The Michaels Companies Inc. (MIK) Q1 2018 Earnings Conference Call Transcript

The Michaels Companies, Inc. (MIK)
Q1 2018 Earnings Conference Call
June 14, 2018, 9:00 a.m. ET

Contents:

• Prepared Remarks
• Questions and Answers
• Call Participants

Prepared Remarks:

Operator

Good morning. My name is Kari and I will be your conference operator today. At this time, we'd like to welcome everyone to The Michaels Companies' First Quarter Earnings Conference Call. All lines have been placed on mute to prevent any background noise. If you need assistance during the conference call, please press "*0" and an operator will assist you. Please note this event is being recorded.

Thank you. And now I'd like to turn the call over to your host, Kiley Rawlins, Vice President of Investor Relations and Communications. Ms. Rawlins, you may begin the conference.

Kiley Rawlins -- Vice President of Investor Relations and Communications

Thank you. Good morning, everyone, and thank you for joining us today. Earlier this morning, we released our financial results for the first quarter of fiscal 2018. A copy of the press release is available in the Investor Relations section of our website at www.michaels.com.

Before we begin our discussion, let me remind you that today's press release and the presentations by our executives on this call may constitute forward-looking statements and are made pursuant to and within the meaning of the Safe Harbor Provisions of the Private Securities Litigation Reform Act of 1995, as amended. While these statements address plans or events which we expect will or may occur in the future, a number of factors, as set forth in our SEC filings and press releases, could cause actual results to differ materially from our expectations. We refer you to and specifically incorporate the cautionary and risk statements contained in today's press release and in our SEC filings.

You are cautioned not to place undue reliance on these forward-looking statements, which speak only as of today, June 14, 2018. We have no obligation to update or revise our forward-looking statements, except as required by law, and you should not expect us to do so.

On today's call, we will reference non-GAAP financial measures, including adjusted EBITDA, as defined in our credit agreement, and adjusted operating income, adjusted net income, and adjusted diluted earnings per share, all adjusted for the restructuring charge and provisional tax adjustments. A reconciliation of these measures to the corresponding GAAP measures are detailed in today's earnings release.

We will begin this morning with highlights from Chuck Rubin, Chairman and CEO, then Denise Paulonis, our CFO, will review our financial results and outlook in more detail. Following our prepared remarks, we will open the call for questions.

Now I'd like to turn the call over to Chuck Rubin.

Chuck Rubin -- Chairman and Chief Executive Officer

Thank you, Kiley, and good morning, everyone. This morning, we reported first quarter sales, adjusted operating income, and adjusted diluted EPS in line with the guidance we provided back in March. Total sales were $1.16 billion, adjusted operating income was $126 million, and adjusted diluted EPS was $0.39.

The quarter unfolded largely as we expected and our teams made progress executing our key initiatives to support longer term profitable growth. As expected, the quarter was negatively impacted by an earlier Easter and continued sluggish core arts and crafts industry growth.

Comp store sales increased 0.4%, driven by strong growth in our e-commerce channels, albeit still a small part of our overall business. Sales in brick-and-mortar were slightly negative. Overall average ticket was higher in the first quarter this year as compared to the first quarter last year, while customer transactions were slightly lower.

From a category perspective, custom framing delivered a nice positive comp for the quarter. The changes we've made to stabilize and strengthen this business are delivering results. As you may recall, last August we improved our pricing structure to provide customers with more flexibility to meet their budgets. We've also changed our field organizational structure in many of our more dense markets to allow our framing teams to focus more on the selling nature of the custom frame transaction.

Paper crafting tools and technology were also strong in the quarter, driven by our expanded assortment of Cricut machines and accessories, including the exclusive Martha Stewart Cricut machine.

Finally, our seasonal décor categories delivered nice growth in the quarter, supported by Easter décor and other home décor categories.

As we've discussed in the past, we manage a portfolio of distinct businesses. Every quarter, some businesses exceed our expectations while others are not as strong as planned. Partially offsetting the growth in custom framing, technology, and seasonal décor was softness in some of our core crafting categories, including unfinished surfaces, jewelry making, and kids' crafting basics.

Finally, a quick update on the progress of the closing of our Aaron Brothers stores. The inventory liquidation is owned and managed by a third party but we continue to expect that the store closures will be completed by the end of the second quarter.

As we turn to Q2 and the rest of the year, our financial expectations and plans have not materially changed. The industry in which we operate remains softer than we would like. While there isn't great third-party data available to track trends in the arts and crafts channel, as we aggregate trends across our individual retail consumer brands, both in brick-and-mortar and online, as well as insights from Darice, our wholesale business, our data continues to suggest that the core arts and crafts channel isn't currently expanding on an aggregate basis.

While we do not believe this is a long-term trend, as the leader in the channel, we're not waiting passively for the industry to improve. Instead, we are aggressively pursuing actions to win even more share of this fragmented industry. Through our CRM efforts, we are building a sustainable, competitive advantage which will help us target our customer communications better and drive increased sales and market share over the longer term. With the continued expansion of our loyalty program and analytical efforts, today we can link 72% of our transactions and more than 80% of our sales to a unique customer. Digging deeper into this data, we continue to see good positive comp growth from our enthusiast customer. However, gaining traction with the more casual customer is taking longer than we had hoped.

Given these trends, we are sharpening our efforts to capture more trips from the casual customer. Our focus is to make it easier for customers to make, offer a more convenient shopping experience, and strengthen our value perception. For the more casual customer, we know DIY can be intimidating. With thousands of components that can be combined in numerous ways, the sheer number of possibilities can be overwhelming and hard to navigate. So we're committed to making it easier, both in stores and online, for the casual customer to bring her inspiration to life.

In stores, we're expanding our FMA layout to make it easier for customers to stay on trend and seasonally relevant. In Q2, we'll convert about 235 stores to this layout, which leverages space in the front of the store to showcase newness and seasonal statements. And as we have simplified the process and reduced the number of standard business assortment, or SBA, core categories that will be moved, we've made it easier for our teams to implement. With these changes added to the approximately 425 stores which already have the FMA layout, about half of our chain will be positioned to present stronger, more cohesive seasonal statements to customers the back half of this year.

