10-K

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

þ Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the fiscal year ended February 3, 2007

or

o 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 of incorporation or organization)	(I.R.S. Employer Identification No.)

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

Registrant’s telephone number, including area code
(662) 365-6000

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

	Name of each exchange
Title of each class	on which registered
Common stock ($.01 par value)	Over-the-Counter (Pink Sheets)
Rights	Over-the-Counter (Pink Sheets)

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

None.

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

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 o No þ

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 o No þ

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. þ

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

Large accelerated filer o  Accelerated filer þ  Non-accelerated filer   o
(Do not check if a smaller reporting company) Smaller Reporting Company o 

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

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Our common stock is traded through broker-to-broker exchanges on what is commonly referred to as “Pink Sheets.” The aggregate market value of Hancock Fabrics, Inc. $.01 par value common stock held by non-affiliates based on 18,738,965 shares of common stock outstanding and the price of $2.20 per share on August 4, 2007 (the last business day of the Registrant’s most recently completed second quarter) was $41,225,723.

As of February 2, 2008 there were 19,285,235 shares of Hancock Fabrics, Inc. $.01 par value common stock outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

None.

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 discussed above. 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 undertake no obligation to update or revise any forward-looking statement.

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HANCOCK FABRICS, INC.
2006 ANNUAL REPORT ON FORM 10-K

TABLE OF CONTENTS

		Page
PART 1
Item 1.	Business		4
Item 1A.	Risk Factors		9
Item 1B.	Unresolved Staff Comments		16
Item 2.	Properties		16
Item 3.	Legal Proceedings		17
Item 4.	Submission of Matters to a Vote of Security Holders		18
PART II
Item 5.	Market for Registrant’s Common Equity and Related Stockholder Matters and Issuer Purchases of Equity Securities		19
Item 6.	Selected Financial Data		21
Item 7.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		22
Item 7A.	Quantitative and Qualitative Disclosures About Market Risk		35
Item 8.	Consolidated Financial Statements and Supplementary Data		36
Item 9.	Changes in and Disagreements with Accountants on Accounting and Financial Disclosure		74
Item 9A.	Controls and Procedures		74
Item 9B.	Other Information		78
PART III
Item 10.	Directors, Executive Officers and Corporate Governance		79
Item 11.	Executive Compensation		82
Item 12.	Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters		96
Item 13.	Certain Relationships and Related Transactions		99
Item 14.	Principal Accountant Fees and Services		100
PART IV
Item 15.	Exhibits and Financial Statement Schedules		101
Signatures			104
EX-10.37 SEVERANCE AGREEMENT KATHLEEN KENNEDY 03/15/06
EX-10.40 2001 STOCK INCENTIVE PLAN, AS AMENDED.
EX-10.41 SEVERANCE AGREEMENT GAIL MOORE 06/12/06
EX-10.43 RATIFICATION AND AMENDMENT AGREEMENT 03/22/07
EX-10.44 AMENDED NO.1 TO RATIFICATION AND AMENDED AGREEMENT 04/19/07
EX-10.45 SEVERANCE AGREEMENT KATHLEEN KENNEDY 05/09/07
EX-10.46 AMENDED AND RESTATED DEPOSIT ACCOUNT CONTROL AGREEMENT 05/24/07
EX-21 SUBSIDIARIES OF THE REGISTRANT
EX-31.1 SECTION 302 CERTIFICATION OF THE CEO
EX-31.2 SECTION 302 CERTIFICATION OF THE CAO
EX-32 SECTION 906 CERTIFICATION OF THE CEO AND CAO

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PART I

Item 1. BUSINESS

General

Hancock Fabrics, Inc., a Delaware corporation (“Hancock” or the “Company,” which may be referred to as “we”, “us” or “our”) 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 a specialty retailer committed to serving creative enthusiasts with a complete selection of fashion and home decorating textiles, sewing accessories, needlecraft supplies and sewing machines. We are one of the largest fabric retailers in the United States, operating 403 stores in 40 states as of February 3, 2007. (See Note 4 to the Consolidated Financial Statements included herewith for a discussion of dispositions occurring after year end.)

Proceedings under Chapter 11 of the Bankruptcy Code

Hancock’s business was generally profitable through its 2004 fiscal year. During fiscal year 2005, Hancock, like most of its competitors, experienced continuing declines in comparable store sales consistent with a prevailing downward trend in the Company’s industry.

The declining sales based on market conditions were exacerbated by inaccuracies in the Company’s 2005 store inventory counts which caused a delay in releasing the Company’s 2005 financial statements. The application of the Company’s practice of accounting for promotional fabric inventory, based on average weight factors, during the 2005 store inventories was determined to be inaccurate. Accordingly, the Company conducted physical inventory recounts using more precise weight factors in all of its stores during February through April of 2006.

The delay in filing our 2005 financial statements caused substantial erosion in confidence among the Company’s key constituents. For example, due to the failure to file timely audited financial statements, many of the Company’s trade vendors that relied on accounts receivable factoring agents for liquidity, reduced terms by as much as 60 days, and the Company was required to issue letters of credit to secure the factors for trade vendors, which further reduced available cash. In addition, it (a) required the Company, among other things, to incur substantial fees from outside inventory service providers, (b) increased audit fees and expenses considerably, and (c) forced the Company to hire a firm to assist with the financial reporting process. The Company estimates that the additional out-of-pocket expense exceeded $6 to $7 million in the aggregate. During February through April 2006, the Company’s field personnel, which included all store employees, store managers, district and regional managers, were burdened by the administrative and other requirements of the new physical inventory process, causing them to divert needed attention away from customers and sales efforts, further driving down already declining comparable store sales. This process thus consumed a material portion of the Company’s cash flow, financed largely by increased borrowings under the Company’s senior collateralized revolving credit facility (the “Credit Facility”) with Wachovia Bank and other lenders.

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Partially in response to the losses and operational difficulties, which continued through fiscal 2006, Hancock analyzed its store base and sales data, contracting its chain moderately to help reduce losses. We closed approximately 40 underperforming stores in 2006 and, in early 2007 elected to close approximately another 30 underperforming stores, liquidating the inventory therein in order to pay down debt and satisfy cash needs. Hancock continued to aggressively prune underperforming stores from its chain, and in March of 2007 began to implement a decision to liquidate and close approximately 104 additional underperforming stores, with a concomitant reduction in corporate overhead and distribution costs. In addition, on September 1, 2006, the Company engaged Houlihan Lokey Howard & Zukin to assist in evaluating the Company’s strategic options.

On March 20, 2007, the Company announced that it had received a notice of default from its bank group due to the previously reported delay in filing its quarterly financial statements and due to the Company’s inability to comply with a financial covenant in the Company’s bank credit facility that required the Company to have at least $25 million of excess availability.

On March 21, 2007, the Company filed a voluntary petition for reorganization under Chapter 11 of the United States Bankruptcy Code (the “Bankruptcy Code”), in the United States Bankruptcy Court for the District of Delaware (the “Court”) (Case No. 07-10353). The reorganization case is being administered under the caption “In re Hancock Fabrics, Inc., Case No. 07-10353.” The Company continues to operate its business as a “debtor-in-possession” under the jurisdiction of the Court and in accordance with the applicable provisions of the Bankruptcy Code and orders of the Court.

On March 22, 2007, the Company received interim approval of the Court of a $105 million “debtor-in-possession” financing arrangement with Wachovia Bank, N.A., in which the Company gained additional borrowing capacity (see Note 7 to the accompanying Consolidated Financial Statements). Also on June 15, 2007, the Company reached a definitive agreement (the “Loan Agreement”) with another lender for an additional loan of up to $17.5 million. The Loan Agreement provides for a term loan facility in the aggregate principal amount of up to $17,500,000. The Company intends to use the proceeds of the loans made under the Loan Agreement for general working capital purposes and to pay fees and expenses related to the Loan Agreement.

On July 2, 2007, the U.S. Bankruptcy Court entered an order pursuant to section 365(d)(4) of the Bankruptcy Code extending the deadline by which the debtors must assume or reject unexpired leases of non-residential real property, extending the debtors’ time to assume or reject unexpired non-residential real property leases through and including October 17, 2007. On August 17, 2007, the debtors sent their landlords a letter requesting that the landlord consent in writing to an extension of the debtors’ period, under section 365(d)(4)(B)(ii), to assume or reject the debtors’ lease(s) with such landlord (the “Written Consent Solicitation Letter”). The Written Consent Solicitation Letter requested that each landlord give its written consent to an extension of the debtors’ time through February 29, 2008, to assume or reject its lease. On October 17, 2007, the debtors notified the Court that approximately 180 landlords had agreed to the extension. In addition, approximately 90 leases for which extensions were not obtained were assumed on October 17, 2007.

On July 18, 2007, the Company filed a motion (the “Motion”) requesting that the Court extend the period during which the Company has the exclusive right to file a plan or plans of reorganization through February 28, 2008, and to extend the period during which the Company has the exclusive right to solicit acceptances thereof through April 30, 2008. On November 30, 2007, the Company filed a motion to extend the time during which the Company has the exclusive right to file a plan or plans through May 30, 2008, and to extend the period during which the Company has the exclusive right to solicit acceptances thereof through July 30, 2008. The motion was further amended on December 14, 2007, with respect specifically to the creditors’ committee to extend the exclusivity period through March 31, 2008, and solicitation period through May 30, 2008, provided that the Company delivers to the creditors’ committee a plan of reorganization term sheet on or by January 15, 2008, and a draft plan of reorganization and disclosure statement on or by January 31, 2008. Such was provided by the due date.

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Under Chapter 11, we are continuing to operate our business without interruptions as a debtor-in-possession under the jurisdiction of the Court and in accordance with the applicable provisions of the Bankruptcy Code. In general, a debtor-in-possession is authorized under Chapter 11 to continue to operate as an ongoing business, but may not engage in transactions outside the ordinary course of business without the prior approval of the Court.

Although we can not currently estimate the impact of Chapter 11 filings on our future financial statements, we have determined that we will be required to review certain assumptions used in determining the fair value of our long-lived assets and goodwill. We are also in the process of reviewing contracts and unexpired leases to determine which, if any, we could reject as permitted by the Bankruptcy Code.

The Company has presented its business plan to both the Official Committee of Unsecured Creditors and the Official Equity Committee to begin the process of formulating and negotiating a plan of reorganization. The Company intends to file a plan during the first calendar quarter of 2008 and exit Chapter 11 two to three months later.

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 2006, we opened 4 stores, closed 44 stores, and relocated 6 stores. Additionally, during the first quarter of 2007, we made decisions to close 134 stores during 2007.

Merchandising/Marketing

The following table shows net sales for each of our merchandise categories as a percentage of our total net sales:

	Year Ended
	February 3,			January 28,			January 30,
	2007			2006			2005
Apparel Fabrics		29	%		28	%		29	%
Home Decorating		23	%		26	%		27	%
Quilting/Craft		24	%		24	%		25	%
Notions and Accessories		24	%		22	%		19	%
		100	%		100	%		100	%

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 to 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 apparel merchandise.

We use promotional advertising, primarily direct mail, and newspapers to reach our target customers. We mail fourteen to eighteen direct mail promotions each year to approximately one million households.

Distribution and Supply

Our retail stores are served by our headquarters facility and 650,000 square foot warehouse and distribution facility in Baldwyn, Mississippi. We completed the transfer of our warehousing and distribution operations

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from our Tupelo, Mississippi facility during February 2004 and moved to our new corporate offices in September 2004. The sale of the Company’s former distribution center was completed during January 2006.

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 3% of our merchandise from any one supplier during the fiscal year ended February 3, 2007. We purchased approximately 13% of our merchandise from our top five suppliers in fiscal year 2006.

Competition

We are among the largest fabric retailers in the United States, serving our customers in their quest of apparel and craft sewing, quilting, home decorating, and other artistic undertakings. We compete nationally with one publicly traded company in the fabric retail industry, Jo-Ann Stores, Inc. In addition, Wal-Mart Stores, Inc. has fabric departments in most store locations; however, management understands that Wal-Mart plans to exclude cut fabric in most of its newly opened stores and will stop selling cut fabric in some of its existing stores. We also compete with a few smaller fabric chains and numerous independent fabric stores. We compete on the basis of price, selection, quality, service and location. We believe that our continued commitment to providing assortments that are affordable, complete, and unique, combined with the expert sewing advice available in each of our stores, provides us with a competitive advantage over our rivals.

Information Technology

Hancock is committed to using information technology to improve operations and efficiency, and enhance the customer shopping experience. Implementation of a point-of-sale (“POS”) system in our stores was completed in early 2005, providing us with detailed sales and gross margin information at the item level for the first time in the Company’s history. Such information can be used to better understand and react to sales trends, evaluate advertising strategies, improve the allocation of merchandise to individual stores, and analyze the results of merchandise programs that are being tested.

Service Mark

The Company has registered the service mark “Hancock Fabrics” with the United States Patent and Trademark Office.

Seasonality

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

Employees

At February 3, 2007, we employed approximately 5,200 people on a full-time and part-time basis. Approximately 4,900 work in our retail stores. The remaining employees work in the Baldwyn headquarters, and warehouse and distribution facility. The Company has no employees covered under collective bargaining agreements.

Government Regulation

The Company is 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

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federal and state minimum wages and, accordingly, any increase in the minimum wage would affect our labor cost.

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, (“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 (“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.

Hancock’s Corporate Governance Guidelines, Code of Business Conduct and Ethics (including the Code of Business Conduct and Ethics for our Chief Executive Officer and Senior Financial Officers), Audit Committee Charter, Corporate Governance and Nominating Committee Charter, and Management Review and Compensation Committee Charter are available free of charge on the Company’s website. In addition, 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 Hancock filed the certifications required by Section 302 of the Sarbanes-Oxley Act as exhibits to the Company’s Annual Report on Form 10-K for the fiscal year ended February 3, 2007.

Operational Restructuring Initiatives

Shortly after filing for Chapter 11, the Company formulated and launched a set of initiatives to improve Hancock’s foundation for future growth. Through these initiatives the Company:

• Developed a comprehensive bottom-up business plan incorporating management’s strategic objectives, supported by a set of underlying assumptions and detailed financial projections on a monthly basis for the next two years and on an annual basis for the following three years

• Worked with a leading outside consulting firm to develop a new, exciting prototype store with a completely redesigned layout and significantly enhances customer experience

• Developed a plan to build new store fixtures for remodeled stores in-house to achieve savings of over 50% versus third-party manufacturing and has developed and implemented the site construction and build-outs, expected to result in similar savings

• Redesigned and shortened the projected store opening process

• Working with other leading outside consultants with expertise in retailing and real estate to evaluate the Company’s current store base and identify opportunities to increase sales and profitability through targeted store relocations

• Implemented a product remerchandising program to enhance product offerings and profitability

• Centralized purchasing and inventory management to reduce direct-to-store shipments in order to help achieve and maintain desired profitability levels of purchased products and appropriate overall stocking levels and reduce freight expenses by eliminating costly drop-shipments from vendors

• Executed a strategic global sourcing program to increase amount of centralized product purchases from overseas to improve product mix and profitability

• Substantially completed implementation of an information technology upgrade, including comprehensive store-level point-of-sale and inventory management information systems

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• Upgraded data transfer platform to and from the stores with state-of-the-art internet-based technology that will provide for faster updates of significantly more data, and allow senior management to perform more real-time analyses of the data

• Developed and began rollout of a new e-commerce strategy, including securing a new third-party business partner to assist in executing a new and improved website supported by a data-driven marketing and advertising program

• Identified attractive candidates to supplement the existing senior management team and take the lead in important areas of focus, including a new senior vice president of operations, a new director of hancockfabrics.com, and a new senior vice president of the Company’s wholesale business

• Implemented additional organization changes and reorganized certain departments to further reduce overall headcount to lower overall operating expenses

• Changed financial reporting from quarterly to monthly to comply with the United States Trustee’s reporting requirements and to provide management with the data critical to effectively manage the business

As these initiatives are completed, a series of “growth” initiatives will be launched that are prioritized and time phased to minimize execution risk and maximize return on capital employed. These growth initiatives will build on and improve upon the direction and results of the foundation initiatives. They are:

• Store remodels

• Store relocations

• New store launches

Six new store prototypes were opened in the fourth quarter of 2007 that will serve as a platform for testing the assumptions, conclusions and processes that come out of the foundation initiatives. The first prototype was opened in November of 2007 in Huntsville, AL with results in line with expectations.

Item 1A. RISK FACTORS

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.

Because we are in Chapter 11 and have incurred significant operating losses, it is uncertain whether we will emerge from bankruptcy or achieve a viable operation.

We are currently operating as debtors-in-possession under Chapter 11 of the Bankruptcy Code, and our continuation as a going concern is contingent upon, among other things, our ability to gain approval of the plan of reorganization by the requisite parties under the Bankruptcy Code and have the plan confirmed by the Bankruptcy Court, comply with terms of existing and future loan agreements, return to profitability, generate sufficient cash flows from operations and obtain financing sources to meet future obligations.

Prolonged continuation of the Chapter 11 proceedings may harm our business.

The prolonged continuation of the Chapter 11 proceedings could adversely affect our business and operations. So long as the Chapter 11 proceedings continue, our senior management will be required to spend a significant amount of time and effort dealing with our reorganization instead of focusing exclusively on business operations. Prolonged continuation of the Chapter 11 proceedings will also make it more difficult to attract and retain management and other key personnel necessary to the success and growth of our business and will likely erode investor confidence. In addition, the longer the Chapter 11 proceedings continue, the more likely it is that our customers, suppliers, distributors and agents will lose confidence in our ability to successfully reorganize our business and seek to establish alternative commercial relationships. Furthermore, so long as the Chapter 11 proceedings continue, we will be required to incur substantial costs for professional fees and other expenses associated with the proceedings. The prolonged continuation of the Chapter 11 proceedings may also

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require us to seek additional financing in order to service debt and other obligations. It may not be possible for us to obtain additional financing during or after the Chapter 11 proceedings on commercially favorable terms or at all. If we were to require additional financing during the Chapter 11 proceedings and were unable to obtain the financing on favorable terms or at all, our chances of successfully reorganizing our business may be seriously jeopardized.

We may not be able to generate a viable plan, and we may not be able to obtain confirmation of the plan. Even if the requisite acceptances of the Plan are received, the Bankruptcy Court may not confirm the plan. A dissenting holder of a claim against or equity interest in the Company may challenge the balloting procedures and results as not being in compliance with the Bankruptcy Code. Even if the Bankruptcy Court determined that the balloting procedures and results were appropriate, the Bankruptcy Court could still decline to confirm the plan if it found that any of the statutory requirements for confirmation had not been met, including that the terms of the plan are fair and equitable to non-accepting Classes. Section 1129 of the Bankruptcy Code sets forth the requirements for confirmation and requires, among other things, a finding by the Bankruptcy Court that (i) the plan “does not unfairly discriminate” and is “fair and equitable” with respect to any non-accepting Classes, (ii) confirmation of the plan is not likely to be followed by a liquidation or a need for further financial reorganization and (iii) the value of distributions to non-accepting Holders of Claims within a particular Class under the plan will not be less than the value of distributions such Holders would receive if the Company were liquidated under Chapter 7 of the Bankruptcy Code. The Bankruptcy Court may determine that the plan does not satisfy one or more of these requirements, in which case it would not be confirmable by the Bankruptcy Court.

If the plan is not confirmed by the Bankruptcy Court, it is unclear whether we will be able to reorganize our business and what, if any, distributions holders of claims against or equity interests in the Company ultimately would receive with respect to their claims or equity interests. If an alternative reorganization could not be agreed upon, it is possible that we would have to liquidate our assets, in which case it is possible that holders of claims would receive substantially less favorable treatment than they would receive under the plan.

We have risk relating to our financial condition and liquidity.

As discussed in Note 2 to the accompanying Consolidated Financial Statements, we are operating as debtors-in-possession under Chapter 11 of the U.S. Bankruptcy Code. As a result of the uncertainty surrounding our current circumstances, it is difficult to predict our actual liquidity needs and sources at this time. Our access to additional financing while in the Chapter 11 bankruptcy process may be limited.

We have been delisted from the New York Stock Exchange.

On March 21, 2007, our common stock was suspended from trading and was later, effective May 4, 2007, delisted from the New York Stock Exchange (“NYSE”). Our common stock is now traded through broker-to-broker transactions on what is commonly referred to as “Pink Sheets”. The price of our stock is quoted through an Over-the-Counter (OTC) bulletin board. This has reduced the market and liquidity of our common stock and consequently the ability of our stockholders and broker/dealers to purchase and sell our shares in an orderly manner or at all. The volume of trading in our stock has generally declined since our bankruptcy filing. Trading in our common stock in this manner entails other risks. Due in part to the decreased trading price of our common stock and reduced analyst coverage, the trading price of the Company’s common stock may change quickly, and brokers may not be able to execute trades as quickly as they could when the common stock was listed on the New York Stock Exchange.

Our ability to continue as a “going concern” is uncertain.

The accompanying consolidated financial statements have been prepared assuming that we will continue to operate as a going concern which contemplates continuity of operations, timely payment for services by customers, control of operating costs and expenses and the realization of asset sales and liquidation of liabilities and commitments. The bankruptcy filing and related circumstances, including our default on all pre-

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petition debt, the losses from operations, as well as current economic conditions, raise substantial doubts about our ability to continue as a going concern. The appropriateness of reporting on a going concern basis is dependent upon, among other things, the availability of sufficient capital to meet expenses, confirmation of a plan of reorganization, future profitable operations, customer and employee retention and the ability to generate sufficient cash from operations and financing sources to meet our obligations as they become due. We have assumed all of the foregoing. Should some or all of our assumptions fail to be realized in the future, our results of operations and financial condition will be adversely affected and our ability to continue as a going concern will be doubtful.

Our continuing failure to timely file certain periodic reports with the SEC poses significant risks to our business, each of which could materially and adversely affect our financial condition and results of operations.

We did not timely file with the SEC our Form 10-K for fiscal 2005 or 2006, and we have not filed with the SEC our Forms 10-Q for the quarterly periods ended April 29, 2006, July 29, 2006, and October 28, 2006. Also, we have not timely filed with the SEC our Forms 10-Q for the quarterly periods ended May 5, 2007, August 4, 2007, and November 3, 2007. Consequently, we are not compliant with the reporting requirements under the Exchange Act.

Our inability to timely file our periodic reports with the SEC involves a number of current and future significant risks, including:

• A breach had been declared under our bank credit facility (see Note 7 to the Accompanying Consolidated Financial Statements) causing our lenders to declare our outstanding loans due and payable.

• Our common stock has been delisted from the NYSE. We may be unable to re-register our common stock on the NYSE or other exchanges.

• We are not eligible to use a registration statement to offer and sell freely tradable securities, which prevents us from accessing the public capital markets.

Any of these events could continue to materially and adversely affect our financial condition and results of operations.

In our internal control assessments, we identified material weaknesses in our internal control over financial reporting, which could materially and adversely affect our business and financial condition.

As discussed in Item 9A. CONTROLS AND PROCEDURES the Company’s assessments of our internal control over financial reporting identified material weaknesses. Due to these material weaknesses, management concluded that we did not maintain effective internal control over financial reporting as of February 3, 2007.

Our inability to maintain effective internal controls over financial reporting could, among other things, cause us to continue to fail to file our periodic reports with the SEC in a timely manner or require us to incur additional costs or divert management resources. 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.

Restrictions placed on us by our bank credit facility may limit our ability to finance future needs or adapt our business plan to changes.

As discussed in Note 7 to the accompanying Consolidated Financial Statements — Long-Term Debt Obligations, we were not in compliance with various debt covenants contained in our Credit Facility (defined

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in Note 7) prior to filing for Bankruptcy in March of 2007. Subsequent to year end our Credit Facility was replaced by a $105 million debtor-in-possession financing arrangement (defined in Note 7 as the “DIP Credit Facility”).

The DIP Credit Facility contains several covenants, including but not limited to limitations on liens, additional indebtedness, sale of assets, investments/acquisitions, loans, and the payment of dividends. Under the DIP Credit Facility we are currently required to maintain at least $15 million of excess availability, as defined. We are currently in compliance with covenants under the DIP Credit Facility. However, future violations of the covenants would permit the lenders to restrict our ability to borrow or initiate letters of credit, and require immediate repayment of amounts outstanding.

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 another taxing authority could audit our current or previously filed tax returns and dispute our treatment of a tax deduction, resulting in an unexpected assessment. Depending on the timing and amount of such an assessment, it could have a material adverse effect on our results of operations, financial condition and liquidity.

Failure to comply with the requirements of the NYSE or other exchanges could cause our stock to continue to be delisted and may impede our ability to re-register our common stock.

The inability to re-register our common stock would have a material adverse effect on us by, among other things, reducing:

• the liquidity and market price of our common stock;

• the number of investors willing to hold or acquire our common stock, thereby restricting our ability to obtain equity financing;

• the availability of information concerning the trading prices and volume of our common stock; and

• the number of broker-dealers willing to execute trades in shares of our common stock.

We expect to continue to incur significant expenses related to our internal control over financial reporting and the preparation of our financial statements.

We have devoted substantial internal and external resources to the completion of our consolidated financial statements for the years ended January 28, 2006 and February 3, 2007. As a result of these efforts, along with efforts to complete our assessments of internal control over financial reporting as of February 3, 2007, as required by Section 404 of the Sarbanes-Oxley Act of 2002, we expect that we will incur incremental fees and expenses for additional auditor hours and fees, financial and other consulting services and legal services. While we do not expect fees and expenses relating to the preparation of our financial results for future periods to remain at this level, we expect that these fees and expenses will remain significantly higher than historical fees and expenses in this category for the next several quarters. These expenses, as well as the substantial time devoted by our management and staff towards addressing these weaknesses, could have a material and adverse effect on our financial condition, results of operations and cash flows.

We are subject to the risk of litigation and regulatory proceedings or actions in connection with the 2005 restatement of prior period financial statements.

In our 2005 Form 10-K filed with the SEC we restated the quarterly financial data for the interim periods of fiscal 2005 and 2004, and the consolidated financial statements for fiscal 2004 and 2003. We may in the future

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be subject to class action suits, other litigation or regulatory proceedings or actions arising in relation to the restatement of our prior period financial statements. Any expenses incurred in connection with this potential litigation or regulatory proceedings or action not covered by available insurance or any adverse resolution of this potential litigation or regulatory proceedings or action could have a material adverse effect on our business, results of operations, cash flows and financial condition. Further, any litigation or regulatory proceedings or action may be time consuming, and it may distract our management from the conduct of our business.

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 would 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.

Competitive changes could have a material adverse effect on our operations.

We are one of the largest fabric retailers in the United States and principally compete with only one national fabric/craft store chain, a few small fabric chains and numerous independent fabric stores. In addition, Wal-Mart Stores, Inc. has a fabric department in most store locations. Changes in our competitive environment could adversely impact our operating results. Such changes include, but are not limited to, the following:

• liquidation of inventory in Hancock’s markets caused by a competitor’s store closings or need to dispose of inventory;

• new entrants into the retail fabric industry;

• expansion by existing competitors into our markets; and

• increased competitive pricing strategies.

The influence of adverse general economic factors on consumers’ spending habits can have a significantly unfavorable impact on our business.

Adverse general economic conditions that are beyond our control can negatively impact consumer confidence and spending habits that in turn could lead to a material adverse effect on our financial condition and operating results. These factors include, but are not limited to, increased interest rates in periods of borrowings, consumer debt levels, tax rates and policies, unemployment trends, recession, inflation, and deflation. Our sales generally originate from disposable income from our customers. As the consumer’s disposable income decreases (i.e., as a result of higher fuel prices), our sales revenue could decline leading to a material adverse impact on our financial condition and operating results.

Changes in customer demands could adversely affect our operating results for the year.

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 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 also lead to negative operating results and cash flow.

A weak fourth quarter would materially adversely affect our operating results for the year.

Like many retailers, our strongest quarter in terms of sales, net earnings and cash flow is the fourth quarter. If our fourth quarter results were substantially below expectations, our operating results for the full year would be negatively impacted, and we could have substantial excess inventory that could be difficult to liquidate.

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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 issues, production difficulties, quality control issues, and problems in delivering agreed-upon quantities on schedule because of their limited resources and lack of financial flexibility. Failure of our key suppliers to withstand a downturn in economic conditions could have a material adverse effect on our operating results.

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

Hancock relies on foreign suppliers for various products. In addition, some of our domestic suppliers manufacture their products overseas or purchase them from foreign vendors. Political or financial instability, trade restrictions, tariffs, currency exchange rates, transport capacity and costs and other factors relating to foreign trade are beyond our control and could adversely impact our operating results.

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 from significant increases in interest rates.

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 shortages in the transportation industry as well as long-term interruptions of service in the national and international transportation infrastructure. In addition, labor shortages 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. Increases in fuel prices may result in increases in our transportation costs for distribution to our stores, as well as our vendors’ transportation costs, which could affect our operating results.

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

Over 70% 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 the 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.

A disruption in the performance of our information systems could occur.

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.

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We have become more dependent upon automated information technology processes, including use of the internet for conducting a portion of our business. Information may be compromised through various means, including penetration of our network security 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, 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.

Our ability to attract and retain skilled people could have a material adverse effect on our operations.

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 their skills, knowledge of our markets and products, years of industry experience and the difficulty of promptly finding qualified replacements. We offer financial packages that are competitive within the industry to effectively compete in this area.

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.

Our debt level upon exit from bankruptcy protection could make us more vulnerable to adverse economic conditions.

Our debt level upon exit from bankruptcy protection could adversely affect our flexibility to respond to changing business and economic conditions and our ability to fund working capital, capital expenditures and other general corporate requirements. This situation could be compounded further if payment terms on our inventory purchases are tightened by our suppliers for any reason. If we do not improve our cash flow from operations and reduce our debt, we might have to seek alternative strategies, including closing additional stores, reducing or delaying capital expenditures, restructuring or refinancing our indebtedness, and seeking additional debt or equity financing.

Litigation developments and failure to comply with various laws and regulations could adversely affect our business operations and financial performance.

We are regularly involved in various litigation matters that arise in the ordinary course of our business, including liability claims. Litigation 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.

Other matters.

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.

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Item 1B. UNRESOLVED STAFF COMMENTS

None.

Item 2. PROPERTIES

As of February 3, 2007, the Company operated 403 stores in 40 states. (See Note 4 to the accompanying Consolidated Financial Statements for a discussion of dispositions occurring after year end.) The number of store locations in each state is shown in the following table:

	Number			Number
State	of Stores		State	of Stores
Alabama		14	Missouri		12
Arizona		9	Montana		2
Arkansas		13	Nebraska		5
California		22	Nevada		4
Colorado		8	New Mexico		4
Delaware		1	North Carolina		16
Florida		12	North Dakota		4
Georgia		17	Ohio		8
Idaho		5	Oklahoma		15
Illinois		19	Oregon		3
Indiana		8	Pennsylvania		5
Iowa		12	South Carolina		10
Kansas		4	South Dakota		3
Kentucky		9	Tennessee		18
Louisiana		14	Texas		46
Maryland		6	Utah		6
Massachusetts		2	Virginia		16
Michigan		9	Washington		10
Minnesota		10	Wisconsin		13
Mississippi		8	Wyoming		1

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

Year	Opened		Closed			Net Change			Year-end Stores		Relocated(1)
2002		27		(36	)		(9	)		430		—
2003		28		(25	)		3			433		—
2004		39		(25	)		14			447		—
2005		11		(15	)		(4	)		443		10
2006		4		(44	)		(40	)		403		6

⁽¹⁾ Prior to 2005, stores that were relocated within the same market were treated as both an opening and a closing.

The Company’s 403 retail stores average 14,019 square feet and are located principally in strip shopping centers.

With the exception of two owned locations, the Company’s retail stores are leased. The original lease terms generally are 10 years in length and most leases contain one or more renewal options, usually of five years in length. As of February 3, 2007, the remaining terms of leases for stores in operation, including renewal

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options, averaged approximately 13 years. During fiscal 2007, 45 store leases are scheduled to expire. We currently have negotiated or are in the process of negotiating renewals on certain of these leases. Additionally, during the first quarter of 2007, the Company decided to close approximately 134 stores (one of which was an owned location) during fiscal 2007. As a result of the Company’s Chapter 11 reorganization process, certain of the leased locations have been sold for $3.6 million and others have been rejected. The Company anticipates settling any remaining lease commitments and rejection claims for $3.7 in the aggregate.

In fiscal 2004, the Company completed construction of and moved into 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 voluntary petition for reorganization under Chapter 11 of the Bankruptcy Code. The reorganization case is being administered under the caption “In re Hancock Fabrics, Inc., Case No. 07-10353.” The Company will continue to operate its business as a “debtor-in-possession” under the jurisdiction of the Court and in accordance with the applicable provisions of the Bankruptcy Code and orders of the Court. For more information about the filing, see Item 1. Business — Proceedings under Chapter 11 of the Bankruptcy Code.

The Company is a party to several legal proceedings and claims. Although the outcome of such proceedings and claims cannot be determined with certainty, we are of the opinion that it is unlikely that these proceedings and claims will have a material effect on the financial condition or operating results of the Company.

The Company has received several tax assessments from the Mississippi State Tax Commission (the “Tax Commission”) resulting from an audit of the Company’s state income, franchise, and sales and use tax returns. The predominant income tax issue underlying these assessments concerns the taxation of certain intercompany payments by and between the Company and certain of its subsidiaries. In essence, the Tax Commission believes that all intercompany payments made to the Company’s subsidiaries domiciled in another state are attributable to the Mississippi operations of the Company and taxable in full in Mississippi. Additionally, the Tax Commission has asserted that those companies located in Mississippi that made the intercompany payments are not entitled to deduct those amounts. Thus, Mississippi is attempting simultaneously to tax the same intercompany payments to both parties to those transactions. The franchise tax assessments are primarily attributable to the Tax Commission’s position that all of the intercompany indebtedness by and between the Company and its subsidiaries is properly classified as taxable capital rather than debt. A proposed settlement is expected to be finalized with the Tax Commission during the first quarter of 2008. The Company does not believe that the amounts ultimately paid for the above matter will materially differ from the amounts accrued.

On July 20, 2007, a putative class action styled Kathy Aliano v. Hancock Fabrics, Inc., et al., Case No. 07-C-4109, was commenced against the Company and others including the Company’s officers, directors, employees and agents in the United States District Court for the Northern District of Illinois, Eastern Division. The complaint filed in the action alleges violation by the Company of the Fair and Accurate Credit Transactions Act amendment to the Fair Credit Reporting Act, which prohibits the printing of more than the last five digits of a credit card number or the expiration date on customer receipts, and seeks (i) statutory damages, (ii) attorneys’ fees, litigation expenses and costs and (iii) other relief the court may deem proper. The Company has settled and the Bankruptcy Court has approved on a preliminary basis, the settlement which will not have a material effect on the financial condition or operating results of the Company.

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Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

No matters were submitted to a vote of security holders during the fiscal year ended February 3, 2007, through the solicitation of proxies or otherwise.

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PART II

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

Through March 20, 2007, the Company’s common stock and the associated common stock purchase rights were listed on the NYSE and traded under the symbol HKF. On March 21, 2007, the Company’s common stock was suspended from trading on the NYSE and was delisted on May 4, 2007. Our common stock is now quoted on the Over-the-Counter (OTC) bulletin board quotation service under the symbol HKFIQ.PK. Our stock is traded through broker-to-broker transactions on what is commonly referred to as “Pink Sheets.” The following table sets forth the high and low closing prices of our common stock for the year and during each quarter in 2005 and 2006, together with dividends.

					Cash
	High		Low		Dividend
2005
First Quarter	$	9.10	$	5.92	$	.06
Second Quarter		6.92		5.36		.06
Third Quarter		7.21		5.70		.06
Fourth Quarter		6.50		3.67		—
Year Ended
January 28, 2006	$	9.10	$	3.67	$	.18
2006
First Quarter	$	4.56	$	3.29	$	—
Second Quarter		3.65		3.01		—
Third Quarter		3.53		2.56		—
Fourth Quarter		4.15		2.84		—
Year Ended
February 3, 2007	$	4.56	$	2.56	$	—

As of February 2, 2008, there were 3,869 record holders of Hancock’s common stock.

The Company did not pay any cash dividends during 2006. The Company announced in November 2005 that Hancock was indefinitely suspending its cash dividend in order to support the Company’s 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 financial covenants.

See Part III, Item 12 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 its Common Stock during the year ended February 3, 2007:

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 29, 2006 through February 25, 2006		—						243,753
February 26, 2006 through April 1, 2006		3,456	$	3.55				243,753
April 2, 2006 through April 29, 2006		—						243,753
April 30, 2006 through May 27, 2006								243,753
May 28, 2006 through July 1, 2006		32,761	$	3.19				243,753
July 2, 2006 through July 29, 2006								243,753
July 30, 2006 through August 26, 2006								243,753
August 27, 2006 through Sep tember 30, 2006		1,807	$	3.03				243,753
October 1, 2006 through October 28, 2006		106	$	3.11		106		243,647
October 29, 2006 through November 25, 2006		13,555	$	3.35				243,647
November 26, 2006 through December 30, 2006		1,520	$	3.19				243,647
December 31, 2006 through February 3, 2007								243,647
Total January 29, 2006 through February 3, 2007		53,205	$	3.25		106		243,647

(1)

The number of shares purchased during the year includes 46,151 shares deemed surrendered to the Company to satisfy tax withholding obligations arising from the lapse of restrictions on shares and 6,948 shares deemed surrendered to the Company to satisfy tax withholding obligations arising from the issuance of shares to members of the Board of Directors (in lieu of cash fees).

(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 1,756,353 shares purchased under this authorization through February 3, 2007. The shares discussed in footnote (1) are excluded from this column. The Company has not repurchased any additional shares through February 2, 2008, other than insignificant odd-lot accounts.

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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 February 3, 2007. 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)	2006(1)			2005			2004			2003			2002
Results of Operations Data:
Sales	$	376,179		$	388,752		$	410,698		$	427,868		$	423,894
Gross profit		149,471			158,191			183,236			203,941			200,802
Earnings (loss) from continuing operations before income taxes		(46,305	)		(28,572	)		3,429			26,865			29,234
Earnings (loss) from discontinued operations, net of tax		(3,943	)		(2,368	)		(490	)		353			305
Net earnings (loss)		(45,907	)		(30,251	)		1,694			17,302			18,927
As a percentage of sales		-12.2	%		-7.8	%		0.4	%		4.0	%		4.5	%
As a percentage of average shareholders’ equity		-69.0	%		-30.5	%		1.4	%		14.3	%		18.2	%
Financial Position Data:
Total assets	$	212,217		$	241,973		$	257,791		$	254,697		$	225,274
Capital expenditures		2,324			5,114			22,785			21,942			17,089
Long-term indebtedness		65,350			55,170			31,000			10,000			—
Common shareholders’ equity		52,462			80,561			118,105			130,409			111,386
Current ratio		2.2			2.7			2.4			2.1			2.0
Per Share Data:
Basic earnings (loss) per share	$	(2.45	)	$	(1.63	)	$	0.09		$	0.98		$	1.06
Diluted earnings (loss) per share		(2.45	)		(1.63	)		0.09			0.93			1.00
Cash dividends per share		—			0.18			0.48			0.40			0.32
Shareholders’ equity per share		2.72			4.20			6.15			6.92			5.85
Other Data:
Number of states		40			43			42			42			42
Number of stores		403			443			447			433			430
Number of shareholders		3,889			4,170			4,453			4,633			4,930
Number of shares outstanding, net of treasury shares		19,311,307			19,189,025			19,200,883			18,847,801			19,049,778
Comparable store sales change		-1.9	%		-6.2	%		-4.2	%		1.2	%		8.3	%
Total selling square footage		4,837,091			5,278,179			5,253,424			5,087,065			4,963,538

⁽¹⁾ Fiscal year 2006 contained 53 weeks while all other years presented contained 52 weeks.

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

Recent Developments

As more fully described in “Item 1. Business — Proceedings under Chapter 11 of the Bankruptcy Code, on March 21, 2007, the Company filed voluntary petition for reorganization under Chapter 11 of the United States Bankruptcy Code. The Company will continue to operate its business as a “debtor-in-possession” under the jurisdiction of the Court and in accordance with the applicable provisions of the Bankruptcy Code and orders of the Court.

As a result of the filing, our creditors were automatically stayed from taking certain enforcement actions under their respective agreements with us unless the stay is lifted by the Bankruptcy Court.

During the Chapter 11 process, we may, with Bankruptcy Court approval, sell assets and settle liabilities for amounts other than those reflected in our financial statements.

We are in the process of reviewing contracts and unexpired leases to determine which, if any, we will reject as permitted by the Bankruptcy Code. Through early December 2007, we have assumed leases for approximately 133 retail locations, rejected leases for approximately 78 retail locations and have negotiated consensual extensions of the time to assume or reject non-residential real property leases for approximately 183 retail locations through, in all but two cases, February 29, 2008. We cannot presently estimate the ultimate liability that may result from rejecting contracts or leases or from the filing of claims for any rejected contracts or leases, and no provisions have yet been made for these items.

The administrative and reorganization expenses resulting from the Chapter 11 process will unfavorably affect our results of operations. Future results of operations may also be affected by other factors related to the Chapter 11 process.

Divestitures

During 2006 the Company closed 44 stores, of which 26 qualified for discontinued operations treatment in accordance with Statement of Financial Accounting Standards “SFAS” 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” Accordingly, the results of operations for the 26 stores are presented separately in the accompanying statement of operations for all periods presented. These stores represent approximately $12.3 million in annualized sales and approximately $3.9 million in operating losses.

Subsequent to year end, in the first quarter of 2007, the Company announced plans to close an additional 134 stores. The Company expects 124 of these stores to qualify for discontinued operations treatment under SFAS 144. The presentation of these 124 stores as discontinued operations will begin, in accordance with SFAS 144, in the first quarter of 2007. Revenues and operating losses for the 124 stores that are expected to qualify as discontinued operations are provided below:

		2006		2005
Revenues	$	86.7M	$	88.8M
Operating Losses	$	(6.0M	)   $	(5.4M	)

See Note 4 in the accompanying Consolidated Financial statements for further discussion regarding discontinued operations.

Overview

Hancock Fabrics, Inc. is a specialty retailer committed to serving creative enthusiasts with a complete selection of fashion and home decorating textiles, sewing accessories, needlecraft supplies and sewing machines. We

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are one of the largest fabric retailers in the United States, operating 403 stores in 40 states as of February 3, 2007.

Our stores present a broad selection of fabrics and notions used in apparel sewing, home decorating and quilting projects. The stores average 14,019 total square feet, of which 12,003 are on the sales floor. During 2006, the average annual sales per store were $905,864.

We use a number of key performance measures to evaluate our financial performance, including the following (dollars in thousands):

	2006			2005			2004
Comparable store sales change (1)		-1.9	%		-6.2	%		-4.2	%
Operating income (loss) ratio (2)		-11.0	%		-6.6	%		1.1	%
Net cash provided by (used in) operating activities (3)	$	(7,424	)	$	(19,198	)	$	10,555
Return on average assets (4)		-17.9	%		-10.9	%		0.9	%

(1)	A new store is included in the comparable store sales computation immediately upon reaching its one-year anniversary. Stores that are relocated are treated as new stores. 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 store sales. The comparable sales decrease for 2006 included a 2.7% benefit from 42 store liquidations in connection with store closing events.
(2)	Measures the degree to which sales translate to profits after deducting the product costs and operating expenses that are required to generate sales (Operating income/loss divided by Sales).
(3)	Measures cash flows from operations, including earnings and changes in working capital (see Consolidated Statements of Cash Flows).
(4)	Measures the productivity of asset investments (Net earnings/loss, excluding the impact of interest, divided by average total assets). This calculation may or may not be comparable to other companies’ return on average assets, depending upon whether they exclude the impact of interest from net earnings.

Critical Accounting Policies and Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America (“GAAP”) requires management to make estimates and assumptions that affect the recorded amount of assets and liabilities at the date of the financial statements and revenues and expenses during the period. Significant accounting policies employed by Hancock, including the use of estimates and assumptions, are presented in the Notes to the accompanying Consolidated Financial Statements. Management bases its estimates on its historical experience, together with other relevant factors, in order to form the basis for making judgments, which will affect the carrying values of assets and liabilities. On an ongoing basis, management evaluates its estimates and makes changes to carrying values as deemed necessary.

The financial statements have been prepared on a “going concern” basis in accordance with AICPA Statement of Position 90-7, Financial Reporting by Entities in Reorganization under the Bankruptcy Code, and do not include possible issues arising from the proceedings. The consolidated financial statements included elsewhere in this Report do not include certain adjustments relating to the recoverability and classification of recorded asset amounts or the amount and classification of liabilities or the effect on existing stockholders’ equity that may result from any plans, arrangements or other actions arising from the proceedings, or the possible inability

23

of the Company to continue in existence. Adjustments necessitated by such plans, arrangements or other actions could materially change the consolidated financial statements included elsewhere in this Report.

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

Inventories. Inventories are stated at the lower of cost or market; cost is determined by the last-in, first-out (“LIFO”) method. Therefore, the Company must estimate the market value for various portions of its inventory periodically to account for slow-moving and discontinued items, resulting in mark-downs and/or reserves for potential obsolescence and market valuation matters. The amounts of such mark-downs and reserves could vary significantly from period-to-period based on actual results affected by various market conditions and other factors. As of February 3, 2007, the Company had recorded reserves totaling $338,000.

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, the Company includes these assumptions as it records 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.

The Company capitalizes costs related to the distribution and handling of inventory as well as 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, the Company 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.

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 significantly 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.

Operating Leases. The Company leases 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. The Company recognizes 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 the Company determines that it is probable that the specified levels will be reached during the fiscal year.

Often, the Company receives 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.

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Revenue Recognition. Sales are recorded at the time customers provide a satisfactory form of payment and take ownership of the merchandise. The Company allows customers to return merchandise under most circumstances. The reserve for returns was $194,000 at February 3, 2007, and $219,000 at January 28, 2006, and is included in accrued liabilities in the accompanying consolidated balance sheet. 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.

Insurance Reserves. Workers’ compensation, general liability and employee medical insurance programs are largely self-insured. It is Hancock’s policy to record its 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.

Store Closing Reserves. Store closing reserves include estimates of net lease obligations and other store closing costs. Hancock recognizes store closing reserves at fair value in the period that the operating lease is considered legally terminated and a liability has been incurred in accordance with the provisions of SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities. In determining fair value, the Company considers the contractual obligation of the lease less any estimated amounts of future sublease receipts which are estimated at the time of closure and revised to reflect actual or revised estimates of the future receipts. Adjustments to store closing reserves are made, as necessary, in the period that events or circumstances requiring such reserve adjustments occur, which may vary significantly from period to period based on actual results.

Asset Retirement Obligations. Obligations created as a result of certain lease requirements that Hancock 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.

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, assumed discount rates and estimated future compensation increases. Hancock determines 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. Hancock expects pension and postretirement benefit expenses to decrease by approximately 24% to 29% during 2007. The projected decrease reflects a reduction in the number of eligible employees resulting from terminations related to store closure activity, offset by the expected cost increases due to aging of the population, extra service costs, interest on growing obligations, a slightly unfavorable asset experience in 2006, and increases in the assumed medical trend rates. The Medicare Prescription Drug Improvement and Modernization Act of 2003 expanded Medicare by adding a prescription drug benefit which covers the individuals affected by the Company’s elimination of prescription drug coverage.

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 Point		One-Percentage Point
	Increase		Decrease
Effect on total service and interest costs	$	122		($104	)
Effect on postretirement benefit obligation	$	1,017		($893	)

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Our pension and postretirement plans are further described in Note 12 to the accompanying Consolidated Financial Statements.

Valuation of Long-Lived Assets. Hancock reviews the net realizable value of long-lived assets at the individual store level annually or whenever events or changes in circumstances indicate impairment has occurred. If the undiscounted cash flows are less than the carrying value, fair values based on the discounted cash flows of the 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 a protracted decline in sales and operating results and a decision made in the fourth quarter to implement a strategic restructuring plan that consisted of decisions to close approximately 134 stores during 2007, the Company assessed its long-lived assets and determined that certain of them were impaired. As a result, the Company has recorded approximately $1.1 million in non-cash impairment charges. Additional charges may be necessary in the future due to changes in the estimated future cash flows. Impairment charges are included in selling, general and administrative expenses in the accompanying income statement.

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 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. Each of the stores acquired in two separate transactions that resulted in the recognition of goodwill represents a reporting unit. Due to declining operating results and other factors, the Company performed an evaluation of goodwill in 2006 which resulted in impairment charges of $579,000. The Company recorded 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 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. Prior to the implementation of SFAS 142, Goodwill and Other Intangible Assets, the Company amortized goodwill. Accordingly, goodwill is presented net of accumulated amortization of $1,239,000.

Deferred Income Taxes. The Company records 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. The Company then evaluates the net deferred tax asset, if any, for realization. Unless the Company determines 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. During the fourth quarter of fiscal 2006, the Company determined that valuation allowances totaling $14.2 million were required through the statement of operations due to the utilization and recognition of all carrybacks of net operating losses, recent operating performance of the Company, and estimated future taxable income. An additional $3.4 million related to the change in minimum pension liabilities was recorded through other comprehensive income during fiscal 2006. Accordingly, the Company may be limited in its ability to recognize future benefits related to operating losses; however, if the Company creates taxable income in the future, the Company may be able to reverse the valuation allowances resulting in a decrease in income tax expense or other comprehensive income.

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

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Stock-based Compensation. Prior to fiscal year 2006, in accordance with APB 25, the Company did not recognize compensation expense for its outstanding stock options; however, the Company did (and still does) amortize and recognize compensation expense for the fair value of restricted stock awarded. Beginning in fiscal year 2006, the Company adopted Statement of Financial Accounting Standards “SFAS” No. 123(R) and began expensing the remaining portion of the fair value for any unvested stock options over the remaining service (vesting) period, which resulted in $1.2 million of additional stock compensation expense during the year. 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 the Company’s stock. The pro forma impact of the additional stock compensation expense for options reduced net earnings (loss) by $2.3 million and $1.6 million for fiscal years 2005 and 2004.

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.

	Fiscal Year
	2006			2005			2004
Sales		100.0	%		100.0	%		100.0	%
Cost of goods sold		60.3	%		59.3	%		55.4	%
Gross profit		39.7	%		40.7	%		44.6	%
Selling, general and administrative expense		49.5	%		45.9	%		42.4	%
Depreciation and amortization		1.2	%		1.4	%		1.1	%
Operating income (loss)		-11.0	%		-6.6	%		1.1	%
Interest expense, net		1.3	%		0.7	%		0.3	%
Earnings (loss) before income taxes		-12.3	%		-7.3	%		0.8	%
Income taxes		-1.0	%		-0.1	%		0.3	%
Earnings (loss) from continuing operations		-11.3	%		-7.2	%		0.5	%

2006 vs. 2005

Sales decreased $12.6 million in 2006 due primarily to a 1.9% reduction in sales at stores that were open more than one full year (“comparable store sales”) including a 2.7% benefit from 42 stores liquidated in connection with store closing sales events. The sales decline in comparable stores was attributable to continued weakness in the home decorating sector, as evidenced by similar results for direct and indirect competitors, and heavy competitive discounting in the industry. A reduction in customer traffic was somewhat offset by an improvement in average ticket. The balance of the sales decline was the result of a reduction in the number of stores during the year. Sales of fashion apparel fabric increased from 28% of total sales in 2005 to 29% in 2006; home decorating sales decreased from 26% to 23%; and sales of quilting/craft merchandise remained unchanged at 24%. Sewing notions and accessories increased from 22% of total sales in 2005 to 24% in 2006.

Gross margins declined from 40.7% in 2005 to 39.7% in 2006. During April 2006, the Company modified agreements with two vendors that have and will continue to supply the majority of the Company’s pattern inventory. In connection with the new agreements, the Company recorded a charge of $8.5 million to reflect additional obligations to the vendors related to future pattern sales. The agreements effectively mitigate our ownership rights in certain pattern inventory, but are expected to help maximize the gross profit realized on the sale of patterns, both consigned and owned, shorten the time for settlement with the pattern companies, and

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reduce the administrative burden of tracking promotional rebates. This charge adversely impacted gross margin in the current year by 2.3%. Gross margin was further reduced by liquidation sales in stores included in continuing operations. These reductions were partially offset by price increases on selected products to match those of competitors. Gross margin was positively affected by the impact of a 2006 LIFO (last-in, first-out) charge of $2.8 million versus $5.0 million in 2005 due primarily to a reduction in inventory levels from the prior year. Although not having a cash impact, LIFO caused a $2.2 million positive swing in gross profit, or about .6% of sales.

Selling, general and administrative expense as a percentage of sales increased to 49.5% in 2006 from 45.9% in 2005. The additional cost relating to the 2005 audit and the re-inventory of all store locations were the primary factors negatively affecting this comparison. This effort resulted in approximately $7.3 million of direct costs and resulted in additional store labor and travel costs, which cannot be quantified. The de-leveraging impact on the expense ratio that results from negative comparable store sales affected the comparison also. The ratio benefited from impairment charges, totaling $1.7 million in 2006, compared to a charge of $4.2 million in 2005.

Depreciation expense decreased $868,000 due to a reduction in the number of store locations and the impairment of fixed assets recognized in the current and prior year.

