CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited)

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

The following discussion should be read in conjunction with the consolidated financial statements as of and for the thirteen and thirty-nine weeks ended October 26, 2013, including the notes to those statements, appearing elsewhere in this report. We also suggest that management’s discussion and analysis appearing in this report be read in conjunction with the management’s discussion and analysis and consolidated financial statements included in our Annual Report on Form 10-K for the fiscal year ended January 26, 2013. Our fiscal year ends on the last Saturday in January and refers to the calendar year ended immediately prior to such date, which contained the substantial majority of the fiscal period (e.g., “fiscal 2012” or “2012” refers to the fiscal year ended January 26, 2013). Fiscal years consist of 52 weeks, comprised of four 13-week fiscal quarters, unless noted otherwise. References herein to third quarter 2013 and third quarter 2012 are for the 13 week periods ended October 26, 2013 and October 27, 2012, respectively. References to thirty-nine weeks 2013 or 2013, and thirty-nine weeks 2012 or 2012 are for the 39 week periods ended October 26, 2013 and October 27, 2012, respectively.

Forward Looking Statements  

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

The risks and uncertainties, either alone or in combination, that could cause our actual results to differ from those expressed in our forward-looking statements include, but are not limited to, those that are discussed in our Annual Report on Form 10-K filed with the SEC on April 26, 2013 under Item 1A. Risk Factors. Forward-looking statements speak only as of the date made, and neither Hancock nor its management undertakes any obligation to update or revise any forward-looking statement.

Our Business

Hancock Fabrics, Inc. is a specialty retailer committed to 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 as of October 26, 2013, 261 stores in 37 states and an internet store under the domain name hancockfabrics.com. Our stores present a broad selection of fabrics and notions used in apparel sewing, home decorating and quilting projects. None of the information on the website referenced above is incorporated by reference into our reports filed with, or furnished to, the Securities and Exchange Commission.

Overview 

Financial Summary:

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

Results of Operations  

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

Net Sales 

The retail comparable store base above consists of the stores which were included in the comparable sales computation for the current period. The third quarter 2013 comparable sales (excluding e-commerce) increased of 1.2% was the result of a 5.8% improvement in average ticket partially offset by a 4.6% decline in transactions evidencing higher sales volumes for each individual transaction. Comparable sales declined 0.1% for the first thirty-nine weeks of 2013, due to a 6.1% decline in transaction count partially offset by a 6.0% increase in average ticket.

Sales provided by our e-commerce channel increased 1.0% in the third quarter of 2013 but declined 3.8% for the first thirty-nine weeks of fiscal 2013.

Three new stores opened and three stores, where we chose not to stay in the market, have closed since the third quarter of 2012. The sales from these locations are included in net sales. During the trailing 12 months, the Company has relocated 6 stores and as of October 26, 2013 had 261 stores in operation.

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

Gross Margin 

Costs of goods sold include:

The classification of these expenses varies across the retail industry.

Specific components of cost of goods sold for the third quarters and first thirty-nine weeks of fiscal 2013 and 2012 are as follows: 

Merchandise cost declined as a percentage of sales by 240 basis points and 280 basis points for the third quarter and first thirty-nine weeks of 2013 as compared to the same periods of 2012, respectively. This improvement resulted primarily from adjustments to our pricing strategy which we believe will allow us to be more competitive while maintaining acceptable margin levels. The other factor influencing merchandise cost for the periods discussed above is the inventory valuation reserve. Excluding the impact of the reserve merchandise cost decreased by 270 basis points and 360 basis points for the quarter and thirty-nine weeks of 2013 as compared to 2012, respectively.

Freight expense was 10 basis points higher as a percentage of sales for the third quarter due to accelerating receipts for the holidays, but 10 basis points lower for the first thirty-nine weeks of 2013 as compared to the same periods of 2012. These changes resulted primarily from the amount of freight being capitalized into inventory, which is affected by inventory turns and a reduction in overall freight expense.

