HANCOCK FABRICS INC - FORM 10-Q - September 13, 2011

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EXCEL - IDEA: XBRL DOCUMENT - HANCOCK FABRICS INC	Financial_Report.xls
EX-32.1 - EXHIBIT 32.1 - HANCOCK FABRICS INC	v234243_ex32-1.htm
EX-31.2 - EXHIBIT 31.2 - HANCOCK FABRICS INC	v234243_ex31-2.htm
EX-31.1 - EXHIBIT 31.1 - HANCOCK FABRICS INC	v234243_ex31-1.htm

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE

SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended July 30, 2011

¨ 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)

Delaware		64-0740905
(State or other jurisdiction		(I.R.S. Employer
of incorporation or organization)		Identification No.)

One Fashion Way, Baldwyn, MS		38824
(Address of principal executive offices)		(Zip Code)

(662) 365-6000

Registrant’s telephone number, including area code

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 by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ¨ No ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large Accelerated Filer ¨ Accelerated Filer ¨

Non-Accelerated Filer ¨ Smaller Reporting Company x

(do not check if a smaller reporting company)

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x

Indicate by check mark whether the registrant has filed all documents and reports required to be filed by Sections 12, 13 or 15(d) of the Securities Exchange Act of 1934 subsequent to the distribution of securities under a plan confirmed by a court. Yes x No ¨

As of August 27, 2011, there were 20,165,494 shares of Hancock Fabrics, Inc. $.01 par value common stock outstanding.

Table of Contents

Hancock Fabrics, Inc.,

INDEX TO FORM 10-Q

		Page

Part I. Financial Information

Item 1. Condensed Financial Statements (unaudited)		3

Consolidated Balance Sheets as of July 30, 2011, July 31, 2010 and January 29, 2011		3

Consolidated Statements of Operations for the Thirteen and Twenty-six Weeks Ended July 30, 2011 and July 31, 2010		4

Consolidated Statement of Shareholders’ Equity for the Twenty-six Weeks Ended July 30, 2011		5

Consolidated Statements of Cash Flows for the Twenty-six Weeks Ended July 30, 2011 and July 31, 2010		6

Notes to Consolidated Financial Statements		7

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		11

Item 3. Quantitative and Qualitative Disclosures about Market Risks		20

Item 4. Controls and Procedures		20

Part II. Other Information

Item 1. Legal Proceedings		21

Item 1A. Risk Factors		21

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds		21

Item 3. Defaults Upon Senior Securities		21

Item 5. Other Information		22

Item 6. Exhibits		22

Signatures		22

PART I. FINANCIAL INFORMATION

ITEM 1. CONDENSED FINANCIAL STATEMENTS

HANCOCK FABRICS, INC.

CONSOLIDATED BALANCE SHEETS

	(unaudited)
	July 30,			July 31,			January 29,
(in thousands, except for share amounts)	2011			2010			2011 (1)
Assets
Current assets:
Cash and cash equivalents	$	2,873		$	3,163		$	2,372
Receivables, less allowance for doubtful accounts		3,239			3,082			3,841
Inventories, net		98,087			104,598			87,804
Prepaid expenses		2,784			2,228			2,465
Total current assets		106,983			113,071			96,482

Property and equipment, net		39,355			41,944			39,335
Goodwill		3,139			3,210			3,139
Other assets		1,973			4,084			1,967
Total assets	$	151,450		$	162,309		$	140,923

Liabilities and Shareholders' Equity
Current liabilities:
Accounts payable	$	23,205		$	23,530		$	17,842
Accrued liabilities		14,068			13,933			14,937
Pre-petition obligations		725			730			730
Total current liabilities		37,998			38,193			33,509

Long-term debt obligations, net		43,233			38,959			28,784
Capital lease obligations		3,007			3,132			3,072
Postretirement benefits other than pensions		2,458			2,243			2,337
Pension and SERP liabilities		28,566			27,553			30,506
Other liabilities		7,304			6,835			7,878
Total liabilities		122,566			116,915			106,086

Commitments and contingencies

Shareholders' equity:
Common stock, $.01 par value; 80,000,000 shares authorized; 33,491,788, 33,364,125 and 33,466,455 issued and 20,089,380, 19,967,163 and 20,068,327 outstanding, respectively		335			334			335
Additional paid-in capital		89,850			89,460			89,671
Retained earnings		110,156			124,637			116,234
Treasury stock, at cost, 13,402,408, 13,396,962 and 13,398,128 shares held, respectively		(153,736	)		(153,730	)		(153,731	)
Accumulated other comprehensive loss		(17,721	)		(15,307	)		(17,672	)
Total shareholders' equity		28,884			45,394			34,837
Total liabilities and shareholders' equity	$	151,450		$	162,309		$	140,923

See accompanying notes to consolidated financial statements.

(1)	From audited balance sheet included in our annual report on Form 10-K for the fiscal year ended January 29, 2011.

HANCOCK FABRICS, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(unaudited)

	Thirteen Weeks Ended						Twenty-six Weeks Ended
	July 30,			July 31,			July 30,			July 31,
(in thousands, except per share amounts)	2011			2010			2011			2010

Sales	$	57,789		$	60,455		$	119,766		$	123,558
Cost of goods sold		32,418			31,596			67,023			66,966
Gross profit		25,371			28,859			52,743			56,592

Selling, general and administrative expense		27,084			27,172			54,424			53,816
Depreciation and amortization		1,029			1,097			2,066			2,169
Operating income (loss)		(2,742	)		590			(3,747	)		607

Reorganization expense, net		-			158			-			354
Interest expense, net		1,184			1,196			2,331			2,340

Loss from continuing operations before income taxes		(3,926	)		(764	)		(6,078	)		(2,087	)
Income taxes		-			-			-			-

Loss from continuing operations		(3,926	)		(764	)		(6,078	)		(2,087	)
Earnings from discontinued operations (net of taxes)		-			7			-			29
Net loss	$	(3,926	)	$	(757	)	$	(6,078	)	$	(2,058	)

Basic and diluted loss per share:
Loss from continuing operations	$	(0.20	)	$	(0.04	)	$	(0.31	)	$	(0.10	)
Earnings from discontinued operations		-			-			-			-
Net loss	$	(0.20	)	$	(0.04	)	$	(0.31	)	$	(0.10	)

Weighted average shares outstanding:
Basic and diluted		19,804			19,649			19,792			19,627

See accompanying notes to consolidated financial statements.