Interest expense increased $2.1 million due to an increasing interest rate environment and the average outstanding debt rising from approximately $51 million during 2005 to $55.9 million in 2006 as the result of operating losses.

Income tax benefit was $689,000 in 2005 compared to an income tax benefit of $3.9 million in 2006. The 2006 benefit is mainly attributable to a change in the estimated net tax receivables related to certain state tax matters and the tax benefit recorded related to the vesting of employee stock. Hancock’s effective tax rate was (2.4%) in 2005 compared to an effective tax benefit of (8.3%) in 2006.

Loss from discontinued operations increased from ($2,368) in 2005 to ($3,943) in 2006 due to declining sales and gross margins.

2005 vs. 2004

Sales decreased $21.9 million in 2005 compared to 2004 due primarily to a 6.2% decline in comparable store sales. The sales decline in comparable stores was attributable in the first half of the year to ineffective marketing and incomplete assortments in the home decorating, quilting and apparel fabric categories, and in the second half to continued weakness in the home decorating sector and heavy competitive discounting in the industry. Approximately two-thirds of the decrease was caused by a lower average ticket, with the remainder being due to reduced customer traffic. The decline in home decorating sales extended into 2006 and, in addition to a weakness in the Company’s assortments, appears to be the result of an overall slow-down in decorating sales, as evidenced by similar results for direct and indirect competitors. Sales of fashion apparel fabric declined from 29% of total sales in 2004 to 28% in 2005; home decorating sales decreased from 27% to 26%; and sales of quilting/craft merchandise declined from 25% to 24%. Sewing notions and accessories increased from 19% of total sales in 2004 to 22% in 2005.

Gross margins declined from 44.6% in 2004 to 40.7% in 2005 due to an increase in pricing discounts in response to competitive pressures within the industry and an increase in the Company’s markdowns as a reaction to the slowing sales environment. In addition, gross margin was negatively affected by the impact of a 2005 LIFO (last-in, first-out) charge of $5.0 million versus $935,000 in 2004 due primarily to an increase in the U. S. Department of Labor’s Producer Price Index (“PPI”) that the Company uses to measure inflation in inventories. Although not having a cash impact, LIFO caused a $4.1 million negative swing in gross profit, or about 1% of sales.

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Selling, general and administrative expense as a percentage of sales increased to 45.9% in 2005 from 42.4% in 2004. The de-leveraging impact on the expense ratio that results from negative comparable store sales was the primary factor affecting the comparison. In addition, impairment charges, totaling $4.2 million in 2005, caused an increase in the expense ratio comparison, partially offset by the inclusion in 2004 expenses of a charge of $1.5 million for the required accelerated recognition of future retirement benefits for the Company’s retiring Chairman and Chief Executive Officer.

Depreciation expense increased $740,000 in 2005 due to a full year of depreciation expense in 2005 for capital expenditures related to the new corporate office facility, which was completed in mid-2004, and the roll-out of point-of-sale (“POS”) systems to our stores, principally in 2003 and 2004, with completion of the last few stores in early 2005.

Interest expense increased $2.1 million due to an increasing interest rate environment and the average outstanding debt rising from $33 million during 2004 to $51 million in 2005 as the result of operating losses.

Income tax expense was $967,000 in 2004 compared to an income tax benefit of ($689,000) in 2005 due to the pretax losses of the Company and recognition of deferred tax asset valuation allowances. Hancock’s effective tax rate was 36.3% in 2004 compared to an effective tax benefit of (2.4%) in 2005 due to the establishment of a valuation allowance on deferred tax assets based on the decline in the Company’s performance during 2005.

Loss from discontinued operations increased from ($490) in 2004 to ($2,368) in 2005 due to declining gross margins.

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, prior to the Bankruptcy filing date, have historically been generated from Hancock’s operations, credit extended by suppliers and borrowings from commercial lenders.

With the filing of our petition for reorganization under Chapter 11 of the United States Bankruptcy Code on March 21, 2007, our administrative expenses of the proceedings, working capital needs, and capital improvements are provided for by cash from operations, the $105 million DIP financing arrangement, and the $17.5 million loan discussed further below.

Hancock’s cash flow related information as of and for the past three fiscal years follows (dollars in thousands):

	2006			2005			2004
Cash and cash equivalents	$	2,499		$	3,215		$	3,792
Net cash flows provided (used):
Operating activites		(7,424	)		(19,198	)		10,555
Investing activities		(1,549	)		(397	)		(22,438	)
Financing activites		8,257			19,018			11,595
Working capital		78,898			106,421			97,306
Long-term indebtedness to total capitalization		55.5	%		40.6	%		20.8	%

Changes in cash and cash equivalents

Cash flows used in operating activities were $7.4 million in 2006, a decrease of $11.8 million from the cash flows used by operating activities in 2005. The Company recorded a net loss of $45.9 million in 2006 compared to a net loss of $30.3 million in 2005. However, this decrease in operating cash flows was offset by

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a $26.2 million change in inventory mainly attributable to the Company’s discontinued operations and related liquidation sales.

In 2005, cash flows from operating activities decreased from the prior year due to a net loss of $30.3 million in 2005, versus net income in 2004 of $1.7 million, partially offset by the net loss being comprised of higher non-cash items, including LIFO ($4.1 million increase) and an impairment charge ($4.2 million). In addition, a $10.5 million decrease in accounts payable contributed to the reduction in cash flows from operating activities. The decline in accounts payable was the result of the timing of payments associated with an expansion of inventory assortments in several key areas to replace products being phased out. Since the new assortments were received in the second and third quarters, we had paid vendors prior to the end of 2005 because of credit pressure arising from operating losses and because we sourced more product overseas, which typically requires quicker payment.

Cash used for investing activities consists primarily of purchases and sales of property and equipment. Capital expenditures during 2006 were at a rate much lower than historical trends due to capital expenditures being made more on an “as-needed” basis. These expenditures were partially offset by sales of surplus property. In 2005, capital expenditures were almost entirely offset by the sale of Hancock’s former distribution center.

Cash provided by financing activities in 2006 included $8.5 million of net borrowings. These borrowings were primarily utilized to fund $7.4 million of cash used in operating activities and $1.5 million of capital expenditures. In 2005, cash provided by financing activities consisted mostly of net borrowings of $20.1 million and $4.3 million of proceeds from lease financing transactions. These inflows were primarily used to fund $19.2 million cash used in operating activities, $3.5 million of cash dividends and $1.2 million of loan costs incurred in connection with a new credit facility. In 2004, cash used for financing activities consisted mostly of net borrowings of $21 million, which were used to fund the significant level of capital expenditures and $9.1 million of cash dividends.

Working capital decreased to $78.9 million at the end of 2006 from $106.4 million in 2005, due to the inventory reduction partially offset by the increase in income tax refundable. Working capital increased to $106.4 million at the end of 2005 from $97.3 million in 2004, due primarily to the aforementioned $10.5 million reduction in accounts payable which was financed with debt.

Bank credit facility

As discussed in Note 7 to the accompanying Consolidated Financial Statements — Long Term Debt Obligations, on June 29, 2005, the Company entered into a senior collateralized revolving credit facility (the “Credit Facility”) with Wachovia Bank and other lenders. The Credit Facility replaced the Company’s previously existing revolving credit agreements with a group of banks which the Company terminated on June 29, 2005.

The Credit Facility is a five-year $110 million commitment, although there are minimum levels of availability that must be maintained which have the effect of limiting the amount that can be borrowed to less than $110 million. The level of borrowings is subject to a borrowing base as defined in the agreement. This agreement provides for an unused line fee, ranging from .25% to .35% depending upon excess availability. The Company has the option of selecting either a “prime rate” or Eurodollar loan. Advances under the Credit Facility will accrue interest either (x) at the Applicable Margin (as defined in the Loan and Security Agreement) plus the higher of (i) the rate of interest periodically announced by Wachovia as its “prime rate”, or (ii) the federal funds effective rate from time to time plus 0.50% or (y) at the Applicable Margin plus the Adjusted Eurodollar Rate (which is a rate derived from the London Interbank Offered Rate). Most borrowings under the Credit Facility are made at the Applicable Margin plus the Adjusted Eurodollar Rate and are outstanding for 30 day periods. At February 3, 2007 and January 28, 2006, Hancock had outstanding borrowings of approximately $59.6 million and $51 million, respectively under the Credit Facility. The estimated weighted average interest rates under the Credit Facility for the years ended February 3, 2007 and January 28, 2006 was approximately 7.1% and 5.9%, respectively.

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The Credit Facility is collateralized by a first priority perfected collateral interest in and liens upon all of the Company’s present and future assets. The Credit Facility also contemplates the issuance of letters of credit aggregating up to $25 million, provided that all borrowings under the Credit Facility do not exceed $110 million.

The Credit Facility contains several covenants, including but not limited to, timely filing of financial statements and limitations on liens, additional indebtedness, sale of assets, investments/acquisitions, loans, and the payment of dividends. In addition, there is a financial covenant that requires the Company to maintain at least $25 million of excess availability, as defined. In March of 2007, the Company received a notice of default (Its waiver expired as of February 28, 2007.) due to the delay in filing its quarterly financial statements and due to the Company’s inability to comply with the financial covenant requiring the Company to have at least $25 million of excess availability.

As previously discussed, in March 2007, the Company filed voluntary petition for reorganization under Chapter 11 of the United States Bankruptcy Code. On March 22, 2007, the Company received approval of the Court of a $105 million “debtor-in-possession” financing arrangement (the “Senior Secured Revolving Credit Facility” or “DIP Credit Facility”) with Wachovia Bank, N.A.. This financing arrangement effectively amended the above Credit Facility. The DIP Credit Facility calls for a maximum $105,000,000 credit. Similar to the previous Credit Facility, there are minimum levels of availability that must be maintained which have the effect of limiting the amount that can be borrowed to less than $105 million. Also, the level of borrowings is subject to a borrowing base as defined in the agreement. The borrowing base is mainly reliant on certain portions of the Company’s credit card receivables, inventory, and real property. The DIP Credit Facility is collateralized by a first priority perfected collateral interest in and liens upon all of the Company’s present and future assets. Also similar to the prior Credit Facility, the DIP Credit Facility may be used for letters of credit up to an aggregate amount of $25,000,000. This agreement provides for an unused line fee of .25% to .35%. The Company may elect that the loans under the DIP Credit Facility bear interest at a rate of the Adjusted Eurodollar Rate plus 1.75% or Prime plus 0.25%, as such terms are defined in the agreement. Upon default the interest rate would be increased by 2% above the highest pre-default rate.

The DIP Credit Facility is for a term ending on the earliest of: 1) two years following the closing of the DIP Credit Facility (two years from March 22, 2007 or March 22, 2009), 2) confirmation of the Company’s plan of reorganization, or 3) the last termination date set forth in the Company’s interim financing orders related to bankruptcy, unless the Company’s permanent financing order has been entered prior to such date.

The DIP Credit Facility contains several covenants, including but not limited to limitations on liens, additional indebtedness, sale of assets, investments/acquisitions, loans, and the payment of dividends. Under the DIP Credit Facility the Company is currently required to maintain at least $15 million of excess availability, as defined. The Company is currently in compliance with covenants under the DIP Credit Facility. However, future violations of the covenants are possible and would permit the lenders to restrict the Company’s ability to borrow or initiate letters of credit, and require immediate repayment of amounts outstanding.

At February 3, 2007 and January 28, 2006, Hancock had commitments under the above credit facility of $6.1 million and $3.0 million, respectively under documentary and standby letters of credit which support purchase orders for merchandise. Hancock also has a standby letter of credit to guarantee payment of potential future workers’ compensation claims. This letter of credit amounted to $5.5 million as of February 3, 2007 and January 28, 2006.

Also on June 15, 2007, the Company reached a definitive agreement (the “Loan Agreement”) with another lender for an additional loan of up to $17.5 million.

The Loan Agreement provides for a term loan facility in the aggregate principal amount of up to $17,500,000. The Company intends to use the proceeds of the loans made under the Loan Agreement for general working capital purposes and to pay fees and expenses related to the Loan Agreement.

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The Borrowers’ obligations under the Loan Agreement are collateralized by substantially all of their real, personal, tangible and intangible assets (whether owned as of the date of the Loan Agreement or subsequently acquired or existing), including, without limitation, (a) accounts; (b) general intangibles (including intellectual property); (c) goods (including inventory and equipment); (d) real property and fixtures; (e) chattel paper (including tangible and electronic chattel paper); (f) instruments (including promissory notes); (g) documents; (h) deposit accounts; (i) letters of credit, banker’s acceptances and similar instruments; (j) supporting obligations and present and future liens, security interests, rights, remedies, title and interest in, to and in respect of receivables; (k) investment property (including securities, securities accounts, security entitlements, commodity contracts or commodity accounts); (l) monies, credit balances, deposits and other property of any Borrower or Guarantor now or hereafter held or received by or in transit to Agent or any Lender (or its affiliates) at any other depository or other institution; (m) commercial tort claims; (n) receivables (to the extent not previously described above); (o) leasehold real property interests existing as of March 22, 2007 (excluding fixtures and subject to certain limitations); and (p) all records.

The Loan Agreement contains terms and conditions customary for financing arrangements of this nature. The replacement term loan facility will mature on the earlier to occur of (a) June 15, 2009, (b) the confirmation of a plan of reorganization for Borrowers and Guarantors in the previously disclosed Chapter 11 cases of Borrowers and Guarantors (which are being administered under the Chapter 11 of the United States Bankruptcy Code in the United States Bankruptcy Court for the District of Delaware), or (c) the last termination date set forth in the Permanent Financing Order (as defined in the Loan Agreement).

Certain borrowings under the Loan Agreement (“Prime Rate Loans”) will bear interest at a rate equal to two (2%) percent per annum in excess of the greater of (a) 8.25%, (b) the rate from time to time publicly announced by JPMorgan Chase Bank in New York, New York, or its successors, as its prime rate, whether or not such announced rate is the best rate available at such bank or (c) the federal funds rate as published by the Federal Reserve Bank of New York in effect on such day plus one-half (1/2%) percent. Other borrowings under the Loan Agreement (“Eurodollar Rate Loans”) will bear interest at a rate equal to five (5%) percent per annum in excess of rate per annum determined by dividing (a) the rate of interest per annum appearing on Reuters Screen LIBOR Page as the London interbank offered rate for deposits in dollars at approximately 11:00 a.m. (London time) two business days prior to the first day of the applicable interest period by (b) a percentage equal to: (i) one (1) minus (ii) the percentage which is in effect from time to time under Regulation D of the Board of Governors of the Federal Reserve System as the maximum reserve requirement applicable with respect to Euro-denominated liabilities, provided that such rate shall not be less than 5.25%. Agent may, at its option or at the direction of the requisite number of Lenders, increase the interest rates to the rate of five (5%) percent per annum in excess of the applicable rate for Prime Rate Loans and the rate of eight (8%) percent per annum in excess of the applicable rate for Eurodollar Rate Loans in certain circumstances.

The representations, covenants and events of default in the Loan Agreement are customary for financing transactions of this nature. Certain mandatory prepayments of the term loan facility will be required upon the occurrence of specified events, including upon the sale of certain assets. Events of default in the Loan Agreement include, among others, (a) the failure to pay when due the obligations owing under the credit facilities; (b) the failure to perform (and not timely remedy, if applicable) certain covenants; (c) the revocation or purported revocation of the obligations of a Guarantor; (d) the occurrence of certain bankruptcy or insolvency events; (e) certain judgments against the Borrowers; (f) any representation or warranty made by the Borrowers subsequently proven to have been false or misleading in any material respect; (g) certain cross default events and (h) the occurrence of a Change in Control (as defined in the Loan Agreement). Upon the occurrence of an event of default, the lenders may terminate the loan commitments, accelerate all loans and exercise any of their rights under the Loan Agreement and the ancillary loan documents as a secured party.

General

As of February 3, 2007, we had $32.4 million of excess availability, or $4.4 million more than required by the covenant. Subsequent to that date, the excess availability continued to decline resulting in the Company’s

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decision to file for bankruptcy protection. Subsequent to the bankruptcy filing, the Company received $57.2 million in proceeds from the liquidation of inventory and fixtures in 134 stores during the first half of 2007. Also during 2007, we completed the sale of an owned property for $3.1 million, received $3.6 million in auction proceeds from surplus properties and we have received $1.9 million of the $10.1 million income taxes refundable shown on the consolidated balance sheet as of February 3, 2007, which related to the expected recovery of income taxes from carrying back losses to years in which we had taxable income. The Company expects to receive the balance of the refunds in 2007 and 2008.

The Company has received several tax assessments from the Mississippi State Tax Commission (the “Tax Commission”) resulting from an audit of the Company’s state income, franchise, and sales and use tax returns. The predominant income tax issue underlying these assessments concerns the taxation of certain intercompany payments by and between the Company and certain of its subsidiaries. In essence, the Tax Commission believes that all intercompany payments made to the Company’s subsidiaries domiciled in another state are attributable to the Mississippi operations of the Company and taxable in full in Mississippi. Additionally, the Tax Commission has asserted that those companies located in Mississippi that made the intercompany payments are not entitled to deduct those amounts. Thus, Mississippi is attempting simultaneously to tax the same intercompany payments to both parties to those transactions. The franchise tax assessments are primarily attributable to the Tax Commission’s position that all of the intercompany indebtedness by and between the Company and its subsidiaries is properly classified as taxable capital rather than debt. A proposed settlement is expected to be finalized with the Tax Commission during the first quarter of 2008. The Company does not believe that the amounts ultimately paid for the above matter differ materially from the amounts accrued.

We announced in November 2005 that Hancock was indefinitely suspending its cash dividend in order to support the Company’s 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 financial covenants. In addition, a decision was made to discontinue treasury stock repurchases for the foreseeable future, except for insignificant purchases from odd-lot shareholders and minor amounts surrendered by employees to satisfy tax withholding obligations arising from the lapse of restrictions on shares of stock.

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

The consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States applicable to a going concern. Except as otherwise disclosed, these principles assume that assets will be realized and liabilities will be discharged in the ordinary course of business. Since March 21, 2007, the Company has been operating as debtors-in-possession under Chapter 11 of the Bankruptcy Code, and their continuation as a going concern is contingent upon, among other things, their ability to gain approval of the plan of reorganization by the requisite parties under the Bankruptcy Code and have the plan confirmed by the Bankruptcy Court, comply with terms of loan agreements, return to profitability, generate sufficient cash flows from operations and obtain financing sources to meet future obligations. There can be no assurance that the Company will be able to achieve any of these results, which could raise substantial doubts about its ability to continue as a going concern and result in the complete liquidation of all assets for the benefit of its creditors. The consolidated financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts or the amounts and classification of liabilities that might result from the outcome of these uncertainties.

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. (Six of the Company’s store leases qualified for capital lease treatment.) Future payments under operating leases are appropriately excluded from the Company’s balance sheet. Capital lease obligations are, however, reflected on the Company’s balance sheet.

33

Contractual Obligations and Commercial Commitments

The following table summarizes our future cash outflows resulting from contractual obligations and commitments as of February 3, 2007 (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		3-5		than 5
	Reference		Total		Year		Years		Years		Years
Long-term debt (1)		7	$	59,584	$	—	$	—	$	59,584	$	—
Minimum lease payments (2)		8		137,098		29,140		45,513		30,899		31,546
Standby letters of credit for insurance		7		5,509		5,509		—		—		—
Standby letters of credit for merchandise		7		6,100		6,100		—		—		—
Capital lease obligations (3)		8		11,547		680		1,360		1,364		8,143
Trade letters of credit				6		6		—		—		—
Total			$	219,844	$	41,435	$	46,873	$	91,847	$	39,689

(1)	The calculation of interest on our Credit Facility is dependent on the average borrowings during the year and a variable interest rate, which was approximately 7.1% at February 3, 2007. Interest payments are excluded from the table because of their subjectivity and estimation required.
(2)	Our aggregate minimum lease payments represent operating lease commitments, which generally include non-cancelable leases for property used in our operations, including sale/leaseback financings. 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, pension and SERP funding obligations, store closing reserves, asset retirement obligations, and 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.

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

Related Party Transactions

Hancock has no balances with any related parties, nor has it had any material transactions with related parties during the three-year period ended February 3, 2007.

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. 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

34

a combination of price adjustments and cost controls, careful evaluation of occupancy needs and efficient purchasing practices are the most effective tools for coping with increased costs and expenses.

Inflation is one of the key factors used in the calculation of the LIFO charge or credit to Cost of Sales. In 2006, 2005, and 2004 increases in the PPI resulted in LIFO charges.

Seasonality

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

Recent Accounting Pronouncements

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

Item 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The Company did not hold derivative financial or commodity instruments at February 3, 2007.

Interest Rate Risk

The Company is exposed to financial market risks, including changes in interest rates. On June 29, 2005, the Company entered into the Credit Facility with Wachovia Bank and other lenders. The Credit Facility replaced the Company’s previously existing revolving credit agreements with three banks which the Company terminated on June 29, 2005.

The Credit Facility is a five-year $110 million commitment. The Company has the option of selecting either a “prime rate” or Eurodollar loan. Advances under the Credit Facility will accrue interest either (x) at the Applicable Margin (as defined in the Loan and Security Agreement) plus the higher of (i) the rate of interest periodically announced by Wachovia as its “prime rate”, or (ii) the federal funds effective rate from time to time plus 0.50% or (y) at the Applicable Margin plus the Adjusted Eurodollar Rate (which is a rate derived from the London Interbank Offered Rate). As of February 3, 2007, the Company had borrowings outstanding of approximately $59.6 million under the Credit Facility with an average interest rate of 7.1%. If interest rates increased 100 basis points, the Company’s annual interest expense would increase $596,000, assuming borrowings of $59.6 million as existed at February 3, 2007.

See Note 7 Long-Term Debt Obligations for a discussion of subsequent events impacting our long term debt.

Foreign Currency Risk

All of the Company’s business is transacted in U.S. dollars and, accordingly, foreign exchange rate fluctuations have not had a significant impact on the Company, and none are expected in the foreseeable future. As of February 3, 2007, the Company 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 February 3, 2007 and January 28, 2006		37
Consolidated Statements of Operations for each of the three years in the period ended February 3, 2007		38
Consolidated Statements of Shareholders’ Equity for each of the three years in the period ended February 3, 2007		39
Consolidated Statements of Cash Flows for each of the three years in the period ended February 3, 2007		40
Notes to Consolidated Financial Statements		41
Reports of Independent Registered Public Accounting Firms		68
Quarterly Financial Data (unaudited)		73

36

Hancock Fabrics, Inc.

Consolidated Balance Sheets

February 3, 2007 and January 28, 2006
(in thousands, except for share and per share amounts)	2006			2005
| |
Assets
Current assets:
Cash and cash equivalents	$	2,499		$	3,215
Receivables, less allowance for doubtful accounts		3,389			5,053
Inventories		127,574			152,893
Income taxes refundable		10,105			7,116
Prepaid expenses		1,613			1,840
Total current assets		145,180			170,117
Property and equipment, at depreciated cost		51,043			55,948
Deferred tax assets		6,273			5,427
Goodwill		3,606			4,218
Other assets		6,115			6,263
Total assets	$	212,217		$	241,973
Liabilities and Shareholders’ Equity
Current liabilities:
Accounts payable	$	37,349		$	37,784
Accrued liabilities		22,660			20,023
Deferred tax liabilities		6,273			5,889
Total current liabilities		66,282			63,696
Long-term debt obligations		59,584			51,056
Capital lease obligations		5,766			4,114
Postretirement benefits other than pensions		9,160			22,872
Pension and SERP liabilities		8,126			9,129
Other liabilities		10,837			10,545
Total liabilities		159,755			161,412
Commitments and contingencies (See Notes 8 and 14)
Shareholders’ equity:
Common stock, $.01 par value; 80,000,000 shares authorized; 32,597,613 and 32,422,126 issued and 19,311,307 and 19,189,025 outstanding, respectively		326			324
Additional paid-in capital		73,948			75,223
Retained earnings		128,935			174,842
Treasury stock, at cost, 13,286,306 and 13,233,101 shares held, respectively		(153,545	)		(153,372	)
Accumulated other comprehensive loss — minimum pension liabilities, net		2,798			(13,345	)
Deferred compensation on restricted stock incentive plan		—			(3,111	)
Total shareholders’ equity		52,462			80,561
Total liabilities and shareholders’ equity	$	212,217		$	241,973

See accompanying notes to consolidated financial statements.

37

Hancock Fabrics, Inc.

Consolidated Statements of Operations

Years Ended February 3, 2007, January 28, 2006 and January 30, 2005     (in thousands, except per share amounts)	2006			2005			2004
Sales	$	376,179		$	388,752		$	410,698
Cost of goods sold		226,708			230,561			227,462
Gross profit		149,471			158,191			183,236
Selling, general and administrative expenses		186,275			178,477			174,303
Depreciation and amortization		4,421			5,289			4,577
Operating income (loss)		(41,225	)		(25,575	)		4,356
Interest expense, net		5,080			2,997			927
Earnings (loss) from continuing operations before income taxes (benefit)		(46,305	)		(28,572	)		3,429
Income taxes (benefit)		(3,854	)		(689	)		1,245
Earnings (loss) from continuing operations		(42,451	)		(27,883	)		2,184
Loss from discontinued operations (net of tax benefit of $0, $0, and $278)		(3,943	)		(2,368	)		(490	)
Net earnings (loss) before cumulative effect of change in accounting principle		(46,394	)		(30,251	)		1,694
Cumulative effect of change in accounting principle, net of tax effect of ($0)		487			—			—
Net earnings (loss)	$	(45,907	)	$	(30,251	)	$	1,694
Basic earnings (loss) per share:
Earnings (loss) from continuing operations	$	(2.27	)	$	(1.50	)	$	0.12
Loss from discontinued operations		(0.21	)		(0.13	)		(0.03	)
Cumulative effect of change in accounting principle		0.03			—			—
Net earnings (loss)	$	(2.45	)	$	(1.63	)	$	0.09
Diluted earnings (loss) per share:
Earnings (loss) from continuing operations	$	(2.27	)	$	(1.50	)	$	0.12
Loss from discontinued operations		(0.21	)		(0.13	)		(0.03	)
Cumulative effect of change in accounting principle		0.03			—			—
Net earnings (loss)	$	(2.45	)	$	(1.63	)	$	0.09
Weighted average shares outstanding
Basic		18,709			18,518			18,187
Diluted		18,709			18,518			18,659

See accompanying notes to consolidated financial statements.

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Hancock Fabrics, Inc .

Consolidated Statements of Shareholders’ Equity

						Additional						Accumulated Other												Total
Years Ended February 3, 2007, January 28, 2006 and January 30, 2005	Common Stock					Paid-in			Retained			Comprehensive			Treasury Stock						Deferred			Shareholders’
(in thousands, except number of shares)	Shares			Amount		Capital			Earnings			Income (Loss)			Shares			Amount			Compensation			Equity
Balance February 1, 2004		31,941,582		$	319	$	70,105		$	216,194		$	(140	)		(13,093,781	)	$	(151,905	)	$	(4,164	)	$	130,409
Comprehensive income:
Net income										1,694															1,694
Minimum pension liabilities, net of taxes of $5,217													(9,017	)											(9,017	)
Total comprehensive loss																									(7,323	)
Cash dividends ($.48 per share)										(9,118	)														(9,118	)
Issuance of restricted stock		151,500			2		1,850			(220	)					100,000			1,163			(2,795	)		—
Cancellation of restricted stock		(13,950	)				(131	)														131			—
Amortization & vesting of deferred compensation on restricted stock incentive plan							1,166															2,422			3,588
Issuance of shares under directors’ stock plan		19,598					225																		225
Issuance of shares as compensation for professional services		3,578					42																		42
Purchases of treasury stock																(133,469	)		(1,987	)					(1,987	)
Stock options exercised		225,825			2		1,698																		1,700
Tax benefit of stock options exercised							569																		569
Balance January 30, 2005		32,328,133			323		75,524			208,550			(9,157)			(13,127,250	)		(152,729	)		(4,406	)		118,105
Comprehensive income:
Net income										(30,251	)														(30,251	)
Minimum pension liabilities, net of taxes of $0													(4,188	)											(4,188	)
Total comprehensive loss																									(34,439	)
Cash dividends ($.18 per share)										(3,457	)														(3,457	)
Issuance of restricted stock		137,000			1		728															(729	)		—
Cancellation of restricted stock		(98,800	)				(1,226	)														1,226			—
Amortization & vesting of deferred compensation on restricted stock incentive plan							(126	)														798			672
Issuance of shares under directors’ stock plan		50,364					289																		289
Issuance of shares as compensation for professional services		554					5																		5
Purchases of treasury stock																(105,851	)		(643	)					(643	)
Stock options exercised		4,875					25																		25
Tax benefit of stock options exercised							4																		4
Balance January 28, 2006		32,422,126			324		75,223			174,842			(13,345	)		(13,233,101	)		(153,372	)		(3,111	)		80,561
Comprehensive loss:
Net loss										(45,907	)														(45,907	)
Minimum pension liabilities (includling the implementation of SFAS 158 of $10,649), net of taxes of $0													16,143												16,143
Total comprehensive loss																									(29,764	)
Adoption of FAS 123(R), net of taxes of $0							(3,598	)														3,111			(487	)
Issuance of restricted stock		148,500			1		(1	)
Cancellation of restricted stock		(54,300	)
Stock compensation expense							2,459																		2,459
Tax benefit of stock compensation							(403	)																	(403	)
Issuance of shares under directors’ stock plan		81,287			1		268																		269
Purchases of treasury stock																(53,205	)		(173	)					(173	)
Balance February 3, 2007		32,597,613		$	326	$	73,948		$	128,935		$	2,798			(13,286,306	)		($153,545	)	$	—		$	52,462

See accompanying notes to consolidated financial statements.

39

Hancock Fabrics, Inc.

Consolidated Statements of Cash Flows

Years Ended February 3, 2007, January 28, 2006 and January 30, 2005 (in thousands)	2006			2005			2004
Cash flows from operating activities:
Net earnings (loss)	$	(45,907	)	$	(30,251	)	$	1,694
Adjustments to reconcile net earnings (loss) to cash flows from operating activities Depreciation and amortization, including cost of goods sold		7,180			7,985			6,841
Amortization of deferred loan costs		456			145			—
LIFO charge		2,758			5,035			935
Deferred income taxes		(865	)		6,550			3,129
Stock compensation expense		2,459			798			2,422
Reserve for store closings charges, including interest expense		1,675			671			650
Reserve for sales returns and bad debts		(20	)		(19	)		(11	)
Reserve for lower of cost or market inventory		(34	)		372			—
Stepped rent accrual		164			541			(209	)
Impairment on property and equipment, goodwill, and other assets		1,691			4,153			—
Cumulative effect of change in accounting principle		(487	)		—			—
(Gain) loss on disposition of property and equipment		(251	)		(236	)		523
Compensation expense for issuance of shares for professional services		—			5			42
Compensation expense for issuance of shares under directors’ stock plan		269			289			225
(Increase) decrease in assets Receivables and prepaid expenses		1,886			(899	)		427
Inventories at current cost		22,924			727			(1,444	)
Income tax refundable		(2,989	)		(7,029	)		(87	)
Other noncurrent assets		(439	)		1,461			1,055
Increase (decrease) in liabilities
Accounts payable		(435	)		(10,506	)		(1,354	)
Accrued liabilities		1,523			1,664			(1,795	)
Income taxes payable		—			(122	)		(4,971	)
Postretirement benefits other than pensions		(916	)		211			293
Long-term pension and SERP liabilities		2,344			1,720			2,103
Reserve for store closings		(990	)		(658	)		(1,045	)
Other liabilities		580			(1,805	)		1,132
Net cash provided by (used in) operating activities		(7,424	)		(19,198	)		10,555
Cash flows from investing activities:
Additions to property and equipment		(2,324	)		(5,114	)		(22,785	)
Proceeds from the disposition of property and equipment		775			4,717			347
Net cash used in investing activities		(1,549	)		(397	)		(22,438	)
Cash flows from financing activities:
Net borrowings on revolving credit agreement		8,528			20,056			21,000
Proceeds from capital lease		—			4,252			—
Payments for capital lease		(98	)		(34	)		—
Payments for loan costs		—			(1,181	)		—
Purchase of treasury stock		(173	)		(643	)		(1,987	)
Proceeds from exercise of stock options		—			25			1,700
Cash dividends paid		—			(3,457	)		(9,118	)
Net cash provided by financing activities		8,257			19,018			11,595
Decrease in cash and cash equivalents		(716	)		(577	)		(288	)
Cash and cash equivalents:
Beginning of period		3,215			3,792			4,080
End of period	$	2,499		$	3,215		$	3,792
Supplemental disclosures:
Cash paid during the period for:
Interest	$	5,218		$	2,843		$	891
Income taxes		—			22			2,975
Non-cash activities:
Change in minimum pension liabilities	$	16,143		$	(4,188	)	$	(9,017	)
Net increase in capital lease obligations		1,652			4,114			—
Issuance of restricted stock		541			729			2,795
Cancellation of restricted stock		(553	)		(1,226	)		(131	)

See accompanying notes to consolidated financial statements.

40

Notes to Consolidated Financial Statements

Note 1 — Description of Business

Hancock Fabrics, Inc. (“Hancock” or the “Company”) is a specialty retailer committed to serving creative enthusiasts with a complete selection of fashion and home decorating textiles, sewing accessories, needlecraft supplies and sewing machines. As of February 3, 2007, Hancock operated 403 stores in 40 states and an internet store under the domain name hancockfabrics.com. Hancock conducts business in one operating business segment. (See Note 4 for a discussion of dispositions occurring after year end.)

Note 2 — Subsequent Event — Proceedings under Chapter 11 and Related Financings

On March 21, 2007, the Company filed voluntary petition for reorganization under Chapter 11 of the United States Bankruptcy Code (the “Bankruptcy Code”), in the United States Bankruptcy Court for the District of Delaware (the “Court”) (Case No. 07-10353). The reorganization case is being administered under the caption “In re Hancock Fabrics, Inc., Case No. 07-10353.” The Company will continue to operate its business as a “debtor-in-possession” under the jurisdiction of the Court and in accordance with the applicable provisions of the Bankruptcy Code and orders of the Court.

On March 22, 2007, the Company received approval of the Court of a $105 million “debtor-in-possession” financing arrangement with Wachovia Bank, N.A., in which the Company will gain additional borrowing capacity (see Note 7 to the accompanying Consolidated Financial Statements). Also on June 15, 2007, the Company reached a definitive agreement (the “Loan Agreement”) with another lender for an additional loan of up to $17.5 million.

The Loan Agreement provides for a term loan facility in the aggregate principal amount of up to $17,500,000. The Company intends to use the proceeds of the loans made under the Loan Agreement for general working capital purposes and to pay fees and expenses related to the Loan Agreement.

On July 18, 2007, the Company filed a motion (the “Motion”) requesting that the Court extend the period during which the Company has the exclusive right to file a plan or plans through February 28, 2008, and to extend the period during which the Company has the exclusive right to solicit acceptances thereof through April 30, 2008.

On July 2, 2007, the U.S. Bankruptcy Court entered an order pursuant to section 365(d)(4) of the Bankruptcy Code extending the deadline by which the debtors must assume or reject unexpired leases of non-residential real property through and including October 17, 2007.

On August 17, 2007, the debtors sent their landlords a letter requesting that the landlord consent in writing to an extension of the debtors’ period, under section 365(d)(4)(B)(ii), to assume or reject the debtors’ lease(s) with such landlord (the “Written Consent Solicitation Letter”). The Written Consent Solicitation Letter requested that each landlord give its written consent to an extension of the debtors’ time through February 29, 2008, to assume or reject its lease. On October 17, 2007, the debtors notified the Court of the landlords who agreed to the extension. In addition, a number of leases for which extensions were not obtained were assumed on October 17, 2007.

On November 30, 2007, the Company filed a motion to extend the time during which the Company has the exclusive right to file a plan or plans through April 30, 2008, and to extend the period during which the Company has the exclusive right to solicit acceptances thereof through June 30, 2008. The motion was further amended on December 21, 2007, with respect specifically to the creditors’ committee to extend the exclusivity period through March 31, 2008, and solicitation period through May 30, 2008, provided that the Company delivers to the creditors’ committee a plan of reorganization term sheet on or by January 15, 2008, and a draft plan of reorganization and disclosure statement on or by January 31, 2008.

41

Chapter 11 is the principal business reorganization chapter of the Bankruptcy Code. Under Chapter 11, a debtor is authorized to continue to operate its business in the ordinary course and to reorganize its business for the benefit of its creditors. A debtor-in-possession under Chapter 11 may not engage in transactions outside of the ordinary course of business without the approval of the Bankruptcy Court, after notice and an opportunity for a hearing.

Pursuant to the Bankruptcy Code, pre-petition obligations of the debtors, including obligations under debt instruments, generally may not be enforced against the debtors. In addition, any actions to collect pre-petition indebtedness are automatically stayed unless the stay is lifted by the Bankruptcy Court.

As debtors-in-possession, the debtors have the right, subject to Bankruptcy Court approval and certain other limitations, to assume or reject executory contracts and unexpired leases. In this context, “assumption” means that the debtors agree to perform their obligations and cure all existing defaults under the contract or lease, and “rejection” means that the debtors are relieved from their obligations to perform further under the contract or lease, but are subject to a claim for damages for the breach thereof. Any damages resulting from rejection of executory contracts and unexpired leases will be treated as general unsecured claims in the Chapter 11 process unless such claims had been secured on a pre-petition basis. The Company is in the process of reviewing their executory contracts and unexpired leases to determine which, if any, they will reject. The Company cannot presently determine or reasonably estimate the ultimate liability that may result from rejecting contracts or leases or from the filing of claims for any rejected contracts or leases, and no provisions have yet been made for these items.

Since the petition date, the Company has conducted business in the ordinary course. The Company is in the process of evaluating their operations as part of the development of a plan of reorganization. After developing a plan of reorganization, the Company will seek the requisite acceptance of the plan by impaired creditors and equity holders and confirmation of the plan by the Bankruptcy Court, all in accordance with the applicable provisions of the Bankruptcy Code.

The consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States applicable to a going concern. (See Note 3 — Financial statement presentation). Except as otherwise disclosed, these principles assume that assets will be realized and liabilities will be discharged in the ordinary course of business. Since March 21, 2007, the Company has been operating as debtors-in-possession under Chapter 11 of the Bankruptcy Code, and their continuation as a going concern is contingent upon, among other things, their ability to gain approval of the plan of reorganization by the requisite parties under the Bankruptcy Code and have the plan confirmed by the Bankruptcy Court, comply with terms of loan agreements, return to profitability, generate sufficient cash flows from operations and obtain financing sources to meet future obligations. There can be no assurance that the Company will be able to achieve any of these results, which could raise substantial doubts about its ability to continue as a going concern and result in the complete liquidation of all assets for the benefit of its creditors. The consolidated financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts or the amounts and classification of liabilities that might result from the outcome of these uncertainties.

The consolidated financial statements do not reflect adjustments that may occur in accordance with AICPA Statement of Position 90-7, “Financial Reporting by Entities in Reorganization Under the Bankruptcy Code” (“SOP 90-7”), which will be adopted for financial reporting in periods ending after February 3, 2007, assuming that the Company will continue as a going concern. In the Chapter 11 proceedings, substantially all unsecured liabilities as of the petition date are subject to compromise or other treatment under a plan of reorganization which must be confirmed by the Bankruptcy Court after submission to any required vote by affected parties. For financial reporting purposes, those liabilities and obligations whose treatment and satisfaction is dependent on the outcome of the Chapter 11 proceedings will be segregated and classified as Liabilities Subject to Compromise in the consolidated balance sheet under SOP 90-7. The ultimate amount of and settlement terms for the debtors’ pre-bankruptcy liabilities are dependent on the outcome of the Chapter 11 proceedings and,

42

accordingly, are not presently determinable. Pursuant to SOP 90-7, professional fees associated with the Chapter 11 proceedings, and certain gains and losses resulting from a reorganization or restructuring of the debtors’ business will be reported separately as reorganization items. In addition, interest expense will be reported only to the extent that it will be paid during the Chapter 11 proceedings or that it is probable that it will be an allowed claim under the bankruptcy proceedings.

Note 3 — Summary of Significant Accounting Policies

Consolidated financial statements include the accounts of Hancock and its wholly owned subsidiaries. All inter-company accounts and transactions are eliminated. For fiscal year 2004, Hancock maintained its financial records on a 52-53 week fiscal year ending on the Sunday closest to January 31. In fiscal year 2005, the Company began maintaining its financial records on a 52-53 week fiscal year ending on the Saturday closest to January 31. Fiscal years 2006, 2005 and 2004, as used herein, refer to the years ended February 3, 2007, January 28, 2006, and January 30, 2005, respectively. The fiscal years 2004 and 2005 contained 52 weeks. Fiscal year 2006 contained 53 weeks.

Financial statement presentation is based on the requirements of AICPA Statement of Position 90-7, Financial Reporting by Entities in Reorganization under the Bankruptcy Code. The financial statements have been prepared on a “going concern” basis and do not include possible impacts arising from the bankruptcy proceedings initiated in March 2007 after the Company’s fiscal year end. The consolidated financial statements included elsewhere in this Report do not include certain adjustments relating to the recoverability and classification of recorded asset amounts or the amount and classification of liabilities or the effect on existing stockholders’ equity that may result from any plans, arrangements or other actions arising from the proceedings, or the possible inability of the Company to continue in existence. Adjustments necessitated by such plans, arrangements or other actions could materially change the consolidated financial statements included elsewhere in this Report.

Discontinued operations are presented and accounted for in accordance with Statement on Financial Accounting Standards (“SFAS”) No. 144, Accounting for the Impairment and Disposal of Long-Lived Assets. 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.

Our loss from discontinued operations consists of operating losses at closed stores that qualify for discontinued operations under the requirements of SFAS 144. 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

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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 Staff Accounting Bulletin No. 104, “Revenue Recognition in Financial Statements.” Sales include the sale of merchandise at the Company’s 403 retail stores and internet store, net of sales taxes collected. The Company allows customers to return merchandise under most circumstances. Sales returns were approximately $2.4 million in 2006, $2.5 million in 2005, and $1.9 million in 2004. The reserve for returns was $194,000 at February 3, 2007, and $219,000 at January 28, 2006, and is included in accrued liabilities in the accompanying consolidated balance sheet. 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. No revenue has been recorded in any of the years presented for gift card breakage, which is the remaining unredeemed balance on gift cards for which the likelihood of redemption by the customer is remote. The Company does not expect to record gift card breakage revenue until there is more certainty regarding retailers’ ability to retain such amounts in light of consumer protection and state escheatment laws.

Cost of goods sold includes merchandise, freight and handling costs.

Cash and cash equivalents include cash on hand, amounts due from banks and overnight repurchase agreements, if any, having original maturities of three months or less and are reflected as such for purposes of reporting cash flows.

Receivables include amounts due from customers for the sale of merchandise and for receivables from financial institutions for credit card payments received for the sale of merchandise. Receivables are stated net of the allowance for doubtful accounts which totaled $56,000 and $51,000 as of February 3, 2007 and January 28, 2006, respectively. The provision for doubtful accounts is included in selling, general and administrative expenses and totaled $5,000, $4,000, and $10,000 for fiscal years 2006, 2005 and 2004, respectively. 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 last-in, first-out (“LIFO”) method. The current cost of inventories exceeded the LIFO cost by $41.7 million at February 3, 2007 and $38.9 million at January 28, 2006. The LIFO reserve increased by approximately $2.8 million, and $5 million, during 2006 and 2005, respectively. Additionally, the costs related to handling and distribution 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 February 3, 2007 and January 28, 2006, inventories included such capitalized costs for handling and distribution totaling $13.3 million and $13.7 million, respectively. During fiscal 2006, 2005 and 2004, the Company included in cost of goods sold $13.5 million, $15.1 million and $15.4 million, respectively, related to handling and distribution costs, and $2.9 million, $2.4 million and $2.0 million, respectively, related to depreciation and amortization expense.

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. At February 3, 2007, and January 28, 2006, the amount of such reserves totaled $338,000 and $372,000, respectively. During April 2006, the Company modified agreements with two vendors that have and will continue to supply the majority of the Company’s pattern inventory. In connection with the new agreements, the Company recorded a charge of $8.5 million to reflect additional obligations to the vendors related to future pattern sales.

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

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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 Financial Statements.

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 annually or when events or changes in circumstances indicate impairment may have occurred. 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 Statement on Financial Accounting Standards (“SFAS”) No. 144, Accounting for the Impairment and Disposal of Long-Lived Assets. 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 from the proceeds from the estimated liquidation values of the assets. During 2006, 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, was $376,000 for stores deemed to be at least partially impaired in the first quarter and $989,000 in the fourth quarter, and the Company recorded total impairment charges of $1.1 million due to the declining operations of the related stores and the impact on expected cash flows. During 2005, 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, was $4.0 million for stores deemed to be at least partially impaired, and the Company recorded an impairment charge of $3.9 million due to the declining operations of the related stores and the impact on expected cash flows. No impairment loss was recorded in 2004. Impairment charges are included in selling, general and administrative expense in the accompanying income statement.

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. Due to declining operating results and other factors, the Company performed an evaluation of goodwill in 2006 which resulted in goodwill impairment charges of $579,000. Additional charges may be required in the future based on changes in the fair value of reporting units as determined by the goodwill impairment evaluation that is performed annually and when events arise indicating potential impairment. Prior to the implementation of SFAS 142, Goodwill and Other Intangible Assets, the Company amortized goodwill. Accordingly, goodwill is presented net of accumulated amortization of $1,239,000.

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Accounts Payable, as of February 3, 2007, includes $5 million dollars of outstanding checks in excess of cash deposits.

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.

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 other noncurrent liabilities in the consolidated balance sheet.

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 in other noncurrent assets and are amortized into rent expense over the expected life of the lease.

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.

Advertising, including production costs, is charged to expense on the first day of distribution. Advertising expense for 2006, 2005, and 2004, was $17.3 million, $16.3 million, and $17.5 million, respectively.

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. 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 (see Note 13).

Financial instruments are evaluated using the following methods and assumptions to estimate the fair value of each class of financial instruments: cash and receivables — the carrying amounts approximate fair value because of the short maturity of those instruments; long-term debt — the carrying amounts approximate fair value because of the variable interest rates. Throughout all years presented, Hancock did not have any financial derivative instruments outstanding.

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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. The Company also recognizes future tax benefits associated with tax loss and credit carry-forwards as deferred tax assets. Hancock’s 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.

Stock options, effective January 29, 2006, are accounted for under the provisions of Statement of Financial Accounting Standards No. 123(revised 2004), “Share-Based Payment” (“SFAS 123(R)”), using the modified prospective application transition method. Under this method, compensation cost is recognized, beginning January 29, 2006, based on the requirements of SFAS 123(R) for all share-based payments granted after the effective date, and based on Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”), for all awards granted to employees prior to January 29, 2006, that remain unvested on the effective date. Prior to January 29, 2006, we applied Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) and related interpretations in accounting for our employee stock benefit plans. We adopted the disclosure-only provisions of SFAS 123 and accordingly, prior to January 29, 2006, no compensation cost was recognized for stock options granted under the plans because the exercise prices for options granted were equal to the quoted market prices on the option grant dates and all option grants were to employees or directors. The Company previously reflected forfeitures of stock awards as they occurred; however, SFAS 123(R) requires estimates of forfeitures in determining the fair value of grants, which upon adoption of SFAS 123(R) at January 29, 2006, led the Company to record a cumulative effect for the accounting change totaling $487,000. Results for prior periods have not been restated for the adoption of SFAS 123(R).

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For periods prior to adoption of SFAS 123(R), SFAS 123 required us to determine pro forma net income and earnings per share as if compensation cost for our employee stock option and stock purchase plans had been determined based upon fair values at the grant date. These pro forma amounts for fiscal years 2005 and 2004 are as follows:

	2005			2004
Net earnings (loss), as reported	$	(30,251	)	$	1,694
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects		(2,283	)		(1,604	)
Pro forma net earnings (loss)	$	(32,534	)	$	90
Earnings (loss) per share:
Basic — as reported	$	(1.63	)	$	.09
Basic — pro forma	$	(1.76	)	$	.00
Diluted — as reported	$	(1.63	)	$	.09
Diluted — pro forma	$	(1.76	)	$	.00

See Note 12 to the accompanying Consolidated Financial Statements for the key assumptions utilized to determine the fair value of options.

Prior to the adoption of SFAS 123(R), restricted stock is recorded as a contra equity account for the total fair value of the shares awarded and is amortized into expense over the vesting period.

Comprehensive income and the components of accumulated comprehensive income include net earnings (loss) and the changes in minimum pension 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. 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.

Occasionally our cash deposits with financial institutions exceed federally insured amounts. As of February 3, 2007, and January 28, 2006 our cash deposits exceeded federally insured amounts by $3.1 million, and $2.1 million, respectively.

Recent Accounting Pronouncements

In December 2004, the FASB issued SFAS No. 123 (revised 2004), Share-Based Payment, which replaces SFAS No. 123, Accounting for Stock-Based Compensation, and supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees (“SFAS 123(R)”). SFAS 123(R) requires that all grants of employee stock options and other similar share-based awards be recognized in the financial statements based on their grant-date fair values. SFAS 123(R) is effective for annual periods beginning after June 15, 2005. The Company was required to apply SFAS 123(R) to all awards granted, modified or settled as of the beginning of the fiscal year beginning January 29, 2006. The Company elected to apply the modified-prospective transition method. Under the modified-prospective method, the Company must recognize compensation cost for all awards, including modifications to existing awards, subsequent to adopting the standard and for the unvested portion of previously granted awards outstanding upon adoption. At the date of adoption, the Company had a fair value

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of total unvested awards totaling $5.2 million which will be expensed over the remaining vesting period. Additionally, the Company previously reflected forfeitures of stock awards as they occurred; however, SFAS 123(R) requires estimates of forfeitures in determining the fair value of grants, which upon adoption of SFAS 123(R) the Company recorded a cumulative effect for the accounting change totaling $487,000. Upon adoption, the Company also reclassified its unearned deferred compensation on restricted stock balance totaling $3.1 million to additional-paid-in capital.

In July 2006, the FASB issued Interpretation No. 48 (“FIN 48”), Accounting for Uncertainty in Income Taxes. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with SFAS No. 109, Accounting for Income Taxes. FIN 48 prescribes a recognition threshold and measurement attributable for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosures and transitions. FIN 48 is effective for fiscal years beginning after December 15, 2006. The impact of the adoption of FIN 48 is expected to decrease beginning retained earnings by approximately $1 million.

In September 2006, the FASB issued Statement No. 157, Fair Value Measurements (“SFAS 157”), which addresses how companies should measure fair value when they are required to use a fair value measure for recognition or disclosure purposes under accounting principles generally accepted in the United States of America. Under SFAS 157, there is now a common definition of fair value to be used throughout accounting principles, which is expected to make the measurement of fair value more consistent and comparable. The Company must adopt SFAS 157 in fiscal 2008, but has not yet begun to evaluate the effects, if any, of adoption on Hancock’s consolidated financial statements.

In September 2006, the FASB issued Statement No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans — An Amendment of FASB Statements No. 87, 88, 106, and 132R (“SFAS 158”). SFAS 158 requires a plan sponsor to (a) recognize in its statement of financial position an asset for a plan’s overfunded status or a liability for a plan’s underfunded status; (b) measure a plan’s assets and its obligations that determine its funded status as of the end of the employer’s fiscal year; and (c) recognize changes in the funded status of a defined benefit postretirement plan in the year in which the changes occur. Such changes will be reported in comprehensive income. The requirement to recognize the funded status of a benefit plan and the disclosure requirements were effective for the Company as of the end of its fiscal year ended February 3, 2007. The Company sponsors a fully-funded defined benefit pension plan, SERP, and an unfunded postretirement health and life plan (“OPEB”). Information relating to the defined benefit pension and postretirement health and life plans are provided in Note 12 to the accompanying Consolidated Financial Statements. The requirement to measure plan assets and benefit obligations as of the date of the employer’s fiscal year end statement of financial position is effective for fiscal years ending after December 15, 2008. The Company currently measures plan assets and benefit obligations at December 31 each year. As such, the Company will be required to perform the measurements as of the end of each fiscal year, but does not believe the change will have a material impact on the reported amounts.

In June 2006, the Emerging Issues Task Force (“EITF”) reached a consensus on Issue No. 06-03, How Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (“EITF 06-03”). EITF 06-03 concluded that the presentation of taxes assessed by a governmental authority that is directly imposed on a revenue producing transaction between a seller and a customer, such as sales, use, value added and certain excise taxes is an accounting policy decision that should be disclosed in a company’s financial statements. Additionally, companies that record such taxes on a gross basis should disclose the amounts of those taxes in interim and annual financial statements for each period for which an income statement is presented if those amounts are significant. EITF 06-03 is effective for the Company’s 2007 fiscal year. Hancock does not expect this statement to have a material impact on its consolidated financial statements.

In October 2006, the SEC issued Staff Accounting Bulletin (‘SAB”) No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements. SAB 108 provides guidance to registrants in evaluating and quantifying financial statement misstatements. SAB 108 became

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effective for the Company as of February 3, 2007, and did not have a significant impact on the Company’s financial position or results from operations, either by restating previously issued financial statements or by adjusting retained earnings as of the beginning of fiscal 2006. The Company does not believe the implementation of the guidance in SAB 108 will have a material impact on the Company’s financial statements.