Sourcing and warehousing costs for the Company vary based on both the volume of inventory received during any period and the rate at which inventory is shipped out, or inventory turns. The cost difference for the third quarter and thirty-nine weeks of 2013 compared to the same periods in 2012 is primarily due to changes in inventory turns during those periods, which influence the amount of sourcing and warehousing costs capitalized into inventory.

In total, gross margin increased by 240 basis points in the third quarter 2013 from third quarter 2012 levels and by 300 basis points for the first thirty-nine weeks of 2013 as compared to the same period of 2012.

Selling, General and Administrative Expenses 

Selling, general and administrative expenses include:

Specific components of selling, general and administrative expenses (SG&A) include:

Retail Store Labor Cost - The Company store labor costs was basically unchanged for the third quarter of 2013 as compared to the same period in 2012, wich increases in labor costs being offset by reductions in benefit expenses. For the thirty-nine weeks of 2013, labor costs increased due to additional store labor cost and benefits related to medical claims.

Advertising – The variance in advertising expense for the third quarter of 2013 compared to the same period of 2012 is related to changes in postal regulations, which increased the cost of direct mail, growth of the text messaging program and increases to printing expense. For the first thirty-nine weeks of 2013 compared to the same period in 2012 the increase in advertising cost is primarily due to the changes in postal regulations, printing expense increases, expansion of planned advertising events and additional advertising for the online store.

Store Occupancy – The Company’s store occupancy expense was basically unchanged as compared to the same period of the prior year for both the third quarter and thirty-nine weeks of 2013. Reductions in occupancy related expenses were primarily offset by increased maintenance and repair expense.

Retail SG&A – Retail selling, general and administrative expense increased for the third quarter of 2013 as compared to the third quarter of 2012 primarily due to increases in insurance claims. For the first thirty-nine weeks of 2013 retail SG&A compared to same period of 2012 decreased primarily due to reductions in insurance claims and reduced expenditures for store supplies.

Corporate SG&A – Corporate selling, general and administrative expense for the third quarter of 2013 as compared to the third quarter of 2012 benefited from reduced cost for professional fees. The variance for the thirty-nine weeks of 2013 as compared to the same period of 2012, reflect higher corporate overhead partially offset by lower capitalizable cost related to warehousing and distribution, and reduced professional fees. In addition, the thirty-nine week period of 2012 includes the benefit of a real estate settlement gain of $156,000 and a gain from the settlement of an insurance claim of $238,000.

Interest Expense 

The Company’s interest costs are driven by borrowings on our credit facilities and a small number of capital leases. Interest expense for the third quarter of 2012 includes $0.6 million of non-cash expense for note discount amortization and the thirty-nine week amounts for 2013 and 2012 include $379,000 and $1.7 million, respectively. Excluding these non-cash items, interest expense was $0.8 million for the third quarter of 2012, and $4.2 million and $2.2 million for the thirty-nine weeks of 2013 and 2012, respectively.

Income Taxes  

The Company did not recognize any income tax benefit during the periods of fiscal 2013 or 2012 presented in this report given the uncertainty in realizing the future benefit. As of October 26, 2013, January 26, 2013, and October 27, 2012 the Company has established a 100% valuation allowance to offset the net deferred tax assets related to net operating loss carryforwards and other book-tax timing differences.

Liquidity and Capital Resources  

Hancock's primary capital requirements are for the financing of inventories and, to a lesser extent, for capital expenditures relating to store locations and its 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 long-term borrowings from commercial lenders.

We anticipate that we will be able to satisfy our working capital requirements, planned capital expenditures, required cash contributions to retirement plans, and debt service requirements through the next twelve months with available cash, proceeds from cash flows from operations, short-term trade credit, borrowings under our revolving credit facility and other sources of financing.

Hancock’s cash flow related information for the first thirty-nine weeks of fiscal 2013 and 2012 follows:

Operating Activities 

Net cash from operating activities, before changes in assets and liabilities, improved by $3.9 million during the first thirty-nine weeks of 2013 compared to the first thirty-nine weeks of 2012. This can be primarily attributed to an improvement in gross profit which reduced the net loss as compared to the prior year. Increases in receivables of $1.5 million, merchandise inventories of $14.6 million less accounts payable support of $6.4 million and a $3.5 million decrease in retirement related liabilities primarily resulted in the $11.5 million of net cash used in operating activities for 2013.