We've enhanced the Michaels app, adding new, easy-to-use visual search capabilities. Now our customer can use the camera on their phone to take a picture of an item or an idea and use it to search our library of products and projects. Then she can use the store specific wayfinding capabilities within the app to identify the exact aisle in her store where she can find the item she needs. So whether it's a mason jar or an idea for door décor, we've made it easier for customers of all skill levels to find and make whatever they want, whether that's in store or online.

Also online, we're building a stronger digital community for customers, whether they are looking for inspiration or assistance. We continue to expand our social platform and reach across multiple social sites and today, with nearly 4.5 million followers across Facebook, Twitter, Instagram, and Pinterest, we have the largest social reach among all the big box arts and crafts players. And with the recently launched Talkie Walkie platform, which enables makers to talk to other makers, we've facilitated more than 45,000 questions asked through this platform.

We've also simplified the michaels.com homepage experience to make it easier for customers to quickly find what they need and we're leveraging the flexibility of the digital space to create customized solutions for unique shopping missions. For example, in Q1 we launched a weddings micro-site on michaels.com that brings together different styles, ideas, and exclusive product across a variety of product types together in one easily searchable platform to help DIY brides execute their vision.

To help customers celebrate key life moments, we've launched Martha Stewart Party, a fully coordinated party program designed by Martha and her team and only available in Michael's stores and on michaels.com. This collection of more than 300 items makes it easy for customers to throw a Martha-approved party that can also reflect their own individual personal style.

And with our recently rebranded aaronbrothers.com, our online framing solution, we're making it easier for customers to frame their own digital assets or a reprint of a favorite artist, and, if they're not happy with the design for any reason, they can leverage the brick-and-mortar part of our business and return it to any Michaels store.

We know customers are busy, so we're focused on making Michaels more convenient to shop. We launched BOPIS, or Buy Online and Pickup In Store, in all U.S. stores in the first quarter. While it's still early, we are very pleased with the level of customer adoption and we continue to test ways to leverage this trip to drive add-on sales.

We've redesigned our coupon page on michaels.com to make it easier for customers to access their coupons, an improvement that is especially helpful on mobile and should make the in-store checkout process faster.

We know customers are looking for value, so we're increasing our efforts to strengthen our value perception. Our Everyday Value program, or EDV, which delivers great prices on basic crafting items every day to our customers without the need for a promotion, continues to drive sales and gross profit and we will continue to add items where appropriate.

We're expanding our use of clear, even dollar price points to reinforce the value we offer. We're reinforcing our price match guarantee through new, clearer messaging. And we've introduced new bulk buy options, supported by our Darice assortment and fulfillment infrastructure, to give customers who may need larger quantities of an individual item an easy, cost-effective way to buy more.

Even as we invest in new customer-friendly capabilities and double-down on core capabilities, we know that we have opportunities to step up our execution. We're refocusing efforts to make sure that our in-store, in-stock levels satisfy what she needs when she needs it. We've identified opportunities to improve our in-stock levels, especially in high growth categories like t-shirts and wedding, where demand has exceeded our initial expectations. We're actively addressing these opportunities but it is taking more time than we would have hoped given some long lead times of our private brand.

We have an opportunity to improve inventory flow when we transition supplier partners. As we have successfully negotiated lower product costs as part of our sourcing efforts, some of the transitions to new suppliers have affected in-stock levels in certain SBA categories. We've adjusted our internal processes to ensure better supplier transitions in the future and are working aggressively to improve in-stocks in new programs. These changes, combined with our efforts to improve inventory flows for the holiday season, will result in temporarily elevated inventory levels at the end of the second quarter. We believe inventory levels will return to normal levels at the end of Q3.

We need to make our promotions less confusing to the customer. We operate in a promotional industry with numerous types of discounts, various exclusions, and inconsistent stackability. Moving forward, we are introducing new approaches to segment discounts by customer and to limit exclusions to reduce this confusion.

Finally, we are making changes to how we highlight these efforts with our customers. We're refreshing our in-store signage to reinforce the ways we make it easier, the convenience we provide, and the value we offer. We're increasing our use of digital marketing and shifting dollars away from traditional circulars to target customers better. And we continue to contemporize the brand and messaging through investments in mass market platforms, like Good Morning America, where we recently helped a bride and groom put a wedding together in just two days.

Importantly, all of these efforts, which are targeted to the more casual customers, also benefit our enthusiast customers and help us sustain our strong growth with them. Even as we sharpen our focus on attracting and retaining more casual customers, we are executing against our investment agenda to support longer term capabilities and growth. As we discussed on our last call, we are investing this year to create a more seamless, omni-channel experience for customers, to expand FMA stores, to bring e-commerce fulfillment in-house, and to strengthen our data analytics. Our plans in each of these areas are on track and progressing as expected.

In summary, Q1 was in line with our expectations and we're making progress against all of our 2018 priorities. As the leader in the arts and crafts space, we intend to leverage our financial strength, size, and scale to expand our customer base and drive profitable growth over the longer term.

With that, let me turn the call over to Denise for a more detailed discussion of our first quarter financial performance and outlook. Denise?

Denise Paulonis -- Chief Financial Officer

Thanks, Chuck, and good morning, everyone. This morning, we reported GAAP results, which include a restructuring charge of $47.5 million primarily related to the closing of 94 of our Aaron Brothers stores, and an $8 million charge for provisional tax adjustments related to the repatriation taxes on accumulated earnings of foreign subsidiaries. As Chuck indicated, excluding the restructuring charge and the provisional tax adjustments, our results for the quarter were in line with the guidance we provided on our last earnings call. A full reconciliation of the GAAP to the adjusted metrics is included in our earnings release.

Starting with sales, net sales for the quarter were $1.16 billion, $3 million less than the net sales in the first quarter last year. The decrease in net sales was primarily due to a $13 million decrease related to the closure of 94 Aaron Brothers stores. Sales for Aaron Brothers in the first quarter of last year were $25.5 million. Excluding sales of Aaron Brothers divisions in both years, net sales for Q1 would have increased 0.8%. This increase was primarily due to a 0.4% increase in comparable store sales and the operation of 18 net additional Michaels stores opened since the first quarter of fiscal 2017.

