Hancock Fabrics, Inc.

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 2, 2008


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 (State or other jurisdiction of incorporation or organization)		64-0740905 (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)

Purchase 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 þ No o

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

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

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 April 5, 2008, there were 19,402,012 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 we undertake no obligation to update or revise any forward-looking statement.

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 269 stores in 37 states as of February 2, 2008.

Proceedings under Chapter 11 of the Bankruptcy Code

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. These declining sales were exacerbated by inaccuracies in the Company’s store inventory counts for the fiscal year ending January 28, 2006 (“2005 financial statements”). These inaccuracies caused a delay in releasing the Company’s 2005 financial statements. Accordingly, the Company conducted physical inventory recounts in all of its stores during February through April of 2006.

During the inventory recount period, the Company’s field personnel were burdened by the 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.

The delay in filing our 2005 financial statements caused substantial erosion in confidence among the Company’s key constituents. This delay required the Company, among other things, to (a) receive reduced terms by as much as 60 days from trade vendors, (b) incur substantial fees from outside inventory service providers, (c) incur considerably higher audit fees and expenses, and (d) 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.

Partially in response to the losses and operational difficulties, which continued through fiscal 2006, Hancock determined the best course of action was to eliminate underperforming stores. We closed 44 underperforming stores in 2006 and an additional 134 stores in 2007. 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. We therefore decided to seek judicial reorganization under Chapter 11 of the United States Bankruptcy Code.

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.”

We have in place a Court-approved $105 million debtor-in-possession credit facility (the “DIP Credit Facility”) to supplement our cash flow during the reorganization process. In addition, the Company has an additional loan of up to $17.5 million (the “Loan Agreement”). This loan is also being utilized for general working capital purposes. See Note 7 to the accompanying Consolidated Financial Statements for further discussion of the DIP Credit Facility and Loan Agreement.

Since the Petition Date, we have received Court approval to reject leases related to approximately 105 locations. We have also assumed approximately 310 leases and assigned 39 of those. Our deadline to assume or reject each of our real property leases expired in February 2008.

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 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. This 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 delivered to the creditor’s 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. The motion was further amended to extend the exclusivity period through April 30, 2008, and solicitation period through June 30, 2008.

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 cannot 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 final phases 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. In addition, we have received and evaluated financing proposals from numerous lenders. The Company and General Electric Capital Corporation (“GE Capital”) entered into a financing commitment letter on April 9, 2008, whereby GE Capital has committed to a senior revolving line of credit to replace the current DIP Credit Facility and Loan Agreement. This financing has yet to be approved by the Court, and the closing for this facility remains subject to a number of conditions, including but not limited to Court confirmation of a Plan of Reorganization (the “Plan”). The Company intends to file a Plan during the second calendar quarter of 2008 and exit Chapter 11 thirty to sixty days 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 2007, we closed 134 stores and relocated two previously existing stores. There were no new store openings during 2007.

For 2008, we plan to remodel 89 existing store locations and relocate 12 stores due to lease or market conditions.

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 2,			February 3,			January 28,
	2008			2007			2006

Apparel Fabrics		30	%		29	%		28	%
Home Decorating		24	%		24	%		26	%
Quilting/Craft		23	%		23	%		24	%
Notions and Accessories		23	%		24	%		22	%

		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 merchandise.

We use promotional advertising, primarily direct mail, and newspapers to reach our target customers. We mail approximately eighteen direct mail circulars each year to approximately 700,000 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. 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 4% of our merchandise from any one supplier during the fiscal year ended February 2, 2008. We purchased approximately 15% of our merchandise from our top five suppliers in fiscal year 2007.

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 in the industry.

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 stock keeping unit (“sku”) 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. In 2006, we began tracking inventory perpetually at the store level. Having access to this new inventory information allows us to make more timely and efficient decisions for planning and replenishment.

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 months.

Employees

At February 2, 2008, we employed approximately 3,700 people on a full-time and part-time basis. Approximately 3,400 work in our retail stores. The remaining employees work in the Baldwyn headquarters, 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 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. 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 2, 2008.

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, which significantly enhances the customer experience and improves in- store efficiency

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

	•		Redesigned and shortened the projected store opening and remodel process

	•		Worked 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 to help achieve and maintain desired profitability levels of purchased products, improve 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

	•		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 chief financial officer, 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 internal financial reporting from quarterly to monthly 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 and improve upon the direction and results of the foundation initiatives. They are:

	•		Store remodels

	•		Store relocations

	•		New store launches

Six new prototype stores 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 initial prototypes opened in 2007 have produced 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 a debtor-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, 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 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 of Reorganization (“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 a debtor-in-possession under Chapter 11 of the U.S. Bankruptcy Code. As a result of the uncertainty surrounding our current circumstances, it is more difficult to predict our actual liquidity needs and sources. Our access to additional financing while in the Chapter 11 bankruptcy process may be more limited.

