations of the guarantors. They (i) rank equally in right of payment with all of MSI's and the guarantors' existing and future senior debt, including the Senior Secured Credit Facilities, (ii) are effectively subordinated to any of MSI's and the guarantors' existing and future secured debt to the extent of the value of the assets securing such debt, including the Senior Secured Credit Facilities, (iii) are structurally subordinated to all of the liabilities of MSI's subsidiaries that are not guaranteeing the Senior Notes, and (iv) are senior in right of payment with all of MSI's and the guarantors' existing and future subordinated debt. At any time prior toJuly 15, 2022 , MSI may redeem (a) up to 40% of the aggregate principal amount of the Senior Notes with the gross proceeds from one or more Equity Offerings, as defined in the Senior Notes Indenture, at a redemption price of 108% of the principal amount plus accrued and unpaid interest thereon to, but excluding, the redemption date and/or (b) all or part of the Senior Notes at 100% of the principal amount plus any accrued and unpaid interest thereon to, but excluding, the redemption date plus a make-whole premium. Thereafter, MSI may redeem all or part of the Senior Notes at the redemption prices set forth below (expressed as percentages of the principal amount of the Senior Notes to be redeemed) plus any accrued and unpaid interest thereon to, but excluding, the applicable date of redemption, if redeemed during the twelve month period beginning onJuly 15 of each of the years indicated
below: Year Percentage 2022 104 % 2023 102 % 2024 and thereafter 100 % Upon a change in control, MSI is required to offer to purchase the Senior Notes at 101% of the aggregate principal amount, plus any accrued and unpaid interest thereon to, but excluding, the date of purchase. Subject to certain exceptions and qualifications, the Senior Notes Indenture contains covenants that, among other things, limit MSI's ability and the ability of its restricted subsidiaries, including the guarantors, to:
? incur additional indebtedness or issue certain disqualified stock or preferred
stock; ? create liens;
? pay dividends on MSI's capital stock or make distributions or redeem or
repurchase MSI's capital stock;
? prepay subordinated debt or make certain investments, loans, advances, and
acquisitions;
? transfer or sell assets;
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? engage in consolidations, amalgamations or mergers, or sell, transfer or
otherwise dispose of all or substantially all of their assets; and
? enter into certain transactions with affiliates.
The covenants also limit MSI's ability, and the ability of MSI's restricted subsidiaries, to pay dividends or distributions on MSI's capital stock or repurchase MSI's capital stock, subject to certain exceptions, including dividends, distributions and repurchases up to (i) an amount equal to the greater of$200.0 million and 25% of MSI's consolidated EBITDA (as defined in the Senior Notes Indenture) and (ii) a basket that builds based on 50% of MSI's consolidated net income (as defined in the Senior Notes Indenture) and certain other amounts, in each case, to the extent such payment capacity is not applied as otherwise permitted under the Senior Notes Indenture and subject to certain conditions. However, there are no limitations on dividends and certain other restricted payments so long as (a) no event of default shall have occurred and be continuing and (b) immediately after giving pro forma effect to such restricted payment(s) and the application of proceeds therefrom, the total net leverage ratio is less than or equal to 3.25 to 1.00. As ofJanuary 30, 2021 , the permitted restricted payment amount pursuant to the immediately foregoing sentence was$546.3 million . The Senior Notes Indenture also provides for customary events of default which, if any of them occurs, would require or permit the principal of and accrued interest on the Senior Notes to become or to be declared due and payable. As ofJanuary 30, 2021 , MSI was in compliance