In February 2007, the Financial Accounting Standards Board issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities—Including an Amendment of FASB Statement No. 115, (“SFAS No. 159”). SFAS No. 159 allows companies the choice to measure many financial instruments and certain other items at fair value. This gives a company the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. SFAS No. 159 is effective for fiscal years beginning after November 15, 2007. We are currently reviewing the impact of SFAS No. 159 on our Consolidated Financial Statements and expect to complete this evaluation in 2007.

Several other new accounting standards became effective during the periods presented or will be effective subsequent to February 3, 2007. None of these new standards had or is expected to have a significant impact on Hancock’s consolidated financial statements.

Note 4 — Discontinued Operations and Related Subsequent Events

During 2006 the Company closed 44 stores, of which 26 qualified for discontinued operations treatment in accordance with the provisions SFAS 144. Certain stores did not qualify for discontinued operations treatment due to portions of the related cash flows migrating to other existing stores. Accordingly, the results of operations for the 26 stores are presented separately in the accompanying statement of operations for all periods presented. Significant components of our results of discontinued operations consisted of the following for the years presented:

Discontinued Operations

									Per Common Share
						Net Earnings			Net Earnings*
	Sales		Gross Profit			(Loss)			Basic			Diluted
2006
First Quarter	$	5,084	$	2,274		$	(563	)	$	(0.03	)	$	(0.03	)
Second Quarter		6,484		1,039			(2,410	)		(0.13	)		(0.13	)
Third Quarter		607		(170	)		(801	)		(0.04	)		(0.04	)
Fourth Quarter		135		(26	)		(169	)		(0.01	)		(0.01	)
	$	12,310	$	3,117		$	(3,943	)	$	(0.21	)	$	(0.21	)
2005
First Quarter	$	3,533	$	1,668		$	(527	)	$	(0.03	)	$	(0.03	)
Second Quarter		2,925		1,336			(726	)		(0.04	)		(0.04	)
Third Quarter		3,739		1,832			(353	)		(0.02	)		(0.02	)
Fourth Quarter		4,288		1,549			(762	)		(0.04	)		(0.04	)
	$	14,485	$	6,385		$	(2,368	)	$	(0.13	)	$	(0.13	)
2004	$	16,012	$	7,810		$	(490	)	$	(0.03	)	$	(0.03	)

* Per share amounts are based on average shares outstanding during each quarter and may not add to the total for the year

In the first quarter of 2007, the Company announced plans to close an additional 134 stores. These stores represent approximately $93 million in annual sales and approximately $6.5 million in operating losses. The

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inventories in the stores identified for closing were liquidated through major sale events in the weeks preceding the closings. Many of these stores have lease commitments that extend past 2007, and it is expected that the continuing occupancy costs for periods beyond the projected closing dates will total $3.7 million.

Note 5 — Property and Equipment (in thousands)

Property and Equipment consists of the following:

	2006			2005
Buildings and improvements	$	28,356		$	26,551
Leasehold improvements		5,779			6,072
Fixtures and equipment		67,377			70,941
Assets held for sale		417			715
		101,929			104,279
Accumulated depreciation and amortization		(54,248	)		(51,693	)
		47,681			52,586
Land		3,362			3,362
Total property and equipment, at depreciated cost	$	51,043		$	55,948

The Company recorded $4.4 million, $5.3 million, and $4.6 million of depreciation expense for the years ended February 3, 2007, January 28, 2006, and January 30, 2005, respectively. The sale of the Company’s former distribution center previously classified as held for sale was completed during January 2006 with no material gain or loss. In addition, the Company completed lease financing transactions for four properties during 2005 with a net book value of $4.1 million. Due to the Company’s continuing involvement, the Company has reflected the proceeds received as long-term lease financing obligations. The transaction also resulted in a potential gain that, subject to the Company’s continued involvement in the property, will be recognized in fiscal 2020. Future minimum lease obligations relating to these transactions are included in Note 7 below.

Note 6 — Accrued Liabilities (in thousands)

Accrued liabilities consist of the following:

	2006		2005
Payroll and benefits	$	3,546	$	3,943
Property taxes		3,797		4,342
Deferred credit on consigned inventory		3,241		—
Workers’ compensation and deferred compensation		1,994		3,215
Medical claims, customer liability claims and property claims		2,268		2,560
Accrued accounting, legal, and professional		1,426		503
Sales taxes		1,688		1,577
Gift card liability		1,079		1,002
Current portion of reserve for store closings (Note 14)		1,388		604
Other		2,233		2,277
	$	22,660	$	20,023

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Note 7 — Long-Term Debt Obligations

On June 29, 2005, the Company entered into the Credit Facility with Wachovia Bank and other lenders. The Credit Facility replaced the Company’s previously existing revolving credit agreements with a group of banks which the Company terminated on June 29, 2005.

The Credit Facility is a five-year $110 million commitment, although there are minimum levels of availability that must be maintained which have the effect of limiting the amount that can be borrowed to less than $110 million. The level of borrowings is subject to a borrowing base as defined in the agreement. This agreement provides for an unused line fee, ranging from .25% to .35% depending upon excess availability. The Company has the option of selecting either a “prime rate” or Eurodollar loan. Advances under the Credit Facility will accrue interest either at the Applicable Margin (as defined in the Loan and Security Agreement) plus the higher of (i) the rate of interest periodically announced by Wachovia as its “prime rate”, or (ii) the federal funds effective rate from time to time plus 0.50% or at the Applicable Margin plus the Adjusted Eurodollar Rate (which is a rate derived from the London Interbank Offered Rate). Most borrowings under the Credit Facility are made at the Applicable Margin plus the Adjusted Eurodollar Rate and are outstanding for 30 day periods. At February 3, 2007 and January 28, 2006, Hancock had outstanding borrowings of approximately $59.6 million and $51 million, respectively under the Credit Facility. The estimated weighted average interest rates under the Credit Facility for the years ended February 3, 2007 and January 28, 2006 was approximately 7.1% and 5.9%, respectively.

The Credit Facility is collateralized by a first priority perfected collateral interest in and liens upon all of the Company’s present and future assets. The Credit Facility also contemplates the issuance of letters of credit aggregating up to $25 million, provided that all borrowings under the Credit Facility do not exceed $110 million.

The Credit Facility contains several covenants, including but not limited to, timely filing of financial statements and limitations on liens, additional indebtedness, sale of assets, investments/acquisitions, loans, and the payment of dividends. In addition, there is a financial covenant that requires the Company to maintain at least $25 million of excess availability, as defined. In March of 2007, the Company received a notice of default (as of February 28, 2007) due to the delay in filing its quarterly financial statements and due to the Company’s inability to comply with the financial covenant requiring the Company to have at least $25 million of excess availability.

As previously discussed, in March 2007, the Company filed voluntary petition for reorganization under Chapter 11 of the United States Bankruptcy Code. On March 22, 2007, the Company received approval of the Court of a $105 million “debtor-in-possession” financing arrangement (the “Senior Secured Revolving Credit Facility” or “DIP Credit Facility”) with Wachovia Bank, N.A.. This financing arrangement effectively amended the above Credit Facility. The DIP Credit Facility calls for a maximum $105,000,000 maximum credit. Similar to the previous Credit Facility, there are minimum levels of availability that must be maintained which have the effect of limiting the amount that can be borrowed to less than $105 million. Also, the level of borrowings is subject to a borrowing base as defined in the agreement. The borrowing base is mainly reliant on certain portions of the Company’s credit card receivables, inventory, and real property. The DIP Credit Facility is collateralized by a first priority perfected collateral interest in and liens upon all of the Company’s present and future assets. Also similar to the replaced Credit Facility, the DIP Credit Facility may be used for letters of credit up to an aggregate amount of $25,000,000. This agreement provides for an unused line fee of .25% to .35%. The Company may elect that the loans under the DIP Credit Facility bear interest at a rate of the Adjusted Eurodollar Rate plus 1.75% or Prime plus 0.25%, as such terms are defined in the agreement. Upon default the interest rate would be increased by 2% above the highest pre-default rate.

The DIP Credit Facility is for a term ending on the earliest of: 1) two years following the closing of the DIP Credit Facility (two years from March 22, 2007 or March 22, 2009), 2) confirmation of the Company’s plan of reorganization, or 3) the last termination date set forth in the Company’s interim financing orders related to bankruptcy, unless the Company’s permanent financing order has been entered prior to such date.

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The DIP Credit Facility contains several covenants, including but not limited to limitations on liens, additional indebtedness, sale of assets, investments/acquisitions, loans, and the payment of dividends. Under the DIP Credit Facility the Company is currently required to maintain at least $15 million of excess availability, as defined. The Company is currently in compliance with covenants under the DIP Credit Facility. However, future violations of the covenants are possible and would permit the lenders to restrict the Company’s ability to borrow or initiate letters of credit, and require immediate repayment of amounts outstanding.

At February 3, 2007 and January 28, 2006, Hancock had commitments under the above Credit Facility of $6.1 million and $3.0 million, respectively under documentary and standby letters of credit which support purchase orders for merchandise. Hancock also has a standby letter of credit to guarantee payment of potential future workers’ compensation claims. This letter of credit amounted to $5.5 million as of February 3, 2007 and January 28, 2006.

Also on June 15, 2007, the Company reached a definitive agreement (the “Loan Agreement”) with another lender for an additional loan of up to $17.5 million.

The Loan Agreement provides for a term loan facility in the aggregate principal amount of up to $17,500,000. The Company intends to use the proceeds of the loans made under the Loan Agreement for general working capital purposes and to pay fees and expenses related to the Loan Agreement.

The Borrowers’ obligations under the Loan Agreement are collateralized by substantially all of their real, personal, tangible and intangible assets (whether owned as of the date of the Loan Agreement or subsequently acquired or existing), including, without limitation, (a) accounts; (b) general intangibles (including intellectual property); (c) goods (including inventory and equipment); (d) real property and fixtures; (e) chattel paper (including tangible and electronic chattel paper); (f) instruments (including promissory notes); (g) documents; (h) deposit accounts; (i) letters of credit, banker’s acceptances and similar instruments; (j) supporting obligations and present and future liens, security interests, rights, remedies, title and interest in, to and in respect of receivables; (k) investment property (including securities, securities accounts, security entitlements, commodity contracts or commodity accounts); (l) monies, credit balances, deposits and other property of any Borrower or Guarantor now or hereafter held or received by or in transit to Agent or any Lender (or its affiliates) at any other depository or other institution; (m) commercial tort claims; (n) receivables (to the extent not previously described above); (o) leasehold real property interests existing as of March 22, 2007 (excluding fixtures and subject to certain limitations); and (p) all records.

The Loan Agreement contains terms and conditions customary for financing arrangements of this nature. The replacement term loan facility will mature on the earlier to occur of (a) June 15, 2009, (b) the confirmation of a plan of reorganization for Borrowers and Guarantors in the previously disclosed Chapter 11 cases of Borrowers and Guarantors (which are being administered under the Chapter 11 of the United States Bankruptcy Code in the United States Bankruptcy Court for the District of Delaware), or (c) the last termination date set forth in the Permanent Financing Order (as defined in the Loan Agreement).

Certain borrowings under the Loan Agreement (“Prime Rate Loans”) will bear interest at a rate equal to two (2%) percent per annum in excess of the greater of (a) 8.25%, (b) the rate from time to time publicly announced by JPMorgan Chase Bank in New York, New York, or its successors, as its prime rate, whether or not such announced rate is the best rate available at such bank or (c) the federal funds rate as published by the Federal Reserve Bank of New York in effect on such day plus one-half (1/2%) percent. Other borrowings under the Loan Agreement (“Eurodollar Rate Loans”) will bear interest at a rate equal to five (5%) percent per annum in excess of rate per annum determined by dividing (a) the rate of interest per annum appearing on Reuters Screen LIBOR Page as the London interbank offered rate for deposits in dollars at approximately 11:00 a.m. (London time) two business days prior to the first day of the applicable interest period by (b) a percentage equal to: (i) one (1) minus (ii) the percentage which is in effect from time to time under Regulation D of the Board of Governors of the Federal Reserve System as the maximum reserve requirement applicable with respect to Euro-denominated liabilities, provided that such rate shall not be less than 5.25%. Agent may, at its option or at

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the direction of the requisite number of Lenders, increase the interest rates to the rate of five (5%) percent per annum in excess of the applicable rate for Prime Rate Loans and the rate of eight (8%) percent per annum in excess of the applicable rate for Eurodollar Rate Loans in certain circumstances.

The representations, covenants and events of default in the Loan Agreement are customary for financing transactions of this nature. Certain mandatory prepayments of the term loan facility will be required upon the occurrence of specified events, including upon the sale of certain assets. Events of default in the Loan Agreement include, among others, (a) the failure to pay when due the obligations owing under the credit facilities; (b) the failure to perform (and not timely remedy, if applicable) certain covenants; (c) the revocation or purported revocation of the obligations of a Guarantor; (d) the occurrence of certain bankruptcy or insolvency events; (e) certain judgments against the Borrowers; (f) any representation or warranty made by the Borrowers subsequently proven to have been false or misleading in any material respect; (g) certain cross default events and (h) the occurrence of a Change in Control (as defined in the Loan Agreement). Upon the occurrence of an event of default, the lenders may terminate the loan commitments, accelerate all loans and exercise any of their rights under the Loan Agreement and the ancillary loan documents as a secured party.

Note 8 — Long-Term Leases

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

Rent expense consists of the following (in thousands):

	2006			2005			2004
Minimum rent	$	31,716		$	32,061		$	30,687
Common area maintenance		3,369			3,291			3,043
Stepped rent adjustment		(437	)		(439	)		(268	)
Equipment leases		625			689			599
	$	35,273		$	35,602		$	34,061
Additional rent based on sales	$	79		$	126		$	183
Taxes	$	5,742		$	6,133		$	5,336
Insurance	$	588		$	532		$	520

The amounts shown in the minimum rental table below (in thousands) 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.

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Future minimum rental payments under all operating and capital leases as of February 3, 2007 are as follows:

	Operating Leases
			Sublease			Capital
Fiscal Year	Payments		Rentals			Leases
2007		30,256		(1,116	)	$	680
2008		25,930		(644	)		680
2009		20,689		(462	)		680
2010		16,958		(356	)		680
2011		14,457		(160	)		684
Thereafter		31,600		(54	)		8,143
Total minimum lease payments (income)	$	139,890	$	(2,792	)		11,547
Less imputed interest							(5,661	)
Present value of capital lease obligations							5,886
Less current portion							(120	)
Long-term capital lease obligations						$	5,766

Assets held under capital leases amounted to $5.8 million and $4.1 as of February 3, 2007 and January 28, 2006. Related depreciation expense amounted to $205,000 and $35,000 for the years ended February 3, 2007 and January 28, 2006, respectively.

Note 9 — Income Taxes (in thousands)

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

	2006			2005			2004
Currently refundable
Federal	$	(2,989	)	$	(7,239	)	$	(2,030	)
State		—			—			(132	)
Total currently refundable	$	(2,989	)	$	(7,239	)	$	(2,162	)
Deferred
Current
Federal		364			1,307			1,020
State		21			103			59
Total Current		385			1,410			1,079
Noncurrent
Federal		(243	)		4,858			1,937
State		(1,007	)		282			113
Total Noncurrent		(1,250	)		5,140			2,050
Total Deferred	$	(865	)*	$	6,550		$	3,129
Continuing operations expense (benefit)		(3,854	)		(689	)		1,245
Discontinued operations (benefit)		—			—			(278	)
	$	(3,854	)	$	(689	)	$	967
Total Federal Deferred		121			6,165			2,957
Total State Deferred		(986	)		385			172

* Includes current year adjustment for valuation allowance related to stock compensation expense of $403 thousand.

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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 (liabilities) are comprised of the following (in thousands):

	2006			2005
Current:
Deferred tax assets:
Other employee benefit costs	$	648		$	881
Insurance reserves		1,253			1,464
Deferred compensation		96			69
Store closing costs		504			286
Leases		176			47
Other		211			168
Valuation allowance established through statement of operations		(5,283	)		(2,397	)
		(2,395	)		518
Deferred tax liabilities — inventory valuation methods		(3,878	)		(6,407	)
Net current deferred tax liabilities		(6,273	)		(5,889	)
Noncurrent:
Deferred tax assets:
Other employee benefit costs		370			396
Insurance reserves		726			688
Postretirement benefits other than pensions		7,970			8,302
Deferred compensation		2,253			2,397
Pension liabilities		2,950			3,314
Valuation allowances established through other comprehensive loss		(4,928	)		(1,520	)
Store closing costs		173			142
NOL carryforward		14,877			3,117
NOL carryforward valuation allowance — state		(14,877	)		(1,370	)
Fixed asset impairment		284			1,353
Other		278			236
Valuation allowances established through statement of operations		(1,021	)		(7,372	)
		9,055			9,683
Deferred tax liabilities:
Accelerated depreciation		(1,898	)		(3,314	)
Lease accounting		(493	)		(480	)
Goodwill amortization		(391	)		(462	)
		(2,782	)		(4,256	)
Net noncurrent deferred tax assets		6,273			5,427
Net deferred tax asset (liability)	$	—		$	(462	)

During 2006, the Company created net operating loss carryforwards for federal income tax purposes totaling $39.2 million which will expire in 2021. Additionally, the Company has net operating losses for state income tax purposes totaling $87.9 million which expire in various periods through 2026.

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

	2006			2005			2004
Statutory federal income tax rate (benefit)		(35.0	)%		(35.0	)%		35.0	%
State income taxes, net of federal income tax effect		(1.3	)		(1.3	)		1.3
Refund adjustment		(6.5	)		—			—
Other permanent differences		0.2			—			—
Valuation allowance		34.1			33.1			—
Other		0.2			0.8			—
Effective tax rate (benefit)		(8.3	)%		(2.4	)%		36.30	%

The Company determined that the net deferred tax assets were not “more likely than not” to be realized and recorded a valuation allowance in the statement of operations totaling 14.2 million and $10.3 million in 2006 and 2005 respectively, and valuation allowances relating to long-term minimum pension liabilities of $3.4 million and $1.5 in 2006 and 2005, respectively, through other comprehensive income (loss).

Note 10 — Other Liabilities (in thousands)

Other Liabilities consisted of the following:

	2006		2005
Long-term workers’ compensation and deferred compensation	$	6,235	$	6,203
Long-term stepped rent accrual		2,345		2,481
Deferred fixed cost liability		640		—
Unapplied rent credit		629		716
Reserve for store closing		476		575
Asset retirement obligations		476		523
Other		36		47
	$	10,837	$	10,545

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.

Common Stock Purchase Rights. Hancock has entered into a Common Stock Purchase Rights Agreement, as amended (the “Rights Agreement”), with Continental Stock Transfer & Trust Company as Rights Agent. The Rights Agreement, in certain circumstances, would permit shareholders to purchase common stock at prices which would be substantially below market value. These circumstances include the earlier of (i) the tenth day after an announcement that a person or group has acquired beneficial ownership of 20% or more of Hancock’s shares, with certain exceptions such as a tender offer that is approved by a majority of Hancock’s Board of Directors, or (ii) the tenth day, or such later date as set by Hancock’s Board of Directors, after a person or group commences, or announces its intention to commence, a tender or exchange offer, the consummation of which would result in beneficial ownership of 30% or more of Hancock’s shares. The Rights Agreement was amended on December 9, 2005, to include a three-year independent director evaluation provision (the “TIDE Provision”). The TIDE provision requires an independent committee of the Company’s Board of Directors to review the Rights Agreement every three years and evaluate whether the Rights Agreement still is in the best interest of the Company and its shareholders.

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Stock Repurchase Plan. In prior years and continuing in fiscal 2006, Hancock has repurchased approximately 13 million shares. As of February 3, 2007, 243,647 shares are available for repurchase under the most recent authorization.

In 2005, Hancock adopted the 2005 Stock Compensation Plan for Non-Employee Directors (the “2005 Plan”) which allows eligible directors to elect to receive all or a portion of their quarterly director fee in shares of common stock. The 2005 Plan, which will expire on June 30, 2010, unless sooner terminated by the Board, authorized the issuance of up to 100,000 shares of common stock which may be authorized and unissued on shares reacquired and not reserved for any other purpose.

Note 12 — Employee Benefit Plans

The Company’s stock based compensation consists of compensation for stock options and restricted stock. Total cost for stock based compensation included in net income was $2.5, $.8, and $2.4 million for 2006, 2005, and 2004, respectively.

Stock Options. In 1996, Hancock adopted the 1996 Stock Option Plan (the “1996 Plan”) which authorized the granting of options to employees for up to 2,000,000 shares of common stock at an exercise price of no less than 50% of fair market value on the date the options are granted. The exercise price of all options granted under this Plan has equaled the fair market value on the grant dates. The employee stock options granted under the 1996 Plan vest ratably over a period of not less than two years and expire ten years after the date of grant. The 1996 Plan expired on September 30, 2001, and a preceding plan, the 1987 Stock Option Plan expired on March 22, 1997. Both plans prohibit grants after the expiration date.

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, with no more than 1,000,000 of those shares being allocated to restricted stock. In 2005, the 2001 Plan was amended to increase the aggregate number of shares authorized for issuance by 350,000 shares, all of which may be issued as restricted stock. Under the 2001 Plan, as amended, the total shares available for issuance is 3,150,000. The 2001 Plan also provides for the granting of options to directors as specified in the plan document. The options granted under the 2001 Plan can have an exercise price of no less than 100% of fair market value on the date the options are granted. Options and restricted stock issued under the 2001 Plan can vest no sooner than 25% per year, and options expire ten years after the date of grant. As of February 3, 2007, a total of 986,850 shares remain available for grant under the 2001 Plan, including 470,100 shares which can be issued as restricted stock.

In 2004, Hancock adopted the 2004 Special Stock Plan (the “2004 Plan”) which authorizes the granting of options or restricted stock to key employees and directors for up to 200,000 shares of common stock in total, with no more than 100,000 of those shares being allocated to restricted stock. The options granted under the 2004 Plan can have an exercise price of no less than 100% of fair market value on the date the options are granted. Options and restricted stock issued under the 2004 Plan can vest no sooner than 25% per year, and options expire ten years after the date of grant. As of February 3, 2007, all of the shares available in the 2004 Plan had been issued upon the hiring of the Company’s Chief Executive Officer.

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A summary of stock option activity in the plans for the years ended February 3, 2007, January 28, 2006 and January 30, 2005 follows:

	2006					2005					2004
				Weighted					Weighted					Weighted
				Average					Average					Average
				Exercise					Exercise					Exercise
	Options			Price		Options			Price		Options			Price
Outstanding at beginning of year		1,959,475		$	12.21		2,436,125		$	12.37		2,208,625		$	12.13
Granted		126,000		$	3.63		13,500		$	5.77		568,200		$	11.71
Canceled		(290,200	)	$	11.93		(485,275	)	$	12.88		(114,875	)	$	14.03
Exercised		—		$	—		(4,875	)	$	5.00		(225,825	)	$	7.53
Outstanding at end of year		1,795,275		$	11.65		1,959,475		$	12.21		2,436,125		$	12.37
Exercisable at end of year		1,394,025		$	12.25		1,361,775		$	11.69		1,339,400		$	11.48

The weighted average remaining contractual life of all outstanding options was 5.31 years at February 3, 2007.

The weighted average grant-date fair value of options granted during 2006, 2005 and 2004 was $1.91, $2.07 and $4.41, 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 2006, 2005 and 2004, respectively: dividend yields of 0%, 2.82% and 2.76%; average expected volatility of .47, .48 and .49; risk-free interest rates of 4.77%, 4.08% and 3.80%; and an average expected life of 6.25 years in 2006 and 4.5 years in each of the other two years.

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 Staff Accounting Bulletin 107. Options granted have a maximum term of ten years. 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 forfeiture rate will decrease compensation expense.

A summary of the outstanding and exercisable options as of February 3, 2007 follows:

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	Options Outstanding						Options Exercisable
			Weighted		Weighted				Weighted
	Number		Average		Average		Number		Average
Range of	Outstanding		Remaining		Exercise		Exercisable		Exercise
Exercise Prices	at 2/3/07		Life (Years)		Price		2/3/2007		Price
$3.025 to $4.25		235,225		6.51	$	3.92		109,225	$	4.25
$5.72 to $6.43		78,100		3.38		5.81		67,975		5.81
$7.50 to $7.50		232,750		4.36		7.50		232,750		7.50
$9.44 to $9.44		100,000		7.86		9.44		50,000		9.44
$12.20 to $12.20		324,100		7.35		12.20		177,550		12.20
$12.22 to $13.125		257,000		1.03		12.89		252,000		12.90
$14.25 to $15.05		11,200		1.47		14.36		11,200		14.36
$15.34 to $15.34		1,000		5.84		15.34		1,000		15.34
$15.84 to $15.84		285,400		6.35		15.84		221,825		15.84
$18.09 to $18.09		270,500		5.36		18.09		270,500		18.09
$3.025 to $18.09		1,795,275		5.31		11.65		1,394,025		12.25

Restricted Stock. On December 6, 1995, Hancock adopted the 1995 Restricted Stock Plan to provide for the issuance of restricted stock awards to employees. The aggregate number of shares that may be issued or reserved for issuance pursuant to the 1995 Restricted Stock Plan shall not exceed one million shares. The 2001 Stock Incentive Plan, as amended, and the 2004 Special Stock Plan authorized the granting of up to 1,450,000 shares of restricted stock. During 2006, 2005 and 2004, restricted shares totaling 148,500, 137,000 and 251,500, respectively, were issued to officers and key employees under the Plans. Compensation expense related to restricted shares issued is recognized over the period for which restrictions apply.

A summary of the status of the Entity’s nonvested restricted shares as of February 3, 2007, and changes during the year ended February 3, 2007, is presented below:

				Weighted-
				Average
				Grant-Date
Nonvested Shares	Shares			Fair Value
Nonvested Shares at January 28, 2006		564,950		$	10.73
Granted		148,500			3.65
Vested		(173,250	)		9.65
Forfeited		(54,300	)		10.18
Nonvested Shares at February 3, 2007		485,900			10.84

As of February 3, 2007, there was $2.5 million of total unrecognized compensation cost related to nonvested share-based compensation arrangements granted under the Plans. That cost is expected to be recognized over a weighted-average period of 2.0 years. The total fair value of shares vested during the years ended February 3, 2007, was $559,000.

Defined Benefit Plans

Effective February 3, 2007, the Company began recognizing the funded status of its defined benefit plans in accordance with SFAS No. 158. SFAS No. 158 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 in stockholders’ equity. Prior to February 3, 2007, the Company had accounted for its defined benefit plans

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according to the provisions of SFAS No. 106, Employers’ Accounting for Postretirement Benefits Other than Pensions and SFAS No. 87, Employer’s Accounting for Pensions.

The following table summarizes the effects from the adoption of SFAS No. 158 on the Company’s Consolidated Balance Sheet at February 3, 2007.

							After
	Before						Application
	Application of						of Statement
	Statement 158			Adjustments			158
Liability for pension and other postretirement benefits	$	27,935		$	(10,649	)	$	17,286
Deferred income taxes		N/A			N/A			N/A
Total liabilities	$	170,404		$	(10,649	)	$	159,755
Accumulated other comprehensive income	$	(7,851	)	$	10,649		$	2,798
Total shareholder’s equity	$	41,813		$	10,649		$	52,462

Retirement Plans. Hancock maintains a noncontributory qualified defined benefit retirement plan and an unfunded nonqualified Supplemental Retirement Benefit Plan (“SERP”) that affords certain benefits that cannot be provided by the qualified plan. Together, these plans provide eligible full-time employees with pension and disability benefits based primarily on years of service and employee compensation. Hancock uses a December 31^st measurement date for its retirement plans.

During 2004, employees under the age of 40 were transitioned from the defined benefit plan into the 401(k) Plan and employees age 40 or older were given a choice between continuing to accrue pension benefits or participating in the 401(k) Plan. Employees who are not eligible or chose not to participate in the defined benefit plan receive an annual 401(k) contribution of 3% and a match of employee contributions up to 2%. Full-time employees hired after December 31, 2004, are eligible only for the 401(k) Plan. During 2006, the Company recognized $1.1 million of expense for its 401(k) contribution and match. The net effect of this change resulted in a reduction in defined benefit obligations.

Changes in Projected Benefit Obligation and Fair Value of Plan Assets (in thousands)

	Retirement Plan						SERP
	2006			2005			2006			2005
Change in benefit obligation
Benefit obligation at beginning of year	$	75,172		$	69,350		$	1,133		$	1,105
Service cost		2,310			2,486			11			21
Interest cost		4,104			4,053			57			62
Benefits paid		(3,345	)		(3,900	)		(50	)		(59	)
Plan amendments		6			—			(9	)		—
Actuarial loss (gain)		(3,386	)		3,183			(111	)		4
Benefit obligation at end of year	$	74,861		$	75,172		$	1,031		$	1,133
Change in plan assets
Fair value of plan assets at beginning of year	$	64,671		$	65,780
Actual return on plan assets		6,449			2,791
Employer contributions		—			—
Benefits paid		(3,345	)		(3,900	)
Fair value of plan assets at end of year	$	67,775		$	64,671

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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
	2006			2005			2006			2005
Funded status	$	(7,095	)	$	(10,501	)	$	(1,031	)	$	(1,133	)
Unrecognized net actuarial loss		N/A			21,680			N/A			364
Unrecognized prior service cost		N/A			(977	)		N/A			—
Net amount recognized		(7,095	)	$	10,202		$	(1,031	)	$	(769	)

Minimum Pension Liability

In accordance with SFAS No. 87, Employers’ Accounting for Pensions, a minimum pension liability was required in 2006 and 2005 as the accumulated benefit obligation exceeded the fair value of pension plan assets for both plans as of the measurement date. The liability, totaling $15,215,000 and $18,562,000 at February 3, 2007, and January 28, 2006, respectively, was recorded as Accumulated Other Comprehensive Loss and, because such entry had no cash impact, it is not reflected in the consolidated statement of cash flows.

Components of Net Periodic Benefit Cost (in thousands)

	Retirement Plan									SERP
	2006			2005			2004			2006		2005		2004
Service cost	$	2,310		$	2,486		$	2,967		$	11	$	21	$	24
Interest cost		4,104			4,053			3,963			58		62		63
Expected return on plan assets		(5,361	)		(5,633	)		(5,424	)		—		—		—
Transition obligation/(asset)		—			—			—			—		—		—
Amortization of prior service cost		(98	)		(98	)		70			—		—		4
Amortization of net loss		1,356			862			789			24		25		38
Curtailment expense		—			—			42			—		—		—
Net periodic benefit cost	$	2,311		$	1,670		$	2,407		$	93	$	108	$	129

Accumulated Benefit Obligation

The accumulated benefit obligation for the retirement plan was $72,767,000 and $72,781,000 at the measurement dates of December 31, 2006 and 2005, respectively. The accumulated benefit obligation for the SERP was $987,000 and $1,019,000 at December 31, 2006 and 2005, respectively.

Assumptions

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

	2006			2005
Discount rate		5.90	%		5.60	%
Rate of increase in compensation levels		4.00	%		4.00	%

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

	2006			2005			2004
Discount rate		5.60	%		6.00	%		6.25	%
Rate of increase in compensation levels		4.00	%		4.00	%		4.00	%
Expected long-term rate of return on assets		8.50	%		8.75	%		8.75	%

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:

	Percentage of Plan
	Assets
	February 3,			January 28,			Target
Asset Category	2007			2006			Allocation
Equity securities		65.9	%		66.1	%		65	%
Fixed income securities		34.1	%		33.9	%		35	%
		100.0	%		100.0	%		100.0	%

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.

Contributions

Hancock does not presently anticipate making any contributions to the retirement plan during 2007. Contributions to the SERP are made as benefits are paid.

Estimated Future Benefit Payments (in thousands)

	Retirement
	Plan		SERP
2007		3,569		75
2008		3,714		75
2009		3,906		75
2010		4,069		75
2011		4,215		75
Years 2012 Through 2016		24,235		373

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Postretirement Benefit Plan. Hancock maintains a postretirement medical/dental/life insurance plan for all full-time employees and retirees hired before January 1, 2003. Eligibility for the plan is limited to employees completing 15 years of credited service while being eligible for the Company’s employee medical benefit program. The Company currently contributes to the plan as benefits are paid. Hancock uses a December 31^st measurement date for its postretirement benefit plan.

On December 9, 2003, the “Medicare Prescription Drug, Improvement and Modernization Act of 2003” (the Act) was signed into law. The Act introduces a prescription drug benefit under Medicare, as well as a federal subsidy to sponsors of retiree health benefit plans that provide prescription drug benefits that are at least actuarially equivalent to Medicare’s prescription drug benefits. During the third quarter of 2004, Hancock adopted FASB Staff Position No. 106-2, Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003, and determined that the Company’s prescription drug coverage for retirees was at least actuarially equivalent to the Medicare coverage provided under the Act. The Company elected to adopt the provisions of FSP No. 106-2 prospectively. The reduction in Hancock’s accumulated postretirement benefit obligation related to the subsidy was $3.3 million and the Company recognized a reduction in net periodic postretirement benefit cost of approximately $300,000 for the fiscal year ended January 30, 2005. During 2005, the Company decided to amend its plan to eliminate prescription drug coverage for all current and future retirees who are eligible for Medicare coverage. The reduction in the benefit obligation related to this amendment totaled $10.2 million, which will be amortized as a reduction of expense over the next eleven years, (the average remaining service period of active plan participants.)

Changes in Accumulated Postretirement Benefit Obligation (in thousands)

	2006			2005
Change in benefit obligation
Benefit obligation at beginning of year	$	9,261		$	16,226
Service cost		309			600
Interest cost		496			937
Benefits paid		(607	)		(861	)
Plan amendments		—			(10,208	)
Actuarial (gain) loss		(515	)		2,567
Plan participant contributions		216			—
Benefit obligation at end of year	$	9,160		$	9,261

Funded Status

The Company currently contributes to the plan as benefits are paid. 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):

	2006			2005
Funded status	$	(9,160	)	$	(9,261	)
Unrecognized prior service benefit		N/A			(11,475	)
Unrecognized net actuarial gain		N/A			(2,136	)
Net amount recognized	$	(9,160	)	$	(22,872	)

Components of Net Periodic Benefit Cost (in thousands)

	2006			2005			2004
Service costs	$	309		$	600		$	574
Interest costs		496			937			904
Amortization of prior service cost		(1,178	)		(405	)		(250	)
Amortization of net actuaurual (gain)/loss		(151	)		(156	)		(369	)
Net periodic postretirement costs	$	(524	)	$	976		$	859

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Assumptions

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

	2006			2005
Discount rate		5.90	%		5.60	%
Rate of increase in compensation levels		4.00	%		4.00	%

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

	2006			2005			2004
Discount rate		5.60	%		6.00	%		6.25	%
Expected return on plan assets		8.50	%		N/A			N/A
Rate of increase in compensation levels		4.00	%		4.00	%		4.00	%

Assumed Health Care Cost Trend Rates

	2006						2005
	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		9.00	%		8.00	%		9.00	%		8.00	%
Rate that the cost trend rate gradually declines to		4.75	%		4.75	%		4.75	%		4.75	%
Year that the rate reaches the rate it is assumed to remain at		2013			2013			2013			2013

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 Point		One-Percentage Point
	Increase		Decrease
Effect on total service and interest costs	$	122		($104	)
Effect on postretirement benefit obligation	$	1,017		($893	)

Contributions

Hancock currently contributes to the plan as medical and dental benefits are paid and expects to continue to do so in 2007. Claims paid in 2006, 2005 and 2004, net of employee contributions, totaled $392,000, $861,000 and $615,000, respectively. Such claims include, in the case of postretirement life benefits, actual claims paid by a life insurance company and, in the case of medical and dental benefits, actual claims paid by the Company on a self-insured basis.

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Estimated Future Benefit Payments (in thousands)

	Net
	Payments
2007		470
2008		496
2009		531
2010		500
2011		559
Years 2012 through 2016		3,147

Note 13 — Earnings per Share

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

	Years Ended
	February 3, 2007								January 28, 2006								January 30, 2005
	Net					Per Share			Net					Per Share			Net				Per Share
	Earnings			Shares		Amount			Earnings			Shares		Amount			Earnings		Shares		Amount
Basic EPS
Earnings available to common shareholders	$	(45,907	)		18,709	$	(2.45	)	$	(30,251	)		18,518	$	(1.63	)	$	1,694		18,187	$	.09
Effect of Dilutive Securities
Stock options																				209
Restricted stock																				263
Diluted EPS
Earnings available to common shareholders plus conversions	$	(45,907	)		18,709	$	(2.45	)	$	(30,251	)		18,518	$	(1.63	)	$	1,694		18,659	$	.09

Certain options to purchase shares of Hancock’s common stock totaling 2,462,000, 2,012,000 and 1,275,000 shares were outstanding during the years ended February 3, 2007, January 28, 2006 and January 30, 2005, 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 79,000 equivalent shares were excluded in 2006 as such shares were anti-dilutive.

Note 14 — Commitments and Contingencies

Litigation. Hancock is a party to several pending legal proceedings and claims. Although the outcome of such proceedings and claims cannot be determined with certainty, we are of the opinion that it is unlikely that these proceedings and claims will have a material effect on the financial condition or operating results of the Company.

Taxes. The Company has received several tax assessments from the Mississippi State Tax Commission (the “Tax Commission”) resulting from an audit of the Company’s state income, franchise, and sales and use tax returns. The predominant income tax issue underlying these assessments concerns the taxation of certain intercompany payments by and between the Company and certain of its subsidiaries. In essence, the Tax Commission believes that all intercompany payments made to the Company’s subsidiaries domiciled in another state are attributable to the Mississippi operations of the Company and taxable in full in Mississippi. Additionally, the Tax Commission has asserted that those companies located in Mississippi that made the intercompany payments are not entitled to deduct those amounts. Thus, Mississippi is attempting simultaneously to tax the same intercompany payments to both parties to those transactions. The franchise tax assessments are primarily attributable to the Tax Commission’s position that all of the intercompany

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indebtedness by and between the Company and its subsidiaries is properly classified as taxable capital rather than debt. A proposed settlement is expected to be finalized with the Tax Commission during the first quarter of 2008. The Company does not believe that the amounts ultimately paid for the above matter will materially differ from the amounts accrued.

Note 15 — Reserve for Store Closings

The reserve for store closings is based on estimates of net lease obligations and other store closing costs. During 2005, the reserve was increased by $504,000 to reflect changes in prospects for sub-leasing properties and by $133,000 for stores closed in 2005. During 2006, Hancock increased the reserve by $1.6 million for stores closed in 2006.

The 2005 and 2006 activity in the reserve is as follows (in thousands):

			Addition to
	Begnning		(Reduction in)							End of
	of Year		Reserve		Interest		Payment			Year
2005
Lease obligations	$	1,166	$	637	$	34	$	(658	)	$	1,179
2006
Lease obligations	$	1,179	$	1,623	$	52	$	(990	)	$	1,864

Note 16 — Asset Retirement Obligations

The Company has adopted the provisions of SFAS No. 143, Accounting for Asset Retirement Obligations (“SFAS No. 143”). SFAS No. 143 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. SFAS No. 143 requires that these costs be recorded at their fair value at lease inception.

At February 3, 2007 and January 28, 2006, the Company had a liability pertaining to the asset retirement obligation in noncurrent liabilities on its consolidated balance sheet. The following is a reconciliation of the beginning and ending carrying amount of the Company’s asset retirement obligations (in thousands):

	2006			2005
Asset retirement obligation, beginning of period	$	523		$	473
Cumulative effect of change in accounting principle		—			—
Asset retirement obligation incurred and accretion expense		(47	)		50
Asset retirement obligation, end of period	$	476		$	523
Related capitalized property and equipment, net of accumulated depreciation	$	137		$	173

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM — BURR PILGER & MAYER LLP

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

We have audited the accompanying consolidated balance sheet of Hancock Fabrics, Inc. (Debtors-in-Possession) (the “Company”) as of February 3, 2007, and the related statement of operations, stockholders’ equity and comprehensive income, and cash flows for the year ended February 3, 2007 (fiscal 2006). Our audit also included the financial statement schedule listed in the Index to the Annual Report on Form 10-K at Part IV, Item 15(a) 2 as of and for the year ended February 3, 2007. 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 based on our audit.

We conducted our audit 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. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of the Company as of February 3, 2007, and the results of their operations and their cash flows for the year ended February 3, 2007 in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the related financial statement schedule as of and for the year ended February 3, 2007, 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.

We have also audited the adjustments to the 2005 and 2004 financial statements to retrospectively apply the change in accounting for discontinued operations, as described in Note 3 and 4 to the consolidated financial statements. In our opinion, such adjustments are appropriate and have been properly applied. We were not engaged to audit, review, or apply any procedures to the 2005 and 2004 financial statements of the Company other than with respect to the adjustments for discontinued operations, and, accordingly, we do not express an opinion or any form of assurance on the 2005 and 2004 financial statements taken as a whole.

The accompanying financial statements have been prepared assuming that the Company will continue as a going concern, which contemplates continuity of the Company’s operations and realization of its assets and payments of its liabilities in the ordinary course of business. As discussed in Note 1 to the consolidated financial statements, on March 21, 2007, the Company filed a voluntary petition for relief under Chapter 11 of the United States Bankruptcy Code (“Chapter 11”). The uncertainties inherent in the bankruptcy process and the Company’s losses from operations during fiscal years 2006 and 2005 raise substantial doubt about the Company’s ability to continue as a going concern. The Company is currently operating its business as a Debtor-in-Possession under the jurisdiction of the Bankruptcy Court, and its continuation of the Company as a going concern is contingent upon, among other things, the confirmation of a Plan of Reorganization, the Company’s ability to comply with all debt covenants under the existing debtor-in-possession financing agreement, generate sufficient cash flow from operations and obtain finance sources to meet its future obligations. If no reorganization plan is approved, it is possible that the Company could be liquidated. The accompanying financial statements do not include any adjustments relating to the recoverability and classification of asset carrying amounts or the amount and classification of liabilities that may result from the outcome of these uncertainties.

As discussed in Note 2 to the consolidated financial statements, the Company changed its method of accounting for stock-based compensation as a result of adopting Statement of Financial Standards No. 123 (revised 2004), “Share-Based Payment”, as of January 29, 2006 applying the modified prospective method.

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As discussed in Note 12 to the consolidated financial statements, the Company changed its method of accounting for pension plans and adopted the provisions of FASB Statement No. 158, “Employer’s Accounting for Defined Benefit Pension and Other Post-Retirement Plans.”

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of February 3, 2007, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated February 12, 2008 expressed an unqualified opinion on management’s assessment of internal control over financial reporting and a qualified opinion on the effectiveness of internal control over financial reporting.

/s/ BURR, PILGER & MAYER LLP

San Francisco, California
February 12, 2008

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM -
PRICEWATERHOUSECOOPERS LLP

To the Board of Directors and Shareholders of Hancock Fabrics, Inc.:

In our opinion, the consolidated balance sheet as of January 28, 2006 and the related consolidated statements of operations, cash flows and shareholders’ equity and comprehensive income for each of the two years in the period ended January 28, 2006, before the effects of the adjustments to retrospectively reflect the discontinued operations described in Note 4, present fairly, in all material respects, the financial position of Hancock Fabrics, Inc. and its subsidiaries at January 28, 2006 and the results of their operations and their cash flows for each of the two years in the period ended January 28, 2006, in conformity with accounting principles generally accepted in the United States of America (the 2006 financial statements before the effects of the adjustments discussed in Note 4 are not presented herein). In addition, in our opinion, the financial statement schedule, for each of the two years in the period ended January 28, 2006 presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements before the effects of the adjustments described above. These financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits. We conducted our audits, before the effects of the adjustments described above, of these statements 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. An audit 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, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

We were not engaged to audit, review, or apply any procedures to the adjustments to retrospectively reflect the discontinued operations described in Note 4 and accordingly, we do not express an opinion or any other form of assurance about whether such adjustments are appropriate and have been properly applied. Those adjustments were audited by other auditors.

PricewaterhouseCoopers LLP
Memphis, Tennessee
January 5, 2007

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM ON INTERNAL
CONTROL OVER FINANCIAL REPORTING

To the Board of Directors and Stockholders
of Hancock Fabrics Incorporated

We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control Over Financial Reporting included in Item 9A, that Hancock Fabrics, Inc (the “Company”) did not maintain effective internal control over financial reporting as of February 3, 2007, because (1) the Company did not maintain a sufficient complement of personnel with a level of financial reporting expertise that is commensurate with the Company’s financial reporting requirements (2) the Company did not maintain effective management controls over the completeness and accuracy of reconciliations of certain financial statement accounts, journal entries and spreadsheets based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.

We conducted our audit of internal control over financial reporting 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 effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A 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 generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) 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 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.

A material weakness is a control deficiency, or combination of control deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. The following material weaknesses have been identified and included in management’s assessment as of February 3, 2007.

(1) The Company did not maintain a sufficient complement of personnel with an appropriate level of accounting knowledge, experience and training in the application of generally accepted accounting principles commensurate with the Company’s financial reporting requirements. Specifically, the Company did not have a sufficient number of qualified personnel to maintain adequate controls over access to financial data, establish or maintain appropriate segregation of duties, and lacked adequate management supervision and oversight of

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finance and accounting staff to ensure the completeness and accuracy of the financial statements and related disclosures. The lack of sufficient personnel resulted in a number of internal control deficiencies that were identified as being significant. These control deficiencies contributed to the material weakness discussed in item (2) below. The number and nature of these significant deficiencies, when aggregated, was determined to be a material weakness. In the aggregate, these significant deficiencies could result in a misstatement of the Company’s account balances or disclosures which could cause a material misstatement of the consolidated financial statements that would not be prevented or detected.

(2) The Company did not maintain effective management controls over the completeness and accuracy of reconciliations of certain financial statement accounts, journal entries and spreadsheets. Specifically, the Company’s controls over the review and monitoring of reconciliations, journal entries and spreadsheets were ineffective to ensure that account balances were accurate and agreed to appropriate supporting detail, calculations or other documentation. The ineffectiveness of the controls resulted in a number of internal control deficiencies that were identified as being significant. Since these significant deficiencies had the potential to impact substantially all accounts and related disclosures, when aggregated, they were determined to constitute a material weakness.

These material weaknesses were considered in determining the nature, timing, and extent of audit tests applied in our audit of the fiscal 2006 financial statements, and our opinion regarding the effectiveness of the Company’s internal control over financial reporting does not affect our opinion on those financial statements.

In our opinion, management’s assessment that Hancock Fabrics, Inc. did not maintain effective internal control over financial reporting as of February 3, 2007, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, because of the effect of the material weaknesses described above on the achievement of the objectives of the control criteria, Hancock Fabrics, Inc. did not maintain effective internal control over financial reporting as of February 3, 2007, based on the COSO criteria.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the balance sheet of Hancock Fabrics, Inc. as of February 3, 2007 and the related statements of operations, shareholders’ equity and comprehensive income, and cash flows for the year ended February 3, 2007, and the related financial statement schedule, as of and for the year ended February 3, 2007 and our report dated February 12, 2008 expressed an unqualified opinion on those financial statements and the related financial statement schedule.

/s/ BURR, PILGER & MAYER LLP

San Francisco, California
February 12, 2008

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QUARTERLY FINANCIAL DATA (unaudited)

Years ended February 3, 2007 and January 28, 2006
  (in thousands, except per share amounts)

	First			Second			Third			Fourth
	Quarter			Quarter			Quarter			Quarter
	2006			2006			2006			2006 *
Sales	$	88,639		$	79,340		$	96,543		$	111,657
Gross profit		29,315			31,912			41,365			46,879
Selling, general and administrative expense		44,960			41,423			48,784			51,108
Depreciation and amortization		1,122			1,073			1,082			1,144
Interest expense		997			1,065			1,377			1,641
Income tax benefit		(1,479	)		(970	)		(822	)		(583	)
Loss before cumulative effect of change in accounting principal		(16,285	)		(10,679	)		(9,056	)		(6,431	)
Loss per share before cumulative effect of change in accounting principal		(.87	)		(.57	)		(.48	)		(.34	)
Net loss from continuing operations		(16,285	)		(10,679	)		(9,056	)		(6,431	)
Loss from discontinued operations, net of tax		(563	)		(2,410	)		(801	)		(169	)
Cumulative effect of change in accounting principal		487
Net loss	$	(16,361	)	$	(13,089	)	$	(9,857	)	$	(6,600	)
Basic and dilutive loss per share (1)	$	(0.88	)	$	(0.70	)	$	(0.52	)	$	(0.35	)

	First			Second			Third			Fourth
	Quarter			Quarter			Quarter			Quarter
	2005			2005			2005			2005
Sales	$	94,344		$	80,292		$	100,081		$	114,035
Gross profit		39,387			32,120			39,249			47,435
Selling, general and administrative expense		43,030			40,711			44,412			50,324
Depreciation and amortization		1,207			1,214			1,240			1,628
Interest expense		332			700			975			990
Income tax expense (benefit)		(125	)		(253	)		(178	)		(133	)
Loss before cumulative effect of change in accounting principal		(5,057	)		(10,252	)		(7,200	)		(5,374	)
Loss per share before cumulative effect of change in accounting principal		(.27	)		(.55	)		(.39	)		(.29	)
Loss from continuing operations		(5,057	)		(10,252	)		(7,200	)		(5,374	)
Loss from discontinued operations, net of tax		(527	)		(726	)		(353	)		(762	)
Net loss	$	(5,584	)	$	(10,978	)	$	(7,553	)	$	(6,136	)
Basic and dilutive loss per share (1)	$	(0.30	)	$	(0.59	)	$	(0.41	)	$	(0.33	)

(1)	Per share amounts are based on average shares outstanding during each quarter and may not add to the total for the y ear.
*	The fourth quarter of 2006 contains 14 weeks whereas the other quarters presented contain 13 weeks.

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

The information required by this item is incorporated herein by reference to Form 8-K dated and filed on June 29, 2007.

Item 9A. CONTROLS AND PROCEDURES

Evaluation of 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 Vice President and Chief Accounting 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 (February 3, 2007), the Company’s management, under the supervision and with the participation of the Company’s President and Chief Executive Officer (principal executive officer) and Vice President and Chief Accounting 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 and as a result of the material weakness discussed in Management’s Annual Report on Internal Control Over Financial Reporting in Item 9, the Company’s President and Chief Executive Officer (principal executive officer) and Vice President and Chief Accounting Officer (principal financial officer), concluded that the Company’s disclosure controls and procedures were not effective as of February 3, 2007. However, the Company’s management has concluded that the consolidated financial statements included in this Annual Report on Form 10-K present fairly, in all material respects, the Company’s financial position, results of operations and cash flows for the periods presented in conformity with GAAP.

Changes in Internal Control over Financial Reporting

Changes were made during the fiscal year and fourth quarter ended February 3, 2007, in the Company’s internal control over financial reporting (as defined in Exchange Act Rule 13a-15(f)) that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting. These changes, as described further below were made to implement policies and procedures to remediate material weaknesses identified in the prior year and to improve internal controls. During our prior-year (2005) assessment of internal control (performed as of January 28, 2006), the Company identified several material weaknesses as follows:

1. The Company did not maintain a sufficient complement of personnel with an appropriate level of accounting knowledge, experience and training in the application of GAAP and internal control over financial reporting commensurate with the Company’s financial reporting requirements. Specifically, the Company did not have a sufficient number of qualified personnel to establish, communicate and apply accounting policies and procedures in accordance with GAAP, and lacked adequate management supervision and oversight of finance and accounting staff to ensure the completeness and accuracy of the financial statements and related disclosures. These control deficiencies contributed to the material weaknesses discussed in items 2 through 6 below and resulted in audit adjustments to the fiscal 2005 annual consolidated financial statements, and the restatement of the Company’s consolidated financial statements for fiscal 2004 and 2003 and the quarterly periods in fiscal 2005 and 2004. Additionally, these control deficiencies could have resulted in a misstatement of substantially all accounts and disclosures that could have, in turn, resulted in a material misstatement of the Company’s annual or interim consolidated financial statements that would not be prevented or detected. Accordingly, management determined that these control deficiencies constituted a material weakness.