We were 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 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 an 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-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, and are striving to validate these assumptions. 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 or our Forms 10-Q for the quarterly periods ended April 29, 2006, July 29, 2006, and October 28, 2006. Also, we did not timely file with the SEC our Forms 10-Q for the quarterly periods ended May 5, 2007, August 4, 2007, and November 3, 2007. Consequently, we were not compliant with the reporting requirements under the Exchange Act. Upon the filing of this report, we will be current with our SEC reporting requirements.

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

•

A breach was 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 was delisted from the NYSE. We may be unable to re-list our common stock on the NYSE or other exchanges.

	•		We have not been 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 recent 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 a material weakness. Due to this material weakness, management concluded that we did not maintain effective internal control over financial reporting.

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 in Note 7) prior to filing for Bankruptcy in March of 2007. In March of 2007, 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. 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 other taxing authorities could audit our current or previously filed tax returns and dispute our treatment of tax deductions, resulting in unexpected assessments. Depending on the timing and amount of such assessments, they could have a material adverse effect on our results of operations, financial condition and liquidity.

States could challenge apportionment formulas used to allocate income between tax jurisdictions.

Due to the Company operating in numerous states, it apportions the income of the entities between states based on the apportionment formulas as prescribed by the various tax jurisdictions. These apportionments could be subject to challenge from the states in which we operate resulting in additional tax liabilities which could have a material adverse effect on our results of operations, financial condition and liquidity.

Failure to meet exchange requirements and re-list our common stock could have an adverse impact on our operations.

The inability to re-list 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 February 2, 2008, February 3, 2007 and January 28, 2006. As a result of these efforts, along with efforts to complete our assessments of internal control over financial reporting as of February 2, 2008, as required by Section 404 of the Sarbanes-Oxley Act of 2002, we expect that we will incur incremental fees and expenses for external audit, financial and other consulting services and legal services. While we do not expect fees and expenses relating to the preparation of our financial statements for future periods to remain at this level, we expect 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 matters, could have a material and adverse effect on our financial condition, results of operations, and cash flows.

We are subject to the risk of proceedings in connection with our earlier restatement of prior period financial statements.

We previously restated in our SEC filings the quarterly financial data for fiscal 2005 and 2004 and the Consolidated Financial Statements for fiscal 2004 and 2003. It is possible that we will become involved in proceedings in the future in relation to these restatements. In connection with such potential proceedings, any expenses incurred not covered by available insurance or any adverse resolution could have a material adverse effect on us. Any such proceedings could be time consuming and 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, deflation and continued devaluation of the U.S. dollar (leading to higher prices or lower margins for imported goods). 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 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.

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 85% 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.

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.

Item 1B. UNRESOLVED STAFF COMMENTS

None.

Item 2. PROPERTIES

As of February 2, 2008, the Company operated 269 stores in 37 states. (See Note 4 to the accompanying Consolidated Financial Statements for a discussion of dispositions occurring during the year.) The number of store locations in each state is shown in the following table:


	Number
State	of Stores

Alabama		10
Arizona		4
Arkansas		8
California		11
Colorado		4
Florida		4
Georgia		14
Idaho		4
Illinois		16
Indiana		5
Iowa		7
Kansas		4
Kentucky		9
Louisiana		12
Maryland		6
Minnesota		9
Mississippi		6
Missouri		10
Montana		1
Nebraska		4
Nevada		3
New Mexico		2
North Carolina		14
North Dakota		1
Ohio		5
Oklahoma		10
Oregon		2
Pennsylvania		1
South Carolina		9
South Dakota		2
Tennessee		11
Texas		28
Utah		5
Virginia		11
Washington		8
Wisconsin		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⁾
2003		28		(25	)		3			433		—
2004		39		(25	)		14			447		—
2005		11		(15	)		(4	)		443		10
2006		4		(44	)		(40	)		403		6
2007		0		(134	)		(134	)		269		2


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

The Company’s 269 retail stores average 14,274 square feet and are located principally in strip shopping centers.

With the exception of one owned location, the Company’s retail stores are leased. The original lease terms generally are 10 years in length and most leases contain one or more renewal options, usually of five years in length. As of February 2, 2008, the remaining terms of leases for stores in operation, including renewal options, averaged approximately 11 years. During fiscal 2008, 42 store leases are scheduled to expire. We currently have negotiated or are in the process of negotiating renewals on certain leases.

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 in the United States Bankruptcy Court for the District of Delaware. 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. The Company has agreed in principal with the Tax Commission on a settlement and this amount has been accrued at year end.

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

No matters were submitted to a vote of security holders during the fourth quarter of the fiscal year ended February 2, 2008, through the solicitation of proxies or otherwise.

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 2006 and 2007, together with dividends.


