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EX-32 - EXHIBIT 32 - HANCOCK FABRICS INCv309391_ex32.htm
EX-31.2 - EXHIBIT 31.2 - HANCOCK FABRICS INCv309391_ex31-2.htm
EX-23.1 - EXHIBIT 23.1 - HANCOCK FABRICS INCv309391_ex23-1.htm
EX-31.1 - EXHIBIT 31.1 - HANCOCK FABRICS INCv309391_ex31-1.htm
EX-10.33 - EXHIBIT 10.33 - HANCOCK FABRICS INCv309391_ex10-33.htm
EX-10.32 - EXHIBIT 10.32 - HANCOCK FABRICS INCv309391_ex10-32.htm
EX-10.31 - EXHIBIT 10.31 - HANCOCK FABRICS INCv309391_ex10-31.htm
EX-10.11 - EXHIBIT 10.11 - HANCOCK FABRICS INCv309391_ex10-11.htm

  

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

 

FORM 10-K

 

x Annual Report Pursuant to Section 13 or 15(d) of the

Securities Exchange Act of 1934

For the fiscal year ended January 28, 2012

or

¨ Transition Report Pursuant to Section 13 or 15(d) of the

Securities Exchange Act of 1934

 

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)

 

Registrant’s telephone number, including area code

(662) 365-6000

 

Securities Registered Pursuant to Section 12 (b) of the Act:

 

None.

 

Securities registered pursuant to Section 12(g) of the Act:

 

Title of Class

 

Common stock ($.01 par value)

Purchase Rights

Warrants to Purchase Common Stock

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ¨ No x

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ¨ No x

 

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 x No ¨

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of the Form 10-K or any amendment to this Form 10-K. ¨

 

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 definition 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 (Do not check if a smaller reporting company) ¨ Smaller reporting company x

 

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

 

Our common stock is traded through broker-to-broker exchanges on the OTC Markets (formerly known as the “Pink Sheets”), a centralized quotation service that collects and publishes market maker quotes for over-the-counter securities. The aggregate market value of Hancock Fabrics, Inc. $.01 par value common stock held by non-affiliates, based on 19,484,967 shares of common stock outstanding and the price of $1.28 per share on July 29, 2011 (the last business day of the Registrant’s most recently completed second quarter) was $24,940,758. Such aggregate market value was computed by reference to the closing sale price of our common stock as reported on the OTC Markets on such date. For purposes of making this calculation only, we have defined “affiliates” as including all directors and executive officers, but excluding any institutional stockholders owning more than ten percent of our common stock.

 

APPLICABLE ONLY TO REGISTRANTS INVOLVED IN BANKRUPTCY

PROCEEDINGS DURING THE PRECEDING FIVE YEARS:

 

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

 

As of April 15, 2012, there were 20,735,130 shares of Hancock Fabrics, Inc. $.01 par value common stock outstanding.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Certain information called for by Part III of Form 10-K is incorporated by reference to the Proxy Statement for our 2012 Annual Meeting of Stockholders to be filed with the Commission within 120 days after January 28, 2012.

 

With the exceptions of those portions that are not specifically incorporated herein by reference, the aforesaid document is not deemed filed as part of this report.

 

 
 

 

HANCOCK FABRICS, INC.

2011 ANNUAL REPORT ON FORM 10-K

 

TABLE OF CONTENTS

 

  Page
PART 1  
     
Item 1. Business 3
Item 1A. Risk Factors 6
Item 1B. Unresolved Staff Comments 12
Item 2. Properties 12
Item 3. Legal Proceedings 13
Item 4.  Mine Safety Disclosures 13
     
PART II  
     
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities 14
Item 6. Selected Financial Data 16
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations 17
Item 7A. Quantitative and Qualitative Disclosures About Market Risk 31
Item 8.  Consolidated financial Statements and Supplementary Data 32
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 64
Item 9A. Controls and Procedures 64
Item 9B. Other Information 65
     
PART III  
     
Item 10. Directors, Executive Officers and Corporate Governance 66
Item 11. Executive Compensation 66
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters 66
Item 13. Certain Relationships and Related Transactions, and Director Independence 66
Item 14. Principal Accountant Fees and Services 66
     
PART IV  
     
Item 15. Exhibits and Financial Statement Schedules 67

 

2
 

 

Forward-Looking Statements

 

This Annual Report on Form 10-K (“Annual Report”) contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. 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,” “could,” “approximates,” “estimates,” “expects,” “may,” “intends,” “predicts,” “projects,” “plans,” or “will” 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 referred to in Item 1A. “Risk Factors” in this annual report on Form 10-K. 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 we undertake no obligation to update or revise any forward-looking statement.

 

PART I

 

Except as otherwise stated, the information contained in this report is given as of January 28, 2012, the end of our latest fiscal year. The words “Hancock Fabrics, Inc.,” “Hancock,” the “Company,” “we,” “our” and “us” refer to Hancock Fabrics, Inc. and, unless the context requires otherwise, to our subsidiaries. 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 2011” or “2011” refers to the fiscal year ended January 28, 2012). Fiscal years consist of 52 weeks, unless noted otherwise.

 

Item 1. BUSINESS

 

General

 

Hancock Fabrics, Inc., a Delaware corporation, was incorporated in 1987 as a successor to the retail and wholesale fabric business of Hancock Textile Co., Inc., a Mississippi corporation and a wholly owned subsidiary of Lucky Stores, Inc., a Delaware corporation (“Lucky”).

 

Founded in 1957, we operated as a private company until 1972 when we were acquired by Lucky. We became a publicly owned company as a result of the distribution of shares of common stock to the shareholders of Lucky on May 4, 1987.

 

The Company is one of the largest fabric retailers in the United States, with 2011 sales of $272.0 million. We are a specialty retailer committed to nurturing creativity through a complete selection of fashion and home decorating textiles, sewing accessories, needlecraft supplies and sewing machines. We believe that providing a large assortment of fabric and other items, combined with expert in-store sewing advice, provides us with a competitive advantage. We operated 263 stores in 37 states and an internet store located on our website with the domain name www.hancockfabrics.com as of January 28, 2012.

 

Operations

 

Our stores offer a wide selection of apparel fabrics, home decorating products (which include drapery and upholstery fabrics and home accent pieces), quilting materials, and notions (which include sewing aids and accessories such as zippers, buttons, threads, sewing machines, and patterns).

 

Our stores are primarily located in strip shopping centers. During 2011, we closed three stores, opened one store, remodeled 45 stores, and relocated five existing stores.

 

3
 

 

Merchandising/Marketing

 

We principally serve the sewing, needle arts, and home decorating markets. These markets primarily consist of women who are creative enthusiasts, making clothing and gifts for their families and friends, and decorating their homes.

 

We offer our customers a wide selection of products at prices that we believe are similar or lower than the prices charged by our competitors. In addition to staple fabrics and notions for apparel, quilting, and home decoration, we provide a variety of seasonal and current fashion merchandise.

 

We use promotional advertising, primarily direct mail, email, and newspaper inserts, to reach our target customers.

 

Distribution and Supply

 

Our retail stores are served by our corporate headquarters and a 650,000 square foot warehouse and distribution facility in Baldwyn, Mississippi.

 

Contract trucking firms, common carriers, and parcel delivery are used to deliver merchandise to our warehouse. These types of carriers are also used to deliver merchandise from our warehouse and vendors to our retail stores.

 

Bulk quantities of fabric are purchased from domestic and foreign mills, fabric jobbers and importers. We have no long-term contracts for the purchase of merchandise and did not purchase more than 4% of our merchandise from any one supplier during 2011. We purchased approximately 15.5% of our merchandise from our top five suppliers in fiscal year 2011.

 

Competition

 

We are among the largest fabric retailers in the United States, serving our customers in their quest for apparel and craft sewing, quilting, home decorating, and other artistic undertakings. Our stores compete with other specialty fabric and craft retailers, such as Jo-Ann Stores, Inc., and selected mass merchants, including Wal-Mart, that dedicate a portion of their selling space to a limited selection of fabrics and craft supply items. In addition, alternative methods of selling fabrics and crafts, such as internet based sales, could result in additional competitors in the future and increased price competition since our customers could more readily comparison shop. We compete on the basis of price, selection, quality, service and location. We believe that our continued commitment to providing a large assortment of fabric and other items that are affordable, complete, and unique, combined with the expert sewing advice available in each of our stores, provides us with a competitive advantage in the industry.

 

Information Technology

 

Hancock is committed to using information technology to improve operations and efficiency and to enhance the customer shopping experience.  In 2009, continuing our commitment to technology, we began the implementation of inventory auto replenishment at the store level and also enhanced our product classifications to provide better visibility to our product mix. In 2010, we continued to improve efficiency and productivity by leveraging this and other technology.  Inventory auto replenishment was expanded, which in return lowered inventory levels in our distribution center and improved in-stock in stores.  A refresh of point-of-sale hardware improved the performance of store systems and provided us a new platform on which to build applications.  New systems to manage fabric cuts and coupons increased productivity at point-of-sale, thereby improving the overall checkout process.  In 2011, key systems were upgraded to increase capacity and performance.  This has provided the resources necessary to develop more sophisticated replenishment and distribution applications.  Additional capacity and performance has also allowed us to improve our reporting and data warehousing.  We continued to leverage our store network to improve perpetual inventory accuracy through new applications.  Our focus remains on inventory control and labor reduction through the implementation and use of efficient systems.

 

4
 

 

Service Mark

 

We operate our stores under the service mark “Hancock Fabrics,” which we have registered with the United States Patent and Trademark Office.

 

Seasonality

 

Our business is seasonal. Peak sales periods occur during the fall and pre-Easter weeks, while the lowest sales periods occur during the summer months.

 

Employees

 

At January 28, 2012, we employed approximately 3,700 people on a full-time and part-time basis. Approximately 3,300 of those employees work in our retail stores. The remaining employees work in the Baldwyn headquarters, warehouse, and distribution facility. We do not have any employees covered under collective bargaining agreements.

 

Government Regulation

 

We are subject to the Fair Labor Standards Act, which governs such matters as minimum wages, overtime and other working conditions. A significant number of our employees are paid at rates related to federal and state minimum wages and, accordingly, any increase in the minimum wage would affect our labor cost.

 

Environmental Law Compliance

 

Our operations and properties are subject to federal, state and local environmental laws and regulations, including those relating to the handling, storage and disposal of chemicals, wastes and other regulated materials, release of pollutants into the air, soil and water, the remediation of contaminated sites and public disclosure of information regarding certain regulated materials. Failure to comply with environmental requirements could result in fines or penalties, as well as investigatory or remedial liabilities and claims for alleged personal injury or property damage. Some environmental laws impose strict, and under some circumstances joint and several liability, for costs of investigation and remediation of contaminated sites on current and prior owners or operators of the sites, as well as those entities that send regulated materials to the sites. We have not incurred material costs for compliance with environmental requirements in the past, and we do not believe that compliance costs will have a material adverse effect upon our capital expenditures, income, or competitive position.

 

Available Information

 

The Company’s internet address is www.hancockfabrics.com. Our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to reports filed pursuant to Sections 13(a) and 15(d) of the Securities Exchange Act of 1934, as amended, (the “Exchange Act”) are made available free of charge on our website as soon as practicable after these documents are filed with or furnished to the Securities and Exchange Commission (the “SEC”). We also provide copies of such filings free of charge upon request. This information is also available from the SEC through their website, www.sec.gov, and for reading and copying at the SEC’s Public Reference Room located at 100 F Street, NE, Washington, D.C. 20549-0102. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330.

 

5
 

 

Our Corporate Governance Guidelines, Code of Business Conduct and Ethics, Audit Committee Charter, Management Review and Compensation Committee Charter as well as the Nominating and Corporate Governance Committee Charter are available free of charge on the Company’s website. We will also provide copies of these documents free of charge upon request. We intend to provide disclosures regarding amendments to or waivers of a provision of our Code of Business Conduct and Ethics by disclosing such information on our website within four business days following the amendment or waiver.

 

Section 302 Certification

 

The Chief Executive Officer and Chief Financial Officer of the Company filed the certifications required by Section 302 of the Sarbanes-Oxley Act as exhibits to this Annual Report on Form 10-K for the fiscal year ended January 28, 2012.

 

Item 1A.  RISK FACTORS

 

There are many risk factors that affect our business and operating results, some of which are beyond our control. The following is a description of all known material risks that may cause our actual operating results in future periods to differ materially from those currently expected or desired. The following risk factors should be considered carefully in evaluating our business along with the other information contained in or incorporated by reference into this Annual Report and the exhibits hereto.

 

Our business and operating results may be adversely affected by the general economic conditions and the slow economic recovery following the recent financial crisis.

 

Our performance and operating results are impacted by conditions in the U.S. and the world economy. The macro-economic environment has been highly volatile in recent years due to a variety of factors, including but not limited to, the lagging demand in the housing market, lack of credit availability, unpredictable fuel and energy prices, volatile interest rates, inflation fears, unemployment concerns, increasing consumer debt, significant stock market volatility, and recession. These economic conditions negatively impact levels of consumer spending, which may remain depressed for the foreseeable future. Consumer purchases of discretionary items, including our merchandise, generally decline during recessionary periods and other periods where disposable income is adversely affected. The slow economic recovery may continue to affect consumer purchases of our merchandise and adversely impact our results of operations and continued growth. In addition, the current credit crisis is causing a significant negative impact on businesses around the world. The impact of this environment on our major suppliers cannot be predicted. The inability of key suppliers to access liquidity, or the insolvency of key suppliers, could lead to their failure to deliver our merchandise. Any or all of these factors, as well as other unforeseen factors, could have a material adverse impact on consumer spending, our availability to obtain financing, our results of operations, liquidity, financial condition and stock price.

 

We are subject to intense competition in our business, which could have a material effect on our operations.

 

Competition is intense in the retail fabric and craft industry, primarily due to low entry barriers. We must remain competitive in the areas of quality, price, selection, customer service, convenience, and reputation.

 

6
 

 

Our primary competition is comprised of specialty fabric retailers and specialty craft retailers such as Jo-Ann Stores, a national chain that operates fabric and craft stores. We also compete with mass merchants, including Wal-Mart, that dedicate a portion of their selling space to a limited selection of fabrics, craft supplies and seasonal and holiday merchandise. We also compete with Hobby Lobby, a national chain that operates craft stores that also carries fabrics, Michaels Stores, Inc., a national chain that operates craft and framing stores, and A.C. Moore Arts & Crafts, Inc., a regional chain that operates craft stores in the eastern United States. Some of our competitors have stores nationwide, several operate regional chains and numerous others are local merchants. Some of our competitors, particularly the national specialty chain stores and the mass merchants, are larger and have greater financial resources than we do. The performance of competitors as well as changes in their pricing and promotional policies, marketing activities, new store openings, merchandising and operational strategies could impact our sales and profitability. Our sales and profitability could also be impacted by store liquidations of our competitors. In addition, alternative methods of selling fabrics and crafts, such as internet based sales, could result in additional competitors in the future and increased price competition since our customers could more readily comparison shop. Moreover, we ultimately compete against alternative sources of entertainment and leisure activities for our customers that are unrelated to the fabric and craft industry. This competition could negatively affect our sales and profitability.

 

Our merchandising initiatives and marketing emphasis may not provide expected results.

 

We believe our future success will depend upon, in part, the ability to develop and execute merchandising initiatives with effective marketing. There is no assurance that we will be successful, or that new initiatives will be executed in a timely manner to satisfy our customers’ needs or expectations. Failure to execute and promote such initiatives in a timely manner could harm our ability to grow the business and could have a material adverse effect on our results of operations and financial condition.

 

Changes in customer demands could adversely affect our operating results.

 

Our financial condition and operating results are dependent upon our ability to anticipate and respond in a timely manner to changing customer demands and preferences for our products. A miscalculation in the anticipated demands of our customers could result in a significant overstock of unpopular products which could lead to major inventory markdowns, resulting in negative consequences to our operating results and cash flow. Likewise, a shortage of popular products could lead to negative operating results and cash flow.

 

Our inability to effectively implement our growth strategy may have an adverse effect on sales growth

 

Our growth strategy includes opening new stores, remodeling existing stores, and introducing changes to our merchandise assortments, among others. Certain risks involved with implementing these strategies may not be adequately addressed, and future sales and operating results may be less than anticipated, which may negatively impact the return on investment. Future growth and profitability is dependent upon the successful implementation of our growth strategy and realizing positive returns on investments.

 

Our ability to attract and retain skilled people is important to our success.

 

Our success depends in part on our ability to retain key executives and to attract and retain additional qualified personnel who have experience in retail matters and in operating a company of our size and complexity. The unexpected loss of one or more of our key personnel could have a material adverse effect on our business because of the unique skills, knowledge of our markets and products, and years of industry experience such personnel contribute to the business and the difficulty of promptly finding qualified replacements. We offer financial packages that are competitive within the industry to effectively compete in this area.

 

7
 

 

Interest rate increases could negatively impact profitability.

 

Our financing, investing, and cash management activities are subject to the market risk associated with changes in interest rates. Our profitability could be negatively impacted by significant increases in interest rates.

 

We have a significant amount of indebtedness, which could have important negative consequences to us.

 

Our significant indebtedness could have important negative consequences to us, including:

 

·making it more difficult for us to satisfy our obligations with respect to such indebtedness;
·increasing our vulnerability to adverse general economic and industry conditions;
·limiting our ability to obtain additional financing to fund capital expenditures or other growth initiatives, and other general corporate requirements;
·requiring us to dedicate a significant portion of our cash flow from operations to interest and principal payments on our indebtedness, thereby reducing the availability of our cash flow to fund capital expenditures or other growth initiatives, and other general corporate requirements;
·limiting our flexibility in planning for, or reacting to, changes in our business and the industry in which we operate;  
·placing us at a competitive disadvantage compared to our less leveraged competitors; and
·limiting our ability to refinance our existing indebtedness as it matures.

 

As a consequence of our level of indebtedness, a significant portion of our cash flow from operations must be dedicated to debt service requirements. In addition, the terms of our revolving credit facility limit our ability to incur additional indebtedness. If we fail to comply with these covenants, a default may occur, in which case the lender could accelerate the debt. We cannot assure you that we would be able to renegotiate, refinance or otherwise obtain the necessary funds to satisfy these obligations.

 

Our business is dependent on the ability to successfully access funds through capital markets and financial institutions and any inability to access funds may limit our ability to execute our business plan and restrict operations we rely on for future growth.

 

Our business is dependent on the availability of credit to fund working capital, capital expenditures and other general corporate requirements. Our five year $100.0 million secured revolving credit facility is scheduled to expire in July 2013, and we can provide no assurances that we will be able to obtain replacement financing on acceptable terms, or at all. While we believe we can meet our capital requirements from our operations and our available sources of financing, we can provide no assurances that we will be able to do so in the future. If we are unable to access financial markets at competitive rates, our ability to implement our business plan and strategy will be negatively affected.

