The Michaels Companies, Inc. (MIK) Q2 2018 Earnings Conference Call Transcript

The Michaels Companies, Inc. (MIK)
Q2 2018 Earnings Conference Call
Aug. 30, 2018, 9:00 a.m. ET

Contents:

• Prepared Remarks
• Questions and Answers
• Call Participants

Prepared Remarks:

Operator

Good morning. My name is Nicole and I will be your conference operator today. At this time, we'd like to welcome everyone to the Michaels Companies Second 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 Communication. Ms. Rawlins, you may begin the conference.

Kiley F. Rawlins -- Vice President of Investor Relations and Communication

Thank you, Nicole. Good morning, everyone, and thank you for joining us today. Earlier this morning, we released our financial results for the second 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 made 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, August 30th, 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 agreements and adjusted operating income, adjusted net income, and adjusted diluted earnings per share, all adjusted for the restructure charge, losses on early extinguishments of debt and refinancing costs, and provisional tax adjustments as applicable. A reconciliation of these measures to the corresponding GAAP measures are detailed in today's earnings release.

We'll begin this morning with highlights from Chuck Rubin, Chairman and CEO, and then Denise Paulonis, our CFO, will review our financial results and outlook in more detail. Following our prepared remarks, we will open up the call for questions. Now, I'd like to turn the call over to Chuck Rubin. Chuck?

Carl S. Rubin -- Chairman of the Board and Chief Executive Officer

Thank you, Kiley, and good morning, everyone. As we've discussed for a few quarters now, all of our data continues to suggest that the growth trends in core arts and crafts products remain soft. Despite this challenging environment, we delivered operating income and EPS for the second quarter that were slightly better than the guidance we provided in June. Before we dig into the specific results for Q2, I want to talk about what we're seeing in the arts and crafts industry, as we know our recent comp performance hasn't been as robust as other retail industries.

As I've said before, it's difficult to get real-time industry data, and while we're the only public company in the space, we believe sales trends for our big-box arts and crafts competitors have also been stagnant. When we triangulate what we're seeing in our own retail direct-to-consumer brands, what we're seeing in our wholesale business, which sells across mass online and dollar channels, and what we're hearing from suppliers, the data suggest that the core arts and crafts industry isn't currently growing total sales, and while other retail industries have seen consolidation of distribution points and/or store closings, we know the distribution points for arts and crafts product supplies are increasing. This is something we anticipated, which led us to acquire Lamrite West two years ago.

Today, all of the arts and crafts big-box players go to market in a similar way, with almost a singular focus on product and price, and yet, we know that consumers in general are demanding more of a solution-based approach. We have done well with the enthusiast maker, and the investments we have made in omnichannel, CRM, and our store layouts have given us more capabilities and a stronger foundation for growth. Our success with this customer continues, as we saw good sales growth in Q2.

However, our success with the more casual customer has not been as robust and consistent, and we recognize that this customer may want a solution that is more of a do-it-for-me or do-it-partially for-me instead of our historical focus on a do-it-yourself offering. We know the foundation we have built -- one that includes industry-leading private brands, a large brick and mortar footprint, and emerging digital capabilities -- is a strong one for the future. However, we also recognize that we need to consider some adjustments to our long-term strategy as it relates to how we think about attracting and retaining more casual customers when there isn't a hot trend to engage their interest. We are confident that our strategic foundation is strong, but do expect to make some slight enhancements to better position us for this casual customer, and we will continue to update you.

Now, let's talk about our Q2 results in a little more detail. Comparable store sales for the quarter decreased 0.4%, driven by a decrease in customer transactions, partially offset by an increase in average ticket. Importantly, our sales trend improved as the quarter progressed, reflecting better merchandise in-stocks and enhanced omnichannel capabilities. On a calendar-shifted basis, comp sales increased 0.3%.

We delivered very strong e-commerce sales, driven by enhanced searchability and an expanded assortment. While still a very small part of our total revenues, online sales in the quarter were more than double the level of online sales in the second quarter last year, driven by increased traffic and higher conversion rates. For reference, our online sales include buy online, pick up in store, commonly known as BOPUIS. From a category standpoint, seasonal, décor, custom framing, technology, and craft storage delivered strong comp store sales growth while other more traditional arts and crafts categories like jewelry and bakeware underperformed.

From an investment perspective, we made good progress in executing our priorities in the second quarter. We successfully converted 238 stores to our flexible merchandising area -- or FMA -- format. This year, we simplified the reset process and reduced the number of impacted categories, making it less disruptive for the customer and easier for our teams to implement. While it's only been a few weeks since the conversion was complete at all stores, these stores are already outperforming the control group.

We rebranded all of our Michaels Custom Framing shops as Aaron Brothers Custom Framing at Michaels. We've seen good sales transference from the closed Aaron Brothers stores and believe we have opportunity to capture more. We upgraded our Canadian POS system and introduced Michaels Rewards to our Canadian customers.

Leveraging our CRM data and new POS capabilities, we tested targeted messaging in serialized offers with encouraging results. We expanded the number of stores in our ship-from-store program. We now have more than 400 stores ready to fulfill e-commerce orders this holiday season, enabling us to leverage store-level inventory, deliver online orders to customers faster, and better control our fulfillment costs. Overall, we anticipate that BOPUIS and ship-from-store could enable almost half of our online sales this holiday season.

Finally, we also completed the retrofit of our Alliance Distribution Center to support the insourcing of our Michaels e-commerce business, giving us the foundation to pick, pack, and ship items to fulfill a customer order. While we won't shift away completely from our third-party provider this year, we will begin to ramp up service from our Alliance DC as an additional fulfillment node to support expected growth this holiday season.