As a reminder, fiscal 2017 was a 53-week year and we are not restating our comp sales reporting periods. Our comp sales reporting for 2018 uses the same 2017 baseline as our fiscal reporting period. In other words, our Q1 comp sales reflect the comparison of January 29 through April 29, 2017, versus February 4 through May 5, 2018. The impact of the one-week shift was immaterial to our Q1 comp.

During the quarter, the company opened six new Michaels stores, closed one Michaels store, and relocated nine Michaels stores. At the end of the first quarter, the company operating 1,243 Michaels stores, three Aaron Brothers stores, and 36 Pat Catan's stores. Offsetting this sales growth was an expected decline in wholesale revenues, reflecting the timing difference between new customer acquisition and the expected attrition of legacy customers. We continue to be very encouraged by our pipeline of new accounts and expect wholesale revenues for the full year will be higher than fiscal 2017 despite the expected reduction from legacy customers.

Gross profit dollars for the quarter were $457 million, compared to $468 million in the first quarter of fiscal 2017. As a percentage of sales, our gross profit rate for the quarter was 39.5% versus 40.4% last year, a decrease of about 90 basis points. The decrease, as a percentage of net sales, was primarily due to expected factors, including higher distribution-related costs, occupancy cost deleverage, and the headwind related to the closure of 94 Aaron Brothers stores in the quarter. The negative impact of these factors was partially offset by continued higher merchandise margin, resulting from the company's ongoing sourcing initiatives. This is the seventh consecutive quarter of higher merchandise margins. As a reminder, we recognize the collection cost when product is sold.

The expected increase in distribution-related costs in Q1 reflect higher supply chain costs incurred in the second half of fiscal 2017 related to the hurricane disruption to our Jacksonville distribution center, as well as higher costs incurred as transportation capacity tightened.

Total store rent expense for the quarter was $99.7 million versus $99.4 million last year, with the increase primarily due to a net 18 additional Michaels stores, partially offset by a decrease in rent associated with the Aaron Brothers store closures.

SG&A expense, including store pre-opening costs, was $330 million, or 28.6% of sales, compared to $328 million, or 28.3% of sales, last year. The increase in SG&A was primarily due to expenses related to strategic investments, expenses associated with the operation of 18 additional stores net of closures, and additional payroll-related expenses. These increases were partially offset by a decrease in expenses related to the closure of 94 Aaron Brothers stores.

As we discussed on our last earnings call, we are proactively reinvesting some of the fiscal 2018 expected benefits from tax reform and accelerating key investments in the business to drive longer term benefit. These investments include converting approximately 235 additional stores to our FMA layout, bringing e-commerce fulfillment in-house, strengthening our data analytics, and enhancing the customer experience in-store and online. We continue to expect the timing of the total spend for these projects will be weighted more toward the first half of the year so that we are well-positioned for the holiday season.

GAAP operating income was $79 million, compared to $139 million in the first quarter of fiscal 2017. Excluding the restructuring charge and $300,000.00 of income from Aaron Brothers earned prior to the store closures, adjusted operating income for Q1 of fiscal 2018 was $126 million, near the upper end of our previously provided guidance.

For the quarter, interest expense was $35 million, about $4 million higher than the first quarter of last year. The increase was primarily due to higher interest expense during the quarter this year. Our average interest rate in the quarter this year was 4.9%, compared to 4.3% in the first quarter of 2017, reflecting higher rates on our floating rate debt.

As I indicated on our last call, we have been looking at levers we can pull to reduce our interest rate exposure given the current expectations for rate increases. I'm pleased to share that we recently completed two transactions which will help us better manage interest expense in the current quarter.

First, in April we executed two interest rate swaps with aggregate notional value of $1 billion associated with our outstanding amended term loan to hedge the variability of cash flows resulting from fluctuations in LIBOR. It's a three-year swap, maturing in April 2021, and we are paying a fixed interest rate of about 2.8% to receive one-month LIBOR with a 1% floor. The swap qualifies for hedge accounting. As a result of this transaction, we have effectively fixed the interest rate for 55% of our outstanding debt, increasing the predictability of our interest expense in 2018 and beyond. Prior to the execution of the swaps, approximately 19% of our debt was fixed-rate debt.

Additionally, last month we successfully amended our term loan to reduce the interest rate to LIBOR plus 2.5% from LIBOR plus 2.75%. The one-time cost to reprice our term loan is estimated to be approximately $2 million and will be recognized as a loss on early extinguishment of debt in Q2. In 2018, we expect to realize approximately $4 million in interest savings from the repricing, but believe these savings will be offset by the incremental interest expense from the cost of the swaps this fiscal year.

The effective tax rate for Q1 was 41.6% compared to 33.7% in the first quarter of fiscal 2017. We continue to get additional clarification from tax authorities regarding the application of the Tax Act. Reflecting this updated guidance, we booked an additional $8 million of provisional adjustments in the quarter related to repatriation taxes on the accumulated earnings of foreign subsidiaries. Excluding the impact of the provisional tax adjustments, the effective tax rate for Q1 of fiscal 2017 was 24%.

On a GAAP basis, net income was $27 million, or $0.15 per diluted share, compared to $72 million, or $0.38 per diluted share, in the first quarter of fiscal 2017. Excluding the restructuring charge and provisional tax adjustments, adjusted net income for Q1 of fiscal 2018 was $71 million. Adjusted diluted EPS was $0.39 per share, slightly higher than our guidance, reflecting diluted weighted average common shares of 183 million. This share count was slightly lower than expected, reflecting fewer stock option exercises and a lower stock price during the quarter than what we had forecasted at the time we provided guidance.

Total merchandise inventory at the end of the quarter increased 1.7% to $1.12 billion, compared to $1.1 billion last year. The increase in inventory was primarily due to additional inventory associated with the operation of 18 net additional stores, partially offset by a decrease in inventory related to the closure of Aaron Brothers stores. Average inventory per Michaels store, including inventory for e-commerce, inventory in our distribution centers, and inventory in transit, was 1% higher than at the end of Q1 last year.