 

8
 

 

There are risks associated with our common stock trading on the OTC Markets, formerly known as the “Pink Sheets”.

 

Effective May 4, 2007, our common stock was delisted from the New York Stock Exchange, and there is currently no established public trading market for our common stock. Our common stock is currently quoted on the OTC Markets (formerly known as “Pink Sheets”) under the symbol “HKFI.PK”. The OTC Markets is a centralized quotation service that collects and publishes market maker quotes for over-the-counter securities in real time. Over-the-counter market quotations, like those on the OTC Markets, reflect inter-dealer prices, without retail mark-up, mark-down, or commission and may not necessarily represent actual transactions. Stocks trading in the OTC Markets generally have substantially less liquidity; consequently, it can be much more difficult for stockholders and broker/dealers to purchase and sell our shares in an orderly manner or at all. Due in part to the decreased trading price of our common stock and reduced analyst coverage, the trading price of our common stock may change quickly, and brokers may not be able to execute trades as quickly as they previously could when our common stock was listed on an exchange. Currently, we are not actively seeking to become listed on any exchange. There can be no assurance that our common stock will again be listed on an exchange, or that a trading market for our common stock will be established.

 

Significant changes in discount rates, actual investment return on pension assets, and other factors could affect our earnings, equity, and pension contributions in future periods.

 

Our earnings may be positively or negatively impacted by the amount of income or expense recorded for our qualified benefit pension plan. Generally accepted accounting principles in the United States of America (“GAAP”) require that income or expense for the plan be calculated at the annual measurement date using actuarial assumptions and calculations. These calculations reflect certain assumptions, the most significant of which relate to the capital markets, interest rates and other economic conditions. Changes in key economic indicators can change the assumptions. The most significant assumptions used to estimate pension income or expense for the year are the expected long-term rate of return on plan assets and the interest rate. These assumptions, along with the actual value of assets at the measurement date, will drive the pension income or expense for the year. In addition, at the measurement date, we must reflect the funded status of the plan liabilities on the balance sheet, which may result in a significant charge to equity through a reduction or increase to Accumulated Other Comprehensive Income (Loss). Although GAAP expense and pension contributions are not directly related, the key economic factors that affect GAAP expense would also likely affect the amount of cash we would contribute to the pension plan. Potential pension contributions include both mandatory amounts required under federal law and discretionary contributions to improve a plan’s funded status.

 

Business matters encountered by our suppliers may adversely impact our ability to meet our customers’ needs.

 

Many of our suppliers are small businesses that produce a limited number of items. Many of these businesses face cash flow constraints, production difficulties, quality control issues, and problems in delivering agreed-upon quantities on schedule because of their limited resources and lack of financial flexibility. Many of our vendors rely on third parties for working capital loans. The third parties’ evaluation of our credit worthiness can significantly impact our suppliers’ ability to produce and deliver product. Failure of our key suppliers to withstand a downturn in economic conditions could have a material adverse effect on our operating results and our ability to meet our customers’ needs. In addition, the significant product safety requirements arising under the U.S. Consumer Product Safety Improvement Act of 2008 and state product safety laws may represent a compliance challenge to some of our suppliers, could negatively impact the ability of such suppliers to deliver compliant products to us and thus negatively impact our business operations and performance. Delivery of non-compliant products could result in liability to our company; while we obtain indemnifications from our suppliers with respect to compliance issues, some suppliers might not have the financial resources to stand behind their indemnifications and we could also suffer damage to our reputation.

 

9
 

 

We are vulnerable to risks associated with obtaining merchandise from foreign suppliers.

 

We rely on foreign suppliers, many of whom are located primarily in China and other Asian countries, for the majority of our products. In addition, some of our domestic suppliers manufacture their products overseas or purchase them from foreign vendors. Foreign sourcing subjects us to a number of risks, including long lead times; work stoppages; transportation delays and interruptions; product quality issues; employee rights issues; other social concerns; political instability; economic disruptions; the imposition of tariffs, duties, quotas, import and export controls and other trade restrictions; changes in governmental policies; and other events. If any of these events occur, it could result in a material adverse effect on our business, financial condition, results of operations and prospects. In addition, reductions in the value of the U.S. dollar or revaluation of the Chinese currency, or other foreign currencies, could ultimately increase the prices that we pay for our products. All of our products manufactured overseas and imported into the United States are subject to duties collected by the United States Customs Service. We may be subjected to additional duties, significant monetary penalties, the seizure and forfeiture of the products we are attempting to import or the loss of import privileges, if we or our suppliers are found to be in violation of U.S. laws and regulations applicable to the importation of our products.

 

Transportation industry challenges and rising fuel costs may negatively impact our operating results.

 

Our products are delivered to our distribution center from vendors and from our distribution center to our stores by various means of transportation. Our ability to furnish our stores with inventory in a timely manner could be adversely affected by labor or equipment shortages in the transportation industry as well as long-term interruptions of service in the national and international transportation infrastructure. In addition, labor shortages and increases in fuel prices could lead to higher transportation costs. With our reliance on the trucking industry to deliver products to our distribution center and our stores, our operating results could be adversely affected if we are unable to secure adequate trucking resources to fulfill our delivery schedules to the stores or if transportation costs increase.

 

Delays or interruptions in the flow of merchandise through our distribution center could adversely impact our operating results.

 

Approximately 83% of our store shipments pass through our distribution center. The remainder of merchandise is drop-shipped by our vendors directly to our store locations. Damage or interruption to our distribution center from factors such as fire, power loss, storm damage or unanticipated supplier shipment delays could cause a disruption in our operations. The occurrence of unanticipated problems at our distribution center would likely result in increased operating expenses and reduced sales that would negatively impact our operating results.

 

Changes in the labor market and in federal, state, or local regulations could have a negative impact on our business.

 

Our products are delivered to our customers at our retail stores by quality associates, many of whom are in entry level or part-time positions. Attracting and retaining a large number of dependable and knowledgeable associates is vital to our success. External factors, such as unemployment levels, prevailing wage rates, minimum wage legislation, workers compensation costs and changing demographics, affect our ability to manage employee turnover and meet labor needs while controlling our costs. Our operations and financial performance could be negatively impacted by changes that adversely affect our ability to attract and retain quality associates.

 

10
 

 

Taxing authorities could disagree with our tax treatment of certain deductions or transactions, resulting in unexpected tax assessments.

 

The possibility exists that the Internal Revenue Service or other taxing authorities could audit our current or previously filed tax returns and dispute our treatment of tax deductions or apportionment formulas, resulting in unexpected assessments. Depending on the timing and amount of such assessments, they could have a material adverse effect on our results of operations, financial condition and liquidity.

 

Our current cash resources might not be sufficient to meet our expected near-term cash needs.

 

If we do not generate positive cash flow from operations, we will need to develop and implement alternative strategies. These alternative strategies could include seeking improvements in working capital management, reducing or delaying capital expenditures, restructuring or refinancing our indebtedness, seeking additional debt or financing, and selling assets. There can be no assurance that any of these strategies could be implemented on satisfactory terms, on a timely basis, or at all.

 

A disruption in the performance of our information systems would negatively impact our business.

 

We depend on our management information systems for many aspects of our business, including effective transaction processing, inventory management, purchasing, selling and shipping goods on a timely basis, and maintaining cost-efficient operations. The failure of our information systems to perform as designed could disrupt our business and cause information to be lost or delayed, which could have a negative impact on our business. Computer viruses, computer “hackers,” or other system failures could lead to operational problems with our information systems. Our operations and financial performance could also be negatively impacted by costs and potential problems related to the implementation of new or upgraded systems, or if we were unable to provide maintenance and support for our existing systems.

 

A failure to adequately maintain the security of confidential information could have an adverse effect on our business.

 

We have become more dependent upon automated information technology processes, including use of the internet for conducting a portion of our business. The regulatory environment surrounding information security and privacy is increasingly demanding, with the frequent imposition of new and constantly changing requirements. In connection with credit card sales, we transmit confidential credit card information. Information may be compromised through various means, including penetration of our network security, hardware tampering, and misappropriation of confidential information. Failure to maintain the security of confidential information could result in deterioration in our employees’ and customers’ confidence in us, expose us to litigation and liability, and any breach in the security and integrity of other business information could put us at a competitive disadvantage, resulting in a material adverse impact on our financial condition and results of operations.

 

Failure to comply with various laws and regulations as well as litigation developments could adversely affect our business operations and financial performance.

 

Our policies, procedures, and internal controls are designed to comply with all applicable laws and regulations, including those imposed by the U.S. Securities and Exchange Commission as well as applicable employment laws. We are involved in various litigation and arbitration matters that arise in the ordinary course of our business, including liability claims. Litigation and arbitration could adversely affect our business operations and financial performance. Also, failure to comply with the various laws and regulations may result in damage to our reputation, civil and criminal liability, fines and penalties, increased cost of regulatory compliance, and restatements of financial statements.

 

11
 

 

We may not be able to maintain or negotiate favorable lease terms for our retail stores.

 

We lease substantially all of our store locations. The majority of our store leases contain provisions for base rent and a small number of store leases contain provisions for base rent plus percentage rent based on sales in excess of an agreed upon minimum annual sales level. If we are unable to renew, renegotiate or replace our store leases or enter into leases for new stores on favorable terms, our growth and profitability could be harmed.

 

Changes in accounting principles may have a negative impact on our reported results.

 

A change in accounting standards or policies may have a significant impact on our reported results from operations. New accounting pronouncements and different interpretations of existing pronouncements have been issued and may be issued in the future. Implementation of these standards or policies may have a negative impact on our reported results.

 

Other matters could adversely affect our business.

 

The foregoing list of risk factors is not all inclusive. Other factors that are not known to us at this time and unanticipated events could adversely affect our business.

 

Item 1B. UNRESOLVED STAFF COMMENTS

 

Not Applicable.

 

Item 2. PROPERTIES

 

As of January 28, 2012, the Company operated 263 stores in 37 states. The number of store locations in each state is shown in the following table:

 

    Number       Number
State   of Stores   State   of Stores
             
Alabama   11   Nebraska   4
Arizona   2   Nevada   3
Arkansas   9   New Mexico   2
California   10   North Carolina   14
Colorado   3   North Dakota   1
Florida   4   Ohio   5
Georgia   14   Oklahoma   10
Idaho   4   Oregon   2
Illinois   13   Pennsylvania   1
Indiana   5   South Carolina   9
Iowa   7   South Dakota   2
Kansas   4   Tennessee   11
Kentucky   8   Texas   29
Louisiana   12   Utah   5
Maryland   5   Virginia   11
Minnesota   10   Washington   7
Mississippi   6   Wisconsin   8
Missouri   10   Wyoming   1
Montana   1        

 

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Our store activity for the last five years is shown in the following table:

 

Year   Opened   Closed   Net Change   Year-end Stores   Relocated 
 2007    0    (134)   (134)   269    2 
 2008    1    (7)   (6)   263    4 
 2009    3    (1)   2    265    2 
 2010    1    (1)   -    265    7 
 2011    1    (3)   (2)   263    5 

 

The Company’s 263 retail stores average 14,263 square feet and are located principally in strip shopping centers.

 

With the exception of one owned location, the Company’s retail stores are leased. The original lease terms generally are ten years in length and most leases contain one or more renewal options, usually of five years in length. During fiscal 2012, forty-six store leases are scheduled to expire. We currently have negotiated or are in the process of negotiating renewals on certain leases.

 

The Company owns and operates a 650,000 square foot warehouse and distribution facility, a 28,000 square foot fixture manufacturing facility, and an 80,000 square foot corporate headquarters facility in Baldwyn, Mississippi. These facilities, which are located on 64 acres of land, are owned by the Company and serve as collateral under the Company’s credit facility.

 

Reference is made to the information contained in Note 8 to the accompanying Consolidated Financial Statements for information concerning our long-term obligations under leases.

 

Item 3. LEGAL PROCEEDINGS

 

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 States Bankruptcy Court closing the bankruptcy case of the Company. On October 17, 2011 the bankruptcy case of the Company was reopened, in order to settle the one remaining pre-petition claim, and closed on November 14, 2011.

 

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.

 

The Company is party to several legal proceedings and claims arising in the ordinary course of business. We expect these matters will be resolved without material adverse effect on our consolidated financial position, results of operations or cash flows. We believe that any estimated loss related to such matters has been adequately provided in accrued liabilities to the extent probable and reasonably estimable.

 

Item 4. MINE SAFETY DISLOSURES

 

Not applicable

 

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PART II

 

Item 5.MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

 

There is currently no established public trading market for our common stock. Our common stock is currently quoted on the OTC Markets, formerly known as the “Pink Sheets”, under the symbol “HKFI.PK”. The OTC Markets is a centralized quotation service that collects and publishes market maker quotes for over-the-counter securities in real time. Over-the-counter market quotations, like those on the OTC Markets, reflect inter-dealer prices, without retail mark-up, mark-down, or commission and may not necessarily represent actual transactions. The following table sets forth the high and low closing prices of our common stock for the year and during each quarter in fiscal 2010 and 2011, as reported by the OTC Markets:

 

   High   Low 
2010          
First Quarter  $3.60   $1.95 
Second Quarter   2.26    1.52 
Third Quarter   1.80    1.23 
Fourth Quarter   1.41    0.98 
           
Year Ended          
January 29, 2011  $3.60   $0.98 
           
2011          
First Quarter  $1.43   $1.00 
Second Quarter   1.28    0.80 
Third Quarter   1.28    0.59 
Fourth Quarter   1.15    0.67 
           
Year Ended          
January 28, 2012  $1.43   $0.67 

 

As of January 28, 2012, there were 3,489 record holders of our common stock.

 

We did not pay any cash dividends during fiscal 2010 or 2011. We have indefinitely suspended cash dividends in order to support our operational needs. Future dividends will be determined by our Board of Directors, in its sole discretion, based on a number of factors including, but not limited to, our results of operations, cash flows, capital requirements, and debt covenants.

 

See Part III, Item 12 herein for a description of our securities authorized for issuance under equity compensation plans.

 

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Issuer Purchases of Equity Securities

 

This table provides information with respect to purchases by the Company of shares of our common stock during the year ended January 28, 2012:

 

Issuer Purchases of Equity Securities

 

            Total Number of   Maximum 
            Shares Purchased as   Number of Shares That 
    Total number of   Average Price   Part of Publicly   May Yet Be Purchased 
Period   Shares Purchased (1)   Paid Per Share   Announced Plans (2)   Under the Plans (2) 
 January  30, 2011 through                     
 February 26, 2011    143   $1.38    -    243,515 
 February 27, 2011 through                     
 April 2, 2011    357    1.16    -    243,515 
 April 3, 2011 through                     
 April 30, 2011    1,284    1.05    -    243,515 
 May 1, 2011 through                     
 May 28, 2011    1,783    1.04    -    243,515 
 May 29, 2011 through                     
 July 2, 2011    713    0.96    -    243,515 
 July 3, 2011 through                     
 July 30, 2011    -    -    -    243,515 
 July 31, 2011 through                     
 August 27, 2011    286    1.00    -    243,515 
 August 28, 2011 through                     
 October 1, 2011    -    -    -    243,515 
 October 2, 2011 through                     
 October 29, 2011    12    0.90    12    243,503 
 October 30, 2011 through                     
 November 26, 2011    -    -    -    243,503 
 November 27, 2011 through                     
 December  31, 2011    143    0.99    -    243,503 
 January 1, 2012 through                     
 January 28, 2012    739    0.95    16    243,487 
 Total January 30, 2011 through                     
 January 28, 2012    5,460   $1.03    28    243,487 

 

(1)The number of shares purchased during the year includes 5,432 shares deemed surrendered to the Company to satisfy tax withholding obligations arising from the lapse of restrictions on shares.

 

(2)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 1,756,513 shares purchased under this authorization through January 28, 2012. The shares discussed in footnote (1) are excluded from this column.

 

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Item 6. SELECTED FINANCIAL DATA

 

Set forth below is selected financial information of the Company for each fiscal year in the 5-year period ended January 28, 2012. The Company has adjusted the previously reported 2007 Consolidated Balance Sheets, Consolidated Statements of Income, Consolidated Statements of Shareholders’ Equity and Consolidated Statements of Cash Flows, in this Annual Report on Form 10-K to reflect the retrospective change in method of valuing inventory to weighted average from the last in, first out method. The selected financial data should be read in conjunction with the “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the Consolidated Financial Statements of the Company and notes thereto which appear elsewhere in this Form 10-K.

 

(dollars in thousands, except per share data and other data)  2011   2010   2009   2008   2007 
                     
Results of Operations Data:                         
Sales  $271,993   $275,465   $274,058   $276,381   $276,247 
Gross profit   112,725    114,645    121,717    119,579    117,580 
(Loss) income from continuing operations   before income taxes   (11,298)   (10,258)   1,838    (12,181)   (24,309)
Income (loss) from discontinued operations, net of tax   -    29    150    (186)   (7,991)
Net (loss) income   (11,298)   (10,461)   1,788    (12,367)   (33,300)
As a percentage of sales   (4.2)%   (3.8)%   0.6%   (4.5)%   (12.1)%
As a percentage of average shareholders' equity   (46.4)%   (25.5)%   3.8%   (22.3)%   (42.3)%
                          
Financial Position Data:                         
Total assets  $146,387   $140,923   $148,546   $164,674   $185,084 
Capital expenditures   4,934    5,392    3,084    8,447    4,357 
Long-term indebtedness   52,320    31,856    30,126    46,264    23,608 
Common shareholders' equity   13,871    34,837    47,212    47,349    63,438 
Current ratio   3.0    2.9    2.8    2.9    3.9 
                          
Per Share Data:                         
Basic (loss) earnings per share  $(0.57)  $(0.53)  $0.09   $(0.65)  $(1.76)
Diluted (loss) earnings per share   (0.57)   (0.53)   0.09    (0.65)   (1.76)
Cash dividends per share   -    -    -    -    - 
Shareholders' equity per share   0.68    1.74    2.37    2.40    3.29 
                          
Other Data:                         
Number of states   37    37    37    37    37 
Number of stores   263    265    265    263    269 
Number of shareholders   3,489    3,561    3,676    3,785    3,843 
Number of shares outstanding, net of treasury shares   20,511,123    20,068,327    19,902,148    19,716,303    19,285,235 
Comparable sales change (1)   (0.8)%   (0.1)%   0.2%   2.5%   13.2%
Total selling square footage   3,217,307    3,250,427    3,036,444    3,232,194    3,297,508 

 

(1) The comparable sales increase for 2008 included a 0.4% benefit from 5 store closing events and the comparable sales increase for 2007 included a 12.7% benefit from 134 store liquidations in connection with store closing events. The comparable sales results for 2011, 2010 and 2009 were not affected by liquidations.