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2.	The Company did not maintain effective controls over the completeness and accuracy of inventory. Specifically, effective controls were not designed and in place to ensure the completeness and accuracy of (i) the weight conversion factors used to determine the accuracy of the fabric inventory, (ii) the unit costs assigned to certain inventory items, (iii) capitalized in-bound freight, (iv) intracompany profit elimination between the warehouse and stores, (v) inventory in-transit at the end of each reporting period, and (vi) inventory obsolescence and lower of cost or market reserves. These control deficiencies resulted in misstatements of the Company’s inventory and cost of goods sold resulting in adjustments to the Company’s 2005 consolidated financial statements and the restatement of the Company’s consolidated financial statements for fiscal 2004 and 2003 and the quarterly periods in fiscal 2005 and 2004. Additionally, these control deficiencies could have resulted in a misstatement of the aforementioned accounts that would, in turn, have resulted in a material misstatement of the Company’s annual or interim consolidated financial statements that would not be prevented or detected. Accordingly, management determined that these control deficiencies constituted a material weakness.
3.	The Company did not maintain effective controls over the completeness, accuracy and validity of pension benefit obligations and pension expense. Specifically, effective controls were not designed and in place to ensure the (i) appropriate monitoring, supervision and review of the actuarial calculations of the Company’s benefit obligations and pension expense, (ii) appropriate review of the completeness and accuracy of the data submitted to the actuary, and (iii) completeness of obligations recorded related to the SERP. Although there was no effect on the funding requirements of the pension plan, these control deficiencies resulted in misstatements of the Company’s benefit obligations and pension expense resulting in adjustments to the Company’s 2005 consolidated financial statements and restatement of the Company’s consolidated financial statements for fiscal 2004 and 2003 and the quarterly periods in fiscal 2005 and 2004. Additionally, these control deficiencies could have resulted in a misstatement of the aforementioned accounts that could have, in turn, resulted in a material misstatement of the Company’s annual or interim consolidated financial statements that would not be prevented or detected. Accordingly, management determined that these control deficiencies constituted a material weakness.
4.	The Company did not maintain effective controls over the complete and accurate recording of leases. Specifically, effective controls were not designed and in place to ensure the (i) completeness and accuracy of straight-line rent calculations, classifications of leasehold improvements/tenant incentives, and asset retirement obligations, (ii) selection of appropriate amortization periods for leasehold improvements, and (iii) appropriate accounting for lease financing transactions. These control deficiencies resulted in misstatements of the Company’s deferred stepped rent accrual, property and equipment, asset retirement obligations, other assets and the related rent and depreciation expenses resulting in adjustments to the Company’s 2005 consolidated financial statements and restatement of the Company’s consolidated financial statements for fiscal 2004 and 2003 and the quarterly periods in fiscal 2005 and 2004. Additionally, these control deficiencies could have resulted in a misstatement of the aforementioned accounts that could have, in turn, resulted in a material misstatement of the Company’s annual or interim consolidated financial statements that would not be prevented or detected. Accordingly, management determined that these control deficiencies constituted a material weakness.
5.	The Company did not maintain effective controls over the completeness and accuracy of certain accrued liabilities and related operating expense accounts. Specifically, effective controls were not designed and in place to ensure the complete and accurate recording of accrued liabilities and related expenses at each period end. This control deficiency primarily affected accrued liabilities for utilities, common area maintenance, property taxes, advertising, payroll, sales and franchise taxes and insurance, and related operating expenses. This control deficiency resulted in misstatements of the aforementioned accounts resulting in adjustments to the Company’s 2005 consolidated financial statements and restatement of the Company’s consolidated financial statements for fiscal 2004 and 2003 and the quarterly periods in fiscal 2005 and 2004. Additionally, this control deficiency could

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have resulted in a misstatement of the aforementioned accounts that could have, in turn, resulted in a material misstatement of the Company’s annual or interim consolidated financial statements that would not be prevented or detected. Accordingly, management determined that this control deficiency constituted a material weakness.

6.

The Company did not maintain effective controls over reconciliations of certain financial statement accounts and related disclosures. Specifically, the Company’s controls over the preparation, review and monitoring of reconciliations were ineffective to ensure that account balances were accurate and agreed to appropriate supporting detail, calculations or other documentation, impacting substantially all accounts and related disclosures. This control deficiency resulted in misstatements resulting in adjustments to the Company’s 2005 consolidated financial statements. This control deficiency could have resulted in misstatements that could have, in turn, resulted in a material misstatement to the annual or interim consolidated financial statements that would not be prevented or detected. Accordingly, management determined that this control deficiency constituted a material weakness.

Because of the material weaknesses described above, management concluded that the Company did not maintain effective internal control over financial reporting in its prior-year assessment as of January 28, 2006.

Significant changes in internal control over financial reporting were made during the fiscal year and fourth quarter ended February 3, 2007. These changes resulted mainly from remediation efforts, including the actions described below, and were designed mainly to address the material weaknesses identified by management in its January 28, 2006 assessment and to enhance the Company’s internal controls.

• The Company engaged a third party accounting and consulting firm to assist with accounting and disclosure matters related to the Company’s financial reporting and accounting requirements. The third party will continue to be utilized until the necessary internal resources are realigned or procured to improve the staffing and knowledge of the financial reporting and accounting functions. To allow additional oversight of the Company’s financial reporting and accounting processes, the Company is providing additional information to the Company’s audit committee on the progress of accounting matters on a routine basis. Although certain significant changes were made in this regard, the Company determined that as of February 3, 2007, two material weaknesses existed as follows: (1) the Company did not maintain a sufficient complement of personnel with a level of financial reporting expertise that is commensurate with the Company’s financial reporting requirements and (2) the Company did not maintain effective management controls over the completeness and accuracy of reconciliations of certain financial statement accounts, journal entries and spreadsheets based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). These material weaknesses are further described in Management’s Annual Report on Internal Control over Financial Reporting.

• The Company has revised all of its physical inventory procedures, including the overall process of analyzing the results of physical inventory counts compared to physical inventory records. Furthermore, the Company began implementation of a perpetual inventory system at its retail locations. Also, weight conversion factors for fabric inventory have been updated and will be periodically validated. Processes have also been established to ensure the completeness and accuracy to properly identify and record in-bound freight, intracompany profit elimination, in-transit inventory and reserves for obsolete inventory.

• The Company has implemented procedures to improve the communication with third party actuaries regarding changes to pension and other post-retirement benefit plans. These procedures include more active monitoring of the actuarial calculations through additional discussions with the third party actuaries and documentation related to changes in the benefit obligations from year to year caused by changes in the assumptions and/or changes in the plan document to facilitate a better understanding of the calculations. Also, the Company established controls to ensure the validity of the census data provided to the actuary.

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• The Company has designed and implemented procedures to perform a comprehensive review to evaluate and properly record all future lease agreements in accordance with GAAP. Additionally, new leases are supported by analysis of the related lease accounting provisions through the use of a checklist with approval from accounting personnel of the decisions made relative to the accounting implications.

• The Company has implemented procedures to accumulate all open invoices for expenses incurred prior to the end of the period based on reviews of subsequent payments and other reviews to ensure that all known expenses are included in accounts payable at the end of the period.

• The Company engaged a third party consulting firm to assist in preparing account reconciliations and account documentation allowing for management to review those reconciliations and documentation as part of its financial reporting and closing process.

Management believes that these measures, have been effectively implemented and maintained, and have remediated the material weaknesses identified in the prior year assessment except as described herein.

Management’s Responsibility for Financial Reporting

Management is responsible for the integrity and objectivity of the financial information included in this report. The financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). Where necessary, the financial statements reflect estimates based on management judgment.

Management has established and maintains internal control over financial reporting for the Company and its subsidiaries. Internal control over financial reporting is designed to provide reasonable assurance that assets are safeguarded, that the books and records properly reflect all transactions, that policies and procedures are implemented by qualified personnel, and that published financial statements are properly prepared and fairly presented. The Company’s internal control over financial reporting is supported by widely communicated written policies, including business conduct policies, which are designed to require all employees to maintain high ethical standards in the conduct of Company affairs. Internal auditors continually review the Company’s 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.

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Hancock’s management conducted an assessment of the effectiveness of the Company’s internal control over financial reporting as of February 3, 2007. 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”).

A material weakness is a control deficiency, or combination of control deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. In connection with the assessment of the Company’s internal control over financial reporting, the Company’s management has identified the following material weaknesses in the Company’s internal control over financial reporting as of February 3, 2007:

1.

The Company did not maintain a sufficient complement of personnel with an appropriate level of accounting knowledge, experience and training in the application of generally accepted accounting principles commensurate with the Company’s financial reporting requirements. Specifically, the Company did not have a sufficient number of qualified personnel to maintain adequate controls over access to financial data, establish or maintain appropriate segregation of duties, and lacked adequate management supervision and oversight of finance and accounting staff to ensure the completeness and accuracy of the financial statements and related disclosures. The lack of sufficient personnel resulted in a number of internal control deficiencies that were identified as being significant. These control deficiencies contributed to the material weakness discussed in item (2) below. The number and nature of these significant deficiencies, when aggregated, was determined to be a material weakness. In the aggregate, these significant deficiencies could result in a misstatement of the Company’s account balances or disclosures which could cause a material misstatement of the consolidated financial statements that would not be prevented or detected.

2.

The Company did not maintain effective management controls over the completeness and accuracy of reconciliations of certain financial statement accounts, journal entries and spreadsheets. Specifically, the Company’s controls over the review and monitoring of reconciliations, journal entries and spreadsheets were ineffective to ensure that certain account balances were accurate and agreed to appropriate supporting detail, calculations or other documentation. The ineffectiveness of the controls resulted in a number of internal control deficiencies that were identified as being significant. Since these significant deficiencies, had the potential to impact substantially all accounts and related disclosures, when aggregated, they were determined to constitute a material weakness.

Because of the material weaknesses described above, management concluded that the Company did not maintain effective internal control over financial reporting as of February 3, 2007, based on the criteria established in Internal Control — Integrated Framework issued by the COSO.

Management’s assessment of the effectiveness of the Company’s internal control over financial reporting as of February 3, 2007 has been audited by Burr, Pilger & Mayer LLP, an independent registered public accounting firm, as stated in their report which appears herein.

Item 9B. OTHER INFORMATION

None.

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PART III

Item 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE

Set forth below are the name, age, positions held with the Company, term of office, business experience during the past five years and other public company directorships held by each individual serving as a director of the Company as of the date of this report.

		Director
Name (Age)	Principal Occupation and Business Experience	Since
	Directors to Serve Until the 2008 Annual Meeting
Jane F. Aggers (59)	President, Chief Executive Officer and Director since January 2005. Co-founder of MMI, Inc., a marketing, sales and business consulting firm in Cleveland, Ohio. Formerly Executive Vice President of Jo-Ann Stores, Inc. (retail), Hudson, Ohio from 1994 to 2001.		2005
Donna L. Weaver (63)	Chairman, MxSecure, Inc., Scottsdale, Arizona (a medical transcription services company). Director of Basic American, Inc., a food processing company in San Francisco, California. Director and member of the Audit Committee of E*TRADE FINANCIAL Corporation (a global financial services company), New York, New York.		1987
	Directors to Serve Until the 2007 Annual Meeting*
Roger T. Knox (70)	Director and member of the Compensation Committee of Fred’s Inc. (retailer), Memphis, Tennessee. President Emeritus and formerly Chief Executive Officer, Memphis Zoo, Memphis, Tennessee. Formerly Chairman and Chief Executive Officer, Goldsmith’s (retailer), a division of Federated Department Stores, Inc., Memphis, Tennessee.		1999
Bernard J. Wein (67)	Formerly Chairman, President and Chief Executive Officer of Catherine’s Stores (retailer), Memphis, Tennessee.		2004
	Directors to Serve Until the 2006 Annual Meeting*
Don L. Frugé (62)	President Emeritus and former Chief Executive Officer of the University of Mississippi Foundation. President, UMAA Foundation. Professor Emeritus of Law, University of Mississippi, Oxford, Mississippi.		1987
Wellford L. Sanders, Jr. (62)	Chairman of Hancock Fabrics, Inc. Managing Director of Wachovia Securities, Inc., Charlotte, North Carolina.		2004

* Note –  The Company did not hold an annual meeting of stockholders during 2006 or 2007, and a date has yet to be established for the 2008 annual meeting of stockholders.

Prior to delisting, the Company was registered on the New York Stock Exchange (“NYSE”), and accordingly maintained certain corporate governance standards as promulgated by the exchange. The Company is no longer listed on the NYSE but has chosen to maintain similar corporate governance standards. The Board of Directors has reviewed the relationships between the Company and each of its directors and has determined that all of the directors, other than Jane F. Aggers, Hancock’s President and Chief Executive Officer (“CEO”),

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are “independent” as defined in the Listing Standards of the NYSE. The Board of Directors has affirmatively determined that no director, other than Ms. Aggers, has a material relationship with the Company. In making this determination, the Board has broadly considered all relevant facts and circumstances. In addition, the Board has adopted the following categorical independence standards for determining the independence of directors. The standards reflect the specific independence requirements of the NYSE and are also available on the Company’s website at www.hancockfabrics.com under the “Investor Relations — Corporate Governance” link.

For the purposes of these standards, the term “immediate family member” has the meaning given in the Listing Standards of the NYSE. A director will not be considered independent if:

• The director is, or has been within the last three years, employed by the Company;

• An immediate family member of the director is, or has been within the last three years, an executive officer of the Company;

• The director or an immediate family member of the director received, during any twelve-month period within the last three years, direct compensation from the Company exceeding $100,000, other than directors’ fees or pension or other forms of deferred compensation that are not contingent upon continued service;

• (A) The director or an immediate family member of the director is a current partner of a firm that is the Company’s internal or external auditor; (B) the director is a current employee of such a firm; (C) the director has an immediate family member who is a current employee of such a firm and who participates in the firm’s audit, assurance or tax compliance (but not tax planning) practice; or (D) the director or an immediate family member was within the last three years (but is no longer) a partner or employee of such a firm and personally worked on the Company’s audit within that time;

• The director or an immediate family member of the director is, or has been within the last three years, employed as an executive officer of another company where any of Hancock’s present executives serve on that company’s compensation committee;

• The director is a current employee of a company that made payments to, or received payments from, Hancock for property or services in an amount which, in any of the last three fiscal years, exceeded the greater of $1 million or 2% of such other company’s consolidated gross revenues;

• An immediate family member of the director is a current executive officer of a company that made payments to, or received payments from, Hancock for property or services in an amount which, in any of the last three fiscal years, exceeded the greater of $1 million or 2% of such other company’s consolidated gross revenues; or

• The Company made contributions to any charitable organization in which a director served as an executive officer and contributions in any single fiscal year exceeded the greater of $1 million or 2% of such charitable organization’s gross revenues.

With respect to any relationship that is not covered by the categorical independence standards, the members of the Board who satisfy the requirements of those standards will make a determination, based on all relevant facts and circumstances, as to whether or not the relationship is material, and therefore whether the director who has the relationship will be considered independent. The Company will disclose and explain the basis for any determination that such a relationship is not material in its next proxy statement. In addition, the Company will disclose and explain the basis for any determination of independence for a director who does not satisfy the categorical independence standards.

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Executive Officers

Set forth below are the name, age, positions held with the Company and business experience during the past five years of each executive officer of the Company as of the date of this report.

			Office Presently Held and
Name	Age		Business Experience During the Last Five Years
Jane F. Aggers		59	President, Chief Executive Officer and Director since January 2005. Co-founder of MMI, Inc., a marketing, sales and business consulting firm in Cleveland, Ohio from 2001 to 2004. Formerly Executive Vice President of Jo-Ann Stores, Inc. (retail), Hudson, Ohio 1994 to 2001.
Bruce D. Smith		49	Executive Vice President, Chief Financial Officer and Treasurer since March 2005 and Senior Vice President, Chief Financial Officer and Treasurer from March 1997 to March 2005. Mr. Smith resigned from the Company effective March 30, 2007.
Dean W. Abraham		60	Senior Vice President – Store Operations from June 2006, Senior Vice President – Merchandising from February 2004 to June 2006 and Senior Vice President – Store Operations from June 1996 to February 2004. Mr. Abraham retired from the Company on April 30, 2007.
L. Gail Moore		54	Senior Vice President – Merchandising since June 2006. Formerly Senior Executive Vice President and Divisional Merchandise Manager from September 1999 through June 2006 of Fred’s, Inc., a specialty retail store chain.
Kathleen Kennedy		54	Senior Vice President – Marketing since February 2006. Formerly Executive Vice President, Corporate Marketing of vFinance Inc., a diversified financial services firm from 2005 to 2006. Also formerly Vice President, Marketing for Office Depot, Inc., an office supply company from 2001 to 2004. On May 9, 2007, Ms. Kennedy ceased to serve as Senior Vice President – Marketing upon the elimination of that position in connection with the restructuring activities of the Company under Chapter 11.

Audit Committee Matters

The Audit Committee of the Board of Directors is charged with oversight of the Company’s accounting and financial reporting process and the audits of its financial statements. The Audit Committee also assists the Board in monitoring the integrity of the Company’s financial statements, the independent auditors’ qualifications and independence, the performance of the Company’s internal audit function and the Company’s compliance with laws and regulations and with the Code of Business Conduct and Ethics and the Code of Business Conduct and Ethics for the Chief Executive Officer and Senior Financial Officers. The Audit Committee has sole authority for the appointment or replacement and pre-approval of the services and fees of the Company’s independent auditors. As of the date of this report, the Audit Committee was comprised of Don L. Frugé (Chair), Roger T. Knox, Wellford L. Sanders, Jr., Donna L. Weaver and Bernard J. Wein. The Board of Directors has determined that each member of the Audit Committee meets the independence requirements of Section 10A(m)(3) of the Exchange Act and the rules and regulations of the SEC, and that a majority of the

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members, including the chairperson, Don L. Frugé, qualify as audit committee financial experts as defined in rules promulgated by the SEC under the Exchange Act, as interpreted by the Board.

Section 16(a) Beneficial Ownership Reporting Compliance

Section 16(a) of the Exchange Act requires the Company’s officers and directors, and persons who own more than 10% of a registered class of the Company’s equity securities, to file reports of ownership and changes in ownership with the SEC. Copies of such reports must also be furnished to the Company. To the Company’s knowledge, based solely on a review of the copies of such reports furnished to the Company, during the fiscal year ended February 3, 2007, all Section 16(a) filing requirements were met.

Code of Ethics

The Company has adopted a Code of Business Conduct and Ethics and a Code of Business Conduct and Ethics for the Chief Executive Officer and Senior Financial Officers, both of which apply to its principal executive officer, principal financial officer, principal accounting officer and controller. These Codes are posted in the “Investor Relations – Corporate Governance” section of the Company’s website at www.hancockfabrics.com. The Company will post any material amendments or waivers to these Codes to its website.

Executive Sessions

On January 31, 2005, Wellford L. Sanders, Jr. was appointed as Non-Executive Chairman of the Board and presides over executive sessions of the Board.

Communications with Directors

Interested party communications with the Board of Directors as a group, the non-management directors as a group, the Non-Executive Chairman of the Board or any individual director should be addressed to “Hancock — Director Communications,” P.O. Box 1718, Oxford, MS 38655.

Item 11. EXECUTIVE COMPENSATION

Compensation Discussion and Analysis

Introduction

This Compensation Discussion and Analysis provides a principles-based overview of our executive compensation program. It discusses our rationale for the types and amounts of compensation that our executive officers receive and how compensation decisions affecting these officers are made. It also discusses our total rewards philosophy, the key principles governing our compensation program, and the objectives we seek to achieve with each element of our compensation program.

What are the Company’s key compensation goals?

The goals of the Company’s compensation program are to align compensation with business performance and the interests of stockholders, and to enable the Company to attract, motivate and retain management that can contribute to the Company’s long-term success. Therefore, the executive compensation program includes base salary, annual cash incentive bonus and long-term incentives in the form of stock options and restricted stock. Other than routine insignificant business amenities, the executive officers of the Company are not provided with any forms of compensation not discussed in this report. Our executive officers’ compensation is determined in the same manner as that of the other corporate officers.

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What are the Company’s overall executive compensation objectives?

The Company sets challenging financial and operating goals, and a significant amount of an executive’s annual cash compensation is tied to these objectives and therefore “at risk” — payment is earned only if performance warrants it. Our compensation program is intended to support long-term focus on stockholder results, so it emphasizes long-term rewards.

Who participates in the Company’s executive compensation programs?

The CEO, the Chief Financial Officer and the other three most highly compensated officers (collectively, the “Named Executive Officers”), as well as other executive officers, participate in the compensation program outlined in this Compensation Discussion and Analysis. However, many elements of the compensation program also apply to other levels of the Company’s management. The intent is to ensure that management is motivated to pursue, and is rewarded for achieving, the same financial, operating and stockholder objectives.

What are the key elements of the Company’s overall executive compensation program?

The table below summarizes the key elements of our executive compensation program and the objectives they are designed to achieve.

Pay Element	Description	Objectives
Base salary	• Annual fixed cash compensation.	• Attraction and retention. • Recognize differences in relative size of positions as well as individual performance over the long term.
Incentive compensation	• Annual variable pay tied to the achievement of key Company financial and operating objectives.	• Communicate key financial and operating objectives. • Drive high levels of performance by ensuring that executives’ total cash compensation is linked to achievement of financial and operating objectives.
		• Support and reward consistent, balanced growth and returns performance (add value every year).
Stock options	• All stock options are granted at fair market value on the grant date (discounted options are prohibited).	• Align long-term compensation with stockholder results. • Opportunities for significant wealth accumulation by executives are tightly linked to stockholder returns.
	• Our current stock option plans prohibit repricing.
Retirement plans	The Company maintains two retirement plans:	• Provide competitive executive retirement benefits.
	• 401(k) defined contribution plan; and

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Pay Element	Description	Objectives
	• Defined benefit pension plan (Frozen to new participants)
Health and other benefits	Executives are eligible for a variety of benefits, including:	• Provide competitive benefits. • Minimize perquisites while ensuring a competitive overall rewards package.
	• Medical, dental and vision plans; and
	• Life and disability insurance plans.

Annual cash compensation. Annual cash compensation consists of base salary and incentive compensation.

Base Salary

The Compensation Committee annually reviews the base salaries of the CEO and the other executive officers and members of corporate management. When reviewing base salary and possible adjustments to base salary, the Compensation Committee subjectively considers individual performance, Company performance (which is not defined as any specific financial measure or measures), the expected impact of long-term decisions, employee retention, changes in level of responsibility, experience level of the employee, and economic conditions in the retail fabric industry. No adjustments were made to the base salary of the CEO or CFO during 2006.

Incentive Compensation

The Compensation Committee believes that executive compensation should be linked to both business and individual performance. During 2005, the Compensation Committee made available two bonus programs based on the Company’s operating earnings before interest and taxes, computed using the first-in, first-out method of accounting for inventories (“FIFO EBIT”). The total of bonuses paid under the Extra Compensation Plan to eligible participants would increase or decrease each year in direct relation to the percentage increase or decrease in the Company’s FIFO EBIT compared to the prior year. However, if FIFO EBIT increased 10% or more over the prior year, officer participation in the Extra Compensation Plan was capped. The second program, the Officer Incentive Compensation Plan provides for various levels of bonuses based on a percentage of an officer’s base salary in relation to a predetermined level of improvement in FIFO EBIT over the prior year as set by the Compensation Committee.

In March 2006, the Board of Directors approved the format of a new Short-Term Incentive Compensation Bonus Program (the “Bonus Program”) and a Long-Term Incentive Compensation Restricted Stock Program (the “Long-Term Program”), designed to replace the Extra Compensation Plan and the Officer Incentive Compensation Plan. All salaried employees at the Company’s corporate office and distribution center are eligible to participate in the Bonus Program. However, in order to receive a bonus under the Bonus Program, the Company must have achieved at least one of three specified Cash Flow from Operations goals (Minimum, Target and Maximum) in 2006. No bonuses were paid to officers for 2006 under the Bonus Program as the performance goals were not achieved. For participants classified as Senior Manager and above, if one of the three Cash Flow levels is achieved in 2007, then 50% of the bonus opportunity at that level will be paid to each participant and between 0% and another 50% will be paid to each participant based on his/her achievement of individual operating goals. For participants classified as Manager and Administrative, payout will depend solely on the Company reaching one of its Cash Flow goals. Payouts, if any, cap at 25%, 50% and 75%, respectively, of salary at the CEO and the Executive Vice President positions, depending on whether the Minimum, Target or Maximum goal is reached. The caps are at 20%, 40% and 50%, respectively, for the Senior Vice President position and continue to descend for the levels below Senior Vice President.

The Compensation Committee believes that the Bonus Program and the Long-Term Program discussed below are important in linking performance with pay. The Compensation Committee will continue to focus on this critical issue as it moves forward.

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Long-term Incentives

To more closely align the interests of the Company’s stockholders and the executive officers, and to focus management’s attention on long-term strategic objectives which will enhance stockholder value, the Compensation Committee grants stock options and awards restricted stock. All grants and awards contain vesting provisions of one to five years to encourage continued employment with the Company and continued attention to long-term objectives and share appreciation. The exercise price for the stock options granted is equal to the fair market value of the underlying stock on the date of grant. Therefore, the ultimate value of these equity incentives to the executive officers and other recipients is directly related to the market value of the common stock and to the common stock dividend yield.

In March 2006, as part of the Long-Term Program, the Board amended the 2001 Stock Incentive Plan (the “Stock Incentive Plan”) in order to add a performance-based feature to our restricted stock program. Prior to the amendment, restricted stock grants were contingent only on the employee staying with the Company for a given period of time. However, the Board believes it is also important to have a portion of such grants be contingent on our achieving certain financial goals. All employees at our corporate office and distribution center that are classified as Senior Manager and above are eligible to participate in the amended Stock Incentive Plan. Each participant will receive shares of our common stock, with the only restriction being that the participant must stay employed with us for four years (the “Base Award”). Other shares may be issued to the participants, but only if we achieve certain goals related to FIFO EBIT (the “Performance Award”). If earned, such shares will vest immediately upon achieving the goal.

Stock options and restricted stock were granted to Ms. Moore and Ms. Kennedy in 2006 as initial grants upon beginning employment with the Company, as indicated in the Grants of Plan-Based Awards Table below. Restricted stock was also awarded to Ms. Aggers, Mr. Smith and Mr. Abraham, as indicated in the Grants of Plan-Based Awards Table, as Base Awards under the Long-Term Program.

How does the Compensation Committee consider and determine executive and director compensation?

Chief Executive Officer. The Compensation Committee establishes the compensation level for the CEO, including base salary and annual cash incentive compensation, and reviews and approves her stock option awards. The CEO’s compensation is reviewed annually by the Compensation Committee in conjunction with a review of her performance by the non-management directors, taking into account all forms of compensation, including base salary, annual cash incentive, stock option awards, and the value of other benefits received.

The CEO’s base salary, incentive compensation and long-term incentives in the form of stock options and restricted stock were determined in a manner consistent with the compensation of the other executive officers and members of corporate management. As discussed above, the CEO’s incentive compensation and long-term incentive compensation are tied to the Company’s performance. The Employment Agreement between Ms. Aggers and the Company provided for a base salary of $450,000 and a bonus to be determined by the Board of Directors in accordance with the Company’s Bonus Plan. No incentive compensation was paid to Ms. Aggers in 2006. Any incentive compensation amount payable to Ms. Aggers in subsequent years will be established by the Compensation Committee based on the Company’s performance and in consultation with Ms. Aggers. Ms. Aggers was awarded 15,000 shares of restricted stock, as a base award under the long term program, in order to better align her interests with those of the stockholders and to expand the level of restricted stock which serves as a retention tool for Ms. Aggers’ continued employment with Hancock.

Other Executive Officers. The Compensation Committee reviews and establishes base salaries for our executive officers other than the CEO based on each executive officer’s performance during the past fiscal year and on the recommendations of the CEO. The Compensation Committee approves the annual cash incentive amounts for the executive officers, which are determined by objectives established by the Compensation Committee at the beginning of each fiscal year as discussed above. The actual bonus amount paid depends on performance relative to the target objectives.

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The Compensation Committee approves awards of stock options to many levels of management, including executive officers. Stock options are granted to executive officers upon initial hire or promotion, and thereafter are typically granted annually in accordance with guidelines established by the Compensation Committee. The actual grant is determined by the Compensation Committee based on the guidelines and the performance of the individual in the position. The Compensation Committee considers the recommendations of the CEO.

What roles do the Chief Executive Officer and other executive officers play in the determination of executive compensation?

The CEO attends most meetings of the Compensation Committee and participates in the process by answering Compensation Committee questions about pay philosophy and by ensuring that the Compensation Committee’s requests for information are fulfilled. She also assists the Compensation Committee in determining the compensation of the other executive officers by providing recommendations and input about such matters as individual performance, experience, and size, scope and complexity of their positions. The CEO makes specific recommendations to the Compensation Committee concerning the compensation of her direct reports and other senior executives, including the other executive officers. These recommendations usually relate to base salary increases. The CEO also recommends pay packages for newly hired executives. Management provides the Compensation Committee with data, analyses and perspectives on market trends and annually prepares information to assist the Compensation Committee in its consideration of such recommendations. Annual incentive awards are based on achievement of business objectives set by the Compensation Committee, but the Compensation Committee may exercise negative discretion, and if it does so, it is typically in reliance on the CEO’s assessment of an individual’s performance. The CEO does not make recommendations to the Compensation Committee regarding her own compensation.

Does the Company use compensation consultants?

Neither the Company nor the Compensation Committee hired compensation consultants during fiscal 2006. The Company does not regularly engage consultants as part of our annual review and determination of executive compensation. Although the company has hired consultants to provide services from time to time, it is not our usual practice. The Compensation Committee has authority, pursuant to its charter, to hire consultants of its selection to advise it with respect to our compensation programs, and it may also limit the use of the Compensation Committee’s compensation consultants by our management as it deems appropriate.

What are our peer group and compensation benchmarking practices?

We do not use information from the peer group or other published sources to set targets or make individual compensation decisions. We do not engage in “benchmarking,” such as targeting base salary at peer group median for a given position. Rather we use such data as context in reviewing our overall compensation levels and approving recommended compensation actions. Broad survey data and peer group information are just two elements that we find useful in maintaining a reasonable and competitive compensation program. Other elements that we consider are individual performance, Company performance, individual experience, position tenure, and succession planning.

What is the Company’s policy concerning the tax deductibility of compensation?

Section 162(m) of the Internal Revenue Code of 1986 imposes a limit, with certain exceptions, on the amount that a publicly held corporation may deduct for federal income tax purposes in any year for the compensation paid or accrued with respect to its executive officers. It is the Compensation Committee’s policy to seek to preserve the tax deductibility of all executive compensation under Section 162(m) to the extent consistent with the overall objectives of the executive compensation program in attracting, motivating and retaining its executives. However, the Compensation Committee recognizes that if there is an appreciation in the

86

Company’s stock price, executive compensation amounts in future years could exceed this limitation due to the timing of stock option exercises and the vesting of restricted shares.

Do the Company’s Executive Officers Have Employment Contracts, Termination of Employment or Change in Control Arrangements?

The Company has entered into substantially identical contingent severance arrangements (the “Severance Agreements”) with Ms. Moore, Mr. Smith, Mr. Abraham and Ms. Kennedy (the “executives”). The Severance Agreements, were to be effective until May 4, 2008 (Mr. Smith, Mr. Abraham and Ms. Kennedy’s employment terminated prior to May 4, 2008) and provide that, if during the three years following a change of control of the Company (as defined in the Severance Agreements), the employment of the executives are terminated by the employer other than for cause, disability or death or the executive terminates employment for good reason (as defined in the Severance Agreements), the executives will receive a lump sum payment equal to the sum of (i) their annual base salary through the termination date (to the extent not yet paid) and (ii) the sum of (a) their annual base salary at the rate in effect when employment was terminated or, if higher, at the highest rate in effect within 90 days preceding the change of control and (b) the highest bonus paid or payable to the executive within the five years preceding the change of control. If participants in the Retirement Plan, the executives are also entitled to a continuation of family health and insurance benefits for one year and to certain supplemental retirement benefits in respect of that continuation period. The Severance Agreements also provide that if any tax under Section 4999 of the Internal Revenue Code, or any comparable provision is imposed on any payment made or benefit provided to the executive, then the amount of such payment or benefit will be increased to the extent necessary to compensate the executive fully for the imposition of such tax. Ms. Kennedy’s amended agreement included a provision for six months of severance pay upon termination of employment.

With respect to the Company’s 1987 and 1996 Stock Option Plans, upon a change of control of the Company (as defined in the plans), options become fully exercisable and, with certain exceptions, remain exercisable by the optionee, including each of the Named Executive Officers, for a period of 90 days following termination of the optionee’s employment if such termination occurs within one year of the change of control. Under the 2001 Stock Incentive Plan change in control provisions (as defined in the plan), the outstanding options become fully vested and may be cashed out at the highest market price occurring during a 60-day period prior to the date of the change of control.

Under the 2001 Stock Incentive Plan change in control provisions (as defined in the plan), all restricted shares held upon the occurrence of a change in control become fully vested and may be cashed out at the highest market price occurring during a 60 day period prior to the date of the change of control.

With respect to the Company’s noncontributory retirement program, under certain circumstances related to a change of control of the Company (as defined in the program documents), part of the benefit to a participant will be paid in a lump sum. See Item 11. Executive Compensation - Pension Plans. This would only apply to Mr. Abraham and Mr. Smith.

The Company has entered into an Employment Agreement (the “Agreement”) with Ms. Aggers, which became effective January 31, 2005, as amended on December 7, 2005, for a three year period and is automatically extended by one year on each anniversary of the effective date, unless either party elects not to extend the Agreement. During the term of the Agreement, Ms. Aggers will receive an annual base salary of $450,000, which may be increased at the discretion of the Company, and benefits as provided to other employees of the Company, such as medical and life insurance. As a base award under the Long-Term Program, the Compensation Committee decided to award approximately $55,000 of restricted stock (15,000 shares), vesting 100% on the fourth anniversary of the award date. This award was to increase Ms. Aggers’ ownership position in the Company in order to better align her interests with those of the stockholders and to expand the level of restricted stock which serves as a retention tool for Ms. Aggers’ continued employment with Hancock. Any bonus amount for subsequent years will be established by the Compensation Committee in consultation with Ms. Aggers. The Agreement provides, in general, that in the event of a change of control or death that all equity awards will be immediately vested and not subject to forfeiture.

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Under the Agreement, termination will have the following effect on the compensation provided: (i) if employment is voluntarily terminated, salary, benefits and stock award vesting will continue for a one-year period; (ii) if employment is terminated by death or disability, salary and benefits will continue for one-year and the bonus will be prorated for the period of employment; (iii) in the case of termination for cause, salary, benefits and vesting of stock awards will cease at the date of termination; (iv) if employment is terminated without cause, salary, benefits and stock award vesting will continue for the remaining term of the Agreement and the bonus payable will be prorated through the date employment was terminated; and (v) if employment is involuntarily terminated without cause during a Change in Control Period (as defined by the Agreement), Ms. Aggers will receive benefits for a three year period, a prorated bonus for the year in which the change in control occurs and a lump sum payment which is equal to three times her annual base salary and three times the bonus paid for the year immediately prior to the year in which the change of control occurred. The change in control provision also provides for a tax equalization payment which would place the Executive in the same after-tax position as if the tax penalty under Section 4999 of the Internal Revenue Code of 1986, or successor statute, had not applied.

How is the Company complying with Section 409A of the Internal Revenue Code?

Section 409A of the Internal Revenue Code was created with the passage of the American Jobs Creation Act of 2004. These new tax regulations create strict rules related to non-qualified deferred compensation earned and vested on or after January 1, 2005. We have conducted a thorough assessment of all affected plans, and continue to take actions necessary to comply with the new requirements by the deadlines established by the Internal Revenue Service.

Compensation Committee Interlocks and Insider Participation

None of the Compensation Committee members is or has been an officer or employee of the Company or any of its subsidiaries. In addition, no executive officer of the Company served during 2006 as a director or a member of the compensation committee of any entity that had an executive officer serving on the Board of Directors of the Company.

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Summary of Cash and Certain Other Compensation

The following table sets forth summary information concerning the compensation during the periods indicated for the Named Executive Officers.

SUMMARY COMPENSATION TABLE

													Change in
													Pension
													Value and
											Non-		Nonquali-
											Equity		fied
											Incentive		Deferred		All
											Plan		Compensa-		Other
Name and							Stock		Option		Compen-		tion		Compen-
Principal			Salary		Bonus		Awards		Awards		sation		Earnings		sation		Total
Position	Year		($)		($)		($)(1)		($)(1)		($)		($)(2)		($)(3)		($)
(a)	(b)		(c)		(d)		(e)		(f)		(g)		(h)		(i)		(j)
Jane Aggers, Chief Executive Officer		2006	$	450,000		—	$	281,448	$	87,556		—		—	$	20,790	$	839,794
Bruce Smith, Chief Financial Officer		2006	$	230,000		—	$	85,175	$	33,833		—	$	9,133	$	12,614	$	370,755
Dean Abraham, Senior Vice President — Store Operations		2006	$	182,923		—	$	74,225	$	20,300		—	$	20,162	$	12,178	$	309,788
L. Gail Moore, Senior Vice President — Merchandising		2006	$	116,923		—	$	10,210	$	13,416		—		—	$	7,348	$	147,897
Kathleen J. Kennedy, Senior Vice President — Marketing & Advertising		2006	$	175,384		—	$	20,059	$	26,529		—		—	$	60,696	$	282,668

(1)	The amounts shown do not reflect compensation actually received by the Named Executive Officers. Instead, the amounts shown are the compensation costs recognized by the Company for the year ended February 3, 2007 as determined pursuant to FAS 123(R). The assumptions used to calculate the value of these stock and option awards are set forth under Note 12 to the accompanying Consolidated Financial Statements included in this Annual Report on Form 10-K.
(2)	See the table below captioned “Pension Benefits.”
(3)	All Other Compensation includes the following:

89

						Company
						Contributions to
						Defined
	Perquisites and			Life Insurance		Contribution
Name	Personal Benefits			Premiums		Plans(B)		Other(C)
Jane Aggers	$	9,000		$	540	$	11,250		—
Bruce Smith		—			—		—	$	12,614
Dean Abraham	$	1,593		$	214		—	$	10,371
L. Gail Moore	$	7,348			—		—		—
Kathleen Kennedy	$	60,456	(A)	$	240		—		—

(A)	This amount represents relocation expenses, including $55,491 in moving expenses and $4,965 in temporary living expense reimbursements.
(B)	Represents employer contributions to the Company’s 401(k) plan, Hancock Fabrics, Inc. Retirement Savings Plan. Participants in the Hancock Fabrics, Inc. Consolidated Retirement Plan were ineligible for the Company contribution.
(C)	Represents amortized amounts of net present value for 2006 under deferred compensation agreements between the Company and Mr. Smith and between the Company and Mr. Abraham. Upon termination, Mr. Smith’s rights to payment under this agreement were forfeited, and Mr. Abraham’s payments are pending as a pre-petition claim.

The following table sets forth summary information concerning the grants of plan-based award to those Named Executive Officers of the Company for which such disclosure is required.

GRANTS OF PLAN-BASED AWARDS

All

All

Other

Other

Stock

Option

Grant

Estimated Future

Awards:

Awards:

Date

Payouts

Estimated Future

Number

Number

Exer-

Fair

Under Non-Equity

Payouts Under

Of

Of

cise or

Value

Incentive

Equity Incentive Plan

Shares

Securities

Base

of

Plan Awards1

Awards1

Of

Under-

Price of

Stock

Thresh-

Tar-

Maxi-

Thresh-

Tar-

Maxi-

Stock

lying

Option

and

Date

Grant

old

get

mum

old

get

mum

Of Units

Options

Award

Option

Name

of

Date

($)

($)

($)

(#)

(#)

(#)

(#)(2)

(#)(3)

($/Sh)(4)

Award

(a)

Action

(b)

(c)

(d)

(e)

(f)

(g)

(h)

(i)

(j)

(k)

(l)

Jane Aggers

3/23/06

3/23/06

—

—

—

—

—

—

15,000

—

$

3.665

$

54,975

Bruce D. Smith

3/23/06

3/23/06

—

—

—

—

—

—

10,000

—

$

3.665

$

36,650

Dean Abraham

3/23/06

3/23/06

—

—

—

—

—

—

5,000

—

$

3.665

$

18,325

L. Gail Moore

5/12/06

6/12/06

—

—

—

—

—

—

25,000

50,000

$

3.16

$

162,000

Kathleen Kennedy

1/23/06

2/20/06

—

—

—

—

—

—

25,000

50,000

$

4.21

$

216,550

⁽¹⁾ No bonuses were paid to officers for 2006 under the Bonus Program as the performance goals were not achieved. Base Awards of restricted shares were issued to Ms. Aggers, Mr. Smith and Mr. Abraham under the Long-Term Program, but no Performance Awards were issued as the performance goals were not met. Restricted shares may be issued to Ms. Aggers under the Long-Term Program in 2007 or 2008, but only if the Company achieves certain goals related to FIFO EBIT. If earned, such shares will vest immediately upon achieving the goal.

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(2)	Represents restricted stock awarded pursuant to the Company’s 2001 Stock Incentive Plan. Ms. Aggers, Mr. Smith and Mr. Abraham received restricted stock grants pursuant to the Long-Term Program. Ms. Moore and Ms. Kennedy received restricted stock grants as initial grants upon beginning employment with the Company.
(3)	Represents stock options awarded pursuant to the 2001 Stock Incentive Plan.
(4)	In accordance with the Company’s practice, the exercise price is the average of the high and low stock price on the date of grant. The closing price of the common stock on June 12, 2006 was $3.15, and the closing price of the common stock on February 20, 2006 was $4.22.

The following table sets forth summary information concerning the outstanding equity awards as of fiscal year end for those Named Executive Officers of the Company for which such disclosure is required.

OUTSTANDING EQUITY AWARDS AT FISCAL YEAR END

											Stock Awards
																	Equity
															Equity		Incentive
															Incentive		Plan
															Plan		Awards:
	Option Awards														Awards:		Market or
					Equity						Number				Number		Payout
					Incentive						Of		Market		Of		Value
					Plan						Shares		Value of		Unearned		Of
	Number				Awards:						Or		Shares		Shares,		Unearned
	Of		Number		Number						Units		of		Units or		Shares,
	Securities		Of		Of						Of		Units of		Other		Units or
	Underlying		Securities		Securities						Stock		Stock		Rights		Other
	Unexercised		Underlying		Underlying						That		That		That		Rights
	Options		Unexercised		Unexercised		Option				Have		Have		Have		That Have
	(#)		Options		Unearned		Exercise		Option		Not		Not		Not		Not
	Exercisable		(#)		Options		Price		Expiration		Vested		Vested		Vested		Vested
Name	(1)		Unexercisable1		(#)		($)		Date		(#)		($)(2)		(#)		($)
(a)	(b)		(c)		(d)		(e)		(f)		(g)		(h)		(i)		(j)
Jane Aggers		50,000		50,000		—	$	9.44		12/15/14		131,250	$	523,688		—		—
Bruce Smith(3)		12,000		—		—	$	13.13		6/12/07		32,900	$	131,271		—		—
		6,000		—		—	$	12.63		6/11/08		—		—		—		—
		6,000		—		—	$	5.81		6/7/09		—		—		—		—
		10,000		—		—	$	4.25		6/15/10		—		—		—		—
		10,000		—		—	$	7.50		6/14/11		—		—		—		—
		10,000		—		—	$	18.09		6/13/12		—		—		—		—
		7,500		2,500		—	$	15.84		6/11/13		—		—		—		—
		5,000		5,000		—	$	12.20		6/9/14		—		—		—		—
Dean Abraham(4)		1,500		—		—	$	7.50		6/14/11		25,700	$	102,543		—		—
		6,000		—		—	$	18.09		6/13/12		—		—		—		—
		4,500		1,500		—	$	15.84		6/11/13		—		—		—		—
		3,000		3,000		—	$	12.20		6/9/14		—		—		—		—
L. Gail Moore		—		50,000		—	$	3.16		6/12/16		25,000	$	99,750		—		—
Kathleen Kennedy(5)		—		50,000		—	$	4.21		2/20/16		25,000	$	99,750		—		—

(1)	Option awards vest ratably on each of the first four anniversaries of the grant date.
(2)	Based on the closing price of the common stock of $3.99 on February 2, 2007.
(3)	Upon Mr. Smith’s termination, all stock awards and option awards were forfeited.

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(4)	Upon Mr. Abraham’s retirement, all stock awards and option awards immediately vested. Mr. Abraham may exercise the option awards until April 30, 2008.
(5)	Upon Ms. Kennedy’s termination, all stock awards and option awards were forfeited.

The following table sets forth summary information concerning the exercise of options and the vesting of stock as of fiscal year end for those Named Executive Officers of the Company for which such disclosure is required.

OPTION EXERCISES AND STOCK VESTED

	Option Awards				Stock Awards
	Number of				Number of
	Shares		Value		Shares		Value
	Acquired		Realized		Acquired		Realized
	on		On		on		On
	Exercise		Exercise		Vesting		Vesting
Name	(#)		($)		(#)		($)(1)
(a)	(b)		(c)		(d)		(e)
Jane Aggers		—		—		38,750	$	123,775	(2)
Bruce Smith		—		—		9,600	$	30,384	(3)
Dean Abraham		—		—		9,300	$	29,435	(3)
L. Gail Moore		—		—		—		—
Kathleen Kennedy		—		—		—		—

(1)	Value is based on the average of the high and low prices of the common stock on the vesting date or the next trading date after the vesting date.
(2)	18,750 restricted shares vested on December 8, 2006, and 20,000 shares vested on December 16, 2006.
(3)	These restricted shares vested on June 15, 2006.

Pension Plans

The Company maintains a noncontributory retirement program under which retirement benefits are provided by a qualified defined benefit pension plan supplemented by a nonqualified unfunded plan affording certain benefits that cannot be provided by the qualified plan. In this description, the qualified and nonqualified plans are treated as one “Plan.” Only Mr. Smith and Mr. Abraham participate in the Plan.

For each year of credited service, a Plan participant accrues a retirement benefit calculated under a formula based on covered compensation for that year. Covered compensation is defined in the Plan documents. It includes, generally, all wages, salary and bonus actually received, plus contributions that the participant elects to be made on his or her behalf pursuant to a “cafeteria plan,” as defined in Section 125 of the Internal Revenue Code of 1986, as amended (the “Code”), or to a “qualified cash or deferred arrangement,” as defined in Section 401(k) of the Code.

Under the Plan formula applicable to the Mr. Smith and Mr. Abraham, the annual retirement benefit payable at normal retirement age as a straight life annuity is the sum of: (1) for years of credited service through 1992, 1% of average annual compensation during the five years ending December 31, 1992, multiplied by years of credited service through 1992, plus 0.33% of such average annual compensation in excess of $50,640 multiplied by years of credited service through 1992 up to a maximum of 30 years, and (2) for each year of credited service following 1992, 1% of annual compensation for that year, plus (for years of credited service up to a maximum of 30 years) 0.33% of such annual compensation in excess of the Social Security maximum wage base for that year.

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PENSION BENEFITS

		Number of Years Credited		Present Value of		Payments During Last
		Service		Accumulated Benefit		Fiscal Year
Name(1)	Plan Name	(#)		($)(2)		($)
(a)	(b)	(c)		(d)		(e)
Bruce Smith	Hancock Fabrics, Inc.
	Consolidated Retirement Plan		10.16	$	84,049		—
	Hancock Fabrics, Inc. Supplemental Retirement Plan		10.16	$	9,880		—
Dean Abraham	Hancock Fabrics, Inc.
	Consolidated Retirement Plan		22.0	$	307,114		—
	Hancock Fabrics, Inc. Supplemental Retirement Plan		22.0	$	8,338		—

(1)	Participation in the Hancock Fabrics, Inc. Consolidated Retirement Plan was frozen to employees with a hire date on or after January 1, 2005; therefore, Ms. Aggers, Ms. Moore and Ms. Kennedy are ineligible for this benefit.
(2)	As of February 3, 2007.

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Compensation Committee Report

The Compensation Committee has reviewed and discussed with management the Compensation Discussion and Analysis required by Item 402(b) of Regulation S-K. Based on the review and discussions, the Compensation Committee recommended to the Board of Directors that the Compensation Discussion and Analysis be included in this Annual Report on Form 10-K.

Members of the Compensation Committee:
Roger T. Knox, Co-Chair
Don L. Frugé
Wellford L. Sanders, Jr.
Donna L. Weaver
Bernard J. Wein, Co-Chair

Compensation of Directors

This table shows the compensation paid to our non-employee directors during the 2006 fiscal year. No amounts were paid to our non-employee directors during the 2006 fiscal year that would be classified as “Non-Equity Incentive Plan Compensation,” “Changes in Pension Value and Nonqualified Deferred Compensation Earnings” or “All Other Compensation,” so these columns have been omitted from the table.

	Fees
	Earned
	or
	Paid in		Stock		Option
	Cash		Awards(1)		Awards(2)		Total
Name	($)		($)		($)		($)
(a)	(b)		(c)		(d)		(h)
Don L. Frugé	$	10,200	$	43,800	$	9,754	$	63,754
Roger Knox	$	15,100	$	44,900	$	9,754	$	69,754
Wellford L. Sanders	$	0	$	60,000	$	12,630	$	72,630
Donna L. Weaver	$	0	$	60,000	$	9,754	$	69,754
Bernard J. Wein	$	0	$	60,000	$	12,611	$	72,611

(1)

Non-employee directors are permitted to receive meeting fees in shares of the Company’s common stock pursuant to the Company’s 2005 Stock Compensation Plan for Non-Employee Directors. The amounts shown reflect the value of fees directors elected to receive in shares.

(2)

Non-employee directors receive stock option grants under the 2001 Stock Incentive Compensation Plan at each annual meeting. No annual meeting was held during 2006; therefore, stock options were not granted to directors during 2006. The amounts shown do not reflect compensation actually received by the non-employee directors. Instead, the amounts shown are the compensation costs recognized by the Company for the year ended February 3, 2007, as determined pursuant to FAS 123(R). The assumptions used to calculate the value of these option awards are set forth under Note 12 to accompanying Consolidated Financial Statements included in this Annual Report on Form 10-K. As of February 3, 2007, each non-employee director held the following aggregate number of outstanding stock options:

	Option Awards
Director	(#)*
Don L. Frugé		20,000
Roger Knox		20,000
Wellford L. Sanders		12,500
Donna L. Weaver		20,000
Bernard J. Wein		12,500

* Includes vested and unvested stock options.

94

Under the 2005 Stock Compensation Plan for Non-Employee Directors which was approved by stockholders in June 2005, each eligible director could elect in advance to receive all or part of their quarterly director’s fee in the form of shares of common stock based on the market value on the date fees are payable. If the eligible director elected to receive less than 100% of the fee in common stock, the fee they received was $12,000. If a director made an election to receive 100% of their fee in common stock, the fee was increased by 25% before the number of shares was determined, having the effect of issuing stock with a value of $15,000. During 2006, two of the eligible directors elected to receive a portion of their quarterly fee in cash. On June 7, 2006, the Board of Directors amended the 2005 Stock Compensation Plan for Non-Employee Directors to remove the provision providing for the 25% fee increase for fees taken in stock and increased the quarterly fee paid to each non-employee director from $12,000 to $15,000. Such fees are payable in either stock or cash at each director’s discretion. No additional fees are paid for meetings attended or chaired.

Also on June 7, 2006, the Board of Directors amended the Company’s 2001 Stock Incentive Plan (the “Stock Incentive Plan”) to increase the annual stock option grant to each incumbent non-employee director from 2,500 to 20,000 shares and to increase the initial stock option grant to a newly appointed non-employee director from 10,000 shares to up to 20,000 shares (pro rated for the length of time remaining until the next June 15th, the approximate date of the Company’s annual meeting). In 2006, an annual meeting was not held; therefore, stock options were not granted to non-employee directors.

Directors who are employees of the Company receive no fees.

Stock Price Performance Graph

The following graph sets forth the Company’s cumulative total shareholder return (assuming reinvestment of dividends) as compared to the Russell 2000 and to the S&P Specialty Stores index. The graph assumes $100 invested on February 3, 2002. Note: The historical stock price performance shown on the graph below is not necessarily indicative of future price performance.

95

Total Return Analysis	2/3/2002		2/3/2003		2/1/2004		1/30/2005		1/28/2006		2/3/2007
Hancock Fabrics	$	100.00	$	116.10	$	119.81	$	66.33	$	33.08	$	30.34
S&P Specialty Stores Index	$	100.00	$	86.41	$	117.85	$	126.50	$	157.94	$	184.02
Russell 2000 Index	$	100.00	$	77.53	$	120.98	$	127.70	$	152.53	$	168.62

Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

Securities Authorized for Issuance Under Equity Compensation Plans

The following table provides certain information as of February 3, 2007, with respect to compensation plans under which shares of the Company’s common stock may be issued.

	(a)				(c)
	Number of				Number of securities
	securities to be		(b)		remaining available for
	issued upon		Weighted-average		future issuance under
	exercise of		exercise price of		equity compensation
	outstanding		outstanding		plans (excluding
	options, warrants		options, warrants		securities reflected
Plan Category	and rights		and rights		in column (a) (3)
Equity compensation plans approved by security holders (1)		1,695,275	$	11.78		986,850
Equity compensation plans not approved by security holders (2)		100,000	$	9.44		0
		1,795,275	$	11.65		986,850

(1)	Consists of shares of the Company’s common stock authorized for issuance under the Company’s 1987 Stock Option Plan, 1996 Stock Option Plan and 2001 Stock Incentive Plan.
(2)	This option grant was made from the 2004 Special Stock Plan, which was adopted to provide an employment inducement award exemption allowed under Section 303A.08 of the New York Stock Exchange Listed Company Manual.
(3)	These securities include shares available under the Company’s 2001 Stock Incentive Plan.