We ended Q1 with more than $1 billion in liquidity, including $422 million in cash on our balance sheet and $674 million available under our revolver. Total debt at the end of the quarter was $2.7 billion. Our total debt to adjusted EBITDA on a trailing 12-month basis was 3.1 times and our trailing 12-month interest coverage was 5.4 times.

Our return on invested capital, adjusted for the restructuring charge, for the trailing four quarters was approximately 7%, well above our cost of capital of approximately 6%. Capital expenditures for the quarter were $28 million, reflecting investments in technology projects, including investments to support the insourcing of our e-commerce fulfillment, and investments in new and relocated stores. For the full year, we continue to expect to invest $160 million to $170 million in capital expenditures.

With that as context, let me walk you through our guidance for the second quarter and the full year. As a reminder, our guidance assumes that Aaron Brothers stores were closed as of the start of the fiscal year and excludes any restructuring charges, provisional tax adjustments, and any one-time costs associated with debt refinancing.

Our expectation for the second quarter has not materially changed since the beginning of the year. As we indicated on our last call, we expect the headwinds from supply chain costs and the cost impact of our investment agenda will disproportionately weigh against the first half of the year. In the second quarter, we expect comp store sales will be flat-ish. For modeling purposes, Aaron Brothers delivered approximately $27 million in sales in the second quarter last year. I would remind you that the second quarter is typically our lowest sales volume quarter and, as such, small movements in sales can have a meaningful impact on the P&L.

We plan to open six new Michaels stores and relocate another eight stores in the second quarter. For comparison purposes, in Q2 last year we opened five new Michaels stores and relocated one store.

We expect adjusted operating income for the second quarter will be between $65 million and $70 million. Similar to the trends we saw in Q1, this guidance includes the expectation of higher supply chain costs, higher occupancy costs, and modest expense deleverage resulting from our investment agenda, partially offset by sourcing benefits.

Our Q2 guidance for adjusted diluted earnings per share is $0.12 to $0.14, assuming a diluted weighted average common share count of 183 million shares.

One note about our inventory plan in the second quarter. To facilitate stronger in-stocks and better inventory flow for the holiday season, as Chuck mentioned earlier, we plan to pull forward a number of our SBA receipts into the quarter. As a result, we expect the inventory per store will be up mid-single digits on a percentage basis versus the end of second quarter last year, but we expect inventory at the end of Q3 to return to more normal levels.

Now turning to our earnings expectations for the full year, we have not changed our outlook. For fiscal 2018, a 52-week year, we expect total sales will be between $5.2 billion and $5.3 billion and comp stores sales will be flat to up 1.5%. This guidance includes our plans to open 19 new Michaels stores and relocated 17 Michaels stores.

One note about comp trends in the second half. As we have not restated last year's comp store sales reporting period to align with this year's calendar, third quarter comp sales this year will benefit from the timing of Halloween, which fell in the first quarter last year. Conversely, Q4 comp sales will be negatively impacted by the timing shift. The net impact of the timing shift is incorporated into our full-year guidance for comp store sales growth.

We continue to expect adjusted operating income for the year will be between $677 million and $710 million. As a reminder, this guidance includes a temporary headwind of $23 million of investment facilitated by tax reform benefits and $10 million to $15 million of increased transportation costs.

We expect net interest expense will be approximately $144 million, reflecting an expectation for two additional rate increases as implied by the current LIBOR curve. Our earnings outlook assumes an effective tax rate of approximately 24% for the full year, reflecting the full benefit of a lower corporate tax rate. These assumptions translate into adjusted diluted EPS range of $2.19 to $2.32 for fiscal 2018 on approximately 185 million dilute weighted average common shares for the full year.

In closing, our first quarter results were in line with our expectations, we are executing against our fiscal '18 plans, and our financial outlook for the fiscal 2018 year has not changed.

Now I'd like to open up the call to take your questions. Operator?

Questions and Answers:

Operator

We will now begin the question-and-answer session. To ask a question, you may press "*1" on your touchtone phone. If you are using a speakerphone, please pick up your handset before pressing the keys. To withdraw your question, please press "*2". Please limit yourself to one question with one follow-up question. If you have additional questions, you may reenter the question queue. At this time, we will pause momentarily to assemble our roster.

The first question will come from Seth Sigman of Credit Suisse. Please go ahead.

Seth Sigman -- Credit Suisse -- Analyst

Thanks. Good morning. So just as we think about the first quarter and how it played out, I know the guidance had embedded some impact from the early Easter this year. Any more quantification of how much that could have impacted the quarter and if there were any other variables in the quarter, such as weather, that may have impacted the results? And also, if you could provide some context on the guidance for Q2 for flat comps, I think that would be helpful also. Thank you.

Denise Paulonis -- Chief Financial Officer

Yeah. So, Seth, it's Denise. Let me give a little commentary on sales in the first quarter. As we had included in our guidance was the potential impact of the earlier Easter and that negative impact, in our minds, did materialize. In addition, we also saw about 60 basis points of impact from weather, very similar to what other retailers had seen as we watched all those storms go through the Northeast. That impacted us as well. But, overall, when we think about how the quarter played out, March was a very strong month, because of that earlier Easter, and the other months were about as we would have expected.

When you look forward into Q2, I think the thing to really think about is that it is our lowest volume quarter of the year. And it is a quarter where there is no natural event to bring her into the stores. I think as you know, we do very well when there is a holiday or occasion to get her shopping into our stores. And historically Q2 has been a rather sluggish quarter for us simply because there are not those events. We don't expect there to be any material difference in that from other years this year.

Seth Sigman -- Credit Suisse -- Analyst

And just one follow-up there. So the sales that were potentially lost in the first quarter because of weather, are those delayed or are they actually lost? I'm just trying to think about do they come into the second quarter. And then, I guess just stepping back, as we think about the comp guidance for the full year, based on the expectations for the first half of the year, to achieve, I guess, the higher end of the range for the full year, you would need to see a pick-up in the second half. Compares do get a little more difficult. I guess, Chuck, you went through a number of initiatives. Is the assumption just that those initiatives will become more meaningful through the year to help offset the challenges in the core craft category? Or do you think that the category actually gets a little bit better as you move through the year?

