CONTENTS || CORPORATE LISTING

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MICHAEL STORES , INC.

NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Description of Business
Michaels Stores, Inc. (the "Company") owns and operates a chain of 496 specialty retail stores in 46 states, Canada and Puerto Rico featuring arts, crafts, framing, floral, decorative wall decor and seasonal merchandise for the hobbyist and do-it-yourself home decorator. A Michaels store typically carries over 40,000 items. The Company's wholly owned subsidiary, Aaron Brothers, Inc., operates a chain of 78 framing and art supply stores. Aaron Brothers stores are located primarily on the West Coast.

Fiscal Year
The Company reports on the basis of a 52/53-week fiscal year, which ends on the Saturday closest to January 31. Fiscal 1998 ("1998"), fiscal 1997 ("1997") and fiscal 1996 ("1996") ended on January 30, 1999, January 31, 1998 and February 1, 1997, respectively; thus, 1998 and 1997 had 52 weeks and 1996 had 53 weeks.

Consolidation
The consolidated financial statements include the accounts of the Company and all wholly owned subsidiaries. All intercompany balances and transactions have been eliminated.

Estimates
The preparation of financial statements in conformity with generally accepted accounting principles requires the Company to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates.

Cash and Equivalents
Cash and equivalents are generally comprised of highly liquid instruments with original maturities of three months or less. Cash equivalents are carried at cost, which approximates fair value.

Reclassifications
Certain prior year amounts have been reclassified to conform to current year presentations.

Merchandise Inventories
Store merchandise inventories are valued as determined by a retail inventory method at the lower of average cost or market. Distribution center inventories are valued at the lower of cost or market determined by the first-in, first-out method.

Fiscal 1996 included a $41.2 million charge recorded in the third quarter to cover losses on a sale to liquidate merchandise that was eliminated following store resets, markdowns on discontinued furniture and other home decor merchandise, and reserves for the closure of four stores and the write-down of leasehold improvements in three stores.

Property and Equipment
Property and equipment is recorded at cost. Depreciation is provided on a straight-line basis over the estimated useful lives of the assets. Useful lives of buildings, fixtures and equipment, leasehold improvements, and capital leases for computer equipment are generally estimated to be 30, 8, 10 and 5 years, respectively. Amortization of assets recorded under capital leases and leasehold improvements is included in depreciation expense.

Costs in Excess of Net Assets of Acquired Operations
Costs in excess of net assets of acquired operations are being amortized over 40 years on a straight-line basis. Accumulated amortization was $21,664,000 and $17,862,000 as of the end of 1998 and 1997, respectively. The Company assesses the recoverability of costs in excess of net assets acquired based on existing facts and circumstances. The Company periodically measures the recoverability of this asset based on projected undiscounted cash flows of the acquired operations. Should the Company's assessment indicate an impairment of this asset in the future, an appropriate write-down will be recorded.

Advertising Costs
Advertising costs are expensed in the period in which the advertising first occurs. Net advertising expense was $58,928,000, $55,143,000 and $63,505,000 for 1998, 1997 and 1996, respectively.

Store Pre-Opening Costs
In April 1998 the American Institute of Certified Public Accountants ("AICPA") issued Statement of Position 98-5, Reporting the Costs of Start-Up Activities ("SOP 98-5"), which requires that costs related to start-up activities be expensed as incurred. Prior to 1998, the Company deferred store pre-opening costs until the fiscal year in which the store opened. The Company adopted the provisions of SOP 98-5 in its financial statements for the first quarter of 1998 and, as a result, began expensing pre-opening costs as incurred. The adoption of SOP 98-5 in its financial statements for the first quarter of 1998 and, as a result, began expensing pre-opening costs as incurred. The adoption of SOP 98-5 resulted in additional expense of $654,000 in 1998. The Company incurred store pre-opening costs of $7,897,000, $2,376,000 and $3,206,000 for 1998, 1997 and 1996, respectively.

