We at The Motley Fool have tracked arts and crafts retailer Michaels Stores (NYSE:MIK) throughout the year, both in good times and challenging ones. Overall, the general sentiment is that there is a lot to like about Michaels, which caters to a variety of do-it-yourselfers and hobbyists. Will its third-quarter results dampen this enthusiasm?

The company earned $0.40 per diluted share in the latest quarter, which was 29% higher than the same period a year ago. The 0.6% reduction in outstanding shares was a minor contribution to its EPS growth.

The primary driver of Michaels' double-digit earnings growth was its improvements to margins. Gross margins were 39% vs. 37% last year. However, selling, general, and administrative expenses were a slight burden on operating efficiency: As a percentage of total revenue, they were slightly higher at 28.5% compared with 27.6% in the year-ago period. But overall, Michaels managed to boost operating margins by 13.2 percentage points to 10.3%. The company attributed this increased profitability to a reduction in clearance merchandise and better sales from regularly priced items.

It's a good thing that Michaels' performance on an operational level was respectable, because its top-line growth for the quarter was far from impressive. The company's revenues increased a mere 5% to $839.7 million. Same-store sales were almost flat, up only 0.8% from the same period last year.

Higher gas prices and better-than-expected weather were two reasons given for the softer sales environment -- both of which are legitimate. It's hard to justify running to your local Michaels for yarn and scrapbooking material when it's warm and sunny outside, or when your wallet is begging you to take a break from driving your car. Competitor Jo-Ann Stores (NYSE:JAS) experienced similar difficulties that took a heavy toll on its bottom line.

While the weaker sales are understandable, they're no less worrisome. My greatest concern about Michaels' most recent quarterly results is its inventory growth. With revenues coming in lower than anticipated, the result is that inventory begins to build up. And that's exactly what we are seeing here. The company's merchandise inventories were 11% higher for the third quarter compared with the same period a year ago, twice the growth in sales. It's not as if the company is expecting blockbuster sales in 2006 and is ramping up inventory in preparation. It is forecasting revenue growth of around 7% next fiscal year, still below the 11% increase in inventory levels.

Although the arts and crafts industry seems to have hit a soft patch recently, the fourth quarter seems to bring out the artistic side of consumers -- think of all the handmade Christmas ornaments you get as gifts. But Fools should keep an eye on those glittering baubles to make sure that Michaels doesn't end up overstocking its stocking stuffers.

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Fool contributor Jeremy MacNealy does not own shares of any companies mentioned.