Denise Paulonis -- Chief Financial Officer

Yeah. So, Seth, on both of your points. So, generally speaking, all of our sales are discretionary in nature. So when we have a weather event, we really don't expect to see that pick-up, nor have we seen that historically, in coming months. Just doesn't play out for us that way that it might do for a grocer retailer or something like that.

On the reason to understand the change in the pick-up from the first half of the year to the second half of the year, in terms of comp store sales, there's a few driving forces. Overall, seasonal becomes a larger part of our business in Q3 and Q4. And, as you know, historically we've been very strong in that space and we anticipate that that will be the case this year as well. We are also lapping the weather from all of the hurricanes in the third quarter last year, which had been a substantial -- I believe we had quantified, in the third quarter last year, a 90 basis point or so impact, negative impact, on our comps.

But then, as you mentioned, and what Chuck had said in his comments, there's a few initiatives we have that we believe will also play out strongly. So we're gonna roll out our FMA stores in Q2, which will be an expense to us in Q2 and potentially some minor disruption to sales in Q2 as that happens. But we do anticipate that to be a help, particularly tied to our seasonal business in Q3 and Q4. We will fully cycle the closure of our Aaron Brothers custom frame stores and so, with that, we would anticipate some benefit to Michaels custom frame come through. And then all the other investments that we've talked about we believe do have benefit to us as we turn to the second half.

Seth Sigman -- Credit Suisse -- Analyst

Great. Thanks very much.

Operator

The next question will come from Matt Fassler of Goldman Sachs. Please go ahead.

Matthew Fassler -- Goldman Sachs -- Analyst

Thanks a lot and good morning. I'd like to focus on gross margin. Denise, when you spoke about the gross margin decline, you spoke about the impact of Aaron's on gross margin. And given that the numbers, I believe, effectively exclude the impact of Aaron's operating business and any charges related to the closing, how did the Aaron Brothers numbers factor in to the gross margin decline?

Denise Paulonis -- Chief Financial Officer

So the numbers that we had quoted specifically for gross margin would have still included Aaron Brothers in it, even though we negated that out of the $300,000.00 in total profit on operating income when we reported operating income. So that Aaron Brothers impact on gross margin is really just deleverage on the portion of the sales that still would have been in the base in the first quarter.

By all means, though, if you looked at the quantification of what drove our gross margin performance, the larger components were our supply chain-related expenses. I'd note that most of those supply chain-related expenses were associated with the incremental DC costs that we incurred in the fourth quarter of last year from the impact to our Jacksonville DC associated with the hurricanes, as well as some increase in transportation costs.

The next biggest increase would have been tied to our occupancy costs, which is around the timing of the opening of new stores. We had more stores open at the end of last year and more stores open at the beginning of this year than what would have been a flat cadence, which drives a near-term bump in our occupancy expenses. But offsetting all of that, we saw very good merch margin performance delivering the sourcing benefits that we had expected to see come through and we did not see an increase in promotional intensity. It was actually the seventh quarter of us seeing merchandise margins increase.

Matthew Fassler -- Goldman Sachs -- Analyst

And if we think about the outlook for gross margin for the rest of the year, seasonally you're margin has generally been down around 300 basis points or more from Q1 to Q2 and you have a tougher gross margin compare, so should we think, as we consider the cadence of the business, that Q2 looks a lot like Q1 from a gross margin perspective? And then is there any reason for the gross margin to stabilize over the rest of the year or, given the supply chain issues, both industrywide and also some of the decisions you all made, is it likely that declines persist through 2018?

Denise Paulonis -- Chief Financial Officer

We do anticipate Q2 will be similar to Q1, in that you will see a gross profit rate decline, mainly driven by the continued lapping of some of those supply chain expenses from the back half of last year, although we will still have sourcing goodness come through. The back half of the year does change. As you move into Q3 and Q4, we have a bit of a turn of the dial of where some of those costs will come through. So occupancy and DC-related headwinds will subside. We will still have transportation increases in our costs. We had said that, throughout the entire year, we expected to realize $10 million to $15 million in increased transportation costs. That will flow through the P&L with sales. So you will still see increased transportation costs in the second half of the year but you will not see that incremental DC expense that we're covering from last year come through our numbers.

Additionally, the incremental investment that we're making, supported by tax reform, to do things like roll out 235 more FMA stores, is all first half weighted. So while there will still be some expense coming through in Q3 and Q4, that subsides quite a bit. So you will see that as one of the other drivers of the return to better gross margin performance in Q3 and Q4.

Matthew Fassler -- Goldman Sachs -- Analyst

Understood and thanks so much for that detail.

Operator

The next question comes from Christopher Horvers of JP Morgan. Please go ahead. Christopher, your line is open if you wish to ask a question.

Christopher Horvers -- JP Morgan -- Analyst

Thanks. Good morning. So my first question is how you're thinking about using potentially promotions to try to drive sales in the category. With crafts sounding like it's roughly flat-ish, would you consider being more aggressive in the market? One would think that you're better positioned than many of your private peers and do you see this as an opportunity to take share and do you think that pulling the promotional lever could be something that would be value added to Michaels?

Chuck Rubin -- Chairman and Chief Executive Officer

Chris, I think, first of all, we already are taking share among our big box competitors. Price clearly is one lever to pull. There's a lot of discounting that goes on in this industry. We're trying to use price on a more targeted basis using the customer data that we have. I've talked about this before. We're making progress. We'll continue to make more progress the back half of this year. You and I may get two different levels of discounts based on our historical shopping performance. So that's one aspect.

But I talked about it in my prepared comments. We're really focused also on convenience. Convenience is increasingly the currency of what customers are using in shopping. So whether it's BOPIS or the improvements in our app or the improvements online or it's the shop-ability and the in-stock nature of what you find in store, these are all things that we're making progress on and I think that's going to be as important as price in the rest of this year.

