UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 10-Q

Commission file number 001-09338

MICHAELS STORES, INC.

(Exact name of registrant as specified in its charter)

8000 Bent Branch Drive

Irving, Texas 75063

(Address of principal executive offices, including zip code)

(972) 409-1300

(Registrant’s telephone number, including area code)

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

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer o     Accelerated filer o     Non-accelerated filer x

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

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

MICHAELS STORES, INC.

FORM 10-Q

2

MICHAELS STORES, INC.

Part I—FINANCIAL INFORMATION

Item 1.  Financial Statements.

MICHAELS STORES, INC.

CONSOLIDATED BALANCE SHEETS

(In thousands, except share data)

(Unaudited)

See accompanying notes to consolidated financial statements.

3

MICHAELS STORES, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands)

(Unaudited)

See accompanying notes to consolidated financial statements.

4

MICHAELS STORES, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

See accompanying notes to consolidated financial statements.

5

MICHAELS STORES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

For the Quarter and Nine Months Ended November 3, 2007

(Unaudited)

Note 1.  Summary of Significant Accounting Policies

Basis of Presentation

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

The accompanying unaudited consolidated financial statements have been prepared in accordance with U.S. 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 three and nine months ended November 3, 2007 are not indicative of the results to be expected for the entire year.

The balance sheet at February 3, 2007 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 3, 2007.

All references herein to “fiscal 2007” relate to the 52 weeks ending February 2, 2008 and all references to “fiscal 2006” relate to the 53 weeks ended February 3, 2007. In addition, all references herein to “the third quarter of fiscal 2007” relate to the 13 weeks ended November 3, 2007 and all references to “the third quarter of fiscal 2006” relate to the 13 weeks ended October 28, 2006.  Finally, all references to “the nine months ended November 3, 2007” relate to the 39 weeks ended November 3, 2007, and “the nine months ended October 28, 2006” relate to the 39 weeks ended October 28, 2006.

Certain prior year amounts were reclassified to conform to current year presentation.  These reclassifications consist primarily of transaction expenses on the statements of operations.

Recent Accounting Pronouncements

In July 2006, the FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes — an interpretation of FASB Statement No. 109, which clarifies the accounting for uncertainty in income tax positions. FIN 48 requires that a company recognize in its consolidated financial statements the impact of a tax position that is more likely than not to be sustained upon examination based on the technical merits of the position. We adopted FIN 48 as of the beginning of our first quarter of fiscal 2007 with no material impact to our consolidated statement of operations, balance sheet, stockholders’ equity, or statement of cash flows.

Upon adoption, we elected to record any interest and penalties associated with audits as a component of income tax expense. The Company identified its federal tax return, Canadian tax return, and its state tax returns in California, Florida, Illinois, New York, North Carolina, Pennsylvania, and Texas as “major” tax jurisdictions.  The periods subject to examination for our federal returns are 2002 to present, 2000 to present for our Canadian returns, and 2003 to present for all “major” state returns except for California, North Carolina, and Texas.  These states are subject to examination as follows:   California from 1999 to present, North Carolina from 2001 to present, and Texas from 2002 to present.

6

In September 2006, the FASB issued Statement of Financial Accounting Standard No. 158, Employers’ Accounting for Defined Benefit Pensions and Other Postretirement Plans, which requires an entity to recognize the overfunded or underfunded status of a defined benefit postretirement plan as an asset or liability in its balance sheet and to recognize changes in that funded status in the year in which the changes occur through comprehensive income.  It also requires an entity to measure the funded status of a plan as of the date of its year-end balance sheet.  As we have no publicly traded equity securities (due to the Merger as described in Note 2 below), FAS 158 is effective for us at the end of fiscal 2007, with early adoption permitted.  We plan to adopt FAS 158 at the end of fiscal 2007, with no material impact expected on our consolidated statement of operations, balance sheet, stockholders’ equity, or statement of cash flows.

In February 2007, the FASB issued Statement of Financial Accounting Standard No. 159, The Fair Value Option for Financial Assets and Financial Liabilities, which permits companies to measure certain financial instruments and other items at fair value (at specified measurement dates) that are not currently required to be measured at fair value. Any unrealized gains or losses applicable to those items measured at fair value shall be reported in earnings. The decision to apply fair value shall generally be made on an instrument by instrument basis, is irrevocable, and is applied only to an entire instrument. The provisions of FAS 159 will be effective for us as of the beginning of fiscal 2008, with early adoption permitted.