Finally, recognizing that the second quarter is the smallest fiscal quarter for us, we chose to test a number of different promotions as we get ready for the large-volume weeks and months in the second half of our fiscal year. Some of these tests met our expectations; some did not. Net-net, we got smarter, but we saw increased pressure on our merchandise margin in the quarter.

While we are only a few weeks into the third quarter, we are encouraged by recent sales results, and we are confident that our focused efforts to make it easier for customers combined with what I think is an outstanding seasonal assortment will deliver stronger trends in the second half of the year.

Toward the end of the first quarter, we introduced BOPUIS in all our U.S. stores to make it easier and more convenient for customers to shop. We are pleased with how our teams are executing and how well our customers are responding to this new convenience. About a third of our e-commerce sales in the second quarter were picked up in stores. We're also pleased with the trend of add-on purchases when customers come to the store to pick up their e-commerce order.

We continue to enhance the Michaels app to make it easier for customers to find what they need in our stores. In the first quarter, we added visual search capabilities to enable customers to use their smartphone camera and pictures to search our library of products and projects. This quarter, we're launching verbal search to make it easier for customers to search for what they want, and we're beginning to leverage messaging in the Michaels app to highlight current promotions when the customer uses the app in-store.

We know kids are a big trip driver for the casual customer, so we are making it easier for customers to find family friendly toys, activities, and supplies at Michaels. Our goal is to be the preferred destination for screen-free creative play. Taking an omnichannel approach, we are rebranding our in-store presentation and launching a new microsite called michaelskids.com. With more than three times the number of in-store SKUs, michaelskids.com will offer customers an expanded breadth of what we offer in stores as well as new categories that inspire creativity and imaginative play. To make it easier to shop our online assortment, customers can search by category or age, and similar to michaelsweddings.com, customers can use Michaels coupons, utilize an integrated shopping cart, leverage BOPUIS, or take advantage of free shipping on thousands of items.

In stores, we are adding 600 new SKUs and are resetting the Kids category to create more intuitive product adjacencies based on a specific shopping mission. We've added a new basic craft section and expanded our assortment of compounds, STEM kits, and national brands like Lego. We've created a new school project section to include everything a parent needs to create a diorama or foam solar system, and for teachers, who represent nearly 4% of our customers and an even greater percent of our sales, we've launched a new classroom décor program and an expanded assortment of storage.

Building on the improvements we've made in custom framing, in the second half of fiscal 2018, we will add new capabilities to make it easier for customers to custom-frame their pictures and artwork. On aaronbrothers.com, we're offering new substrates to print on, including wood, metal, and acrylic, and we have introduced BOPUIS for custom framing so customers can pick up their projects in their local Michaels store. In stores, customers will be able to upload pictures from their smartphones into our proprietary design system, where one of our personal custom frame designers can work with them to create a custom frame.

We remain focused on strengthening our value perception. Customers continue to respond well to our everyday value or EDV program, which delivers great prices on basic crafting items every day without the need for a promotion. Based on customer response, we have expanded this program. Today, our EDV program includes nearly 1,500 items across multiple categories and continues to drive nice sales and gross profit dollar growth. In stores, we've recently created new merchandise stackouts to highlight key basic items like bulk canvas or wood crates at clear, sharp prices. We've also expanded our assortment of bulk buys, both in stores and online.

We know from our customer analytics that our casual customers, who generally only shop us once or twice a year, are more likely to shop us in the third or fourth quarter, when seasonal décor, school projects, and holiday are more likely to drive trips. This year, we have expanded our seasonal assortment and presentation, both in stores and online, and made it easier for all customers, whether they are enthusiasts or novice makers, to find and get what they need. Each year, we have improved our holiday assortment, and this year, we have the biggest and best holiday assortment we've ever offered the customer, and with more than 700 stores leveraging the flexible merchandising area format, we will be positioned to present stronger, more cohesive seasonal statements to customers in more stores this holiday season.

Starting with fall and Halloween, we've expanded our offering of home décor, adding new exclusives from Lemax and Martha Stewart, and introduced our compelling even-dollar price points throughout the store to create a compelling value message. For holiday, we've again expanded our selection of trees, ornaments, and home décor, all with clear, even-dollar price points to reinforce value, and we've simplified our in-store presentations to make it easier for customers to shop.

Online, all the enhancements we've made this year to michaels.com to improve navigation and discoverability combined with the assortment expansions like Hancock fabric, bulk buys, michaelsweddings.com, and michaelskids.com help us deliver more convenience and value for the customer this season. The addition of BOPUIS in all stores gives us another way to make it easier for customers during this busy time of the year.

To communicate our compelling seasonal assortments and the benefits of all the customer-facing investments we've made, we have strong marketing support planned for the second half of the year. We are not increasing our overall marketing spend, but are shifting dollars away from traditional print circulars to other media, including television and digital, to target customers better. We plan to increase our use of television advertising to support key events like our lowest price of the season and holiday. We will continue to use mass-market platforms like Good Morning America, and we will offer more digital content, including new make-ops with Busy Philipps, new videos with Martha Stewart, and more Facebook Live videos to highlight our assortment and how easy it is to make with Michaels. In addition, we have produced new décor guides for fall and holiday as well as a new kids-focused gift guide, and we will offer even greater value to our customers through a number of new "gift with purchase" offers.