Christopher Horvers -- JP Morgan -- Analyst

Understood. And then following up, it's the second quarter in a row that you haven't repurchased shares. The stock is trending around $18.00, $19.00 during the quarter. Is it that you don't see value or did you know the street was too high in the second quarter and you were trying to be patient or more opportunistic? A general update on how you're thinking about cash deployment and any insights into the lack of share repurchase over the past two years. If you don't, it looks like you'll end the year with $850 million in cash and that's quite a fortress that you're building, especially in light of the overall debt level that you're carrying.

Denise Paulonis -- Chief Financial Officer

So, Chris, two points on that topic. In the quarter itself, we were involved in an activity that just didn't allow us to be in the market. More broadly, our capital allocation policy hasn't changed. So we're still focused on returning capital to shareholders, managing our balance sheet well, and then making the investments and potentially any strategic acquisitions we believe will help grow the fundamental business.

Chuck Rubin -- Chairman and Chief Executive Officer

And just to address your point about valuation, our valuation yesterday, when were, whatever, $22.00, was, we believe, dramatically low. And we think our opening today is laughable at how low it's gone. So we're a company that generates better than $800 million of EBITDA, $500 million of cash, so we think that the stock price is an incredibly attractive opportunity right now.

Christopher Horvers -- JP Morgan -- Analyst

So are you no longer precluded from being in the market?

Chuck Rubin -- Chairman and Chief Executive Officer

I think we'll leave it at what Denise said. We were, during the quarter, precluded from acting upon that. But our philosophy about capital allocation hasn't changed and I think best we leave it at that, Chris.

Christopher Horvers -- JP Morgan -- Analyst

Thanks very much.

Chuck Rubin -- Chairman and Chief Executive Officer

Thank you.

Operator

The next question comes from Steve Forbes of Guggenheim Securities. Please go ahead.

Steven Forbes -- Guggenheim Securities -- Analyst

Good morning.

Chuck Rubin -- Chairman and Chief Executive Officer

Morning, Steve.

Steven Forbes -- Guggenheim Securities -- Analyst

So you briefly mentioned the FMA layout conversions, but can you expand on how the 425 existing layouts performed relative to the chain average in the first quarter, especially as we think about kind of Easter and that time period in general? And then maybe just touch on any plans to address the remaining 50% of the base over some sort of time period, whether it's intermediate or longer term.

Denise Paulonis -- Chief Financial Officer

Yeah, Steve, we were very pleased with the performance of the FMA pads in the first quarter. If I take you back a little bit in history, both Q3 and Q4 last year saw an outperformance of the stores that did have the FMA pad versus those that did not. That did continue into the first quarter. So while we had a little bit of a bumpy road when we first made the transition and our customer had to adjust to where other items might have been moved in the store, we have seen a benefit now that we've kind of cycled that challenge with the customer.

With the next set of stores we're doing, we actually came up with a little different way to move the product in the store that actually will have less disruption to the positioning of core categories in the store. So we think that there's a more smooth transition that will happen as we convert that for our customers. And doing it now to really set us up for the timing for the back half of the year and the way that it can benefit seasonal is what we're focused on.

Your other question was about the ability to do more of the chain. When we get these 235 stores done, we'll have about half the chain converted. If the program continues to work, we'll continue to roll it out where it makes sense. But that said, there will always be some constraints as to where it rolls out. As you know, we have a bit of a snowflake in terms of our box size and so there are some stores that just won't accommodate it. There will also be other stores where it's cost prohibitive to get it done and we will be smart in making those choices to not roll it beyond where we believe we'll see the return from having done it.

Steven Forbes -- Guggenheim Securities -- Analyst

Thank you. And just a quick follow-up. If you can update us on your efforts to bring e-commerce distribution in-house and maybe just help us understand how that impacts the model from a cadence perspective. So how did it impact the first quarter and how should we think about the gross and net impact throughout the rest of the year? Thank you.

Denise Paulonis -- Chief Financial Officer

So our plans are on track. We are both doing the work in our DC in Alliance here in Texas to be able to in-source that product, as well as the technology work associated with being able to manage the order flow. So we are on track with what we expected. We'll have an opportunity as we get to the back half of this year to be able to test and prove out the system works. But in the fourth quarter, we will still be reliant upon our third-party provider to actually deliver for our customers for the holiday period. We will not have the facility online until 2019. And in 2019 is when we start to see the benefit. So we anticipate that our ability to better control those shipments for our customers should hopefully provide for a better customer experience and our ability to absorb it in-house, where we will have a bit of fixed costs that we will be able to leverage as volume increases over time, we think are both wins for us.

Steven Forbes -- Guggenheim Securities -- Analyst

Thank you.

Operator

The next question comes from Mike Baker of Deutsche Bank. Please go ahead.

Michael Baker -- Deutsche Bank -- Analyst

Hi. Thanks. I wanted to ask about your sourcing initiatives. I think your guidance was for $40 million in benefit this year. Is that still the plan?

Denise Paulonis -- Chief Financial Officer

That is.

Michael Baker -- Deutsche Bank -- Analyst

So still on track for $150 million over the three-year period.

Denise Paulonis -- Chief Financial Officer

Correct. And the $40 million, as you'll remember, we still anticipate that that'll flow with the cadence of sales flow through the year as we've seen in the prior year and a half of the benefits we've seen through.

Michael Baker -- Deutsche Bank -- Analyst

Okay. That makes sense. Thanks. A couple of bigger picture questions. I think, Chuck, you had said that the industry is not expanding. I'm wondering can you talk about the trend? Is that similar to what you saw last year or the end of last year or has something happened such that the industry growth or lack thereof has actually slowed this quarter? Or is it just sort of still the same sort of flat-ish industry?

Chuck Rubin -- Chairman and Chief Executive Officer

Mike, I think it's not a change. It seems to be a trend that has been for the past number of quarters. And, again, we've talked about this publicly before. There's no third-party data that's very reliable. There's no MPD, for instance. We base this on a whole bunch of data points. Remember, to start with, we go to market with a number of nameplates that the customer doesn't necessarily understand are connected. So you do get kind of independent verification. So between Michaels, Pat Catan, Aaron Brothers, consumercrafts.com is another one of our websites, we have that data. We also have data from Darice, who is selling into wholesale accounts, including both brick-and-mortar and online, in this industry, in this big box industry as well as other types of players. Remember, this is an incredibly fragmented industry.