HANCOCK FABRICS, INC.

CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY

(unaudited)

																	Accumulated
						Additional											Other			Total
	Common Stock					Paid-in		Retained			Treasury Stock						Comprehensive			Shareholders'
(in thousands, except for number of shares)	Shares			Amount		Capital		Earnings			Shares			Amount			Loss			Equity
Balance January 29, 2011		33,466,455		$	335	$	89,671	$	116,234			(13,398,128	)	$	(153,731	)	$	(17,672	)	$	34,837
Comprehensive loss:
Net loss									(6,078	)											(6,078	)
Minimum pension, SERP and OPEB liabilities, net of taxes of $0																		(49	)		(49	)
Total comprehensive loss																					(6,127	)
Stock options exercised		1,333					1														1
Issuance of restricted stock		28,000																			-
Cancellation of restricted stock		(4,000	)																		-
Stock compensation expense							178														178
Purchase of treasury stock												(4,280	)		(5	)					(5	)
Balance July 30, 2011		33,491,788		$	335	$	89,850	$	110,156			(13,402,408	)	$	(153,736	)	$	(17,721	)	$	28,884

See accompanying notes to consolidated financial statements.

HANCOCK FABRICS, INC.

CONSOLIDATED STATEMENT OF CASH FLOWS

(unaudited)

	Twenty-six Weeks Ended
	July 30,			July 31,
(in thousands)	2011			2010
Cash flows from operating activities:
Net loss	$	(6,078	)	$	(2,058	)
Adjustments to reconcile net loss to cash flows from operating activities
Depreciation and amortization, including cost of goods sold		2,948			3,222
Amortization of deferred loan costs		123			124
Amortization of discount on notes		1,165			1,165
Amortization of pre-paid rent		105			93
Stock compensation expense		178			318
Inventory valuation reserve		(3,578	)		(27	)
Other		45			81
Reorganization expense, net		-			354
Change in assets and liabilities
Receivables and prepaid expenses		283			(371	)
Inventory at current cost		(6,625	)		(13,147	)
Other noncurrent assets		(234	)		406
Accounts payable		5,363			4,802
Accrued liabilities		(851	)		(1,148	)
Postretirement benefits other than pensions		(373	)		(448	)
Long-term pension and SERP liabilities		(1,495	)		1,016
Other liabilities		(604	)		(345	)
Net cash used in operating activities before reorganization activities		(9,628	)		(5,963	)
Net cash used for reorganization activities		-			(385	)
Net cash used in operating activities		(9,628	)		(6,348	)
Cash flows from investing activities:
Additions to property and equipment		(3,420	)		(3,451	)
Proceeds from the disposition of property and equipment		323			17
Net cash used in investing activities		(3,097	)		(3,434	)
Cash flows from financing activities:
Net borrowings on revolving credit facility		13,284			10,852
Payments for pre-petition liabilities and other		(58	)		(400	)
Net cash provided by financing activities		13,226			10,452
Increase in cash and cash equivalents		501			670
Cash and cash equivalents:
Beginning of period		2,372			2,493
End of period	$	2,873		$	3,163
Supplemental disclosures:
Cash paid during the period for:
Interest	$	938		$	1,014
Income taxes		35			300
Non-cash activities:
Noncash change in funded status of benefit plans		(49	)		(61	)

See accompanying notes to consolidated financial statements.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (unaudited)

NOTE 1 – BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Organization

Hancock Fabrics, Inc. (“Hancock” or the “Company”) is a specialty retailer committed to nurturing creativity through a complete selection of fashion and home decorating textiles, crafts, sewing accessories, needlecraft supplies and sewing machines. As of July 30, 2011, Hancock operated 265 stores in 37 states and an internet store under the domain name hancockfabrics.com. Hancock conducts business in one operating business segment.

References herein to “Hancock,” the “Company,” “Registrant,” “we,” “our” or “us” refer to Hancock Fabrics, Inc. and its subsidiaries unless the context specifically indicates otherwise. References herein to second quarter 2011 and second quarter 2010 are for the 13 week periods ended July 30, 2011 and July 31, 2010, respectively. References to twenty-six weeks 2011, first half 2011 or 2011, and twenty-six weeks 2010, first half 2010 or 2010 are for the 26 week periods ended July 30, 2011 and July 31, 2010, respectively.

Basis of Presentation

We maintain our financial records on a 52-53 week fiscal year ending on the Saturday closest to January 31.

The accompanying unaudited Consolidated Financial Statements should be read in conjunction with our audited Consolidated Financial Statements and accompanying notes in our Annual Report on Form 10-K for the year ended January 29, 2011 filed with the U.S. Securities and Exchange Commission (“SEC”) on April 26, 2011. The accompanying (a) consolidated balance sheet as of January 29, 2011, which has been derived from audited financial statements, and (b) unaudited consolidated financial statements have been prepared pursuant to SEC Rule 10-01 of Regulation S-X. Certain information and note disclosures normally included in annual financial statements prepared in accordance with generally accepted accounting principles in the United States of America (“GAAP”) have been condensed or omitted pursuant to those rules and regulations, although we believe that the disclosures made are adequate to make the information not misleading.