Finally, we will leverage our extensive CRM capabilities to target our messaging and drive sales and traffic. Today, we can link 74% of our transactions and 83% of our sales to a unique customer. Through our expanding customer analytics, we are starting to identify specific customer insights and will continue to improve in using these insights to target customers with more personalized, more effective communications based on their previous shopping habits and preferences.

In closing, while comps for the first half of the year were flat, we remain confident our trend will improve in the second half. We have an outstanding seasonal assortment with strong marketing support, we will have more omnichannel platforms to meet customer needs, including michaelsweddings.com, michaelskids.com, and enhanced offerings on michaels.com and consumercrafts.com. We have BOPUIS in all stores, offering customers an easy and convenient way to shop. We have more than 700 of our stores with the flexible merchandising area format as we head into the most important seasonal period of the year.

We have more EDV items, more clear, even-dollar price points, and more bulk buys to reinforce the value we offer. We have stronger CRM capabilities to target our customer communications. We have 50,000 engaged team members who are excited to help make it easier for our customers this holiday season. We are encouraged by recent sales trends and believe the investments we have made this year to make Michaels easier to shop will help us deliver our revenue and earnings expectations for the second half of fiscal 2018. Now, I'll turn the call over to Denise for a more detailed discussion of our second-quarter financial performance and outlook. Denise?

Denise A. Paulonis -- Executive Vice President and Chief Financial Officer

Thanks, Chuck, and good morning, everyone. Starting with sales, net sales for the second quarter were $1.05 billion, $19 million less than net sales in the second quarter last year. After considering the $27 million decrease in sales related to the closure of 94 full-size Aaron Brothers stores in the quarter, total sales increased $8 million and comp store sales decreased by 0.4%. The ex Aaron Brothers sales increase was driven by the operation of 21 net additional Michaels stores opened since the second quarter of fiscal 2017 and an increase in wholesale revenues.

As a reminder, fiscal 2017 was a 53-week year, and we are not restating our comp sales reporting periods. In other words, our Q2 comp sales reflect the comparison of April 30th through July 29th last year versus May 6th through August 4th this year. As Chuck mentioned earlier, if we compare the 13-week period ending August 4th this year to the comparable 13-week period ending August 5th last year, comp store sales would have increased 0.3%.

During the quarter, the company opened nine new Michaels stores, closed one Michaels store, and relocated seven Michaels stores. I want to note that included in the count of new Michaels stores are three small-format Aaron Brothers stores, which have been integrated into the Michaels stores organization, so at the end of the quarter, we operated 1,251 Michaels stores and 36 Pat Catan stores.

Gross profit was $373 million compared to $403 million in the second quarter of fiscal 2017. As a percentage of sales, our gross profit rate for the quarter was 35.4% versus 37.5% last year, a decrease of about 210 basis points. Similar to what we saw in Q1, the decrease as a percentage of net sales was primarily due to expected factors, including higher distribution-related costs and occupancy costs deleveraged. In addition, we saw merchandise margin pressure from higher promotional activity and a higher mix of technology products, which generally have lower merchandise markets.

As Chuck discussed, we saw an opportunity to test different promotional vehicles during the quarter to help us learn more about what motivates our customers. Partially offsetting these factors, our sourcing initiatives continued to deliver a nice benefit. As we discussed last quarter, we recognize supply chain costs when product is sold. The expected increase in distribution-related costs in Q2 reflects the remaining flowthrough of higher supply chain costs incurred in the second half of fiscal 2017 related to the hurricane disruption to our Jacksonville DC as well as higher transportation costs, reflecting tighter overall capacity and higher spot rate.

Total store rent expense for the quarter was $101 million versus $98 million last year. The increase in store rent expense was primarily due to a net 21 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 $302 million or 28.7% sales, compared to $315 million or 29.3% of sales last year. The decrease in SG&A was primarily due to an $11.5 million decrease in performance-based compensation and a $9 million decrease in expenses related to the closure of 94 full-size Aaron Brothers stores. The decrease was partially offset by $4 million in higher marketing expenses in the quarter resulting from increased digital marketing, partially offset by a decrease in print advertising. For the full year, we continue to expect advertising expense will be approximately flat as a percentage of sales.

Regarding performance-based compensation, we are lapping some timing differences in the second quarter and third quarter of last year related to our bonus accrual. For the full year, we expect performance-based compensation will be comparable to last year. However, in Q2, performance-based compensation was a benefit to SG&A compared to last year, and in Q3, we expect it will be more of a headwind.

Operating income was $74 million compared to $88 million in the second quarter of last year. During the quarter, we recognized a $3 million gain, primarily related to the settlement of lease obligations associated with the closure of 94 full-sized Aaron Brothers stores in the first quarter. Excluding the $3 million gain, adjusted operating income for the quarter was $71 million.

Interest expense increased $6 million to $37 million from $31 million last year due to higher LIBOR rates associated with our variable-rate term loan, as well as settlement payments associated with our interest rate swaps. Recall that early in the second quarter, we amended our term loan to reduce the interest rate to LIBOR plus 2.50% from LIBOR plus 2.75%. As a result of this transaction, we recognized a loss on the early extinguishment of debt of approximately $2 million in the quarter.

The effective tax rate was 24% compared to 36% in the second quarter of last year, primarily due to a reduction of the federal tax rate in connection with the enactment of the Tax Act. Net income was $27 million or $0.15 per diluted share compared to $36 million or $0.19 per diluted share in the second quarter last year. Excluding the gain related to the settlement of lease obligations associated with the closure of 94 full-sized Aaron Brothers stores and the losses on early extinguishments of debt and refinancing costs, both net of taxes, adjusted net income was $26.4 million or $0.15 per diluted share.