All these data points continue to show that it's just a flat-ish kind of industry right now. There is not a hot product that's moving the overall industry. And the enthusiast is carrying it but the more casual customer is proving to be a bit more problematic. So it's nothing that we see that's worsening but it has been ongoing for the past number of quarters. When that more casual customer is in the market, like during the big holiday time frames in the back half of the year, you've seen we do much better. But in the front half when, as Denise said, there isn't that natural motivating calendar event, that's where the sluggish manifests itself more so.

Michael Baker -- Deutsche Bank -- Analyst

Okay. One more, if I could, just to follow up on something you said. If you're seeing from your wholesale business trends in both online and other brick-and-mortar retailers, can you sort of differentiate what you're seeing in growth or lack thereof in those two channels? In other words, is online growing and brick-and-mortar shrinking industrywide according to your data points?

Chuck Rubin -- Chairman and Chief Executive Officer

Well, e-commerce is clearly growing because it started from such a small base. It's like our business. So we had significant percentage growth in our online sales in Q1, as we expected to, and we're seeing growth from other online players as well. But it is still an incredibly small part of the overall industry. This is still a brick-and-mortar based industry. So, as I mentioned before and we've mentioned many times before, it's a very fragmented industry. You've got a lot of players out there. As Denise said, we're seeing good progress in our wholesale accounts.

And what's happening is you've got some new players coming in, not with the full breadth of what we sell, but picking off little pieces of the assortment from one department or another department because the margin structure is so attractive. You're seeing some of that happen in the mass market. So that's more of what's happening than online repositioning how the customer is shopping. You're seeing just new players who are skimming some high-margin categories start to play in this space a little bit more.

Michael Baker -- Deutsche Bank -- Analyst

Thank you. Appreciate the color.

Operator

The next question will come from Simeon Gutman of Morgan Stanley. Please go ahead.

Simeon Gutman -- Morgan Stanley -- Analyst

Thanks, everyone. My first question is a follow-up on the second quarter guidance. You mentioned it's not materially different than you planned. Can you discuss if that's on both the sales and the margin line? And then related, I don't know if you mentioned how much disruption you're planning on the sales line from some of the FMA changeovers.

Denise Paulonis -- Chief Financial Officer

So, Simeon, there's no material difference from the beginning of the year on the sales line nor on the operating income line. I'll address operating income first and then come back to sales.

On the operating income line, as we attempted to communicate but perhaps we didn't do it as clearly as we could have, the investment that we are putting forward associated with the tax reform is extra weighted to the first half of the year and the second quarter includes the cost of executing the FMA conversions. So there is more incremental expense in there than you might have anticipated. The other piece that, for us, remains real in the second quarter is the continued -- the end of the flow through of these increases in our Jacksonville DC costs from the end of last year. I know it sounds like Q2 is a far part away from Q3 and Q4 last year, but given our inventory only turns twice a year, we still bleed off some of those costs into the second quarter of this year. So we had always anticipated those, as well as the sourcing goodness, in the numbers that we put forward.

And then on the sales front, we always know that Q2 is a lighter volume quarter. We anticipated that. The amount that we've built in for the disruption for FMA we think is appropriate but it is not a big number on the quarter.

Chuck Rubin -- Chairman and Chief Executive Officer

Let me just reinforce this. Q1 and Q2, both how Q1 unfolded and what we're forecasting for Q2, is very much aligned to what we saw when we gave guidance for the full year. We don't give quarterly guidance except the upcoming quarter. So the dislocation between estimates on the street and what we're now saying on Q2 is disappointing to us but we haven't changed anything for the full year and nothing has changed in terms of our operating view.

With that said, as we've said a number of times on this call, we wish our business, our top-line, was better and we're working incredibly diligently to make it better. But that's all reflected in the guidance that we have. But what's unfolded by quarter is very much in line with what we've said before. And if you think about the comp guidance for Q2, we've described it as flat-ish. It's a $1 billion quarter, so a move of sales of $1 million here or $1 million there moves it by a reportable amount. So to Denise's comment, everything that we see in this quarter, including the FMA set, is reflected in the guidance but we still feel very good about our plans for the back half of the year and feel as confident today as we did when we gave the guidance for the year, that the year will turn out as we believe it will.

Simeon Gutman -- Morgan Stanley -- Analyst

Got it. Okay. And my follow-up on the $23 million of investment, I think, from tax savings and reinvestment back in the business, did you say or can you say how much was spent in the first quarter? And then unrelated, what percentage of the custom framing business has been touched by these new selling approaches? I think not the full chain, if I'm not mistaken, which means by the back half, you should be fully up to speed.

Denise Paulonis -- Chief Financial Officer

So let me answer in reverse order. So the custom framing approaches that we've adjusted, there's two different pieces of what we've adjusted. There's one piece that affects the entire custom framing world, all of our stores, which will be where we made some changes to both the assortment as well as the pricing structure last year. What we really focused on was giving the customer a better ability to match her budget when she came into the store by there being more elements of price tiers than what she had before. So she can get closer to her ideal price point. That part is affecting all of our chain.

For the piece that we've done, which is a bit of a new management approach and a bit more focused on a selling system and how we think about interacting with the customer and the incremental district manager support role that we've put into place, that affects about half of the chain. It is in more dense markets where you will see that because there's efficiency in being able to roll out that level of coverage. But, all in all, we do believe that both sets of changes are very positive for the custom frame business and we were pleased to see good comp results in the first quarter.

On your other comment on investment, we aren't gonna break out by quarter exactly how much fell in the quarter. I would just reiterate that disproportionately weighted to the full first half. The second quarter is a bit higher than the first quarter. There will be some expense in every quarter, just because some of these are continuing initiatives that will roll through the year.

Chuck Rubin -- Chairman and Chief Executive Officer

And, Simeon, I'm not sure if I misunderstood part of your question. The changes in the management structure that Denise touched on for the roughly half the chain that it has been implemented, that will be the extent that we go for this year. We do not anticipate going to the rest of the chain this year. It's still relatively new. It needs to get settled in. We'll learn some things from it. We hope to extend it next year, into 2019, but don't anticipate this year extending beyond the half of the chain.

