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FORM 10-Q

SECURITIES AND EXCHANGE COMMISSION
Washington, D. C. 20549

[X] Quarterly Report Pursuant to Section 13 or 15 (d) of the
Securities Exchange Act of 1934

For the quarterly period ended August 4, 2002

OR

[  ] Transition Report Pursuant to Section 13 or 15 (d) of the
Securities Exchange Act of 1934

For the transition period from_____________to___________.

Commission File Number 1 – 9482

HANCOCK FABRICS, INC.
(Exact name of registrant as specified in its charter)

Registrant’s telephone number, including area code
(662) 842-2834

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [  ]

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practical date.

As of August 4, 2002, the registrant had outstanding an aggregate of 18,889,008 shares of common stock, $.01 par value.

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INDEX

Part I. Financial Information:

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CONSOLIDATED BALANCE SHEET

PART I. FINANCIAL INFORMATION
CONSOLIDATED BALANCE SHEET
(unaudited)

See accompanying notes to consolidated financial statements.

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CONSOLIDATED STATEMENT OF INCOME
(unaudited)

See accompanying notes to consolidated financial statements.

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CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY
(unaudited)

See accompanying notes to consolidated financial statements.

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CONSOLIDATED STATEMENT OF CASH FLOWS
(unaudited)
(in thousands)

See accompanying notes to consolidated financial statements.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (unaudited)

NOTE 1: BASIS OF PRESENTATION

The accompanying unaudited consolidated financial statements of Hancock Fabrics, Inc. (“Hancock” or the “Company”) have been prepared in accordance with the instructions to Form 10-Q and therefore do not include all information and footnotes necessary for a fair presentation of financial position, results of operations and cash flows in conformity with generally accepted accounting principles. The statements do reflect all adjustments (consisting of only normal recurring entries) which are, in the opinion of management, necessary for a fair presentation of financial position in conformity with generally accepted accounting principles. The statements should be read in conjunction with the Notes to the Consolidated Financial Statements for the fiscal year ended February 3, 2002 incorporated into the Company’s Annual Report on Form 10-K.

The results of operations for the thirteen and twenty-six week periods are not necessarily indicative of the results to be expected for the full fiscal year.

NOTE 2: EARNINGS PER SHARE

Basic earnings per share excludes dilution and is computed by dividing income available to common shareholders by the weighted-average number of common shares outstanding for the period. Diluted earnings per share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the Company.

COMPUTATION OF EARNINGS PER SHARE (unaudited)

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NOTE 3: RESERVE FOR STORE CLOSINGS

Store closing reserves are established based on estimates of net lease obligations and other store closing costs. During the fourth quarter of 1998, the Company recorded a charge of $8,604,000 for revised estimates of net lease obligations for stores closed at January 31, 1999 and stores committed to be closed in fiscal 1999. This charge, when combined with an already existing reserve, resulted in a total reserve of $9,022,000 at January 31, 1999.

At August 4, 2002, the total reserve balance included in current and noncurrent liabilities was $2,285,000 which represents the present value of the future net lease obligations for the locations which have been closed. The 2002 activity in the reserve is as follows (in thousands):

NOTE 4: RECENT ACCOUNTING PRONOUNCEMENTS

Recently Adopted

In July 2001, the FASB issued SFAS No. 142, Goodwill and Other Intangible Assets. SFAS No. 142 changes the accounting for goodwill and other indefinite-lived intangible assets from an amortization method to an impairment-only approach. Amortization of goodwill and other indefinite-lived intangible assets will cease upon adoption of this Statement. The Company implemented SFAS No. 142 on February 4, 2002. Therefore, annual goodwill amortization expense of $383,000 will not recur; however, if the value of such goodwill is deemed impaired, a charge to earnings will be recorded for the impairment.