Investing Activities 

Cash used for investing activities consists primarily of purchases of property and equipment. Capital expenditures of $3.2 million during the first thirty-nine weeks of 2013 consisted primarily of store fixtures for two new stores, four relocated units, and maintenance capital expenditures for the Corporate headquarters and distribution center. Capital expenditures of $2.1 million in the prior year consisted primarily of store fixtures related to six relocations reduced by the proceeds from a sale of surplus property.

Financing Activities 

During the first thirty-nine weeks of 2013, the seasonal build up of inventory and fixtures for six stores drove up net debt obligations by $13.4 million, excluding the remainder of the discount on notes of $379,000, which has been fully amortized. This change in debt obligations and a reduction in the amount outstanding for capital leases produced a net increase in cash provided by financing activities of $13.3 million.

Long-Term Debt Obligations 

The following should be read in conjunction with Note 4 to the Consolidated Financial Statements included in this report and Note 7 to the Company’s Consolidated Financial Statements included in the Company’s Annual Report on Form 10-K filed with the SEC on April 26, 2013.

As of October 26, 2013, the Company had outstanding borrowings under the Revolver of $60.0 million and $15.0 million under the Term Loan, and amounts available to borrow of $24.1 million.

At October 26, 2013, Hancock had commitments under the above credit facility of $1.2 million, on documentary letters of credit, which support purchase orders for merchandise. Hancock also has standby letters of credit to guarantee payment of potential insurance claims and shipments of inventory. These letters of credit amounted to $5.6 million as of October 26, 2013.

As of October 26, 2013, the Company had an outstanding balance of $8.2 million on the New Notes.

Off-Balance Sheet Arrangements 

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

Contractual Obligations and Commercial Commitments 

Hancock has an arrangement within its Revolver that provides up to $20.0 million in letters of credit. At October 26, 2013, Hancock had commitments of $1.2 million on documentary letters of credit under the facility, which support purchase orders for merchandise. Hancock also has $5.6 million on standby letters of credit to guarantee payment of potential insurance claims and shipments of inventory. Hancock leases its retail fabric store locations under operating leases expiring at various dates through 2024.

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

For further information on our contractual obligations, please refer to Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Contractual Obligations and Commercial Commitments” as presented in our Annual Report on Form 10-K for the fiscal year ended January 26, 2013.

Critical Accounting Policies and Estimates 

The preparation of financial statements in accordance with accounting principles generally accepted in the United States of America requires management to adopt accounting policies and make significant judgments and estimates to develop amounts reflected and disclosed in the financial statements. In many cases, there are alternative policies or estimation techniques that could be used. We maintain a process to review the application of our accounting policies and to evaluate the appropriateness of the many estimates that are required to prepare the financial statements of a large corporation. However, even under optimal circumstances, estimates routinely require adjustment based on changing circumstances and the receipt of new or better information. There have been no significant changes to our accounting policies and estimates as discussed under Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Critical Accounting Policies and Estimates” in our Annual Report on Form 10-K for the fiscal year ended January 26, 2013.

Related Party Transactions

See Note 16 to the Company’s Consolidated Financial Statements included in the Company’s Annual Report on Form 10-K for the fiscal year ended January 26, 2013 filed with the SEC on April 26, 2013, for details regarding the related party transactions that the Company has entered into.

The Company has no other balances with related parties, nor has it had any other material transactions with related parties during the thirty-nine week period ended October 26, 2013.