Simeon Gutman -- Morgan Stanley -- Analyst

Okay. Great. Thanks.

Operator

The next question comes from Zach Fadem of Wells Fargo. Please go ahead.

Quinn Burch -- Wells Fargo -- Analyst

Hi. This is Quinn Burch on for Zach. My question is around -- so Etsy announced today that they're raising their transaction fee for sellers on their website. And I know your marketplace is very early days but have you thought about your market positioning relative to Etsy and how you plan to go to market with respect to your fee structure, as well as leveraging your core Michaels offerings?

Chuck Rubin -- Chairman and Chief Executive Officer

Yeah, it's really early. We haven't launched our marketplace. We're working on it. So when we launch it, we'll talk more about it. Marketplace is an attractive space for us. Clearly a lot of people who are selling on marketplaces today are buying the pieces and the parts that they're using at Michaels so we do see goodness from that. But as we launch it in 2019, we'll talk more about the specifics behind the fees, etc.

Quinn Burch -- Wells Fargo -- Analyst

Great. Thank you.

Operator

The next question will come from Elizabeth Suzuki of Bank of America. Please go ahead.

Elizabeth Suzuki -- Bank of America Merrill Lynch -- Analyst

Great. Thank you. Where do you see the biggest opportunities right now to grow your product offering? I think you mentioned that new players are getting involved and skimming some high-margin categories but what do you think are the categories that you can skim that you aren't as involved in right now?

Chuck Rubin -- Chairman and Chief Executive Officer

Well, we carry a big portfolio. I think there are some things that we could skim. I'm not sure I'd describe it as skim. I think there are things that we can delve into, both from a product standpoint and a positioning standpoint. So, for instance, we have launched fabric online. So we bought the Hancock Fabric trademark a year or two ago. We have launched fabric online. Still a small part of our business but growing nicely and we're pleased with how that's going. That's a new business that we really haven't been in. we're big believers in this celebrations space. So between our seasonal business, Christmas, Halloween, as an example, and the efforts that we have around Martha Stewart party and celebration, we think there's something we can go much bigger and better on with that.

Kids, certainly there's a disruption in the kids space. We're not a toy retailer. We tend to skew toward the educational side of the kids space. But clearly, with the Toys R Us disruption, there's business to be had out there and we're playing for our fair share of it. The nice thing about our business is in the creativity world, lots of things can apply, in both adding some categories and then going deeper in some categories. But, importantly, what I said earlier, making it more convenient for the customer, providing a solution, like we're doing with wedding, with all the different things you need to plan your own wedding, that's the opportunity that I think we can tap deeper into.

Elizabeth Suzuki -- Bank of America Merrill Lynch -- Analyst

Great. Thank you. And I think in last year's Investor Day slides, you had a stat that 55% of your customers only have one transaction per year and 65% spend $50.00 or less per year at Michaels. So how can you drive that to two transactions or three and drive higher revenue per customer? What do you think are the biggest levers you can use to improve customer frequency from a merchandising and marketing standpoint?

Chuck Rubin -- Chairman and Chief Executive Officer

Well, we could talk for an hour on that. But in simple form, I keep coming back to some core pieces of what we do. There is nobody in this industry that does trend better than us. And it's not simply a grand slam trend, it's trend, whether it's color, fabrication, highlighting something. As I've described before, it's tough to find the grand slams. There's always singles and we've got some singles out there. We do that better than anyone.

Value is core to the customer. We have made progress in how we project value but we have an opportunity to do it better. It is a confusing scenario, given how discount-oriented this industry is. So we continue to make some progress on that.

But convenience. If you're an enthusiast and you make jewelry, you bake, you knit on a regular basis, we're seeing very health positive comps with that customer. But this casual customer is proving to be more elusive and that's where shopping at an arts and crafts retailer can be intimidating because there's a lot of products and a lot of things that I have to put together. It's kind of an infinite array of options.

So you go back to all the things that we've talked about, whether it is our app, where you can take a picture of a product or a project and it will search our files, it will come back with what products you need to make that project and the aisles that you can find it in your local store, if you want to go to the store, or you can buy it online. BOPIS, to make it easier. All of these things are focused on, certainly the enthusiast, but that casual customer, to show her that making the trip to Michaels warrants the extra trip from the mass retailer that she may have been in.

And these are things that, for the most part, we are either unique in doing them -- for instance, our app with visual search is unique in this industry -- or we're just much better at it. The capability is more advanced and it's easier to use than a lot of our competitors. So we're incredibly focused on doing this. We are frustrated that it's taking more time to win this customer over but we're absolutely convinced that, given our strength and scale, we will be the winner over time.

So, with that, I appreciate everybody joining us this morning. I would leave you with just a comment to remember the position of financial strength that Michaels has. We are the industry leader with healthy operating margins, strong cash flows, and high returns on invested capital. With an eye to the long-term opportunity, we are accelerating our planned investments to drive future sales and earnings growth. And while this acceleration is pressuring operating margins in the first half of fiscal '18, I am confident these investments will position us to increase our market share and expand our leadership in the arts and crafts channel while driving additional sales and margins.

I want to also thank our 50,000 plus team members across the United States and Canada, as well as China. And, with that, we look forward to updating you on Q2 at the end of the summer. Thank you.

Operator

The conference is now concluded. Thank you for attending today's presentation. You may now disconnect your lines. Have a great day.

Duration: 62 minutes

Call participants:

Kiley Rawlins -- Vice President of Investor Relations and Communications

Chuck Rubin -- Chairman and Chief Executive Officer

Denise Paulonis -- Chief Financial Officer

Seth Sigman -- Credit Suisse -- Analyst

Matthew Fassler -- Goldman Sachs -- Analyst

Christopher Horvers -- JP Morgan -- Analyst

Steven Forbes -- Guggenheim Securities -- Analyst

Michael Baker -- Deutsche Bank -- Analyst

Simeon Gutman -- Morgan Stanley -- Analyst

Quinn Burch -- Wells Fargo -- Analyst

Elizabeth Suzuki -- Bank of America Merrill Lynch -- Analyst

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