I'm feeling a bit lonely during this Rule Breaker week at The Motley Fool. My specialty is retail companies, and it's hard to fit many of the bricks-and-mortar variety of those animals into the classic Rule Breaker mold. I mean, how easy can it be these days for a store-based retailer to truly be called a first mover in an important, emerging field? But as specialty retailers go, Michaels (NYSE:MIK) nearly fits the bill.
Michaels just announced its first-quarter sales results. Comparable store sales were up 7.8%, with a nifty 5% increase in transactions and a jump of more than 2% in average purchase. After a few disappointing months of comps during last year's holiday season, it looks as though sales growth is back on track.
The company also announced that earnings for the first quarter should fall near the high end of expectations. That could mean 30% or higher growth in earnings per share. And the company reaffirmed full-year earnings guidance of 20% to 25% growth.
Michaels is the largest player in the pure arts-and-crafts retailing arena. At $3.4 billion in annual revenues, it's 50% larger than its two major competitors -- A.C. Moore Arts & Crafts (NASDAQ:ACMR) and Jo-Ann Stores (NYSE:JAS) -- combined. Nailing down share in this fragmented business is tough, but the key players estimate that it's about a $30 billion industry. If that's the case, Michaels has about an 11% share. And as the recent proliferation of home-decorating shows like Trading Spaces and Design on a Dime suggest, this is a growing market. I understand that bigger is not always better (think Kmart or Sears 20 years ago), but Michaels has a reputation for quality and prime store locations, so I'll give the company a nod for holding down the industry's top brand position.
Whether Michaels has a sustainable advantage, however, is up for grabs. Arts-and-crafts retailing is a tough little business, with more than 40,000 SKUs crammed into stores that barely clear 18,000 square feet. That's a lot of stuff to keep track of, but it's also what might give Michaels an advantage. The company has invested heavily in perpetual inventory and automated replenishment systems over the past several years. Michaels is still a long way behind the best mass retailers like Wal-Mart (NYSE:WMT) and Best Buy (NYSE:BBY) in terms of inventory-management technology, but it's well on its way to being the best in its industry niche. We should call this one an imminent nod for sustainable advantage -- not quite there, but close.
In terms of good management, I submit that long-term, sustained top- and bottom-line performance says a lot. Since 1997, Michaels has delivered average annual sales and earnings growth of 12.8% and 31.3%, respectively, with nary a down year since then. A chart of the stock price over that time period shows a consistent upward trend. The company generates solid cash flow, and within the past few years, it has begun to return some of that to shareholders in the form of share repurchases and dividends. Is that an indication of slowing growth? Well, the company grew sales at 20% annually in the late '90s, whereas recent sales growth is in the low teens. But I admire a company that uses its cash wisely and is prepared to return some greenbacks to shareholders when its cash flow exceeds attractive new investment prospects. The company manages its balance sheet conservatively, with only 13% debt to total capitalization, and it generates a return on equity of more than 17%.
Perhaps what I like best about Michaels is that it sticks to its knitting, so to speak. It's found a profitable niche to occupy, and it's the dominant player. No flashy acquisitions or brand extensions for these folks. Michaels has preferred to integrate vertically by manufacturing its own custom frames and moldings. It's now expanding into the wholesale distribution of key product lines to interior decorators, wedding/event planners and hotels. It's not glamorous, but it is a solid, low-risk growth way of capitalizing on its strengths.
Is Michaels breaking any rules? Hardly. Is the stock cheap at 21 times trailing 12-month earnings? No way. But the company has a lot of the other characteristics that we do look for in Rule Breakers. Look at it this way: You know that any good portfolio needs the right mix. The best baseball teams lead off the batting order with hitters who consistently get on base and then follow up with the sluggers. Michaels is like that lead-off batter, who also rewards with doubles and triples. That could just make this stock worth adding to your starting lineup.
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Fool contributor Timothy M. Otte is addicted to reruns of This Old House. He owns shares of Wal-Mart but none of the other companies mentioned in this article. The Motley Fool has a disclosure policy.
