Three weeks ago, I wrote a piece suggesting that Michaels Stores (NYSE:MIK) came close to meeting the criteria for a Motley Fool Rule Breaker. First-quarter earnings released on Wednesday only confirm my conviction that this is a company worth owning.
Total revenues for the first quarter increased 13.1% on comparable-store sales growth, or comps, of 7.8%. We knew that a few weeks ago from the preliminary sales release. But we didn't know the company would also deliver a 59% increase in net income and earnings per share of $0.33 for the quarter, a full $0.04 (or 14%) more than the already aggressive analyst estimates.
As with a lot of first-quarter earnings releases I've seen this month, you have to look beyond the headlines to understand the earnings' quality. I give Michaels high marks for transparency; the company clearly discussed the unusual items. It turns out that Michaels delayed some typical first-quarter merchandise resets until the second quarter, which added between $0.04 and $0.05 to first-quarter EPS. The expense will hit next quarter, which brings comparable first-quarter earnings growth down from 59% to about 36%. All the same, this performance deserves praise.
The key drivers of earnings growth were the same initiatives I talked about three weeks ago. Michaels has invested heavily in perpetual-inventory and automated-replenishment systems in the past few years, and it's realizing the benefits big time. Keep in mind that arts-and-crafts retail is a complicated business, with more than 40,000 Stock Keeping Units (SKUs) stuffed into 18,000-square-foot stores.
Keeping track of all those crafty little items is a big chore. A retailer with effective systems to identify available and hot-selling merchandise has a major advantage in delivering sales for maximum gross margin. Michaels is beginning to nail this fundamental retail process; its inventories for the first quarter were up only 6% on the 13% sales increase, a clear indication of improved inventory management.
Inventory management systems can drive better promotional programs and help the company remain in stock on key items. One of K-Mart's (NASDAQ:SHLD) longtime problems was exhausting stocks of promotional items, thereby disappointing customers and sending them to Wal-Mart (NYSE:WMT) in droves. Michaels' sales momentum is growing, in part because of having the items customers want, when they want them.
One new item I discovered on the call was the company's remodeling strategy for the next few years. About one-third (250-300) of its stores don't use the customer-friendly "racetrack" layout prevalent among today's successful retailers. A "racetrack" layout has a wide main aisle that circles the store and makes it easier to shop. The company is remodeling its older stores to bring them up to speed. Many of these stores occupy prime locations with top-notch demographics. Early results show solid sales increases as the remodels are completed -- one more reason to believe Michaels can drive above-average sales growth for the next few years.
Michaels reaffirmed its earnings guidance for fiscal 2005. It expects comp sales growth in the mid-single digits, total revenue growth around 10%, expansion of gross margins, and leverage of expenses -- all driving 25% to 30% annual EPS growth this year. Those are retail numbers worthy of any investor's excitement.
With a trailing-12-month P/E of 21, the stock is not cheap, but good stocks rarely are. I'd look for a buying opportunity in the next few months. Because of the merchandise resets mentioned above, and some upcoming charges from the early redemption of some high coupon debt, second-quarter earnings will be under some pressure. After that, look for a strong back half of the year.
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Fool contributor Timothy M.Otte surveys the retail scene from Atlanta, where he welcomes comments on his articles. He owns stock in Wal-Mart but none of the other companies mentioned in this article. The Fool has a disclosure policy.