with all covenants. Senior Secured Notes OnOctober 1, 2020 , MSI issued$375 million in aggregate principal amount of 4.75% senior secured notes maturing in 2027 ("Senior Secured Notes"). The Senior Secured Notes were issued pursuant to an indenture among MSI,Michaels Funding, Inc. and certain subsidiaries of MSI, as guarantors, andU.S. Bank National Association , as trustee (the "Senior Secured Notes Indenture"). The Senior Secured Notes will mature onOctober 1, 2027 and bear interest at a rate of 4.75% per year, with interest payable semi-annually onApril 1 andOctober 1 of each year, beginning onApril 1, 2021 . The net proceeds from the Senior Secured Notes, together with cash on hand, were used to voluntarily pay down$500.1 million of MSI's then outstanding term loan credit facility and to pay related fees and expenses. The Senior Secured Notes are fully and unconditionally guaranteed, jointly and severally, on a senior secured basis byMichaels Funding, Inc. and each of MSI's subsidiaries that guarantee indebtedness under the Senior Secured Credit Facilities. The Senior Secured Notes are senior secured obligations of MSI, and the guarantees are senior secured obligations of the guarantors. The Senior Secured Notes and guarantees will be secured equally and ratably with the Amended Term Loan Credit Facility and, accordingly, will be secured, subject to certain exceptions, by substantially all of the assets of MSI and the guarantors, including:
a first-priority pledge of MSI's capital stock and all of the capital stock
held directly by MSI and its subsidiaries that guarantee the Senior Secured
? Notes (which pledge, in the case of any foreign subsidiary or foreign
subsidiary holding company, is limited to 65% of the voting stock of such
foreign subsidiary or foreign subsidiary holding company and 100% of the non-voting stock of such subsidiary);
a first-priority security interest in, and mortgages on, substantially all
other tangible and intangible assets of MSI and each guarantor, including
substantially all of MSI's and the guarantors' owned real property and
? equipment, but excluding, among other things, the collateral described below
(collectively, and together with the pledge of capital stock described in the
immediately preceding paragraph, referred to as the "Term Priority Collateral"); and a second-priority security interest in personal property consisting of
inventory and related accounts, cash, deposit accounts, all payments received
? by MSI or the guarantors from credit card clearinghouses and processors or
otherwise in respect of all credit card charges and debit card charges for
sales of inventory by MSI and the guarantors, and certain related assets and
proceeds of the foregoing.
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At any time prior to October 1, 2023 MSI may redeem (a) up to 40% of the Senior
Secured Notes with the gross proceeds from one or more Equity Offerings, as
defined in the Senior Secured Notes Indenture, at a redemption price of 104.75%
of the principal amount plus accrued and unpaid interest and/or (b) all or part
of the Senior Secured Notes at 100.0% of the principal amount plus any accrued
and unpaid interest plus a make-whole premium. Thereafter, MSI may redeem all or
part of the notes at the redemption prices set forth below (expressed as
percentages of the principal amount of the Senior Secured Notes to be redeemed)
plus any accrued and unpaid interest, if redeemed during the twelve month period
beginning on October 1 of each of the years indicated below:
Year Percentage
2023 102.375 %
2024 101.188 %
2025 and thereafter 100.000 %
Upon a change of control, MSI is required to offer to purchase the Senior Secured Notes at 101.0% of the aggregate principal amount plus accrued and unpaid interest. In addition, if MSI or its restricted subsidiaries sells certain assets constituting Term Priority Collateral, then under certain circumstances MSI will be required to offer to repurchase the notes at 100.0% of the aggregate principal amount plus accrued and unpaid interest.
Subject to certain exceptions and qualifications, the Senior Secured Notes Indenture contains covenants that, among other things, limit MSI's ability and the ability of its restricted subsidiaries, including the guarantors, to:
? incur additional indebtedness or issue certain disqualified or preferred stock;
? create liens;
? pay dividends on MSI's capital stock or make distributions or redeem or
repurchase MSI's capital stock;
? prepay subordinated debt or make certain investments, loans, advances, and
acquisitions;
? transfer or sell assets;
? engage in consolidations, amalgamations or mergers, or sell, transfer or
otherwise dispose of all or substantially all of their assets; and
? enter into certain transactions with affiliates.