					Cash
	High		Low		Dividend

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	$	—


2007
First Quarter	$	3.88	$	.83	$	—
Second Quarter		3.16		2.20		—
Third Quarter		2.20		1.45		—
Fourth Quarter		1.45		.61		—


Year Ended February 2, 2008	$	3.88	$	.61	$	—

As of February 2, 2008, there were 3,843 record holders of Hancock’s common stock.

The Company did not pay any cash dividends during 2007. 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.

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 2, 2008:

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⁾
February 4, 2007 through March 3, 2007		1,882	$	3.35		30		243,617
March 4, 2007 through April 7, 2007		4,221	$	1.53		—		243,617
April 8, 2007 through May 5, 2007		8,082	$	2.23		—		243,617
May 6, 2007 through June 2, 2007		—		—		—		243,617
June 3, 2007 through July 7, 2007		15,727	$	2.84		—		243,617
July 8, 2007 through August 4, 2007		—		—		—		243,617
August 5, 2007 through September 1, 2007		—		—		—		243,617
September 2, 2007 through October 6, 2007		—		—		—		243,617
October 7, 2007 through November 3, 2007		—		—		—		243,617
November 4, 2007 through December 1, 2007		—		—		—		243,617
December 2, 2007 through January 5, 2008		—		—		—		243,617
January 6, 2008 through February 2, 2008		—		—		—		243,617
Total February 4, 2007 through February 2, 2008		29,912	$	2.52		30		243,617


⁽¹⁾		The number of shares purchased during the year includes 27,197 shares deemed surrendered to the Company to satisfy tax withholding obligations arising from the lapse of restrictions on shares and 2,715 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 1,756,383 shares purchased under this authorization through February 2, 2008. 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.

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 2, 2008. The selected financial data should be read in conjunction with the “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the Consolidated Financial Statements of the Company and notes thereto which appear elsewhere in this Form 10-K.



(dollars in thousands, except per
share data and other data)	2007			2006⁽¹⁾			2005			2004			2003


Results of Operations Data:
Sales	$	276,247		$	289,484		$	299,951		$	326,095		$	346,358
Gross profit		118,630			115,056			121,466			145,652			165,142
Earnings (loss) from continuing operations before income taxes		(23,259	)		(34,597	)		(20,650	)		1,575			20,236
Earnings (loss) from discontinued operations, net of tax		(3,723	)		(15,651	)		(10,290	)		692			4,574
Net earnings (loss)		(27,982	)		(45,907	)		(30,251	)		1,694			17,302
As a percentage of sales		-10.1	%		-15.9	%		-10.1	%		0.5	%		4.0	%
As a percentage of average shareholders’ equity		-70.4	%		-69.0	%		-30.5	%		1.4	%		14.3	%

Financial Position Data:
Total assets	$	150,944		$	212,217		$	241,973		$	257,791		$	254,697
Capital expenditures		4,357			2,324			5,114			22,785			21,942
Long-term indebtedness		26,973			65,350			55,170			31,000			10,000
Common shareholders’ equity		27,056			52,462			80,561			118,105			130,409
Current ratio		2.6			2.2			2.7			2.4			2.1

Per Share Data:
Basic earnings (loss) per share	$	(1.48	)	$	(2.45	)	$	(1.63	)	$	0.09		$	0.98
Diluted earnings (loss) per share		(1.48	)	$	(2.45	)		(1.63	)		0.09			0.93
Cash dividends per share		—			—			0.18			0.48			0.40
Shareholders’ equity per share		1.40			2.72			4.20			6.15			6.92

Other Data:
Number of states		37			40			43			42			42
Number of stores		269			403			443			447			433
Number of shareholders		3,843			3,889			4,170			4,453			4,633
Number of shares outstanding, net of treasury shares		19,285,235			19,311,307			19,189,025			19,200,883			18,847,801
Comparable store sales change ⁽²⁾		13.2	%		-1.9	%		-6.2	%		-4.2	%		1.2	%
Total selling square footage		3,297,508			4,837,091			5,278,179			5,253,424			5,087,065


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

⁽²⁾		The comparable sales increase for 2007 included a 12.7% benefit from 134 store liquidations in connection with store closing events and 2006 included a benefit of 2.7% from 42 stores liquidated.

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 a 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, with Bankruptcy Court approval, we have and will continue to sell assets and settle liabilities for amounts other than those reflected in our financial statements. The administrative and reorganization expense 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 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS 144”). In the first quarter of 2007, the Company announced plans to close an additional 134 stores. Thirty of these locations were liquidated and closed in the first quarter and 104 in the second quarter, of which 124 qualified for discontinued operations treatment under SFAS 144. Accordingly, the results of operations for the 150 stores are presented separately in the accompanying statement of operations for all periods presented. Revenues and operating losses for the 150 stores that qualify as discontinued operations are provided below:

2007

2006

2005

Revenues

61.2M

99M

103M

Operating Losses

(3.7M

)

(15.7M

)

(10.3M

)

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 are one of the largest fabric retailers in the United States, operating 269 stores in 37 states as of February 2, 2008.