The unaudited results of operations for the interim periods shown in these financial statements are not necessarily indicative of operating results for the entire year. In the opinion of management, the accompanying unaudited Consolidated Financial Statements recognize all adjustments of a normal recurring nature considered necessary to fairly state our consolidated financial position as of July 30, 2011, and July 31, 2010, and our consolidated results of operations and cash flows for the twenty-six weeks ended July 30, 2011, and July 31, 2010.

The Consolidated Financial Statements have been prepared in accordance with accounting principles generally accepted in the United States applicable to a going concern. Except as otherwise disclosed, these principles assume that assets will be realized and liabilities will be discharged in the ordinary course of business.

Recently Issued Accounting Standards

In January 2010, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2010-06, “Improving Disclosures about Fair Value Measurements” an update to Accounting Standards Codification (ASC) Topic 820, “Fair Value Measurements and Disclosures.” This update requires an entity to: (i) disclose separately the amounts of significant transfers in and out of Level 1 and Level 2 fair value measurements and describe the reasons for the transfers and (ii) present separate information for Level 3 activity pertaining to gross purchases, sales, issuances, and settlements. This update became effective for the Company beginning the 13-weeks ended May 1, 2010, and the disclosure on the roll forward activities for Level 3 fair value measurements became effective for the Company beginning with the 13-weeks ended April 30, 2011. Other than requiring additional disclosures, adoption of this new guidance did not have a material impact on the Company’s consolidated financial statements.

The FASB issued Accounting Standards Update 2010-12 (ASU), which codifies an SEC Staff Announcement relating to accounting for the Health Care and Education Reconciliation Act of 2010 and the Patient Protection and Affordable Care Act under ASC 740, “Income Taxes.” Management completed its assessment and adoption of ASU 2010-12 in the first quarter of fiscal 2010, and determined it has no impact on the Company.

In June 2011, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2011-05, Presentation of Comprehensive Income. ASU 2011-05 amends ASC 220-10, Comprehensive Income, and requires that all changes in comprehensive income be presented either in a single continuous statement of comprehensive income or in two separate but consecutive statements, and also requires the presentation of reclassification adjustments on the face of the financial statements from other comprehensive income to net income. ASU 2011-05 is effective for the first interim or annual reporting period beginning on or after December 15, 2011. Early adoption is permitted, but the Company does not plan to adopt until its first quarter 2012.

Several other new accounting standards became effective during the periods presented or will be effective subsequent to July 30, 2011. None of these new standards had or is expected to have a significant impact on Hancock’s Consolidated Financial Statements.

NOTE 2 – PROCEEDINGS UNDER CHAPTER 11 AND RELATED FINANCINGS

On March 21, 2007, the Company filed a voluntary petition for reorganization under Chapter 11 of the United States Bankruptcy Code, in the United States Bankruptcy Court for the District of Delaware. On August 1, 2008 (the “Effective Date”), the Company’s Plan of Reorganization (the “Plan”) became effective and the Company emerged from bankruptcy protection. On August 17, 2010 the Final Decree was approved by the United State Bankruptcy Court closing the bankruptcy case of the Company.

As of the Effective Date, in general and except as otherwise provided under the Plan, the Company was discharged and released from all claims and interests in accordance with the Plan. The Plan provides for payment in full in cash plus interest, as applicable, or reinstatement of allowed administrative, secured, priority, and general unsecured claims in addition to the retention of ownership by holders of equity interest in the Company. Therefore, there were no impaired classes of creditors or stockholders.

FASB ASC 852, “Reorganizations” (“ASC 852”), provides financial reporting guidance for entities that are reorganizing under the United States Bankruptcy Code. The Company implemented this guidance for all periods presented. Pursuant to ASC 852, estimated claims were presented as Liabilities Subject to Compromise due to the uncertainty of the eventual settlement amount. Due to the Plan becoming effective and the claims reconciliation process being substantially complete, there is little uncertainty as to the total amount to be distributed under the Plan. Therefore, after the Effective Date, pre-petition liabilities are no longer presented as Liabilities Subject to Compromise.

Pre-petition obligations (in thousands):

	July 30,		July 31,		January 29,
	2011		2010		2011
Real estate claims	$	-	$	5	$	5
Professional fee claim		725		725		725
Total pre-petition claims	$	725	$	730	$	730

NOTE 3 – EMPLOYEE BENEFIT PLANS

Retirement Plans. The determination of the obligation and expense for Hancock’s defined benefit pension retirement plan and postretirement health care benefit plan is dependent on the Company’s selection of assumptions used by actuaries in calculation those amounts. Those assumptions are described in the Company’s 2010 Annual Report on Form 10-K and include the discount rate, the expected long-term rate of return on plan assets, and the rates of increase in compensation and health care costs, in addition to other disclosures. Actual results that differ from the assumptions are accumulated and amortized over future periods and, therefore, generally affect the recognized expense and recorded obligation in such future periods. While the Company believes that the assumptions are appropriate, significant differences in actual experience or significant changes in assumptions may materially affect the pension and other postretirement obligations and future expense.