The Senior Secured Notes Indenture also provides for customary events of default which, if any of them occurs, would require or permit the principal and accrued interest to become or to be declared due and payable. As ofJanuary 30, 2021 , MSI was in compliance with all covenants. Revolving Credit Facility OnAugust 30, 2019 , MSI entered into an amendment withWells Fargo Bank, National Association ("Wells Fargo") and other lenders to, among other things, extend the maturity date of our Amended Revolving Credit Facility. The Amended Revolving Credit Facility matures inAugust 2024 , subject to an earlier springing maturity date if certain of our outstanding indebtedness has not been repaid, redeemed, refinanced, or cash collateralized or if the necessary availability reserves have not been established prior to such time (the "ABL Maturity Date").
The Amended Revolving Credit Facility provides for senior secured financing of up to$850 million , subject to a borrowing base. The borrowing base under the Amended Revolving Credit Facility equals the sum of: (i) 90% of eligible credit card receivables, (ii) 85% of eligible trade receivables, (iii) 90% to 92.5% of the appraised value of eligible inventory, plus (iv) 90% to 92.5% of the lesser of (a) the appraised value of eligible inventory supported by letters of credit, and (b) the face amount of the letters of credit, less (v) certain reserves. 36 Table of Contents
As ofJanuary 30, 2021 , the borrowing base was$624.1 million of which MSI had availability of$536.8 million . Borrowing capacity is available for letters of credit and borrowings on same-day notice. Outstanding standby letters of credit as ofJanuary 30, 2021 totaled$87.3 million . The Amended Revolving Credit Facility also provides MSI with the right to request up to$200 million of additional commitments. The lenders will not be under any obligation to provide any such additional commitments, and any increase in commitments is subject to customary conditions. If we were to request additional commitments, and the lenders were to agree to provide such commitments, the facility size could be increased up to$1,050 million , however, MSI's ability to borrow would still be limited by the borrowing base. Borrowings under the Amended Revolving Credit Facility bear interest at a rate per annum equal to, at our option, either (a) a base rate determined by reference to the highest of (1) the prime rate of Wells Fargo, (2) the federal funds effective rate plus 0.50% and (3) LIBOR subject to certain adjustments plus 1.00% or (b) LIBOR subject to certain adjustments, in each case plus an applicable margin. The initial applicable margin is (a) 0.25% for prime rate borrowings and 1.25% for LIBOR borrowings. The applicable margin is subject to adjustment each fiscal quarter based on the excess availability under the Amended Revolving Credit Facility. Excess availability is defined as the Loan Cap (as defined below) plus certain unrestricted cash of Holdings, MSI and the Subsidiary Guarantors, less the outstanding credit extensions. Same-day borrowings bear interest at the base rate plus the applicable margin. MSI is required to pay a commitment fee on the unutilized commitments under the Amended Revolving Credit Facility, which is 0.25% per annum, subject to reduction to 0.20% when excess availability is less than 50% of the Loan Cap (as defined below). In addition, MSI must pay customary letter of credit fees and agency fees. All obligations under the Amended Revolving Credit Facility are unconditionally guaranteed, jointly and severally, by Holdings and the Subsidiary Guarantors. All obligations under the Amended Revolving Credit Facility, and the guarantees of those obligations, are secured, subject to certain exceptions, by substantially all of the assets of Holdings, MSI and the Subsidiary Guarantors, including:
a first-priority security interest in personal property consisting of inventory
and related accounts, cash, deposit accounts, all payments received by
? Holdings, MSI or the Subsidiary Guarantors from credit card clearinghouses and
processors or otherwise in respect of all credit card charges and debit card
charges for sales of inventory by Holdings, MSI and the Subsidiary Guarantors,
and certain related assets and proceeds of the foregoing;
a second-priority pledge of all of MSI's capital stock and the capital stock
held directly by MSI and the Subsidiary Guarantors (which pledge, in the case
? of the capital stock of any foreign subsidiary or foreign subsidiary holding
company, is limited to 65% of the voting stock of such foreign subsidiary or