96

Security Ownership of Certain Beneficial Owners and Management

Security Ownership of Certain Beneficial Owners

The following table provides information about the persons known to the Company to be the beneficial owners of more than 5% of the Company’s common stock as of February 2, 2008:

Name and Address of	Number of Shares		Percent of
Beneficial Owner	Beneficially Owned		Class(1)
Aspen Advisors LLC (2) 152 West 57th Street		382,210		2.0	%
New York, NY, 10019
Sopris Capital Advisors, LLC (2) 314 S. Galena Street, Suite 300		1,834,890		9.5	%
Aspen, CO 81611
Sopris Capital, LLC (2) 314 S. Galena Street, Suite 300		1,314,740		6.8	%
Aspen, CO 81611
Nikos Hecht (2) 314 S. Galena Street, Suite 300		2,217,100		11.5	%
Aspen, CO 81611
Berg & Berg Enterprises, LLC (3) 10050 Brandley Drive		2,717,000		14.1	%
Cupertino, CA 94014
Rutabaga Capital Management (4) 64 Broad Street, 3rd Floor		1,436,800		7.4	%
Boston, MA 02109
Dimensional Fund Advisors LP (5) 1299 Ocean Avenue,		1,267,054		6.6	%
Santa Monica, CA 90401
Warren B. Kandars(6) C/o Kanders & Company, Inc. One Landmark Square, 22nd Floor		1,930,000		10	%
Stamford, CT 06901

(1)	Based on 19,285,235 shares of common stock outstanding as of February 2, 2008.
(2)	The information as to beneficial ownership is based on a Schedule 13G filed with the SEC on June 5, 2007, reflecting beneficial ownership of the Company’s common stock. The Schedule 13G was filed together for the following reporting persons:

Aspen Advisors LLC (“Aspen Advisors”)
Sopris Capital Advisors, LLC (“Sopris Advisors”)
Sopris Partners Series A, a series of Sopris Capital Partners, L.P. (“Sopris Partners”)
Sopris Capital, LLC (“Sopris Capital”)
Nikos Hecht

Of the shares reported as beneficially owned in this Schedule 13G, 1,314,740 shares are owned directly by Sopris Partners and 382,210 shares are owned by private clients of Aspen Advisors and 520,150 are owned by private clients of Sopris Advisors. Sopris Capital is the general partner of Sopris Partners and, as such, may be deemed to share beneficial ownership of the Common Stock owned directly by Sopris Partners. Mr. Hecht is the managing member of each of Aspen Advisors and of Sopris Advisors

97

	and the sole member of the managing member of Sopris Capital. As the managing member of Aspen Advisors and Sopris Advisors, the sole member of the managing member of Sopris Capital and the owner of a majority of the membership interests in each of Sopris Capital, Aspen Advisors and of Sopris Advisors, Mr. Hecht may be deemed to be the controlling person of Sopris Capital, Aspen Advisors and of Sopris Advisors, and through Sopris Capital, Sopris Partners. Each of Aspen Advisors and Sopris Advisors, as investment manager for their respective private clients, and with respect to Sopris Advisors, also as investment manager for Sopris Partners, has discretionary investment authority over the Common Stock held by their respective private clients and Sopris Partners, as applicable. Accordingly, Mr. Hecht may be deemed to be the beneficial owner of the Common Stock held by Sopris Partners and the private clients of Aspen Advisors and Sopris Advisors. Each of Sopris Partners and Sopris Capital disclaims any beneficial interest in the Common Stock owned by the accounts managed by Sopris Advisors and Aspen Advisors.
(3)	The information as to beneficial ownership is based on a Schedule 13G filed with the SEC on April 27, 2007.
(4)	The information as to beneficial ownership is based on a Schedule 13G/A filed with the SEC on January 23, 2007, reflecting beneficial ownership of the Company’s common stock. The Schedule 13G/A states that Rutabaga Capital Management beneficially owns 1,436,800 shares of common stock, including 488,500 shares as to which it has sole voting power, 948,300 shares as to which it has shared voting power and 1,436,800 shares as to which it has sole dispositive power.
(5)	The information as to beneficial ownership is based on a Schedule 13G/A filed with the SEC on January 23, 2007, reflecting beneficial ownership of the Company’s common stock. In the Schedule 13G, Dimensional Fund Advisors LP (“Dimensional”) states that it is an investment advisor registered under Section 203 of the Investment Advisors Act of 1940, furnishes investment advice to four investment companies registered under the Investment Company Act of 1940, and serves as investment manager to certain other commingled group trusts and separate accounts. These investment companies, trusts and accounts are the “Funds.” In its role as investment advisor or manager, Dimensional possesses investment and/or voting power over the securities of the Company that are owned by the Funds, and may be deemed to be the beneficial owner of the shares of the Company held by the Funds. Dimensional states that all securities reported in the Schedule 13G are owned by the Funds. Dimensional disclaims beneficial ownership of such securities.
(6)	The information as to beneficial ownership is based on a Schedule 13G filed with the SEC on November 30, 2007.

Security Ownership of Management

The following table provides information, as of February 2, 2008, about the beneficial ownership of the Company’s common stock by each of the Company’s directors, Named Executive Officers and all directors and executive officers as a group:

Name of	Number of Shares		Percent of
Beneficial Owner(1)	Beneficially Owned(2)		Class(3)
Jane F. Aggers		265,000		1.4	%
Bruce D. Smith(4)		150,658		*
Dean W. Abraham(4)		48,065		*
L. Gail Moore		35,693		*

98

Name of	Number of Shares		Percent of
Beneficial Owner(1)	Beneficially Owned(2)		Class(3)
Kathleen J. Kennedy(4)		35,618		*
Don L. Frugé		76,955		*
Roger T. Knox		60,825		*
Wellford L. Sanders, Jr.		45,839		*
Donna L. Weaver		141,797		*
Bernard J. Wein		47,066		*
All directors and executive officers as a group (10 persons)		907,516		4.6	%

*	Less than 1%
(1)	Unless otherwise indicated, the address for each beneficial owner is One Fashion Way, Baldwyn, Mississippi 38824.
(2)	As used in this table, beneficial ownership means the sole or shared power to vote, or direct the voting of a security, or the sole or shared power to dispose, or direct the disposition, of a security. All persons listed above have (i) sole voting power and investment power with respect to their shares of common stock, except to the extent that authority is shared by spouses under applicable law, and (ii) record and beneficial ownership with respect to their shares of common stock. Included in the above table are options to acquire shares of common stock which the listed individuals, respectively, have the right to acquire beneficial ownership of on or before April 2, 2008 (60 days from February 2, 2008). Also included in the above table are shares of unvested restricted stock in which the respective individuals have the right to vote and receive dividends before vesting. Options and unvested restricted shares included in the above table are as follows:

			Unvested
	Options		Restricted Shares
•      Ms. Aggers:		75,000		92,500
•      Mr. Smith:		66,500		32,900
•      Mr. Abraham:		15,000		25,700
•      Ms. Moore		12,500		20,000
•      Ms. Kennedy		12,500		20,000
•      Mr. Frugé:		18,125
•      Mr. Knox:		18,125
•      Mr. Sanders:		8,750
•      Ms. Weaver:		18,125
•      Mr. Wein:		8,750

(3)	Based on 19,285,235 shares of common stock outstanding as of February 2, 2008.
(4)	Mr. Smith resigned from the Company effective March 30, 2007. Mr. Abraham retired from the Company effective April 30, 2007. Ms. Kennedy’s termination was effective May 9, 2007. Shares are reflected for these individuals as of their respective termination dates.

Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

There are no relationships or transactions that are required to be reported.

99

Item 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES

Aggregate fees for professional services rendered for the Company by Burr Pilger & Mayer LLP in 2006 and by PricewaterhouseCoopers LLP in 2005 were as follows:

	Year Ended		Year Ended
	February 3,		January 28,
	2007		2006
Audit Fees(1)	$	1,564,000	$	3,900,000
Audit-Related Fees(1)		—		36,000
Tax Fees		—		9,798
Other Services		—		10,000
Total	$	1,564,000	$	3,955,798

⁽¹⁾ Reflects actual fees paid to date and fees anticipated.

In the above table, in accordance with the definition and rules of the SEC, “Audit Fees” are fees billed to the Company for professional services for the audit of the Company’s consolidated financial statements included in Form 10-K and review of financial statements included in Forms 10-Q, or for services that are normally provided by the independent auditors in connection with statutory and regulatory filings or engagements. “Audit Related Fees” are fees billed for assurance and related services that are reasonably related to the performance of the audit or review of the Company’s financial statements. “Tax fees” are fees billed for tax compliance, tax advice and tax planning.

The Audit Committee pre-approves all services performed by the Company’s independent auditors in accordance with the Company’s Audit Committee Pre-Approval Policy. The Pre-Approval Policy requires that any audit or non-audit services performed by the Company’s independent auditors receive either specific or appropriate general pre-approval by the Audit Committee. In addition, any service performed by the independent auditors that exceeds a pre-determined fee level is required to receive specific pre-approval by the Audit Committee. The Company’s independent auditor is permitted to provide audit, audit-related, tax and other services as detailed in the Pre-Approval Policy. The Company’s independent auditor is prohibited from performing certain non-audit services detailed in the policy. The Audit Committee pre-approved 100% of the services described above

100

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 36 of this Report.

(a) (2) Financial Statement Schedules

Schedule II – Valuation and qualifying accounts. (see page 106 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
3.1 3.2 3.3	b e t		Certificate of Incorporation. By-Laws. Amended and Restated By-Laws, effective July 3, 2007.
4.1	h		Amended and restated Rights Agreement with Continental Stock and Transfer Company, dated March 23, 1987, and amended and restated most recently on March 4, 2001.
4.2	c		Agreement with Continental Stock and Transfer Company (as Rights Agent) dated July 16, 1992.
10.1	e		Form of Indemnification Agreement, dated June 8, 1995, for each of Don L. Frugé, Larry G. Kirk and Donna L. Weaver.
10.2 10.3	f a	ª	Indemnification Agreement for Bruce D. Smith dated December 10, 1996. Agreement (deferred compensation) with Larry G. Kirk dated June 9, 1988.
10.4	a	ª	Agreement to Secure Certain Contingent Payments with Larry G. Kirk dated June 9, 1988.
10.5	e	ª	Form of Amendment, Extension and Restatement of Severance Agreement for Larry G. Kirk dated March 14, 1996.
10.6	f	ª	Amendment of Deferred Compensation Agreement, Severance Agreement and Agreement to Secure Contingent Payments with Larry G. Kirk dated June 13, 1996.
10.7	f	ª	Agreement (deferred compensation) with Bruce D. Smith dated December 10, 1996.
10.8	f	ª	Severance Agreement with Bruce D. Smith dated December 10, 1996.
10.9	f	ª	Agreement to Secure Certain Contingent Payments with Bruce D. Smith dated December 10, 1996.
10.10	d	ª	Supplemental Retirement Plan, as amended.
10.11	f	ª	1996 Stock Option Plan.
10.12	b	ª	Extra Compensation Plan.
10.13	g		Indemnification Agreement for Roger T. Knox dated June 21, 1999.
10.14	g	ª	Form of Agreement and Renewal of Severance Agreement for each of Larry G. Kirk and Bruce D. Smith dated May 4, 1999.
10.15	i	ª	2001 Stock Incentive Plan.
10.16	j	ª	Officer Incentive Compensation Plan as amended.
10.17	j	ª	Amended and Restated 1995 Restricted Stock Plan and Deferred Stock Unit Plan.
10.18	k	ª	Letter Agreement re Resignation and Compensation Arrangements (and Retirement Compensation Schedule) with Larry G. Kirk, dated as of December 15, 2004.
10.19	k	ª	Employment Agreement with Jane F. Aggers, dated as of December 15, 2004.
10.20	l	ª	2004 Special Stock Plan.
10.21	k	ª	Amendment to Agreement and Agreement to secure Certain Contingent Payments with Bruce D. Smith, dated as of March 15, 2005.

101

(a) (3)			Exhibits
10.22	k		Form of Indemnification Agreement, dated September 23, 2004 for Wellford L. Sanders, Jr. and June 10, 2004 for Bernard J. Wein.
10.23	m		Loan and Security Agreement (“Wachovia Credit Facility”), dated June 29, 2005, by and among Hancock Fabrics, Inc., HF Merchandising Inc., Hancock Fabrics of MI, Inc., hancockfabrics.com, Inc., Hancock Fabrics, LLC, HF Enterprises, Inc., HF Resources, Inc. and Wachovia Bank, National Association, in its capacity as agent.
10.24	m		Pledge and Security Agreement, dated June 29, 2005, by Hancock Fabrics, Inc., to and in favor of Wachovia Bank, National Association, in its capacity as agent.
10.26	m		Pledge and Security Agreement, dated June 29, 2005, by HF Resources, Inc., to and in favor of Wachovia Bank, National Association, in its capacity as agent.
10.27	m		Pledge and Security Agreement, dated June 29, 2005, by HF Enterprises, Inc., to and in favor of Wachovia Bank, National Association, in its capacity as agent.
10.28	m		Trademark Collateral Assignment and Security Agreement, dated June 29, 2005, by and among HF Enterprises, Inc. and Wachovia Bank, National Association, in its capacity as agent.
10.29	m		Guarantee, dated June 29, 2005, by Hancock Fabrics, Inc., HF Merchandising Inc., Hancock Fabrics of MI, Inc., hancockfabrics.com, Inc., Hancock Fabrics, LLC, HF Enterprises, Inc. and HF Resources, Inc. in favor of Wachovia Bank, National Association, in its capacity as agent.
10.30	m		Deposit Account Control Agreement, dated June 29, 2005, by and among BancorpSouth Bank, Hancock Fabrics, Inc. and Wachovia Bank, National Association, in its capacity as agent.
10.31	m		Deed of Trust, Security Agreement, Assignment of Rents and Leases and Fixtures, dated June 29, 2005, by and from Hancock Fabrics, Inc. to Donald G. Ogden for the benefit of Wachovia Bank, National Association, in its capacity as agent.
10.32	m		Affiliate Subordination Agreement, dated June 29, 2005, by and among Wachovia Bank, National Association, in its capacity as agent, HF Resources, Inc. and HF Enterprise, Inc.
10.33 10.34	n o	ª	First Amendment to Wachovia Credit Facility dated July 26, 2005. 2005 Stock Compensation Plan for Non-Employee Directors.
10.35	p	ª	Amendment to Employment Agreement with Jane F. Aggers, dated December 15, 2004.
10.36	p	ª	Amendment No. 1, dated December 9, 2005, to the Amended and Restated Rights Agreement.
10.37	*	ª	Severance agreement with Kathleen Kennedy, dated March 15, 2006.
10.38	q	ª	Amendment No. 2, dated March 20, 2006, to the Amended and Restated Rights Agreement.
10.39	q	ª	Amended and Restated Rights Agreement with Continental Stock Transfer and Trust Company as amended through March 20, 2006.
10.40	*	ª	2001 Stock Incentive Plan, as amended.
10.41	*	ª	Severance agreement with Gail Moore, dated June 12, 2006.
10.42	r		Fifth Amendment to Wachovia Credit Facility dated October 31, 2006.
10.43	*		Ratification and Amendment Agreement, dated March 22, 2007, by and among Hancock Fabrics, Inc., HF Merchandising Inc., Hancock Fabrics of MI, Inc., hancockfabrics.com, Inc., Hancock Fabrics, LLC, HF Enterprises, Inc., HF Resources, Inc. and Wachovia Bank, National Association, in its capacity as agent.
10.44	*		Amendment No. 1 to Ratification and Amendment Agreement, and Amendment No. 7 to Wachovia Credit Facility, dated April 19, 2007.
10.45	*	ª	Severance agreement with Kathleen Kennedy, dated May 9, 2007.
10.46	*		Amended and restated, Deposit Account Control Agreement, dated May 24, 2007, by and among BancorpSouth Bank, Hancock Fabrics, Inc. and Wachovia Bank, National Association, in its capacity as agent.
10.47	s		Loan and Security Agreement (Ableco Facility), dated June 15, 2007.

102

(a) (3)		Exhibits
21	*	Subsidiaries of the Registrant.
31.1	*	Certification of Chief Executive Officer
31.2	*	Certification of Chief Accounting Officer
32	*	Certification of Chief Executive Officer and Chief Accounting Officer Pursuant to 18 U.S.C. Section 1350
* Filed herewith.

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

a	Form 10-K dated April 26, 1990.
b	Form 10–K dated April 27, 1992.
c	Form 10–K dated April 26, 1993.
d	Form 10–K dated April 24, 1995.
e	Form 10–K dated April 22, 1996.
f	Form 10–K dated April 22, 1997.
g	Form 10–K dated April 25, 2000.
h	Form 8–K dated April 6, 2001.
i	Form S-8 dated September 7, 2001.
j	Form 10-K dated April 28, 2003.
k	Form 10-K dated April 15, 2005.
l	Form S-8 dated April 14, 2005.
m	Form 8–K dated July 6, 2005.
n	Form 10–Q dated September 8, 2005.
o	Form S-8 (File No. 333-128432) dated September 20, 2005.
p	Form 8–K dated December 9, 2005.
q	Form 8-K dated March 20, 2006.
r	Form 8-K dated November 1, 2006.
s	Form 8-K dated June 20, 2007.
t	Form 8-K dated July 5, 2007.
ª	Denotes management contract or compensatory plan or arrangement.

103

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, on the 18th day of February 2008.

HANCOCK FABRICS, INC.
 

By /s/ Jane F. Aggers  

Jane F. Aggers 

President, Director and
Chief Executive Officer
(Principal Executive Officer) 

By /s/ Larry D. Fair  

Larry D. Fair 

Vice President, and Chief
Accounting Officer (Principal
Financial and Accounting Officer) 

104

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/ Jane F. Aggers Jane F. Aggers	February 18, 2008
President, Director and Chief Executive Officer
(Principal Executive Officer)
/s/ Larry D. Fair	February 18, 2008
Larry D. Fair
Vice President and Chief Accounting Officer
(Principal Financial and Accounting Officer)
/s/ Don L. Frugé	February 18, 2008
Don L. Frugé
Director
/s/ Roger T. Knox	February 18, 2008
Roger T. Knox Director
/s/ Wellford L. Sanders, Jr. Wellford L. Sanders. Jr.	February 18, 2008
Director
/s/ Donna L. Weaver	February 18, 2008
Donna L. Weaver
Director
/s/ Bernard J. Wein Bernard J. Wein	February 18, 2008
Director

105

HANCOCK FABRICS, INC.

SCHEDULE II — VALUATION AND QUALIFYING ACCOUNTS
FOR FISCAL YEARS 2006, 2005 AND 2004
(In thousands)

			Additions
			Charged		Charged
	Balance		to Costs		to						Balance
	Beginning of		and		Other						Ending of
	Year		Expenses		Accounts			Deductions			Year
For the year ended February 3, 2007
Allowance for doubtful accounts	$	51	$	5	$	—		$	—		$	56
Reserve for sales returns		219		25		—			(50	)		194
Reserve for lower of cost or market inventory		372		—		—			(34	)		338
Reserves for store closings		1,179		1,675		—			(990	)		1,864
Asset retirement obligations		523		1		—			(48	)		476
Deferred tax asset valuation allowance		12,659		10,042		3,408			—			26,109
For the year ended January 28, 2006
Allowance for doubtful accounts	$	47	$	4	$	—		$	—		$	51
Reserve for sales returns		242		219		—			(242	)		219
Reserve for lower of cost or market inventory		—		372		—			—			372
Reserves for store closings		1,166		671		—			(658	)		1,179
Asset retirement obligations		473		50		—			—			523
Deferred tax asset valuation allowance		838		10,301		1,520	(a)		—			12,659
For the year ended January 30, 2005
Allowance for doubtful accounts	$	37	$	10	$	—		$	—		$	47
Reserve for sales returns		263		242		—			(263	)		242
Reserve for lower of cost or market inventory		—		—		—			—			—
Reserves for store closings		1,561		650		—			(1,045	)		1,166
Asset retirement obligations		428		45		—			—			473
Deferred tax asset valuation allowance		838		—		—			—			838

(a) — Recorded as a component of other comprehensive income (loss) related to minimum pension, SERP, and OPEB liabilitie

106

EX-10.37

EXHIBIT 10.37

SEVERANCE AGREEMENT

for Kathleen Kennedy

     THIS AGREEMENT between Hancock Fabrics, Inc., a Delaware corporation (the “Corporation”), and Kathleen Kennedy whose address is 6554 NW 31st^st Way, Boca Raton, FL 33496 (the “Executive”), dated as of March 15, 2006

W I T N E S S E T H :

     WHEREAS, the Corporation wishes to attract and retain well qualified executive and key personnel and, in the event of any Change of Control (as defined in Section 2) of the Corporation, to assure both itself and the Executive of continuity of management; and

     WHEREAS, the Corporation, wishes to enter into this Agreement until May 4, 2008 (“the Expiration Date”), and to automatically renew the Severance Agreement for an additional three year period on the Expiration Date and each subsequent expiration, unless the Incumbent Board elects to cancel the agreement as of the next Expiration Date; and

     WHEREAS, except as provided in Section 5(b) of this Agreement, no benefits shall be payable under this Agreement unless the Effective Date shall occur and thereafter the Executive’s employment is terminated; and

     WHEREAS, the employment of the Executive is “at will” and, except as provided in Section 5(b) of this Agreement, may be terminated by the Corporation without payment of any benefits hereunder until the occurrence of a Change of Control;

     NOW, THEREFORE, in consideration of the premises and mutual covenants herein contained, it is hereby agreed by and between the Corporation and the Executive as follows:

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     1. Operation of Agreement. No benefits shall be payable hereunder unless a Change of Control (as defined in Section 2) occurs during the Change of Control Period (as defined in Section 3). For the purposes of this Agreement, the date on which such a Change of Control occurs is referred to herein as the “Effective Date.”

     2. Change of Control. For the purposes of this Agreement, a “Change of Control” shall mean a change of control of a nature that would be required to be reported by the Corporation in response to Item 1(a) of the Current Report on Form 8-K (or its successor Item or Form, as the case may be), as in effect on the date hereof (or from time to time thereafter), pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 (the “Exchange Act”); provided that, without limitation, such a “Change of Control” shall be deemed to have occurred if: (i) a third person, including an aggregation of persons constituting a “person” as defined in Section 13(d)(3) of the Exchange Act, becomes the beneficial owner, directly or indirectly, of 20% or more of the combined voting power of the Corporation’s outstanding voting securities ordinarily having the right to vote for the election of directors of the Corporation or (ii) individuals who constitute the Board of Directors of the Corporation as of the date hereof (the “Incumbent Board”) cease for any reason to constitute at least two-thirds thereof, provided that any person becoming a director subsequent to the date hereof whose election, or nomination for election by the Corporation’s stockholders, was approved by a vote of at least three-quarters of (or if less, all but one of) the directors comprising the Incumbent Board (other than an election or nomination in connection with an actual or threatened election contest relating to the election of directors of the Corporation, as such terms are used in Rule 14a-12(c) of the Regulation 14A promulgated under the Exchange Act) shall be, for purposes of this Agreement, considered as though such person were a member of the Incumbent Board.

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     3. Change of Control Period. The “Change of Control Period” is the period commencing on the date of this Agreement and ending on the earlier to occur of (i) the Expiration Date, or (ii) the first day of the month coinciding with or next following the Executive’s 65th birthday. The expiration of the Change of Control Period shall not limit the Corporation’s obligation to provide, or the Executive’s right to collect, payments and benefits pursuant to Section 5 and Section 10 hereof.

     4. Certain Definitions.

          (a) Death or Disability. The Executive’s employment shall terminate automatically upon the Executive’s death (“Death”). The Corporation will be considered to have terminated the Executive’s employment for Disability, if after having established the Executive’s Disability (as defined below), the Executive receives written notice given in accordance with Section 9(b) of the Corporation’s intention to terminate her employment. The Executive’s employment will terminate for Disability effective on the 90th day after receipt of such notice (the “Disability Effective Date”) if within such 90-day period after such receipt the Executive shall fail to return to full-time performance of her duties. For purposes of this Agreement, “Disability” means a disability that, after the expiration of more than 180 days after its commencement, is determined to be total and permanent by a physician selected by the Corporation or its insurers and acceptable to the Executive or her legal representative (such agreement as to acceptability not to be withheld unreasonably).

     Consistent with, and not in limitation of, the provisions of Section 6 of this Agreement, neither a termination for, nor a determination of, Disability pursuant to this Section 4(a) shall be deemed in and of itself a termination for or determination of disability with respect to the Executive’s eligibility to receive long-term disability benefits, continued medical, dental, or life insurance coverage, retirement benefits, or benefits under any other plan or program provided by the Corporation or one of its affiliated companies and for which the Executive may qualify.

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          (b) Cause. The Executive’s employment will be terminated for Cause if the majority of the Incumbent Board determines that Cause (as defined in this Agreement) exists. For purposes of this Agreement, “Cause” means (i) an act or acts of fraud or misappropriation on the Executive’s part that result in or are intended to result in her personal enrichment at the expense of the Corporation or one of its affiliated companies or (ii) conviction of a felony.

          (c) Good Reason. For purposes of this Agreement, “Good Reason” means

               (i) without the express written consent of the Executive, (A) the assignment to the Executive of any duties inconsistent in any substantial respect with the Executive’s position, authority or responsibilities as in effect during the 90-day period immediately preceding the Effective Date, or (B) any other substantial adverse change in such position (including titles and reporting requirements), authority or responsibilities;

               (ii) any failure by the Corporation to furnish the Executive and/or, where applicable, her family with compensation (including annual bonus) and benefits at a level equal to or exceeding those received (on an annual basis) by the Executive from the Corporation during the 90-day period preceding the Effective Date, including a failure by the Corporation to maintain the Corporation’s extra compensation plan(s)(Extra Compensation Plan”) and “Officers Incentive Compensation Plan” or any subsequent plans) (including the right to defer the receipt of payments thereunder), other than an insubstantial and inadvertent failure remedied by the Corporation promptly after receipt of notice thereof given by the Executive;

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               (iii) the Corporation’s requiring the Executive to be based or to perform services at any office or location other than that at which the Executive is primarily based during the 90-day period preceding the Effective Date, except for travel reasonably required in the performance of the Executive’s responsibilities; or

               (iv) any failure by the Corporation to obtain the assumption and agreement to perform this Agreement by a successor as contemplated by Section 8(b).

     For the purposes of this Section 4(c), any good faith determination of “Good Reason” made by the Executive shall be conclusive.

          (d) [Reserved].

          (e) Notice of Termination. Any termination by the Corporation for Cause or by the Executive for Good Reason shall be communicated by Notice of Termination to the other party hereto given in accordance with Section 9(b). Any notice of termination by the Corporation for Disability shall be given in accordance with Section 4(a). For purposes of this Agreement, a “Notice of Termination” means a written notice that (i) indicates the specific termination provision in this Agreement relied upon, (ii) sets forth in reasonable detail the facts and circumstances claimed to provide a basis for termination of the Executive’s employment under the provision so indicated and (iii) if the termination date is other than the date of receipt of such notice, specifies the termination date (which date shall not be more than 15 days after the giving of such notice).

          (f) Date of Termination. Date of Termination means the date of receipt of the Notice of Termination or any later date specified therein as the termination date, as the case may be, or if the Executive’s employment is terminated by the Corporation for any reason other than Cause, Death or Disability, the date on which the Corporation notifies the Executive of such termination. Notwithstanding any contrary provision in this Section 4(f), if the Executive’s employment terminates due to Disability, the Date of Termination shall be the Disability Effective Date.

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     5. Obligations of the Corporation Upon Termination.

          (a) Good Reason, Other Than For Cause, Death or Disability on or After the Effective Date. Regardless of whether the Change of Control Period has expired, if, within three years after the Effective Date, (i) the Corporation shall terminate the Executive’s employment for any reason other than for Cause, Death or Disability, or (ii) the Executive shall terminate her employment for Good Reason:

               (I) the Corporation shall pay to the Executive in a lump sum in cash within 20 days after the Date of Termination the aggregate of the amounts determined pursuant to the following clauses (A) and (B):

                    (A) if not theretofore paid, the Executive’s base salary through the Date of Termination at the rate in effect at the time the Notice of Termination was given; and

                    (B) the sum of (x) the Executive’s annual base salary at the rate in effect at the time the Notice of Termination was given, or if higher, at the highest rate in effect at any time within the 90-day period preceding the Effective Date and (y) an amount equal to the highest bonus paid or payable to the Executive pursuant to the applicable cash incentive compensations plan(s) within five fiscal years prior to the Effective Date, provided, however, that in no event shall the Executive be entitled to receive under this clause (B) more than the product obtained by multiplying the amount determined as hereinabove provided in this clause (B) by a fraction whose numerator shall be the number of months (including fractions of a month) that at the Date of Termination remain until the first day of the month coinciding with or next following the Executive’s 65th birthday and whose denominator shall equal twelve (12); and

               (II) until the earlier to occur of (i) the date one year following the Date of Termination, or (ii) the first day of the first month coinciding with or next following the Executive’s 65th birthday (the period of time from the Date of Termination until the earlier of (i) or (ii) is hereinafter referred to as the “Unexpired Period”), the Corporation shall

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continue to provide all benefits that the Executive and/or her family is or would have been entitled to receive under all medical, dental, vision, disability, executive life, group life, accidental death and travel accident insurance plans and programs of the Corporation and its affiliated companies, in each case on a basis providing the Executive and/or her family with the opportunity to receive benefits at least equal to those provided by the Corporation and its affiliated companies for the Executive under such plans and programs if and as in effect at any time during the 90-day period preceding the Effective Date.

          (b) Severance before the Effective Date. If the Corporation terminates Executive’s employment other than for Cause, Death or Disability before the earlier of the Effective Date or January 1, 2008, the Corporation shall pay the Executive in a lump sum in cash within 20 days after the Date of Termination (or if later, as soon as practical after the expiration of any revocation period related to the release described below), severance pay equal to 12 months of the Executive’s annual base salary at the rate in effect at the time the Notice of Termination was given; provided the Corporation’s obligation to make such payment shall be conditioned on the Executive executing in favor of the Corporation an agreement, in such form and with such terms as the Corporation in its sole discretion may dictate, providing for, among other things, a release by the Executive of all claims against the Corporation and its affiliates, and for the Executive to observe various restrictive covenants and confidentiality requirements.

     6. Non-exclusivity of Rights. Nothing in this Agreement shall prevent or limit the Executive’s continuing or future participation in any benefit, bonus, incentive or other plan or program provided by the Corporation or any of its affiliated companies and for which the Executive may qualify, nor shall anything herein limit or otherwise affect such rights as the Executive may have under any employment, stock option or other agreements with the Corporation or any of its affiliated companies. Amounts that are vested benefits or that the Executive is otherwise entitled to receive under any plan

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or program of the Corporation or any of its affiliated companies at or subsequent to the Date of Termination shall be payable in accordance with such plan or program.

     7. Full Settlement. The payments provided for in this Agreement are in full settlement of any claims the Executive may have against the Corporation arising out of her termination, including, but not limited to, any claims for wrongful discharge. The Corporation’s obligation to make the payments provided for in this Agreement and otherwise to perform its obligations hereunder shall not be affected by any circumstances, including, without limitation, any setoff, counterclaim, recoupment, defense or other right that the Corporation may have against the Executive or others; provided, however, that the Corporation’s failure to make any such setoff shall not constitute a waiver of any claim of the Corporation against the Executive. In no event shall the Executive be obligated to seek other employment by way of mitigation of the amounts payable to the Executive under any of the provisions of this Agreement. The Corporation agrees to pay, to the full extent permitted by law, all legal fees and expenses the Executive may reasonably incur as a result of any contest (regardless of the outcome thereof) by the Corporation or others of the validity or enforceability of, or liability under, any provision of this Agreement or any guarantee of performance thereof, in each case plus interest, compounded monthly, on the total unpaid amount determined to be payable under this Agreement, such interest to be calculated on the basis of the prime commercial lending rate announced by Union Planters Bank, in effect from time to time during the period of such non-payment.

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     8. Successors.

          (a) This Agreement is personal to the Executive and without the prior written consent of the Corporation shall not be assignable by the Executive otherwise than by will or the laws of descent and distribution. This Agreement shall inure to the benefit of and be enforceable by the Executive’s legal representatives, executors, heirs and legatees.

          (b) This Agreement shall inure to the benefit of and be binding upon the Corporation and its successors. The Corporation shall require any successor to all or substantially all of the business and/or assets of the Corporation, whether directly or indirectly, by purchase, merger, consolidation, acquisition of stock, or otherwise, by an agreement in form and substance satisfactory to the Executive, expressly to assume and agree to perform this Agreement in the same manner and to the same extent as the Corporation would be required to perform if no such succession had taken place.

     9. Miscellaneous.

          (a) The captions of this Agreement are not part of the provisions hereof and shall have no force or effect. This Agreement may not be amended or modified otherwise than by a written agreement executed by the parties hereto or their respective successors and legal representatives.

          (b) All notices and other communications hereunder shall be in writing and shall be given by hand delivery to the other party or by registered or certified mail, return receipt requested, postage prepaid, addressed as follows:

If to the Executive:

At the address first hereinabove written.

If to the Corporation:

Hancock Fabrics, Inc.
One Fashion Way
Baldwyn, Mississippi 38824

Attn: Corporate Secretary

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or to such other address as either party shall have furnished to the other in writing in accordance herewith. Notice and communications shall be effective when actually received by the addressee.

          (c) The invalidity or unenforceability of any provision of this Agreement shall not affect the validity or enforceability of any other provision of this Agreement.

          (d) The Corporation may withhold from any amounts payable under this Agreement such federal, state or local taxes as shall be required to be withheld pursuant to any applicable law or regulation, provided, however, that such withholding shall be consistent with the calculations made by Accounting Firm under Section 10 of the Agreement.

          (e) This Agreement contains the entire understanding with the Executive with respect to the subject matter hereof.

          (f) Whenever used in this Agreement, the masculine gender shall include the feminine or neuter wherever necessary or appropriate and vice versa and the singular shall include the plural and vice versa.

          (g) The Executive and the Corporation acknowledge that the employment of the Executive by the Corporation is “at will” and may be terminated by either the Executive or the Corporation at any time and for any reason. Nothing contained in the Agreement shall affect such rights to terminate, it being agreed, however, that nothing in this Section 9(g) shall prevent the Executive from receiving any amounts payable pursuant to Section 5(a), or 10 of this Agreement in the event of a termination described in such Section 5(a), or 10 on or after the Effective Date.

     10. Penalty Taxes.

          (a) Payment. In the event that the Accounting Firm determines that any payment or other compensation or benefits made or provided to or for the benefit of the Executive in any way connected with employment of the Executive by the Corporation will be subject to tax pursuant to section 4999 of the Code or any successor provision or any counterpart provision of state tax law (the “Penalty Taxes”), the Corporation shall pay to the Executive

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within 20 days after receipt of a written demand therefor from the Executive an amount which, after deduction of all additional Federal, state and local taxes (including, without limitation, income taxes and additional Penalty Taxes) required to be paid by the Executive in respect of receipt of such amount, shall be equal to the Penalty Taxes. In calculating the income taxes required to be paid by the Executive, the Accounting Firm shall assume that the Executive will pay tax at the maximum marginal Federal, state and local rates and that the Executive will have no deductions or credits available to reduce such taxes. In consideration of the payment of such amounts, the Executive shall report and pay such taxes and promptly provide the Corporation with a written statement that such filing and payment have occurred executed by the person or firm that signed as income tax return preparer of the Executive’s federal income tax return, or if prepared by the Executive, executed by the Executive.

          (b) Indemnity. If the Executive shall be required to pay Penalty Taxes in addition to those reimbursed pursuant to paragraph (a) above, or if based upon failure to receive the opinion of Tax Counsel referred to in paragraph (d) below the Executive reports and pays greater amounts of Penalty Taxes than are reimbursed pursuant to paragraph (a) above (any such event hereafter being referred to as a “Loss”), the Executive shall notify the Corporation and the Corporation shall pay to the Executive as an indemnity an amount which, after deduction of all income taxes and additional Federal, state and local taxes (including, without limitation, income taxes and additional Penalty Taxes) required to be paid by the Executive in respect of receipt of such amount (assuming, for this purpose, that the Executive is subject to the maximum marginal rates of taxation applicable to individuals at such time as such amount becomes due and that the Executive will have no deductions or credits available to reduce such taxes), shall be equal to the sum of (x) the Penalty Taxes resulting in the Loss and (y) the net amount of any interest, penalties or additions to tax payable to the United States Government or any state or local government (after allowing for the deduction

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of such amounts, to the extent properly deductible, for Federal, state or local income tax purposes) as a result of such Loss. Each payment by the Corporation hereunder shall be made within 30 days after receipt of a written demand therefor from the Executive accompanied by a written statement describing in reasonable detail the Loss in question, the amount of additional tax, interest, penalties or additions to tax and the calculation of the payment due in respect thereof; provided that, if a contest of the Loss is being conducted pursuant to paragraph (c) below, payment shall not be required by the Corporation until 30 days after the completion or termination of such contest.

          (c) Contest.

               (1) The Executive shall notify the Corporation within 30 days of receipt from the Internal Revenue Service of a revenue agent’s report, a 30-day letter or a notice of deficiency (as described in Section 6212 of the Code or any successor provision) or of a similar written claim from a state taxing authority, in which an adjustment is proposed to the federal or state taxes of the Executive for which the Corporation would be required to indemnify the Executive hereunder. If the Corporation (i) requests the Executive to do so within 30 days after such notice, and (ii) furnishes the Executive an opinion of recognized tax counsel selected by the Corporation and approved by the Executive, which approval shall not unreasonably be withheld, (hereinafter “Tax Counsel”) to the effect that a reasonable basis exists for contesting such proposed adjustment, the Executive shall contest the proposed adjustment in good faith, shall keep the Corporation reasonably informed as to the progress of such contest, and shall consider in good faith any suggestion made by the Corporation as to the method of pursuing such contest; provided, however, that the Executive shall not be obligated to contest such adjustment unless (i) the Corporation acknowledges in writing its liability under paragraph (b) above to indemnify the Executive in the event that the Internal Revenue Service or a state taxing authority prevails in its position regarding the proposed adjustment; (ii) the Corporation shall have fully performed its

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prior obligations under this Agreement; and (iii) the subject matter thereof shall not have been previously decided pursuant to the contest provisions of this paragraph (c) with respect to any other executive of the Corporation, unless the Corporation shall have furnished an opinion of Tax Counsel to the Executive that more likely than not the Executive will prevail in the contest; provided, further, that the Executive shall determine, in her sole discretion, the nature of all action to be taken to contest such proposed adjustment, including (x) whether any action to contest such proposed adjustment initially shall be by way of judicial or administrative proceedings, or both, (y) whether any such proposed adjustment shall be contested by resisting payment thereof or by paying the same and seeking a refund thereof, and (z) if the Executive shall undertake judicial action with respect to such proposed adjustment, the court or other judicial body before which such action shall be commenced. The Executive shall, if requested by the Corporation within 30 days of an adverse determination by any court, and if Tax Counsel is of the opinion that there is a reasonable basis for a successful appeal of the matter in question, be obligated to appeal such adverse determination.

               (2) The Executive shall not be required to take any action pursuant to this paragraph (c) unless and until the Corporation shall have agreed in writing to indemnify the Executive in a manner reasonably satisfactory to the Executive for any fees, expenses, statutory or regulatory penalties, interest, additions to tax, or other similar liabilities or losses which the Executive may incur as a result of contesting the validity of any proposed adjustment and shall have agreed to pay (or in the Executive’s sole discretion to prepay) to the Executive on demand all costs and expenses which the Executive may incur in connection with contesting such proposed adjustment (including without limitation fees and disbursements of counsel). If the Executive determines to contest any adjustment by paying the additional tax and suing for a refund, the Corporation shall timely advance to the Executive on an interest free basis an amount equal to the sum of any tax, interest, penalties and additions to tax which are required to be paid; provided,

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however, that, if the Executive is required to include in income any amount with respect to such loan or the imputation of interest thereon in any taxable year of the Executive prior to final determination of the contest, then the Corporation, within 30 days of written notice thereof by the Executive, shall pay to the Executive an amount which, after deduction of all additional Federal, state and local taxes required to be paid by the Executive in respect of the receipt of such amount (assuming, for this purpose, that the Executive is subject to the maximum marginal rate of taxation applicable to individuals at such times as such amount becomes due), shall be equal to the aggregate additional federal and state income taxes payable by the Executive with respect to such taxable year as a result of such inclusion. Upon receipt by the Executive of a refund of any amounts paid by the Executive based on any adjustment in respect of which amounts the Executive shall have been paid or advanced an equivalent amount by the Corporation, the Executive shall pay to the Corporation the amount of such refund (which, in the case of any contest in which a loan has been advanced pursuant to this paragraph, shall be deemed to be in repayment of the loan advanced by the Corporation to the extent fairly attributable thereto), but not in excess of the amount paid or advanced by the Corporation, together with any interest received by the Executive on such refund plus any net additional Federal, state or local tax benefits actually realized by the Executive as the result of such payment, and reduced by the amount of any Federal, state or local tax actually payable with respect to receipt of such refund; provided, however, that the Executive may offset the amount of such refund and benefits against any amount due and owing by the Corporation to the Executive pursuant to this Agreement. Upon disallowance of any such refund, the Corporation shall forgive the amount of the advance fairly attributable thereto and shall pay to the Executive the amount of its indemnity obligation hereunder, including such amount as, after deduction of all taxes required to be paid by the Executive in respect of the receipt of such amount under the laws of any Federal, state or local government or taxing authority of the United States, shall be equal to the sum on an after-tax

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basis, of any tax, interest, penalties or additions to tax payable with respect to the forgiveness of such advance.

               (3) If any adjustment referred to in this paragraph (c) shall be proposed and the Corporation shall have requested the Executive to contest such adjustment as above provided and shall have duly complied with the terms of this paragraph (c), the Corporation’s liability with respect to such adjustment shall become fixed upon final determination of such adjustment; provided, however, that if the Corporation shall not deliver the opinion of Tax Counsel provided in this paragraph (c) to the effect that there is a reasonable basis for a contest or appeal, then the Corporation’s obligation to pay such indemnity shall become immediately fixed.

          (d) No Inconsistent Action. The Executive agrees that he will not take any action, directly or indirectly, or file any returns or other documents inconsistent with the assumption that the payments to which the indemnification of paragraph (b) applies do not result in imposition of the tax under section 4999, and the Executive shall file such returns, take such actions, maintain such records and execute such documents as may be reasonably requested by the Corporation; provided, however, that the Executive’s obligations hereunder to file returns or other documents shall apply only if the Executive receives an opinion of Tax Counsel at least 10 days prior to the due date of the return (without regard to extensions) required to be made with respect to the payments to which the indemnification of paragraph (b) applies that the Executive will not be subject to the penalties described in sections 6651, 6662 or 6663 of the Code, or successor provisions then in effect, as a result of taking such position.

          (e) Disbursements. Any payments required to be made by the Corporation pursuant to this Section 10 shall be made directly by the Corporation to the Executive. Payments made by the Corporation or the Executive pursuant to this Agreement shall be made by wire transfer of immediately available funds to such bank and/or account in the continental United States as specified by the other party in written directions to such

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payor party, and if no such direction shall have been given, by check payable to the order of such other party and mailed to such other party by certified mail, postage prepaid.

          (f) No Setoff. No payment required to be made by the Corporation pursuant to this Section 10 shall be subject to any right of setoff, counterclaim, defense, abatement, suspension, deferment or reduction, and, except in accordance with the express terms hereof, the Corporation shall have no right to terminate the Agreement or to be released, relieved or discharged from any obligation or liability thereunder for any reason whatsoever.

          (g) Late Payment, Interest. Any late payment by any party hereto of any of its obligations under this Agreement shall bear interest to the extent permitted by applicable law, at a fluctuating rate per annum equal to the Prime Rate as announced publicly by Union Planters Bank from time to time plus two percentage points, for the period such interest is payable.

          (h) Accounting Firm. The Accounting Firm shall mean the Memphis, Tennessee Main Office of PricewaterhouseCoopers, or, at the election of the Executive, the Memphis, Tennessee Main Office of such other national or regional accounting firm as the Executive shall select subject to the approval of the Corporation, which approval shall not unreasonably be withheld. Compensation of the Accounting Firm with respect to its services hereunder shall be the responsibility of the Executive.

          (i) Notwithstanding the foregoing, if any provision of this Agreement would cause compensation to be includible in the Executive’s income pursuant to Section 409A of the Internal Revenue Code, then such provision shall be null and void and the Corporation shall amend the Agreement in such a way as to cause substantially similar economic results without causing such inclusion; any such amendment shall be binding on Executive.

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     IN WITNESS WHEREOF, the Executive has hereunto set her hand and, pursuant to the authorization of its Board of Directors, the Corporation has caused these presents to be executed in its name on its behalf, and its corporate seal to be hereunto affixed, all as of the day and year first above written.

/s/ Kathleen Kennedy
	Executive
HANCOCK FABRICS, INC.
By	/s/ Bruce D. Smith, CFO

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EX-10.40

EXHIBIT 10.40

HANCOCK FABRICS, INC.

2001 STOCK INCENTIVE PLAN

1. Purpose.

     The purpose of the HANCOCK FABRICS, INC. 2001 STOCK INCENTIVE PLAN (the “Plan”) is to further the earnings of HANCOCK FABRICS, INC., a Delaware corporation, and its subsidiaries (collectively, the “Company”) by assisting the Company in attracting, retaining and motivating key employees and directors of high caliber and potential. The Plan provides for the award of long-term incentives to those key employees and directors who make substantial contributions to the Company by their loyalty, industry and invention.

2. Administration.

     The Plan shall be administered by the Stock Plan Committee (the “Committee”) selected by the Board of Directors of the Company (the “Board of Directors”) consisting solely of two or more members who are “outside directors” as described in Section 162(m) of the Internal Revenue Code of 1986, as amended (the “Code”). Except to the extent permitted under paragraph 6(g) hereof or Rule 16b-3 under the Securities Exchange Act of 1934, as amended (the “1934 Act”) (or any successor rule of similar import), each Committee member shall be ineligible to receive, and shall not have been, during the one-year period prior to appointment thereto, granted or awarded stock options or restricted stock pursuant to this Plan or any other similar plan of the Company or any affiliate of the Company. Without limiting the foregoing, the Committee shall have full and final authority in its discretion to interpret the provisions of the Plan and to decide all questions of fact arising in its application. Subject to the provisions hereof, the Committee shall have full and final authority in its discretion to determine the employees and directors to whom awards shall be made under the Plan; to determine the type of awards to be made and the amount, size and terms and conditions of each such award; to determine the time when awards shall be granted; to determine the provisions of each agreement evidencing an award; and to make all other determinations necessary or advisable for the administration of the Plan.

3. Stock Subject to the Plan.

     The Company may grant awards under the Plan with respect to not more than a total of 3,150,000 shares of $.01 par value common stock of the Company (the “Shares”), (subject to adjustment as provided in paragraph 18, below). Such Shares may be authorized and unissued Shares or treasury Shares. The total shares available to be awarded as Restricted Stock Awards (paragraph 7, below) shall not exceed 1,350,000 shares in aggregate (subject to adjustment as provided in paragraph 18, below). Except as otherwise provided herein, any Shares subject to an option which for any reason is surrendered before exercise or expires or is terminated unexercised as to such Shares shall again be available for the granting of awards under the Plan. Similarly, if any Shares granted pursuant to restricted stock awards are forfeited, such forfeited Shares shall again be available for the granting of awards under the Plan.

4. Eligibility to Receive Awards.

     Persons eligible to receive awards under the Plan shall be limited to those officers, other key employees and directors of the Company who are in positions in which their decisions, actions and counsel have a significant impact upon the profitability and success of the Company (but excluding members of the Committee, except as provided in paragraph 6(g)).

5. Form of Awards.

     Awards may be made from time to time by the Committee in the form of stock options to purchase Shares, restricted stock, or any combination of the above. Stock options shall be limited to options which do not qualify (“Nonqualified Stock Options”) as incentive stock options within the meaning of Section 422(b) of the Code.

6. Stock Options.

     Stock options for the purchase of Shares shall be evidenced by written agreements in such form not inconsistent with the Plan as the Committee shall approve from time to time; provided that the maximum number of options which may be granted to any one grantee during any twelve-month period is 100,000 ((as adjusted pursuant to paragraph 18, below). Such agreement shall contain the terms and conditions applicable to the options, including in substance the following terms and conditions:

(a)	Number of Shares. Each option agreement shall identify the options represented as Nonqualified Stock Options, and shall set forth the number of Shares subject to the option (as adjusted pursuant to paragraph 18, below).
(b)	Option Price. The option exercise price to be paid by the optionee to the Company for each Share purchased upon the exercise of an option shall be determined by the Committee, but shall in no event be less than 100 percent of the fair market value per Share on the date the option is granted, as determined by the Committee. Notwithstanding anything herein to the contrary, the Committee shall not reprice any options to a lower exercise price at any time during the term of any option granted under this Plan.
(c)	Exercise Term. Each option agreement shall state the period or periods of time within which the option may be exercised, in whole or in part, as determined by the Committee and subject to such terms and conditions as are prescribed for such purpose by the Committee, provided that no option shall be exercisable, except as provided in paragraph 16 or in the event of Retirement (as defined below), death or Disability (as defined below), any more rapidly than from (i) the first anniversary of the date of grant thereof, to the extent of 25% of the Shares covered thereby, (ii) the second anniversary of the date of grant thereof, to the extent of an additional 25% of the Shares covered thereby, (iii) the third anniversary of the date of grant thereof, to the extent of an additional 25% of the Shares covered thereby, and (iv) the fourth anniversary of the date of grant thereof, to the extent of the remaining 25% of the Shares covered thereby. The Committee, in its discretion, may provide in the option agreement that the option

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shall become immediately exercisable, in whole or in part, in the event of Retirement, death or Disability. Notwithstanding the foregoing, no option shall be exercisable after ten years from the date of grant.

(d)

Payment for Shares. The purchase price of the Shares with respect to which an option is exercised shall be payable in full at the time of exercise in cash, Shares at fair market value, or a combination thereof, as the Committee may determine and subject to such terms and conditions as may be prescribed by the Committee for such purpose. If the purchase price is paid by tendering Shares, the Committee in its discretion may grant the optionee a new stock option for the number of Shares used to pay the purchase price.

(e)

Rights Upon Termination. In the event of Termination (as defined below) of an optionee’s status as an employee or director of the Company for any cause other than Retirement, death or Disability, all unexercised options shall terminate immediately unless otherwise specified in the Option Grant Agreement or unless the Committee shall determine otherwise. (As used herein, “Termination” means, (i) in the case of an employee, the cessation of the grantee’s employment by the Company for any reason, and (ii) in the case of a director, the cessation of the grantee’s service as a director of the Company; and “Terminates” has the corresponding meaning. As used herein, “Retirement” means (in the case of an employee) termination of employment under circumstances entitling the participant to elect immediate payment of retirement benefits under the Hancock Fabrics, Inc. Consolidated Retirement Plan or any successor plan, or (in the case of a director), the same meaning as Termination or Terminates and “Retires” has the corresponding meaning. As used herein, “Disability” means failure to return to full-time employment duties immediately after the participant has exhausted the short term disability benefits under the then applicable short term disability policy or procedures of the Company, and “Disabled” has the corresponding meaning). In the event that an optionee Retires, dies or becomes Disabled prior to the expiration of his option and without having fully exercised his option, the optionee or his Beneficiary (as defined below) shall have the right to exercise the option during its term within a period of (i) one year after Termination due to Retirement, death or Disability, or (ii) one year after death if death occurs either within one year after Termination due to Retirement or Disability to the extent that the option was exercisable at the time of death or Termination, or within such other period, and subject to such terms and conditions, as may be specified by the Committee. (As used herein, “Beneficiary” means the person or persons designated in writing by the grantee as his Beneficiary with respect to an award under the Plan; or, in the absence of an effective designation or if the designated person or persons predecease the grantee, the grantee’s Beneficiary shall be the person or persons who acquire by bequest or inheritance the grantee’s rights in respect of an award). In order to be effective, a grantee’s designation of a Beneficiary must be on file with the Committee before the grantee’s death, but any such designation may be revoked and a new designation substituted therefor at any time before the grantee’s death.

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(f)	Nontransferability. Except as provided in paragraph 14(b), options granted under the Plan shall not be sold, assigned, transferred, exchanged, pledged, hypothecated, or otherwise encumbered, other than by will or by the laws of descent and distribution. Except as provided in paragraph 14(b), during the lifetime of the optionee the option is exercisable only by the optionee.
(g)	Automatic Grant of Options to Nonemployee Directors. Notwithstanding any other provision of the Plan, the grant of options hereunder to directors who are not also employees of the Company (“Nonemployee Directors”) shall be subject to the following terms and conditions:

(i)	Immediately following the 2001 Annual Meeting, if this Plan is approved by the holders of a majority of the Company’s voting securities, each Nonemployee Director of the Company shall be granted a Nonqualified Stock Option to purchase 10,000 Shares (as adjusted pursuant to paragraph 18, below).
(ii)	Immediately following each of the consecutive annual meetings of the stockholders of the Company (“Annual Meeting”) beginning with the first Annual Meeting subsequent to June 7, 2006, each Nonemployee Director of the Company who is then incumbent shall be granted a Nonqualified Stock Option to purchase 20,000 Shares (as adjusted pursuant to paragraph 18, below).
(iii)	If, during the period beginning June 7, 2006 and ending with the 2010 Annual Meeting, a person, who is not an incumbent, is elected or appointed as a Nonemployee Director of the Company, such person shall thereupon be granted a Nonqualified Stock Option to purchase up to 20,000 Shares, pro rated for the length of time remaining until the next June 15th (as adjusted pursuant to paragraph 18, below).
(iv)	The purchase price of stock subject to an option granted to Nonemployee Directors under this paragraph 6(g) shall be equal to 100 percent of the fair market value of such stock on the date the option is granted, as determined by the Committee.
(v)	Except as provided in paragraph 16, each option granted to Nonemployee Directors under this paragraph 6(g) shall not be exercisable until one year after the date of grant; provided, however, that no portion of the option shall be exercisable any earlier than the date the Plan is approved by the stockholders of the Company.
(vi)	Unless otherwise provided in the Plan, all provisions with respect to the terms of Nonqualified Stock Options hereunder shall be applicable to options granted to Nonemployee Directors under this paragraph 6(g).