Revenue Recognition
Revenue from sales of the Company's merchandise and services is recognized at the time of the merchandise sale.

Earnings Per Share
The following table sets forth the computation of basic and diluted earnings per common share:


The convertible subordinated notes were not included in the diluted earnings per common share calculation because they were antidilutive for the periods presented. The convertible subordinated notes could potentially affect diluted earnings per common share in the future.

New Pronouncements
The AICPA issued Statement of Position 98-1, Accounting for Costs of Computer Software Developed or Obtained for Internal Use ("SOP 98-1"), which is effective for fiscal years beginning after December 15, 1998. Beginning in the first quarter of fiscal year 1999, the Company will adopt SOP 98-1. The Company believes that the adoption of SOP 98-1 will not have a material effect on the Company's financial statements. In June 1998 the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities ("SFAS No. 133"). SFAS No. 133 establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in the statements of financial position and measure those instruments at fair value. SFAS No. 133 is effective for fiscal years beginning after June 15, 1999. The Company's use of derivatives has been minimal, historically, and therefore we do not expect this standard to have a material impact on the Company's reporting requirements.

NOTE 2 - DETAIL OF CERTAIN BALANCE SHEET ACCOUNTS


NOTE 3 - DEBT

In June 1996 the Company completed a public offering of $125 million of Senior Notes (the "Notes"). The Notes bear interest at a rate of 107/8% payable June 15 and December 15 of each year and mature on June 15, 2006. The Notes are not redeemable prior to June 15, 2001, except that, until June 15, 1999, the Company may redeem, at its option, up to an aggregate of $25 million principal amount of the Notes at 110.00%, plus accrued interest to the date of redemption, with the net proceeds of one or more equity offerings if at least $100 million aggregate principal amount of the Notes remains outstanding after each redemption. On or after June 15, 2001, the Notes are redeemable at the option of the Company, in whole or in part, at redemption prices ranging from 105.44% in 2001 to 100.00% in 2004, plus accrued interest to the date of redemption. In addition, the indenture under which the Notes have been issued contains certain covenants, including but not limited to restrictions on (1) debt; (2) payments such as dividends, repurchases of the Company's Common Stock or repurchases of subordinated obligations; (3) distributions from subsidiaries; (4) sales of assets; (5) transactions with affiliates; (6) liens; and (7) mergers, consolidations and transfers of all or substantially all assets. The Company used the full amount of the net proceeds from the sale of the Notes to reduce indebtedness under a bank credit agreement. The fair value, based on dealer quotes, of the outstanding Notes as of January 30, 1999 and January 31, 1998 was $131.6 million and $139.5 million, respectively.

In January 1993 the Company issued $97.75 million of convertible subordinated notes ("Subordinated Notes") due January 15, 2003. Interest, payable semi-annually on January 15 and July 15, was computed at the rate of 43/4% from the date of issuance to January 15, 1996, and at 63/4% thereafter. Interest expense is accrued by the Company based on an effective interest rate of 6.38% (including amortization of deferred issuance costs) over the full term. The Subordinated Notes are redeemable at the option of the Company at redemption prices ranging from 102.62% currently to 100.00% in 2003, and are not entitled to any sinking fund. They are convertible into the Company's Common Stock at any time, at a conversion price of $38 per share. A total of 2,551,053 shares of Common Stock are reserved for conversion. The fair value, based on dealer quotes, of the outstanding Subordinated Notes as of January 30, 1999 and January 31, 1998 was $84.6 million and $100.3 million, respectively.