The following summarizes the net periodic benefit cost for Hancock’s defined benefit pension retirement plan and its postretirement health care benefit plan for the thirteen and twenty-six weeks ended July 30, 2011 and July 31, 2010 (in thousands):

	Retirement Plan						Postretirement Benefit Plan						Retirement Plan						Postretirement Benefit Plan
	Thirteen Weeks Ended												Twenty-six Weeks Ended
	July 30,			July 31,			July 30,			July 31,			July 30,			July 31,			July 30,			July 31,
	2011			2010			2011			2010			2011			2010			2011			2010
Service costs	$	127		$	107		$	21		$	17		$	253		$	214		$	43		$	34
Interest cost		1,138			1,139			34			33			2,277			2,278			68			65
Expected return on assets		(1,012	)		(959	)		-			-			(2,025	)		(1,918	)		-			-
Amortization of prior service costs		-			-			(181	)		(199	)		-			-			(362	)		(398	)
Recognized net actuarial (gain) loss		254			240			(66	)		(72	)		507			480			(132	)		(144	)
Net periodic benefit cost (gain)	$	507		$	527		$	(192	)	$	(221	)	$	1,012		$	1,054		$	(383	)	$	(442	)

At July 30, 2011, the fair value of the assets held by the pension plan was $56.8 million reflecting a $2.4 million increase from January 29, 2011.

Based on management’s assessment of the Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act of 2010 (the “Acts”) as they relate to the Company’s Postretirement Benefit Plan, management does not believe the impact of this legislation is a significant event to the Company and believes the Acts will not materially impact costs in subsequent periods.

NOTE 4 – EARNINGS (LOSS) PER SHARE

Earnings (loss) per share is presented for basic and diluted earnings per share. Basic earnings per share excludes dilution and is computed by dividing income available to holders of common stock 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.

As of July 30, 2011, there were outstanding warrants for 9,485,600 shares with an exercise price of $1.12 and stock options for 1,156,751 shares with a weighted average exercise price of $3.16, which would be included in the computation of common stock equivalents for diluted earnings per share, if the impact was not anti-dilutive.

COMPUTATION OF LOSS PER SHARE

(in thousands, except for share and	Thirteen Weeks Ended						Twenty-six Weeks Ended
per share amounts)	July 30,			July 31,			July 30,			July 31,
	2011			2010			2011			2010
Basic and diluted loss per share:
Net loss	$	(3,926	)	$	(757	)	$	(6,078	)	$	(2,058	)

Weighted average number of common shares outstanding during period		19,803,648			19,648,694			19,792,464			19,626,553

Basic and diluted loss per share	$	(0.20	)	$	(0.04	)	$	(0.31	)	$	(0.10	)

Using the Treasury Stock method, the number of shares excluded from the diluted loss per share calculation totaled approximately 10.9 and 4.7 million for the second quarters and 11.0 and 5.6 million for the twenty-six weeks of 2011 and 2010, respectively.

NOTE 5 – FAIR VALUE MEASUREMENTS AND FINANCIAL INSTRUMENTS

FASB ASC 820, Fair Value Measurements and Disclosures, defines fair value, establishes a three-level valuation hierarchy for disclosures of fair value measurement and enhances disclosure requirements for fair value measures. The three levels are defined as follows:

Level 1 - inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities in active markets.

Level 2 - inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the assets or liability, either directly or indirectly, for substantially the full term of the financial instruments.

Level 3 - inputs to the valuation methodology are unobservable and significant to the fair value.

The carrying amounts of certain of the Company’s financial instruments, which are not required to be valued at fair value on a recurring basis, including cash and cash equivalents, accounts receivable, accounts payable, accrued liabilities and debt, approximate fair value due to their short maturities or the nature and terms of the obligation.

NOTE 6 – LONG-TERM DEBT OBLIGATIONS

At July 30, 2011, the Company had outstanding borrowings of $26.4 million under its revolving credit facility (the “Revolver”) with General Electric Capital Corporation, which has a maturity date of August 1, 2013. Outstanding standby letters of credit were $5.7 million, outstanding documentary letters of credit were $1.4 million and availability was $36.5 million at July 30, 2011. The Revolver is collateralized by a fully perfected first priority security interest in all real and personal, tangible and intangible assets of the Company. The Company is not subject to any financial covenants pursuant to the Revolver.

At the Company’s option, any portion of the outstanding borrowings under the Revolver can bear interest at LIBOR - based rates plus an applicable margin, or a floating interest rate plus the applicable margins. At July 30, 2011, the Company had $20.0 million of its outstanding borrowings at a LIBOR-based interest rate of 1.81%

In addition to the Revolver, the Company has $21.6 million of Floating Rate Secured Notes (the “Notes”) outstanding at July 30, 2011. The Notes mature on August 1, 2013, are subordinated to the Revolver, and are secured by a junior lien on all of the Company’s assets. Interest on the Notes is payable quarterly at a rate of LIBOR plus 4.5%. An additional $1.2 million of interest expense was recorded for the first half of 2011 and 2010 related to the amortization of the discount recorded at the time of issuance of the Notes. As of July 30, 2011 the balance of the unamortized discount was $4.8 million.

NOTE 7 – SUBSEQUENT EVENTS

The Company has evaluated subsequent events through the date on which this report was issued and determined there were no subsequent events that required adjustment or disclosure in connection with the financial statements for the period ended July 30, 2011.

ITEM 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion should be read in conjunction with the consolidated financial statements as of and for the thirteen and twenty-six weeks ended July 30, 2011, including the notes to those statements, appearing elsewhere in this report. We also suggest that management’s discussion and analysis appearing in this report be read in conjunction with the management’s discussion and analysis and consolidated financial statements included in our Annual Report on Form 10-K for the fiscal year ended January 29, 2011. Our fiscal year ends on the Saturday closest to January 31 and refers to the calendar year ended immediately prior to such date, which contained the substantial majority of the fiscal period (e.g., “fiscal 2010” or “2010” refers to the fiscal year ended January 29, 2011). Fiscal years consist of 52 weeks, comprised of four 13-week fiscal quarters, unless noted otherwise. References herein to second quarter 2011 and second quarter 2010 are for the 13 week periods ended July 30, 2011 and July 31, 2010, respectively.