 

16
 

 

Item 7.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

Overview

 

Hancock Fabrics, Inc. is a specialty retailer committed to nurturing creativity through 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 263 stores in 37 states as of January 28, 2012. Our stores present a broad selection of fabrics and notions used in apparel sewing, home decorating and quilting projects. The stores average 14,263 total square feet, of which 12,233 are on the sales floor. During 2011, the average annual sales per store were approximately $1.0 million.

 

Significant financial items during fiscal 2011 include:

 

·Sales for fiscal 2011 were $272.0 million compared with $275.5 million in fiscal 2010, and comparable store sales decreased 0.8% and 0.1% in 2011 and 2010, respectively.

 

·Our online sales for 2011, which are included in the sales and comparable sales results above, decreased 7.9% to $4.8 million.

 

·Operating results for 2011 and 2010 as adjusted for one-time and non-comparable items are summarized in the table below.

 

   Fiscal Year 
   2011   2010 
         
Operating (loss)  $(6,462)  $(4,948)
           
One-time, non-comparable items          
Asset impairment   1,666    1,523 
Contract arbitration professional fees   1,614    - 
Severance related costs   401    1,272 
CEO relocation costs   300    - 
Inventory obsolescence   -    6,674 
Total one-time, non-comparable items   3,981    9,469 
           
Normalized operating (loss) income  $(2,481)  $4,521 

 

For 2011, the asset impairment charge of $1.7 million is the difference between asset values and projected future cash flows related to specific store locations.

 

During 2011, the company had to defend itself in an arbitration proceeding arising from a disputed consulting agreement. In connection with that arbitration, the Company incurred substantial professional fees of $1.6 million, which are not expected to reoccur in future periods.

 

The severance costs of $401,000 related to the departure of one Sr. Vice-President and three Vice-Presidents of the Company during the fiscal year. The relocation costs $300,000 cover the relocation payment and reimbursements as provided in the Company CEO’s employment agreement.

 

17
 

  

For 2010, the significant charge of $6.7 million for inventory obsolescence resulted from a strategy initiated in the fourth quarter to address aged and underperforming inventory on an abbreviated time cycle. Management believed eliminating this aged product on a more expedited basis and replacing it with current merchandise would be beneficial to future operations. Previously, the Company’s practice was to carry product over to the next season. While the Company was generally able to sell these items above cost, the existence of such inventory often made the stores’ inventory appear dated. The severance costs of $1.3 million relate to the departure of the Company’s President and CEO on the last day of the fiscal year. It represents the value of future payments as required under the former President and CEO’s contract. The asset impairment charge of $1.5 million is the difference between asset values and projected future cash flows related primarily to certain 2008 store remodels.

 

Excluding the one-time charges outlined above, which total approximately $4.0 million in 2011, the net loss for 2011 would have been $7.3 million or $0.37 per basic share, and excluding the $9.5 million of one-time charges from 2010, the net loss for 2010 would have been $1.0 million or $0.05 per basic share .

 

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

 

   Fiscal Year 
   2011   2010   2009 
             
Sales (in thousands)  $271,993   $275,465   $274,058 
                
Gross margin percentage   41.4%   41.6%   44.4%
                
Number of stores               
Open at end of period(1)   263    265    265 
Comparable stores at year end (2)   262    264    263 
                
Sales growth               
All retail outlets   (1.3)%   0.5%   (0.8)%
Comparable retail outlets (3)   (0.8)%   (0.1)%   0.2%
                
Total store square footage at year end (in thousands)   3,751    3,792    3,780 
                
Net sales per total square footage  $73   $73   $73 

 

(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)Sales growth for comparable retail outlets 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 includes the $4.0 million and $9.5 million of one-time and non-comparable charges occurring in 2011 and 2010, respectively, and should be read in conjunction with the following discussion and with our Consolidated Financial Statements, including the related notes.

 

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   Fiscal Year 
   2011   2010   2009 
Sales   100.0%   100.0%   100.0%
Cost of goods sold   58.6    58.4    55.6 
Gross profit   41.4    41.6    44.4 
Selling, general and administrative expense   42.3    41.8    40.0 
Depreciation and amortization   1.5    1.6    1.6 
Operating (loss) income   (2.4)   (1.8)   2.8 
Reorganization expense, net   -    0.1    0.3 
Interest expense, net   1.8    1.8    1.9 
(Loss) income  from continuing operations before income taxes   (4.2)   (3.7)   0.6 
Income taxes   -    (0.1)   (0.1)
Income from discontinued operations   -    -    0.1 
Net (loss) income   (4.2)%   (3.8)%   0.6%

 

Sales

 

(in thousands)  Fiscal Year 
   2011   2010   2009 
Retail comparable store base  $266,595   $268,504   $269,113 
E-Commerce   4,782    5,190    4,745 
Comparable sales   271,377    273,694    273,858 
New stores   616    -    - 
Closed stores   -    1,771    200 
Total sales  $271,993   $275,465   $274,058 

 

The retail comparable store base above consists of sales which were included in the comparable sales computation for the year. Retail comparable store sales decreased by 0.7% in 2011, 0.2% in 2010 and were flat in 2009. This resulted from a 1.0% increase in average ticket and a 1.7% decrease in transactions in fiscal 2011, and no change in average ticket and a 0.3% decrease in transactions in fiscal 2010.

 

Sales provided by our E-commerce channel decreased by 7.9% in 2011 as compared to increases of 9.4% in 2010 and 14.1% in 2009. We believe the downturn in 2011 is attributable to merchandising issues which were recognized during the year, but could not be fully corrected. The two prior years reaped the benefit of the internet platform which was launched in 2008.

 

New stores include the results for one location which has not reached its 53rd week anniversary. Three stores closed in 2011, one store closed in 2010 and one store closed in 2009, none of which qualified as discontinued operations.

 

The Company routinely closes and opens stores, as leases expire or as better locations become available. The Company does not consider these strategic moves as discontinued operations. Only when the Company closes significant stores in conjunction with downsizing under a plan agreed upon by the Company’s Board of Directors, will the Company consider the requirement disclosures under discontinued operations.

 

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Our merchandise mix for the last three years is reflected in the table below:

 

   Fiscal Year 
   2011   2010   2009 
             
Apparel and Craft Fabrics   43%   44%   44%
Home Decorating Fabrics   12%   12%   13%
Sewing Accessories   31%   31%   31%
Non-Sewing Products   14%   13%   13%
    100%   100%   100%

  

We are constantly making adjustments to our merchandise mix based on anticipated consumer demand and current sales trends. Apparel and craft fabrics declined, due to merchandising issues in this product category, which impacted most of 2011. The increase in non-sewing products can be attributed to expansion of the craft products into additional stores during the year and is expected to continue.

 

Gross Margin

 

Costs of goods sold include:

 

·the cost of merchandise

 

·inventory rebates and allowances including term discounts

 

·inventory shrinkage and valuation adjustments (including our inventory obsolescence charge)

 

·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. 

 

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Specific components of cost of goods sold over the previous three years are as follows:

 

(in thousands)  2011   % of Sales   2010   % of Sales   2009   % of Sales 
                         
Total sales  $271,993    100.0%  $275,465    100.0%  $274,058    100.0%
                               
Merchandise cost   135,570    49.9%   138,544    50.3%   129,726    47.3%
Freight   9,506    3.5%   8,429    3.1%   7,883    2.9%
Sourcing and warehousing   14,192    5.2%   13,847    5.0%   14,732    5.4%
                               
Gross Profit  $112,725    41.4%  $114,645    41.6%  $121,717    44.4%

 

Merchandise cost increased during 2011, over 2010, as adjusted for the one-time obsolescence charge which is explained below, due to continued promotional activity and consumer sensitivity to pricing, which made it difficult to pass on product cost increases. Merchandising issues in our core product lines further impacted costs as aggressive promotions were necessary late in 2011 to regain customer traffic lost earlier in the year.

 

The inventory obsolescence charge of $6.7 million recognized in 2010 is included in merchandise cost and increased this cost by 240 basis points. Merchandise cost, excluding the inventory charge was $131.8 million or 47.9% which increased by 60 basis points in 2010 compared to 2009 due to increased promotional activity during the year and an increase of cotton prices which peaked in the fourth quarter.

 

Freight costs have increased steadily over the periods presented due to rising fuel cost which have more than offset the efficiencies achieved in our shipping process.

 

Sourcing and warehousing costs for the Company vary based on both the volume of inventory received and shipped during any period, and the rate at which inventory turns. For 2011 and 2010, the sourcing and warehousing costs incurred were consistent year-over-year, as were inventory turns.

 

In total, 2011 gross profit declined by 260 basis points as compared to 2010, excluding inventory obsolescence, and 40 basis point from 2009 to 2010. The continuation of promotional activity and consumer resistance to price increases have impacted gross profit results year over year.

 

Selling, General & Administrative Expenses

 

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

 

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Specific components of selling, general & administrative expenses include: 

 

(in thousands)  2011   % of Sales   2010   % of Sales   2009   % of Sales 
                         
Retail store labor costs  $41,291    15.2%  $41,533    15.1%  $41,429    15.1%
Advertising   9,618    3.5%   10,114    3.7%   10,016    3.7%
Store occupancy   30,325    11.1%   29,624    10.7%   29,363    10.7%
Retail SG&A   20,953    7.7%   21,462    7.8%   19,474    7.1%
Corp SG&A   12,860    4.8%   12,365    4.5%   9,399    3.4%
                               
Total SG&A  $115,047    42.3%  $115,098    41.8%  $109,681    40.0%

 

Retail Store Labor Costs – We were successful at maintaining store labor cost at consistent levels for 2011 and 2010 as a result of greater corporate oversight. We will continue to leverage our technology investment in store infrastructure to improve labor efficiency and enhance store performance.

 

Advertising – Our advertising medium is primarily direct mail and newspaper inserts, and as a result, our costs have remained constant. For the near term we believe this combination is the most effective, although we will continue to explore the effectiveness of other advertising channels.

 

Store Occupancy – These costs are driven primarily by the long term leases we enter into with the owners of our retail locations and to a lesser degree building maintenance costs. The marginal increases in the three years presented were the result of renewals of leases already in place and increases in maintenance expenditures to improve the appearance and operating standard of the retail units. We are optimistic that lease related costs will not substantially increase going forward given the current weakness in the commercial real estate market and beneficial modifications to many of our existing leases.

 

Retail SG&A – The decline in costs for 2011 can be attributed to reduced workers compensation related costs and a decline in credit card fees, which offset increases in supplies and utilities. Costs related to insurance claims, utilities, credit card fees and store maintenance were primarily responsible for cost increases for 2010 over 2009.

 

Corporate SG&A – These are costs related primarily to staffing and operation of the Company’s headquarters. In addition to normal recurring expenses, which include the write-off of the one remaining pre-petition obligation in 2011, this category includes the following one-time or non-comparable expenses for 2011 and 2010. For 2011, relocation charges of $300,000 were recorded which relate to the Company CEO’s relocation payment and expenses and $1.6 million related to contract arbitration professional fees. For 2011 and 2010, respectively, severance expenses of $401,000 and $1.3 million, and an asset impairment charge of $1.7 million and $1.5 million were recorded. Excluding these one-time, non-comparable items, 2011 corporate SG&A would have been $9.2 million and 2010 $9.6 million.

 

Reorganization Expenses, Net

 

(in thousands)  2011   % of Sales   2010   % of Sales   2009   % of Sales 
                               
Reorganization expense, net  $-    0.0%  $485    0.1%  $755    0.3%

 

Reorganization expenses are comprised of costs for professional fees associated with our bankruptcy proceedings. With the filing of the final decree on August 17, 2010, and the settlement of the one remaining claim on November 4, 2011, all bankruptcy related issues have been resolved, and these costs will not continue.

 

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Interest Expense, Net

 

(in thousands)  2011   % of Sales   2010   % of Sales   2009   % of Sales 
                               
Interest expense, net  $4,836    1.8%  $4,825    1.8%  $5,114    1.9%

 

Our interest costs are driven by borrowings on our credit facilities. Our current credit facilities consist of both an asset based facility and a subordinated debt facility. In general, between 2011 and 2010 average outstanding borrowings increased and interest rates decreased. Interest expense for fiscal 2011 and 2010 includes non-cash bond discount amortization costs of $2.3 million in each year.

 

Income Taxes

 

(in thousands)  2011   % of Sales   2010   % of Sales   2009   % of Sales 
                               
Income taxes  $-    0.0%  $232    0.1%  $200    0.1%

 

No income tax expense was recognized in 2011 and the amounts expensed for 2010 and 2009 consist of Federal Alternative Minimum Tax (AMT). All tax related items are fully reserved with a valuation allowance.

 

Income from Discontinued Operations

 

(in thousands)  2011   % of Sales   2010   % of Sales   2009   % of Sales 
                               
Income from discontinued operations  $-    0.0%  $29    0.0%  $150    0.1%

  

Discontinued operations relates to the 124 stores closed in 2007 which qualified as discontinued operations. All of these store closures were part of a reorganization plan implemented prior to seeking bankruptcy protection. The income recognized in 2010 and 2009 resulted from the settlement of bankruptcy claims for less than the amount reserved.

 

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, required cash contributions to the defined benefit pension plan, 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 (the “Revolver”) and other sources of financing. We expect to generate adequate cash flow from operating activities to sustain current levels of operations.

 

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We consolidate our daily cash receipts into a centralized account. In accordance with the terms of our $100.0 million Revolver, on a daily basis, all collected and available funds are applied to the outstanding loan balance. We then determine our daily cash requirements and request those funds from the Revolver availability.

 

Our cash flow related information as of and for the past three fiscal years follows (in thousands):

 

   2011   2010   2009 
             
Net cash flows provided (used):               
Operating activites  $(13,255)  $6,160   $22,976 
Investing activities   (4,586)   (5,340)   (3,016)
Financing activites   18,117    (941)   (19,805)

 

Operating Activities

 

In 2011, net cash flows used in operating activities was $13.3 million compared to cash flows provided by operations of $6.2 million in 2010. In 2011, the cash loss from operations was $5.2 million; inventory increased $3.6 million; and a cash contribution of $5.7 million was made to the defined benefit pension plan.

 

In 2010, net cash flows provided by operating activity declined by $16.8 million compared to 2009.  This decrease was led by a reduction in net income of $12.2 million, including one-time charges of $9.5 million, and as further explained in the “Results of Operations” discussion above.  In addition to the decline in income, the Company did not experience the reduction in inventories which occurred in 2009.

 

We believe future inventory reductions can be obtained as we refine our supply chain management systems, but this additional efficiency did not occur in 2010 or 2011 and may not occur in the near-term due to expansion of craft product lines to additional stores in 2012.

 

Accounts payable as a percent of inventory was 20.2% and 20.3% at year-end 2011 and 2010, respectively.

 

The Company expects to make contributions to our defined benefit pension plan during 2012 of $6.4 million.

 

Investing Activities

 

Cash used for investing activities consists primarily of purchases and sales of property and equipment.

 

Expenditures for 2011 consist primarily of store fixtures for one new store, five relocations, the expanded craft assortment introduced in numerous locations, and IT equipment upgrades. Expenditures for 2010 consist primarily of store fixtures for eight relocations, new product lines and point of sale (POS) equipment upgrades. These activities totaled approximately $4.9 and $5.4 million for 2011 and 2010, respectively.

 

Financing Activities

 

We increased the outstanding borrowings against the Revolver by $18.2 million during 2011 to provide working capital, fund required cash contributions to the defined benefit pension plan, and for capital expenditures.

 

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During 2010, we used $0.9 million generated from operations to reduce the outstanding Revolver balance and pay pre-petition obligations. The Revolver balance as of January 28, 2012 was $31.3 million compared to $13.1 million as of January 29, 2011.

 

General

 

We have indefinitely suspended our cash dividend in order to support our operational needs. Future dividends will be determined by our Board of Directors, in its sole discretion, based on a number of factors including, but not limited to, our results of operations, cash flows, capital requirements, and debt covenants. Treasury stock repurchases in 2011 were minor, primarily insignificant purchases from odd-lot shareholders and small amounts surrendered by employees to satisfy tax withholding obligations arising from the lapse of restrictions on shares of stock.

 

Over the long term, our ability to improve our liquidity will ultimately depend on a positive trend in cash flow from operating activities through comparable sales increases, improved gross margin, and control of expenses.

 

Credit Facilities

 

The following should be read in conjunction with Note 7 to the accompanying Consolidated Financial Statements – Long Term Debt Obligations.

 

We have a five year $100.0 million secured revolving credit facility scheduled to expire in July 2013 (the “Revolver”). The level of borrowings available is subject to a borrowing base computation, as defined in the Loan Agreement, which includes credit card receivables, inventory, and real property. 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.

 

The Revolver is collateralized by a fully perfected first priority security interest in all of the existing and after acquired real and personal tangible and intangible assets of the Company and restricts the Company from incurring significant additional debt obligations.

 

As of January 28, 2012, we had outstanding borrowings under the Revolver of $31.3 million and outstanding letters of credit of $5.5 million. Additional amounts available to borrow at that time were $31.5 million.

 

In addition to the Revolver, we 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 issuing $1.6 million of additional Notes. The Notes mature 5 years from the date of issuance (August 1, 2013), are subordinated to the Revolver, and are secured by a junior lien on all of our assets. Purchasers of the Notes received a detachable warrant to purchase a total of 9.5 million shares of our common stock. The warrants were valued at $11.7 million at the time of issuance and were recorded as a discount on notes payable under “Long-term debt obligations”. As of January 28, 2012, the aggregate Note balance was $21.6 million and the unamortized warrant discount on the Notes was $3.5 million.

 

Off-Balance Sheet Arrangements

 

Hancock has no off-balance sheet financing arrangements. We lease our retail fabric store locations mainly under non-cancelable operating leases. Four of our store leases qualified for capital lease treatment. Future payments under operating leases are excluded from our balance sheet. The four capital lease obligations are reflected on our balance sheet.

 

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Contractual Obligations and Commercial Commitments

 

The following table summarizes our future cash outflows resulting from contractual obligations and commitments as of January 28, 2012. Note references refer to the applicable footnotes to the accompanying Consolidated Financial Statements contained in Item 8 of this report:

 

Contractual Obligations (in thousands)

 

           Less           More 
   Note       than 1   1-3   4-5   than 5 
   Reference   Total   Year   Years   Years   Years 
                         
Long-term debt (1)   7   $52,320   $-   $52,320   $-   $- 
Minimum lease payments (2)   8    79,345    20,776    29,674    18,078    10,817 
Standby letters of credit   7    4,934    4,934    -    -    - 
Capital lease obligations (3)   8    5,642    472    944    901    3,325 
Trade letters of credit        600    600    -    -    - 
Open purchase orders        20,890    20,890    -    -    - 
Total       $163,731   $47,672   $82,938   $18,979   $14,142 

 

(1)The calculation of interest on the Revolver and the Notes is dependent on the average borrowings during the year and a variable interest rate. The interest rates on the Revolver and the Notes were approximately 2.0% and 4.9% at January 28, 2012.  Interest payments are excluded from the table because of their subjectivity and the estimation required.