foreign subsidiary holding company and 100% of the non-voting stock of such
subsidiary); and
a second-priority security interest in, and mortgages on, substantially all
? other tangible and intangible assets of Holdings, MSI and each Subsidiary
Guarantor, including substantially all of MSI's and the Subsidiary Guarantors
owned real property and equipment. If, at any time, the aggregate amount of outstanding loans, unreimbursed letter of credit drawings and undrawn letters of credit under the Amended Revolving Credit Facility exceeds the lesser of (i) the commitment amount and (ii) the borrowing base (the "Loan Cap"), MSI will be required to repay outstanding loans and cash collateralize letters of credit in an aggregate amount equal to such excess, with no reduction of the commitment amount. If availability under the Amended Revolving Credit Facility is less than the greater of (i) 10% of the Loan Cap and (ii)$50 million for five consecutive business days, or, if certain events of default have occurred, MSI will be required to repay outstanding loans and cash collateralize letters of credit with the cash MSI would be required to deposit daily in a collection account maintained with the agent under the Amended Revolving Credit Facility. Availability under the Amended Revolving Credit Facility means the Loan Cap minus the outstanding credit extensions. MSI may voluntarily reduce the unutilized portion of the commitment amount and repay outstanding loans at any time without premium or penalty, other than customary breakage costs with respect to LIBOR loans. The principal amount of the loans outstanding is due and payable in full on the ABL Maturity Date. 37 Table of Contents The covenants limiting dividends and other restricted payments, investments, loans, advances and acquisitions, and prepayments or redemptions of indebtedness, each permit the restricted actions in an unlimited amount, subject to the satisfaction of certain payment conditions, principally that MSI must meet specified excess availability requirements and minimum consolidated fixed charge coverage ratios, to be tested on a pro forma basis as of the date of the restricted action and for the 30-day period preceding such restricted action. Adjusted EBITDA, as defined in the Amended Revolving Credit Facility, is used in the calculation of the consolidated fixed charge coverage ratios. From the time when MSI has excess availability less than the greater of (a) 10% of the Loan Cap and (b)$50 million , until the time when MSI has excess availability more than the greater of (a) 10% of the Loan Cap and (b)$50 million for 30 consecutive days, the Amended Revolving Credit Facility will require MSI to maintain a consolidated fixed charge coverage ratio of at least 1.0 to 1.0. The Amended Revolving Credit Facility also contains certain customary representations and warranties, affirmative covenants and provisions relating to events of default (including change of control and cross-default to material indebtedness).
The Amended Revolving Credit Facility contains a number of covenants that, among other things and subject to certain exceptions, restrict MSI's ability, and the ability of its restricted subsidiaries, to:
? incur or guarantee additional indebtedness;
? pay dividends on MSI's capital stock or redeem, repurchase or retire MSI's
capital stock;
? make investments, loans, advances and acquisitions;
? create restrictions on the payment of dividends or other amounts to MSI from
its restricted subsidiaries;
? engage in transactions with MSI's affiliates;
? sell assets, including capital stock of MSI's subsidiaries;
? prepay or redeem indebtedness;
? consolidate or merge; and ? create liens.
5.875% Senior Subordinated Notes due 2020
OnDecember 19, 2013 , MSI issued$260 million in principal amount of 5.875% senior subordinated notes maturing in 2020 ("2020 Senior Subordinated Notes"). OnJune 16, 2014 , MSI issued an additional$250 million of the 2020 Senior Subordinated Notes at 102% of face value, resulting in an effective interest rate of 5.76%. OnJuly 29, 2019 , the Company redeemed the 2020 Senior Subordinated Notes in the aggregate principal amount of$510.0 million plus accrued interest. This payment retired the 2020 Senior Subordinated Notes and discharged the obligations under the indenture governing the 2020 Senior Subordinated Notes.
Off-Balance Sheet Arrangements
We have no material off-balance sheet arrangements as defined in Item 303(a)(4)(ii) of Regulation S-K. Neither we nor our subsidiaries typically guarantee the obligations of unrelated parties.