Forward Looking Statements

This Quarterly Report on Form 10-Q (“Quarterly Report”) contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements are not historical facts and reflect our current views regarding matters such as operations and financial performance. In general, forward-looking statements are identified by such words or phrases as “anticipates,” “believes,” “approximates,” “estimates,” “expects,” “intends” or “plans” or the negative of those words or other terminology. Forward-looking statements involve inherent risks and uncertainties; our actual results could differ materially from those expressed in our forward-looking statements.

The risks and uncertainties, either alone or in combination, that could cause our actual results to differ from those expressed in our forward-looking statements include, but are not limited to, those that are discussed in our Annual Report on Form 10-K filed with the SEC on April 26, 2011 under Item 1A. Risk Factors. Other risks not presently known to us, or that we currently believe are immaterial, could also adversely affect our business, financial condition or results of operations. Forward-looking statements speak only as of the date made, and neither Hancock nor its management undertakes any obligation to update or revise any forward-looking statement.

Our Business

Hancock Fabrics, Inc. is a specialty retailer committed to serving creative enthusiasts with a complete selection of fashion and home decorating textiles, sewing accessories, needlecraft supplies and sewing machines. We are one of the largest fabric retailers in the United States, operating 265 stores in 37 states and an internet store under the domain name hancockfabrics.com as of July 30, 2011. Our stores present a broad selection of fabrics and notions used in apparel sewing, home decorating and quilting projects.

Overview

Financial summary:

Sales for the second quarter of fiscal 2011 were $57.8 million compared to $60.5 million for the second quarter of fiscal 2010, and comparable store sales decreased 4.1% in the second quarter of 2011 compared to an increase of 0.7% in the second quarter of 2010.

Our online sales for the second quarter of fiscal 2011, which are included in the sales number and comparable sales percentage above, increased 1.2% to $0.8 million.

Gross margin for the second quarter of fiscal 2011 was 43.9% compared with 47.7% for the second quarter of fiscal 2010.

Operating loss was $2.7 million in the second quarter of fiscal 2011 compared to income of $0.6 million in the second quarter of fiscal 2010.

Net loss was $3.9 million, or $0.20 per basic share, in the second quarter of fiscal 2011 compared to a net loss of $0.8 million, or $0.04 per basic share in the second quarter of fiscal 2010.

We use a number of key performance measures to evaluate our financial performance, including the following:

	Thirteen Weeks Ended						Twenty-six Weeks Ended
	July 30,			July 31,			July 30,			July 31,
	2011			2010			2011			2010

Sales (in thousands)	$	57,789		$	60,455		$	119,766		$	123,558

Gross margin percentage		43.9	%		47.7	%		44.0	%		45.8	%

Number of stores
Open at end of period (1)		265			266			265			266
Comparable stores at period end (2)		264			264			264			264

Sales growth
All retail outlets		(4.4	) %		1.5	%		(3.1	) %		(0.1	) %
Comparable retail outlets (3)		(4.1	) %		0.7	%		(2.7	) %		(0.7	) %

Total store square footage at period end (in thousands)		3,775			3,816			3,775			3,816

Sales per total square footage	$	15.31		$	15.84		$	31.73		$	32.38

(1)	Open store count does not include the internet store.

(2)	A new store is included in the comparable sales computation immediately upon reaching its one-year anniversary. In those rare instances where stores are either expanded or down-sized, the store is not treated as a new store and, therefore, remains in the computation of comparable sales.

(3)	Comparable sales growth computation also includes net sales derived from e-commerce.

Results of Operations

The following table sets forth, for the periods indicated selected statement of operations data expressed as a percentage of sales. This table should be read in conjunction with the following discussion and with our Consolidated Financial Statements, including the related notes.

	Thirteen Weeks Ended						Twenty-six Weeks Ended
	July 30,			July 31,			July 30,			July 31,
	2011			2010			2011			2010
Sales		100.0	%		100.0	%		100.0	%		100.0	%
Cost of goods sold		56.1			52.3			56.0			54.2
Gross profit		43.9			47.7			44.0			45.8
Selling, general and administrative expense		46.9			44.9			45.4			43.6
Depreciation and amortization		1.8			1.8			1.7			1.7
Operating income (loss)		(4.8	)		1.0			(3.1	)		0.5
Reorganization expense, net		0.0			0.3			0.0			0.3
Interest expense, net		2.0			2.0			2.0			1.9
Loss from continuing operations before income taxes		(6.8	)		(1.3	)		(5.1	)		(1.7	)
Income taxes		-			-			-			-
Income from discontinued operations		-			-			-			-
Net loss		(6.8	) %		(1.3	) %		(5.1	) %		(1.7	) %

Sales

	Thirteen Weeks Ended				Twenty-six Weeks Ended
(in thousands)	July 30,		July 31,		July 30,		July 31,
	2011		2010		2011		2010
Retail comparable store base	$	56,879	$	59,335	$	117,778	$	121,103
E-Commerce		817		807		1,843		1,815
Comparable sales		57,696		60,142		119,621		122,918
New stores		93		-		93		-
Closed stores		-		313		52		640

Total sales	$	57,789	$	60,455	$	119,766	$	123,558

The retail comparable store base above consists of the stores which were included in the comparable sales computation for the current period. The second quarter 2011 retail comparable sales decrease of 4.1% was the result of a 3.5% decrease in transaction count and a 0.5% decline in average ticket. Sales improvement in home decorating and non-sewing products were offset by declines in apparel and craft fabrics, and sewing accessories.