Note 2.  Merger Transaction

On October 31, 2006, substantially all of the Common Stock of Michaels Stores, Inc. was acquired through a merger transaction (the “Merger”) by affiliates of two private investment firms, Bain Capital Partners, LLC and The Blackstone Group (collectively, together with their applicable affiliates, the “Sponsors”), with certain shares retained by affiliates of Highfields Capital Partners (a then-existing shareholder of Michaels Stores, Inc.). As a result of the Merger, Michaels Holdings LLC, an entity controlled by the Sponsors, owns approximately 93% of our outstanding Common Stock, which is no longer publicly traded. We accounted for the Merger as a leveraged recapitalization whereby the historical book value of the assets and liabilities of Michaels were maintained with no push down accounting required.

The Merger consideration paid to then-existing equity holders was approximately $5.8 billion, with fees and expenses totaling an additional $239.7 million. The purchase price was funded by:

·Aggregate cash equity contribution by the Sponsors of approximately $1.7 billion;

·Retention of certain shares held by affiliates of Highfields Capital Partners totaling $110.0 million;

·The issuance of the following debt (See Note 4 for further information concerning our issuance of debt):

·$750.0 million of 10% Senior Notes due 2014;

·$400.0 million of 113¤8% Senior Subordinated Notes due 2016;

·$250.0 million of 13% Subordinated Discount Notes due 2016 (with an accreted value at maturity of $469.4 million);

·$2.4 billion Senior secured term loan facility; and

·$400.0 million of borrowings under our Asset-based revolving credit facility; and

·Our available cash as of the date of the Merger.

The Merger occurred simultaneously with the closing of the financing and equity transactions described above as well as the termination of our previous $300 million senior unsecured credit facility with Bank of America, N.A.

7

We capitalized $124.7 million of costs related to our issuance of various debt instruments.  We amortize the deferred financing costs over the lives of the respective debt agreements (which range from five to ten years) and record the amortization to interest expense. Amortization of the deferred financing costs was $4.2 million and $12.7 million for the three and nine months ended November 3, 2007, respectively.

Transaction expenses for the three and nine months ended November 3, 2007 relate primarily to compensation arrangements associated with the change in control.

Note 3.  Share-Based Compensation

On February 15, 2007, our stockholders and Board of Directors approved the 2006 Equity Incentive Plan (“2006 Plan”), which provides for the grant of share-based awards exercisable for up to 14.2 million shares of Common Stock.  The table below sets forth a summary of stock option activity for the three and nine months ended November 3, 2007.  As of November 3, 2007, there are 0.1 million shares of restricted stock outstanding and share-based awards exercisable for up to 2.6 million shares of Common Stock remain available for grant.

Generally, awards granted under the 2006 Plan vest ratably over five years and expire eight years from the grant date. The exercise prices of the awards issued during the three and nine months ended November 3, 2007 ranged, depending upon the tranche in which issued, from $15 per share to $52.50 per share. The fair value of the awards, for purposes of calculating compensation expense, was determined after considering various factors, and using the Black-Scholes-Merton option valuation model. Share-based compensation expense for the three and nine months ended November 3, 2007 was $1.4 million and $4.2 million, respectively.

All share-based awards outstanding immediately prior to the Merger were settled on the Merger date. There were no share-based awards outstanding as of February 3, 2007.

8

Note 4.  Debt

Our outstanding debt is detailed in the table below.  We had no debt outstanding as of October 28, 2006. We were in compliance with the terms and conditions of all debt agreements for all periods presented.

Asset-based revolving credit facility

The Asset-based revolving credit facility provides senior secured financing of up to $1.0 billion, subject to a borrowing base described below. As of November 3, 2007, the borrowing base was $958.6 million with $509.4 million of unused availability.