Our stores present a broad selection of fabrics and notions used in apparel sewing, home decorating and quilting projects. The stores average 14,274 total square feet, of which 12,258 are on the sales floor. During 2007, the average annual sales per store were $996,002.

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


	2007			2006			2005
Comparable store sales change ⁽¹⁾		13.2	%		(1.9	)%		(6.2	)%
Operating loss ratio ⁽²⁾		(1.1	)%		(10.2	)%		(5.9	)%
Net cash provided by (used in) operating activities ⁽³⁾	$	37,689		$	(7,424	)	$	(19,198	)


⁽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 increase for 2007 included a 12.7% benefit from 134 store liquidations in connection with store closing events and 2006 included a benefit of 2.7% from 42 stores liquidated.

⁽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 before reorganization activities, including earnings and changes in working capital (see Consolidated Statements of Cash Flows).

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 our bankruptcy 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 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 2, 2008, the Company had recorded reserves totaling $344,000.

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.

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 demographic changes in some markets, which caused a decline in sales and operating results 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 $70,000 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.

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.

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 $128,000 at February 2, 2008, and $194,000 at February 3, 2007, 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. Due to the restructuring during 2007, the Company reduced the future service of active participants by approximately 18%. This decrease prompted curtailment accounting for both the retirement plan and postretirement benefit plan. For 2007, approximately $2.2 million of curtailment income was credited to discontinued operations. The Company does not anticipate this amount recurring in the future. Other than this curtailment adjustment, we anticipate the future pension expense to be comparable to 2007.

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	$	112	$	(94	)
Effect on postretirement benefit obligation	$	1,100	$	(949	)

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

Goodwill. Goodwill represents the excess of the purchase price over the fair value of the net assets acquired. On at least an annual basis or when events or changes in circumstances indicate impairment may have occurred, a two-step approach is used to test goodwill for impairment. First, the fair value of 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 77 stores acquired in two separate transactions that resulted in the recognition of goodwill represents a reporting unit. Due to a decline in operating results, the Company performed an evaluation of goodwill in 2007 which resulted in impairment charges of $200,000. 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 in fiscal year 2002, the Company amortized goodwill. Accordingly, goodwill is presented net of accumulated amortization of $1,035,000.

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. 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.

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 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 $527,000 and $1.2 million of additional stock compensation expense during 2007 and 2006, respectively. The amounts of future stock compensation expense may vary based on the types of awards, vesting periods, estimated fair values of the awards using various assumptions regarding future dividends, interest rates and volatility of the trading prices of the Company’s stock. The pro forma impact of the additional stock compensation expense for options would have increased the net loss by $2.3 million for fiscal year 2005.

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
	2007			2006			2005
Sales		100.0	%		100.0	%		100.0	%
Cost of goods sold		57.1			60.3			59.5

Gross profit		42.9			39.7			40.5
Selling, general and administrative expense		42.6			48.8			45.2
Depreciation and amortization		1.4			1.1			1.2

Operating loss		(1.1	)		(10.2	)		(5.9	)
Reorganization expense, net		5.4			—			—
Interest expense, net		1.9			1.8			1.0

Loss from continuing operations before income taxes		(8.4	)		(12.0	)		(6.9	)
Income (taxes) benefit		(0.4	)		1.3			0.2
Loss from discontinued operations		(1.3	)		(5.2	)		(3.4	)

Net loss		(10.1	)%		(15.9	)%		(10.1	)%

2007 vs. 2006

Sales decreased $13.2 million in 2007 due to ten closed stores that were included in continuing operations in 2006, and 2006 containing an extra week of sales, which off-set the 0.5% comparable store sales increase in non-liquidating stores. A 1.4% improvement in average ticket combined with a 0.3% decline in customer count to produce the comparable sales improvement for the year. Sales of apparel fabrics increased to 30% of total sales in 2007 from 29% in 2006, while notions and accessories decreased to 23% of total sales compared to 24% in the prior year. Home decorating and quilting/craft percentages remained unchanged at 24% and 23%, respectively.

Gross margins increased to 42.9% in 2007 from 39.7% in 2006. Gross margin was positively affected by the impact of a 2007 LIFO (last-in, first-out) credit of $1.1 million, related to continuing operations, versus a $2.8 million charge in 2006 due to continuing reductions in inventory levels from the prior year. Although not having a cash impact, LIFO caused a $3.9 million positive swing in gross profit increasing gross margin by approximately 1.4%. In addition to this favorable LIFO impact, gross margin increased as a result of the $5.7 million charge included in 2006 continuing operations related to consigned inventory.