Sales provided by our e-commerce channel increased 1.2% in the second quarter and have increased 1.5% in the first half of fiscal 2011.

Since the second quarter of 2010, we closed two stores, due to lease expirations in declining markets where we chose not to extend or relocate, and opened one new store. The sales from these locations are included in sales

Our merchandise mix has had minimal change year over year, as reflected in the table below.

	Thirteen Weeks Ended						Twenty-six Weeks Ended
	July 30,			July 31,			July 30,			July 31,
	2011			2010			2011			2010

Apparel and Craft Fabrics		41	%		43	%		42	%		42	%
Home Decorating Fabrics		14	%		12	%		14	%		14	%
Sewing Accessories		30	%		31	%		30	%		31	%
Non-Sewing Products		15	%		14	%		14	%		13	%
		100	%		100	%		100	%		100	%

Gross Profit

Costs of goods sold include:

the cost of merchandise

inventory rebates and allowances including term discounts

inventory shrinkage and valuation adjustments

freight charges

costs associated with our sourcing operations, including payroll and related benefits

costs associated with receiving, processing, and warehousing merchandise

The classification of these expenses varies across the retail industry.

Specific components of cost of goods sold for the second quarter and first twenty-six weeks of fiscal 2011 and 2010 are as follows:

	Thirteen Weeks Ended										Twenty-six Weeks Ended
	July 30,		% of			July 31,		% of			July 30,		% of			July 31,		% of
(dollars in thousands)	2011		Sales			2010		Sales			2011		Sales			2010		Sales

Total sales	$	57,789		100.0	%	$	60,455		100.0	%	$	119,766		100.0	%	$	123,558		100.0	%

Merchandise cost		27,449		47.5	%		27,442		45.5	%		56,467		47.1	%		57,700		46.7	%
Freight		2,253		3.9	%		1,713		2.8	%		4,366		3.7	%		3,712		3.0	%
Sourcing and warehousing		2,716		4.7	%		2,441		4.0	%		6,190		5.2	%		5,554		4.5	%

Gross Profit	$	25,371		43.9	%	$	28,859		47.7	%	$	52,743		44.0	%	$	56,592		45.8	%

Merchandise cost increased 200 basis points in the second quarter of 2011 compared to the same period of 2010, due to clearance activity in slow moving product lines. For the first half of 2011 merchandise cost was 40 basis points higher than 2010 as the clearance activity in the second quarter more than offset the benefit of reduced promotional activity achieved in the first quarter of this year.

Freight expense increased by 110 basis points in the second quarter 2011 compared to the second quarter 2010. This increase was the result of higher fuel surcharges and additional freight charges which resulted from the rollout of the expanded craft assortment.

Sourcing and warehousing costs for the Company vary based on the volume of inventory received and the rate at which inventory is shipped out during any period, and inventory turns. Although warehousing and distribution cost incurred declined for both the second quarter and twenty-six weeks of 2011 due to a reduction of receipts, inventory turns drove the amount expensed as cost of sales higher than the prior year amounts.

In total, gross margin declined by 380 basis points in the second quarter 2011 from second quarter 2010, and by 180 basis points for the first twenty-six weeks of 2011 over the first twenty-six weeks of 2010.

Selling, General & Administrative Expenses

Selling, general & administrative expenses (SG&A) include:

payroll and related benefits (for our store operations, field management, and corporate functions)

advertising

general and administrative expenses

occupancy, including rent, common area maintenance, taxes and insurance for our retail locations

operating costs of our headquarter facilities

other expense (income)

Specific components of selling, general & administrative expenses include:

	Thirteen Weeks Ended										Twenty-six Weeks Ended
	July 30,		% of			July 31,		% of			July 30,		% of			July 31,		% of
(dollars in thousands)	2011		Sales			2010		Sales			2011		Sales			2010		Sales

Retail store labor costs	$	9,921		17.2	%	$	10,013		16.6	%	$	19,959		16.7	%	$	19,998		16.2	%
Advertising		2,057		3.6	%		2,236		3.7	%		3,942		3.3	%		4,654		3.8	%
Store occupancy		7,656		13.2	%		7,359		12.2	%		15,287		12.8	%		14,681		11.9	%
Retail SG&A		5,396		9.3	%		5,168		8.5	%		10,524		8.8	%		9,861		8.0	%
Corp SG&A		2,054		3.6	%		2,396		3.9	%		4,712		3.8	%		4,622		3.7	%

Total SG&A	$	27,084		46.9	%	$	27,172		44.9	%	$	54,424		45.4	%	$	53,816		43.6	%

Retail Store Labor Costs – The retail store labor costs were lower during the second quarter and consistent with prior year for the first twenty-six weeks of 2011, but due to lower revenue such costs increased as a percentage of sales.

Advertising – The variances in advertising expense for the second quarter and first half of 2011 compared to the same periods in 2010 are attributable to shifting events to the seasonally more productive second half of the year.

Store Occupancy – The increase in occupancy cost is related to maintenance expenditures to improve the appearance and operating standard for the retail store units. Real estate related costs have remained constant year over year as we’ve made significant efforts to restructure rents as a result of the current commercial real estate market. These efforts in some cases resulted in rent reductions, concessions on future escalations, and term extensions.

Retail SG&A – Expenditures for supplies and housekeeping related to enhanced store standards and the craft assortment rollout drove the increase in retail SG&A in the second quarter 2011. Utility cost also contributed to the increase over last year.

Corporate SG&A –Corporate overhead was lower for the second quarter due to a reduction in professional fees and compensation related accruals, while year over year twenty-six week amounts were comparable.