Diluted weighted average common shares during the quarter were 178 million shares compared to 188 million shares last year. During the quarter, we entered into an accelerated share repurchase agreement, commonly referred to as an ASR, to purchase approximately $250 million of our common stock. Pursuant to this agreement, we paid $250 million and received an initial delivery of approximately 10.7 million shares. We expect the final settlement of the ASR transaction, including a receipt of the remaining shares, will occur in the third quarter. Once the ASR is complete, we expect to have approximately $100 million remaining under our current share repurchase authorization.

As expected, total merchandise inventory at the end of the quarter increased 7% to $1.28 billion compared to $1.2 billion last year. The increase in inventory was primarily due to inventory associated with the operation of 21 net additional stores and increased inventory to facilitate stronger in-stocks and better inventory flow for the holiday season. As we discussed last quarter, we pulled forward some core item receipts into the second quarter to smooth out the flow of freight into stores for the holiday season. The increase was partially offset by a decrease in inventory related to the closed Aaron Brothers store.

Average inventory per Michaels store including inventory for e-commerce, inventory in distribution centers, and inventory in transit was 6.6% higher than at the end of Q2 last year. We continue to expect inventory at the end of Q3 will be back to a more normal level. We ended Q2 with $123 million in cash on our balance sheet and $645 million available under our revolver. Total debt at the end of the quarter was $2.8 billion. Our total debt to adjusted EBITDA on a trailing 12-month basis was 3.3x and our trailing 12-month interest coverage was 5.1x. Our return on invested capital adjusted for the restructuring charge for the trailing four quarters was approximately 27%, well above our cost of capital of approximately 6%.

Capital expenditures year to date through the second quarter totaled $70 million, reflecting increased 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.

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

So, let's start with the full year. Our expectations for comp store sales growth have not changed. However, we have increased our full-year EPS guidance by $0.10 to reflect three changes. First, higher-than-anticipated distribution-related costs, which we anticipate realizing primarily in the third quarter. We expect this will negatively impact full-year diluted EPS by about $0.04. Second, a lower effective tax rate, which we expect will benefit full-year diluted EPS by about $0.02. And third, the estimated full share impact of the ASR, which we expect will benefit full-year diluted EPS by about $0.12.

Let me take a minute to talk about our expectations for distribution-related costs. While we initially contemplated $10 million to $15 million in incremental transportation expense in fiscal 2018 related to increased international rates and higher domestic carrier rates, we are seeing additional pressure from rising fuel cost and increased small partial shipping costs as well as more impact from higher domestic carrier rates than we originally planned.

In addition, as we've moved higher levels of inventory through our system to facilitate better in-stocks and inventory flow, and also managed key supply chain initiatives including the retrofit of our Alliance Distribution Center to support e-commerce fulfillment, we've incurred higher-than-planned DC and transportation costs. We now expect distribution and transportation costs will be approximately $10 million or $0.04 per diluted share higher than our initial expectations for fiscal '18.

With that as context, for fiscal 2018, a 52-week year, we continue to expect total sales will be between $5.2 billion and $5.3 billion, and comp store sales will be flat to up 1.5%. This guidance includes our plans to open 19 net new Michaels stores and relocate 21 Michaels stores. We expect adjusted operating income for the year will be between $667 million and $700 million. As a reminder, this guidance includes a temporary headwind of $23 million of investment to support longer-term profitable growth facilitated by the tax reform benefits. 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.

We continue to receive additional clarification on the Tax Act, and now estimate that our go-forward effective tax rate will be closer to 23% compared to the 24% we had previously estimated. However, our effective tax rate may differ from this estimate if there are changes in interpretation or additional guidance issued related to the Tax Act.

All of these assumptions translate to an adjusted diluted EPS range of $2.29 to $2.42 for the fiscal 2018 on approximately 176 million diluted weighted average common shares for the full year. This expectation for the share count includes the anticipated full impact of the ASR, which will settle in the third quarter, but does not include the impact of any additional shares we may repurchase this year.

For the third quarter, we expect comp store sales will increase between 1.5% and 3%. As a reminder, we have not restated last year's comp store sales reporting periods to align with this year's calendar, so our Q3 comp this year will reflect the 13-week period ended November 3rd, 2018 compared to the 13-week period ended October 28th, 2017. As a result, sales from the Halloween and our annual holiday tree event, which kicks off on October 28th, will fall into the third quarter this year. Conversely, Q4 comp sales will be negatively impacted by the timing shift.

We plan to open five net new Michaels stores and relocate another five stores in the third quarter. Last year in Q3, we opened seven new Michaels stores, one new Pat Catan store, and relocated four stores. For modeling purposes, Aaron Brothers delivered approximately $25 million in sales in the third quarter last year.

We expect adjusted operating income for the third quarter will be between $131 million and $138 million. For modeling purposes, we expect Q3 gross margin rate will be lower than last year, reflecting higher distribution-related costs and the continued execution of our investment agenda, partially offset by sourcing benefits. Our Q3 guidance for adjusted diluted earnings per common share is $0.42 to $0.45 assuming diluted weighted average common shares of 171 million.

While we're not providing explicit Q4 guidance today, our full-year guidance implies operating margin expansion in Q4 on a comparable 13-week basis. This reflects less incremental spending to support our investment agenda in Q4 and less margin pressure from distribution-related costs than earlier in the year, as we anniversary the flowthrough of higher distribution and transportation costs in Q4 last year. As previously disclosed, the extra week in the fourth quarter last year contributed approximately $79 million in sales and approximately $27 million in operating income.