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In October 2001, the FASB issued SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, effective for years beginning after December 15, 2001. This Statement supersedes SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and Long-Lived Assets to Be Disposed of, but retains the fundamental provision of SFAS No. 121 for recognition and measurement of the impairment of long-lived assets to be held and used and measurement of long-lived assets to be held for sale. The statement requires that whenever events or changes in circumstances indicate that a long-lived asset’s carrying value may not be recoverable, the asset should be tested for recoverability. The statement also requires that a long-lived asset classified as held for sale should be carried at the lower of its carrying value or fair value, less cost to sell. The Company adopted SFAS No. 144 on February 4, 2002 and it did not have a material effect on its financial statements upon adoption.

Pronouncements Not Yet Adopted

In June 2001, the FASB issued SFAS No. 143, Accounting for Asset Retirement Obligations. FAS 143 requires that obligations associated with the retirement of a tangible long-lived asset be recorded as a liability when those obligations are incurred, with the amount of the liability initially measured at fair value. Upon initially recognizing a liability for an asset retirement obligation (“ARO”), an entity must capitalize the cost by recognizing an increase in the carrying amount of the related long-lived asset. Over time, the liability is accreted to its present value each period, and the capitalized cost is depreciated over the useful life of the related asset. Upon settlement of the liability, an entity either settles the obligation for its recorded amount or incurs a gain or loss upon settlement. The Statement will be effective for financial statements for fiscal years beginning after June 15, 2002. The Company does not believe that the adoption of this statement will have a material impact on its financial statements.

In May 2002, the FASB issued SFAS 145, Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13 and Technical Corrections as of April 2002. This statement eliminates an inconsistency between the required accounting for sale-leaseback transactions and the required accounting for certain lease modifications that have economic effects that are similar to sale-leaseback transactions. This Statement also amends other existing authoritative pronouncements to make various technical corrections, clarify meanings, or describe their applicability under changed conditions, and it eliminates the treatment of early extinguishments of debt as extraordinary items. The provisions of this Statement related to the rescission of SFAS 4 shall be applied in fiscal years beginning after May 15, 2002. The provisions related to SFAS 13 shall be effective for transactions occurring after May 15, 2002. All other provisions of this Statement shall be effective for financial statements issued on or after May 15, 2002. The Company does not believe that adoption of this statement will have a material impact on its financial statements.

In July 2002, the FASB issued SFAS 146 Accounting for Costs Associated with Exit or Disposal Activities. This Statement addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies Emerging Issues Task Force (EITF) Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).” This Statement requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred rather than at the date of an entity’s commitment as provided under Issue 94-3. This Statement also establishes that fair value is the objective for initial measurement of the liability. The provisions of this Statement are effective for exit or disposal activities that are initiated after December 31, 2002. The Company does not believe adoption of the provisions of this statement will have a material impact on its financial statements.

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ITEM 2: MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

FINANCIAL CONDITION

Historically, cash flow from operations has been sufficient to finance the expansion and operation of Hancock’s business. Hancock’s principal capital requirements are for the financing of inventories and to a lesser extent for capital expenditures relating to store locations and its warehouse and distribution facility. Funds for such purposes are generated from Hancock’s operations and, if necessary, supplemented by borrowings from commercial lenders. In addition to cash dividends, Hancock has historically used excess cash and, if necessary, borrowings from commercial lenders to purchase treasury stock as market and financial conditions dictate. Hancock opened 6 stores and closed 7 stores during the thirteen weeks ended August 4, 2002, resulting in a total of 436 stores at quarter end.

On May 7, 2002, Hancock announced the acquisition of a 473,000 square foot warehouse/distribution facility on 64 acres north of the Tupelo headquarters for $7.7 million. This facility initially will be utilized to stock, allocate and distribute merchandise groups that require special handling, such as foam/batting, seasonal products and home accents, as well as a growing cross-docking operation.

During the twenty-six weeks ended August 4, 2002, net earnings of $5.3 million, $12.2 million provided through the exercise of stock options, and $11 million in borrowings were used to fund $12.1 million in additions to property and equipment, a $5.9 million increase in inventory, a $3.3 million reduction in accrued liabilities and a $3.4 million decrease in current income tax obligations. At August 4, 2002, the Company had $11 million in debt, or 9% of total capitalization, compared to $27 million, or 24% of total capitalization at July 29, 2001.