Selling, general and administrative expense as a percentage of sales were 42.6% in 2007 compared to 48.8% in 2006. This reduction occurred due to the closure of under performing store locations, personnel reductions in the Corporate headquarter/distribution center and restructuring efforts. The comparison also benefited from the absence of additional cost incurred in 2006 which related to the 2005 audit and the re-inventory of all store locations during 2006. The ratio further benefited from the leveraging impact of the comparable store sales improvement.

Depreciation expense increased $581,000 due to a reduction in the amount capitalized into inventory for the year.

Interest expense increased $240,000 due to the write-off of deferred loan costs on the pre-petition credit facility, a higher interest rate as a result of the default on the credit facility during 2007 and amortization of loan costs on the DIP credit facility over a compressed time period.

Reorganization expense of $14.9 million in 2007 includes the legal and professional fees, which are being expensed as incurred, that are directly related to the Company’s bankruptcy filing and reorganization efforts. In addition to the fees paid to professionals working on behalf of the Company, it includes the fees of professionals engaged by the creditors and equity holders.

Income tax expense was $1.0 million in 2007 compared to a benefit of $3.9 million in 2006. The expense recognized in 2007 reflects the balance of a settlement agreed to in principle with the state of Mississippi, while 2006 includes a benefit from the elimination of a valuation allowance related to the deferred tax asset for stock compensation and an increase in the income tax receivables related to certain state tax matters. Hancock’s effective tax expense rate was 4.3% in 2007 compared to an effective tax benefit rate of 11.1% in 2006.

Loss from discontinued operations declined in 2007 to $3.7 million from $15.7 million in 2006 due to the closure of 124 additional locations during the first five months of the year. This comparison also benefited from a higher recovery on inventory than in the previous year, a $3.5 million gain from the auction of store leases and $2.2 million of curtailment income related to pension and post retirement benefits.

2006 vs. 2005

Sales decreased $10.5 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 24%; and sales of quilting/craft merchandise declined from 24% to 23%. Sewing notions and accessories increased from 22% of total sales in 2005 to 24% in 2006.

Gross margins declined from 40.5% 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 consigned inventory. In connection with the new agreements, the Company recorded a charge of $5.7 million, related to continuing operations, to reflect additional obligations to the vendors for future sales. The agreements effectively mitigate our ownership rights in non-consigned inventory supplied by the vendors, but will help maximize the gross profit realized on the sale of this product, both consigned and owned, shorten the time for settlement with the vendors, and reduce the administrative burden of tracking promotional rebates. This charge adversely impacted gross margin in 2006 by 2.0%. 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 0.6% of sales.

Selling, general and administrative expense as a percentage of sales increased to 48.8% in 2006 from 45.2% 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 $5.3 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 also affected the comparison. 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 $380,000 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 $51.0 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 benefit rate was 3.3% in 2005 compared to an effective tax benefit rate of 11.1% in 2006.

Loss from discontinued operations increased from $10.3 million in 2005 to $15.7 million in 2006 due to declining sales and 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):


	2007			2006			2005

Cash and cash equivalents	$	2,280		$	2,499		$	3,215
Net cash flows provided (used):
Operating activites		37,689			(7,424	)		(19,198	)
Investing activities		(253	)		(1,549	)		(397	)
Financing activites		(37,655	)		8,257			19,018
Working capital		58,517			78,898			106,421

Changes in cash and cash equivalents

Cash flows provided by operating activities net of reorganization activities were $37.7 million in 2007, compared to $7.4 million of cash flows used by operating activities in 2006. The Company recorded a net loss of $28.0 million in 2007, which includes $14.9 million of reorganization expenses, compared to a net loss of $45.9 million in 2006. The increase in operating cash flows was provided by a $54.0 million reduction in inventory mainly attributable to the Company’s discontinued operations and related liquidation sales and a $5.9 million net increase in accounts payable and accrued liabilities due to the bankruptcy filing offset by a $3.0 million reduction in the postretirement benefit liability.

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 flow was offset by a $26.2 million change in inventory mainly attributable to store closures and the related liquidation sales.

Cash used for investing activities consists primarily of purchases and sales of property and equipment. Capital expenditures during 2007 were at a rate below historical trends, but included expenditures for the development and opening of six new prototype stores and system upgrades. These expenditures were more than offset by sales of real property and fixtures from store closures. In 2006, capital expenditures 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 used in financing activities for 2007 consisted of a reduction in net borrowing of $36.0 million which was provided by operating activities. Cash provided by financing activities in 2006 included $8.5 million of net borrowings. These borrowings in 2006 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 of 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.

Working capital decreased to $58.5 million at the end of 2007, from $78.9 million in 2006, due to the inventory reduction and decrease in accounts payable resulting from 134 stores closed in 2007.

During 2007, the Company generated cash of approximately $54.0 million related to the reduction of inventory resulting from the 134 stores closed in 2007. Also during 2007, we completed the sale of an owned property for $3.1 million and 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 fiscal 2008 and 2009. As of February 2, 2008, there was $50.5 million of excess availability under the DIP Credit Facility.