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Contractual Obligations
As of January 30, 2021 , our contractual obligations were as follows (in
thousands):
Payments Due By Fiscal Year
Less Than More Than
Total 1 Year 1-3 Years 3-5 Years 5 Years
Total debt (1) $ 2,536,650 $ 16,700 $ 33,400 $ 33,400 $ 2,453,150
Operating lease commitments (2) 2,079,796 420,508 736,902 466,340 456,046
Interest payments (3) 635,351 85,168 155,298 187,894 206,991
Other commitments (4) 126,447 115,365 11,082 - -
$ 5,378,244 $ 637,741 $ 936,682 $ 687,634 $ 3,116,187 (1) Total debt only includes principal payments owed on the Senior Notes, Senior
Secured Notes and the Amended Term Loan Credit Facility. The amounts shown
above do not include unamortized discounts and deferred debt issuance costs
reflected in the Company's consolidated balance sheets since they do not
represent contractual obligations.
(2) Our operating lease commitments generally include non-cancelable leases for
property and equipment used in our operations. Excluded from our operating
lease commitments are amounts related to insurance, taxes and common area
maintenance associated with property and equipment. Such amounts historically
represented approximately 36% of the total lease obligation over the previous
three fiscal years.
(3) Debt associated with our Amended Term Loan Credit Facility was
million at
amounts included in interest payments in the table for the Amended Term Loan
Credit Facility were based on the indexed interest rate in effect at January
30, 2021. In
an aggregate notional value of
interest rate risk associated with future changes in interest rates for
borrowings under our Amended Term Loan Credit Facility. In fiscal 2020, we
executed two interest rate cap agreements with an aggregate notional value of
with future changes in interest rates for borrowings under our Amended Term
Loan Credit Facility. Debt associated with the Senior Notes and Senior
Secured Notes were
outstanding borrowings under our Amended Revolving Credit Facility at January
30, 2021. Under our Amended Revolving Credit Facility, we are required to pay
a commitment fee of 0.25% per year on the unutilized commitments, subject to
reduction to 0.20% when excess availability is less than 50% of the Loan Cap.
The amounts included in interest payments for the Amended Revolving Credit
Facility were based on this annual commitment fee.
(4) Other commitments include trade letters of credit and service contract
obligations. Our service contract obligations were calculated based on the
time period remaining in the contract or to the earliest possible date of
termination, if permitted to be terminated by Michaels upon notice, whichever
is shorter.
Non-GAAP Measures
The following table sets forth certain non-GAAP measures used by the Company to
manage our performance and measure compliance with certain debt covenants. The
Company defines "EBITDA" as net income before interest, income taxes,
depreciation and amortization. The Company defines "Adjusted EBITDA" as EBITDA
adjusted for certain defined amounts in accordance with the Company's Senior
Secured Credit Facilities.
The Company has presented EBITDA and Adjusted EBITDA to provide investors with
additional information to evaluate our operating performance and our ability to
service our debt. Adjusted EBITDA is a required calculation under the Company's
Senior Secured Credit Facilities that is used in the calculations of fixed
charge coverage and leverage ratios, which, under certain circumstances
determine mandatory repayments or maintenance covenants and may restrict the
Company's ability to make certain payments (characterized as restricted
payments), investments (including acquisitions) and debt repayments.
As EBITDA and Adjusted EBITDA are not measures of liquidity calculated in
accordance with U.S. generally accepted accounting principles ("GAAP"), these
measures should not be considered in isolation of, or as substitutes for, net
cash provided by operating activities as an indicator of liquidity. Our
computation of EBITDA and Adjusted EBITDA may differ from similarly titled
measures used by other companies.