RESULTS OF OPERATIONS

Thirteen weeks ended August 4, 2002 compared to thirteen weeks ended July 29, 2001

Net earnings were $1.5 million, or $.08 per diluted share, compared with $590 thousand, or $.03 per diluted share, in the same period of the prior year. Earnings were influenced by higher sales, a higher gross margin and lower expenses as a percentage of sales than last year.

Sales increased to $92.7 million from $86.8 million in last year’s first quarter, as the result of an increase of 7.3% in comparable store sales. Sales benefited from the remerchandising of our product mix, which has led to higher sales in the home decorating side of our business and the continued repositioning of our store base. The store repositioning strategy has consisted of closing smaller, low potential stores that were often located too closely together, while opening or acquiring larger stores spaced farther apart to better support an expanded product offering within our core merchandise competency. Gross margins increased to 51.3% from 50.4% last year due to a LIFO credit resulting from product cost deflation, enhancements to the merchandise mix related to higher-margin home decorating products, and a more effective marketing/advertising program.

In the second quarter of 2002, total selling, general and administrative expenses as a percentage of sales were slightly lower than in the second quarter of 2001 due to expense leverage from comparable store sales increases. Such improvements were partially offset by higher pension costs resulting from the two-year weakness in investment returns, rising employee medical insurance expense and higher advertising costs due to a direct mail promotion that was required to be expensed in the second quarter although most of the ad related to the third quarter.

Interest expense decreased due to a lower level of outstanding debt and lower interest rates throughout the quarter.

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Twenty-six weeks ended August 4, 2002 compared to twenty-six weeks ended July 29, 2001

Net earnings were $5.3 million, or $.28 per diluted share, compared with $3.1 million, or $.18 per diluted share, in the same period of the prior year. Earnings were influenced by higher sales, a higher gross margin and lower expenses as a percentage of sales than last year.

Sales increased to $196.7 million from $184.4 million in last year’s first half, as the result of an increase of 7.3% in comparable store sales. Sales benefited from the remerchandising of our product mix, which has led to higher sales in the home decorating side of our business and the continued repositioning of our store base. The store repositioning strategy has consisted of closing smaller, low potential stores that were often located too closely together, while opening or acquiring larger stores spaced farther apart to better support an expanded product offering within our core merchandise competency. Gross margins increased to 50.9% from 50.0% last year due to a LIFO credit resulting from product cost deflation, the enhancements to the merchandise mix related to higher-margin home decorating products, and a more effective marketing/advertising program.

In the first half of 2002, total selling, general and administrative expenses as a percentage of sales were slightly lower than in the same period of 2001 due to expense leverage from comparable store sales increases. Such improvements were partially offset by higher pension costs resulting from the two-year weakness in investment returns, rising employee medical insurance expense and higher advertising costs due to a direct mail promotion that was required to be expensed in the second quarter although most of the ad related to the third quarter.

Interest expense decreased due to a lower level of outstanding debt and lower interest rates throughout the twenty-six weeks of 2002.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the recorded amount of assets and liabilities at the date of the financial statements and revenues and expenses during the period. Significant accounting policies employed by the Company, including the use of estimates and assumptions, are presented in the Notes to Consolidated Financial Statements incorporated into the Company’s Annual Report on Form 10-K. Management bases its estimates on its historical experience, together with other relevant factors, in order to form the basis for making judgments which will affect the carrying values of assets and liabilities. On an ongoing basis, management evaluates its estimates and makes changes to carrying values as deemed necessary and appropriate. The Company believes that estimates related to the following areas involve a higher degree of judgment and/or complexity:

	Inventories are valued at the lower of cost or market; cost is determined by the LIFO method. As with other retailers, it is not practical to perform physical inventory counts for all stores on the last day of a period; therefore, certain assumptions must be made in order to record cost of sales and the related change in inventory for the period of time from each store’s most recent physical count to the end of the period. Although, under certain circumstances, actual results could prove to be materially different from the estimates used, Hancock has consistently used the same methodology throughout its existence with dependable results, and management believes that it provides an inventory valuation which results in carrying inventory at the lower of cost or market.
	Worker’s compensation, general liability and employee medical insurance programs are largely self-insured. It is the Company’s policy to record its self-insurance liabilities using estimates of claims incurred but not yet reported or paid, based on historical trends and other relevant factors. Actual results can vary from estimates for many reasons including, among others, future inflation rates, claims settlement patterns, litigation trends and legal interpretations.
	Store closing reserves are based on estimates of net lease obligations and other store closing costs, including assumptions about anticipated future subleases of properties. If real estate leasing markets change, the reserves will have to be adjusted.

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OFF-BALANCE SHEET ARRANGEMENTS

The Company has no off-balance sheet financing arrangements.

CONTRACTUAL OBLIGATIONS AND COMMERCIAL COMMITMENTS

The Company has arrangements with two banks that provide for up to $10 million in letters of credit. At August 4, 2002, Hancock had commitments under these arrangements of $3,520,000 to guarantee payment of potential workers’ compensation claims and $4,696,000 on issued letters of credit, which support purchase orders for merchandise to be imported. Also, Hancock leases its retail fabric store locations under operating leases expiring at various dates through 2022.

The Company has no standby repurchase obligations or guarantees of other entities’ debt.

EFFECTS OF INFLATION

The impact of inflation on labor and occupancy costs can significantly affect Hancock’s operations. Many of Hancock’s employees are paid hourly rates related to Federal and State minimum wage requirements; accordingly, any increases will affect Hancock. In addition, payroll taxes, employee benefits and other employee costs continue to increase. Health insurance costs, in particular, continue to rise at an unsettling rate in the United States each year, and higher employer contributions to the Company’s pension plan have been necessary recently in light of weaker investment returns. Costs of leases for new store locations remain stable, but renewal costs of older leases continue to increase. Property and casualty insurance premiums are now increasing substantially after several years of soft pricing in the insurance industry. Hancock believes the practice of maintaining adequate operating margins through a combination of price adjustments and cost controls, careful evaluation of occupancy needs and efficient purchasing practices are the most effective tools for coping with increased costs and expenses.

Inflation is one of the key factors used in the calculation of the LIFO charge or credit to Cost of Sales. In 2001, an increase in the producer price indices (PPI) resulted in a LIFO charge. A decrease in the PPI resulted in a LIFO credit in 2002.

SEASONALITY

Hancock’s business is slightly seasonal. Peak sales periods occur during the fall and pre-Easter weeks, while the lowest sales periods occur during the summer and the month of January.

RECENT ACCOUNTING PRONOUNCEMENTS

Recently Adopted

In July 2001, the FASB issued SFAS No. 142, Goodwill and Other Intangible Assets. SFAS No. 142 changes the accounting for goodwill and other indefinite-lived intangible assets from an amortization

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method to an impairment-only approach. Amortization of goodwill and other indefinite-lived intangible assets will cease upon adoption of this Statement. The Company implemented SFAS No. 142 on February 4, 2002. Therefore, annual goodwill amortization expense of $383,000 will not recur; however, if the value of such goodwill is deemed impaired, a charge to earnings will be recorded for the impairment. An impairment test was performed, and no impairment was noted as of May 5, 2002.

In October 2001, the FASB issued SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, effective for years beginning after December 15, 2001. This Statement supersedes SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and Long-Lived Assets to Be Disposed of, but retains the fundamental provision of SFAS No. 121 for recognition and measurement of the impairment of long-lived assets to be held and used and measurement of long-lived assets to be held for sale. The Statement requires that whenever events or changes in circumstances indicate that a long-lived asset’s carrying value may not be recoverable, the asset should be tested for recoverability. The Statement also requires that a long-lived asset classified as held for sale should be carried at the lower of its carrying value or fair value, less cost to sell. The Company adopted SFAS No. 144 on February 4, 2002 and it did not have a material effect on its financial statements upon adoption.