Before we take questions, I'd like to make a comment about the latest round of proposed tariffs that are scheduled to take effect in October. To this point, the number of SKUs impacted by the first two rounds of China tariffs impacted less than 1% of our cost of goods, so as it relates to fiscal 2018, we don't expect much financial impact. However, the expanded list of proposed tariffs which are scheduled to be implemented in October will impact more of our assortment.

Based on our analysis of the products we currently sell that are manufactured in China, both what we source directly and what we buy from domestic suppliers, we estimate that approximately $400 million of our product costs would be subject to the tariffs as currently proposed. Given the timing of the potential implementation, we expect there will be minimal financial impact to our fiscal 2018 results. However, it's difficult to quantify with certainty their impact beyond this year, as these tariffs have not been finalized. We are closely monitoring the tariff discussions and are actively working on mitigation strategies.

In general, we continue to believe that our size and scale, our sourcing capabilities, the low average item price, and the high penetration of private brands in our assortment gives us a number of levers to manage the impact of commodity increases in tariffs. Our larger concern is the longer-term impact on consumer spending, as consumers will likely have to spend more overall for everyday consumer goods.

In closing, when we started the year, we shared our plans to leverage some of the benefits of tax reform and accelerate our investment into the business. Halfway through the year, we are doing just that, and have delivered operating income at the high end of our guidance and EPS that has exceeded our guidance. As we turn to the second half of the year, we are focused on continuing to execute our plan and look forward to serving our customers throughout our peak selling season. Now, I'd like to open up the call to take questions. Operator?

Questions and Answers:

Operator

Thank you. 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. Our first question comes from Simeon Gutman of Morgan Stanley. Please go ahead.

Simeon Gutman -- Morgan Stanley -- Executive Director

Good morning. It's Simeon. My first question for you, Chuck, is you talked about that through your channel knowledge, the industry looks soft. Curious if you can maybe diagnose why you think it's soft, if customers are just looking elsewhere, other categories, there's just not enough product trend at the moment. Any diagnosis would be helpful.

Carl S. Rubin -- Chairman of the Board and Chief Executive Officer

I think it's a little bit of what you said and more. We do think that it's overall a rather stagnant industry. There is no hot trend. Using the terminology we've used before, we don't see any home runs or triples. There's trends within individual departments that the enthusiast is reacting to, but nothing that's broad-based for the casual customer. As I mentioned in the prepared comments, we are seeing more distribution points. We have -- through our wholesale business -- either opened or expanded a number of accounts. We knew that the high-margin nature of this business would likely make it attractive for others to skim pieces. No one's getting into the full assortment, but people are skimming pieces. So, you have a stagnant industry, more distribution points, and it's causing some challenge.

The other point that I talked about is the segmentation of our customers. We continue to do very well with the enthusiast -- that person who's really into making homemade products, we're doing very well with her. It's the more casual customer, and while we're making progress on some of the convenience aspects to make it easier for her, we're increasingly of the opinion that while some casual customers want a DIY solution, there's certainly a portion of them that are looking for things that have more of a do-it-for-me or a do-it-partially for-me orientation, and I think that's what we've got to step up. As we do that, we think that we'll be able to take some additional business for this casual customer.

Simeon Gutman -- Morgan Stanley -- Executive Director

Okay. And, my follow-up is two parts. First, why do you think growth has rebounded in the third quarter? Is it more of what you're doing, or does the industry seem a little stronger? I realize it's only a few weeks. And then, the second part is on freight. I don't know if we've talked about this in the past, but can you just give us some parameters -- what percentage of your sourcing or distribution is third-party? I think a significant amount. How much you contract versus spot market, the length of your contracts, and then, outside of fuel, what gives you comfort that this won't be a recurring surprise?

Carl S. Rubin -- Chairman of the Board and Chief Executive Officer

Simeon, I'll take the first part, and I think Denise will step in on the second. So, going into the back half of the year, we've seen this movie before in many ways. The casual customer reacts when either there's a need, or a hot trend, or a solution to something that she can do easily. So, right now, our back-to-school business is quite good. We're pleased with how that's going. So, there's that need opportunity, if you will, that she's getting ready for that back-to-school window.

Our seasonal business is kind of that do-it-for-me or do-it-partially for-me solution. It's an easier creative solution when you're decorating your home for Halloween, or for fall, or for Christmas, and we've gotten exceedingly good at that type of business, and it fits with that casual customer. So, our challenge continues to be for us in that casual segment much more in the first half than the back half because we have the natural calendar to help with that casual customer, and it matches with the products and the solutions that we put forth. So, that gives us great confidence. And, the second part, Denise?

Denise A. Paulonis -- Executive Vice President and Chief Financial Officer

Simeon, let me talk about freight a little bit. You asked a lot of questions, so I'm just going to step back one and give the broader view of how we see freight. Up through most of the second quarter of this year, we were primarily using spot rate freight shipments going through, so we did not have dedicated carriers carrying our product, and in general, that has served us quite well in terms of being able to be efficient in how we would go and contract for carriers.

By the end of the second quarter and now coming into the third quarter, we have a dedicated fleet going into place, and so, 80% plus of our volume going forward is going to flow through a dedicated fleet, where, at least, for the cost of the capacity itself, we're going to have much more predictability about what that's going to be than we had through most of Q2 and all of last year.