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, Hancock had outstanding borrowings of approximately $59.6 million under the Credit Facility. The estimated weighted average interest rate under the Credit Facility for the year ended February 3, 2007 was approximately 7.1%.

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 was a financial covenant that required 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 from 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 million 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 million. This agreement provides for an unused line fee of 0.25% to 0.35%. 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. At February 2, 2008, Hancock had outstanding borrowings of approximately $6.1 million under the DIP Credit Facility. The estimated weighted average interest rate under the DIP Credit Facility for the year ended February 2, 2008, was approximately 8.4%.

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. 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 2, 2008 and February 3, 2007, Hancock had commitments under the above credit facilities of $716,000 and $6.1 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 $5.8 million as of February 2, 2008 and $5.5 million as of February 3, 2007.

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 $17.5 million. The Company has and will continue 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. As of February 2, 2008, $17.5 million is outstanding under the Loan Agreement.

The Company’s obligations under the Loan Agreement are collateralized, subject to the superior lien of the DIP Credit Facility lender, by substantially all of its 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 the Company 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 the Company in the previously disclosed Chapter 11 cases of the Company (which are being administered under 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 the Company; (d) the occurrence of certain bankruptcy or insolvency events; (e) certain judgments against the Company; (f) any representation or warranty made by the Company 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

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. The Company has agreed in principal with the Tax Commission on a settlement and this amount has been accrued at year end.

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 a debtor-in-possession under Chapter 11 of the Bankruptcy Code, and its continuation as a going concern is contingent upon, among other things, its 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 raises substantial doubts about its ability to continue as a going concern and could 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.

Contractual Obligations and Commercial Commitments

The following table summarizes our future cash outflows resulting from contractual obligations and commitments as of February 2, 2008. (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	$	23,608	$	—	$	23,608	$	—	$	—
Minimum lease payments ⁽²⁾		8		89,268		19,729		30,448		21,534		17,557
Standby letters of credit for insurance		7		5,844		5,844		—		—		—
Standby letters of credit for merchandise		7		300		300		—		—		—
Capital lease obligations ⁽³⁾		8		7,182		478		956		970		4,778
Trade letters of credit				416		416		—		—		—
Purchase obligations				32,526		32,526		—		—		—

Total			$	159,144	$	59,293	$	55,012	$	22,504	$	22,335


⁽¹⁾		The calculation of interest on the Loan Agreement and DIP Credit Facility is dependent on the average borrowings during the year and a variable interest rate, which was approximately 10.25% and 8.4%, respectively, at February 2, 2008. 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, SERP funding obligations, store closing reserves, asset retirement obligations, anticipated capital expenditures, 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 2, 2008.

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 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 2007, increases in the PPI partially offset the credit that was recorded to LIFO due to inventory liquidation. In 2006 and 2005, 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 2, 2008.

Interest Rate Risk

The Company is exposed to financial market risks, including changes in interest rates. On March 22, 2007, the Company entered into the DIP Credit Facility with Wachovia Bank. The Credit Facility replaced the Company’s previously existing Credit Facility on which the Company was in default as of February 28, 2007.

The DIP Credit Facility is a two-year, $105 million commitment. This agreement provides for an unused line fee of 0.25% to 0.35%. The Company may elect that loans under the DIP Credit Facility bear interest at a rate of the Adjusted Eurodollar Rate by 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. As of February 2, 2008, the Company had borrowings outstanding of approximately $6.1 million under the DIP Credit Facility with an average interest rate of 8.4%. If interest rates increased 100 basis points, the Company’s annual interest expense would increase $61,000, assuming borrowings of $6.1 million as existed at February 2, 2008.

Also, on June 15, 2007, the Company reached a definitive agreement (“Loan Agreement”) with another lender for an additional loan of up to $17.5 million. Certain borrowings under the loan agreement will bear interest at a rate equal 2% 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 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 1/2%. Other borrowings under the Loan Agreement will bear interest at a rate equal to 5% 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) Governors of the Federal Reserve System as the maximum reserve requirement applicable with respect to the 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 numbers of Lenders, increase the interest rate to the rate of 5% per annum in excess of the applicable rate for Prime Rate Loans and the rate of 8% per annum in excess of the applicable rate for Eurodollar Rate Loans in certain circumstances. As of February 2, 2008, borrowings under the Loan Agreement were $17.5 million with an average interest rate of 10.25%.

Foreign Currency Risk

All of the Company’s business is transacted in U.S. dollars and, accordingly, devaluation of the dollar against other currencies has increased product costs although this did not significantly impact 2007 results. As of February 2, 2008, the Company had no financial instruments outstanding that were sensitive to changes in foreign currency rates.