Pronouncements Not Yet Adopted

In June 2001, the FASB issued SFAS No. 143, Accounting for Asset Retirement Obligations. FAS 143 requires that obligations associated with the retirement of a tangible long-lived asset be recorded as a liability when those obligations are incurred, with the amount of the liability initially measured at fair value. Upon initially recognizing a liability for an asset retirement obligation (“ARO”), an entity must capitalize the cost by recognizing an increase in the carrying amount of the related long-lived asset. Over time, the liability is accreted to its present value each period, and the capitalized cost is depreciated over the useful life of the related asset. Upon settlement of the liability, an entity either settles the obligation for its recorded amount or incurs a gain or loss upon settlement. The Statement will be effective for financial statements for fiscal years beginning after June 15, 2002. The Company does not believe that the adoption of this Statement will have a material impact on its financial statements.

In May 2002, the FASB issued SFAS 145, Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13 and Technical Corrections as of April 2002. This Statement eliminates an inconsistency between the required accounting for sale-leaseback transactions and the required accounting for certain lease modifications that have economic effects that are similar to sale-leaseback

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transactions. This Statement also amends other existing authoritative pronouncements to make various technical corrections, clarify meanings, or describe their applicability under changed conditions, and it eliminates the treatment of early extinguishments of debt as extraordinary items. The provisions of this Statement related to the rescission of SFAS 4 shall be applied in fiscal years beginning after May 15, 2002. The provisions related to SFAS 13 shall be effective for transactions occurring after May 15, 2002. All other provisions of this Statement shall be effective for financial statements issued on or after May 15, 2002. The Company does not believe that adoption of this Statement will have a material impact on its financial statements.

In July 2002, the FASB issued SFAS 146 Accounting for Costs Associated with Exit or Disposal Activities. This Statement addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies Emerging Issues Task Force (EITF) Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).” This Statement requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred rather than at the date of an entity’s commitment as provided under Issue 94-3. This Statement also establishes that fair value is the objective for initial measurement of the liability. The provisions of this Statement are effective for exit or disposal activities that are initiated after December 31, 2002. The Company does not believe adoption of the provisions of this Statement will have a material impact on its financial statements.

FORWARD-LOOKING STATEMENTS

From time to time, the Company may publish forward-looking statements relating to such matters as anticipated financial performance, financial items and results, plans for future expansion, store closures and other business development activities, capital spending or financing sources, capital structure and similar matters. The Private Securities Litigation Reform Act of 1995 provides a safe harbor for forward-looking statements. In order to comply with the terms of the safe harbor, the Company notes that a variety of factors could cause the Company’s actual results and experience to differ materially from the anticipated results or other expectations expressed in the Company’s forward-looking statements. The risks and uncertainties that may affect the operations, performance, development and results of the Company’s business include, but are not limited to, stability of interest rates during periods of borrowings and the effects of regulation, general economic trends (including inflation), changes in consumer demand or purchase patterns, delays or interruptions in the flow of merchandise between the Company’s suppliers and/or its distribution center and its stores, disruption in the Company’s data processing services, and competitive changes, including, but not limited to, liquidations of inventory in Hancock’s markets in connection with a competitor’s store closings or mass liquidations of old inventory.

Item 3: Quantitative and Qualitative Disclosures about Market Risks

The Company does not hold derivative financial or commodity instruments at August 4, 2002. The Company is exposed to financial market risks, including changes in interest rates. All borrowings under the Company’s Revolving Credit Agreement bear interest at a negotiated rate, a floating rate (the higher of the federal funds rate plus 1/2% or the prime rate), a rate derived from the money market rate, or a rate derived from the London Interbank Offered Rate. An increase in interest rates of 100 basis points would not significantly affect the Company’s results. All of the Company’s business is transacted in U. S. dollars and, accordingly, foreign exchange rate fluctuations have never had a significant impact on the Company, and they are not expected to in the foreseeable future.

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PART II. OTHER INFORMATION:

Item 6: Exhibits and Reports on Form 8-K

     (b)  Reports on Form 8-K

                 None

SIGNATURE

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.