In August 1998 the Company entered into a new unsecured revolving credit agreement with BankBoston, N.A. and other lending institutions (the "Credit Agreement") providing for a revolving loan of $100 million which may be increased to $125 million pursuant to certain terms and conditions as set forth in the Credit Agreement. Borrowings available under the Credit Agreement are reduced by the aggregate amount of letters of credit outstanding. There were no borrowings outstanding under the previous revolving line of credit at any time during 1997, and in 1998 borrowings under the Credit Agreement were outstanding for 54 days during our peak season of seasonal inventory buildup (with average outstanding borrowings of $23 million and a weighted average interest rate of 7.09%), with no borrowings outstanding at January 30, 1999. The interest rate on the Credit Agreement is generally (a) the higher of (i) an annual rate of interest announced from time to time by BankBoston, N.A. or (ii) one-half of one percent (1/2%) above the Federal Funds Effective Rate or (b) the Eurodollar Rate as defined by the Credit Agreement. The Company is required to pay a facility fee from .2% to .3% per annum on the unused portion of the revolving line of credit. The Credit Agreement provides certain annual restrictions on the aggregate amount of capital expenditures, restricts the payment of dividends and requires the Company to maintain compliance with various financial ratios. The Credit Agreement expires in August 2001.

NOTE 4 - INCOME TAXES

Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of deferred tax assets and liabilities as of the respective year end balance sheets are as follows:


The federal and state income tax provision (benefit) is as follows:

Reconciliation between the actual income tax provision (benefit) and the income tax provision (benefit) calculated by applying the federal statutory rate is as follows:

At January 30, 1999, the Company had federal and state net operating loss carryforwards to reduce future taxable income of approximately $14 million and $122 million, respectively, expiring at various dates between 1999 and 2012. The Company utilized $9 million of acquired net operating loss carryforwards in 1998 for which the benefit was recorded as a reduction to goodwill. The Company also has tax credit carryforwards of approximately $8 million available to offset future income taxes.

NOTE 5 - STOCKHOLDERS' EQUITY

In April 1996 the Company completed a private placement of 2,000,000 shares of the Company's Common Stock at a price of $12.50 per share (the "Private Placement"). The Common Stock was sold through three private transactions with separate entities owned by independent trusts of which family members of Sam Wyly and Charles J. Wyly, Jr. (the "Wyly Family") are beneficiaries. Sam Wyly and Charles J. Wyly, Jr. are Chairman and Vice Chairman of the Board of Directors of the Company, respectively.

In February 1997 options to purchase 2,000,000 shares of the Company's Common Stock were exercised through private transactions with entities owned by independent trusts of which Wyly Family members are beneficiaries. The options were purchased in December of 1996 with an exercise price equal to the then current market price. The exercise of the options provided the Company with $20 million of additional capital in 1997.

In October 1997 the Company began issuing Common Stock through its Dividend Reinvestment and Stock Purchase Plan (the "Stock Purchase Plan"). The Stock Purchase Plan provides owners of shares of Common Stock and other interested investors with a convenient and economical method to purchase Common Stock. The Stock Purchase Plan also provides the Company with a cost-efficient and flexible mechanism to raise equity capital. The Company may establish a discount of 0% to 5% in certain transactions to purchase shares under the Stock Purchase Plan. During 1998 and 1997 the Company issued 178,730 and 241,370 shares, respectively, through the Stock Purchase Plan, generating $6,218,000 and $7,872,000, respectively, in new equity.

In October 1998 the Company repurchased 1,145,000 shares of its Common Stock for an aggregate purchase price of $20.4 million and placed the shares in treasury.

Select employees and key advisors of the Company, including directors, may participate in the 1997 Stock Option Plan (the "Plan"), with an aggregate of 3,815,088 shares of Common Stock remaining for issuance thereunder. Options issued to employees under the Plan generally have a three or five year term and vest over a two or three year period following the date of grant and those issued to directors generally vest immediately.

The Company has elected to follow Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees ("APB 25") and related Interpretations in accounting for its employee stock options. The exercise price of the Company's employee stock options equals the market price of the underlying stock on the date of grant and, as a result, the Company does not recognize compensation expense for stock option grants in accordance with the provisions of APB 25.