With that said, there's two other pieces that are also weighing a bit on transportation. First is fuel cost. So, fuel costs are not necessarily built into those contracts associated with the dedicated fleet, so we do still have exposure to fuel costs as they might rise or fall. We continue to look at plans on how we might offset that a bit, but we're still at the mercy of a bit of where fuel costs will go. And then, finally, we have also continued to see pressure on small parcel rates. That shouldn't surprise any of us as that many more things continue to get shipped around the U.S., but we have just gone through a recent negotiation and settled on a set of new rates with our small parcel carriers, so we now have more predictability about what those will be going forward, but they do continue to increase as well. So, hopefully that covers off all the points on freight you were looking to understand.

Simeon Gutman -- Morgan Stanley -- Executive Director

Yeah, thank you.

Operator

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

Steven Forbes -- Guggenheim Partners -- Director

Good morning.

Carl S. Rubin -- Chairman of the Board and Chief Executive Officer

Good morning, Steve.

Steven Forbes -- Guggenheim Partners -- Director

I wanted to focus on the second-half gross margin outlook. So, you talked about the $10 million increased in distribution costs. How much of that hits in the third quarter? And then, as we move to the fourth quarter, should we expect a step change in the trajectory of the gross margin profile? I think the guidance implies that, but I wanted to see if we can get some color here, given the three pressures you called out within the release.

Denise A. Paulonis -- Executive Vice President and Chief Financial Officer

Starting with the third quarter, when we think about the third quarter, most of the increase in the supply chain costs that we indicated we do expect to see come through in the third quarter, and that's a bit of new news compared to the last time we provided an update. More broadly than that, gross margin for the third quarter -- while we don't expect it to be the drag that it was in the second quarter, as we mentioned in our prepared comments, we do still believe that it'll be slightly negative, so that's going to reflect those supply chain costs and some of the continued investments that we're putting through the business, but it's going to be nicely offset by the sourcing benefit, so we still do believe that there'll be a lot of sourcing benefit come through, not only in the third quarter, but also in the fourth.

And then, if you look at where we're trending for Q4 versus Q3, there's a couple of important things that happen. 1). As we mentioned, our $23 million in investments are front-weighted into the year, so those investments are lower in the fourth quarter versus the third quarter, and then, as I mentioned on the call in the script, our third quarter we are also still incurring those higher supply chain costs. As we move into the fourth quarter, we're going to start lapping the increase in cost from last year -- so, from Q4 2017 -- and so, while it's strange to think about it that way, it's actually a bit more of a tailwind versus the headwind that it's been year to date simply because we're lapping those expenses.

Steven Forbes -- Guggenheim Partners -- Director

Thank you. And, just a quick follow-up, maybe for Chuck. You mentioned trying to reengage the casual consumer. So, are there any changes to this year's resets as it relates to holiday? Are you going to bring it in earlier to try to drive engagement with the casual consumer? And then, how do you plan on incorporating some of those promotional tests that you ran this past quarter?

Carl S. Rubin -- Chairman of the Board and Chief Executive Officer

A few things, Steve. The additional FMA pads -- we now have close to 700 stores for the FMA pads, so that is up give or take a third of what -- actually, close to 50% over what we had last year. The FMA pad is an easier pad. It shows seasonal product better than our traditional set, so that's one point. We have tried to simplify our pricing. We have a lot more rounded price points, even price points.

We have stackout programs on higher-velocity items that also are set up in the stores now, so each of these are things that -- from a product standpoint -- we think connect better with a casual customer, and we're also going back and revisiting some of our marketing approach, both in the type of copy that we send out to a customer -- and sometimes, our copy is very attuned to an enthusiast, but not as understandable by a casual customer, so, how we're doing that. And, some of our media shift that we talked about -- we're spending a little bit more money on some mass-market to speak to that casual customer maybe in a different way than a Sunday newspaper tab has been able to do. So, a lot of levers that we're pulling for the back half of this year, and we anticipate there'll be some additional things as we look into 2019 that we'll talk about on a later call.

Steven Forbes -- Guggenheim Partners -- Director

Thank you.

Operator

Our next question comes from Matt Fassler of Goldman Sachs. Please go ahead.

Matt Fassler -- Goldman Sachs -- Managing Director

Thanks so much and good morning.

Carl S. Rubin -- Chairman of the Board and Chief Executive Officer

Good morning, Matt.

Matt Fassler -- Goldman Sachs -- Managing Director

For my first question, I would like to follow up on the comments you made on promotional activity. If you could talk about the timing of when you decided to pursue a stepped-up program, and perhaps talk about the efficacy of the price cuts of the promotions when you chose to talk them.

Carl S. Rubin -- Chairman of the Board and Chief Executive Officer

A good number of them were post our last earnings call. Q2 being a low-volume quarter, getting ready for the higher-volume times later in the year, we thought it was an appropriate time to try a few things. We had a version of our lowest price of the season event that we run in the spring and the fall -- kind of a scaled-down version, but we did something for the summer timeframe. We had another event where we gave out a gift card. So, we tried some of these things, recognizing that the upside or the downside wouldn't be huge, but the learning could be quite valuable for the balance of the year. Net-net, while we learned a lot of things, it was more of a drain than a help on our second-quarter performance.

Matt Fassler -- Goldman Sachs -- Managing Director

So, is that something that you're going to pursue going forward? It sounds like your inclination would be not to continue the promotional program.

Carl S. Rubin -- Chairman of the Board and Chief Executive Officer

Well, I wouldn't say it's a -- I guess in some ways, we stepped up a couple of things, but we were trying to look at different ways of running a promotion with a customer to see how a customer would respond. I wouldn't categorize our approach in Q2 or the industry overall as being a whole lot more promotional than it has been. It remains a very promotional industry. So, these were different ways of trying to attract a customer that -- as I say, we learned a lot, and as we have done in the past, when we've done something that hasn't worked, we don't go back and do the same thing again. We either make an adjustment or we kill it, and that's what I would expect out of those couple of events that we did in the second quarter.