The borrowing base equals the sum of (i) 90% of eligible credit card receivables and debit card receivables; (ii) between 85% and 90% of the appraised net orderly liquidation value of eligible inventory and of eligible letters of credit; (iii) a percentage of eligible in-transit inventory, less certain reserves; and (iv) the sum of an additional 10% of the appraised net orderly liquidation value of eligible inventory and of eligible letters of credit plus an additional 5% of eligible credit card receivables and debit card receivables, up to a maximum amount of $100.0 million.

Senior secured term loan facility

Borrowings under the Senior secured term loan facility bear interest at a rate per annum equal to, at our option, either (a) a base rate determined by reference to the higher of (1) the prime rate of Deutsche Bank and (2) the federal funds effective rate plus ½ of 1% or (b) a LIBOR rate, subject to certain adjustments, in each case plus an applicable margin. The applicable margin at November 3, 2007 was 1.25% with respect to base rate borrowings and 2.25% with respect to LIBOR borrowings, subject to downward adjustment based on the leverage and ratings thresholds set forth in the Senior secured term loan facility agreement.

On May 10, 2007, we amended the Senior secured term loan facility to reduce the applicable margin to 1.25% with respect to base rate borrowings and 2.25% with respect to LIBOR borrowings. The amendment also provides that if there is a repricing transaction that reduces the interest rate margins prior to May 10, 2008, then each lender will receive a fee equal to 1.00% of the principal amounts of loans that are repriced. Finally, the amendment eliminated the requirement that we maintain a specified consolidated secured debt ratio.

9

Note 5.  Comprehensive (Loss) Income

Our comprehensive (loss) income is as follows:

Note 6.  Derivative instruments

We are exposed to fluctuations in exchange rates between the US and Canadian dollars, as the functional currency of our Canadian subsidiary is the Canadian dollar.  To mitigate the effects of currency fluctuations, during the second quarter of fiscal 2007, we executed a foreign currency cash flow hedge. To facilitate cash flow hedge accounting, the objective is to hedge payments for forecasted purchases of intercompany inventory by our Canadian subsidiary denominated in US dollars.  The term of this cash flow hedge extends through fiscal 2007.

To achieve our objective and to minimize the risk of ineffectiveness, the notional values represent a portion of our Canadian subsidiary’s forecasted intercompany purchases.  Any hedge ineffectiveness is recorded in Other income. For the three and nine month periods ended November 3, 2007, the ineffective portion of the hedge was recorded as a loss of $1.5 million.

For the portion of the hedge that is effective, the change in fair value of that hedge will initially be recorded in Other comprehensive income.  As the underlying inventory is sold to our customers, amounts will be reclassified from Other comprehensive income to Cost of sales and occupancy expense in the statement of operations.  The change in fair value of the hedge for the three and nine month periods ended November 3, 2007, were recorded as losses of $2.2 million and $2.1 million, respectively.

The table below provides the remaining quarterly notional values and the average CAD/USD exchange rate associated with the hedge (dollars in thousands).

Note 7.  Commitments and Contingencies

Reference is made to the action described under “Part I. Item 3. Legal Proceedings – Employee Class Action Claims – Clark Claim” in our Annual Report on Form 10-K for fiscal 2006.  In that action, on November 14, 2007, the court granted final approval of the settlement.  The settlement had no material impact on our statement of operations, balance sheet, or statement of cash flows for any period presented.

Reference is made to the description of the potential Section 16 liability issues under “Item 3. Legal Proceedings — Governmental Inquiries and Related Matters — Non-U.S. Trust Inquiry” in our Annual Report on Form 10-K for fiscal 2006.  The tolling agreement with the Wylys expired on October 5, 2007. On October 4, 2007, our Board of Directors determined that it was in the best interest of the Company and its stockholders not to further pursue the potential Section 16 liability.

We are involved in ongoing legal and regulatory proceedings. Other than the updates described in the preceding paragraphs, there were no material changes to our disclosures of commitments and contingencies from our Annual Report on Form 10-K for fiscal 2006 and our Quarterly Reports on Form 10-Q for the quarters ended April 5, 2007 and August 4, 2007.