Pro forma information regarding net income and earnings per share, as required by the provisions of Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation ("SFAS No. 123"), has been determined as if the Company had accounted for its employee stock options under the fair value method. The fair value for the options was estimated at the date of grant using the Black-Scholes option valuation model with the following weighted-average assumptions for 1998, 1997 and 1996, respectively: risk-free interest rates of 4.93%, 5.69% and 6.08%; no dividend yield; volatility factors of the expected market price of the Company's Common Stock of 58.4%, 54.7% and 56.6%; and a weighted-average expected life of the options of 2.14, 1.81 and 2.95 years.

The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. The Company's employee stock options have characteristics significantly different from those of traded options and changes in the subjective input assumptions can materially affect the fair value estimate. In addition, options vest over several years and additional option grants are expected. As a result, the Company believes the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options and the effects of the following hypothetical calculations are not likely to be representative of similar future calculations.

For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the options' vesting period. The pro forma effects of applying SFAS No. 123 are not indicative of future amounts because this statement does not apply to options granted prior to fiscal 1996. The Company's pro forma information is as follows:


For 1998, 1997 and 1996, the Company's stock option activity is summarized below:

The following table summarizes information about stock options outstanding at January 30, 1999:

NOTE 6 - RETIREMENT PLAN

The Company sponsors a 401(k) savings plan (the "401(k) Plan") for eligible employees of the Company and certain of its subsidiaries. Participation in the 401(k) Plan is voluntary and available to any employee who is 21 years of age and has completed 500 hours of service in a six-month eligibility period. Participants may elect to contribute up to 15% of their compensation on a pre-tax basis and up to 10% on an after-tax basis. In accordance with the provisions of the 401(k) Plan, the Company makes a matching contribution to the account of each participant in an amount equal to 50% of the first 6% of eligible compensation contributed by each participant not to exceed 3% of the participant's total compensation for the year. The Company's matching contribution expense, net of forfeitures, was $1,293,000, $1,095,000 and $1,338,000 for 1998, 1997 and 1996, respectively.

NOTE 7 - COMMITMENTS AND CONTINGENCIES
Commitments

The Company operates stores and uses distribution centers, office facilities and equipment generally leased under noncancelable operating leases, the majority of which provide for renewal options. In addition, the Company also leases its POS system under a five-year capital lease with IBM at an interest rate of approximately 8% (the "IBM Capital Lease"). Financing activities not affecting cash during 1998, 1997 and 1996 included capital lease obligations incurred in connection with the IBM Capital Lease of $2,735,000, $2,515,000 and $18,879,000, respectively. Future minimum annual rental commitments for all noncancelable leases as of January 30, 1999 are as follows:


Rental expense applicable to noncancelable operating leases was $103,735,000, $92,659,000 and $87,941,000 in 1998, 1997 and 1996, respectively.

The Company has entered into an operating lease for two distribution facilities that requires that the Company guarantee payment of the residual value of the property to the lessor at the end of the lease. As of January 30, 1999, the guaranteed residual value of assets subject to this lease was $24,063,000.

Contingencies
 A lawsuit was commenced against the Company and several other parties on September 19, 1994 on behalf of a former employee, Naomi Snyder, her child and her husband. The complaint alleged that the former employee and her then-unborn child were exposed to excessive levels of carbon monoxide in one of the Company's stores, resulting in severe and permanent injuries to the child. Plaintiffs' Statement of Damages sought $11 million. A settlement agreement was reached by the parties and the Company's portion of the settlement amount was fully covered by insurance. The lawsuit was dismissed with prejudice on January 4, 1999.

The Company is a defendant from time to time in lawsuits incidental to its business. Based on currently available information, the Company believes that resolution of all known contingencies is uncertain, and there can be no assurance that future costs related to such litigation would not be material to the Company's financial position or results of operations.

Financial Highlights || Letter to Shareholders || Four Cornerstones
Management's Discussion and Analysis || Consolidated Statements || Notes to Consolidated Statements
Auditors Report || Quarterly Financial Data || Board of Directors || Corporate and Stockholder Data