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Table of Contents
The following table shows a reconciliation of EBITDA and Adjusted EBITDA to net income and net cash provided by operating activities (in thousands):
Fiscal Year
2020 2019 2018
Net cash provided by operating activities $ 1,222,436 $ 493,175 $ 444,256
Non-cash operating lease expense (308,777) (325,962) -
Depreciation and amortization (130,303) (125,499) (124,271)
Share-based compensation (25,010) (22,910) (27,082)
Debt issuance costs amortization (3,507) (4,451) (4,997)
Loss on write-off of investment - (5,036) -
Accretion of long-term debt, net (1,391) 129 518
Restructure and impairment charges (28,835) (48,332) (104,238)
Impairment of intangible assets (3,500) - - Deferred income taxes (52,114) (9,455) (8,131) Gain on sale of building 101 - - Losses on early extinguishments of debt and refinancing costs (22,044) (1,316) (1,835) Changes in assets and liabilities (352,121) 322,252 145,325 Net income 294,935 272,595 319,545 Interest expense 152,442 154,090 147,085 Income taxes 65,669 85,776 97,509 Depreciation and amortization 130,303 125,499 124,271 Interest income (1,570) (3,185) (3,160) EBITDA 641,779 634,775 685,250 Adjustments: COVID-19 expense(1) 19,842 - - Losses on early extinguishments of debt and refinancing costs 22,044 1,316 1,835 Share-based compensation 25,010 22,910 27,082 Restructure and impairment charges 28,835 48,332 104,238 Darice liquidation costs 45,244 - - Severance costs 8,972 5,607 902 Store pre-opening costs 3,082 4,608 4,417 Store remodel costs 1,739 337 5,153
Foreign currency transaction (gains) losses, net (8)
276 (278) Store closing costs 1,528 (156) 3,134 Consulting costs 20,625 - - CEO transition costs(2) - 9,236 - Other(3) 11,846 6,661 2,916 Adjusted EBITDA$ 830,538 $ 733,902 $ 834,649
(1) Includes costs attributable to the COVID-19 pandemic including hazard pay for
team members, costs associated with furloughed employees, certain inventory
charges and sanitation supplies. This amount also includes
wage subsidies resulting from COVID-19 relief legislation.
(2) CEO transition costs includes
CEO and a
(3) Other adjustments primarily relate to items such as moving and relocation
expenses, franchise taxes, sign-on bonuses, director's fees, search costs and
the support center move.
Critical Accounting Policies and Estimates
We have prepared our consolidated financial statements in conformity withU.S. GAAP. These consolidated financial statements include some amounts that are based on our informed judgments and estimates. Our significant accounting policies are discussed in Note 1 to the consolidated financial statements. Our critical accounting policies represent those policies that are subject to judgments and uncertainties. The following discussion addresses our most critical accounting policies, which are those that are both important to the portrayal of our financial condition and results of operations and that require significant judgment or use of complex estimates. 40 Table of Contents
Merchandise Inventories. Merchandise inventories are valued at the lower of cost or net realizable value, with cost determined using a weighted-average method. Cost is calculated based upon the purchase price of an item at the time it is received by us and also includes the cost of warehousing, handling, purchasing, and importing, as well as inbound and outbound transportation, net of vendor allowances. Inventory cost is recognized through cost of sales when it is sold. It is impractical for us to assign overhead costs and vendor allowances to individual units of inventory. As such, to match inventory costs against the related revenues, we estimate the amount of overhead costs and vendor allowances to be deferred and recognized each period as the inventory is sold. We utilize perpetual inventory records to value inventory in our stores. Physical inventory counts are performed in a significant number of stores during each fiscal quarter primarily by a third-party inventory counting service, with substantially all stores open longer than one year subject to at least one count each fiscal year. We adjust our perpetual records based on the results of the physical counts. We maintain a provision for estimated shrinkage based on the actual historical results of our physical inventories. We compare our estimates to the actual results of the physical inventory counts as they are taken and adjust the shrink estimates accordingly. We also evaluate our merchandise to ensure that the expected net realizable value of the merchandise held at the end of a fiscal period exceeds cost. In the event that the expected net realizable value is less than cost, we reduce the value of that inventory accordingly. A 10% change in our inventory valuation and shrink reserves would have affected net income by$0.8 million in fiscal 2020. Vendor allowances, which primarily represent volume rebates and cooperative advertising funds, are recorded as a reduction of the cost of the merchandise inventories and a subsequent reduction in cost of sales when the inventory is sold. We generally earn vendor allowances as a percentage of certain merchandise purchases with no minimum purchase requirements. Long-Lived Assets. Long-lived assets (other than goodwill and assets with indefinite lives), such as property and equipment, operating lease assets and intangible assets subject to amortization, are evaluated for indicators of impairment whenever events or changes in circumstances indicate their carrying amounts may not be recoverable. For store assets, we evaluate the performance of individual stores for indicators of impairment and underperforming stores are selected for further evaluation to determine whether their carrying amounts
are recoverable.