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(vii) The automatic grants described in this paragraph 6(g) shall constitute the only awards under the Plan permitted to be made to Nonemployee Directors.

7. Restricted Stock Awards.

     Restricted stock awards under the Plan shall consist of Shares free of any purchase price, or for such purchase price as may be established by the Committee, restricted against transfer, subject to forfeiture, and subject to such other terms and conditions (including attainment of performance objectives) as may be determined by the Committee. Shares available for issuance as restricted shares shall be subject to the limitation in Paragraph 3, above. Restricted stock shall be evidenced by written restricted stock agreements in such form not inconsistent with the Plan as the Committee shall approve from time to time, which agreement shall contain the terms and conditions applicable to such awards, including in substance the following terms and conditions:

     (a) Restriction Period. Restrictions shall be imposed for such period or periods as may be determined by the Committee. The Committee, in its discretion, may provide in the agreement circumstances under which the restricted stock shall become immediately transferable and nonforfeitable, or under which the restricted stock shall be forfeited, provided that no restricted stock award shall become immediately transferable and nonforfeitable, except as provided in paragraph 16 or in the event of Retirement, death or Disability, any more rapidly than from (i) the first anniversary of the date of grant thereof, to the extent of 25% of the Shares covered thereby, (ii) the second anniversary of the date of grant thereof, to the extent of an additional 25% of the Shares covered thereby, (iii) the third anniversary of the date of grant thereof, to the extent of an additional 25% of the Shares covered thereby, and (iv) the fourth anniversary of the date of grant thereof, to the extent of the remaining 25% of the Shares covered thereby.

     (b) Restrictions Upon Transfer. Restricted stock and the right to vote such Shares and to receive dividends thereon, may not be sold, assigned, transferred, exchanged, pledged, hypothecated, or otherwise encumbered, except as herein provided, during the restriction period applicable to such Shares. Notwithstanding the foregoing, and except as otherwise provided in the Plan, the grantee shall have all of the other rights of a stockholder, including, but not limited to, the right to receive dividends and the right to vote such Shares.

(c)

Certificates. A certificate or certificates representing the number of restricted Shares granted shall be registered in the name of the grantee. The Committee, in its sole discretion, shall determine when the certificate or certificates shall be delivered to the grantee (or, in the event of the grantee’s death, to his Beneficiary), may provide for the holding of such certificate or certificates in escrow or in custody by the Company or its designee pending their delivery to the grantee or Beneficiary, and may provide for any appropriate legend to be borne by the certificate or certificates.

(d)

Lapse of Restrictions. The restricted stock agreement shall specify the terms and conditions upon which any restriction upon restricted stock awarded under the Plan shall expire, lapse, or be removed, as determined by the Committee. Upon

5

the expiration, lapse, or removal of such restrictions, Shares free of the restrictive legend shall be issued to the grantee or his legal representative.

8. Loans and Supplemental Cash.

     The Committee, in its sole discretion to further the purpose of the Plan, may provide for supplemental cash payments or loans to individuals in connection with all or any part of an award under the Plan. Supplemental cash payments shall be subject to such terms and conditions as shall be prescribed by the Committee at the time of grant, provided that in no event shall the amount of payment exceed:

(a)	In the case of an option, the excess fair market value of a Share on the date of exercise over the option price multiplied by the number of Shares for which such option is exercised, or
(b)	In the case of a restricted stock award, the value of the Shares issued in payment of such award.

Any loan shall be evidenced by a written loan agreement or other instrument in such form and containing such terms and conditions (including, without limitation, provisions for interest, payment schedules, collateral, forgiveness or acceleration) as the Committee may prescribe from time to time.

9. General Restrictions.

     Each award under the Plan shall be subject to the requirement that if at any time the Company shall determine that (i) the listing, registration or qualification of the Shares subject or related thereto upon any securities exchange or under any state or federal law, or (ii) the consent or approval of any regulatory body, or (iii) an agreement by the recipient of an award with respect to the disposition of Shares, or (iv) the satisfaction of withholding tax or other withholding liabilities is necessary or desirable as a condition of or in connection with the granting of such award or the issuance or purchase of Shares thereunder, such award shall be consummated in whole or in part only if such listing, registration, qualification, consent, approval, agreement, or withholding shall have been effected or obtained on terms acceptable to the Company. Any such restriction affecting an award shall not extend the time within which the award may be exercised; and neither the Company nor its directors or officers nor the Committee shall have any obligation or liability to the grantee or to a Beneficiary with respect to any Shares with respect to which an award shall lapse or with respect to which the grant, issuance or purchase of Shares shall not be effected, because of any such restriction.

10. Single or Multiple Agreements.

     Multiple awards, multiple forms of awards, or combinations thereof may be evidenced by a single agreement or multiple agreements, as determined by the Committee.

11. Rights of the Shareholder.

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     The recipient of any award under the Plan, shall have no rights as a shareholder, except as provided in Paragraph 7(b), with respect thereto unless and until certificates for Shares are issued to him, and the issuance of Shares shall confer no retroactive right to dividends.

12. Rights to Terminate.

     Nothing in the Plan or in any agreement entered into pursuant to the Plan shall confer upon any person the right to continue in the employment of the Company or to serve as a director, or affect any right which the Company may have to terminate the employment or directorship of such person.

13. Withholding.

     Prior to the issuance or transfer of Shares under the Plan, the recipient shall remit to the Company an amount sufficient to satisfy any federal, state or local withholding tax requirements. The amount to be withheld shall be determined by the Company and shall be the based on the minimum statutory requirements. The recipient may satisfy the withholding requirement in whole or in part by electing to have the Company withhold Shares having a value equal to the amount required to be withheld. The value of the Shares to be withheld shall be the fair market value, as determined by the Committee, of the stock on the date that the amount of tax to be withheld is determined (the “Tax Date”). Such election must be made prior to the Tax Date, must comply with all applicable securities law and other legal requirements, as interpreted by the Committee, and may not be made unless approved by the Committee, in its discretion.

14. Non-Assignability.

(a)

Except as provided in paragraph 14(b), no award under the Plan shall be sold, assigned, transferred, exchanged, pledged, hypothecated, or otherwise encumbered, other than by will or by the laws of descent and distribution, or by such other means as the Committee may approve. Except as provided in paragraph 14(b), or as otherwise provided herein, during the life of the recipient, such award shall be exercisable only by such person or by such person’s guardian or legal representative.

(b)

The Committee may, in its sole discretion from time to time, permit the assignment of any Nonqualified Stock Option to one or more of an optionee’s “Immediate Family” (as defined herein). As used herein, members of an optionee’s “Immediate Family” shall include only (i) persons who, at the time of transfer, are the optionee’s spouse or natural or adoptive lineal ancestors or descendants, and (ii) trusts established for the exclusive benefit of the optionee and/or one or more of the persons described in clause (i) of this paragraph 14(b).

15. Non-Uniform Determinations.

     The Committee’s determinations under the Plan (including without limitation determinations of the persons to receive awards, the form, amount and timing of such awards, the terms and provisions of such awards and the agreements evidencing same, and the establishment of values and performance targets) need not be uniform and may be made selectively among

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persons who receive, or are eligible to receive, awards under the Plan, whether or not such persons are similarly situated.

16. Change In Control Provisions.

(a) In the event of (1) a Change in Control (as defined below) or (2) a Potential Change in Control (as defined below), but only if and to the extent so determined by the Board of Directors at or after grant (subject to any right of approval expressly reserved by the Board of Directors at the time of such determination), the following acceleration and valuation provisions shall apply:

(i)	Any stock options awarded under the Plan not previously exercisable and vested shall become fully exercisable and vested.
(ii)	Any restrictions and deferral limitations applicable to any restricted stock to the extent not already vested under the Plan, shall lapse and such shares shall be deemed fully vested.
(iii)	The value of all outstanding stock options and restricted stock, in each case to the extent vested, shall, unless otherwise determined by the Committee in its sole discretion at or after grant but prior to any Change in Control, be cashed out on the basis of the Change in Control Price (as defined) as of the date such Change in Control or such Potential Change in Control is determined to have occurred or such other date as the Committee may determine prior to the Change in Control.

(b) As used herein, the term “Change in Control” means the happening of any of the following:

(i)

Any person or entity, including a “group” as defined in Section 13(d)(3) of the 1934 Act, other than the Company, a subsidiary of the Company, or any employee benefit plan of the Company or its subsidiaries, becomes the beneficial owner of the Company’s securities having 20 percent or more of the combined voting power of the then outstanding securities of the Company that may be cast for the election for directors of the Company (other than as a result of an issuance of securities initiated by the Company in the ordinary course of business), or

(ii)

As the result of, or in connection with, any cash tender or exchange offer, merger or other business combination, sale of assets or contested election, or any combination of the foregoing transactions, less than a majority of the combined voting power of the then outstanding securities of the Company or any successor corporation or entity entitled to vote generally in the election of directors of the Company or such other corporation or entity after such transaction, are held in the aggregate by holders of the

8

Company’s securities entitled to vote generally in the election of directors of the Company immediately prior to such transactions; or

(iii) During any period of two consecutive years, individuals who at the beginning of any such period constitute the Board of Directors cease for any reason to constitute at least a majority thereof, unless the election, or the nomination for election by the Company’s stockholders, of each director of the Company first elected during such period was approved by a vote of at least two-thirds of the directors of the Company then still in office who were directors of the Company at the beginning of any such period.

(c) As used herein, the term “Potential Change in Control” means the happening of any of the following:

(i)

The approval by stockholders of an agreement by the Company, the consummation of which would result in a Change in Control of the Company; or

(ii)

The acquisition of beneficial ownership, directly or indirectly, by any entity, person or group (other than the Company, a wholly-owned subsidiary thereof or any employee benefit plan of the Company or its subsidiaries (including any trustee of such plan acting as such trustee)) of securities of the Company representing 10 percent or more of the combined voting power of the Company’s outstanding securities and the adoption by the Board of Directors of a resolution to the effect that a Potential Change in Control of the Company has occurred for purposes of this Plan.

(d) As used herein, the term “Change in Control Price” means the highest price per share paid in any transaction reported on the New York Stock Exchange — Composite Transactions, or paid or offered in any bonafide transaction related to a Potential or actual Change in Control of the Company at any time during the 60 day period immediately preceding the occurrence of the Change in Control (or, where applicable, the occurrence of the Potential Change in Control event), in each case determined by the Committee.

17. Non-Competition Provision.

     Unless the award agreement relating to a stock option or restricted stock specifies otherwise, a grantee shall forfeit all unexercised, unearned and/or unpaid awards, including, but not by way of limitation, awards earned but not yet paid, all unpaid dividends and dividend equivalents, and all interest, if any, accrued on the foregoing, if the grantee, without the written consent of the Company, engages directly or indirectly in any manner or capacity as principal, agent, partner, officer, director, employee or otherwise, in any business or activity which is, in the opinion of the Committee, (i) competitive with the business conducted by the Company or

9

any of its subsidiaries, or (ii) inimical to the best interests of the Company or any of its subsidiaries.

18. Adjustments.

     In the event of any change in the outstanding common stock of the Company, by reason of a stock dividend or distribution, recapitalization, merger, consolidation, reorganization, split-up, combination, exchange of Shares or the like, the Board of Directors, in its discretion, may adjust proportionately the number of Shares which may be issued under the Plan, the number of Shares subject to outstanding awards, and the option exercise price of each outstanding option, and may make such other changes in outstanding options and restricted stock awards, as it deems equitable in its absolute discretion to prevent dilution or enlargement of the rights of grantees, provided that any fractional Shares resulting from such adjustments shall be eliminated.

19. Amendment.

     The Board of Directors may terminate, amend, modify or suspend the Plan at any time, except that the Board shall not, without the authorization of the holders of a majority of Company’s voting securities, modify existing awards respecting the number of shares, exercise price or extension of terms, issue new awards in exchange for the cancellation of outstanding awards, increase the maximum number of Shares which may be issued under the Plan (other than pursuant to paragraph 18 hereof), extend the last date on which awards may be granted under the Plan, extend the date on which the Plan expires, change the class of persons eligible to receive awards, or change the minimum option price. In no event, however, shall the provisions of paragraph 6(g) be amended more often than once every six months, other than to comport with changes in the Code, the Employment Retirement Income Security Act of 1974, as amended, or the rules thereunder. No termination, modification, amendment or suspension of the Plan shall adversely affect the rights of any grantee or Beneficiary under an award previously granted, unless the grantee or Beneficiary shall consent; but it shall be conclusively presumed that any adjustment pursuant to paragraph 18 hereof does not adversely affect any such right.

20. Effect on Other Plans.

     Participation in this Plan shall not affect a grantee’s eligibility to participate in any other benefit or incentive plan of the Company. Any awards made pursuant to this Plan shall not be used in determining the benefits provided under any other plan of the Company unless specifically provided therein.

21. Effective Date and Duration of the Plan.

     The Plan shall become effective when adopted by the Board of Directors, provided that the Plan is approved by the holders of a majority of the Company’s voting securities on the date of its adoption by the Board or before the first anniversary of that date. Unless it is sooner terminated in accordance with paragraph 19 hereof, the Plan shall remain in effect until all awards under the Plan have been satisfied by the issuance of Shares or payment of cash or have expired or otherwise terminated, but no award shall be granted more than ten years after the earlier of the date the Plan is adopted by the Board of Directors or is approved by the holders of the Company’s voting securities.

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22. Unfunded Plan.

     The Plan shall be unfunded, except to the extent otherwise provided in accordance with Section 7 hereof. Neither the Company nor any affiliate shall be required to segregate any assets that may be represented by stock options and neither the Company nor any affiliate shall be deemed to be a trustee of any amounts to be paid under any stock option. Any liability of the Company or any affiliate to pay any grantee or Beneficiary with respect to an option shall be based solely upon any contractual obligations created pursuant to the provisions of the Plan; no such obligations will be deemed to be secured by a pledge or encumbrance on any property of the Company or an affiliate.

23. Governing Law.

     The Plan shall be construed and its provisions enforced and administered in accordance with the laws of the State of Delaware except to the extent that such laws may be superseded by any federal law.

ADOPTED BY THE BOARD OF DIRECTORS OF HANCOCK FABRICS, INC., ON THE                      DAY OF                     , 200.

By:

As amended June 9, 2005 and June 7, 2006

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STOCK OPTION AGREEMENT
PURSUANT TO THE HANCOCK FABRICS, INC.
2001 STOCK INCENTIVE PLAN

     HANCOCK FABRICS, INC., a Delaware corporation (the “Company”), hereby grants to v1 (the “Optionee”) an option (“Option”) to purchase a total of v2 shares of $.01 par value common stock of the Company (the “Shares”), at the price determined as provided herein, and in all respects subject to the terms, definitions and provisions of the 2001 STOCK INCENTIVE PLAN (the “Plan”) adopted by the Company which is incorporated herein by reference.

     1. Nature of the Option. This Option is not intended to be an “incentive stock option” within the meaning of section 422 of the Internal Revenue Code of 1986, as amended.

     2. Option Price. The option price is $v3 for each Share.

     3. Exercise of Option. This Option shall be exercisable only in accordance with the provisions of the Plan, and only by written notice which shall:

(a)	state the election to exercise the Option, the number of Shares in respect of which it is being exercised, the person in whose name the stock certificate or certificates for such Shares is to be registered, his or her address and Social Security Number (or if more than one, the names, addresses and Social Security Numbers of such persons);
(b)	contain such representations and agreements as to the holder’s investment intent with respect to such Shares as may be required by the Company pursuant to the Plan or this Agreement;
(c)	be signed by the person or persons entitled to exercise the Option, and if the Option is being exercised by any person or persons other than the Optionee, be accompanied by proof, satisfactory to the Company, of the right of such person or persons to exercise the Option;
(d)	be in writing and delivered in person or by certified mail to the Secretary of the Company; and
(e)	be accompanied by payment in full (including applicable withholding taxes, if any, as described in Section 8 of this Agreement). Payment of the purchase price shall be in cash, currency, by certified or bank cashier’s check and/or Shares, or a combination thereof pursuant to the provisions of the Plan.

     Unless the sale of Shares pursuant to this Option has been registered under the Securities Act of 1933 on Form S-8 or successor form, the certificate or certificates for Shares as to which the Option shall be exercised shall contain the following legend:

“THE SHARES REPRESENTED BY THIS CERTIFICATE HAVE NOT BEEN REGISTERED UNDER THE SECURITIES ACT OF 1933 AND HAVE BEEN ACQUIRED FOR INVESTMENT PURPOSES ONLY AND NOT WITH A

12

VIEW TO THE DISTRIBUTION THEREOF, AND SUCH SECURITIES MAY NOT BE SOLD OR TRANSFERRED UNLESS SUCH SALE OR TRANSFER IS REGISTERED UNDER SUCH ACT OR THE COMPANY RECEIVES AN OPINION OF COUNSEL FOR THE HOLDER OF THESE SECURITIES SATISFACTORY TO THE COMPANY STATING THAT SUCH SALE OR TRANSFER IS EXEMPT FROM THE REGISTRATION REQUIREMENTS OF THE ACT, AND UNLESS SUCH SALE OR TRANSFER IS AUTHORIZED UNDER APPLICABLE STATE LAW.”

     4. Extent of Exercise. This Option shall be exercisable at any time in such amounts and at such times as are set forth below:

(a)	Exercisable to the extent of 25% of the Shares covered hereby on or after the first anniversary of the date of grant set forth below (“Date of Grant”); exercisable to the extent of an additional 25% of the Shares covered hereby on or after the second anniversary of the Date of Grant; exercisable to the extent of an additional 25% of the Shares covered hereby on or after the third anniversary of the Date of Grant; and exercisable to the extent of the remaining 25% of the Shares covered hereby on or after the fourth anniversary of the Date of Grant.
(b)	Notwithstanding paragraph 4(a) hereof, the entire unexercised portion of this Option shall be exercisable on or after the date of Optionee’s Retirement (as defined in the Plan), death or Disability (as defined in the Plan).
(c)	Notwithstanding paragraphs 4(a) and 4(b) hereof, no portion of this Option shall be exercisable any earlier than the date the Plan is approved by the stockholders of the Company.

     5. Restrictions on Exercise. This Option may not be exercised if the issuance of such Shares upon such exercise would constitute a violation of any applicable federal or state securities laws or other law or regulation. As a condition to the exercise of this Option, the Company may require the Optionee to make any representation and warranty to the Company as may be required by any applicable law or regulation or may otherwise be appropriate.

     6. Nontransferability of Option.

(a)

Except as provided in paragraph 6(b), this Option may not be sold, assigned, transferred, exchanged, pledged, hypothecated, or otherwise encumbered, other than by will or by the laws of descent and distribution. Except as provided in paragraph 6(b), during the lifetime of the Optionee this Option is exercisable only by the Optionee. The terms of this Option shall be binding upon the executors, administrators, heirs, successors and assigns of the Optionee.

(b)

The Optionee may transfer this Option, with the permission of the Committee in its sole discretion, to a member of the Optionee’s Immediate Family by satisfying all of the following terms and conditions:

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(1)	the Optionee and the transferee execute and deliver to the Company an assignment in form and substance satisfactory to the Company and its counsel;
(2)	the transferee agrees to be subject to all of the terms and conditions of this Agreement and the Plan; and
(3)	The transferee shall have no right to further assign or transfer this Option.

     7. Term of Option. This Option may not be exercised more than ten (10) years from the date of grant of this Option and may be exercised during such term only in accordance with the Plan and the terms of this Agreement.

     8. Withholding. Prior to the issuance of Shares under this Option, the Optionee shall remit to the Company an amount sufficient to satisfy the minimum statutory federal, state or local withholding tax requirements. The Optionee may satisfy the withholding requirement in whole or in part by electing to have the Company withhold Shares having a value equal to the amount required to be withheld. The value of the Shares to be withheld shall be the fair market value, as determined by the Committee, of the stock on the date that the amount of tax to be withheld is determined (the “Tax Date”). Such election must be made prior to the Tax Date, must comply with all applicable securities law and other legal requirements, as interpreted by the Committee, and may not be made unless approved in advance by the Committee, in its discretion. The Company reserves the right to make whatever further arrangements it deems appropriate for the withholding of any taxes in connection with any transaction contemplated by this Agreement or the Plan.

     9. Merger. This Agreement supersedes any other agreement, written or oral, between the parties with respect to the subject matter hereof.

     10. Optionee Acknowledgment. Optionee acknowledges receipt of a copy of the Plan, which is annexed hereto, and represents that he or she is familiar with the terms and provisions thereof, and hereby accepts this Option subject to all the terms and provisions thereof. Optionee hereby agrees to accept as binding, conclusive and final decisions or interpretations of the Committee upon any questions arising under the Plan.

DATE OF GRANT:                     

HANCOCK FABRICS, INC.

By:

Its:

Agreed to and accepted this ___ day of                     , 200_.

v1

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EX-10.41

EXHIBIT 10.41

SEVERANCE AGREEMENT

for Gail Moore

     THIS AGREEMENT between Hancock Fabrics, Inc., a Delaware corporation (the “Corporation”), and Gail Moore whose address is One Fashion Way, Baldywn, MS 38824 (the “Executive”), dated as of June 12, 2006

W I T N E S S E T H :

     WHEREAS, the Corporation wishes to attract and retain well qualified executive and key personnel and, in the event of any Change of Control (as defined in Section 2) of the Corporation, to assure both itself and the Executive of continuity of management; and

     WHEREAS, the Corporation, wishes to enter into this Agreement until May 4, 2008 (“the Expiration Date”), and to automatically renew the Severance Agreement for an additional three year period on the Expiration Date and each subsequent expiration, unless the Incumbent Board elects to cancel the agreement as of the next Expiration Date; and

     WHEREAS, except as provided in Section 5(b) of this Agreement, no benefits shall be payable under this Agreement unless the Effective Date shall occur and thereafter the Executive’s employment is terminated; and

     WHEREAS, the employment of the Executive is “at will” and, except as provided in Section 5(b) of this Agreement, may be terminated by the Corporation without payment of any benefits hereunder until the occurrence of a Change of Control;

     NOW, THEREFORE, in consideration of the premises and mutual covenants herein contained, it is hereby agreed by and between the Corporation and the Executive as follows:

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     1. Operation of Agreement. No benefits shall be payable hereunder unless a Change of Control (as defined in Section 2) occurs during the Change of Control Period (as defined in Section 3). For the purposes of this Agreement, the date on which such a Change of Control occurs is referred to herein as the “Effective Date.”

     2. Change of Control. For the purposes of this Agreement, a “Change of Control” shall mean a change of control of a nature that would be required to be reported by the Corporation in response to Item 1(a) of the Current Report on Form 8-K (or its successor Item or Form, as the case may be), as in effect on the date hereof (or from time to time thereafter), pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 (the “Exchange Act”); provided that, without limitation, such a “Change of Control” shall be deemed to have occurred if: (i) a third person, including an aggregation of persons constituting a “person” as defined in Section 13(d)(3) of the Exchange Act, becomes the beneficial owner, directly or indirectly, of 20% or more of the combined voting power of the Corporation’s outstanding voting securities ordinarily having the right to vote for the election of directors of the Corporation or (ii) individuals who constitute the Board of Directors of the Corporation as of the date hereof (the “Incumbent Board”) cease for any reason to constitute at least two-thirds thereof, provided that any person becoming a director subsequent to the date hereof whose election, or nomination for election by the Corporation’s stockholders, was approved by a vote of at least three-quarters of (or if less, all but one of) the directors comprising the Incumbent Board (other than an election or nomination in connection with an actual or threatened election contest relating to the election of directors of the Corporation, as such terms are used in Rule 14a-12(c) of the Regulation 14A promulgated under the Exchange Act) shall be, for purposes of this Agreement, considered as though such person were a member of the Incumbent Board.

     3. Change of Control Period. The “Change of Control Period” is the period commencing on the date of this Agreement and ending on the earlier to occur of (i) the Expiration Date, or (ii) the first day of the month

-2-

coinciding with or next following the Executive’s 65th birthday. The expiration of the Change of Control Period shall not limit the Corporation’s obligation to provide, or the Executive’s right to collect, payments and benefits pursuant to Section 5 and Section 10 hereof.

     4. Certain Definitions.

          (a) Death or Disability. The Executive’s employment shall terminate automatically upon the Executive’s death (“Death”). The Corporation will be considered to have terminated the Executive’s employment for Disability, if after having established the Executive’s Disability (as defined below), the Executive receives written notice given in accordance with Section 9(b) of the Corporation’s intention to terminate her employment. The Executive’s employment will terminate for Disability effective on the 90th day after receipt of such notice (the “Disability Effective Date”) if within such 90-day period after such receipt the Executive shall fail to return to full-time performance of her duties. For purposes of this Agreement, “Disability” means a disability that, after the expiration of more than 180 days after its commencement, is determined to be total and permanent by a physician selected by the Corporation or its insurers and acceptable to the Executive or her legal representative (such agreement as to acceptability not to be withheld unreasonably).

     Consistent with, and not in limitation of, the provisions of Section 6 of this Agreement, neither a termination for, nor a determination of, Disability pursuant to this Section 4(a) shall be deemed in and of itself a termination for or determination of disability with respect to the Executive’s eligibility to receive long-term disability benefits, continued medical, dental, or life insurance coverage, retirement benefits, or benefits under any other plan or program provided by the Corporation or one of its affiliated companies and for which the Executive may qualify.

          (b) Cause. The Executive’s employment will be terminated for Cause if the majority of the Incumbent Board determines that Cause (as defined in this Agreement) exists. For purposes of this Agreement, “Cause” means (i) an act or acts of fraud or misappropriation on the Executive’s part that result in or are intended to result in her personal enrichment at the expense

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of the Corporation or one of its affiliated companies or (ii) conviction of a felony.

          (c) Good Reason. For purposes of this Agreement, “Good Reason” means

               (i) without the express written consent of the Executive, (A) the assignment to the Executive of any duties inconsistent in any substantial respect with the Executive’s position, authority or responsibilities as in effect during the 90-day period immediately preceding the Effective Date, or (B) any other substantial adverse change in such position (including titles and reporting requirements), authority or responsibilities;

               (ii) any failure by the Corporation to furnish the Executive and/or, where applicable, her family with compensation (including annual bonus) and benefits at a level equal to or exceeding those received (on an annual basis) by the Executive from the Corporation during the 90-day period preceding the Effective Date, including a failure by the Corporation to maintain the Corporation’s extra compensation plan(s)(Extra Compensation Plan”) and “Officers Incentive Compensation Plan” or any subsequent plans) (including the right to defer the receipt of payments thereunder), other than an insubstantial and inadvertent failure remedied by the Corporation promptly after receipt of notice thereof given by the Executive;

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               (iii) the Corporation’s requiring the Executive to be based or to perform services at any office or location other than that at which the Executive is primarily based during the 90-day period preceding the Effective Date, except for travel reasonably required in the performance of the Executive’s responsibilities; or

               (iv) any failure by the Corporation to obtain the assumption and agreement to perform this Agreement by a successor as contemplated by Section 8(b).

     For the purposes of this Section 4(c), any good faith determination of “Good Reason” made by the Executive shall be conclusive.

          (d) [Reserved].

          (e) Notice of Termination. Any termination by the Corporation for Cause or by the Executive for Good Reason shall be communicated by Notice of Termination to the other party hereto given in accordance with Section 9(b). Any notice of termination by the Corporation for Disability shall be given in accordance with Section 4(a). For purposes of this Agreement, a “Notice of Termination” means a written notice that (i) indicates the specific termination provision in this Agreement relied upon, (ii) sets forth in reasonable detail the facts and circumstances claimed to provide a basis for termination of the Executive’s employment under the provision so indicated and (iii) if the termination date is other than the date of receipt of such notice, specifies the termination date (which date shall not be more than 15 days after the giving of such notice).

          (f) Date of Termination. Date of Termination means the date of receipt of the Notice of Termination or any later date specified therein as the termination date, as the case may be, or if the Executive’s employment is terminated by the Corporation for any reason other than Cause, Death or Disability, the date on which the Corporation notifies the Executive of such termination. Notwithstanding any contrary provision in this Section 4(f), if the Executive’s employment terminates due to Disability, the Date of Termination shall be the Disability Effective Date.

     5. Obligations of the Corporation Upon Termination.

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          (a) Good Reason, Other Than For Cause, Death or Disability on or After the Effective Date. Regardless of whether the Change of Control Period has expired, if, within three years after the Effective Date, (i) the Corporation shall terminate the Executive’s employment for any reason other than for Cause, Death or Disability, or (ii) the Executive shall terminate her employment for Good Reason:

               (I) the Corporation shall pay to the Executive in a lump sum in cash within 20 days after the Date of Termination the aggregate of the amounts determined pursuant to the following clauses (A) and (B):

                    (A) if not theretofore paid, the Executive’s base salary through the Date of Termination at the rate in effect at the time the Notice of Termination was given; and

                    (B) the sum of (x) the Executive’s annual base salary at the rate in effect at the time the Notice of Termination was given, or if higher, at the highest rate in effect at any time within the 90-day period preceding the Effective Date and (y) an amount equal to the highest bonus paid or payable to the Executive pursuant to the applicable cash incentive compensations plan(s) within five fiscal years prior to the Effective Date, provided, however, that in no event shall the Executive be entitled to receive under this clause (B) more than the product obtained by multiplying the amount determined as hereinabove provided in this clause (B) by a fraction whose numerator shall be the number of months (including fractions of a month) that at the Date of Termination remain until the first day of the month coinciding with or next following the Executive’s 65th birthday and whose denominator shall equal twelve (12); and

               (II) until the earlier to occur of (i) the date one year following the Date of Termination, or (ii) the first day of the first month coinciding with or next following the Executive’s 65th birthday (the period of time from the Date of Termination until the earlier of (i) or (ii) is hereinafter referred to as the “Unexpired Period”), the Corporation shall continue to provide all benefits that the Executive and/or her family is or would have been entitled to receive under all medical, dental, vision, disability, executive life, group life, accidental death and travel accident

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insurance plans and programs of the Corporation and its affiliated companies, in each case on a basis providing the Executive and/or her family with the opportunity to receive benefits at least equal to those provided by the Corporation and its affiliated companies for the Executive under such plans and programs if and as in effect at any time during the 90-day period preceding the Effective Date.

     6. Non-exclusivity of Rights. Nothing in this Agreement shall prevent or limit the Executive’s continuing or future participation in any benefit, bonus, incentive or other plan or program provided by the Corporation or any of its affiliated companies and for which the Executive may qualify, nor shall anything herein limit or otherwise affect such rights as the Executive may have under any employment, stock option or other agreements with the Corporation or any of its affiliated companies. Amounts that are vested benefits or that the Executive is otherwise entitled to receive under any plan or program of the Corporation or any of its affiliated companies at or subsequent to the Date of Termination shall be payable in accordance with such plan or program.

     7. Full Settlement. The payments provided for in this Agreement are in full settlement of any claims the Executive may have against the Corporation arising out of her termination, including, but not limited to, any claims for wrongful discharge. The Corporation’s obligation to make the payments provided for in this Agreement and otherwise to perform its obligations hereunder shall not be affected by any circumstances, including, without limitation, any setoff, counterclaim, recoupment, defense or other right that the Corporation may have against the Executive or others; provided, however, that the Corporation’s failure to make any such setoff shall not constitute a waiver of any claim of the Corporation against the Executive. In no event shall the Executive be obligated to seek other employment by way of mitigation of the amounts payable to the Executive under any of the provisions of this Agreement. The Corporation agrees to pay, to the full extent permitted by law, all legal fees and expenses the Executive may reasonably incur as a result of any contest (regardless of the outcome thereof) by the Corporation or others of the validity or enforceability of, or liability

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under, any provision of this Agreement or any guarantee of performance thereof, in each case plus interest, compounded monthly, on the total unpaid amount determined to be payable under this Agreement, such interest to be calculated on the basis of the prime commercial lending rate announced by Union Planters Bank, in effect from time to time during the period of such non-payment.

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     8. Successors.

          (a) This Agreement is personal to the Executive and without the prior written consent of the Corporation shall not be assignable by the Executive otherwise than by will or the laws of descent and distribution. This Agreement shall inure to the benefit of and be enforceable by the Executive’s legal representatives, executors, heirs and legatees.

          (b) This Agreement shall inure to the benefit of and be binding upon the Corporation and its successors. The Corporation shall require any successor to all or substantially all of the business and/or assets of the Corporation, whether directly or indirectly, by purchase, merger, consolidation, acquisition of stock, or otherwise, by an agreement in form and substance satisfactory to the Executive, expressly to assume and agree to perform this Agreement in the same manner and to the same extent as the Corporation would be required to perform if no such succession had taken place.

     9. Miscellaneous.

          (a) The captions of this Agreement are not part of the provisions hereof and shall have no force or effect. This Agreement may not be amended or modified otherwise than by a written agreement executed by the parties hereto or their respective successors and legal representatives.

          (b) All notices and other communications hereunder shall be in writing and shall be given by hand delivery to the other party or by registered or certified mail, return receipt requested, postage prepaid, addressed as follows:

If to the Executive:

At the address first hereinabove written.

If to the Corporation:

Hancock Fabrics, Inc.
One Fashion Way
Baldwyn, Mississippi 38824
Attn: Corporate Secretary

or to such other address as either party shall have furnished to the other in writing in accordance herewith. Notice and communications shall be effective when actually received by the addressee.

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          (c) The invalidity or unenforceability of any provision of this Agreement shall not affect the validity or enforceability of any other provision of this Agreement.

          (d) The Corporation may withhold from any amounts payable under this Agreement such federal, state or local taxes as shall be required to be withheld pursuant to any applicable law or regulation, provided, however, that such withholding shall be consistent with the calculations made by Accounting Firm under Section 10 of the Agreement.

          (e) This Agreement contains the entire understanding with the Executive with respect to the subject matter hereof.

          (f) Whenever used in this Agreement, the masculine gender shall include the feminine or neuter wherever necessary or appropriate and vice versa and the singular shall include the plural and vice versa.

          (g) The Executive and the Corporation acknowledge that the employment of the Executive by the Corporation is “at will” and may be terminated by either the Executive or the Corporation at any time and for any reason. Nothing contained in the Agreement shall affect such rights to terminate, it being agreed, however, that nothing in this Section 9(g) shall prevent the Executive from receiving any amounts payable pursuant to Section 5(a), or 10 of this Agreement in the event of a termination described in such Section 5(a), or 10 on or after the Effective Date.

     10. Penalty Taxes.

          (a) Payment. In the event that the Accounting Firm determines that any payment or other compensation or benefits made or provided to or for the benefit of the Executive in any way connected with employment of the Executive by the Corporation will be subject to tax pursuant to section 4999 of the Code or any successor provision or any counterpart provision of state tax law (the “Penalty Taxes”), the Corporation shall pay to the Executive within 20 days after receipt of a written demand therefor from the Executive an amount which, after deduction of all additional Federal, state and local taxes (including, without limitation, income taxes and additional Penalty Taxes) required to be paid by the Executive in respect of receipt of such amount, shall be equal to the Penalty Taxes. In calculating the income taxes

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required to be paid by the Executive, the Accounting Firm shall assume that the Executive will pay tax at the maximum marginal Federal, state and local rates and that the Executive will have no deductions or credits available to reduce such taxes. In consideration of the payment of such amounts, the Executive shall report and pay such taxes and promptly provide the Corporation with a written statement that such filing and payment have occurred executed by the person or firm that signed as income tax return preparer of the Executive’s federal income tax return, or if prepared by the Executive, executed by the Executive.

          (b) Indemnity. If the Executive shall be required to pay Penalty Taxes in addition to those reimbursed pursuant to paragraph (a) above, or if based upon failure to receive the opinion of Tax Counsel referred to in paragraph (d) below the Executive reports and pays greater amounts of Penalty Taxes than are reimbursed pursuant to paragraph (a) above (any such event hereafter being referred to as a “Loss”), the Executive shall notify the Corporation and the Corporation shall pay to the Executive as an indemnity an amount which, after deduction of all income taxes and additional Federal, state and local taxes (including, without limitation, income taxes and additional Penalty Taxes) required to be paid by the Executive in respect of receipt of such amount (assuming, for this purpose, that the Executive is subject to the maximum marginal rates of taxation applicable to individuals at such time as such amount becomes due and that the Executive will have no deductions or credits available to reduce such taxes), shall be equal to the sum of (x) the Penalty Taxes resulting in the Loss and (y) the net amount of any interest, penalties or additions to tax payable to the United States Government or any state or local government (after allowing for the deduction of such amounts, to the extent properly deductible, for Federal, state or local income tax purposes) as a result of such Loss. Each payment by the Corporation hereunder shall be made within 30 days after receipt of a written demand therefor from the Executive accompanied by a written statement describing in reasonable detail the Loss in question, the amount of additional tax, interest, penalties or additions to tax and the calculation of the payment due in respect thereof; provided that, if a contest of the Loss is

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being conducted pursuant to paragraph (c) below, payment shall not be required by the Corporation until 30 days after the completion or termination of such contest.

          (c) Contest.

               (1) The Executive shall notify the Corporation within 30 days of receipt from the Internal Revenue Service of a revenue agent’s report, a 30-day letter or a notice of deficiency (as described in Section 6212 of the Code or any successor provision) or of a similar written claim from a state taxing authority, in which an adjustment is proposed to the federal or state taxes of the Executive for which the Corporation would be required to indemnify the Executive hereunder. If the Corporation (i) requests the Executive to do so within 30 days after such notice, and (ii) furnishes the Executive an opinion of recognized tax counsel selected by the Corporation and approved by the Executive, which approval shall not unreasonably be withheld, (hereinafter “Tax Counsel”) to the effect that a reasonable basis exists for contesting such proposed adjustment, the Executive shall contest the proposed adjustment in good faith, shall keep the Corporation reasonably informed as to the progress of such contest, and shall consider in good faith any suggestion made by the Corporation as to the method of pursuing such contest; provided, however, that the Executive shall not be obligated to contest such adjustment unless (i) the Corporation acknowledges in writing its liability under paragraph (b) above to indemnify the Executive in the event that the Internal Revenue Service or a state taxing authority prevails in its position regarding the proposed adjustment; (ii) the Corporation shall have fully performed its prior obligations under this Agreement; and (iii) the subject matter thereof shall not have been previously decided pursuant to the contest provisions of this paragraph (c) with respect to any other executive of the Corporation, unless the Corporation shall have furnished an opinion of Tax Counsel to the Executive that more likely than not the Executive will prevail in the contest; provided, further, that the Executive shall determine, in her sole discretion, the nature of all action to be taken to contest such proposed adjustment, including (x) whether any action to contest such proposed adjustment initially shall be by way of judicial or administrative proceedings, or both,

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(y) whether any such proposed adjustment shall be contested by resisting payment thereof or by paying the same and seeking a refund thereof, and (z) if the Executive shall undertake judicial action with respect to such proposed adjustment, the court or other judicial body before which such action shall be commenced. The Executive shall, if requested by the Corporation within 30 days of an adverse determination by any court, and if Tax Counsel is of the opinion that there is a reasonable basis for a successful appeal of the matter in question, be obligated to appeal such adverse determination.

               (2) The Executive shall not be required to take any action pursuant to this paragraph (c) unless and until the Corporation shall have agreed in writing to indemnify the Executive in a manner reasonably satisfactory to the Executive for any fees, expenses, statutory or regulatory penalties, interest, additions to tax, or other similar liabilities or losses which the Executive may incur as a result of contesting the validity of any proposed adjustment and shall have agreed to pay (or in the Executive’s sole discretion to prepay) to the Executive on demand all costs and expenses which the Executive may incur in connection with contesting such proposed adjustment (including without limitation fees and disbursements of counsel). If the Executive determines to contest any adjustment by paying the additional tax and suing for a refund, the Corporation shall timely advance to the Executive on an interest free basis an amount equal to the sum of any tax, interest, penalties and additions to tax which are required to be paid; provided, however, that, if the Executive is required to include in income any amount with respect to such loan or the imputation of interest thereon in any taxable year of the Executive prior to final determination of the contest, then the Corporation, within 30 days of written notice thereof by the Executive, shall pay to the Executive an amount which, after deduction of all additional Federal, state and local taxes required to be paid by the Executive in respect of the receipt of such amount (assuming, for this purpose, that the Executive is subject to the maximum marginal rate of taxation applicable to individuals at such times as such amount becomes due), shall be equal to the aggregate additional federal and state income taxes payable by the Executive with respect to such taxable year as a result of such inclusion. Upon receipt by

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the Executive of a refund of any amounts paid by the Executive based on any adjustment in respect of which amounts the Executive shall have been paid or advanced an equivalent amount by the Corporation, the Executive shall pay to the Corporation the amount of such refund (which, in the case of any contest in which a loan has been advanced pursuant to this paragraph, shall be deemed to be in repayment of the loan advanced by the Corporation to the extent fairly attributable thereto), but not in excess of the amount paid or advanced by the Corporation, together with any interest received by the Executive on such refund plus any net additional Federal, state or local tax benefits actually realized by the Executive as the result of such payment, and reduced by the amount of any Federal, state or local tax actually payable with respect to receipt of such refund; provided, however, that the Executive may offset the amount of such refund and benefits against any amount due and owing by the Corporation to the Executive pursuant to this Agreement. Upon disallowance of any such refund, the Corporation shall forgive the amount of the advance fairly attributable thereto and shall pay to the Executive the amount of its indemnity obligation hereunder, including such amount as, after deduction of all taxes required to be paid by the Executive in respect of the receipt of such amount under the laws of any Federal, state or local government or taxing authority of the United States, shall be equal to the sum on an after-tax basis, of any tax, interest, penalties or additions to tax payable with respect to the forgiveness of such advance.

               (3) If any adjustment referred to in this paragraph (c) shall be proposed and the Corporation shall have requested the Executive to contest such adjustment as above provided and shall have duly complied with the terms of this paragraph (c), the Corporation’s liability with respect to such adjustment shall become fixed upon final determination of such adjustment; provided, however, that if the Corporation shall not deliver the opinion of Tax Counsel provided in this paragraph (c) to the effect that there is a reasonable basis for a contest or appeal, then the Corporation’s obligation to pay such indemnity shall become immediately fixed.

          (d) No Inconsistent Action. The Executive agrees that he will not take any action, directly or indirectly, or file any returns or other

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documents inconsistent with the assumption that the payments to which the indemnification of paragraph (b) applies do not result in imposition of the tax under section 4999, and the Executive shall file such returns, take such actions, maintain such records and execute such documents as may be reasonably requested by the Corporation; provided, however, that the Executive’s obligations hereunder to file returns or other documents shall apply only if the Executive receives an opinion of Tax Counsel at least 10 days prior to the due date of the return (without regard to extensions) required to be made with respect to the payments to which the indemnification of paragraph (b) applies that the Executive will not be subject to the penalties described in sections 6651, 6662 or 6663 of the Code, or successor provisions then in effect, as a result of taking such position.

          (e) Disbursements. Any payments required to be made by the Corporation pursuant to this Section 10 shall be made directly by the Corporation to the Executive. Payments made by the Corporation or the Executive pursuant to this Agreement shall be made by wire transfer of immediately available funds to such bank and/or account in the continental United States as specified by the other party in written directions to such payor party, and if no such direction shall have been given, by check payable to the order of such other party and mailed to such other party by certified mail, postage prepaid.

          (f) No Setoff. No payment required to be made by the Corporation pursuant to this Section 10 shall be subject to any right of setoff, counterclaim, defense, abatement, suspension, deferment or reduction, and, except in accordance with the express terms hereof, the Corporation shall have no right to terminate the Agreement or to be released, relieved or discharged from any obligation or liability thereunder for any reason whatsoever.

          (g) Late Payment, Interest. Any late payment by any party hereto of any of its obligations under this Agreement shall bear interest to the extent permitted by applicable law, at a fluctuating rate per annum equal to the Prime Rate as announced publicly by Union Planters Bank from time to time plus two percentage points, for the period such interest is payable.

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          (h) Accounting Firm. The Accounting Firm shall mean the Memphis, Tennessee Main Office of PricewaterhouseCoopers, or, at the election of the Executive, the Memphis, Tennessee Main Office of such other national or regional accounting firm as the Executive shall select subject to the approval of the Corporation, which approval shall not unreasonably be withheld. Compensation of the Accounting Firm with respect to its services hereunder shall be the responsibility of the Executive.

          (i) Notwithstanding the foregoing, if any provision of this Agreement would cause compensation to be includible in the Executive’s income pursuant to Section 409A of the Internal Revenue Code, then such provision shall be null and void and the Corporation shall amend the Agreement in such a way as to cause substantially similar economic results without causing such inclusion; any such amendment shall be binding on Executive.

     IN WITNESS WHEREOF, the Executive has hereunto set her hand and, pursuant to the authorization of its Board of Directors, the Corporation has caused these presents to be executed in its name on its behalf, and its corporate seal to be hereunto affixed, all as of the day and year first above written.

	Executive
HANCOCK FABRICS, INC.
By

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EX-10.43

EXHIBIT 10.43

[Execution]

RATIFICATION AND AMENDMENT AGREEMENT

     This RATIFICATION AND AMENDMENT AGREEMENT (this “Ratification Agreement”), dated as of March ___, 2007, is by and among HANCOCK FABRICS, INC., a Delaware corporation, as Debtor and Debtor-in-Possession (“Parent”), HF MERCHANDISING, INC., a Delaware corporation, as Debtor and Debtor-in-Possession (“Merchandising”), HANCOCK FABRICS OF MI, INC., a Delaware corporation, as Debtor and Debtor-in-Possession (“Fabrics MI”), HANCOCKFABRICS.COM, INC., a Delaware corporation, as Debtor and Debtor-in-Possession (“Fabrics.com”), HANCOCK FABRICS, LLC, a Delaware limited liability company, as Debtor and Debtor-in-Possession (“Fabrics LLC”, and together with Parent, Merchandising, Fabrics MI and Fabrics.com, each individually a “Borrower” and collectively, “Borrowers”), HF ENTERPRISES, INC., a Delaware corporation, as Debtor and Debtor-in-Possession (“Enterprises”), HF RESOURCES, INC., a Delaware corporation, as Debtor and Debtor-in-Possession (“Resources”, and together with Enterprises, each individually a “Guarantor” and collectively, “Guarantors”), the financial institutions from time to time party to the Loan Agreement (as hereinafter defined) as lenders (each individually, a “Lender” and collectively, “Lenders”), and WACHOVIA BANK, NATIONAL ASSOCIATION, a national banking association, in its capacity as agent acting for and on behalf of the Lenders (in such capacity, “Agent”).

W I T N E S S E T H:

     WHEREAS, each Borrower and Guarantor (collectively, the “Debtors”) has commenced a case under Chapter 11 of Title 11 of the United States Code in the United States Bankruptcy Court for the District of Delaware, and each Borrower and Guarantor has retained possession of its assets and each is authorized under the Bankruptcy Code to continue the operation of its businesses as a debtor-in-possession;

     WHEREAS, prior to the commencement of the Chapter 11 Cases (as hereinafter defined), Agent and Lenders made loans and advances and provided other financial accommodations to Borrowers secured by substantially all of the assets and properties of Borrowers and Guarantors as set forth in the Existing Financing Agreements (as hereinafter defined) and the Existing Guarantor Documents (as hereinafter defined);

     WHEREAS, the Bankruptcy Court (as hereinafter defined) has entered a Financing Order (as hereinafter defined) pursuant to which Agent and Lenders may make post-petition loans and advances and provide other financial accommodations, to Borrowers secured by substantially all the assets and properties of Borrowers and Guarantors as set forth in the Financing Order and the Financing Agreements (as hereinafter defined);

     WHEREAS, the Financing Order provides that as a condition to the making of such post-petition loans, advances and other financial accommodations, Borrowers and Guarantors shall execute and deliver this Ratification Agreement;

     WHEREAS, Borrowers and Guarantors desire to reaffirm their obligations to Agent and Lenders pursuant to the Existing Financing Agreements and acknowledge their continuing

liabilities to Agent and Lenders thereunder in order to induce Agent and Lenders to make such post-petition loans and advances and provide such other financial accommodations to Borrowers; and

     WHEREAS, Borrowers and Guarantors have requested that Agent and Lenders make post-petition loans and advances and provide other financial accommodations to Borrowers and make certain amendments to the Loan Agreement, and Agent and Lenders are willing to do so, subject to the terms and conditions contained herein.

     NOW, THEREFORE, in consideration of the foregoing, the mutual covenants and agreements contained herein and other good and valuable consideration, the receipt and sufficiency of which are hereby acknowledged, Agent, Lenders, Borrowers and Guarantors mutually covenant, warrant and agree as follows:

     1. DEFINITIONS.

          1.1 Additional Definitions. As used herein, the following terms shall have the respective meanings given to them below and the Loan Agreement and the other Financing Agreements shall be deemed and are hereby amended to include, in addition and not in limitation, each of the following definitions:

          (a) “Bankruptcy Court” shall mean the United States Bankruptcy Court for the District of Delaware or the United States District Court for the District of Delaware.

          (b) “Chapter 11 Cases” shall mean the Chapter 11 cases of Borrowers and Guarantors which are being jointly administered under the Bankruptcy Code and are pending in the Bankruptcy Court.

          (c) “Bankruptcy Code” shall mean the United States Bankruptcy Code, being Title 11 of the United States Code as enacted in 1978, as the same has heretofore been or may hereafter be amended, recodified, modified or supplemented, together with all rules, regulations and interpretations thereunder or related thereto.

          (d) “Budget” shall mean the initial budget of Borrowers and Guarantors to be delivered to Agent and Lenders in accordance with Section 5.3(a) hereof setting forth the Projected Information for the periods covered thereby, together with any subsequent or amended budget(s) thereto delivered to Agent and Lenders pursuant Section 5.3(b) hereof.

          (e) “DIP Fee Letter” shall mean the letter agreement, dated of even date herewith, by and among Borrowers and Agent, setting forth certain fees payable by Borrowers in connection with the Credit Facility, as the same now exists or may hereafter be amended, modified, supplemented, extended, renewed, restated or replaced.

          (f) “Excluded Collateral Items” shall have the meaning set forth Section 1.1(o) hereof.

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          (g) “Existing Financing Agreements” shall mean the Financing Agreements (as defined in the Existing Loan Agreement), including, without limitation, the Existing Guarantor Documents (as defined below), in each case as in effect immediately prior to the Petition Date.

          (h) “Existing Guarantor Documents” shall mean, collectively, (i) the Guarantee, dated June 29, 2005, by Borrowers and Guarantors in favor of Agent and Lenders, (ii) the Pledge and Security Agreement, dated June 29, 2005, by Resources in favor of Agent and Lenders with respect to the Capital Stock of Merchandising and Enterprises, (iii) the Pledge and Security Agreement, dated June 29, 2005, by Enterprises in favor of Agent and Lenders with respect to membership interests of Fabrics LLC, (iv) the Trademark Collateral Assignment and Security Agreement, dated June 29, 2005, by and between Enterprises and Agent, and (v) the Affiliate Subordination Agreement, dated June 29, 2005, by and among Agent, Resources and Enterprises, as acknowledged and agreed to by Parent and Merchandising, in each case as in effect immediately prior to the Petition Date.

          (i) “Existing Loan Agreement” shall mean the Loan and Security Agreement, dated June 29, 2005, by and among Borrowers, Guarantors, Agent and Lenders, as amended by Amendment No. 1 to Loan and Security Agreement, dated as of July 26, 2005, Amendment No. 2 to Loan and Security Agreement, dated as of December 31, 2005, Amendment No. 3 to Loan and Security Agreement, dated as of April 25, 2006, Amendment No. 4 to Loan and Security Agreement, dated as of June 14, 2006, Amendment No. 5 to Loan and Security Agreement, dated as of October 31, 2006, and Amendment No. 6 to Loan and Security Agreement, dated as of December 29, 2006, and otherwise as in effect immediately prior to the Petition Date.

          (j) “Financing Order” shall mean the Interim Financing Order, the Permanent Financing Order and such other orders relating thereto or authorizing the granting of credit by Agent and Lenders to Borrowers on an emergency, interim or permanent basis pursuant to Section 364 of the Bankruptcy Code as may be issued or entered by the Bankruptcy Court in the Chapter 11 Cases.

          (k) “Guarantor Documents” shall mean, collectively, the Existing Guarantor Documents, as amended by this Ratification Agreement, in each instance, as the same now exists or may hereafter be amended, modified, supplemented, extended, renewed, restated or replaced.