 

(2)Our aggregate minimum lease payments represent operating lease commitments, which generally include non-cancelable leases for property used in our operations. Contingent rent in addition to minimum rent, which is typically based on a percentage of sales, is not reflected in the minimum lease payment totals. Minimum payments are reflected net of expected sublease income.

 

(3)Capital lease obligations include related interest.

 

Postretirement benefits other than pensions, Supplemental Retirement Benefit Plan (“SERP”) funding obligations, defined benefit pension plan contributions, asset retirement obligations, anticipated capital expenditures, amounts included in other noncurrent liabilities for workers’ compensation and deferred compensation have been excluded from the contractual obligations table because of the unknown variables required to determine specific payment amounts and dates.

 

We have no standby repurchase obligations or guarantees of other entities' debt.

 

Critical Accounting Policies and Estimates

 

The preparation of our consolidated financial statements in conformity with GAAP requires us to make estimates and assumptions in applying our critical accounting policies that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amount of revenues and expenses during the reporting period. Significant accounting policies we employ, including the use of estimates and assumptions, are presented in Notes to Consolidated Financial Statements. We evaluate those estimates and assumptions on an ongoing basis based on historical experience and on various other factors which we believe are reasonable under the circumstances.

 

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Financial Accounting Standards Board (“FASB”), Accounting Standards Codification (“ASC”), FASB ASC 852, “Reorganizations,” (“ASC 852”), provides financial reporting guidance for entities that are reorganizing under the Bankruptcy Code. We implemented this guidance for the fiscal years ended January 28, 2012, and January 29, 2011. Due to the Plan becoming effective and the claims reconciliation process being complete, there are no amounts remaining to be distributed under the Plan; for prior periods, claims are presented as other pre-petition obligations (See Note 2 to the accompanying Consolidated Financial Statements). Financial statement preparation and presentation is in accordance with ASC 852.

 

We believe that estimates related to the following areas involve a higher degree of judgment and/or complexity:

 

Inventories. We value inventory using the lower of weighted average cost or market method. Market price is generally based on the projected selling price of the merchandise. We regularly review inventories to determine if the carrying value of the inventory exceeds market value and we record a reserve to reduce the carrying value to its market price, as necessary. Historically, we have rarely recognized significant occurrences of obsolescence or slow moving inventory. However, in the fourth quarter of 2010, we initiated a strategy to address aged and unproductive inventory, which resulted in a significant obsolescence charge of $6.7 million for the quarter. This policy is not expected to have a material impact on future earnings as product is sold. As of January 28, 2012 and January 29, 2011, we had recorded reserves totaling $2.5 million and $7.1 million, respectively.

 

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 for the period of time from each store's most recent physical count to the end of the period. For the periods between the date of the last physical count and the end of the applicable reporting period, we include these assumptions as we record cost of goods sold, including certain estimates for shrinkage of inventory due to theft, miscuts of fabric and other matters. These estimates are based on previous experience and could fluctuate from period-to-period and from actual results at the date of the next physical inventory count.

 

Shrink expense is accrued as a percentage of merchandise sales based on historical shrink trends. The Company performs physical inventories at the stores and distribution center throughout the year. The reserve for shrink represents an estimate for shrink for each of our locations since the last physical inventory date through the reporting date. Estimates by location and in the aggregate are impacted by internal and external factors and may vary significantly from actual results.

 

We capitalize costs related to the acquisition, distribution, and handling of inventory as well as freight, duties and fees related to import purchases of inventory as a component of inventory each period. In determining the amount of costs to be allocated to inventory each period, we must estimate the amount of costs related to the inventory, based on inventory turnover ratios and the ratio of inventory flowing through the warehouse. Changes in these estimates from period-to-period could significantly change the reported amounts for inventory and cost of goods sold. As of January 28, 2012, we had capitalized costs related to acquisition, distribution, and handling in inventory of $9.0 million and expensed $14.2 million as cost of sales during 2011.

 

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Property and Equipment. Determining appropriate depreciable lives and reasonable assumptions for use in evaluation of the carrying value of property and equipment requires judgment and estimates. Changes to those estimates could cause operating results to vary. The Company utilizes the straight-line depreciation method over a variety of depreciable lives while land is not depreciated. Leasehold costs and improvements are amortized over the lesser of their estimated useful lives or the remaining lease term as discussed in “Operating Leases” below. Buildings and related improvements are amortized over 5-40 years, leasehold improvements over 5-15 years and fixtures and equipment over 3-8 years. Generally, no estimated salvage value at the end of the useful life is considered.

 

Valuation of Long-Lived Assets. We review the net realizable value of long-lived assets at the individual store level whenever events or changes in circumstances indicate impairment testing is warranted. If the undiscounted cash flows are less than the carrying value, fair values based on the projected future discounted cash flows of the site and estimated liquidation proceeds are compared to the carrying value to determine the amount of the impairment loss to be recognized during that period. Due to the decline in operating results for 2011, we assessed our long-lived assets and determined that certain of them were impaired. As a result, we had recorded approximately $1.7 million in non-cash impairment charges. Additional charges may be necessary in the future due to changes in estimated future cash flows. Impairment charges are included in selling, general, and administrative expenses in the accompanying Consolidated Statements of Operations.

 

Operating Leases. We lease stores under various operating leases. The operating leases may include rent holidays, rent escalation clauses, contingent rent provisions for additional lease payments based on sales volume, and Company options for renewal. We recognize rent holiday periods and scheduled rent increases on a straight-line basis over the estimated lease term beginning with the date of possession. Additionally, renewals and option periods reasonably assured of exercise due to economic penalties are included in the estimated lease term. Liabilities for contingent rent are recorded when we determine that it is probable that the specified levels will be reached during the fiscal year.

 

Often, we receive allowances from landlords. If the landlord is considered the primary beneficiary of the property, the portion of the allowances attributable to the property owned by the landlord is considered to be a deferred rent liability, whereas the corresponding improvements by the Company are classified as prepaid rent in other noncurrent assets.

 

Revenue Recognition. Sales are recorded at the time customers provide a satisfactory form of payment and take ownership of the merchandise. We allow customers to return merchandise under most circumstances. The reserve for returns was $125,000 at January 28, 2012 and $122,000 at January 29, 2011, and is included in accrued liabilities in the accompanying Consolidated Balance Sheet. The reserve is estimated based on our prior experience of returns made by customers after period end.

 

Insurance Reserves. Workers' compensation, general liability and employee medical insurance programs are largely self-insured. It is our policy to record our self-insurance liabilities using estimates of claims incurred but not yet reported or paid based on historical trends, severity factors and/or valuations provided by third-party actuaries. Actual results can vary from estimates for many reasons including, among others, future inflation rates, claim settlement patterns, litigation trends, and legal interpretations.

 

Asset Retirement Obligations. Obligations created as a result of certain lease requirements that we remove certain assets and restore the properties to their original condition are recorded at the inception of the lease. The obligations are based on estimates of the actions to be taken and the related costs. Adjustments are made when necessary to reflect actual or estimated results, including future lease requirements, inflation or other changes to determine the estimated future costs.

 

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Pension and Postretirement Benefit Obligations. The value of assets and liabilities associated with pension and postretirement benefits is determined on an actuarial basis. These values are affected by the fair value of plan assets, estimates of the expected return on plan assets, and assumed discount rates. We determine the discount rates primarily based on the rates of high quality, fixed income investments. Actual changes in the fair value of plan assets, differences between the actual return and the expected return on plan assets and changes in the discount rate used affect the amount of pension expense recognized.

 

Assumed health care cost trend rates have a significant effect on the amounts reported for the health care plans. A one-percentage point change in the assumed health care trend rates would have the following effects (in thousands):

 

   One-Percentage   One-Percentage 
   Point   Point 
   Increase   Decrease 
Effect on total service and interest costs  $10   $(9)
Effect on postretirement benefit obligation  $94   $(84)

 

Our pension and postretirement plans are further described in Note 14 to the accompanying Consolidated Financial Statements.

 

Goodwill. Goodwill represents the excess of the purchase price over the fair value of the net assets acquired. On at least an annual basis or when events or changes in circumstances indicate impairment may have occurred, a two-step approach is used to test goodwill for impairment. First, the fair value of our reporting units are estimated using the discounted present value of future cash flows approach and then compared with their carrying values. If the carrying value of a reporting unit exceeds its fair value, a second step is performed to measure the amount of the impairment loss, if any. In the second step, the implied fair value of the goodwill is estimated as the fair value of the reporting unit used in the first step less the fair values of all other net tangible and intangible assets of the reporting unit. If the carrying amount of the goodwill exceeds its implied fair value, an impairment loss is recognized in an amount equal to that excess, not to exceed the carrying amount of the goodwill. Each of the 34 remaining stores acquired in two separate transactions that resulted in the recognition of goodwill represents a reporting unit. We performed an evaluation of goodwill in 2011 which resulted in impairment charges of $259,000 related to two store locations. We determined the goodwill impairment charges by estimating the fair value of the related reporting units using the present value of the related estimated cash flows. Additional impairment charges may be required in the future based on changes in the fair value of reporting units and the annual goodwill impairment evaluation performed in the fourth quarter of each fiscal year and updated when events arise indicating potential impairment. Specifically, the remaining goodwill allocated to the two locations partially impaired in 2011 is $71,000; should the operating results of these locations continue to decline, additional impairment charges will occur. Prior to the implementation of ASC 350, “Intangibles-Goodwill and Other,” (“ASC 350”) in fiscal year 2002, the Company was amortizing and presenting goodwill net of accumulated amortization of $1.0 million.

 

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Deferred Income Taxes. We record deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis. We then evaluate the net deferred tax asset, if any, for realization. Unless we determine that realization is “more likely than not,” a valuation allowance against the net deferred tax asset is established through a provision to income tax expense or in some cases other comprehensive income (loss). Accordingly, we may be limited in our ability to recognize future benefits related to operating losses; however, if we create taxable income in the future, we may be able to reverse the valuation allowances resulting in a decrease in income tax expense or other comprehensive income (loss).

 

At the present time, we do not anticipate recognizing any portion of our deferred income tax benefit in fiscal year 2012.

 

Deferred taxes are summarized in Note 9 to the accompanying Consolidated Financial Statements.

 

Stock-based Compensation. Beginning in fiscal year 2006, the Company adopted ASC 718, Compensation-Stock Compensation, (“ASC 718”) and began expensing the remaining portion of the fair value for any unvested stock options over the remaining service (vesting) period, which resulted in $140,000 and $281,000 of additional stock compensation expense during 2011 and 2010, respectively. The amounts of future stock compensation expense may vary based on the types of awards, vesting periods, estimated fair values of the awards using various assumptions regarding future dividends, interest rates and volatility of the trading prices of our stock.

 

Related Party Transactions

 

As part of the Company’s issuance of Notes on August 1, 2008, and in connection with our reorganization, certain members of the Official Committee of Equity Holders of Hancock Fabrics, Inc. (the “Equity Committee”) who were “related persons” as defined in Item 404 of Regulation S-K, participated in a Backstop Arrangement (“Backstop”) in which each party agreed to purchase all of the Notes not purchased by other purchasers during the offering. The Backstop provided for an additional 3,750 warrants to purchase our common stock to be issued to each participant. The related parties purchased approximately $18.0 million of the $20.0 million Note offering. The debt to related parties is subordinate to our revolving credit facility. See Note 16 to the accompanying Consolidated Financial Statements for details regarding each related party Equity Committee member’s participation in the Backstop. The Company has no other balances with any other related parties, nor has it had any other material transactions with related parties during the fiscal years 2011, 2010, or 2009.

 

Effects of Inflation

 

Inflation in labor and occupancy costs could significantly affect our operations. Many of our employees are paid hourly rates related to federal and state minimum wage requirements; accordingly, any increases in those requirements will affect us. In addition, payroll taxes, employee benefits, and other employee costs continue to increase. Health insurance costs, in particular, continue to rise at a high rate in the United States each year, and higher employer contributions to our 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. We believe 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.

 

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Seasonality

 

Our 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.

 

Recent Accounting Pronouncements

 

Recent accounting pronouncements are discussed in Note 3 - Summary of Significant Accounting Policies in the Notes to Consolidated Financial Statements.

 

Item 7A.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

We did not hold derivative financial or commodity instruments at January 28, 2012.

 

Interest Rate Risk

 

We are exposed to financial market risks, including changes in interest rates. At our 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 January 28, 2012, we had borrowings outstanding of approximately $31.3 million under the Revolver. If interest rates increased 100 basis points, our annual interest expense would increase approximately $313,000, assuming borrowings under the Revolver of $31.3 million as existed at January 28, 2012.

 

In addition to the Revolver, we 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%. The Notes mature 5 years from the date of issuance (August 1, 2013), are subordinated to the Revolver, and are secured by a junior lien on all of our assets. Purchasers of the Notes also received a detachable warrant to purchase shares of our common stock. These warrants representing 9.5 million shares were issued in conjunction with the Notes, and were exercisable upon the date of issuance (August 1, 2008) for $1.12 per share and terminate five years from the anniversary date of issuance (August 1, 2013). The warrants were valued at $11.7 million using the Black-Scholes option pricing model and were recorded as a discount on Long-term debt obligations and will be amortized to interest expense through the maturity date of the Notes. If interest rates increased 100 basis points, our annual interest expense would increase $216,000, assuming borrowings under the Notes of $21.6 million as existed at January 28, 2012.

 

Foreign Currency Risk

 

All of our business is transacted in U.S. dollars and, accordingly, fluctuations in the valuation of the dollar against other currencies will affect product costs. No significant impact was experienced on 2011 results. As of January 28, 2012, we had no financial instruments outstanding that were sensitive to changes in foreign currency rates.

 

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Item 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA 

 

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

 

HANCOCK FABRICS, INC.

  Page
   
Consolidated Balance Sheets as of January 28, 2012 and January 29, 2011 33
   
Consolidated Statements of Operations for each of the three years in the period ended January 28, 2012 34
   
Consolidated Statements of Shareholders’ Equity for each of the three years in the period ended January 28, 2012 35
   
Consolidated Statements of Cash Flows for each of the three years in the period ended January 28, 2012 36
   
Notes to Consolidated Financial Statements 37
   
Report of Independent Registered Public Accounting Firm 62
   
Quarterly Financial Data (unaudited) 63

 

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Hancock Fabrics, Inc.
Consolidated Balance Sheets
 

 

January 28, 2012 and January 29, 2011      
(in thousands, except for share and per share amounts)   2011    2010 
Assets          
Current assets:          
Cash and cash equivalents  $2,648   $2,372 
Receivables, less allowance for doubtful accounts   3,993    3,841 
Inventories, net   95,925    87,804 
Prepaid expenses   3,069    2,465 
Total current assets   105,635    96,482 
           
Property and equipment, net   36,275    39,335 
Goodwill   2,880    3,139 
Other assets   1,597    1,967 
Total assets  $146,387   $140,923 
           
Liabilities and Shareholders' Equity          
Current liabilities:          
Accounts payable  $19,350   $17,842 
Accrued liabilities   16,306    14,937 
Other pre-petition obligations   -    730 
Total current liabilities   35,656    33,509 
           
Long-term debt obligations   49,373    28,784 
Capital lease obligations   2,947    3,072 
Postretirement benefits other than pensions   2,429    2,337 
Pension and SERP liabilities   35,683    30,506 
Other liabilities   6,428    7,878 
Total liabilities   132,516   106,086 
           
Commitments and contingencies (See Notes 8 and 15)          
           
Shareholders' equity:          
Common stock, $.01 par value; 80,000,000 shares authorized; 33,914,711 and 33,466,455 issued and 20,511,123 20,068,327 outstanding, respectively   339    335 
Additional paid-in capital   90,013    89,671 
Retained earnings   104,936    116,234 
Treasury stock, at cost, 13,403,588 and 13,398,128 shares held, respectively   (153,737)   (153,731)
Accumulated other comprehensive loss   (27,680)   (17,672)
Total shareholders' equity   13,871    34,837 
Total liabilities and shareholders' equity  $146,387   $140,923 

 

See accompanying notes to consolidated financial statements.

 

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Hancock Fabrics, Inc.
Consolidated Statements of Operations
 

 

Years Ended January 28, 2012, January 29, 2011, and January 30, 2010            
(in thousands, except per share amounts)  2011    2010   2009 
             
Sales  $271,993   $275,465   $274,058 
Cost of goods sold   159,268    160,820    152,341 
                
Gross profit   112,725    114,645    121,717 
                
Selling, general and administrative expenses   115,047    115,098    109,681 
Depreciation and amortization   4,140    4,495    4,329 
                
Operating (loss) income   (6,462)   (4,948)   7,707 
                
Reorganization expense, net   -    485    755 
Interest expense, net   4,836    4,825    5,114 
                
(Loss) income from continuing operations before income taxes   (11,298)   (10,258)   1,838 
Income taxes   -    232    200 
                
(Loss) income from continuing operations   (11,298)   (10,490)   1,638 
Income from discontinued operations (net of taxes of $0 and $0)   -    29    150 
                
Net (loss) income  $(11,298)  $(10,461)  $1,788 
                
Basic (loss) earnings per share:               
(Loss) earnings from continuing operations  $(0.57)  $(0.53)  $0.08 
(Loss) earnings from discontinued operations   -    -    0.01 
Net (loss) earnings  $(0.57)  $(0.53)  $0.09 
                
Diluted (loss) earnings per share:               
(Loss) earnings from continuing operations  $(0.57)  $(0.53)  $0.08 
(Loss) earnings from discontinued operations   -    -    0.01 
Net (loss) earnings  $(0.57)  $(0.53)  $0.09 
                
Weighted average shares outstanding               
Basic   19,846    19,684    19,349 
Diluted   19,846    19,684    20,925 

 

See accompanying notes to consolidated financial statements.