Our initial indicator that store assets, including operating lease assets, are considered to be recoverable is that the estimated undiscounted cash flows for the remaining lease term exceed the carrying value of the assets. If the evaluation indicates that the carrying value of the asset may not be recoverable, the potential impairment is measured based on a projected discounted cash flow method using assumptions about key store variables, including sales, growth rate, gross margin, payroll and other controllable expenses. The fair value of our operating lease assets are based on the present value of comparable market rents. Furthermore, management considers other factors when evaluating stores for impairment, including the individual store's execution of its operating plan and other local market conditions. If the carrying value exceeds the fair value, an impairment is recorded. Our evaluation requires consideration of a number of factors including changes in consumer demographics, key store level assumptions and other uncertain future events. Accordingly, our accounting estimates may change from period to period. These factors could cause management to conclude impairment indicators exist and require that tests be performed, which could result in a determination that the value of long-lived assets, including operating lease assets, is impaired, resulting in a write down to fair value.Goodwill and Other Indefinite-Lived Intangible Assets. We review goodwill and other indefinite-lived intangible assets for impairment each year in the fourth quarter, or more frequently if events occur which indicate the carrying value may not be recoverable. We have historically performed a qualitative assessment for our Michaels-U.S. reporting unit to determine whether it is more likely than not (that is, a likelihood of more than 50 percent) that the fair value of the reporting unit is less than its carrying value, including goodwill. Factors used in our qualitative assessment include, but are not limited to, macroeconomic conditions, industry and market conditions, cost factors, overall financial performance and Company and reporting unit specific events. If, based on our qualitative assessment, we determine that it is more likely than not that the estimated fair value of the reporting unit is less than the carrying amount, including goodwill, we will calculate the fair value of the Michaels-U.S. reporting unit using the present value of future cash flows expected to be generated by the reporting unit. If the carrying value of the reporting unit exceeds its estimated fair value, an impairment loss will be recognized not to exceed the total amount of goodwill allocated to the reporting unit. 41 Table of Contents For all other reporting units, we estimated the fair value of each reporting unit using the present value of future cash flows expected to be generated by the reporting units. If the carrying value of the reporting unit or indefinite-lived intangible assets exceeds the estimated fair value, an impairment charge is recorded to write the assets down to their estimated fair value. We estimate fair value using the present value of future cash flows expected to be generated by the reporting unit using a weighted-average cost of capital, terminal values and updated financial projections for the next five years. If our actual results are not consistent with the estimates and assumptions used to calculate fair value, we could be required to recognize additional impairments in a future period. Income Taxes. Deferred tax assets, including the benefit of net operating loss and tax credit carryforwards, are evaluated based on the guidelines for realization and are reduced by a valuation allowance if it is deemed more likely than not that such assets will not be realized. We consider several factors in evaluating the realizability of our deferred tax assets, including the nature, frequency and severity of recent losses, the remaining years available for carryforwards, changes in tax laws, the future profitability of the operations in the jurisdiction, and tax planning strategies. Our judgments and estimates concerning realizability of deferred tax assets could change if any of the evaluation factors change, resulting in an increase or decrease to income tax expense in any period. We record a liability for uncertain tax positions to the extent a tax position taken or expected to be taken in a tax return does not meet certain recognition or measurement criteria. Considerable management judgment is necessary to assess the inherent uncertainties related to the interpretations of complex tax laws, regulations and taxing authority rulings, as well as to the expiration of statutes of limitations in the numerous and varied jurisdictions in which we operate. Our judgments and estimates may change as a result of evaluation of new information, such as the outcome of tax audits or changes to or further interpretations of tax laws and regulations, resulting in an increase or decrease to income tax expense in any period.
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