Matt Fassler -- Goldman Sachs -- Managing Director

Thanks for that. And then, by way of follow-up, you mentioned marketing a screen-free program, if you will, for Michaels Kids, and also, we haven't spoken much in the context of Michaels about the Toys'R'Us liquidation, but what was really the headquarters for kids from a consumer perspective is now gone. If you think more broadly about the market opportunity on the kid side -- and, I know kids have always driven lots of your business -- in any event, is there an opening here for you to step into that role for a piece of the mix that toys may have once served?

Carl S. Rubin -- Chairman of the Board and Chief Executive Officer

Yeah. I think a lot of retailers are going to be looking to pick up a piece of it, but our view is our place should be in that creative piece of the kids' industry, so I wouldn't expect for customers to see video games, for instance, from Michaels, but I think our assortment will skew on the younger age of the spectrum. I'll focus more on educational, creative elements of the toy market. It will introduce some brands, like Lego, that we haven't historically carried in the past. So, more along the proverbial STEM-type products, but much more on the creative, educational side of the spectrum as opposed to the true video or toy kind of spectrum -- end of the spectrum.

Matt Fassler -- Goldman Sachs -- Managing Director

Thank you, Chuck. I appreciate it.

Operator

Our next question comes from Christopher Horvers of JPMorgan. Please go ahead.

Christopher Horvers -- JPMorgan Chase -- Analyst

Thanks. Good morning, everybody.

Carl S. Rubin -- Chairman of the Board and Chief Executive Officer

Good morning, Chris.

Christopher Horvers -- JPMorgan Chase -- Analyst

I wanted to ask a clarification question and then a bigger-picture question. So, the first question is to verify the decline in the operating income guidance for the year is all distribution cost. It's nothing related to the promotional pressures or the promotional outlook for the back half, as you just talked about. And then, checking our math, does the comp outlook for 3Q and the year imply about a 0.7% comp for the fourth quarter, and could you quantify the potential weak shift impact in the third and fourth quarter?

Carl S. Rubin -- Chairman of the Board and Chief Executive Officer

I'm going to take the first part because I want to make sure there's no confusion. The margin pressure that we're having is distribution-related. These are supply chain pressures. We are not anticipating a more intense promotional environment. Our testing in the second quarter was not an intent to step up what we plan on doing in the back half of the year. The intent on our promotions in the second quarter was to get smarter on the type of promotion, not on the quantity of promotion.

Denise A. Paulonis -- Executive Vice President and Chief Financial Officer

And then, the second part of your question, which really got to an implied guide for Q4 comp given what we've put out for Q3 -- the way that I would really characterize this is Q3 does have this one-week timing shift that is beneficial to the third quarter, and so, that is both where Halloween fits, but also, our holiday tree event that is a pretty sizable event for us, and that's shifting as goodness in the third quarter from the fourth quarter. We're not going to give explicit guidance to where we are with the fourth quarter, but directionally, the math at the midpoint of our guidance would say the fourth quarter would be slightly positive, which I think is in line with the direction you were headed, but we would just keep the range that we had it there. So, you can think about that as being the comp shift between the quarters.

I think the other important part that I'd mention is that what we're a bit more focused on is there's a bit of a change in trajectory from the first half of the year to the second half of the year, and that second half of the year where we feel better in total about versus where we were in the first half, we pick up a bigger portion of seasonal as part of our business, and our novice customer still responds quite strongly to that seasonal process. FMA and the set of all the additional stores that we have done gives us a source of advantage there, and we've talked about this omnichannel and kids' activity, which is also a change for us as we move into the back half of the year.

You combine that with new capabilities like buy online, pick up in store, more value messaging, and more capabilities tied to our CRM efforts than marketing, and so, what we really want people to understand is why, since the beginning of the year, we've communicated that H1 is going to be a little bit lighter, and in H2, you'll see an in-aggregate pickup. So, with that, it's just that timing difference of the third-quarter/fourth-quarter weak shift that is really causing a bit of the noise between the two quarters.

Christopher Horvers -- JPMorgan Chase -- Analyst

Understood. That's great. So, bigger-picture question -- looking back to when you joined the company, Chuck, it looks like the average store carried about 39,000 SKUs. A year ago on this call, you talked about around 50,000 SKUs, and you mentioned you're adding more here, so can you talk about -- is that accurate, and can you talk about your ability to continue to add SKUs? Has that been mainly in seasonal, and that's what's really been a big comp driver over the past five years?

Carl S. Rubin -- Chairman of the Board and Chief Executive Officer

So, a few things. While we're adding SKUs, the greatest SKU count addition is online. We are adding kids' SKUs in-store. I would not equate that to additional SKUs for the total brick and mortar store, though. There are edits that go on elsewhere. The number of SKUs in a store will vary based on the time of the year. It does tend to range around 50,000 SKUs. I don't anticipate that SKU count getting a lot higher. Quite honestly, if anything, it'll come down maybe slightly, but here again, I don't view that as a material shift.

Christopher Horvers -- JPMorgan Chase -- Analyst

Was that additions for the past five years mainly in seasonal?

Carl S. Rubin -- Chairman of the Board and Chief Executive Officer

You're catching me off guarded. The 30,000-odd five years ago -- I'm not sure that number is -- I'd have to check that number. I don't think we've added -- that would imply roughly a one-third increase in SKU count, and I don't think that's accurate.

Christopher Horvers -- JPMorgan Chase -- Analyst

Okay, we can follow up after.