 

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Hancock Fabrics, Inc.
Consolidated Statements of Shareholders' Equity
 
Years Ended January 28, 2012, January 29, 2011, and January 30, 2010
(in thousands, except number of shares)

           Additional           Accumulated Other       Total 
   Common Stock   Paid-in   Treasury Stock   Comprehensive   Retained   Shareholders' 
   Shares   Amount   Capital   Shares   Amount   (Loss)   Earnings   Equity 
Balance January 31, 2009   33,084,570   $331   $88,017    (13,368,267)  $(153,684)  $(12,222)  $124,907   $47,349 
Comprehensive loss:                                        
Net income                                 1,788    1,788 
Benefit plans, net of taxes of $0                            (3,024)        (3,024)
Total comprehensive loss                                      (1,236)
Stock options exercised   91,874    1    144                        145 
Issuance of restricted stock   161,000    2    (2)                       - 
Cancellation of restricted stock   (53,500)   (1)                            (1)
Stock compensation expense             866                        866 
Amortization of directors' stock fees             103                        103 
Purchases of treasury stock                  (13,529)   (14)             (14)
Balance January 30, 2010   33,283,944    333    89,128    (13,381,796)   (153,698)   (15,246)   126,695    47,212 
Comprehensive loss:                                        
Net loss                                 (10,461)   (10,461)
Benefit plans, net of taxes of $0                            (2,426)        (2,426)
Total comprehensive loss                                      (12,887)
Stock options exercised   43,511    -    36                        36 
Issuance of restricted stock   167,000    2    (2)                       - 
Cancellation of restricted stock   (28,000)   -    -                        - 
Stock compensation expense             324                        324 
Amortization of directors' stock fees             185                        185 
Purchases of treasury stock                  (16,332)   (33)             (33)
Balance January 29, 2011   33,466,455    335    89,671    (13,398,128)   (153,731)   (17,672)   116,234    34,837 
Comprehensive loss:                                        
Net loss                                 (11,298)   (11,298)
Benefit plans, net of taxes of $0                            (10,008)        (10,008)
Total comprehensive loss                                      (21,306)
Stock options exercised   7,999    -    5                        5 
Issuance of restricted stock   474,857    4    (4)                       - 
Cancellation of restricted stock   (34,600)   -    -                        - 
Stock compensation expense             341                        341 
Warrants issued with notes                                      - 
Purchases of treasury stock                  (5,460)   (6)             (6)
Balance January 28, 2012   33,914,711   $339   $90,013    (13,403,588)  $(153,737)  $(27,680)  $104,936   $13,871 

 

See accompanying notes to consolidated financial statements.

 

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Hancock Fabrics, Inc.
Consolidated Statements of Cash Flows

 

Years Ended January 28, 2012, January 29, 2011, and January 30, 2010            
(in thousands)  2011   2010   2009 
Cash flows from operating activities:               
Net (loss) income  $(11,298)  $(10,461)  $1,788 
Adjustments to reconcile net (loss) income  to cash flows from operating activities               
Depreciation and amortization, including cost of goods sold   6,068    6,538    6,619 
Amortization of deferred loan costs   246    246    247 
Amortization of note discount   2,331    2,331    2,331 
Amortization of pre-paid rent   249    181    203 
Interest paid-in-kind on notes   -    -    694 
Stock-based compensation   341    509    968 
Inventory valuation reserve   (4,601)   6,650    - 
Impairment on property and equipment, goodwill, and other assets   1,666    1,523    - 
Loss (gain) on disposition of property and equipment   333    21    (8)
Other   (544)   -    (90)
Reorganization expense, net   -    485    755 
Change in assets and liabilities:               
Receivables and prepaid expenses   (756)   (1,352)   152 
Inventories   (3,584)   (3,023)   12,187 
Other assets   (223)   2,059    (341)
Accounts payable   1,508    (900)   (3,559)
Accrued liabilities   1,230    -    322 
Postretirement benefits other than pensions   (956)   (869)   (953)
Pension and SERP liabilities   (3,783)   2,119    3,179 
Other liabilities   (1,482)   686    (784)
Net cash (used in) provided by operating activities before reorganization activities   (13,255)   6,743    23,710 
Net cash used for reorganization activites   -    (583)   (734)
Net cash (used in) provided by operating activities   (13,255)   6,160    22,976 
Cash flows from investing activities:               
Additions to property and equipment   (4,934)   (5,392)   (3,084)
Proceeds from the disposition of property and equipment   348    52    68 
Net cash used in investing activities   (4,586)   (5,340)   (3,016)
Cash flows from financing activities:               
Net (payments) borrowings on revolving  credit facility   18,258    (489)   (19,060)
Payments for pre-petition liabilities and other   (141)   (452)   (745)
Net cash (used in) provided by financing activities   18,117    (941)   (19,805)
Increase (decrease) in cash and cash equivalents   276    (121)   155 
Cash and cash equivalents:               
Beginning of year   2,372    2,493    2,338 
End of year  $2,648   $2,372   $2,493 
Supplemental disclosures:               
Cash paid during the period for:               
Interest  $2,174   $2,174   $1,508 
Income taxes   42    390    73 
                
Non-cash change in funded status of benefit plans  $(10,008)  $(2,426)  $(3,024)

 

See accompanying notes to consolidated financial statements.

 

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Notes to Consolidated Financial Statements

 

Note 1 - Description of Business

 

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, sewing accessories, needlecraft supplies and sewing machines. As of January 28, 2012, Hancock operated 263 stores in 37 states and an internet store under the domain name hancockfabrics.com. Hancock conducts business in one operating business segment.

 

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 States Bankruptcy Court closing the bankruptcy case of the Company. On October 17, 2011 the bankruptcy case of the Company was reopened, in order to settle the one remaining pre-petition claim, and closed on November 14, 2011.

 

Treatment of Claims and Interest

 

The Plan provides for payment in full in cash plus interest, as applicable, or reinstatement of equity interest in the Company. Therefore, there were no impaired classes of creditors or stockholders.

 

Exit Financing

 

On the Effective Date, the Company closed on a $100.0 million senior revolving line of credit facility, as well as issued $20.0 million of floating rate secured notes and warrants to purchase 9,500,000 shares of the common stock of the Company (See Note 7).

 

Claims Resolution and Plan Distributions

 

The Company resolved a majority of the claims against it prior to the Effective Date through settlement or by Court order. The claims resolution process has been completed and all known claims are resolved.

 

Accounting Impact

 

Financial Accounting Standards Board (FASB), Accounting Standards Codification (ASC), ASC 852, “Reorganizations” provides financial reporting guidance for entities that are reorganizing under the Bankruptcy Code. This guidance was implemented in the accompanying consolidated financial statements. Under this guidance, the Company was not required to adopt the “fresh-start reporting” provisions of ASC 852 upon emergence from bankruptcy. Due to the Plan becoming effective and the claims reconciliation process being complete, there is little uncertainty as to the total amount to be distributed under the Plan. As such, pre-petition liabilities after the Effective Date are presented as other pre-petition obligations.

 

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Subsequent Distribution

 

During the fifty-two weeks ended January 28, 2012, the Company settled the two remaining claims totaling approximately $730,000. As of January 28, 2012, there are no known unresolved pre-petition obligations.

 

  January 28,   January 29, 
(in thousands)   2012   2011 
Real estate claims  $-   $5 
Professional fee claim   -    725 
Total pre-petition obligations  $-   $730 

 

Note 3 - Summary of Significant Accounting Policies and Basis of Accounting

 

Consolidated Financial Statements include the accounts of Hancock and its wholly owned subsidiaries. All inter-company accounts and transactions are eliminated. The Company maintains its financial records on a 52-53 week fiscal year ending on the Saturday closest to January 31. Fiscal years 2011, 2010, and 2009, as used herein, refer to the years ended January 28, 2012, January 29, 2011, and January 30, 2010, respectively. The fiscal years 2011, 2010, and 2009 contained 52 weeks. The 2012 fiscal year which began January 29, 2012 and will end February 2, 2013 will be a 53 week year.

 

Financial Statement presentation is in accordance with FASB ASC 852, “Reorganizations,” which provides financial reporting guidance for entities that are reorganizing under the Bankruptcy Code. The Company implemented this guidance for the fiscal years ended January 28, 2012 and January 29, 2011. Due to the Plan becoming effective and the claims reconciliation process being complete, there is little uncertainty as to the total amount to be distributed under the Plan. As such, pre-petition liabilities after the Effective Date are no longer presented as subject to compromise (See Note 2).

 

Discontinued operations are presented and accounted for in accordance with FASB ASC 360, “Property, Plant and Equipment,” (“ASC 360”). When a qualifying component of the Company is disposed of or has been classified as held for sale, the operating results of that component are removed from continuing operations for all periods presented and displayed as discontinued operations if: (a) elimination of the component’s operations and cash flows from the Company’s ongoing operations has occurred (or will occur) and (b) significant continuing involvement by the Company in the component’s operations does not exist after the disposal transaction. In determining whether elimination of the component’s operations and cash flows from the Company’s ongoing operations has occurred (or will occur), the Company considers the generation of (or expected generation of) continuing cash flows. Actual or expected continuing cash inflows or outflows result from activities involving the Company and the component. The effect the existence of any continuing cash flows has on the classification of the component as discontinued operations hinges on whether those continuing cash flows are direct or indirect. Both the significance and nature of the continuing cash flows factor into our direct/indirect determination. Direct continuing cash flows exist if there has been a significant migration of revenues (cash inflows) or costs (cash outflows) from the component to the Company. Also, direct continuing cash flows exist if significant cash inflows or outflows result from the continuation of activities between the entity and the component. When determining the significance of: (a) revenues (cash inflows) or costs (cash outflows) resulting from migration and (b) cash inflows or outflows resulting from the continuation of activities, the Company considers the cash inflows and outflows that would have been expected if the disposal did not take place and the cash inflows and outflows that are expected after the disposal takes place.

 

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The 2009 and 2010 earnings from discontinued operations resulted from the settlement of bankruptcy claims on stores that closed in prior years which qualified for discontinued operations under the requirements of ASC 360.  We have not allocated interest expense to discontinued operations.

 

Use of estimates and assumptions that affect the reported amount of assets and liabilities and disclosure of contingent assets and liabilities at the date of the Consolidated Financial Statements and the reported amount of revenues and expenses during the reporting period is required by management in the preparation of the Consolidated Financial Statements in accordance with accounting principles generally accepted in the United States of America. Actual results could differ from those estimates.

 

Revenue recognition occurs at the time of sale of merchandise to Hancock’s customers, in compliance with FASB ASC 605, “Revenue Recognition”. Sales include the sale of merchandise at the Company’s retail stores and internet store, net of sales taxes collected and net of estimated customer returns. The Company allows customers to return merchandise under most circumstances. The reserve for returns was $125,000 at January 28, 2012 and $122,000 at January 29, 2011, and is included in accrued liabilities in the accompanying consolidated balance sheets. The reserve is estimated based on the Company’s prior experience of returns made by customers after period end of merchandise sold prior to period end.

 

Proceeds received from the sale of gift cards are recorded as a liability and recognized as sales when redeemed by the holder. The Company escheats a portion of unredeemed gift cards according to Delaware escheatment requirements that govern remittance of the cost of the merchandise portion of unredeemed gift cards over five years old. After reflecting the amount to be escheated, any remaining liability after 60 months (referred to as breakage) is relieved and recognized as a reduction of selling, general, and administrative expenses as an offset to the costs of administering the gift card program. The liability for gift cards is recorded in accrued liabilities and was $1.3 million at January 28, 2012 and January 29, 2011.

 

Cost of goods sold includes merchandise, freight, and sourcing and warehousing costs.

 

Cash and cash equivalents. Cash on hand and in banks, together with other highly liquid investments which are subject to market fluctuations and having an initial maturity of three months or less, are classified as cash and cash equivalents.

 

Receivables include amounts due from customers for the sale of merchandise, amounts related to insurance claims, and amounts from financial institutions for credit card payments received for the sale of merchandise. Receivables are stated net of the allowance for doubtful accounts, which was zero for both 2011 and 2010. Bad debt expense is included in selling, general and administrative expenses and was insignificant in years 2011, 2010, and 2009. Generally, past due receivables are charged interest and accounts are charged off against the allowance for doubtful accounts when deemed uncollectible.

 

Inventories consist of fabrics, sewing notions, and patterns held for sale and are stated at the lower of cost or market; cost is determined by the weighted average cost method. The costs related to sourcing and warehousing as well as freight, duties, and fees related to purchases of inventories are capitalized into ending inventory with the net change recorded as a component of costs of goods sold. At January 28, 2012 and January 29, 2011, inventories included such capitalized costs for sourcing and warehousing totaling $9.0 million. During fiscal 2011, 2010, and 2009, the Company included in cost of goods sold $12.3 million, $11.9 million, and $12.4 million, respectively, related to sourcing and warehousing costs, and $1.9 million, $2.0 million, and $2.3 million, respectively, related to depreciation and amortization expense.

 

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Hancock provides for slow-moving or obsolete inventories throughout the year by marking down impacted inventory to its net realizable value. In addition, Hancock records specific reserves when necessary to the extent that markdowns have not yet been reflected. During the fourth quarter of 2010, the Company initiated an aggressive strategy to address aged and unproductive inventory, which resulted in a charge of $6.7 million. At January 28, 2012, and January 29, 2011, the amount of such reserves totaled $2.5 million and $7.1 million, respectively.

 

Vendor allowances and rebates are recorded as a reduction of the cost of inventory and cost of goods sold.

 

Property and equipment are stated at cost less accumulated depreciation and amortization. Depreciation is computed by use of the straight-line method over the estimated useful lives of buildings, fixtures and equipment. Leasehold costs and improvements are amortized over the lesser of their estimated useful lives or the remaining lease term as discussed in “Operating leases” below. Average depreciable lives are as follows: buildings and improvements 5-40 years, leasehold improvements 5-15 years and fixtures and equipment 3-8 years.

 

Assets under capital leases are amortized in accordance with the Company’s normal depreciation policy for owned assets or over the lease term (regardless of renewal options), if shorter, and the charge to earnings is included in depreciation expense in the Consolidated Statements of Operations.

 

Asset retirement obligations are created as a result of certain lease requirements that Hancock remove certain assets and restore the properties to their original condition. The obligations are recorded at the inception of the lease based on estimates of the actions to be taken and related costs. Adjustments are made when necessary to reflect actual results.

 

Long-lived asset impairment is assessed when events or changes in circumstances indicate impairment testing is warranted. The assessment is performed at the individual store level by comparing the carrying value of the assets with their estimated future undiscounted cash flows in accordance with ASC 360, “Property, Plant and Equipment”. If the undiscounted cash flows are less than the carrying value, the discounted cash flows or comparable fair values are compared to the carrying value to determine the amount of the impairment loss to be recognized during that period. Fair values are estimated based on the discounted cash flows plus the proceeds from the estimated liquidation values of the assets. During 2011 and 2010, the Company evaluated the carrying amounts of certain store related long-lived assets, primarily leasehold improvements, fixtures and equipment, and prepaid rent. The net book value of long-lived assets other than goodwill, net of noncurrent liabilities for fiscal 2011 and fiscal 2010, was $2.0 million and $2.3 million, respectively, for stores deemed to be at least partially impaired, and the Company recorded total impairment charges of $1.4 million and $1.5 million, respectively, primarily due to the operations of the related stores failing to produce adequate cash flows. During 2009, the Company determined there were no events that indicate the need for impairment testing. Impairment charges are included in selling, general, and administrative expense in the accompanying consolidated statements of operations.

 

Goodwill. Goodwill represents the excess of the purchase price over the fair value of the net assets acquired. On at least an annual basis or when events or changes in circumstances indicate impairment may have occurred, a two-step approach is used to test for impairment. First, the fair value of Hancock’s reporting units are estimated using the discounted present value of future cash flows approach and then compared with their carrying values. If the carrying value of a reporting unit exceeds its fair value, a second step is performed to measure the amount of the impairment loss, if any. In the second step, the implied fair value of the goodwill is estimated as the fair value of the reporting unit used in the first step less the fair values of all other net tangible and intangible assets of the reporting unit. If the carrying amount of the goodwill exceeds its implied fair value, an impairment loss is recognized in an amount equal to that excess not to exceed the carrying amount of the goodwill. The fair value of the reporting unit is estimated using the discounted present value of future cash flows. Each of the stores acquired in two separate transactions that resulted in the recognition of goodwill represents a reporting unit. Impairment of goodwill was required due to declining operating results and other factors during 2011 and 2010, and the Company recorded goodwill impairment charges of $259,000 and $71,000, respectively. Prior to the implementation of ASC 350, “Intangibles-Goodwill and Other,” the Company amortized goodwill. Accordingly, goodwill is presented net of accumulated amortization of $1.0 million.

 

40
 

 

Accounts Payable, as of January 28, 2012 and January 29, 2011, includes $3.1 million and $3.7 million, respectively, for checks that are issued and outstanding.

 

Self-insured reserves are recorded for the Company’s self-insured programs for general liability, employment practices, workers’ compensation, and employee medical claims, although the Company maintains certain stop-loss coverage with third-party insurers to limit its total liability exposure. A reserve for liabilities associated with these losses is established for claims filed and incurred but not yet reported based upon the Company’s estimate of ultimate cost, which is calculated with consideration of analyses of historical data, severity factors, and/or valuations provided by third-party actuaries. The Company monitors new claims and claim development as well as negative trends related to the claims incurred but not reported in order to assess the adequacy of its insurance reserves. While the Company does not expect the amounts ultimately paid to differ significantly from its estimates, the Company’s self-insurance reserves and corresponding expenses could be affected if future claim experience differs significantly from historical trends and actuarial assumptions.

 

Claims and Litigation. The Company evaluates claims for damages and records its estimate of liabilities when such liabilities are considered probable and an amount or range can be easily estimated.

 

Operating leases result in rent expense recorded on a straight-line basis over the expected life of the lease beginning with the point at which the Company obtains control and possession of the lease properties. The expected life of the lease includes the build-out period where no rent payments are typically due under the terms of the lease, rent holidays, and available lease renewals and option periods reasonably assured of exercise due to economic penalties. Also, the leases often contain predetermined fixed escalations of the minimum rentals during the term of the lease, which are also recorded on a straight-line basis over the expected life of the lease. The difference between the lease payment and rent expense in any period is recorded as stepped rent accrual in accrued liabilities and other liabilities in the consolidated balance sheets.

 

The Company records tenant allowances from landlords as lease incentives, which are amortized as a reduction of rent expense over the expected life of the lease. Furthermore, improvements made by the Company as required by the lease agreements are capitalized by the Company as prepaid rent expense and recorded as prepaid expenses and other noncurrent assets in the consolidated balance sheets and are amortized into rent expense over the expected life of the lease. These improvements are typically the result of negotiations with the landlords which require the Company to make a significant investment to build-out the space for occupancy, which reduces the base rent on the property. Improvements classified as leasehold improvements and amortized into depreciation expense would be those that are routine in nature, necessary to modify the property for our operation and do not result in a reduction in base rent on the property.

 

Additionally, certain leases provide for contingent rents that are not measurable at inception. These contingent rents are primarily based on sales volume in excess of a predetermined level. These amounts are excluded from minimum rent and are included in the determination of total rent expense when it is probable that the expense has been incurred and the amount is reasonably estimable.

 

Maintenance and repairs are charged to expense as incurred and major improvements are capitalized.

 

41
 

 

Advertising, including production costs, is charged to expense in the period in which advertising first takes place. Advertising expense was $9.6 million for 2011, $10.1 million for 2010, and $10.0 million for 2009.

 

Pre-opening costs of new stores are charged to expense as incurred.