          (l) “Interim Financing Order” shall have the meaning set forth in Section 10.8 hereof.

          (m) “Permanent Financing Order” shall have the meaning set forth in Section 10.9 hereof.

          (n) “Petition Date” shall mean the date of the commencement of the Chapter 11 Cases.

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          (o) “Post-Petition Collateral” shall mean, collectively, all now existing and hereafter acquired real and personal property of each Debtor’s estate, wherever located, of any kind, nature or description, including any such property in which a lien is granted to Agent pursuant to the Financing Agreements, the Financing Order or any other order entered or issued by the Bankruptcy Court, and shall include, without limitation:

               (i) all of the Pre-Petition Collateral;

               (ii) all Accounts;

               (iii) all general intangibles, including, without limitation, all Intellectual Property;

               (iv) all goods, including, without limitation, all Inventory and all Equipment;

               (v) all Real Property and fixtures;

               (vi) all chattel paper, including, without limitation, all tangible and electronic chattel paper;

               (vii) all instruments, including, without limitation, all promissory notes;

               (viii) all documents;

               (ix) all deposit accounts;

               (x) all letters of credit, banker’s acceptances and similar instruments and including all letter-of-credit rights;

               (xi) all supporting obligations and all present and future liens, security interests, rights, remedies, title and interest in, to and in respect of Receivables and other Collateral, including, without limitation, (A) rights and remedies under or relating to guaranties, contracts of suretyship, letters of credit and credit and other insurance related to the Collateral, (B) rights of stoppage in transit, replevin, repossession, reclamation and other rights and remedies of an unpaid vendor, lienor or secured party, (C) goods described in invoices, documents, contracts or instruments with respect to, or otherwise representing or evidencing, Receivables or other Collateral, including returned, repossessed and reclaimed goods, and (D) deposits by and property of account debtors or other persons securing the obligations of account debtors;

               (xii) all (A) investment property (including securities, whether certificated or uncertificated, securities accounts, security entitlements, commodity contracts or commodity accounts) and (B) monies, credit balances, deposits and other property of Borrowers and Guarantors now or hereafter held or received by or in transit to Agent, any Lender or their respective Affiliates or at any other depository or other

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institution from or for the account of Borrowers or Guarantors, whether for safekeeping, pledge, custody, transmission, collection or otherwise;

               (xiii) all commercial tort claims;

               (xiv) to the extent not otherwise described above, all Receivables;

               (xv) all Records; and

               (xvi) all products and proceeds of the foregoing, in any form, including insurance proceeds and all claims against third parties for loss or damage to or destruction of or other involuntary conversion of any kind or nature of any or all of the other Collateral.

Notwithstanding anything to the contrary contained in this Agreement or the other Financing Agreements, the Post-Petition Collateral shall not include the following (collectively, the “Excluded Collateral Items”): (i) any leasehold real property interests of Borrowers or Guarantors existing as of the date of this Ratification Agreement (collectively, the “Real Property Leasehold Interests”), (ii) any actions maintained or taken pursuant to Sections 544, 545, 547, 548, 549, 550, 551 and 553 of the Bankruptcy Code, and (iii) any proceeds of the items referred to in clauses (i), (ii) of this paragraph and post-petition loans or other financial accommodations obtained by Borrowers and Guarantors other than from Agent or any Lender that are secured solely by the Real Property Leasehold Interests or other Excluded Collateral Items; provided, that all such proceeds referenced in this clause (iii) shall at all times be segregated by Borrowers and Guarantors from the proceeds of Agent’s and Lenders’ Collateral and the Loans and Letters of Credit provided by Agent and Lenders to Borrowers.

          (p) “Post-Petition Obligations” shall mean all Loans, Letter of Credit Obligations and other loans, advances, letter of credit accommodations, debts, obligations, liabilities, covenants and duties of Borrowers and Guarantors to Agent and Lenders of every kind and description, however evidenced, whether direct or indirect, absolute or contingent, joint or several, secured or unsecured, due or not due, primary or secondary, liquidated or unliquidated, arising on and after the Petition Date and whether arising on or after the conversion or dismissal of the Chapter 11 Cases, or before, during and after the confirmation of any plan of reorganization in the Chapter 11 Cases, and whether arising under or related to this Ratification Agreement, the Loan Agreement, the Guarantor Documents, the other Financing Agreements, a Financing Order, by operation of law or otherwise, and whether incurred by such Borrower or Guarantor as principal, surety, endorser, guarantor or otherwise and including, without limitation, all principal, interest, financing charges, letter of credit fees, unused line fees, servicing fees, line increase fees, debtor-in-possession facility fees, early termination fees, other fees, commissions, costs, expenses and attorneys’, accountants’ and consultants’ fees and expenses incurred in connection with any of the foregoing.

          (q) “Pre-Petition Collateral” shall mean, collectively, (i) all “Collateral” as such term is defined in the Existing Loan Agreement as in effect immediately prior to

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the Petition Date, (ii) all “Collateral” as such term is defined in each of the Existing Guarantor Documents as in effect immediately prior to the Petition Date, and (iii) all other security for the Pre-Petition Obligations as provided in the Existing Loan Agreement, the Existing Guarantors Documents and the other Existing Financing Agreements immediately prior to the Petition Date.

          (r) “Pre-Petition Obligations” shall mean all Loans, Letter of Credit Obligations and other loans, advances, letter of credit accommodations, debts, obligations, liabilities, indebtedness, covenants and duties of Borrowers and Guarantors to Agent and Lenders of every kind and description, however evidenced, whether direct or indirect, absolute or contingent, joint or several, secured or unsecured, due or not due, primary or secondary, liquidated or unliquidated, arising before the Petition Date under or related to the Existing Loan Agreement, the Existing Guarantor Documents, the other Existing Financing Agreements, by operation of law or otherwise, and whether incurred by such Borrower or Guarantor as principal, surety, endorser, guarantor or otherwise and including, without limitation, all principal, interest, financing charges, letter of credit fees, unused line fees, servicing fees, line increase fees, early termination fees, other fees, commissions, costs, expenses and attorneys’, accountants’ and consultants’ fees and expenses incurred in connection with any of the foregoing.

          (s) “Projected Information” shall have the meaning set forth in Section 5.3(a) hereof.

          (t) “Ratification Agreement” shall mean this Ratification and Amendment Agreement by and among Borrowers, Guarantors, Agent and Lenders, as the same now exists or may hereafter be amended, modified, supplemented, extended, renewed, restated or replaced.

          (u) “Real Property Leasehold Interests” shall have the meaning set forth in Section 1.1(o) hereof.

          1.2 Amendments to Definitions.

               (a) Collateral. All references to the term “Collateral” in the Loan Agreement and the other Financing Agreements, or any other term referring to the security for the Pre-Petition Obligations, shall be deemed, and each such reference is hereby amended to mean, collectively, the Pre-Petition Collateral and the Post-Petition Collateral.

               (b) Debtors. All references to Debtors, including, without limitation, to the terms “Borrower,” “Borrowers,” “Guarantor” or “Guarantors” in the Loan Agreement and the other Financing Agreements, shall be deemed, and each such reference is hereby amended, to mean and include the Debtors as defined herein, and their respective successors and assigns (including any trustee or other fiduciary hereafter appointed as its legal representative or with respect to the property of the estate of such corporation whether under Chapter 11 of the Bankruptcy Code or any subsequent Chapter 7 case and its successor upon conclusion of the Chapter 11 Case of such corporation).

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               (c) Financing Agreements. All references to the term “Financing Agreements” in the Loan Agreement and the other Financing Agreements shall be deemed, and each such reference is hereby amended, to include, in addition and not in limitation, this Ratification Agreement and all of the Existing Financing Agreements, as ratified, assumed and adopted by each Borrower and Guarantor pursuant to the terms hereof, as amended and supplemented hereby, and the Financing Order, as each of the same now exists or may hereafter be amended, modified, supplemented, extended, renewed, restated or replaced.

               (d) Interest Rate. The definition of “Interest Rate” set forth in Section 1.72 of the Loan Agreement is hereby amended by deleting such definition in its entirety and replacing it with the following:

               “1.72 ‘Interest Rate’ shall mean,

          (a) Subject to clause (b) of this definition below:

                    (i) as to Prime Rate Loans, a rate equal to one quarter (¹/4%) percent per annum in excess of the Prime Rate, and

                    (ii) as to Eurodollar Rate Loans, a rate equal to one and three-quarters (1³/4%) percent per annum in excess of the Adjusted Eurodollar Rate (in each case, based on the London Interbank Offered Rate applicable for the Interest Period selected by a Borrower, or by Administrative Borrower on behalf of such Borrower, as in effect two (2) Business Days prior to the commencement of the Interest Period, whether such rate is higher or lower than any rate previously quoted to any Borrower or Guarantor).

          (b) Notwithstanding anything to the contrary contained in clause (a) of this definition, Agent may, at its option, and Agent shall, at the direction of the Required Lenders, without notice, increase the Interest Rate to the rate of two and one-quarter (2¹/4 %) percent per annum in excess of the Prime Rate as to Prime Rate Loans and the rate of three and three-quarters (3³/4 %) percent per annum in excess of the Adjusted Eurodollar Rate as to Eurodollar Rate Loans either (i) for the period (A) from and after the effective date of termination or non-renewal hereof until Agent and Lenders have received full and final payment of all outstanding and unpaid Obligations which are not contingent and cash collateral or letter of credit, as Agent may specify, in the amounts and on the terms required under Section 13.1 hereof for contingent Obligations (notwithstanding entry of a judgment against any Borrower or Guarantor), or (B) from and after the date of the occurrence of an Event of Default and for so long as such Event of Default is continuing as determined by Agent and (ii) on Revolving Loans at any time outstanding in excess of the Borrowing Base (whether or not such excess(es) arise or are made without the knowledge or consent of Agent or any Lender and whether made before or after an Event of Default).”

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               (e) Letter of Credit Limit. The definition of “Letter of Credit Limit” set forth in Section 1.79 of the Loan Agreement is hereby amended by deleting such definition in its entirety and replacing it with the following:

               “1.79 ‘Letter of Credit Limit’ shall mean $25,000,000.”

               (f) Loan Agreement. All references to the term “Loan Agreement” in the Loan Agreement and the other Financing Agreements shall be deemed, and each such reference is hereby amended, to mean the Existing Loan Agreement, as amended by this Ratification Agreement and as ratified, assumed and adopted by each Borrower and Guarantor pursuant to the terms hereof and the Financing Order, as the same now exists or may hereafter be amended, modified, supplemented, extended, renewed, restated or replaced.

               (g) Material Adverse Effect. All references to the term “Material Adverse Effect,” “material adverse effect” and “material adverse change” in the Loan Agreement, this Ratification Agreement and the Financing Agreements, shall be deemed, and each such reference in the Financing Agreements is hereby amended, to add at the end thereof: “provided, that, the following shall not constitute a material adverse effect: (i) the commencement of the Chapter 11 Cases, (ii) the financial condition of the Borrowers and Guarantors immediately prior to the Petition Date as disclosed to Agent and Lenders in writing, (iii) the delisting of the stock of Parent or any of its Subsidiaries from the New York Stock Exchange, or (iv) Borrowers closing certain of their store locations with the prior written consent of Agent with respect to such store closures.”.

               (h) Maximum Credit. The definition of “Maximum Credit” set forth in Section 1.88 of the Loan Agreement is hereby amended by deleting such definition in its entirety and replacing it with the following:

               “1.88 ‘Maximum Credit” shall mean the amount of $105,000,000.”

               (i) Obligations. All references to the term “Obligations” in the Loan Agreement, this Ratification Agreement and the Financing Agreements shall be deemed, and each such reference in the Financing Agreements is hereby amended, to mean both the Pre-Petition Obligations and the Post-Petition Obligations.

               (j) Real Property Availability. The definition of “Real Property Availability” set forth in Section 1.109 of the Loan Agreement is hereby amended by deleting such definition in its entirety and replacing it with the following:

     “1.109 ‘Real Property Availability’ shall mean the amount equal to sixty (60%) percent of the fair market value of Eligible Real Property as set forth in the most recent acceptable appraisal (or acceptable updates of existing appraisals) of such Real Property received by Agent in accordance with Section 4.1 or 7.4 hereof.”

               (k) Reserves. The definition of “Reserves” in Section 1.114 of the Loan Agreement is hereby amended by:

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                    (i) adding the following clause (e) immediately prior to the period at the end of the first sentence of such definition:

     “or (e) to establish the reserve provided for in Section 2.4 of the Financing Order.”; and

     (ii) deleting the “.” at the end of the last sentence of such definition and adding the following at the end thereof:

     “; provided, however, that the amount of any Reserve established by Agent during the Chapter 11 Case shall have a reasonable relationship to the event, condition or other matter which is the basis for such Reserve as Agent shall determine in its reasonable discretion. Notwithstanding the foregoing, Borrowers and Guarantors shall acknowledge and agree that Agent shall have the right in its sole discretion to establish Reserves in respect of (i) the Carve Out Expenses (as defined in the Financing Order), (ii) the amount of any senior liens or claims in or against the Collateral that, in Agent’s reasonable determination, have priority over the liens and claims of Agent and Lenders, and (iii) the amount of priority or administrative expense claims that require payment during the Chapter 11 Case, provided, that (A) Agent will consult with Borrowers or their consultant prior to the establishment of such Reserve and (B) upon payment or satisfaction of such claims, the Reserve established in respect thereof shall be released by Agent.”

               (l) Specified Amount. The definition of “Specified Amount” set forth in Section 1.121 of the Loan Agreement is hereby amended by deleting such definition in its entirety and replacing it with the following:

     “1.121 ‘Specified Amount’ shall mean $15,000,000; provided, that, (a) the Specified Amount shall be reduced to $10,000,000 on the date (if any) that each of the following conditions precedent shall have been satisfied: (i) Agent and each Lender shall have received a certified copy of the Permanent Financing Order as entered in the Chapter 11 Case, and (ii) Agent and each Lender shall have received a statement filed with the Bankruptcy Court setting forth the Borrowers’ and Guarantors’ plan to close ninety (90) or more specified retail store locations and outlining the commencement and completion dates of such store closures; and (b) the Specified Amount may be reduced by up to $5,000,000 commencing on the date (if any) that Agent and each Lender shall have received evidence that Borrowers have implemented and tested a management information system with respect to Inventory which is satisfactory to Agent and each Lender.”

          1.3 Interpretation.

               (a) For purposes of this Ratification Agreement, unless otherwise defined or amended herein, including, but not limited to, those terms used and/or defined in the

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recitals hereto, all terms used herein shall have the respective meanings assigned to such terms in the Loan Agreement.

               (b) All references to the term “Agent,” “Lender,” “Borrower,” “Guarantor,” “Debtor” or any other person pursuant to the definitions in the recitals hereto or otherwise shall include its respective successors and assigns.

               (c) All references to any term in the singular shall include the plural and all references to any term in the plural shall include the singular unless the context of such usage requires otherwise.

               (d) All terms not specifically defined herein which are defined in the Uniform Commercial Code, as in effect in the State of New York as of the date hereof, shall have the meaning set forth therein, except that the term “Lien” or “lien” shall have the meaning set forth in § 101(37) of the Bankruptcy Code.

     2. ACKNOWLEDGMENT.

          2.1 Pre-Petition Obligations. Borrowers and Guarantors hereby acknowledge, confirm and agree that, as of March 21, 2007, Borrowers are indebted to Agent and Lenders in respect of all Pre-Petition Obligations in the aggregate principal amount of not less than $64,936,402.70, consisting of (a) Revolving Loans made pursuant to the Existing Financing Agreements in the aggregate principal amount of not less than $56,095,894.94, together with interest accrued and accruing thereon, and (b) Letter of Credit Obligations in the amount of not less than 8,840,507.76, together with interest accrued and accruing thereon, and all costs, expenses, fees (including attorneys’ fees and legal expenses) and (c) other charges now or hereafter owed by Borrowers to Agent and Lenders, all of which are unconditionally owing by Borrowers to Agent and Lenders, without offset, defense or counterclaim of any kind, nature and description whatsoever.

          2.2 Guaranteed Obligations. Each Guarantor hereby acknowledges, confirms and agrees that:

               (a) all obligations of such Guarantor under the Guarantor Documents are unconditionally owing by such Guarantor to Agent and Lenders without offset, defense or counterclaim of any kind, nature and description whatsoever, and

               (b) the absolute and unconditional guarantee of the payment of the Pre-Petition Obligations by such Guarantor pursuant to the Guarantor Documents extends to all Post-Petition Obligations, subject only to the limitations set forth in the Guarantor Documents.

          2.3 Acknowledgment of Security Interests. Borrowers and Guarantors hereby acknowledge, confirm and agree that Agent, for the benefit of itself and the other Lenders, has and shall continue to have valid, enforceable and perfected first priority and senior security interests in and liens upon all Pre-Petition Collateral (other than the Excluded Collateral Items) heretofore granted to Agent and Lenders pursuant to the Existing Financing Agreements as in effect immediately prior to the Petition Date to secure all of the Obligations, as well as valid and enforceable first priority and senior security interests in and liens upon all Post-Petition

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Collateral granted to Agent, for the benefit of itself and the other Lenders, under the Financing Order or hereunder or under any of the other Financing Agreements or otherwise granted to or held by Agent and Lenders, in each case, subject only to liens or encumbrances expressly permitted by the Loan Agreement and any other liens or encumbrances expressly permitted by the Financing Order that may have priority over the liens in favor of Agent and Lenders.

          2.4 Binding Effect of Documents. Each Borrower and Guarantor hereby acknowledges, confirms and agrees that: (a) each of the Existing Financing Agreements to which it is a party was duly executed and delivered to Agent and Lenders by such Borrower or Guarantor and each is in full force and effect as of the date hereof, (b) the agreements and obligations of such Borrower or Guarantor contained in the Existing Financing Agreements constitute the legal, valid and binding obligations of such Borrower or Guarantor enforceable against it in accordance with the terms thereof, and such Borrower or Guarantor has no valid defense, offset or counterclaim to the enforcement of such obligations, and (c) Agent and Lenders are and shall be entitled to all of the rights, remedies and benefits provided for in the Financing Agreements and the Financing Order.

     3. ADOPTION AND RATIFICATION

     Each Borrower and Guarantor hereby (a) ratifies, assumes, adopts and agrees to be bound by all of the Existing Financing Agreements to which it is a party and (b) agrees to pay all of the Pre-Petition Obligations in accordance with the terms of such Existing Financing Agreements, as amended by this Ratification Agreement, and in accordance with the Financing Order. All of the Existing Financing Agreements are hereby incorporated herein by reference and hereby are and shall be deemed adopted and assumed in full by Borrowers and Guarantors, each as Debtor and Debtor-in-Possession, and considered as agreements between such Borrowers or Guarantors, on the one hand, and Agent and Lenders, on the other hand. Each Borrower and Guarantor hereby ratifies, restates, affirms and confirms all of the terms and conditions of the Existing Financing Agreements, as amended and supplemented pursuant hereto and the Financing Order, and each Borrower and Guarantor agrees to be fully bound, as Debtor and Debtor-in-Possession, by the terms of the Financing Agreements to which such Borrower or Guarantor is a party.

     4. GRANT OF SECURITY INTEREST.

     As collateral security for the prompt performance, observance and payment in full of all of the Obligations (including the Pre-Petition Obligations and the Post-Petition Obligations), Borrowers and Guarantors, each as Debtor and Debtor-in-Possession, hereby grant, pledge and assign to Agent, for the benefit of itself and the other Lenders, and also confirm, reaffirm and restate the prior grant to Agent and Lenders of, continuing security interests in and liens upon, and rights of setoff against, all of the Collateral.

     5. REPRESENTATIONS, WARRANTIES AND COVENANTS.

     Except as specifically modified or superseded pursuant to the terms hereof and the Financing Order, and to the extent not prohibited by the Bankruptcy Code or as would otherwise require authorization by the Bankruptcy Court not provided in the Financing Order, Borrowers and Guarantors hereby reaffirm the continuing representations, warranties and covenants

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heretofore and hereafter made by Borrowers and Guarantors to Agent and Lenders, whether pursuant to the Financing Agreements or otherwise. In addition, and not in limitation thereof, each Borrower and Guarantor hereby represents, warrants and covenants to Agent and Lenders the following (which shall survive the execution and delivery of this Ratification Agreement), the truth and accuracy of which, or compliance with, to the extent such compliance does not violate the terms and provisions of the Bankruptcy Code, shall be a continuing condition of the making of Loans by Agent and Lenders:

          5.1 Financing Order. The Interim Financing Order (and, following the expiration of the Interim Financing Period defined therein, the Permanent Financing Order) has been duly entered, is valid, subsisting and continuing and has not been vacated, modified, reversed on appeal, or vacated or modified by any order of the Bankruptcy Court (other than as consented to by Agent) and is not subject to any pending appeal or stay.

          5.2 Use of Proceeds. All Loans and Letters of Credit provided by Agent or any Lender to Borrowers pursuant to the Financing Orders, the Loan Agreement or otherwise, shall be used by Borrowers for general operating and working capital purposes in the ordinary course of business of Borrowers. Notwithstanding anything to the contrary contained in the Loan Agreement or the other Financing Agreement, unless authorized by the Bankruptcy Court and approved by Agent in writing, no portion of any claims against any Borrower or Guarantor existing or created prior to the Petition Date, or of any administrative expense claim or other claim relating to the Chapter 11 Cases, shall be paid with the proceeds of such Loans or Letters of Credit provided by Agent and Lenders to Borrowers, other than allowed professional fees of Borrowers and Guarantors (but subject to the terms and conditions relating to the payment of such fees contained in the Financing Agreement and the Financing Order) and those administrative expense claims and other claims relating to the Chapter 11 Cases directly attributable to the post-petition operation of the business of any Borrower or Guarantor in the ordinary course of such business in accordance with the Financing Agreements. Notwithstanding anything to the contrary contained in this Section 5.2 or otherwise, such proceeds shall not be used by Borrowers or Guarantors to affirmatively commence or support, or to pay any professional fees incurred in connection with, any adversary proceeding, motion or other action that seeks to challenge, contest or otherwise seek to impair or object to the validity, extent, enforceability or priority of Agent’s and Lenders’ pre-petition and/or post-petition liens, claims and rights

          5.3 Budget.

               (a) Borrowers have prepared and delivered to Agent and Lenders, in form satisfactory to Agent, an initial thirteen (13) week Budget. The initial Budget has been thoroughly reviewed by the Borrowers and their management and sets forth for the periods covered thereby: (i) projected weekly operating cash receipts for each week commencing with the week ending March 24, 2007, (ii) projected weekly operating cash disbursements for each week commencing with the week ending March 24, 2007, (iii) projected aggregate principal amount of outstanding Loans and Letter of Credit Obligations for each week commencing with the week ending as of March 24, 2007, and (iv) projected weekly amounts of Loans and Letters of Credit available to Borrowers under the terms, conditions and formulae of the Loan

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Agreement for each week commencing with the week ending March 24, 2007 (collectively, the “Projected Information”).

               (b) In addition to the initial Budget, (1) by no later than 5:00 p.m. (Eastern time) on the Friday of each week commencing on March 30, 2007, Borrowers shall furnish to Agent and Lenders, in form satisfactory to Agent, a report that sets forth for the immediately preceding week a comparison of the actual cash receipts, cash disbursements, loan balance and loan availability to the Projected Information for such weekly periods set forth in the Budget on a cumulative, weekly roll-forward basis, (2) by no later than 5:00 p.m. on April 13, 2007 and on the Friday of each fourth week thereafter, Borrowers shall prepare and present to Agent and Lenders, in form satisfactory to Agent, a subsequent thirteen (13) week Budget.

               (c) Notwithstanding any approval by Agent or any Lender of the initial Budget or any subsequent or amended Budget(s), Agent and Lenders will not, and shall not be required to, provide any Loans or Letters of Credit to Borrowers pursuant to the Budget, but shall only provide Loans and Letters of Credit in accordance with the terms and conditions set forth in the Loan Agreement as amended by this Ratification Agreement, the other Financing Agreements and the Financing Order.

          5.4 Ratification of Blocked Account Agreement. To the extent Agent deems it necessary in its discretion and upon Agent’s request, Borrower and Guarantors shall promptly provide Agent with evidence, in form and substance satisfactory to Agent, that the Blocked Account Agreement (as defined in the Financing Order) and other deposit account arrangements provided for under Section 6.3 of the Loan Agreement have been ratified and amended by the parties thereto, or their respective successors in interest, in form and substance satisfactory to Agent, to reflect the commencement of the Chapter 11 Cases, that each Borrower and Guarantor, as Debtor and Debtor-in-Possession, is the successor in interest to such Borrower or Guarantor, that the Obligations include both the Pre-Petition Obligations and the Post-Petition Obligations, that the Collateral includes both the Pre-Petition Collateral and the Post-Petition Collateral as provided for.

          5.5 ERISA. Each Borrower and Guarantor hereby represents and warrants with, to and in favor of Agent and Lenders that (a) there are no liens, security interests or encumbrances upon, in or against any assets or properties of any Borrower or Guarantor arising under ERISA, whether held by the Pension Benefit Guaranty Corporation (the “PBGC”) or the contributing sponsor of, or a member of the controlled group thereof, any pension benefit plan of any Borrower or Guarantor and (b) no notice of lien has been filed by the PBGC (or any other Person) pursuant to ERISA against any assets or properties of any Borrower or Guarantor.

     6. DIP FACILITY FEE.

          In addition to all other fees, charges, interest and expenses payable by Borrowers to Agent and Lenders under the Loan Agreement, the Fee Letter and the other Financing Agreements, in connection with the execution and delivery of this Ratification Agreement, Borrowers agree to pay to Agent the fees and other amounts set forth in the DIP Fee Letter in the amounts and at the times specified therein.

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     7. AMENDMENTS TO LOAN AGREEMENT.

          7.1 Letter of Credit Fees. Section 2.2(b) of the Loan Agreement is hereby amended by deleting such Section in its entirety and replacing it with the following:

     “(b) In addition to any charges, fees or expenses charged by any bank or issuer in connection with the Letters of Credit, Borrowers shall pay to Agent, for the benefit of Lenders, monthly a letter of credit fee at a rate equal to equal to one (1%) percent per annum on the daily outstanding balance of the Commercial Letters of Credit and equal to one and three-quarters (1³/4%) percent per annum on the daily outstanding balance of the Standby Letters of Credit during the immediately preceding month (or part thereof), payable in arrears as of the first of each succeeding month, except that Agent may, and upon the written direction of Required Lenders shall, require Borrowers to pay to Agent, for the benefit of Lenders, such letter of credit fee, at a rate equal to three (3%) percent per annum on the daily outstanding balance of the Commercial Letters of Credit and equal to three and three-quarters (3³/4%) percent per annum on the daily outstanding balance of the Standby Letters of Credit for: (i) the period (A) from and after the effective date of termination or non-renewal hereof until Agent and Lenders have received full and final payment of all outstanding and unpaid Obligations which are not contingent and cash collateral or a letter of credit, as Agent may specify, in the amounts and on the terms required under Section 13.1 hereof for contingent Obligations (notwithstanding entry of a judgment against any Borrower or Guarantor) and (B) from and after the date of the occurrence of an Event of Default and for so long as such Event of Default is continuing as determined by Agent and (ii) on the Letters of Credit at any time outstanding in excess of the Letter of Credit Limit (whether or not such excess(es) arise or are issued with or without the knowledge or consent of Agent or any Lender and whether issued before or after an Event of Default). Such letter of credit fee shall be calculated on the basis of a three hundred sixty (360) day year and actual days elapsed and the obligation of Borrowers to pay such fee shall survive the termination of this Agreement.”

          7.2 Increase or Decrease in Maximum Credit. Section 2.3 of the Loan Agreement is hereby amended by deleting such Section in its entirety and replacing it with the following:

     “2.3 [Intentionally Deleted.]”

          7.3 Limits and Sublimits. Section 2 of the Loan Agreement is hereby amended by adding the following new Section 2.4 at the end of such Section:

     “2.4 All limits and sublimits set forth in this Agreement, and any formula or other provision to which a limit or sublimit may apply, shall be determined on an aggregate basis considering together both the Pre-Petition Obligations and the Post-Petition Obligations.”

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               7.4 Fees.

                    (a) Unused Line Fee. Section 3.2(a) of the Loan Agreement is hereby amended by deleting such Section in its entirety and replacing it with the following:

     “(a) Borrowers shall pay to Agent, for the account of Lenders, monthly an unused line fee at a rate equal to .35% per annum calculated upon the amount by which the Maximum Credit exceeds the average daily principal balance of the outstanding Revolving Loans and Letters of Credit during the immediately preceding month (or part thereof) while this Agreement is in effect and for so long thereafter as any of the Obligations are outstanding. Such fee shall be payable on the first day of each month in arrears and shall be calculated based on a three hundred sixty (360) day year and actual days elapsed.”

                    (b) Limitation on Certain Fees. Notwithstanding the provisions of the Loan Agreement, the Fee Letter or any of the other Financing Agreements to the contrary, so long as no Default or Event of Default exists or has occurred and is continuing, (i) the aggregate amount of (A) the servicing fees payable by Borrowers to Agent pursuant to Section 2 of the Fee Letter, (B) the unused line fees payable by Borrowers to Agent pursuant to Section 3.2(a) of the Loan Agreement, and (C) audit fees and appraisal fees payable by Borrowers under Section 9.22 of the Loan Agreement, shall not exceed $300,000 in any twelve (12) month period and (ii) the aggregate amount of consulting fees payable by Borrowers for the consultants retained by Borrowers at the request of Agent shall not exceed $200,000 in any twelve (12) month period.

               7.5 Payments. Section 6.4 of the Loan Agreement is hereby amended by adding the following at the end of such Section:

     “Without limiting the generality of the foregoing, Agent may, in its discretion, apply any such payments or proceeds first to the Pre-Petition Obligations until all Pre-Petition Obligations are paid and satisfied in full.”

               7.6 Cash Management; Collection of Collateral Proceeds. Section 6.3(c) of the Loan Agreement is hereby amended by deleting the reference to “at any time that a Cash Dominion Event occurs” and replacing it with “at any time”.

               7.7 Power of Attorney. Section 7.5(b) of the Loan Agreement is hereby amended by deleting each reference to “if a Cash Dominion Event has occurred”.

               7.8 Compliance with Other Agreements and Applicable Laws.. Section 8.7(a) of the Loan Agreement is hereby amended to delete the first sentence of such section in its entirety and substitute the following therefor:

“(a) Borrowers and Guarantors are not in default (other than a default occasioned by or solely as a result of the commencement of the Chapter 11 Cases and which default is unenforceable pursuant to the Bankruptcy Code) in any respect under, or in violation in any respect of the terms of, any material agreement, contract, instrument, lease or other commitment to which it is a party or by which it or any of its assets are bound.”

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          7.9 Material Contracts. The last sentence of Section 8.15 of the Loan Agreement is hereby deleted in its entirety and the following substituted therefor:

“Borrowers and Guarantors are not in breach or in default in any material respect of or under any Material Contract (other than a default occasioned by or solely as a result of the commencement of the Chapter 11 Cases and which default is unenforceable pursuant to the Bankruptcy Code) and have not received any notice of the intention of any other party thereto to terminate any Material Contract.”

          7.10 Additional Financial Reporting Requirements.

                    (a) Section 9.6(a)(ii) of the Loan Agreement is hereby amended to delete each reference to “audited”.

                    (b) Section 9.6 of the Loan Agreement is hereby amended by adding the following new Section 9.6(e) at the end of such Section:

                    “(e) Each Borrower and Guarantor shall provide Agent and Lenders with copies of all financial reports, schedules and other materials and information at any time furnished by or on behalf of any Borrower or Guarantor to the Bankruptcy Court, or the U.S. Trustee or to any creditors’ committee appointed in the Chapter 11 Cases or to such Borrower’s or Guarantor’s shareholders, concurrently with the delivery thereof to the Bankruptcy Court, U.S. Trustee, creditors’ committee or shareholders, as the case may be.”

          7.11 Sale of Assets, Consolidation, Merger, Disabilities, Etc. Notwithstanding anything to the contrary contained in Section 9.7(b) of the Loan Agreement or any other provision of the Loan Agreement or any of the other Financing Agreements, Borrowers and Guarantors shall not, directly or indirectly, sell, transfer, lease, encumber, return or otherwise dispose of any portion of the Collateral, including, without limitation, enter into any agreement to return Inventory to any vendor, whether pursuant to section 546 of the Bankruptcy Code or otherwise or, on and after the occurrence of an Event of Default, assume, reject, assign or pledge as collateral security any real property leasehold interest or use the proceeds thereof, without, in each instance, the prior written consent of Agent (and no such consent shall be implied, from any action, inaction or acquiescence by Agent or any Lender) except for sales of Borrowers’ and Guarantors’ Inventory in the ordinary course of their respective businesses, and “going out of business” or store closing sales of Borrowers’ and Guarantors’ Inventory conducted at certain store locations with respect to which sales Agent has previously consented in writing.

          7.12 Minimum Excess Availability. Section 9.19 of the Loan Agreement is hereby amended by deleting such Section in its entirety and replacing it with the following:

                    “9.19 Minimum Excess Availability. Borrowers shall at all times maintain Excess Availability of not less than the Specified Amount plus $7,500,000 (it being understood that, solely for purposes of calculating this Section 9.19, the amount of Excess Availability shall be determined as if the Maximum Credit were equal to the Maximum Credit plus the Specified Amount).”

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          7.13 Events of Default.

                    (a) Sections 10.1(g) and (h) of the Loan Agreement are hereby amended to delete all references to “any Borrower or Guarantor” and substitute “any Obligor (other than Debtors)” therefor.

                    (b) Section 10.1 of the Loan Agreement is hereby amended by (i) deleting the reference to the word “or” at the end of Section 10.1(o), (ii) replacing the period at the end of Section 10.1(p) with a semicolon, and (iii) adding the following at the end of such Section:

                    “(q) the occurrence of any condition or event which permits Agent and Lenders to exercise any of the remedies set forth in the Financing Order, including, without limitation, any “Event of Default” (as defined in the Financing Order);

                    (r) the termination or non-renewal of the Financing Agreements as provided for in the Financing Order;

                    (s) any Borrower or Guarantor suspends or discontinues or is enjoined by any court or governmental agency from continuing to conduct all or any material part of its business, or a trustee, receiver or custodian is appointed for any Borrower or Guarantor, or any of its properties;

                    (t) any act, condition or event occurring after the Petition Date that has or would reasonably expect to have a Material Adverse Effect upon the assets of any Borrower or Guarantor, or the Collateral or the rights and remedies of Agent and Lenders under the Loan Agreement or any other Financing Agreements or the Financing Order;

                    (u) the conversion of any of the Chapter 11 Cases to a Chapter 7 case under the Bankruptcy Code;

                    (v) the dismissal of any of the Chapter 11 Cases or any subsequent Chapter 7 case, either voluntarily or involuntarily;

                    (w) the grant of a lien on or other interest in any of the Collateral other than a lien or encumbrance permitted by Section 9.8 hereof or by the Financing Order or an administrative expense claim other than an administrative expense claim permitted by the Financing Order or this Ratification Agreement by the grant of or allowance by the Bankruptcy Court which is superior to or ranks in parity with Agent’s security interest in or lien upon the Collateral or their Superpriority Claim (as defined in the Financing Order);

                    (x) the Financing Order shall be modified, reversed, revoked, remanded, stayed, rescinded, vacated or amended on appeal or by the Bankruptcy Court without the prior written consent of Agent (and no such consent shall be implied from any other authorization or acquiescence by Agent or any Lender);

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     (y) the appointment of a trustee pursuant to Sections 1104(a)(1) or 1104(a)(2) of the Bankruptcy Code;

     (z) the appointment of an examiner with special powers pursuant to Section 1104(a) of the Bankruptcy Code;

     (aa) the filing of a plan of reorganization by or on behalf of any Borrower or Guarantor to which Agent has not consented in writing, which does not provide for payment in full of all Obligations on the effective date thereof in accordance with the terms and conditions contained herein; or

     (bb) the confirmation of any plan of reorganization in the Chapter 11 Case of any Borrower or Guarantor to which Agent has not consented to in writing, which does not provide for payment in full of all Obligations on the effective date thereof in accordance with the terms and conditions contained herein.”

          7.14 Governing Law; Choice of Forum; Service of Process; Jury Trial Waiver. Section 11.1(a) of the Loan Agreement is hereby amended by adding the following immediately prior to the period at the end of such Section:

     “, except to the extent that the provisions of the Bankruptcy Code are applicable and specifically conflict with the foregoing.”

          7.15 Term.

     (a) Section 13.1(a) of the Loan Agreement is hereby amended by deleting the first two sentences of such Section and replacing them with the following:

     “This Agreement and the other Financing Agreements shall become effective as of the date set forth on the first page hereof and shall continue in full force and effect for a term ending on the earlier to occur of (i) March 22, 2009, (ii) the confirmation of a plan of reorganization for Borrowers and Guarantors in the Chapter 11 Cases, or (iii) the last termination date set forth in the Interim Financing Order, unless the Permanent Financing Order has been entered prior to such date, and in such event, then the last termination date set forth in the Permanent Financing Order (the earlier to occur of clauses (i), (ii) and (iii) referred to herein as the “Maturity Date”); provided, that, this Agreement and all other Financing Agreements must be terminated simultaneously.”

     (b) Section 13.1(c) of the Loan Agreement is hereby amended by deleting the first sentence of such Section and replacing it with the following:

     “If for any reason this Agreement is terminated prior to the second anniversary of the date of the Ratification Agreement, in view of the impracticality and extreme difficulty of ascertaining actual damages and by mutual agreement of the parties as to a reasonable calculation of Agent’s and each Lender’s lost profits as a result thereof, Borrowers agree to pay to Agent, for the

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benefit of Lenders, upon the effective date of such termination, an early termination fee in the amount equal to .25% of Maximum Credit.”

          7.16 Notices. Section 13.3 of the Loan Agreement is hereby amended by adding that any notices, requests and demands also be sent to the following parties:

If to Borrowers or Guarantors:	Hancock Fabrics, Inc.
	One Fashion Way
	Baldwyn, MS 38824
	Facsimile No.: (662) 365-6025
	Attention: Jeff Nerland
	Attention: Jane Aggers
with a copy to:	Morris, Nichols, Arsht & Tunnell LLP
	Chase Manhattan Centre, 18th Floor
	1201 North Market Street
	P.O. Box 1347
	Wilmington, DE 19899-1347
	Facsimile No.: 302.425.4673
	Attention: Robert J. Dehney, Esq.
If to Agent:	Wachovia Bank, National Association
	Heritage Square II, Suite 1050
	5001 LBJ Freeway
	Dallas, TX 75244
	Facsimile No.: (214) 748-9118
	Attention: Portfolio Manager
with a copy to:	Otterbourg, Steindler, Houston & Rosen, P.C.
	230 Park Avenue
	New York, New York 10169
	Facsimile No.: (212) 682-6104
	Attn: Jonathan N. Helfat, Esq.
	Daniel F. Fiorillo, Esq.

     8. WAIVER.

          8.1 Subject to the terms and conditions set forth herein, Agent and Lenders hereby waive the Events of Default arising under Section 10.1(a)(iii) of the Loan Agreement as a result of (A) the failure of Debtors to comply with the provisions of Section 9.6(a)(i) of the Loan Agreement due to Debtors failure to deliver to Agent by February 28, 2007 the unaudited consolidated financial statements and unaudited consolidating financial statements for Parent and its Subsidiaries for the fiscal quarters ending on or about April 29, 2006, July 29, 2006 and October 28, 2006, and (B) the failure of Borrowers to comply with the minimum Excess Availability covenant as set forth in Section 9.19 of the Loan Agreement at various times prior to the date hereof (the foregoing clauses (A) and (B) are collectively referred to herein as the “Subject Defaults”).

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          8.2 Agent and Lenders have not waived, are not hereby waiving, and have no intention of waiving any Event of Default which may have occurred on or prior to the date hereof, whether or not continuing on the date hereof, or which may occur after the date hereof (whether the same or similar to the Event of Default referred to above or otherwise), other than the Subject Defaults as and to the extent set forth in this Section 8. The foregoing waiver shall not be construed as a bar to or a waiver of any other or further Event of Default on any future occasion, whether similar in kind or otherwise and shall not constitute a waiver, express or implied, of any of the rights and remedies of Agent or Lenders arising under the terms of the Financing Order, Loan Agreement or any other Financing Agreements on any future occasion or otherwise.

     9. RELEASE.

          9.1 Release of Pre-Petition Claims.

                    (a) Upon the earlier of (i) the entry of the Permanent Financing Order or (ii) the entry of an Order extending the term of the Interim Financing Order beyond thirty (30) calendar days after the date of the Interim Financing Order, in consideration of the agreements of Agent and Lenders contained herein and the making of any Loans by Agent and Lenders, each Borrower and Guarantor, pursuant to the Loan Agreement, and for other good and valuable consideration, the receipt and sufficiency of which is hereby acknowledged, on behalf of itself and its respective successors, assigns, and other legal representatives, hereby absolutely, unconditionally and irrevocably releases, remises and forever discharges Agent, each Lender and their respective successors and assigns, and their present and former shareholders, affiliates, subsidiaries, divisions, predecessors, directors, officers, attorneys, employees and other representatives (Agent, each Lender and all such other parties being hereinafter referred to collectively as the “Releasees” and individually as a “Releasee”), of and from all demands, actions, causes of action, suits, covenants, contracts, controversies, agreements, promises, sums of money, accounts, bills, reckonings, damages and any and all other claims, counterclaims, defenses, rights of set-off, demands and liabilities whatsoever (individually, a “Pre-Petition Released Claim” and collectively, “Pre-Petition Released Claims”) of every name and nature, known or unknown, suspected or unsuspected, both at law and in equity, which any Borrower or Guarantor, or any of their respective successors, assigns, or other legal representatives may now or hereafter own, hold, have or claim to have against the Releasees or any of them for, upon, or by reason of any nature, cause or thing whatsoever which arises at any time on or prior to the day and date of this Agreement, including, without limitation, for or on account of, or in relation to, or in any way in connection with the Loan Agreement, as amended and supplemented through the date hereof, and the other Financing Agreements.

                    (b) Upon the earlier of (i) the entry of the Permanent Financing Order or (ii) the entry of an Order extending the term of the Interim Financing Order beyond thirty (30) calendar days after the date of the Interim Financing Order, each Borrower and Guarantor, on behalf of itself and its successors, assigns, and other legal representatives, hereby absolutely, unconditionally and irrevocably, covenants and agrees with each Releasee that it will not sue (at law, in equity, in any regulatory proceeding or otherwise) any Releasee on the basis of any Pre-Petition Released Claim released, remised and discharged by each Borrower and Guarantor pursuant to this Section 9.1. If any Borrower or Guarantor violates the foregoing covenant,

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Borrowers and Guarantors agree to pay, in addition to such other damages as any Releasee may sustain as a result of such violation, all attorneys’ fees and costs incurred by any Releasee as a result of such violation.

          9.2 Release of Post-Petition Claims. Upon (a) the receipt by Agent, on behalf of itself and the other Lenders, of payment in full of all Obligations in cash or other immediately available funds, plus cash collateral or other collateral security acceptable to Agent to secure any Obligations that survive or continue beyond the termination of the Financing Agreements, and (b) the termination of the Financing Agreements (the “Payment Date”), in consideration of the agreements of Agent and Lenders contained herein and the making of any Loans by Agent and Lenders, each Borrower and Guarantor hereby covenants and agrees to execute and deliver in favor of Agent and Lenders a valid and binding termination and release agreement, in form and substance satisfactory to Agent. If Borrower or any Guarantor violates such covenant, Borrowers and Guarantors agree to pay, in addition to such other damages as any Releasee may sustain as a result of such violation, all attorneys’ fees and costs incurred by any Releasee as a result of such violation.

          9.3 Releases Generally.

                    (a) Each Borrower and Guarantor understands, acknowledges and agrees that the releases set forth above in Sections 9.1 and 9.2 hereof may be pleaded as a full and complete defense and may be used as a basis for an injunction against any action, suit or other proceeding which may be instituted, prosecuted or attempted in breach of the provisions of such releases.

                    (b) Each Borrower and Guarantor agrees that no fact, event, circumstance, evidence or transaction which could now be asserted or which may hereafter be discovered shall affect in any manner the final and unconditional nature of the releases set forth in Section 9.1 hereof and, when made, Section 9.2 hereof.

     10. CONDITIONS PRECEDENT.

     In addition to any other conditions contained herein or the Loan Agreement, as in effect immediately prior to the Petition Date, with respect to the Loans and other financial accommodations available to Borrowers (all of which conditions, except as modified or made pursuant to this Ratification Agreement shall remain applicable to the Loans and be applicable to other financial accommodations available to Borrowers), the following are conditions to Agent’s and Lenders’ obligation to extend further loans, advances or other financial accommodations to Borrowers pursuant to the Loan Agreement:

          10.1 Borrowers and Guarantors shall furnish to Agent and Lenders all financial information, projections, budgets, business plans, cash flows and such other information as Agent and Lenders shall reasonably request from time to time;

          10.2 as of the Petition Date, the Existing Financing Agreements shall not have been terminated;

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          10.3 no trustee, examiner or receiver or the like shall have been appointed or designated with respect to any Borrower or Guarantor, as Debtor and Debtor-in-Possession, or its respective business, properties and assets and no motion or proceeding shall be pending seeking such relief;

          10.4 the execution and delivery of this Ratification Agreement and all other Financing Agreements to be delivered in connection herewith by Borrowers and Guarantors in form and substance satisfactory to Agent;

          10.5 the Interim Financing Order or other Order(s) of the Bankruptcy Court shall ratify and amend the Blocked Account Agreement and deposit account arrangements of Borrowers and Guarantors to reflect the commencement of the Chapter 11 Cases, that each Debtor, as Debtor and Debtor-in-Possession, is the successor in interest to such Borrower or Guarantor, as the case may be, that the Obligations include both the Pre-Petition Obligations and the Post-Petition Obligations, that the Collateral includes both the Pre-Petition Collateral and the Post-Petition Collateral as provided for in this Ratification Agreement;

          10.6 the execution or delivery to Agent and Lenders of all other Financing Agreements, and other agreements, documents and instruments which, in the good faith judgment, of Agent are necessary or appropriate. The implementation of the terms of this Ratification Agreement and the other Financing Agreements, as modified pursuant to this Ratification Agreement, all of which contains provisions, representations, warranties, covenants and Events of Default, as are satisfactory to Agent and its counsel;

          10.7 satisfactory review by counsel for Agent of legal issues attendant to the post-petition financing transactions contemplated hereunder;

          10.8 Each Borrower and Guarantor shall comply in full with the notice and other requirements of the Bankruptcy Code and the applicable Bankruptcy Rules with respect to any relevant Financing Order in a manner acceptable to Agent and its counsel, and an Interim Financing Order shall have been entered by the Bankruptcy Court (the “Interim Financing Order”) authorizing the secured financing under the Financing Agreements as ratified and amended hereunder on the terms and conditions set forth in this Ratification Agreement and, among other things, modifying the automatic stay, authorizing and granting the senior security interest in liens in favor of Agent and Lenders described in this Ratification Agreement and in the Financing Order, and granting super-priority expense claims to Agent and Lenders with respect to all obligations due Agent and Lenders. The Interim Financing Order shall authorize post-petition financing under the terms set forth in this Ratification Agreement in an amount acceptable to Agent and Lenders, in their sole discretion, and it shall contain such other terms or provisions as Agent and its counsel shall require;

          10.9 with respect to further credit after expiration of the Interim Financing Order, on or before the expiration of the Interim Financing Order, the Bankruptcy Court shall have entered a Permanent Financing Order authorizing the secured financing on the terms and conditions set forth in this Ratification Agreement, granting to Agent and Lenders the senior security interests and liens described above and super-priority administrative expense claims described above (except as otherwise specifically provided in the Interim Financing Order), and

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modifying the automatic stay and other provisions required by Agent and its counsel (“Permanent Financing Order”). Neither Agent nor any Lender shall provide any Loans (or other financial accommodations) other than those authorized under the Interim Financing Order unless, on or before the expiration of the Interim Financing Order, the Permanent Financing Order shall have been entered, and there shall be no appeal or other contest with respect to either the Interim Financing Order or the Permanent Financing Order and the time to appeal to contest such order shall have expired;

          10.10 other than the voluntary commencement of the Chapter 11 Cases, no material impairment of the priority of Agent’s and Lenders’ security interests in the Collateral shall have occurred from the date of the latest field examinations of Agent and Lenders to the Petition Date; and

          10.11 other than the Events of Default identified in the letter by Agent to Borrowers and Guarantors, dated March 19, 2007, re: Notice of Default, no Event of Default shall have occurred or be existing under any of the Existing Financing Agreements, as modified pursuant hereto, and assumed by Borrowers and Guarantors.

     11. MISCELLANEOUS.

          11.1 Amendments and Waivers. Neither this Ratification Agreement nor any other instrument or document referred to herein or therein may be changed, waived, discharged or terminated orally, but only by an instrument in writing signed by the party against whom enforcement of the change, waiver, discharge or termination is sought.

          11.2 Further Assurances. Each Borrower and Guarantor shall, at its expense, at any time or times duly execute and deliver, or shall use its best efforts to cause to be duly executed and delivered, such further agreements, instruments and documents, including, without limitation, additional security agreements, collateral assignments, UCC financing statements or amendments or continuations thereof, landlord’s or mortgagee’s waivers of liens and consents to the exercise by Agent and Lenders of all the rights and remedies hereunder, under any of the other Financing Agreements, any Financing Order or applicable law with respect to the Collateral, and do or use its best efforts to cause to be done such further acts as may be reasonably necessary or proper in Agent’s opinion to evidence, perfect, maintain and enforce the security interests of Agent and Lenders, and the priority thereof, in the Collateral and to otherwise effectuate the provisions or purposes of this Ratification Agreement, any of the other Financing Agreements or the Financing Order. Upon the request of Agent, at any time and from time to time, each Borrower and Guarantor shall, at its cost and expense, do, make, execute, deliver and record, register or file updates to the filings of Agent and Lenders with respect to the Intellectual Property with the United States Patent and Trademark Office, the financing statements, mortgages, deeds of trust, deeds to secure debt, and other instruments, acts, pledges, assignments and transfers (or use its best efforts to cause the same to be done) and will deliver to Agent and Lenders such instruments evidencing items of Collateral as may be requested by Agent.

          11.3 Headings. The headings used herein are for convenience only and do not constitute matters to be considered in interpreting this Ratification Agreement.

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          11.4 Counterparts. This Ratification Agreement may be executed in any number of counterparts, each of which shall be deemed to be an original, but all of which shall together constitute one and the same agreement. In making proof of this Ratification Agreement, it shall not be necessary to produce or account for more than one counterpart thereof signed by each of the parties hereto. Delivery of an executed counterpart of this Ratification Agreement by telefacsimile shall have the same force and effect as delivery of an original executed counterpart of this Ratification Agreement. Any party delivering an executed counterpart of this Ratification Agreement by telefacsimile also shall deliver an original executed counterpart of this Ratification Agreement, but the failure to deliver an original executed counterpart shall not affect the validity, enforceability, and binding effect of this Ratification Agreement as to such party or any other party.

          11.5 Additional Events of Default. The parties hereto acknowledge, confirm and agree that the failure of any Borrower or Guarantor to comply with any of the covenants, conditions and agreements contained in this Ratification Agreement or in any other agreement, document or instrument executed on or after the date hereof by such Borrower or Guarantor in connection with this Ratification Agreement shall constitute an Event of Default under the Financing Agreements; provided, that, in the event Borrowers fail to comply with the requirements of Section 5.3(b) herein, Borrowers shall be have an additional two (2) business days in which to comply with the requirements of such section (the “Reporting Grace Period”); provided, further, that, unless otherwise consented to in writing by Agent, Borrowers shall not be entitled to more than two (2) Reporting Grace Periods during any calendar month. This Section 11.5 shall not, and shall not be construed to, supersede or otherwise replace Section 10.1(a) of the Loan Agreement.

          11.6 Costs and Expenses. Borrowers shall pay to Agent and Lenders on demand all costs and expenses that Agent or Lenders pay or incurs in connection with the negotiation, preparation, consummation, administration, enforcement, and termination of this Ratification Agreement and the other Financing Agreements and the Financing Order, including, without limitation: (a) reasonable attorneys’ and paralegals’ fees and disbursements of counsel to, and reasonable fees and expenses of consultants, accountants and other professionals retained by, Agent and Lenders; (b) costs and expenses (including reasonable attorneys’ and paralegals’ fees and disbursements) for any amendment, supplement, waiver, consent, or subsequent closing in connection with this Ratification Agreement, the other Financing Agreements, the Financing Order and the transactions contemplated thereby; (c) taxes, fees and other charges for recording any agreements or documents with any governmental authority, and the filing of UCC financing statements and continuations, and other actions to perfect, protect, and continue the security interests and liens of Agent and Lenders in the Collateral; (d) sums paid or incurred to pay any amount or take any action required of Borrowers and Guarantors under the Financing Agreements or the Financing Order that Borrowers and Guarantors fail to pay or take; (e) costs of appraisals, inspections and verifications of the Collateral and including travel, lodging, and meals for inspections of the Collateral and the Debtors’ operations by Agent or its agent and to attend court hearings or otherwise in connection with the Chapter 11 Cases; (f) costs and expenses of preserving and protecting the Collateral; (g) all out-of-pocket expenses and costs heretofore and from time to time hereafter incurred by Agent during the course of periodic field examinations of the Collateral and Debtors’ operations, plus a per diem charge at the rate of $850 per person per day for Agent’s examiners in the field and office; and (h) costs and expenses

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(including attorneys’ and paralegals’ fees and disbursements) paid or incurred to obtain payment of the Obligations, enforce the security interests and liens of Agent and Lenders, sell or otherwise realize upon the Collateral, and otherwise enforce the provisions of this Ratification Agreement, the other Financing Agreements and the Financing Order, or to defend any claims made or threatened against Agent or any Lender arising out of the transactions contemplated hereby (including, without limitation, preparations for and consultations concerning any such matters). The foregoing shall not be construed to limit any other provisions of the Financing Agreements regarding costs and expenses to be paid by Borrowers. All sums provided for in this Section 11.6 shall be part of the Obligations, shall be payable on demand, and shall accrue interest after demand for payment thereof at the highest rate of interest then payable under the Financing Agreements. Agent is hereby irrevocably authorized to charge any amounts payable hereunder directly to any of the account(s) maintained by Agent with respect to any Borrower or Guarantor.