10

Note 8.  Segments

We consider our Michaels, Aaron Brothers, Recollections stores and our Star Decorators Wholesale operations to be our operating segments for purposes of determining reportable segments based on the criteria of SFAS No. 131, Disclosures About Segments of an Enterprise and Related Information. We determined that our Michaels and Aaron Brothers operating segments have similar economic characteristics and meet the aggregation criteria set forth in paragraph 17 of SFAS No. 131. With regard to our Aaron Brothers operating segment, we determined that it did not meet the quantitative thresholds for separate disclosure set forth in SFAS No. 131. We also determined that individually, and in the aggregate, the Recollections stores and Star Decorators Wholesale operations were immaterial for segment reporting purposes. Therefore, we combine all operating segments into one reporting segment.

Subsequent to the Merger, our chief operating decision makers evaluate historical operating performance, plan and forecast future periods’ operating performance and base incentive compensation targets for certain management personnel on earnings before interest, income taxes, and depreciation and amortization (“EBITDA”). A reconciliation of income before income taxes and cumulative effect of accounting change to EBITDA is presented below. Segment income for the three and nine months ended October 28, 2006 was restated to conform to current year presentation.

Our sales and assets by country are as follows:

11

Note 9.  Related Party Transactions

We pay annual management fees to the Sponsors in the amount of $12.0 million and an annual management fee to Highfields Capital Management LP in the amount of $1.0 million. During the three and nine months ended November 3, 2007, we recognized $3.5 million and $10.3 million, respectively, of expense related to annual management fees and related expenses.

As previously disclosed in our fiscal 2006 Annual Report on Form 10-K, we amortize over a two-year period Separation Agreements with each of Charles J. Wyly, Jr. and Sam Wyly, who were executive officers and directors of the Company prior to the Merger. Amortization expense for the three and nine months ended November 3, 2007 was $0.7 million and $2.3 million, respectively.

During the first quarter of fiscal 2007, The Blackstone Group acquired a majority ownership stake in an external vendor we utilize to count our store inventory. Expenses associated with this vendor during the three and nine months ended November 3, 2007 were approximately $1.7 million and $4.0 million, respectively.

During the nine months ended November 3, 2007, officers of Michaels Stores, Inc. and its subsidiaries were offered the opportunity to purchase shares of our Common Stock. During the first quarter of fiscal 2007, we sold 289,334 shares, or approximately $4.3 million, of our Common Stock at a price of $15 per share to certain officers. During the third quarter of fiscal 2007, we sold 251,672 shares, or approximately $3.8 million, of our Common Stock at a price of $15 per share to certain officers.  Also, during the three and nine month periods ended November 3, 2007, we repurchased 13,333 shares and 62,666 shares, respectively, of our Common Stock at $15 per share from officers who are no longer with the Company.

Note 10.  Exit Costs for Concept Businesses

On October 16, 2007, we announced plans to align resources around our core retail chains, Michaels stores and Aaron Brothers. As a result, we will be discontinuing our concept businesses, Recollections and Star Decorators’ Wholesale (“Star”). We anticipate closing 11 Recollections and three of the four Star locations by the end of the fourth quarter of fiscal 2007.

In accordance with Statement of Financial Accounting Standard No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, we performed impairment analyses for these stores. Based on estimated future cash flows, an impairment loss for property and equipment of $6.1 million was recognized during the third quarter of fiscal 2007. Also, $0.9 million of related severance and termination costs were recorded during the same period. All of these exit costs are reflected in a separate line item on the consolidated statements of operations.

At the time the stores are closed, we expect to incur approximately $4.4 million of additional pre-tax charges related to remaining lease obligations. This amount may change if actual results materially differ from certain estimates inherent in our calculations.

Note 11.   Condensed Consolidating Financial Information

All of the Company’s obligations under the Senior notes, Senior subordinated notes, Subordinated discount notes, Senior secured term loan, and Asset-based revolving credit facility are guaranteed by the Company’s subsidiaries. The following condensed consolidating financial information represents the financial information of Michaels Stores, Inc. and its wholly-owned subsidiary guarantors, prepared on the equity basis of accounting.  The information is presented in accordance with the requirements of Rule 3-10 under the SEC’s Regulation S-X.  The financial information may not necessarily be indicative of results of operations, cash flows, or financial position had the subsidiary guarantors operated as independent entities.

12

Supplemental Condensed Consolidating Balance Sheets

14

Supplemental Condensed Consolidating Statements of Operations

15