 

Earnings 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 common shareholders by the weighted-average number of common shares outstanding for the period, which represent common shares outstanding, less treasury stock and non-vested restricted shares. 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 Hancock. For the fiscal years 2011 and 2010, basic and diluted earnings per share are the same because the Company was in a loss position and the effect of additional securities or contracts to purchase additional common stock would be anti-dilutive. Options to purchase 1,156,000 shares in 2009 were excluded from the computation of diluted earnings per share because the respective exercise prices per share of those options were greater than the average market price of our shares of common stock during the year, or because by including the unvested compensation expense associated with the options, the calculation of common stock equivalents under the treasury method would be anti-dilutive. For 2009, using the treasury stock method, the calculation of fully diluted earnings per share includes an additional 1,576,000 shares based upon the impact of outstanding options, restricted shares and warrants deemed “in the money”. As of January 28, 2012, warrants entitling the purchase of an aggregate 9,485,600 shares are outstanding.

 

Financial Instruments and Fair Value Measurements. The Company’s financial instruments consist of cash and cash equivalents, accounts receivable, accounts payable, accrued expenses, long term debt, and benefit plan liabilities. The fair value of these financial instruments, excluding benefit plan liabilities, approximate the carrying value based upon the short term maturity of the items or the market rate terms and conditions. The Company does not have any financial instruments that are required to be measured at fair value on a recurring basis except for benefit plan liabilities.

 

Income taxes are recorded using the asset and liability method. Under this method, deferred tax assets and liabilities are recognized for the expected future tax consequences of temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis. We also recognize future tax benefits associated with tax losses and credit carryforwards as deferred tax assets. Our deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is “more likely than not” that some portion or all of the deferred tax assets will not be realized. Deferred tax assets and liabilities are measured using enacted tax rates in effect for the year in which the Company expects to recover or settle the temporary differences. The effect of a change in tax rates on deferred taxes is recognized in the period that the change is enacted.

 

Uncertain Tax Positions are accounted for in accordance with FASB ASC 740, “Income Taxes” (“ASC 740”). This interpretation clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements and prescribes a minimum recognition threshold of more-likely-than-not to be sustained upon examination that a tax position must meet before being recognized in the financial statements. The impact of an uncertain income tax position on the income tax return must be recognized at the largest amount that is more-likely-than-not to be sustained upon audit by the relevant taxing authority. An uncertain income tax position will not be recognized if it has less than a 50% likelihood of being sustained.

 

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Stock-Based Compensation is accounted for in accordance with FASB ASC 718, “Stock Compensation,” which requires the recognition of the fair value of stock compensation as an expense in the calculation of net income (loss). The Company recognizes stock compensation expense in the period in which the employee is required to provide service, which is generally over the vesting period of the individual equity instruments.

 

Comprehensive income (loss) and the components of accumulated comprehensive income (loss) include net income (loss) and the changes in benefit plan liabilities, net of taxes.

 

Treasury stock is repurchased periodically by Hancock. These treasury stock transactions are recorded using the cost method.

 

Concentration of Credit Risk. Financial instruments which potentially subject Hancock to concentrations of risk are primarily cash and cash equivalents and trade and other receivables. Hancock places its cash and cash equivalents in various insured depository institutions which limits the amount of credit exposure to any one institution. Occasionally our cash deposits with financial institutions exceed federal insurance provided on such deposits but to date the Company has not experienced any losses on such deposits.

 

In the ordinary course of business, Hancock extends credit to certain parties which are unsecured; however, Hancock has not historically had significant losses on the realization of such assets.

 

Recent Accounting Pronouncements

 

In May 2011, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2011-04, “Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS,” which amends U.S. GAAP to conform with measurement and disclosure requirements in International Financial Reporting Standards (“IFRS”).  The amendments change the wording used to describe the requirements in U.S. GAAP for measuring fair value and for disclosing information about fair value measurements, and they include those that clarify the FASB’s intent about the application of existing fair value measurement and disclosure requirements and those that change a particular principle or requirement for measuring fair value or for disclosing information about fair value measurements.  In addition, to improve consistency in application across jurisdictions, some changes in wording are necessary to ensure that U.S. GAAP and IFRS fair value measurement and disclosure requirements are described in the same way (for example, using the word shall rather than should to describe the requirements in U.S. GAAP). The amendments in this standard are to be applied prospectively and are effective during interim and annual periods beginning after December 15, 2011, which would be the first quarter of fiscal 2012 for the Company.  The Company does not believe ASU 2011-04 will have a significant impact on its Consolidated Financial Statements.

 

In June 2011, the FASB issued 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.

 

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In September 2011, the FASB issued ASU 2011-08, Intangible – Goodwill and Others. ASU 2011-08 amends ASC 350-20, Testing Goodwill for Impairment and permits an entity to first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount as a basis for determining whether it is necessary to perform the two-step goodwill impairment test. ASU 2011-08 is effective for interim or annual goodwill impairment test performed for fiscal years beginning on or after December 15, 2011, early adoption is permitted. The Company does not believe ASU 2011-08 will have a significant impact on its Consolidated Financial Statements.

 

Several other new accounting standards became effective during the periods presented or will be effective subsequent to January 28, 2012. None of these new standards had or is expected to have a significant impact on the Company’s Consolidated Financial Statements.

 

Note 4 – Discontinued Operations

 

The Company closed three stores in 2011 and one store in each of 2010 and 2009, none of which qualified for discontinued operations treatment in accordance with the provisions of FASB ASC 360, “Property, Plant and Equipment”. The amounts classified as discontinued operations relate to the adjustment of bankruptcy related claims on the 124 stores closed in 2007 that qualified for discontinued operations. Significant components of our results of discontinued operations consisted of the following for the years presented:

  

Discontinued Operations (in thousands, except per share amounts)            
             
  

 

 

 

Sales

  

 

 

 

Gross Profit

  

 

 

 

Net Income

   Basic and
diluted net
income per
common share
 
                 
2010                    
Discontinued operations  $-   $-   $29   $- 
                     
2009                    
Discontinued operations  $-   $-   $150   $0.01 

 

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Note 5 - Property and Equipment (in thousands)

 

Property and Equipment consists of the following:

 

   2011   2010 
         
Buildings and improvements  $25,873   $25,837 
Leasehold improvements   6,015    5,878 
Fixtures and equipment   63,655    67,234 
Assets held for sale   324    705 
    95,867    99,654 
Accumulated depreciation and amortization   (60,805)   (61,532)
    35,062    38,122 
Land   1,213    1,213 
Total property and equipment, net  $36,275   $39,335 

 

The Company recorded $4.1 million, $4.5 million, and $4.3 million of depreciation expense for the years 2011, 2010, and 2009, respectively. The Company also expensed $1.9 million, $2.0 million, and $2.3 million, of depreciation to cost of sales in 2011, 2010, and 2009, respectively.

 

Assets held under capital leases amounted to $3.6 million at the end of fiscal years 2011 and 2010, respectively. Accumulated depreciation related to these assets at the end of fiscal year 2011 and 2010, totaled $1.0 million and $0.8 million, respectively. Related depreciation expense amounted to $165,000, $170,000, and $168,000 for 2011, 2010, and 2009, respectively.

 

Note 6 - Accrued Liabilities (in thousands)

 

Accrued liabilities consist of the following:

 

   2011   2010 
         
Workers' compensation and deferred compensation  $3,255   $3,249 
Property taxes   3,051    3,174 
Payroll and benefits   2,061    2,047 
Short-term lease obligations   1,492    1,515 
Medical claims, customer liability claims and property claims   1,448    1,161 
Accrued professional fees   1,427    90 
Gift card / merchandise credit liability   1,313    1,327 
Sales taxes   914    949 
Other   1,345    1,425 
   $16,306   $14,937 

 

Note 7 – Long-Term Debt Obligations

 

On August 1, 2008, the Company and General Electric Capital Corporation (along with certain of its affiliates, "GE Capital") entered into a financing arrangement whereby GE Capital provided the Company with a revolving line of credit (the "Revolver") in the maximum amount of $100.0 million (the "Maximum Amount"). The Maximum Amount includes a letter of credit sub-facility of up to $20.0 million. There are no financial covenants. The Company is, however, precluded from incurring significant additional debt obligations.

 

45
 

 

The Revolver has a 60-month term. 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. The applicable margins range from 0.0% to 2.375% depending on the nature of the borrowing under the Revolver. Starting on January 1, 2009, the applicable margins are subject to adjustment (up or down) prospectively for three calendar month periods based on the Company's average excess availability under the Revolver.

 

The Revolver is collateralized by a fully perfected first priority security interest in all of the existing and after acquired real and personal tangible and intangible assets of the Company. As of January 28, 2012, the Company had outstanding borrowings under the Revolver of $31.3 million and amounts available to borrow of $31.5 million.

 

At January 28, 2012, Hancock had commitments under the above credit facility of $0.6 million, under documentary letters of credit, which support purchase orders for merchandise. Hancock also has standby letters of credit to guarantee payment of potential insurance claims. These letters of credit amounted to $4.9 million as of January 28, 2012.

 

In addition to the Revolver, the Company issued $20.0 million of Floating Rate Secured Notes (the “Notes”) on August 1, 2008. The Notes were offered pursuant to a prospectus dated June 17, 2008, to shareholders of common stock. The non-convertible notes had a $1,000 purchase price. Interest on the Notes is payable quarterly at LIBOR plus 4.50%. For the first four quarters, in lieu of interest payments, additional Notes were allowed to be issued at a rate equal to LIBOR plus 5.50%. The Notes mature 5 years from the date of issuance (August 1, 2013), are subordinated to the Revolver, and are secured by a junior lien on all of the Company’s assets. Purchasers of the Notes also received a detachable warrant to purchase shares of common stock. These warrants representing 9.5 million shares were issued in conjunction with the Notes and were exercisable upon the date of issuance (August 1, 2008) for $1.12 per share and terminate 5 years from the date of issuance (August 1, 2013). The warrants were valued at $11.7 million using the Black-Scholes option pricing model (term of 5 years, risk-free interest rate of 3.75%, expected volatility of 72%, and 0% dividend) and were recorded as a discount on Long-term debt obligations. The balance will be amortized to interest expense through the maturity date of the Notes. The unamortized discount at January 28, 2012, totaled approximately $3.5 million.

 

The Company elected to make the first four quarterly interest payments on the Notes by issuing additional Notes which resulted in the capitalization of $0.7 million of interest into the outstanding balance for 2009. As of January 28, 2012, the outstanding balance of the Notes was $21.6 million.

 

Note 8 - Long-Term Leases

 

Hancock leases its retail fabric store locations mainly under non-cancelable operating leases expiring at various dates through 2024. Four of the Company’s stores qualify for capital lease treatment. Two of the leases expire in 2020; the others expire in 2016 and 2021.

 

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Rent expense consists of the following (in thousands):

 

   2011   2010   2009 
             
Minimum rent  $21,563   $21,125   $21,070 
Common area maintenance   2,053    2,055    2,036 
Stepped rent adjustment   (12)   108    (156)
Equipment leases   455    402    409 
Additional rent based on sales   96    85    155 
Taxes   4,036    4,321    4,332 
Insurance   356    354    394 
                
   $28,547   $28,450   $28,240 

 

The amounts shown in the minimum rental table below reflect only future minimum rent payments required under existing store operating leases and income from non-cancelable sublease rentals. In addition to those obligations, certain of Hancock’s store operating leases require payment of pass-through costs such as common area maintenance, taxes, and insurance.

 

Future minimum rental payments under all operating and capital leases as of January 28, 2012, are as follows (in thousands):

 

   Operating Leases     
       Sublease    Capital 
Fiscal Year  Payments   Rentals   Leases  
2012  $20,776   $(139)  $472 
2013   16,986    (88)   472 
2014   12,688    (88)   472 
2015   10,330    (88)   472 
2016   7,748    (66)   429 
Thereafter   10,817    -    3,325 
Total minimum lease payments (income)  $79,345   $(469)   5,642 
                
Less imputed interest             (2,570)
Present value of capital lease obligations             3,072 
Less current portion             (125)
Long-term capital lease obligations            $2,947 

 

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Note 9 - Income Taxes

 

The components of income tax expense are as follows (in thousands):

 

   2011   2010   2009 
Currently payable               
Federal  $-   $42   $200 
State   -    -    - 
Total currently payable  $-   $42   $200 
                
Deferred               
Federal  $-   $-   $- 
State   -    -    - 
Total Deferred  $-   $-   $- 
                
Total Expense  $-   $232   $200 

 

A reconciliation of the statutory federal income tax rate to the effective tax rate is as follows:

 

   2011   2010   2009 
             
Statutory federal income tax rate   35.0%   35.0%   35.0%
State income taxes, net of federal income tax effect   3.1    1.3    1.3 
Other permanent differences   (0.5)   (0.2)   12.9 
Valuation allowance   (37.6)   (36.1)   (49.2)
Other   -    (2.3)   10.9 
Effective tax rate   -   (2.3)%   10.9%

 

Deferred income taxes are provided in recognition of temporary differences in reporting certain revenues and expenses for financial statement and income tax purposes.

 

The deferred tax assets are comprised of the following (in thousands):

 

   2011   2010 
Deferred tax assets:          
NOL carryforward  $21,048   $12,475 
Pension and other postretirement benefits   18,242    13,632 
Deferred compensation   2,627    2,773 
Reserves and accruals   2,328    2,664 
Inventory valuation method   4,138    2,575 
Property and equipment   2,149    1,118 
Other   (957)   (788)
Total deferred tax asset   49,575    34,449 
Valuation allowance   (49,575)   (34,449)
Net deferred tax asset  $-   $- 

 

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A valuation allowance is provided when it is more likely than not that some portion of the deferred tax assets will not be realized. The Company established a 100% valuation allowance due to the uncertainty of realizing future tax benefits from its net operating loss carryforwards and other deferred tax assets. At January 28, 2012, the Company had a usable net operating loss carryforward of approximately $46.1 million for federal income tax purposes, which will be available to offset future taxable income until they expire between 2026 and 2031, and a usable $160.5 million net operating loss carryforward for state income tax purposes, which will be available to offset future taxable income until they expire between 2012 and 2031. Upon conversion from the LIFO method of accounting for tax purposes, the Company is obligated to recognize the accumulated LIFO inventory reserve of approximately $36.4 million into taxable income equally over a four year period beginning in fiscal 2008, the remaining $9.1 million will be recognized into taxable income in 2011 and is not reflected in the net operating loss carryforward amount noted above. The Company recognizes its pension and other postretirements benefit liabilities as a deferred tax asset but since the realization of such tax benefit is contingent upon the future payment of such amounts, a full valuation allowance is established for these deferred tax assets.

 

Internal Revenue Code Section 382 places a limitation (the “Section 382 Limitation”) on the amount of taxable income which can be offset by net operating loss carryforwards after a change in control (generally greater than a 50% change in ownership) of a loss corporation. Generally, after a control change, a loss corporation cannot deduct operating loss carryforwards in excess of the Section 382 Limitation. The Company does not currently believe it is subject to any Section 382 limitations.

 

The Company classifies interest and penalties related to uncertain tax positions as a component of tax expense. At January 28, 2012, the Company had no unrecognized tax differences which should have impacted the effective tax rate in fiscal 2011. No interest and penalties were included in the balance sheet or statement of operations as of or for the year ended January 28, 2012. As of January 28, 2012, the Company files tax returns with the Federal government and approximately 37 different states. There currently are no tax audits in process. The Company believes that as part of its emergence from Chapter 11 it is substantially protected against any tax claims made prior to the bankruptcy filing.

 

Note 10 - Other Liabilities

 

Other liabilities consisted of the following (in thousands):

 

   2011   2010 
Long-term workers' compensation and deferred compensation  $3,851   $5,198 
Long-term stepped rent accrual   1,936    1,855 
Other   641    825 
   $6,428   $7,878 

 

The Company has adopted the provisions of ASC 410, “Asset Retirement and Environmental Obligations,” (“ASC 410”). ASC 410 requires the capitalization of any retirement obligation costs as part of the carrying amount of the long-lived asset and the subsequent allocation of the total expense to future periods using a systematic and rational method. The Company has determined that certain leases require that the premises be returned to its original condition upon lease termination. As a result, the Company will incur costs, primarily related to the removal of signage from its retail stores, at the lease termination. ASC 410 requires that these costs be recorded at their fair value at lease inception.

 

At January 28, 2012 and January 29, 2011, the Company had a liability pertaining to the asset retirement obligation in other liabilities of $312,000 and $314,000, respectively.

 

Note 11 - Shareholders’ Interest

 

Authorized Capital. Hancock’s authorized capital includes five million shares of $.01 par value preferred stock, none of which have been issued.

 

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Common Stock Purchase Rights. Hancock amended the Common Stock Purchase Rights Agreement with Continental Stock Transfer & Trust Company as Rights Agent, as amended and restated, on November 13, 2009 (the “Rights Agreement”). The Rights Agreement governs the terms of each right (a “Right”) that has been issued with each share of common stock of Hancock (the “Common Stock”). Each Right initially represents the right to purchase one share of Common Stock.

 

Hancock adopted the 2009 amendment to the Rights Agreement to preserve the value of the Company’s tax assets, including the Company’s net operating loss carryforwards (“Tax Benefits”) for both the Company and its stockholders. The Company’s ability to fully use its Tax Benefits to offset future income may be limited if it experiences an “ownership change” for purposes of Section 382 of the Internal Revenue Code of 1986.

 

The Rights Agreement is designed to reduce the likelihood that Hancock will experience an ownership change by (i) discouraging any person (together with such person’s affiliates or associates) from acquiring 4.95% or more of the then outstanding Common Stock and (ii) discouraging any person (together with such person’s affiliates or associates) that currently beneficially owns at least 4.95% of the outstanding Common Stock from acquiring more than a specified percentage of additional shares of Common Stock. There is no guarantee, however, that the Rights Agreement will prevent the Company from experiencing an ownership change.

 

Stock Repurchase Plan. In prior years, Hancock has repurchased approximately 13.4 million shares of its Common Stock. There are 243,487 shares available for repurchase as of January 28, 2012, under the most recent authorization.

 

Warrants. In August 2008, Hancock issued 23,750 warrants which entitle the holder to purchase Common Stock of the Company. The warrants were issued in conjunction with the $20.0 million of Notes (See Note 7) and are detachable from the related note. Each warrant entitles the holder to purchase 400 shares at an exercise price of $1.12 per share and has an expiration date of August 1, 2013. As of January 28, 2012, warrants entitling the purchase of an aggregate 9,485,600 shares are outstanding.