Hancock Fabrics, Inc.
(Debtor-In-Possession)
Consolidated Balance Sheets



February 2, 2008 and February 3, 2007 (in thousands, except for share and per share amounts)	2007			2006

Assets
Current assets:
Cash and cash equivalents	$	2,280		$	2,499
Receivables, less allowance for doubtful accounts		4,453			3,389
Inventories		77,907			127,574
Income taxes refundable		8,118			10,105
Prepaid expenses		1,748			1,613

Total current assets		94,506			145,180

Property and equipment, net		43,683			51,043
Deferred tax assets		2,242			6,273
Goodwill		3,406			3,606
Other assets		7,107			6,115

Total assets	$	150,944		$	212,217


Liabilities and Shareholders’ Equity
Liabilities not subject to compromise:
Current liabilities:
Accounts payable	$	19,393		$	37,349
Accrued liabilities		14,354			22,660
Deferred tax liabilities		2,242			6,273

Total current liabilities		35,989			66,282

Long-term debt obligations		23,608			59,584
Capital lease obligations		—			5,766
Postretirement benefits other than pensions		315			9,160
Pension and SERP liabilities		270			8,126
Other liabilities		3,071			10,837

Total liabilities not subject to compromise		63,253			159,755

Liabilities subject to compromise		60,635			—

Total liabilities		123,888			159,755

Commitments and contingencies (See Notes 8 and 14)


Shareholders’ equity:
Common stock, $.01 par value; 80,000,000 shares authorized; 32,601,483 and 32,597,613 issued and 19,285,235 and 19,311,307 outstanding, respectively		326			326
Additional paid-in capital		75,324			73,948
Retained earnings		100,953			128,935
Treasury stock, at cost, 13,316,248 and 13,286,306 shares held, respectively		(153,622	)		(153,545	)
Accumulated other comprehensive income		4,075			2,798

Total shareholders’ equity		27,056			52,462

Total liabilities and shareholders’ equity	$	150,944		$	212,217

See accompanying notes to consolidated financial statements.

Hancock Fabrics, Inc.
(Debtor-In-Possession)
Consolidated Statements of Operations



Years Ended February 2, 2008, February 3, 2007 and January 28, 2006 (in thousands, except per share amounts)	2007			2006			2005


Sales	$	276,247		$	289,484		$	299,951
Cost of goods sold		157,617			174,428			178,485


Gross profit		118,630			115,056			121,466

Selling, general and administrative expenses		117,815			141,339			135,505
Depreciation and amortization		3,815			3,234			3,614


Operating loss		(3,000	)		(29,517	)		(17,653	)

Reorganization expense, net		14,939			—			—
Interest expense, net		5,320			5,080			2,997


Loss from continuing operations before income taxes (benefit)		(23,259	)		(34,597	)		(20,650	)
Income taxes (benefit)		1,000			(3,854	)		(689	)


Loss from continuing operations		(24,259	)		(30,743	)		(19,961	)
Loss from discontinued operations (net of tax benefit of $0, $0, and $0)		(3,723	)		(15,651	)		(10,290	)


Net loss before cumulative effect of change in accounting principle		(27,982	)		(46,394	)		(30,251	)
Cumulative effect of change in accounting principle, net of tax effect of ($0)		—			487			—


Net loss	$	(27,982	)	$	(45,907	)	$	(30,251	)


Basic and diluted loss per share:
Loss from continuing operations	$	(1.28	)	$	(1.64	)	$	(1.08	)
Loss from discontinued operations		(0.20	)		(0.84	)		(0.55	)
Cumulative effect of change in accounting principle		—			0.03			—


Net loss	$	(1.48	)	$	(2.45	)	$	(1.63	)


Weighted average shares outstanding Basic and diluted		18,895			18,709			18,518

See accompanying notes to consolidated financial statements.

Hancock Fabrics, Inc.
(Debtor-In-Possession)
Consolidated Statements of Shareholders’ Equity

Years Ended February 2, 2008, February 3, 2007 and January 28, 2006
(in thousands, except number of shares)


						Additional						Accumulated Other												Total
	Common Stock					Paid-in			Retained			Comprehensive			Treasury Stock						Deferred			Shareholders’
	Shares			Amount		Capital			Earnings			Income (Loss)			Shares			Amount			Compensation			Equity

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	)
Benefit plans (including 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
Comprehensive loss:
Net loss										(27,982	)														(27,982	)
Benefit plans, net of taxes of $0													1,277												1,277

Total comprehensive loss																									(26,705	)
Issuance of restricted stock		58,000																							—
Cancellation of restricted stock		(85,350	)																						—
Stock compensation expense							1,307																		1,307
Issuance of shares under directors’ stock plan		31,220					69																		69
Purchases of treasury stock																(29,942	)		(77	)					(77	)

Balance February 2, 2008		32,601,483		$	326	$	75,324		$	100,953		$	4,075			(13,316,248	)	$	(153,622	)	$	—		$	27,056

See accompanying notes to consolidated financial statements.