Interest Expense, Net

	Thirteen Weeks Ended										Twenty-six Weeks Ended
(dollars in thousands)	July 30,		% of			July 31,		% of			July 30,		% of			July 31,		% of
	2011		Sales			2010		Sales			2011		Sales			2010		Sales
Interest expense, net	$	1,184		2.0	%	$	1,196		2.0	%	$	2,331		2.0	%	$	2,340		1.9	%

The Company’s interest costs are driven by borrowings on our credit facilities and a small number of capital leases. Our current credit facilities consist of both an asset-based facility and a subordinated-debt facility. Interest expense for each of the second quarters and the first twenty-six weeks of 2011 and 2010 included note discount amortization of $0.6 million and $1.2 million, respectively. Excluding this non-cash item, interest expense was 1.0% of sales for each of the periods presented above.

Income Taxes

The Company did not recognize any income tax benefit during the first half of fiscal 2011 or 2010 given the uncertainty in realizing the future benefit. As of July 30, 2011, January 29, 2011 and July 31, 2010 the Company has established a 100% valuation allowance to offset the net deferred tax assets related to net operating loss carryforwards and other book-tax timing differences.

Liquidity and Capital Resources

Hancock's primary capital requirements are for the financing of inventories and, to a lesser extent, for capital expenditures relating to store locations and the Company’s distribution facility. Funds for such purposes have historically been generated from Hancock's operations, short-term trade credit in the form of extended payment terms from suppliers for inventory purchases, and borrowings from commercial lenders.

We anticipate that we will be able to satisfy our working capital requirements, planned capital expenditures and debt service requirements with available cash, proceeds from cash flows from operations, short-term trade credit, borrowings under our revolving credit facility and other sources of financing. We expect to generate adequate cash flow from operating activities to sustain current levels of operations.

Hancock’s cash flow related information for the first twenty-six weeks of fiscal 2011 and 2010 follows (in thousands):

	Twenty-six Weeks Ended
	July 30,			July 31,
	2011			2010

Net cash flows provided by (used in):
Operating activites	$	(9,628	)	$	(6,348	)
Investing activities		(3,097	)		(3,434	)
Financing activites		13,226			10,452

Operating Activities

Net cash used in operating activities during the first twenty-six weeks of 2011 increased by $3.3 million compared to the first twenty-six weeks of 2010. The reduced inventory buildup as compared to the prior year was offset by a larger net loss for the period, a reduction in the inventory valuation reserve and a required cash contribution to the pension.

Investing Activities

Cash used for investing activities consists primarily of purchases and sales of property and equipment. Capital expenditures during the first twenty-six weeks 2011 were $3.1 million compared to $3.4 million for the first twenty-six weeks of 2010. Expenditures for 2011 consist primarily of fixtures, for one new store, three relocations and the expanded craft assortment introduced in 42 locations, compared to fixtures for new product lines and point of sale (POS) equipment upgrades completed during the first twenty-six weeks of 2010.

Financing Activities

Borrowings from the Revolver of $13.3 million were used to provide working capital and fund capital expenditures during the first twenty-six weeks of 2011.

Credit Facilities

The following should be read in conjunction with Note 6 to the Consolidated Financial Statements included in this report and Note 7 to the Company’s Consolidated Financial Statements included in the Company’s Annual Report on Form 10-K filed with the SEC on April 26, 2011.

As of July 30, 2011, the Company had outstanding borrowings under the Revolver of $26.4 million and outstanding letters of credit of $7.1 million. Additional amounts available to borrow at that time were $36.5 million.

As of July 30, 2011, the balance of the Company’s Floating Rate Secured Notes was $21.6 million and the unamortized discount on Notes Payable related to warrants issued was $4.8 million.

Off-Balance Sheet Arrangements

Hancock has no off-balance sheet financing arrangements. Hancock leases its retail fabric store locations mainly under non-cancelable operating leases. Four of the Company’s store leases qualified for capital lease treatment. Future payments under the operating leases are appropriately excluded from the Company’s balance sheet. Capital lease obligations are, however, reflected on the Company’s balance sheet.

Contractual Obligations and Commercial Commitments

Hancock has an arrangement within its Revolver that provides up to $20.0 million in letters of credit. At July 30, 2011, Hancock had commitments of $1.4 million on documentary letters of credit under the facility, which support purchase orders for merchandise. Hancock also has $5.7 million on standby letters of credit to guarantee payment of potential insurance claims. Hancock leases its retail fabric store locations under operating leases expiring at various dates through 2024.

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

Critical Accounting Policies and Estimates

The preparation of financial statements in accordance with accounting principles generally accepted in the United States of America requires management to adopt accounting policies and make significant judgments and estimates to develop amounts reflected and disclosed in the financial statements. In many cases, there are alternative policies or estimation techniques that could be used. We maintain a process to review the application of our accounting policies and to evaluate the appropriateness of the many estimates that are required to prepare the financial statements of a large corporation. However, even under optimal circumstances, estimates routinely require adjustment based on changing circumstances and the receipt of new or better information. There have been no significant changes to our accounting policies and estimates as discussed in our Annual Report on Form 10-K for the fiscal year ended January 29, 2011.

Related Party Transactions

See Note 17 to the Company’s Consolidated Financial Statements included in the Company’s Annual Report on Form 10-K filed with the SEC on April 26, 2011, for details regarding the sole related party transaction that the Company has entered into.

The Company has no other balances with related parties, nor has it had any other material transactions with related parties during either of the twenty-six week periods ended July 30, 2011 and July 31, 2010.

Effects of Inflation

Inflation in labor and occupancy costs could 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 in those requirements will affect Hancock. In addition, payroll taxes, employee benefits, and other employee costs continue to increase, and the full impact of the recently enacted health care reform legislation will not be known for several years. Health insurance costs, in particular, continue to rise at a high rate in the United States each year, and higher employer contributions to Hancock’s pension plan could be necessary if investment returns are weak. Costs of leases for new store locations remain stable, but renewal costs of older leases continue to increase. Hancock believes the practice of maintaining adequate operating margins through a combination of product 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.