 

Note 12 – Earnings per Share

 

A reconciliation of basic earnings (loss) per share to diluted earnings (loss) per share follows (in thousands, except per share amounts):

 

   Years Ended 
   January 28, 2012   January 29, 2011   January 30, 2010 
   Net       Per Share   Net       Per Share   Net       Per Share 
   Earnings   Shares   Amount   Earnings   Shares   Amount   Earnings   Shares   Amount 
Basic EPS                                             
Earnings (loss) available to common shareholders  $(11,298)   19,846   $(.57)  $(10,461)   19,684   $(.53)  $1,788    19,349   $.09 
                                              
Effect of Dilutive Securities                                             
Stock options                                      64      
Restricted stock                                      126      
Warrants                                      1,386      
                                              
Diluted EPS                                             
Earnings (loss) available to common shareholders plus conversions  $(11,298)   19,846   $(.57)  $(10,461)   19,684   $(.53)  $1,788    20,925   $.09 

  

Certain options to purchase shares of Hancock’s common stock totaling 990,000, 494,000, and 1,156,000, shares were outstanding during the fiscal years 2011, 2010, and 2009, respectively, but were not included in the computation of diluted EPS because the exercise price was greater than the average price of common shares. Additionally, securities totaling 10,070,000 and 10,846,000 equivalent shares were excluded in 2011 and 2010 as such shares were anti-dilutive.

 

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Note 13 – Stock-Based Compensation

 

The Company’s stock-based compensation consists of compensation for stock options and restricted stock. Total cost for stock-based compensation included in net loss was $341,000 for 2011, $0.5 million for 2010 and $1.0 million for 2009.

 

Stock Options. In 2001, Hancock adopted the 2001 Stock Incentive Plan (the “2001 Plan”) which authorized the granting of options or restricted stock to key employees for up to 2,800,000 shares of common stock in total. In 2005, the 2001 Plan was amended to increase the aggregate number of shares authorized for issuance by 350,000 shares. Additionally, the 2001 Plan was amended and restated pursuant to the Company’s Plan of Reorganization, approved on August 1, 2008, to increase the aggregate number of shares authorized for issuance by 3,150,000, to award each non-employee director installed pursuant to the Plan of Reorganization 50,000 shares of restricted stock, to allow non-employee directors to receive restricted stock and stock options, and to allow directors to elect to receive fees as restricted shares instead of cash. Under the 2001 Plan, as amended and restated, the total shares available for issuance is 6,300,000. The options granted under the 2001 Plan, as amended and restated, can have an exercise price of no less than 100% of fair market value on the date the options are granted, vest 25% upon the first anniversary of the grant date and 1/36th per month over the next three years, and expire seven years from the grant date. Restricted stock issued under the 2001 Plan, as amended and restated, can vest no sooner than 50% upon the first anniversary and 25% upon the second and third anniversaries.

 

On April 16, 2009, the Stock Plan Committee of the Company’s Board of Directors amended the 2001 Plan, as amended and restated, to provide for the issuance of stock options under the terms of the Long Term Incentive Plan. In general, the Long Term Incentive Plan provides for the granting of stock options with vesting over three years conditional on achieving annual performance goals as determined by the Board of Directors. If the goals are not achieved, the shares available for vesting that year are forfeited. As of January 28, 2012, a total of 3,152,789 shares remain available for grant under the 2001 Plan, as amended and restated.

 

A summary of stock option activity in the plan for the years ended 2011, 2010, and 2009 follows:

 

   2011   2010   2009 
       Weighted       Weighted       Weighted 
       Average       Average       Average 
       Exercise       Exercise       Exercise 
   Options   Price   Options   Price   Options   Price 
Outstanding at beginning of year   1,377,682   $3.19    1,545,804   $3.17    1,260,075   $4.21 
                               
Granted   147,497   $1.06    168,593   $1.75    717,329   $.92 
                               
Forfeited / canceled   (583,814)  $2.79    (293,204)  $2.99    (339,726)  $2.65 
                               
Exercised   (7,999)  $.65    (43,511)  $.84    (91,874)  $1.58 
                               
Shares outstanding, vested, and expected to  vest at end of year   850,139   $3.69                     
                               
Outstanding at end of year   933,366   $3.48    1,377,682   $3.19    1,545,804   $3.17 
                               
Exercisable at end of year   661,199   $4.34    677,586   $5.13    474,221   $7.69 

 

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The total intrinsic value of shares exercised during the years 2011 and 2010 was $2,000 and $23,000, respectively. Cash proceeds from stock options exercised were $5,000 during the year 2011. The tax benefit related to stock option exercises will not be recognized until the net operating loss carryforward has been utilized.

 

For shares outstanding, vested, and expected to vest the intrinsic value is $28,000 and the weighted average remaining contractual life is 3.43 years at January 28, 2012.

 

The weighted average grant-date fair value of options granted during 2011, 2010, and 2009 was $0.72, $1.75, and $0.92, respectively. The fair value of each option grant is estimated on the date of the grant using the Black-Scholes option pricing model with the following weighted-average assumptions for 2011, 2010, and 2009 respectively: dividend yields of 0%, 0%, and 0%; average expected volatility of 99%, 102%, and 95%; risk-free interest rates of 1.05%, 1.5%, and 1.93% and an average expected life of 4.19 years, 3.98 years, and 4.50 years, respectively.

 

The following is a summary of the methodology applied to develop each assumption:

 

Expected Volatility — This is a measure of the amount by which a price has fluctuated or is expected to fluctuate. The Company uses actual historical changes in the market value of our stock to calculate expected price volatility because management believes that this is the best indicator of future volatility. The Company calculates daily market value changes from the date of grant over a past period representative of the expected life of the options to determine volatility. An increase in the expected volatility will increase compensation expense.

 

Risk-free Interest Rate — This is the yield of a U.S. Treasury zero-coupon bond issue effective at the grant date with a remaining term equal to the expected life of the option. An increase in the risk-free interest rate will increase compensation expense.

 

Expected Lives — This is the period of time over which the options granted are expected to remain outstanding and is based on the simplified method as outlined in the SEC Staff Accounting Bulletin 110. The Company will continue to estimate expected lives based on the simplified method until reliable historical data becomes available. An increase in the expected life will increase compensation expense.

 

Dividend Yield — This is based on the anticipated dividend yield over the expected life of the option. An increase in the dividend yield will decrease compensation expense.

 

Forfeiture Rate — This is the estimated percentage of options granted that are expected to be forfeited or cancelled before becoming fully vested. This estimate is based on historical experience. An increase in the actual forfeiture rate will decrease compensation expense.

 

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A summary of the outstanding and exercisable options as of January 28, 2012, follows: 

 

Options Outstanding  Options Exercisable 
       Weighted   Weighted       Weighted   Weighted 
   Number   Average   Average   Number   Average   Average 
Range of  Outstanding   Remaining   Exercise   Exercisable   Remaining   Exercise 
Exercise Prices  at 1/28/12   Life (Years)   Price   at 1/28/12   Life (Years)   Price 
$0.40 to $0.65   81,325    4.17   $0.60    77,159        $0.61 
$0.88 to $1.45   255,441    5.87   $1.14    77,418        $1.15 
$1.58 to $2.43   429,000    3.66   $1.60    353,273        $1.59 
$3.30 to $12.20   78,000    3.14   $9.31    63,749        $10.50 
$15.84 to $18.09   89,600    0.85   $16.93    89,600        $16.93 
$0.40 to $18.09   933,366    3.95         661,199    4.34      
                               
Intrinsic value  $28,453             $25,903           

 

Restricted Stock. The 2001 Plan, as amended and restated, authorized the granting of up to 6,300,000 shares of restricted stock or stock options. During 2011, 2010, and 2009, restricted shares totaling 475,000, 167,000, and 161,000, respectively, were issued to directors, officers and key employees under the Plan. Compensation expense related to restricted shares issued is recognized over the period for which restrictions apply.

 

A summary of the status of the Company’s non-vested restricted shares as of January 28, 2012, and changes during 2011, is presented below:

 

Nonvested Shares   Shares   Weighted-
Average Grant-
Date Fair
Value
 
Nonvested shares at January 29, 2011    291,800   $1.52 
Granted    474,857   $1.03 
Vested    (129,700)  $1.60 
Forfeited    (34,600)  $1.15 
Nonvested shares at January 28, 2012    602,357   $1.14 

 

As of January 28, 2012, there was $591,000 of total unrecognized compensation cost related to non-vested share-based compensation arrangements granted under the Plans. That cost is expected to be recognized over a weighted-average period of 2.5 years. The total fair value of shares vested during the years ended January 2011, 2010, and 2009 was $200,000, $400,000, and $1.1 million, respectively.

 

Note 14 – Employee Benefit Plans

 

Defined Benefit Plans

 

Effective February 3, 2007, the Company began recognizing the funded status of its defined benefit plans in accordance with FASB ASC 715, “Compensation-Retirement Benefits,” (“ASC 715”). ASC 715 requires the Company to display the net over-or-under funded position of a defined benefit plan as an asset or liability with any unrecognized prior service costs, transition obligations, or actuarial gains/losses reported as a component of accumulated other comprehensive income (loss) in stockholders’ equity.

 

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Retirement Plans. Hancock maintained a noncontributory qualified defined benefit retirement plan and an unfunded nonqualified Supplemental Retirement Benefit Plan (“SERP”) that afforded certain benefits that could not be provided by the qualified plan through December 31, 2008; at which time the plans were frozen and do not accrue additional benefits for service. Together, these plans provided eligible full-time employees with pension and disability benefits based primarily on years of service and employee compensation. The service cost amounts shown in the table below reflect administrative expenses to be paid out of the pension trust.

 

Changes in projected benefit obligation and fair value of plan assets (in thousands)

 

   Retirement Plan   SERP 
   2011   2010   2011   2010 
Change in benefit obligation                    
Benefit obligation at beginning of year  $84,018   $79,993   $1,000   $988 
Service cost   505    428    -    - 
Interest cost   4,505    4,563    51    52 
Benefits paid   (4,725)   (4,857)   (74)   (76)
Plan expenses paid   (632)   (506)   -    - 
Actuarial loss   8,370    4,397    74    36 
Benefit obligation at end of year  $92,041   $84,018   $1,051   $1,000 
                     
Change in plan assets                    
Fair value of plan assets at beginning of year  $54,438   $53,889           
Actual return on plan assets   2,555    5,912           
Employer Contributions   5,699    -           
Plan expenses paid   (632)   (506)          
Benefits paid   (4,725)   (4,857)          
Fair value of plan assets at end of year  $57,335   $54,438           

 

Funded Status

 

The funded status and the amounts recognized in Hancock’s consolidated balance sheet for the retirement plans based on an actuarial valuation were as follows (in thousands):

 

   Retirement Plan   SERP 
   2011   2010   2011   2010 
                 
Amounts recognized in the Consolidated Balance Sheets           
Current liabilities  $-   $-   $74   $74 
Non-current liabilities   34,707    29,580    976    926 
Net Liability at end of year  $34,707   $29,580   $1,050   $1,000 
                     
Amounts recognized in accumulated other comprehensive income                    
Net actuarial loss  $39,313   $30,420   $234   $167 

 

54
 

 

The actuarial loss that will be amortized from accumulated other comprehensive income into net periodic benefit cost during the following fiscal year is $1,330,000 for the Retirement Plan and $10,000 for the SERP and the estimated prior service cost/(credit) for both plans will be zero.

  

Components of net periodic benefit cost (in thousands)

 

   Retirement Plan   SERP 
   2011   2010   2009   2011   2010   2009 
                         
Service cost  $506   $428   $651   $-   $-   $- 
Interest cost   4,505    4,563    4,854    51    53    61 
Expected return on plan assets   (4,039)   (3,831)   (3,199)   -    -    - 
Actuarial loss   961    976    887    7    6    - 
Net periodic benefit cost  $1,933   $2,136   $3,193   $58   $59   $61 

 

Other changes in plan assets and benefit obligation recognized in other comprehensive loss (in thousands)

 

   Retirement Plan   SERP 
   2011   2010   2011   2010 
                 
Net actuarial loss  $9,854   $2,316   $74   $36 
Reversal of amortization - net actuarial gain   (961)   (976)   (8)   (6)
Total recognized in other comprehensive loss  $8,893   $1,340   $66   $30 

 

Accumulated benefit obligation

 

The accumulated benefit obligation for the retirement plan was $92.0 million and $84.0 million at the measurement dates of January 28, 2012, and January 29, 2011, respectively. The accumulated benefit obligation for the SERP was $1.1 million and $1.0 million at the measurement dates of January 28, 2012 and January 29, 2011, respectively.

 

Assumptions

 

Weighted-average actuarial assumptions used in the period-end valuations to determine benefit obligations were as follows:

   Retirement Plan   SERP 
   2011   2010   2011   2010 
                 
Discount rate   4.74%   5.52%   4.53%   5.22%
Rate of increase in compensation levels   N/A    N/A    N/A    N/A 

 

55
 

 

Weighted-average actuarial assumptions used in the valuations to determine net periodic benefit cost were as follows: 

 

   Retirement Plan   SERP 
   2011   2010   2009   2011   2010   2009 
                         
Discount rate   5.52%   5.80%   7.55%   5.22%   5.55%   7.46%
Rate of increase in compensation levels   N/A    N/A    N/A    N/A    N/A    N/A 
Expected long-term rate of return on assets   7.50%   7.50%   7.50%   N/A    N/A    N/A 

 

The discount rate is the rate used to determine the present value of the Company’s future benefit obligation for its Retirement Plan and SERP. The discount rate selected for each plan was developed using the expected cash flows and the Aon Hewitt AA Above Median Curve at the plan’s measurement date.

 

The expected long-term rate of return on plan assets reflects Hancock’s expectations of long-term average rates of return on funds invested to provide for benefits included in the projected benefit obligation. In developing the expected long-term rate of return assumption, Hancock evaluated input from the Company’s third party actuarial and investment firms and considered other factors including inflation, interest rates, peer data and historical returns.

 

Plan Assets

 

Hancock’s retirement plan weighted-average asset and target allocations were as follows:

 

Hancock invests in a diversified portfolio of equity and fixed income securities designed to maximize returns while minimizing risk associated with return volatility. Risk tolerance is established through careful consideration of plan liabilities, plan funded status, and the Company’s financial condition. Investment risk is measured and monitored on an ongoing basis through quarterly investment portfolio reviews, annual liability measurements, and periodic asset/liability studies. In addition, the target asset allocation is periodically reviewed and adjusted, as appropriate.

 

Fair values of plan assets are determined based on valuation techniques categorized as follows: Level 1 uses inputs from quoted prices in active markets for identical assets or liabilities; Level 2 uses inputs of quoted prices for identical or similar instruments in markets that are not active or are directly or indirectly observable; and Level 3 uses inputs that are unobservable. The fair value of the retirement plan assets assigned to each class of asset category as defined by FASB ASC 715 and target allocations for both years presented is as follows:

56
 

 

(in thousands)  Plan Assets 
   January 28, 2012 
   Level 1   Level 2   Total   Target
Allocation
 
Equity securities  $25,453   $8,614   $34,067    60%
Fixed Income                    
Mutual funds   21,686    -    21,685      
Cash and Equivalents   1,583    -    1,583      
    23,269    -    23,268    40%
                     
Total  $48,722   $8,614   $57,335    100%

 

   Plan Assets 
   January 29, 2011 
   Level 1   Level 2   Total   Target
Allocation
 
Equity securities   29,972    3,155    33,127    65%
Fixed Income                    
Mutual funds   17,915    -    17,915      
Cash and Equivalents   3,396    -    3,396      
    21,311    -    21,311    35%
                     
Total  $51,283   $3,155   $54,438    100%

 

Contributions

 

Hancock made contributions of $5.7 million during 2011 and expects to make contributions of $6.3 million to the retirement plan during 2012. This estimate is based on many assumptions including asset values, actual rates of return on plan assets, assumed discount rates, projected census data, and recently passed legislation regarding funding requirements.  Accordingly, actual contribution amounts could vary greatly from the estimated amounts. 

 

Contributions to the SERP are made as benefits are paid.

 

Estimated Future Benefit Payments (in thousands)

 

    Retirement     
    Plan   SERP 
2012   $5,170   $74 
2013    5,290    74 
2014    5,394    74 
2015    5,517    74 
2016    6,561    74 
Years 2017 through 2021    29,472    370 

 

57
 

 

 

Postretirement Benefit Plan. Hancock maintained an unfunded postretirement medical/dental/life insurance plan for all full-time employees and retirees hired before January 1, 2003. Eligibility for the plan was limited to employees completing 15 years of credited service while being eligible for the Company’s employee medical benefit program. Effective December 31, 2008, Hancock revised its policy respecting postretirement benefits. Retirees that are Medicare eligible no longer receive medical benefits, and all eligible present or future retirees must pay the estimated cost of medical/dental/life insurance coverage provided by the Company.

 

Changes in Accumulated Postretirement Benefit Obligation (in thousands)

 

   2011   2010 
Change in benefit obligation          
Benefit obligation at beginning of year  $2,490   $2,312 
Service cost   64    75 
Interest cost   126    132 
Benefits paid   (444)   (287)
Actuarial (gain)/loss   54    7 
Plan participant contributions   288    251 
Total  $2,578   $2,490 

 

Funded Status

 

The funded status and the amounts recognized in Hancock’s consolidated balance sheets for other postretirement benefits based on an actuarial valuation were as follows (in thousands):

 

   2011   2010 
Amounts recognized in the Consolidated Balance Sheets          
Current liabilities  $149   $153 
Non-current liabilities   2,429    2,337 
Net liability at end of year  $2,578   $2,490 
           
Amounts recognized in Accumulated other comprehensive income          
Prior service credit  $(4,617)  $(5,340)
Net actuarial (gain)/loss   (2,118)   (2,443)
Total  $(6,735)  $(7,783)

 

Components of net periodic benefit cost (in thousands)

 

   2011   2010   2009 
             
Service costs  $64   $75   $49 
Interest costs   126    132    140 
Amortization of prior service credits   (724)   (795)   (801)
Amortization of net actuarial gain   (270)   (254)   (317)
Net periodic postretirement costs gain  $(804)  $(842)  $929)

 

The estimated prior service credit and actuarial gain that will be amortized from accumulated other comprehensive income into net periodic benefit cost during the following fiscal year are $724,000 and $224,000, respectively.

 

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Other changes in the benefit obligation recognized in other comprehensive loss (in thousands)

 

   2011   2010 
         
Net actuarial (gain)/loss  $54   $7 
Reversal of amortization - net actuarial loss   270    254 
Reversal of amortization - prior service cost   725    795 
Total recognized in other comprehensive loss  $1,049   $1,056 

 

Assumptions

 

Weighted-average actuarial assumptions used in the period-end valuations to determine benefit obligations were as follows:

 

   2011   2010 
         
Discount rate   4.81%   5.61%
Rate of increase in compensation levels   2.50%   2.50%

 

Weighted-average actuarial assumptions used in the valuations to determine net periodic benefit cost were as follows:

 

   2011   2010   2009 
             
Discount rate   5.61%   5.84%   7.52%
Expected return on plan assets   N/A    N/A    N/A 
Rate of increase in compensation levels   2.50%   2.50%   2.50%

  

The discount rate is the rate used to determine the present value of the Company’s future benefit obligation for its postretirement benefit plan. The discount rate selected for each plan was developed using the expected cash flows and the Aon Hewitt AA Above Median Curve at the plan’s measurement date.