          11.7 Effectiveness. This Ratification Agreement shall become effective upon the execution hereof by Agent and Lenders and the entry of the Interim Financing Order.

[REMAINDER OF THIS PAGE INTENTIONALLY LEFT BLANK]

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     IN WITNESS WHEREOF, the parties hereto have caused this Ratification Agreement to be duly executed as of the day and year first above written.

BORROWERS

HANCOCK FABRICS, INC., as Debtor and Debtor-in-Possession

By:

Title:

HF MERCHANDISING, INC., as Debtor and Debtor-in-Possession

By:

Title:

HANCOCK FABRICS OF MI, INC. , as Debtor and Debtor-in-Possession

By:

Title:

HANCOCKFABRICS.COM, INC. , as Debtor and Debtor-in-Possession

By:

Title:

HANCOCK FABRICS, LLC, as Debtor and Debtor-in-Possession

By:

Title:

[SIGNATURES CONTINUE ON NEXT PAGE]

[SIGNATURES CONTINUED FROM PREVIOUS PAGE

GUARANTORS

HF ENTERPRISES, INC. , as Debtor and Debtor-in-Possession

By:

Title:

HF RESOURCES, INC., as Debtor and Debtor-in-Possession

By:

Title:

AGENT

WACHOVIA BANK, NATIONAL ASSOCIATION

By:

Title:

LENDER

WACHOVIA BANK, NATIONAL ASSOCIATION

By:

Title:

EX-10.44

EXHIBIT 10.44

AMENDMENT NO. 1 TO RATIFICATION AND AMENDMENT AGREEMENT AND
AMENDMENT NO. 7 TO LOAN AND SECURITY AGREEMENT

     AMENDMENT NO. 1 TO RATIFICATION AND AMENDMENT AGREEMENT AND AMENDMENT NO. 7 TO LOAN AND SECURITY AGREEMENT, dated as of April 19, 2007 (this “First Ratification Amendment”), by and among HANCOCK FABRICS, INC., a Delaware corporation, as Debtor and Debtor-in-Possession (“Parent”), HF MERCHANDISING, INC., a Delaware corporation, as Debtor and Debtor-in-Possession (“Merchandising”), HANCOCK FABRICS OF MI, INC., a Delaware corporation, as Debtor and Debtor-in-Possession (“Fabrics MI”), HANCOCKFABRICS.COM, INC., a Delaware corporation, as Debtor and Debtor-in-Possession (“Fabrics.com”), HANCOCK FABRICS, LLC, a Delaware limited liability company, as Debtor and Debtor-in-Possession (“Fabrics LLC”, and together with Parent, Merchandising, Fabrics MI and Fabrics.com, each individually a “Borrower” and collectively, “Borrowers”), HF ENTERPRISES, INC., a Delaware corporation, as Debtor and Debtor-in-Possession (“Enterprises”), HF RESOURCES, INC., a Delaware corporation, as Debtor and Debtor-in-Possession (“Resources”, and together with Enterprises, each individually a “Guarantor” and collectively, “Guarantors”), the financial institutions from time to time party to the Loan Agreement (as hereinafter defined) as lenders (each individually, a “Lender” and collectively, “Lenders”), and WACHOVIA BANK, NATIONAL ASSOCIATION, a national banking association, in its capacity as agent acting for and on behalf of the Lenders (in such capacity, “Agent”).

W I T N E S S E T H:

     WHEREAS, Borrowers, Guarantors, Agent and Lenders have entered into financing arrangements pursuant to which Agent and Lenders may make loans and advances and provide other financial accommodations to Borrowers as set forth in the Loan and Security Agreement, dated June 29, 2005, by and among Borrowers, Guarantors, Agent and Lenders, as amended by Amendment No. 1 to Loan and Security Agreement, dated as of July 26, 2005, Amendment No. 2 to Loan and Security Agreement, dated as of December 31, 2005, Amendment No. 3 to Loan and Security Agreement, dated as of April 25, 2006, Amendment No. 4 to Loan and Security Agreement, dated as of June 14, 2006, Amendment No. 5 to Loan and Security Agreement, dated as of October 31, 2006, and Amendment No. 6 to Loan and Security Agreement, dated as of December 29, 2006, as further amended by the Ratification and Amendment Agreement, dated March 22, 2007 (as amended hereby and as may hereafter be further amended, modified, supplemented, extended, renewed, restated or replaced the “Loan Agreement”, and together with all agreements, documents and instruments at any time executed and/or delivered in connection therewith or related thereto, as from time to time amended, modified, supplemented, extended, renewed, restated or replaced, collectively, the “Financing Agreements”);

     WHEREAS, each Debtor has commenced a case under Chapter 11 of Title 11 of the United States Code in the United States Bankruptcy Court for the District of Delaware and has retained possession of its assets and each is authorized under the Bankruptcy Code to continue the operation of its businesses as a debtor-in-possession; and

     WHEREAS, Debtors have requested that Agent and Lenders make certain amendments to the Loan Agreement and Agent and Lenders are willing to agree to such request, subject to the terms and conditions contained herein; and

     WHEREAS, by this First Ratification Amendment, Agent, Lenders and Debtors intend to evidence such consent and amendments;

     WHEREAS, this First Ratification Amendment has been authorized by the Bankruptcy Court pursuant to an Order entered by the Bankruptcy Court authorizing Borrowers and Guarantors to execute and deliver this First Ratification Amendment;

     NOW, THEREFORE, in consideration of the premises and covenants set forth herein and other good and valuable consideration, the receipt and sufficiency of which is hereby acknowledged, the parties hereto agree as follows:

     1. DEFINITIONS.

          (a) Additional Definitions. As used herein, the following terms shall have the meanings given to them below and the Loan Agreement and the other Financing Agreements are hereby amended to include, in addition and not in limitation, the following definitions:

               (i) “First Ratification Amendment” shall mean this Amendment No. 1 to Ratification and Amendment Agreement and Amendment No. 7 to Loan and Security Agreement, as the same now exists and may hereafter be amended, modified, supplemented, extended, renewed, restated or replaced.

               (ii) “BancorpSouth Deposit Account Control Agreement” shall mean the Deposit Account Control Agreement, dated June 29, 2005, by and among Parent, Bancorp South Bank and Agent, as the same now exists and may hereafter be amended, modified, supplemented, extended, renewed, restated or replaced.

               (iii) “GOB Stores” shall have the meaning set forth in the Final Order Under 11 U.S.C. §§ 105, 327, 328, 363, 365 and 554 (I) Authorizing Debtors To Conduct Going-Out-Of-Business Sales And To Close Certain Stores, (II) Authorizing The Assumption Of Consulting Agreement With And Retention Of Consultant And (III) Granting Related Relief, dated April 5, 2007, as in effect on the date hereof.

               (iv) “Nova” shall mean NOVA Information Systems, Inc.

               (v) “Nova Event” shall mean (i) the sending by Nova to Parent of the notice of termination, dated March 2, 2007, with respect to the Processing Agreement, (ii) the extension of the date of termination of the Processing Agreement from time to time and the amendment and continuation of the Processing Agreement, as the case may be, and (iii) the establishment of the $1,890,000 reserve held by Nova in accordance with the terms of the Processing Agreement (in such form as such reserve may be held from time to time, including, without limitation, cash on deposit, certificate of deposit or letter of credit).

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               (vi) “Processing Agreement” shall mean the Merchant Processing Agreement, dated September 21, 2004, between Nova, Regions Bank and Parent, as the same now exists and may hereafter be amended, modified, supplemented, extended, renewed, restated or replaced.

          (b) Amendments to Definitions.

               (i) ERISA Event. All references to the term “ERISA Event” in the Loan Agreement and the other Financing Agreements shall be deemed, and each such reference is hereby amended, to add at the end thereof: “provided, that, the following shall not constitute an ERISA Event: (i) the commencement of the Chapter 11 Cases, (ii) the financial condition of the Borrowers and Guarantors immediately prior to the Petition Date as disclosed to Agent and Lenders in writing, or (iii) the delisting of the stock of Parent or any of its Subsidiaries from the New York Stock Exchange.”

               (ii) Material Adverse Effect. All references to the term “Material Adverse Effect,” “material adverse effect” and “material adverse change” in the Loan Agreement and the other Financing Agreements, shall be deemed, and each such reference in the Financing Agreements is hereby amended, to add at the end thereof: “provided, that, the following shall not constitute a material adverse effect: (i) the commencement of the Chapter 11 Cases, (ii) the financial condition of the Borrowers and Guarantors immediately prior to the Petition Date as disclosed to Agent and Lenders in writing, (iii) the delisting of the stock of Parent or any of its Subsidiaries from the New York Stock Exchange, or (iv) Borrowers closing certain of their store locations with the prior written consent of Agent with respect to such store closures or as provided in Section 3 of the First Ratification Amendment.”

          (c) Interpretation. For purposes of this First Ratification Amendment, unless otherwise defined herein, all capitalized terms used herein shall have the meanings assigned thereto in the Loan Agreement unless otherwise defined herein.

     2. AMENDMENTS.

          (a) Limitation on Certain Fees. Section 7.4(b)(ii) of the Ratification Agreement is hereby deleted in its entirety and the following substituted therefor:

     “(ii) the aggregate amount of consulting fees payable by Borrowers for the consultants (including Huron Consulting) retained by Borrowers at the request of Agent shall not exceed $200,000 in any twelve (12) month period.”

          (b) Collateral Reporting.

               (i) Section 7.1(a)(ii)(C) of the Loan Agreement is hereby amended by deleting such Section in its entirety and replacing it with the following:

     “a certificate of an authorized officer of the Administrative Borrower certifying that sales and use tax collections, deposits and payments are current.”

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               (ii) Section 7.1(a)(iii)(D) of the Loan Agreement is hereby amended by deleting such Section in its entirety.

               (iii) Section 7.1(a)(iv) of the Loan Agreement is hereby amended by deleting “fifteen (15)” and replacing it with “forty-five (45)”.

               (iv) Section 7.1(a)(v) of the Loan Agreement is hereby amended by adding “reasonable” after the word “Agent”.

               (v) Section 7.1(a)(vi) of the Loan Agreement is hereby amended by adding “reasonable” after the word “Agent”.

               (vi) Section 7.1(a)(vii) of the Loan Agreement is hereby amended by adding “reasonably” after the word “shall”.

          (c) Inventory Covenants.

               (i) Section 7.3(a) of the Loan Agreement is hereby amended by deleting “itemizing and” and replacing it with “reasonably”.

               (ii) Section 7.3(c) of the Loan Agreement is hereby amended by adding “except as provided in Section 3 of the First Ratification Amendment” after the word “Agent”.

          (d) Qualification as Certain Representations and Warranties. Section 7.8(iv) of the Ratification Agreement is hereby amended to add at the end thereof: “except as provided in Section 3 of the First Ratification Amendment.”

          (e) Sale of Assets, Consolidation, Merger, Disabilities, Etc. Section 7.10 of the Ratification Agreement is hereby deleted in its entirety and the following substituted therefor:

     “7.10 Sale of Assets, Consolidation, Merger, Disabilities, Etc. Notwithstanding anything to the contrary contained in Section 9.7(b) of the Loan Agreement or any other provision of the Loan Agreement or any of the other Financing Agreements, Borrowers and Guarantors shall not, directly or indirectly, sell, transfer, lease, encumber, return or otherwise dispose of any portion of the Collateral, including, without limitation, enter into any agreement to return Inventory to any vendor, whether pursuant to section 546 of the Bankruptcy Code or otherwise or, on and after the occurrence of an Event of Default, assume, reject, assign or pledge as collateral security any real property leasehold interest or use the proceeds thereof, without, in each instance, the prior written consent of Agent (and no such consent shall be implied, from any action, inaction or acquiescence by Agent or any Lender) except for sales of Borrowers’ and Guarantors’ Inventory in the ordinary course of their respective businesses, and except as provided in Section 3 of the First Ratification Amendment.”

          (f) Waiver. Section 8.1 of the Ratification Agreement is hereby deleted in its entirety and the following substituted therefor:

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     “8.1 Subject to the terms and conditions set forth herein, Agent and Lenders hereby waive (A) the Event of Default arising under Section 10.1(a)(iii) of the Loan Agreement as a result of the failure of Debtors to comply with the provisions of Section 9.6(a)(i) of the Loan Agreement due to Debtors failure to deliver to Agent by February 28, 2007 the unaudited consolidated financial statements and unaudited consolidating financial statements for Parent and its Subsidiaries for the fiscal quarters ending on or about April 29, 2006, July 29, 2006 and October 28, 2006, (B) the Event of Default arising under Section 10.1(a)(iii) of the Loan Agreement as a result of the failure of Borrowers to comply with the minimum Excess Availability covenant as set forth in Section 9.19 of the Loan Agreement at various times prior to the date hereof, (C) the Event of Default which may arise under Section 10.1(k) of the Loan Agreement as a result of the sending by BancorpSouth Bank to Agent and Administrative Borrower of the notice of termination, dated March 20, 2007, with respect to the BancorpSouth Deposit Account Control Agreement, and (D) the Event of Default arising under Section 10.1(i) or 10.1(j) of the Loan Agreement as a result of the Nova Event (the foregoing clauses (A), (B), (C) and (D) are collectively referred to herein as the “Subject Defaults”).

          (g) Events of Default.

               (i) Section 10.1(i) of the Loan Agreement is hereby deleted in its entirety and the following substituted therefor:

               “(i) any default (other than any default resulting from (A) the commencement of the Chapter 11 Cases, (B) the financial condition of the Borrowers and Guarantors immediately prior to the Petition Date as disclosed to Agent and Lenders in writing, (C) the delisting of the stock of Parent or any of its Subsidiaries from the New York Stock Exchange, or (D) Borrowers closing certain of their store locations with the prior written consent of Agent with respect to such store closures or as otherwise provided in Section 3 of the First Ratification Amendment) by any Borrower or Guarantor under any agreement, document or instrument relating to any Indebtedness owing to any person other than Lenders, or any capitalized lease obligations, contingent indebtedness in connection with any guarantee, letter of credit, indemnity or similar type of instrument in favor of any person other than Lenders, in an amount in excess of $750,000 which default continues for more than the applicable cure period, if any, with respect thereto, or any default (other than any default resulting from (A) the commencement of the Chapter 11 Cases, (B) the financial condition of the Borrowers and Guarantors immediately prior to the Petition Date as disclosed to Agent and Lenders in writing, (C) the delisting of the stock of Parent or any of its Subsidiaries from the New York Stock Exchange, or (D) Borrowers closing certain of their store locations with the prior written consent of Agent with respect to such store closures or as otherwise provided in Section 3 of the First Ratification Amendment) by any Borrower or Guarantor under any Material Contract, which default continues for more than the applicable cure period, if any, with respect thereto and/or is not waived in writing by the other parties thereto or, other than in connection with the Nova Event, any Credit Card Issuer or Credit

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Card Processor withholds payment of amounts otherwise payable to a Borrower to fund a reserve account or otherwise hold as collateral, or shall require a Borrower to pay funds into a reserve account or for such Credit Card Issuer or Credit Card Processor to otherwise hold as collateral, or any Borrower shall provide a letter of credit, guarantee, indemnity or similar instrument to or in favor of such Credit Card Issuer or Credit Card Processor such that in the aggregate all of such funds in the reserve account, other amounts held as collateral and the amount of such letters of credit, guarantees, indemnities or similar instruments shall exceed $750,000 or any such Credit Card Issuer or Credit Card Processor shall debit or deduct any amounts in excess of $750,000 in the aggregate in any fiscal year of Borrowers and Guarantors from any deposit account of any Borrower;”

               (ii) Section 10.1(j) of the Loan Agreement is hereby amended to add at the beginning thereof: “other than in connection with the Nova Event.”

               (iii) Section 10.1(k) of the Loan Agreement is hereby amended to add at the end thereof: “unless (in the case of any of the foregoing), Borrower or Guarantor shall have entered into arrangements with such person or other persons within thirty (30) days of such failure.”

               (iv) Section 10.1(p) of the Loan Agreement is hereby deleted in its entirety and the following substituted therefor:

               “(p) Intentionally omitted.”

               (v) Section 10.1(r) of the Loan Agreement is hereby deleted in its entirety and the following substituted therefor.

               “(r) the termination or non-renewal of the Financing Agreements other than as provided for in the Financing Order.

               (vi) Section 10.1(t) of the Loan Agreement is hereby amended by adding the following immediately prior to the period at the end of such Section: “provided, that, Agent shall give notice of the Event of Default in accordance with the Financing Order that shall identify such act, condition or event giving rise to the Event of Default.”

               (vii) Section 10.1(w) of the Loan Agreement is hereby deleted in its entirety and the following substituted therefor:

               “(w) the grant by any Person of a lien on or other interest in any of the Collateral other than a lien or encumbrance permitted by Section 9.8 hereof or by the Financing Order or an administrative expense claim other than an administrative expense claim permitted by the Financing Order or the Ratification Agreement by the grant of or allowance by the Bankruptcy Court which is superior to or ranks in parity with Agent’s security interest in or lien upon the Collateral or their Superpriority Claim (as defined in the Financing Order);

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               (viii) Section 10.2(a) of the Loan Agreement is hereby amended by deleting the first sentence of such Section and replacing it with the following:

               “(a) At any time an Event of Default has occurred and is continuing, Agent and Lenders shall have all rights and remedies provided in this Agreement, the other Financing Agreements, the UCC and other applicable law, all of which rights and remedies may be exercised without notice to or consent by any Borrower or Guarantor, except as such notice or consent is expressly provided for hereunder or under the Financing Order or required by applicable law.”

          (h) Term. Section 13.1(c) of the Loan Agreement is hereby amended by deleting the first sentence of such Section and replacing it with the following:

     “If for any reason this Agreement is terminated prior to the second anniversary of the date of the Ratification Agreement, in view of the impracticality and extreme difficulty of ascertaining actual damages and by mutual agreement of the parties as to a reasonable calculation of Agent’s and each Lender’s lost profits as a result thereof, Borrowers agree to pay to Agent, for the benefit of Lenders, upon the effective date of such termination, an early termination fee in the amount equal to         .25% of Maximum Credit; provided, that, such early termination fee shall not be payable if such termination arises in connection with the Bankruptcy Court confirming a plan of reorganization in the Chapter 11 Cases (which plan is in form and substance acceptable to Agent) pursuant to which Agent is providing exit financing to the reorganized Borrowers on terms and conditions acceptable to Agent.”

     3. CONSENT TO LIQUIDATION OF CERTAIN LEASEHOLD INTERESTS AND STORE CLOSINGS. Notwithstanding any provision to the contrary contained in the Loan Agreement or any Financing Agreement:

          (a) No consent of Agent or any Lender shall be required with respect to either (i) the closing of a GOB Store or (ii) the sale or other disposition of leasehold real property interests associated with a GOB Store.

          (b) No consent of Agent or any Lender shall be required with respect to the closing of an additional thirteen (13) store locations (in addition to the GOB Stores) to be selected by the Borrowers and Guarantors; provided, that, if applicable, Agent’s consent shall be required to the sale of the leasehold real property interests associated with such closed store.

          (c) No consent of Agent or any Lender shall be required in connection with the closing of a store by Borrowers or Guarantors in which all inventory and other assets of Borrowers or Guarantors located in such closed store are moved to a new, operating store location; provided, that, if applicable, consent shall be required to the sale of the leasehold real property interests associated with the closed store.

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     4. ADDITIONAL REPRESENTATIONS, WARRANTIES AND COVENANTS. Borrowers and Guarantors hereby represent, warrant and covenant with and to Agent and Lenders as follows, which representations, warranties and covenants are continuing and shall survive the execution and delivery of this First Ratification Amendment, the truth and accuracy of, or compliance with each, together with the representations, warranties and covenants in the other Financing Agreements, being a condition of the effectiveness of this First Ratification Amendment and a continuing condition of the making or providing of any Loans or Letter of Credit Accommodations by Agent and Lenders to Borrowers and Guarantors:

          (a) This First Ratification Amendment has been duly authorized, executed and delivered by Borrowers and Guarantors and the agreements and obligations of Borrowers and Guarantors contained herein constitute legal, valid and binding obligations of Borrowers and Guarantors enforceable against Borrowers and Guarantors in accordance with their respective terms.

          (b) No Event of Default or act, condition or event which with notice or passage of time or both would constitute an Event of Default exists or has occurred as of the date of this First Ratification Amendment.

     5. CONDITIONS PRECEDENT. The amendments contained herein shall only be effective upon the satisfaction of each of the following conditions precedent, each in a manner satisfactory to Agent:

          (a) Agent shall have received this First Ratification Amendment, duly authorized, executed and delivered by Borrowers, Guarantors and the Required Lenders;

          (b) The Bankruptcy Court shall have entered the Permanent Financing Order authorizing Borrowers and Guarantors to execute and deliver this First Ratification Amendment; and

          (c) No Default or Event of Default shall have occurred and be continuing after giving effect to this First Ratification Amendment.

     6. ADDITIONAL EVENTS OF DEFAULT. The parties hereto acknowledge, confirm and agree that the failure of a Borrowers or Guarantors to comply with the covenants, conditions and agreements contained herein shall constitute an Event of Default under the Loan Agreement and the other Financing Agreements (subject to the applicable cure period, if any, with respect thereto provided for in the Loan Agreement as in effect on the date hereof).

     7. MISCELLANEOUS.

          (a) Amendments and Waivers. Neither this First Ratification Amendment nor any other instrument or document referred to herein or therein may be changed, waived, discharged or terminated orally, but only by an instrument in writing signed by the party against whom enforcement of the change, waiver, discharge or termination is sought.

          (b) Binding Effect. This First Ratification Amendment shall be binding upon and inure to the benefit of each of the parties hereto and their respective successors and assigns.

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          (c) Further Assurances. Borrowers and Guarantors shall execute and deliver such additional documents and take such additional action as may be reasonably requested by Agent to effectuate the provisions and purposes of this First Ratification Amendment.

          (d) Headings. The headings listed herein are for convenience only and do not constitute matters to be construed in interpreting this First Ratification Amendment.

          (e) Counterparts. This First Ratification Amendment (i) may be executed in separate counterparts, each of which when taken together shall constitute one and the same agreement, and (ii) may be executed and delivered by telecopier with the same force and effect as if it were a manually executed and delivered counterpart. In making proof of this First Ratification Amendment, it shall not be necessary to produce or account for more than one counterpart thereof signed by each of the parties hereto.

[REMAINDER OF THIS PAGE INTENTIONALLY LEFT BLANK]

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     IN WITNESS WHEREOF, the parties hereto have caused this First Ratification Amendment to be duly executed and delivered by their authorized officers as of the date and year first above written.

BORROWERS

HANCOCK FABRICS, INC., as Debtor and Debtor-in-Possession

By:

Title:

HF MERCHANDISING, INC., as Debtor and Debtor-in-Possession

By:

Title:

HANCOCK FABRICS OF MI, INC. , as Debtor and Debtor-in-Possession

By:

Title:

HANCOCKFABRICS.COM, INC. , as Debtor and Debtor-in-Possession

By:

Title:

HANCOCK FABRICS, LLC, as Debtor and Debtor-in-Possession

By:

Title:

[SIGNATURES CONTINUE ON NEXT PAGE]

[SIGNATURES CONTINUED FROM PREVIOUS PAGE]

GUARANTORS

HF ENTERPRISES, INC. , as Debtor and Debtor-in-Possession

By:

Title:

HF RESOURCES, INC., as Debtor and Debtor-in-Possession

By:

Title:

AGENT

WACHOVIA BANK, NATIONAL ASSOCIATION

By:

Title:

LENDER

WACHOVIA BANK, NATIONAL ASSOCIATION

By:

Title:

WELLS FARGO RETAIL FINANCE, LLC

By:

Title:

EX-10.45

EXHIBIT 10.45

May 9, 2007

Kathleen Kennedy
2519 Woodgreen Dr.
Belden, MS 38826

     Severance Agreement

Dear Kathleen:

Effective with the close of business on Wednesday, May 9, 2007, your “Severance Date”) your employment with Hancock Fabrics, Inc. (the “Company”) is terminated.

Subject to the terms and conditions of this Severance Agreement and for, and in consideration of the release and other obligations contained in this letter, you will be entitled to $95,000.00 of separation pay and other benefits, all as described in more detail in Schedule A. The separation pay will be paid at regular payroll intervals as soon as administratively practicable following the date this letter agreement becomes effective.

By signing this Severance Agreement, you release and forever discharge Hancock Fabrics, Inc. and its parent corporations, subsidiaries and affiliates, and their shareholders, officers, employees, agents, representatives, independent contractors, successors, assigns and benefit plans (the “Company”) from any and all claims, actions, liabilities and suits, whether known or unknown, whether existing now or arising, accruing, or maturing later, arising out of anything that has occurred up through the date you sign this Severance Agreement, or your Severance Date, which ever is later, including but not limited to any claims that arise from your employment with the Company, the Severance Agreement for Kathleen Kennedy dated March 15, 2006 or your offer letter of employment as Senior Vice President Marketing dated February 6, 2006, but excluding any claim for vested benefits from a retirement plan in which you are a participant.

Without limiting the generality of the foregoing, you are agreeing that, by signing this Severance Agreement, you are releasing and waiving any and all claims that you ever had or may have as of the date you sign this Severance Agreement for age discrimination under the Age Discrimination in Employment Act, 29 U.S.C. §§ 621, et seq. You are advised to consult with an attorney before signing this Severance Agreement; that the consideration you receive in exchange for signing this Severance Agreement is in addition to amounts to which you were already entitled; and that you may, before signing this Severance Agreement, consider this Severance Agreement for a period of 21 calendar days. You may revoke this Severance Agreement within 7 calendar days from the date of the signing of this Severance Agreement. This Severance Agreement is not effective until 7 calendar days following its signing.

By signing this Severance Agreement, you also agree to provide to the Company, upon request, (i) information concerning your employment with the Company, and (ii) reasonable assistance relating to your previous employment with the Company, including but not limited to providing

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truthful testimony in any legal action pursued or defended by the Company in which you have information or knowledge.

You acknowledge that information, observations and data obtained by you while employed by the Company (“Confidential Information”) are the property of the Company. By signing this Severance Agreement, you agree not to disclose to any unauthorized person, or use for your own purpose, any Confidential Information without the prior written consent of the Company, unless and to the extent that the aforementioned matters become generally known to and available for use by the public other than as a result of your acts or omissions.

You acknowledge that all inventions, innovations, improvements, developments, methods, designs, analyses, drawings, reports and all similar or related information (whether patentable or not) which relate to the Company’s actual or anticipated business, research and development or existing or future products or services and which are conceived, developed or made by you while employed by the Company (“Work Products”) belong to the Company. You shall promptly disclose such Work Products to the Company and perform all actions reasonably requested by the Company (whether during of after employment) to establish and confirm such ownership.

Notwithstanding the obligations set forth in the above two paragraphs, after termination of your employment with the Company, you are free to use Residuals of the Company’s Confidential Information and Work Products for any purpose subject only to the obligations with respect to disclosure set forth herein and any copyrights of patents of the Company. The term “Residuals” means information in non-tangible form that may be retained in your unaided memory derived form the Company’s Confidential Information and Work Product to which you had access during your employment with the Company. You may not retain or use the documents and any other tangible materials containing the Company’s Confidential Information or Work Product after the termination of your employment with the Company.

By signing this Severance Agreement, you agree that for the duration of the Severance Period, you will not directly or indirectly own any interest in, manage, control, participate in, work for, consult with or render any services for any Material Competitor of the Company. “Material Competitor” is defined as a retailer of both fabrics and home décor items on a national or multi-state scale. Examples of such competitors include, but are not limited to Jo-Ann Stores, Hobby Lobby and Michaels. Nothing in this paragraph shall prohibit you from being a passive owner of not more than 2% of the outstanding stock of any class of a corporation which is publicly traded so long as you have no active participation in the business of such corporation. The Company reserves the right to enforce this provision in any state in which it is enforceable.

By signing this Severance Agreement, you agree that for the duration of the Severance Period, you will not directly or indirectly through another entity 1) induce or attempt to induce any employee of the Company to leave the employ of the Company or in any way interfere with the relationship between the Company and any employee thereof, 2) hire any person who was an employee of the Company at any time of his/her employment history, or 3) induce or attempt to induce any customer, supplier, licensee, licenser, franchisee or other business relation of the Company to cease doing business with the Company or in any way interfere with the relationship between such supplier, licensee, licenser, franchisee or other business relation and the Company

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(including, without limitation, making negative statements or communications about the Company).

This Severance Agreement contains the entire understanding between you and the Company concerning the termination of your employment and may only be amended by a written instrument signed by both parties.

You have 21 days from the date of receipt to sign this Severance Agreement in the space provided below and return it to the Company. After such 21-day period, the offer contained in this letter is withdrawn. You may revoke this Severance Agreement within 7 calendar days from the date of the signing of this Severance Agreement. This Severance Agreement is not effective until 7 calendar days following its signing.

Sincerely,

Jim Britz
VP-Human Resources

I hereby agree to and accept the terms contained in this Severance Agreement.

Date Signature

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SCHEDULE A

SEVERANCE BENEFITS

     You will receive the following amounts as described below:

1. Severance and Other Payments.

     (a) Severance Payment. You will receive separation pay at your regular base pay at regular payroll intervals for a period of 26 weeks, less applicable taxes and withholdings. The total gross amount of these payments is $95,000.00. The number of weeks will be referred to in this Schedule A and in the Severance Agreement as your “Severance Period.” The Severance Period begins on the Severance Date of Wednesday, May 9, 2007 and ends November 7. 2007.

     (b) Vacation and Bonus Benefit. You will receive a one-time lump-sum payment, less applicable taxes and withholdings, equal to the value of (i) your total earned, unused and outstanding vacation days, and (ii) your bonuses earned, all determined as of your Severance Date.

     (c) Life Insurance Benefit. Subject to the terms of the underlying plans and any applicable insurance policies, you may continue your group life insurance benefits during your Severance Period.

     (d) Restricted Stock Award. To the extent that you have a grant(s) of restricted stock under the Hancock Fabrics, Inc. Stock Incentive Plan and are not vested as of the end of your Severance Date in shares of that stock, the Company will pay you the cash equivalent of the fair market value of your unvested, outstanding, restricted stock grants that would have vested as of the end of the Severance Period had your employment continued. Payment will be in an amount equal to the per share closing price for each share of unvested restricted stock on your Severance Date. The Company will pay this amount in a single lump-sum payment.

2. Health Benefit.

     (a) COBRA Coverage. You will have the opportunity to elect continuation coverage of your medical and dental benefits for yourself, your spouse and/or eligible dependents if you are participating in the Company’s plans for those benefits as of your Severance Date, in accordance with the provisions of COBRA. If elected in a timely manner, COBRA coverage generally will end on the last day of the 18^th month following your Severance Date (unless an earlier end date or an extension is required under COBRA).

     (b) Company Subsidy of COBRA Coverage. If and to the extent you timely elect COBRA continuation coverage, you and the Company will share the cost of COBRA coverage for yourself, your spouse and/or eligible dependents during your Severance Period. During that period, you will be responsible for paying the same amount for coverage as a similarly-situated active employee. The Company will pay the remaining costs on your behalf. To the extent you continue COBRA continuation coverage after your Severance Period, you will be responsible for

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paying the full cost of the COBRA continuation coverage in accordance with the procedures of the Company generally applicable to all qualified beneficiaries receiving COBRA continuation coverage.

EX-10.46

EXHIBIT 10.46

AMENDED AND RESTATED
DEPOSIT ACCOUNT CONTROL AGREEMENT

     THIS AMENDED AND RESTATED DEPOSIT ACCOUNT CONTROL AGREEMENT (“Amended Agreement”) is dated May 24, 2007 (but effective as of the Effective Date) by and among BancorpSouth Bank (together with its successors and assigns, “Bank”), Hancock Fabrics, Inc. (together with its successors and assigns, the “Company”) and Wachovia Bank, National Association, in its capacity as agent pursuant to the Loan Agreement (as hereinafter defined) acting for and on behalf of the parties thereto as lenders (in such capacity, together with its successors and assigns, “Agent”).

W I T N E S S E T H

     WHEREAS, Bank maintains for the use of the Company the following deposit accounts:

01-210513 (the “Concentration Account”)
01-236083 (the “Operating Account”)
01-247794 (the “Merchandise Vendor AP Account”)

     which deposit accounts are hereinafter referred to collectively as the “Deposit Accounts”, and individually, each as a “Deposit Account”;

     WHEREAS, Bank additionally maintains for the use of the Company the following deposit accounts:

01-230662 (the “Salaried Payroll Account”)
60-550191 (the “Hourly Payroll Account”)
60-466018 (the “Pension Benefits Account”)

     which deposit accounts are hereinafter referred to collectively as the “Payroll Accounts”, and individually, each as a “Payroll Account”;

     WHEREAS, the Company maintains numerous deposit accounts with numerous financial institutions (including Bank) throughout the United States into which are deposited revenues generated by Company’s various stores, which deposit accounts are hereinafter referred to collectively as the “Store Accounts”, and individually, each as a “Store Account”;

     WHEREAS, pursuant to the terms of a Deposit Account Control Agreement dated June 29, 2005, by and among the Bank, the Company and the Agent (the “Prior Agreement”) and pursuant to the Loan Agreement as therein defined, Agent and the parties to the Loan Agreement as lenders (collectively, together with their respective successors and assigns, “Lenders”) have a security interest in, among other things, all right, title and interest of the Company in and to the following, whether now or hereafter existing or arising (collectively, the “Deposit Account Collateral”): (a) the Deposit Accounts, (b) all checks, money orders, drafts, instruments,

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electronic funds transfers and other items and forms of remittances and all funds and other amounts at any time paid, deposited or credited (whether for collection, provisionally or otherwise), held or otherwise in the possession or under the control of, or in transit to, Bank or any agent or custodian thereof for credit to or to be deposited in any Deposit Account, (c) all funds and cash balances or other amounts in or attributable to any Deposit Account, and (d) any and all proceeds of any of the foregoing;

     WHEREAS, on March 19, 2007, Agent served Bank with a Notice of Exclusive Control pursuant to Section 2 of the Prior Agreement;

     WHEREAS, pursuant to Section 7(a) of the Prior Agreement, on March 20, 2007, Bank gave written notice to the Agent and to the Company of Bank’s intention to terminate the Prior Agreement thirty (30) days from said date;

     WHEREAS, on March 21, 2007, the Company commenced a voluntary Chapter 11 bankruptcy case as case number 07-10353(BLS) on the docket of the United States Bankruptcy Court for the District of Delaware;

     WHEREAS, the Company and the Agent desire to continue the terms and conditions of the Prior Agreement, notwithstanding the pending termination of the same, and the Bank is willing to amend and restate the terms and conditions of the Prior Agreement, but on the amended terms and conditions set forth in this Amended Agreement;

     NOW, THEREFORE, in order for the Company to comply with the requirements of Agent and Lenders under their financing arrangements with the Company, as authorized by the Bankruptcy Court, the Company, Bank and Agent agree as follows:

     1. Deposit Account Collateral. Bank hereby represents, warrants and covenants with and to Agent and Lenders that: Bank has established and will maintain the Deposit Accounts and has identified the Company as the sole owner of the Deposit Accounts, subject to the rights of Agent therein as provided herein; the records of Bank do not reflect, and it has not received any notice of, any assignment or pledge of, or security interest in the Deposit Accounts or any of the other Deposit Account Collateral (other than the pledge and security interest of Agent referred to herein), or any notice of any adverse claim with respect to any of the same; Bank has not entered and will not enter into any agreement with any person other than Agent by which it is obligated for any reason to comply with instructions from such other person as to the disposition of funds in or from the Deposit Accounts or with respect to any other dealings with any of the Deposit Account Collateral; Bank will not agree that any person other than the Company or Agent is the Bank’s customer with respect to any Deposit Account; the Deposit Accounts are each a “deposit account” as such term is defined in the UCC; Bank acknowledges that it holds and will hold possession of the Deposit Account Collateral consisting of instruments and money as bailee for Agent and for the benefit of Agent, subject to the terms and provisions of this Amended Agreement; and Bank is hereby irrevocably authorized and instructed to change the designation of the customer on any Deposit Account to Agent upon the request of Agent and Bank shall so change the customer promptly upon such request by Agent. This

2

Amended Agreement shall be inapplicable to any account maintained by Company at Bank other than the Deposit Accounts, the Payroll Accounts and the Store Accounts.

     2. Control.

     (a) Notwithstanding any other term or provision of this Amended Agreement or any other agreement between Bank and the Company or otherwise, Bank is hereby irrevocably authorized and directed to, and Bank agrees that it will, comply with written instructions originated by Agent directing the disposition of funds from time to time in any Deposit Account or as to any other matters relating to any Deposit Account or any of the other Deposit Account Collateral without further consent by the Company (which instructions may include the giving of stop payment orders for any items being presented to a Deposit Account for payment).

     (b) Bank shall not permit the Company or any of its affiliates to withdraw any amounts from, to draw upon or otherwise exercise any authority or powers with respect to the Concentration Account and Bank shall not at any time honor, any instructions with respect to the Concentration Account, other than those approved in writing by Agent.

     3. Remittance of Funds; Use of Cash Management Facilities.

     (a) Unless the Company is otherwise directed by the Agent, the Company shall cause all Deposit Account Collateral to be deposited into the Concentration Account. Each banking day, Bank shall transfer to Agent all available funds in the Concentration Account by wire to Wachovia Bank, ABA #053000219, Account Name: Wachovia Bank National Association, Account Number: 5000000030295, Reference: Hancock Fabrics.

     (b) Unless otherwise agreed to in writing between Agent and the Company, the proceeds of the loans and advances made by Agent and Lenders to the Company pursuant to the terms and conditions set forth in the Loan Agreement and related documents, agreements, and instruments that are deposited into the Operating Account will be utilized by the Company to fund, subject to the terms and conditions set forth in this Amended Agreement, (i) all transactions made by Company on the Payroll Accounts and (ii) all other transactions made by Company on the Operating Account. Each banking day, or so often as may be required, Company, through use of Bank’s cash management facilities, shall transfer available funds in the Operating Account to the Payroll Accounts in such amounts as are sufficient, in the Company’s determination, to fund all transactions made on the Payroll Accounts. Nothing contained in this subsection (b) or any other provision contained in this Amended Agreement or otherwise shall or shall be construed to obligate or create in any way any liability or responsibility on the part of Agent or any Lender to fund or to ensure that the Company has sufficient funds to make the payments specified in this subsection or any other payments related to the operation of the Company’s business.

     (c) Bank will permit transactions on the Deposit Accounts and the Payroll Accounts only to the extent that sufficient funds are available therein. Bank may reject any ACH Debit Entry for the Payroll Accounts if sufficient funds are not available therein at least two (2) banking days prior to the Effective Entry Date. [As used in this subsection (c), the terms “ACH”, “Debit”,

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“Entry” and “Effective Entry Date” shall have the respective meanings ascribed in Bank’s cash management agreements with the Company.]

     (d) The Company will cause funds to be transferred from the Operating Account into the Merchandise Vendor AP Account in amounts sufficient to fund, in the Company’s determination, all transactions made on the Merchandise Vendor AP Account. Bank will permit transactions on the Merchandise Vendor AP Account only to the extent that sufficient funds are available therein. Within thirty (30) days following the Effective Date, Agent or Company shall cause the Merchandise Vendor AP Account to be closed and the available balance therein to be transferred to Agent’s order.

     (e) Notwithstanding any provision of this Amended Agreement to the contrary, until Agent otherwise advises Bank in writing, Company shall have access to all of the Deposit Accounts via Bank’s cash management facilities for the following purposes (with reference parenthetically to the name of Bank’s cash management products which may be used by Customer to accomplish such purposes):

     (i) Concentration Account: Company may deposit Deposit Account Collateral into the Concentration Account (Express Deposit Services). Company may originate ACH entries to transfer funds to the Concentration Account from any Store Account (InView).

     (ii) Operating Account: Company may make transfers from the Operating Account and may originate outgoing wires from the Operating Account (InView). Company may run fraud, error detection and reconciliation cash management products on the Operating Account (Positive Pay).

     (iii) Merchandise Vendor AP Account: Until such time as the Merchandise Vendor AP Account is closed pursuant to Section 3(b) hereof, Company may make transfers from the Merchandise Vendor AP Account and may originate outgoing wires from the Merchandise Vendor AP Account (InView). Company may run fraud, error detection and reconciliation cash management products on the Merchandise Vendor AP Account (Positive Pay).

     (iv) Payroll Accounts: Company may make transfers from the Payroll Accounts. Company may run fraud, error detection and reconciliation cash management products on the Payroll Accounts (Positive Pay).

     (v) All Accounts: In addition, with regard to all Deposit Accounts, including the Concentration Account, all Payroll Accounts, and all Store Accounts maintained at Bank, Company may view all transactions on all such accounts and may retrieve all balance information concerning all such accounts. (InView).

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     4. Indemnity; Bank’s Responsibility. The Company agrees to indemnify, defend and hold harmless Bank against any loss, liability or expense (including reasonable fees and disbursements of counsel) incurred in connection with this Amended Agreement, including any action taken by Bank pursuant to the instructions of Agent, except to the extent due to the gross negligence or willful misconduct of Bank or breach of any of the provisions hereof. The Company confirms and agrees that neither Bank nor Agent or Lenders shall have any liability to the Company for wrongful dishonor of any items or transaction as a result of any instructions of Agent or otherwise in accordance with the terms of this Amended Agreement. Bank shall have no duty to inquire or determine whether the obligations of the Company to Agent or Lenders are in default, or whether Agent or Lenders are authorized by the Bankruptcy Court, the Loan Agreement, applicable law or otherwise to take any action, or whether Agent is entitled to give any such instructions, and Bank is fully entitled to rely upon such instructions from Agent (even if such instructions are contrary or inconsistent with any instructions or demands given by the Company).

     5. Statements, Confirmations and Notices of Adverse Claims. At such time or times as Agent may request, Bank will promptly report to Agent the amounts received in and held in the Deposit Accounts and will furnish to Agent any copies of bank statements, deposit tickets, deposited items, debit and credit advices and other records maintained by Bank under the terms of its arrangements with the Company (as in effect on the date hereof). Agent will reimburse Bank for its reasonable expenses in providing such items to Agent. Upon receipt of notice of any lien, encumbrance or adverse claim against any Deposit Account Collateral, Bank will promptly notify Agent and the Company thereof.

     6. Subordination of Bank’s Security Interest; Setoff Rights; Bank’s Fees and Expenses.

          (a) In the event that at any time Bank has a security interest in or lien upon any of the Deposit Account Collateral, such security interest and lien of Bank shall be subject and subordinate to the security interest and lien of Agent therein. Bank shall not for any reason charge, debit, deduct or offset, or exercise any security interest or lien rights, against any checks, automated clearinghouse transfers or other form of remittances at any time deposited in or credited to any Deposit Account, except that Bank may setoff against funds in the Deposit Accounts (i) for all amounts due to Bank in respect of its fees and expenses as provided in Section 6(c) hereof that are unpaid and outstanding, (ii) for the amount of any checks, automated clearinghouse transfers, items or other form of remittances that have been credited to any Deposit Account and subsequently returned unpaid or lawfully demanded to be refunded by any paying or collecting bank(whether for insufficient funds or any other reason), (iii) for the amount of any checks, automated clearinghouse transfers, items or other form of remittances which have been credited to any Deposit Account incorrectly by reason of inadvertent error which is corrected as soon as practicable after the discovery of such error, and (iv) for any overdrafts arising as a result of any of the foregoing; provided, that, Bank shall first setoff for such amounts due to it against funds held in the Operating Accounts before any other Deposit Account.

          (b) In the event that the funds in the Operating Account or any other Deposit

5

Account are insufficient to reimburse Bank for any amounts specified in Section 6(a) above, Agent shall reimburse Bank upon demand for all such amounts; provided, that, (i) in respect of amounts specified under clause (i) of 6(a) above, Agent shall have first received written demand from Bank for payment of such fees and expenses prior to the date that is 60 days after the date such fees or expenses were due and payable to Bank, and (ii) in respect of amounts specified in clauses (ii), (iii) and (iv) of Section 6(a) above, Agent received final payment in respect thereof and Agent has received notice of failure of the Company to pay Bank prior to the date that is 90 days after such check, automated clearinghouse transfer items, or other form of remittance is returned to the Bank or such demand is made to Bank or such error was discovered by Bank. The Company shall reimburse Agent for any amounts paid by Agent to Bank under this Section 6(b) or otherwise under this Amended Agreement promptly upon demand by Agent (without inquiry as to, and regardless of, any dispute between the Company and Bank). Such amounts shall be paid to Agent by Company (or at Agent’s option, Agent may charge any loan account of the Company or its affiliates maintained by Agent) without offset, defense or counterclaim.

          (c) As compensation for Bank’s services rendered to Agent and to Company under this Amended Agreement, Bank shall be entitled to the fees and expenses set forth in Exhibit “A” hereto.

     7. Termination. In the event that the Bankruptcy Court shall require that any of the Deposit Accounts yield earnings or be bonded or secured as provided in 11 U.S.C. § 345, then Bank may at any time thereafter immediately terminate this Amended Agreement upon written notice to the Company and Agent. Otherwise, this Amended Agreement cannot be changed, modified or terminated except that this Amended Agreement may be terminated either: by Bank upon thirty (30) days prior written notice to the Company and Agent and upon written notice by Agent to Bank. In the event that for any reason this Amended Agreement shall be terminated, Bank will, on the effective date of such termination, transfer all available funds in the Deposit Accounts to the account of Agent specified in Section 3(a) hereof.

     8. Notices. All notices hereunder to the Bank shall be in writing, sent by telecopier and by nationally recognized overnight courier with instructions to deliver the next business day, and shall be deemed to have been given or made when Bank has had a reasonable period of time to act thereon (but in no event longer than two business days after the Bank has received such notice). All notices to any other party hereunder shall be in writing and deemed to have been given or made: if delivered in person, immediately upon delivery; if by telex, telegram or facsimile transmission, immediately upon sending and upon confirmation of receipt; if by nationally recognized overnight courier service with instructions to deliver the next business day, one (1) business day after sending; and if by certified mail, return receipt requested, five (5) days after mailing. All notices to any party shall be given to its address set forth below (or to such other address as any party may designate by notice in accordance with this Section).

     9. Customer Agreements. This Amended Agreement supplements all other agreements between the Company and Bank with respect to the Deposit Accounts, as such agreements may now exist or may hereafter be amended and whether now existing or hereafter arising, including, but not limited to, all agreements pertaining to use of Bank’s cash

6

management facilities and the daily transmission limits set forth therein. No consent of the Agent or the Lenders shall be required to amend any such other agreement or for the Company and the Bank to enter into any additional agreement. In the event of any inconsistency between this Amended Agreement and the terms of such other agreements of the Company or its affiliates with Bank, the terms of this Amended Agreement control.

     10. Governing Law. This Amended Agreement shall be governed by the laws of the State of Mississippi. Notwithstanding anything to the contrary contained in any other agreement among any of the parties hereto, for purposes of the UCC, the State of Mississippi shall be deemed to be the Bank’s jurisdiction within the meaning of Section 9-304 of the UCC. All references to the “UCC” herein shall mean the Uniform Commercial Code as in effect on the date hereof in the State of Mississippi.

     11. Counterparts. This Amended Agreement may be executed in any number of counterparts, each of which shall be an original, but all of which taken together shall constitute one and the same agreement. Delivery of an executed counterpart of this Amended Agreement by telefacsimile or other means of electronic transmission shall have the same force and effect as the delivery of an original executed counterpart of this Amended Agreement. Any party delivering an executed counterpart of any such agreement by telefacsimile or other means of electronic transmission shall also deliver an original executed counterpart, but the failure to do so shall not affect the validity, enforceability or binding effect of such agreement.

     12. Successors and Assigns. Agent and Lenders are relying upon this Amended Agreement in providing financing to the Company and this Amended Agreement shall be binding upon the Company and Bank and their respective successors and assigns and inure to the benefit of Agent and Lenders and their respective successors and assigns.

     13. Effect on Prior Agreement. This Amended Agreement replaces and supersedes the Prior Agreement. No pre-petition amounts are owed by Company or by Agent to Bank, and no pre-petition amounts are owed by Bank to Company or to Agent.

     14. Effective Date. This Amended Agreement, regardless of when executed by the parties, shall be effective as of March 21, 2007 (the “Effective Date”).

[SIGNATURE PAGE FOLLOWS]

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AMENDED AND RESTATED

DEPOSIT ACCOUNT CONTROL AGREEMENT

SIGNATURE PAGE

HANCOCK FABRICS, INC.

By:

Title:

Address for Notices:

One Fashion Way
Baldwyn, MS 38824
Attention: Larry D. Fair

Telecopy: 662-365-6025

WACHOVIA BANK, NATIONAL ASSOCIATION, as Agent

By:

Title:

Address for Notices:

Heritage Square II, Suite 1050
5001 LBJ Freeway
Dallas, TX 75244
Attention: Portfolio Manager
Telecopy: 214-761-9044

BANCORPSOUTH BANK

By:

Title:

Address for Notices:

Corporate Banking Department
201 South Spring Street
Tupelo, Mississippi 38804
Attention: Coy Livingston

Telecopy: 662-680-2261

with a copy to:

Cash Management Department
6363 Poplar Avenue, Suite 429
Memphis, Tennessee 38119
Attention: E.P. Morgan
Telecopy: 901-374-0860

with a copy to:

Cash Management Department
2830 West Jackson Street, Building B
Tupelo, Mississippi 38801
Attention: Tracey Hall
Telecopy: 662-620-4029

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EX-21

EXHIBIT 21

Subsidiaries of the Registrant

	State of	Names Under Which	Level of
Name	Incorporation	Subsidiary Does Business	Ownership
HF Enterprises, Inc.	Delaware	HF Enterprises		100	%
HF Resources, Inc.	Delaware	HF Resources		100	%
HF Merchandising	Delaware	HF Merchandising		100	%
Hancock Fabrics of MI, Inc.	Delaware	Hancock Fabrics		100	%
Hancock Fabrics, LLC	Delaware	Hancock Fabrics		100	%
Hancockfabrics.com, Inc.	Delaware	hancockfabrics.com		100	%

EX-31.1

EXHIBIT 31.1

Certification of Chief Executive Officer

I, Jane F. Aggers, certify that:

1.	I have reviewed this annual report on Form 10-K of Hancock Fabrics, Inc.;
2.	Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;
3.	Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;
4.	The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and we have:

a)	designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;
b)	designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external reporting purposes in accordance with generally accepted accounting principles;
c)	evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and
d)	disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s fourth fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of registrant’s board of directors:

a)	All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and
b)	Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Date: February 18, 2008

/s/ Jane F. Aggers

Jane F. Aggers

President and Chief Executive Officer

EX-31.2

EXHIBIT 31.2

Certification of Principal Financial Officer

I, Larry D. Fair, certify that:

1.	I have reviewed this annual report on Form 10-K of Hancock Fabrics, Inc.;
2.	Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;
3.	Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;
4.	The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and we have:

a)	designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;
b)	designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external reporting purposes in accordance with generally accepted accounting principles;
c)	evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and
d)	disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s fourth fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of registrant’s board of directors:

a)	All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and
b)	Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Date: February 18, 2008

/s/ Larry D Fair

Larry D. Fair

Vice President and Chief

Accounting Officer (Principal

Financial and Accounting Officer)

EX-32

EXHIBIT 32

Certification of Chief Executive Officer and Chief Financial Officer
Pursuant to 18 U.S.C. Section 1350

Each of the undersigned, Jane F. Aggers and Larry D. Fair, certifies pursuant to 18 U.S.C. Section 1350, that: (1) this annual report on Form 10-K of Hancock Fabrics, Inc. (“Hancock”) for the year ended February 3, 2007 fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934, and (2) the information contained in this annual report fairly presents, in all material respects, the financial condition and results of operations of Hancock.

Date: February 18, 2008

/s/ Jane F. Aggers

Jane F. Aggers

President and Chief Executive Officer

/s/ Larry D. Fair

Larry D. Fair

Vice President, and Chief Accounting Officer

(Principal Financial and Accounting Officer)