Seasonality

Hancock's business is seasonal. Peak sales periods occur during the fall and early spring weeks, while the lowest sales periods occur during the summer. Working capital requirements needed to finance our operations fluctuate during the year and reach their highest levels during the second and third fiscal quarters as we increase our inventory in preparation for our peak selling season during the fourth quarter.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS

Hancock did not hold derivative financial or commodity instruments at July 30, 2011.

Interest Rate Risk

The Company is exposed to financial market risks, including changes in interest rates. At the Company's option, all loans under the Revolver bear interest at either (a) a floating interest rate plus the applicable margins or (b) absent a default, a fixed interest rate for periods of one, two or three months equal to the reserve adjusted London Interbank Offered Rate, or LIBOR, plus the applicable margins.

As of July 30, 2011, the Company had borrowings outstanding of approximately $26.4 million under the Revolver. If interest rates increased 100 basis points, the Company’s annual interest expense would increase approximately $264,000, assuming borrowings under the Revolver of $26.4 million as existed at July 30, 2011.

In addition to the Revolver, the Company issued $20.0 million of Floating Rate Secured Notes (the “Notes”) on August 1, 2008. Interest on the Notes is payable quarterly at LIBOR plus 4.50%. Interest for the first four quarters was paid by the issuance of additional notes at a rate equal to LIBOR plus 5.50%, which resulted in the capitalization of $1.6 million into the balance.

The Company will pay the subsequent interest payments on the Notes in cash, the next payment date being November 1, 2011. If interest rates increased 100 basis points, the Company’s annual interest expense would increase $216,000, based on balance of the Notes of $21.6 million at July 30, 2011.

Foreign Currency Risk

All of the Company’s business is transacted in U.S. dollars and, accordingly, devaluation of the dollar against other currencies can increase product costs, although this risk did not significantly impact the twenty-six week period ended July 30, 2011. As of July 30, 2011 the Company had no financial instruments outstanding that were sensitive to changes in foreign currency rates.

ITEM 4. CONTROLS AND PROCEDURES

Disclosure Controls and Procedures

The Company maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in the reports filed or submitted under the Securities Exchange Act of 1934, as amended (the “Exchange Act”) is recorded, processed, summarized, and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms and that such information is accumulated and communicated to the Company’s management, including our President and Chief Executive Officer (principal executive officer) and Executive Vice President and Chief Financial Officer (principal financial officer), as appropriate, to allow timely decisions regarding the required disclosures.

In connection with the preparation of this Quarterly Report on Form 10-Q as of July 30, 2011, the Company’s management, under the supervision and with the participation of the Company’s interim President and Chief Executive Officer, and Executive Vice President and Chief Financial Officer, performed an evaluation of the effectiveness of our disclosure controls and procedures (as such term is defined in the Rules 13a-15(e) and 15d-15(e) under the Exchange Act). Based upon this evaluation, the Company’s principal executive officer and principal financial officer concluded that the Company’s disclosure controls and procedures were effective as of July 30, 2011.

Changes in Internal Control Over Financial Reporting

There have been no changes in our internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) within the fiscal quarter to which this report relates that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II. OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

“Item 3. Legal Proceedings” of our Form 10-K includes a discussion of other legal proceedings. There have been no material changes from the legal proceedings described in our Form 10-K.

ITEM 1A. RISK FACTORS

The risk factors listed in Part I “Item 1A. Risk Factors” in the Company’s Annual Report on Form 10-K for the fiscal year ended January 29, 2011, should be considered with the information provided elsewhere in this Quarterly Report on Form 10-Q, which could materially adversely affect the business, financial condition or results of operations. There have been no material changes to the risk factors as previously disclosed in such Annual Report on Form 10-K.

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

In June of 2000 the Board of Directors authorized the repurchase of up to 2,000,000 shares of the Company’s Common Stock from time to time when warranted by market conditions. There have been 1,756,485 shares purchased under this authorization through July 30, 2011, and the number of shares that may yet be purchased under this authorization is 243,515. The Company did not repurchase any shares in the market during the period covered by this Quarterly Report, but did accept shares in settlement of tax withholding obligations on restricted shares.

The Company did not sell any unregistered equity securities during the period covered by this Quarterly Report.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

None.

ITEM 4. REMOVED AND RESERVED

ITEM 5. OTHER INFORMATION

None.

ITEM 6. EXHIBITS

31.1	Certification of Chief Executive Officer Pursuant to Rule 13a-14(a) Under The Securities Exchange Act of 1934
31.2	Certification of Chief Financial Officer Pursuant to Rule 13a-14(a) Under The Securities Exchange Act of 1934
32.1	Certification of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant To Section 906 of The Sarbanes-Oxley Act of 2002

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.

	HANCOCK FABRICS, INC.
		(Registrant)

	By:	/s/ Robert W. Driskell
		Robert W. Driskell
		Executive Vice President and
		Chief Financial Officer
		(Principal Financial Officer)

Date: September 13, 2011

EXHIBIT INDEX

Exhibit No.		Description
31.1		Certification of Chief Executive Officer Pursuant to Rule 13a-14(a) Under The Securities Exchange Act of 1934
31.2		Certification of Chief Financial Officer Pursuant to Rule 13a-14(a) Under The Securities Exchange Act of 1934
32.1		Certification of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant To Section 906 of The Sarbanes-Oxley Act of 2002

HANCOCK FABRICS INC - FORM 10-Q - September 13, 2011

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