 

Assumed Health Care Cost Trend Rates

 

   2011   2010  
   Employees   Employees  Employees   Employees  
   under age 65   age 65 or older  under age 65   age 65 or older  
Health care cost trend rate assumed for next year   8.00%  N/A   8.50%  N/A  
Rate that the cost trend rate gradually declines to   5.00%  N/A   5.00%  N/A  
Year that the rate reaches the rate at which it is  assumed to remain   2018   N/A   2018   N/A  

 

Assumed health care cost trend rates have a significant effect on the amounts reported for the health care plans. A one-percentage point change in the assumed health care trend rates would have the following effects (in thousands):

59
 

 

   One-Percentage   One-Percentage 
   Point   Point 
   Increase   Decrease 
Effect on total service and interest costs  $10   $(9)
Effect on postretirement benefit obligation   94   (84)

 

Contributions

 

Hancock currently contributes to the plan as medical and dental benefits are paid. The Company expects to continue to do so in 2012 for all eligible present or future retirees electing to pay the estimated cost of medical/dental/life insurance coverage provided by the Company. Claims paid in 2011, 2010, and 2009, net of employee contributions, totaled $156,000, $37,000, and $89,000, respectively. Such claims include, in the case of postretirement life benefits, net premiums paid to a life insurance company and, in the case of medical and dental benefits, actual claims paid by the Company on a self-insured basis.

 

Estimated Future Benefit Payments (in thousands)

  

    Net 
    Payments 
 2012   $149 
 2013    166 
 2014    164 
 2015    160 
 2016    167 
 Years 2017 through 2020    904 

 

Note 15 - Commitments and Contingencies

 

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

 

The Company is party to several legal proceedings and claims arising in the ordinary course of business. We expect these matters will be resolved without material adverse effect on our consolidated financial position, results of operations or cash flows. We believe that any estimated loss related to such matters has been adequately provided in accrued liabilities to the extent probable and reasonably estimable.

 

Note 16 – Related Party Transactions

 

As part of the Company’s issuance of Notes on August 1, 2008, certain members of the Official Committee of Equity Holders of Hancock Fabrics, Inc. (the “Equity Committee”) who were “related persons” as defined in Item 404 of Regulation S-K, participated in a Backstop Arrangement (“Backstop”) in which each party agreed to purchase all of the Notes not purchased by other purchasers during the offering. The Backstop provided for an additional 3,750 warrants to purchase the Company’s common stock to be issued to each participant. The Notes purchased and the warrants issued to each related person are detailed below:

 

Carl E Berg – Former, Non-Executive Chairman of the Board of Hancock Fabrics, Inc., and beneficial owner of more than 10% of the Company’s common stock through either controlling or majority interest and/or controlling investment management in the following entities: (Berg and Berg Enterprises, Lightpointe Communications, Inc.)

 

60
 

 

 

 

Notes purchased:   7,503 
Purchase amount:  $7,503,000 
Common stock warrants issued:   9,120 
Shareholder’s shares underlying warrants:   3,648,000 

 

Nikos Hecht – Beneficial owner of more than 10% of the Company’s common stock through either controlling or majority interest and/or controlling investment management in the following entities: (Sopris Capital Advisors, LLC; Sopris Partners Series A, Sopris Capital, LLC; Aspen Advisors LLC; EnterAspen Ltd.; The Richmond Fund LP)

 

Notes purchased:   7,724 
Purchase amount:  $7,724,000 
Common stock warrants issued:   9,341 
Shareholder’s shares underlying warrants:   3,736,400 

 

The Company has no other balances with related parties, nor has it had any other material transactions with related parties during the fiscal years 2011, 2010, or 2009.

 

Note 17 – Subsequent Event

 

Subsequent to fiscal year end, the Company concluded binding arbitration which was the dispute resolution mechanism within a consulting agreement. As part of this proceeding, the Company incurred and recorded substantial professional fees which are reflected in the operating results for 2011.

 

Management is not aware of any additional subsequent events which should be reported, through the date of this report.

 

61
 

 

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

To the Board of Directors and Stockholders
Hancock Fabrics, Inc.

 

We have audited the accompanying consolidated balance sheets of Hancock Fabrics, Inc. (a Delaware Corporation) (the “Company”) as of January 28, 2012 and January 29, 2011, and the related statements of operations, shareholders’ equity, and cash flows for the years ended January 28, 2012, January 29, 2011, and January 30, 2010. Our audits also included the financial statement schedule listed in Item 15(a) (2). These consolidated financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedule based on our audits.

 

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Hancock Fabrics, Inc. as of January 28, 2012 and January 29, 2011, and the results of their operations and their cash flows for the years ended January 28, 2012, January 29, 2011, and January 30, 2010 in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the related financial statement schedule when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects the information set forth therein.

 

/s/ Burr Pilger Mayer, Inc.

San Francisco, California

April 20, 2012

 

62
 

 

QUARTERLY FINANCIAL DATA (unaudited)

Years ended January 28, 2012 and January 29, 2011

(in thousands, except per share amounts)

 

 

   First   Second   Third   Fourth 
   Quarter   Quarter   Quarter   Quarter 
   2011   2011   2011   2011 
Sales  $61,977   $57,789   $70,790   $81,437 
                     
Gross profit   27,372    25,371    30,806    29,176 
                     
Selling, general and administrative expense   27,340    27,084    28,517    32,106 (a) 
Depreciation and amortization   1,037    1,029    1,046    1,028 
                     
Interest expense   1,147    1,184    1,283    1,222 
                     
Net earnings (loss)  $(2,152)  $(3,926)  $(40)  $(5,180)
                     
Basic (loss) per share (1)  $(0.11)  $(0.20)  $(0.00)  $(0.26)
                     
Dilutive (loss) per share (1)  $(0.11)  $(0.20)  $(0.00)  $(0.26)

 

(a)Includes one-time non-comparable charge of $401 for severance related costs, $300 for relocation costs, $1,614 for contract arbitration costs, and $1,666 for asset impairment.

 

   First   Second   Third   Fourth 
   Quarter   Quarter   Quarter   Quarter 
   2010   2010   2010   2010 
Sales  $63,103   $60,455   $73,454   $78,453 
                     
Gross profit   27,733    28,859    32,218    25,835(b)
                     
Selling, general and administrative expense   26,644    27,172    28,254    33,028(c)
Depreciation and amortization   1,072    1,097    1,144    1,182 
                     
Reorganization expense, net   196    158    131    - 
Interest expense   1,144    1,196    1,329    1,156 
                     
Income tax expense   -    -    -    232 
                     
Earnings (loss) from continuing operations, net of tax   (1,323)   (764)   1,360    (9,763)
                     
Earnings from discontinued operations, net of tax   22    7    -    - 
Net (loss) earnings  $(1,301)  $(757)  $1,360   $(9,763)
                     
Basic (loss) earnings per share (1)  $(0.07)  $(0.04)  $0.07   $(0.49)
                     
Dilutive (loss) earnings per share (1)  $(0.07)  $(0.04)  $0.07   $(0.49)

 

(b)Includes one-time non-comparable charge of $6,674 for inventory obsolescence.
(c)Includes one-time non-comparable charges of $1,272 for severance related costs and $1,523 for asset impairment.
(1)Per share amounts are based on average shares outstanding during each quarter and may not add to the total for the year.

 

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Item 9.CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

 

None.

 

Item 9A. 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 Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms and that such information is accumulated and communicated to the Company’s management, including the 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.

 

As of the end of the period covered by this report (January 28, 2012), the Company’s management, under the supervision and with the participation of the Company’s President and Chief Executive Officer (principal executive officer) and Executive Vice President and Chief Financial Officer (principal 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 January 28, 2012.

 

Changes in Internal Controls over Financial Reporting

 

There have been no changes in our internal control over financial reporting during our most recent fiscal quarter ended January 28, 2012, which have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 

Management’s Annual Report on Internal Control Over Financial Reporting

 

Management of the Company is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act). The Company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with GAAP. Internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the Company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with GAAP, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Company’s assets that could have a material effect on the interim or annual Consolidated Financial Statements.

 

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

64
 

 

Hancock’s management conducted an assessment of the effectiveness of the Company’s internal control over financial reporting as of January 28, 2012. In making this assessment, management used the criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). Based on this assessment, management concluded that our internal control over financial reporting was effective as of January 28, 2012.

 

This annual report does not include an attestation report of the Company’s registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by the Company’s registered public accounting firm pursuant to temporary rules of the Securities and Exchange Commission that permit the Company to provide only management’s report in this annual report.

 

Item 9B. OTHER INFORMATION

 

None.

 

65
 

 

PART III

 

ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE

 

The information required by this Item is incorporated by reference to the Proxy Statement for our Annual Meeting of Stockholders.

 

ITEM 11. EXECUTIVE COMPENSATION

 

The information required by this Item is incorporated by reference to the Proxy Statement for our Annual Meeting of Stockholders.

 

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS

 

From time to time our directors, executive officers and other insiders may adopt stock trading plans pursuant to Rule 10b5-1(c) promulgated by the Securities and Exchange Commission under the Securities Exchange Act of 1934, as amended.

 

The remainder of the information required by this Item is incorporated by reference to the Proxy Statement for our Annual Meeting of Stockholders.

 

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE

 

The information required by this Item is incorporated by reference to the Proxy Statement for our Annual Meeting of Stockholders.

 

ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES

 

The information required by this Item is incorporated by reference to the Proxy Statement for our Annual Meeting of Stockholders.

 

66
 

 

PART IV

 

Item 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES

 

  (a) (1) Financial Statements

 

The Consolidated Financial Statements of the Company are set forth in Item 8 of this Report as listed on the Index to Consolidated Financial Statements on page 32 of this Report.

 

  (a) (2) Financial Statement Schedules

 

Schedule II – Valuation and qualifying accounts. (see page 70 of this Report)

 

All other schedules are omitted because they are not applicable, or are not required, or because the required information is included in the Consolidated Financial Statements or notes thereto.

 

  (a) (3) Exhibits

 

Note to Exhibits: Any representations and warranties of a party set forth in any agreement (including all exhibits and schedules thereto) filed with this Annual Report on Form 10-K have been made solely for the benefit of the other party to the agreement. Some of those representations and warranties were made only as of the date of the agreement or such other date as specified in the agreement, may be subject to a contractual standard of materiality different from what may be viewed as material to stockholders, or may have been used for the purpose of allocating risk between the parties rather than establishing matters as facts. Such agreements are included with this filing only to provide investors with information regarding the terms of the agreements, and not to provide investors with any other factual or disclosure information regarding the registrant or its business.

 

3.1    a   Amended and Restated Certificate of Incorporation

  3.2   a   Amended and Restated By-Laws
  4.1   m ª Amendment to Amended and Restated Rights Agreement dated November 13, 2009
  4.2   b ª Amendment No. 2, dated March 20, 2006, to the Amended and Restated RightsAgreement
  4.3   b ª Amended and Restated Rights Agreement with Continental Stock Transfer & Trust Company as amended through March 20, 2006
  4.4   c   Specimen representing the Common Stock, par value $0.01 per share, of Hancock Fabrics, Inc..
  4.5   c   Indenture between Hancock Fabrics, Inc. and Deutsche Bank National Trust Company
  4.6   c   Master Warrant Agreement between Hancock Fabrics, Inc. and Continental Stock Transfer & Trust Company
  4.7   c   Specimen representing the Floating Rate Secured notes of Hancock Fabrics, Inc.
  4.8   c   Specimen representing the Warrants of Hancock Fabrics, Inc.
  4.9   c   Form of Subscription Certificate for Rights
  10.2  l   Form of Indemnification Agreements (Directors and Executive Officers)
  10.3 d ª Form of Agreement (deferred compensation) with William A. Sheffield, Jr., dated June 13, 1996
  10.5 e ª Supplemental Retirement Plan, as amended

 

67
 

 

  10.8  g ª Amended and Restated 2001 Stock Incentive Plan
  10.9  n ª Amended and Restated 2001 Stock Incentive Plan, dated June 8, 2010
  10.10 l ª Employment Agreement with Jane F. Aggers, effective as of August 1, 2008
  10.11 * ª Employment Agreement with Steven R. Morgan, effective as of October 17, 2011
  10.13 p   +  Loan and Security Agreement, dated August 1, 2008, by and among Hancock Fabrics, Inc., HF Merchandising Inc., Hancock Fabrics of MI, Inc., hancockfabrics.com, Inc., Hancock Fabrics, LLC, as Borrowers; HF Enterprises, Inc. and HF Resources, Inc. as Guarantors; General Electric Capital Corporation, as Agent, Issuing Bank and Syndication Agent; and GE Capital Markets, Inc., as Sole Lead Arranger, Manager and Bookrunner
  10.14 l   Pledge and Security Agreement (Corporations), dated August 1, 2008 by Hancock Fabrics, Inc., HF Merchandising Inc., Hancock Fabrics of MI, Inc., hancockfabrics.com, Hancock Fabrics, LLC, HF Enterprises, Inc. and HF Resources, Inc., to and in favor of General Electric Capital Corporation, in its capacity as agent
  10.15 l   Pledge and Security Agreement (LLCs), dated August 1, 2008 by Hancock Fabrics, Inc., HF Merchandising Inc., Hancock Fabrics of MI, Inc., hancockfabrics.com, Hancock Fabrics, LLC, HF Enterprises, Inc. and HF Resources, Inc., to and in favor of General Electric Capital Corporation, in its capacity as agent
  10.16 l   Trademark Collateral Assignment and Security Agreement, dated August 1, 2008, by and among Hancock Fabrics, Inc., HF Merchandising Inc., Hancock Fabrics of MI, Inc., hancockfabrics.com, Hancock Fabrics, LLC, HF Enterprises, Inc. and HF Resources, Inc. and General Electric Capital Corporation, in its capacity as agent
  10.17 l   Guarantee, dated August 1, 2008, by Hancock Fabrics, Inc., HF Merchandising Inc., Hancock Fabrics of MI, Inc., hancockfabrics.com, Hancock Fabrics, LLC, HF Enterprises, Inc. and HF Resources, Inc. in favor of General Electric Capital Corporation, in its capacity as agent
  10.18 l + Deposit Account Control Agreement, dated August 1, 2008, by and among BancorpSouth Bank, Hancock Fabrics, Inc. and General Electric Capital Corporation, in its capacity as agent
  10.19 l + Deposit Account Control Agreement (Elavon Account), dated August 1, 2008 by and among BancorpSouth Bank, Hancock Fabrics, Inc. and General Electric Capital Corporation, in its capacity as agent
  10.25 k ª Form of Amendment to the Deferred Compensation Agreement for William A. Sheffield, Jr.
  10.26 l ª Form of Amendment to the Deferred Compensation Agreement for William A. Sheffield, Jr.
  10.27 c   Subscription Agent Agreement, dated June 17, 2008 between Hancock Fabrics, Inc. and Wunderlich Securities, Inc.
  10.29p ª Form of Change in Control Agreement (SVP)
  10.31 * ª Form of Restricted Stock Agreement
  10.32 * ª Form of Nonqualified Stock Option Agreement
  10.33 * ª Form of Nonqualified Stock Option Agreement (Performance Vesting)
  10.34 p ª Second Amendment to the Hancock Fabrics, Inc. Supplemental Retirement Benefit Plan
  10.35 p ª Amended and Restated 2001 Stock Incentive Plan, effective as of January 30, 2011
  10.36p ª Short Term Incentive Plan, effective as of January 30, 2011
  10.37 p ª Form of Third Amendment to the Deferred Compensation Agreement
  10.38 p ª Form of Change in Control Agreement (Executive Vice Presidents)
  10.39p ª Confidential Separation Agreement and General Release with Jane F. Aggers
  10.40 o ª Employment Letter Agreement with Susan van Benten

 

68
 

 

 

  18.1 l Preferability Letter from Burr, Pilger & Mayer LLP – an Independent Registered Public Accounting Firm
  21 * Subsidiaries of the Registrant.
  23.1 * Consent of Burr Pilger Mayer, Inc. – an Independent Registered Public Accounting Firm
  31.1 * Certification of Chief Executive Officer.
  31.2 * Certification of Chief Financial Officer.
  32 * Certification of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. Section 1350.

 

  *  Filed herewith.
  +  Information redacted pursuant to a confidential treatment request. Omitted portions have been filed separately with the SEC.

 

Incorporated by reference to (Commission file number for Section 13 reports is 001-9482):

 

a Form  8–K filed July 31, 2008
   
b Form  8–K filed March 22, 2006
   
c Form  S-1/A filed June 19, 2008
   
d Form 10–K filed April 23, 1997  (File No. 001-09482)
   
e Form 10–K filed April 25, 1995  (File No. 001-09482)
   
f Form 10–K filed April 27, 2000  (File No. 001-09482)
   
g Form 10-Q filed September 15, 2008
   
h Form 10-K filed April 15, 2005
   
i Form S-8 filed April 15, 2005
   
j Form  8-K filed December 9, 2005
   
k Form 10–K filed April 17, 2008
   
l Form 10–K filed April 10, 2009
   
m Form  8–K filed November 17, 2009
   
n Form  8–K filed June 9, 2010
   
o Form  8–K filed September 21, 2010
   
p Form  10–K filed April 26, 2011
   
ª Denotes management contract or compensatory plan or arrangement.

 

69
 

 

SIGNATURES

 

Pursuant to the requirements of Section 13 or 15 (d) 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.
   
 

By

/s/ Steven R. Morgan
    Steven R. Morgan
    Director and President and
    Chief Executive Officer
    (Principal Executive Officer)
    April 20, 2012
     
 

By

/s/ Robert W. Driskell
    Robert W. Driskell
    Executive Vice President and
    Chief Financial Officer
    (Principal Financial and Accounting
    Officer)
    April 20, 2012

 

70
 

 

Pursuant to the requirements of the Securities and Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.

 

Signature   Date
     
/s/ Steven R. Morgan   April 20, 2012
Steven R. Morgan    
Director and President and    
Chief Executive Officer    
(Principal Executive Officer)    
     
/s/ Robert W. Driskell   April 20, 2012
Robert W. Driskell    
Executive Vice President and    
Chief Financial Officer    
(Principal Financial and    
 Accounting Officer)    
     
/s/ Steven D. Scheiwe   April 20, 2012
Steven D. Scheiwe    
Director    
     
/s/ Sam P. Cortez   April 20, 2012
Sam P. Cortez    
Director    
     
/s/ Neil S. Subin   April 20, 2012
Neil S. Subin    
Director    

 

71
 

 

HANCOCK FABRICS, INC.

SCHEDULE II — VALUATION AND QUALIFYING ACCOUNTS

FOR FISCAL YEARS 2011, 2010, AND 2009

(In thousands)

 

       Additions         
       Charged   Charged         
   Balance