Carl S. Rubin -- Chairman of the Board and Chief Executive Officer

We can follow up offline, but we have certainly added seasonal SKUs as we've expanded that business, but it has -- in many ways -- come as a reduction of SKUs in other departments. We have sized down some other core crafting departments that have been challenged in their performance for an extended period of time.

Christopher Horvers -- JPMorgan Chase -- Analyst

Understood. Thanks very much.

Operator

Our next question comes from Laura Champine of Loop Capital. Please go ahead.

Laura Champine -- Loop Capital Markets -- Managing Director

Thanks for taking my question. I wanted to talk to the extent that you can about changes in your store economics with the potential pickup of some business that was going to the Aaron Brothers stores and the resets. What changes do you see as you reset your stores, or perhaps pick up some volume from the stores that you closed?

Denise A. Paulonis -- Executive Vice President and Chief Financial Officer

So, overall, when you think about the closure of the Aaron Brothers' 94 full-sized stores, we have seen a nice transfer of that sales volume into our Michaels stores. We thought there was real merit in rebranding inside of our Michaels stores for those customers who really understand that Aaron Brothers experience, and we've seen positive transfer there. I think more broadly, what I'd want to mention is that outside of the Aaron Brothers transfer of custom frame volume into the stores, we have seen our comp sales in custom frame be positive as well. So, not only does the Aaron Brothers transfer help us, but we've also done two other things. We had made some changes late last year in our pricing and assortment, and we also changed a bit of our selling model and senior leadership support over that space in the field, both of which we think are also delivering positive results in addition to a bit of the tailwind from Aaron Brothers.

Laura Champine -- Loop Capital Markets -- Managing Director

Got it. And then, on the store resets, do you see a significant list in your sales trends, products, or margins in those store resets?

Denise A. Paulonis -- Executive Vice President and Chief Financial Officer

We've seen nice performance out of those resets. So, in the set we just did, we're very pleased to see that we've seen a bit of an uptake in our seasonal performance, which is primarily what comes into that reset space at the front of the store this time of year, and we have not seen the disruption that we saw when we did the last set of stores because we actually chose to move fewer things in the stores to have less disruption for the customer. But, if you trace back to the set we did before that that's now been a year-plus in running, we still see good performance with those stores. So, with a bit over half the chain now in that format, we're pleased with the performance that FMA provides us.

Laura Champine -- Loop Capital Markets -- Managing Director

Got it. Thank you.

Kiley F. Rawlins -- Vice President of Investor Relations and Communication

Nicole, I think we have time for one more question, please.

Operator

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

Michael Baker -- Deutsche Bank -- Analyst

Thanks. A couple of clarifications or quantifications -- can you talk about the impact of the change and timing of marketing costs? If they were up in the second quarter and flat for the year, there's a shift somewhere in there. And, same on incentive comp, please.

Denise A. Paulonis -- Executive Vice President and Chief Financial Officer

Sure. So, on the marketing cost, for the full year, we are expecting it to be flattish. We are talking plus or minus a couple million dollars by quarter, so I think we were down a little in the first quarter. As we go into the back half of the year, it will just even itself out, so it's not going to be a material shift. On the incentive comp, it's an important one to call out that when you look at the $11.5 million that was a positive help to SG&A in Q2, a good amount of that will reverse in the third quarter. So, it's just a timing shift from last year, where there was a bit of a different cadence in that accrual last year, and this year, as we accrue with our operating income, you're going to see that headwind come to us in the third quarter, but for the full year, we're expecting incentive comp to be comparable to last year.

Michael Baker -- Deutsche Bank -- Analyst

And so, presumably, no impact to fourth quarter on a year-over-year basis?

Denise A. Paulonis -- Executive Vice President and Chief Financial Officer

Minimal, and as you would guess, the fourth quarter would be the one where we true up our full-year performance versus our plan, so that would be the larger effect versus any of the lapping of last year's accruals.

Michael Baker -- Deutsche Bank -- Analyst

Right, OK. That makes sense. And, one more, if I could. Have you discussed the cadence -- I don't think I heard it -- the cadence of comps through the quarter? It sounds like from your press release, it did get better through the quarter, but any color or quantification of that?

Carl S. Rubin -- Chairman of the Board and Chief Executive Officer

Each month got better, Mike, within the quarter.

Michael Baker -- Deutsche Bank -- Analyst

Okay, that's helpful. Appreciate that. Thank you.

Carl S. Rubin -- Chairman of the Board and Chief Executive Officer

Well, I want to thank everybody for joining us this morning. As we close, I do want to extend my sincere thanks to the team of 50,000 dedicated team members that we have that work throughout Michaels to make us the leader in our industry. We are encouraged by our recent sales trends and believe the investments we've made will help us deliver our revenue and earnings expectations for the second half of fiscal 2018, and we look forward to giving you another update on our progress when we report Q3 in early December. Thanks very much for your interest.

Operator

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.

Duration: 58 minutes

Call participants:

Kiley F. Rawlins -- Vice President of Investor Relations and Communication

Carl S. Rubin -- Chairman of the Board and Chief Executive Officer

Denise A. Paulonis -- Executive Vice President and Chief Financial Officer

Simeon Gutman -- Morgan Stanley -- Executive Director

Steven Forbes -- Guggenheim Partners -- Director

Matt Fassler -- Goldman Sachs -- Managing Director

Christopher Horvers -- JPMorgan Chase -- Analyst

Laura Champine -- Loop Capital Markets -- Managing Director

Michael Baker -- Deutsche Bank -- Analyst

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