Effects of Inflation  

Inflation in labor and occupancy costs could significantly affect Hancock's operations. Many of Hancock's employees are paid hourly rates related to federal and state minimum wage requirements; accordingly, any increases in those requirements will affect Hancock. In addition, payroll taxes, employee benefits, and other employee costs continue to increase, and the full impact of the recently enacted health care reform legislation will not be known for several years. Health insurance costs, in particular, continue to rise at a high rate in the United States each year, and higher employer contributions to Hancock’s pension plan could be necessary if investment returns are weak. Costs of leases for new store locations remain stable, but renewal costs of older leases continue to increase. Hancock believes the practice of maintaining adequate operating margins through a combination of price adjustments and cost controls, careful evaluation of occupancy needs, and efficient purchasing practices are the most effective tools for coping with increased costs and expenses.

Seasonality  

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

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS 

Hancock did not hold derivative financial or commodity instruments at October 26, 2013.

Interest Rate Risk 

We are exposed to financial market risks, including changes in interest rates. At our option, all loans under the Revolver and the Term Loan 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 October 26, 2013, we had borrowings outstanding of approximately $60.0 million under the Revolver and $15.0 million under the Term Loan. If interest rates increased 100 basis points, our annual interest expense would increase approximately $750,000, assuming borrowings under the Revolver and Term Loan as existed at October 26, 2013.

In addition to the Revolver and Term Loan, as of October 26, 2013, the Company has outstanding New Notes for $8.2 million on which interest is payable quarterly on the anniversary of the issuance date of November 20, 2012. The quarterly interest is payable at LIBOR plus 12.0% on the New Notes. If interest rates increased 100 basis points, our annual interest expense would increase $82,000, assuming borrowings under the New Notes as existed at October 26, 2013.

Foreign Currency Risk 

All of the Company’s business is transacted in U.S. dollars and, accordingly, devaluation of the dollar against other currencies can increase product costs although this did not significantly impact the thirty-nine week period ended October 26, 2013. As of October 26, 2013, the Company had no financial instruments outstanding that were sensitive to changes in foreign currency exchange rates.

ITEM 4. CONTROLS AND PROCEDURES 

Disclosure Controls and Procedures 

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

In connection with the preparation of this Quarterly Report on Form 10-Q as of October 26, 2013, the Company’s management, under the supervision and with the participation of the Company’s President and Chief Executive Officer and Executive Vice President and Chief Financial Officer, performed an evaluation of the effectiveness of our disclosure controls and procedures (as such term is defined in the Rules 13a-15(e) and 15d-15(e) under the Exchange Act).  Based upon this evaluation, the Company’s principal executive officer and principal financial officer concluded that the Company’s disclosure controls and procedures were effective as of October 26, 2013.

Changes in Internal Control Over Financial Reporting 

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

PART II. OTHER INFORMATION 

ITEM 1. LEGAL PROCEEDINGS  

“Item 3. Legal Proceedings” of our Form 10-K for the fiscal year ended January 26, 2013 includes a discussion of other legal proceedings. There have been no material changes from the legal proceedings described in our Form 10-K.

ITEM 1A. RISK FACTORS  

The risk factors listed in Part I “Item 1A. Risk Factors” in the Company’s Annual Report on Form 10-K for the fiscal year ended January 26, 2013, should be considered with the information provided elsewhere in this Quarterly Report on Form 10-Q, which could materially adversely affect the Company’s business, financial condition or results of operations.  There are no material changes to the risk factors disclosed in the Company’s Annual Report on Form 10-K for the fiscal year ended January 26, 2013.

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

In June of 2000 the Board of Directors authorized the repurchase of up to 2,000,000 shares of the Company’s Common Stock from time to time when warranted by market conditions. There have been 1,756,673 shares purchased under this authorization through October 26, 2013, and the number of shares that may yet be purchased under this authorization is 243,327. The Company did not repurchase any shares in the market during the period covered by this Quarterly Report, but did accept shares in settlement of tax withholding obligations on restricted shares.

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

ITEM 3. DEFAULTS UPON SENIOR SECURITIES 

None.

ITEM 4. MINE SAFETY DISCLOSURES 

Not Applicable.

ITEM 5. OTHER INFORMATION 

None.

ITEM 6. EXHIBITS 

SIGNATURE  

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

Date: December 10, 2013

EXHIBIT INDEX

24