Hancock Fabrics, Inc.
(Debtor-In-Possession)
Consolidated Statements of Cash Flows


Years Ended February 2, 2008, February 3, 2007 and
January 28, 2006 (in thousands)	2007			2006			2005

Cash flows from operating activities:
Net loss	$	(27,982	)	$	(45,907	)	$	(30,251	)
Adjustments to reconcile net loss to cash flows from operating activities
Depreciation and amortization, including cost of goods sold		7,122			7,180			7,985
Amortization of deferred loan costs		2,153			456			145
LIFO inventory reserve		(5,318	)		2,758			5,035
Deferred income taxes		—			(865	)		6,550
Stock compensation expense		1,307			2,459			798
Reserve for store closings charges, including interest expense		3,532			685			13
Reserve for sales returns and bad debts		(66	)		(20	)		(19	)
Reserve for lower of cost or market inventory		6			(34	)		372
Stepped rent accrual		(217	)		164			541
Impairment on property and equipment, goodwill, and other assets		270			1,691			4,153
Cumulative effect of change in accounting principle		—			(487	)		—
(Gain) loss on disposition of property and equipment		(998	)		(251	)		(236	)
(Gain) on disposal of lease financing obligations		(153	)					—
Compensation expense for issuance of shares for professional services		—			—			5
Compensation expense for issuance of shares under directors’ stock plan		69			269			289
Reorganization expense, net		14,939			—			—
(Increase) decrease in assets
Receivables and prepaid expenses		(1,199	)		1,886			(899	)
Inventories at current cost		54,019			22,924			727
Income tax refundable		1,987			(2,989	)		(7,029	)
Other noncurrent assets		(1,622	)		(439	)		1,461
Increase (decrease) in liabilities
Accounts payable		11,027			(435	)		(10,506	)
Accrued liabilities		(4,377	)		1,523			1,542
Postretirement benefits other than pensions		(3,073	)		(916	)		211
Long-term pension and SERP liabilities		936			2,344			1,720
Other liabilities		(431	)		580			(1,805	)

Net cash provided (used) in operating activities before reorganization activities		51,931			(7,424	)		(19,198	)
Net cash used for reorganization activites		(14,242	)		—			—

Net cash provided (used) in operating activities		37,689			(7,424	)		(19,198	)

Cash flows from investing activities:
Additions to property and equipment		(4,357	)		(2,324	)		(5,114	)
Proceeds from the disposition of property and equipment		4,104			775			4,717

Net cash provided (used) in investing activities		(253	)		(1,549	)		(397	)

Cash flows from financing activities:
Net (payments) borrowings on revolving credit facility		(59,584	)		8,528			20,056
Net borrowings on DIP credit facility		6,108			—			—
Net borrowings on other loan agreement		17,500			—			—
Proceeds from capital lease		—			—			4,252
Payments for capital lease		(79	)		(98	)		(34	)
Payments for loan costs		(1,523	)		—			(1,181	)
Purchase of treasury stock		(77	)		(173	)		(643	)
Proceeds from exercise of stock options		—			—			25
Cash dividends paid		—			—			(3,457	)

Net cash provided (used) by financing activities		(37,655	)		8,257			19,018

Decrease in cash and cash equivalents		(219	)		(716	)		(577	)
Cash and cash equivalents:
Beginning of period		2,499			3,215			3,792

End of period	$	2,280		$	2,499		$	3,215

Supplemental disclosures:
Cash paid during the period for:
Interest	$	1,990		$	5,218		$	2,843
Income taxes		—			—			22
Non-cash activities:
Non-cash change in funded status of benefit plans	$	1,277		$	16,143		$	(4,188	)
Net increase (decrease) in capital lease obligations		(2,401	)		1,652			4,114
Issuance of restricted stock		90			541			729
Cancellation of restricted stock		772			(553	)		(1,226	)

See accompanying notes to consolidated financial statements.

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 2, 2008, Hancock operated 269 stores in 37 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 during the year.)

Note 2 — Proceedings under Chapter 11 and Related Going Concern Considerations

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.”

We have in place a Court-approved $105 million debtor-in-possession credit facility (the “DIP Credit Facility”) to supplement our cash flow during the reorganization process. In addition, the Company has an additional loan of up to $17.5 million (the “Loan Agreement”). This loan also is being utilized for general working capital purposes. See Note 7 for further discussion of the DIP Credit Facility and Loan Agreement.

We cannot currently estimate the impact of Chapter 11 filings on our future financial statements. We are in the process of reviewing contracts and unexpired leases to determine which, if any, we could reject as permitted by the Bankruptcy Code.

facility remains subject to a number of conditions, including but not limited to Court confirmation of a Plan. The Company intends to file a plan of reorganization during the second calendar quarter of 2008 and exit Chapter 11 thirty to sixty days later.

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 debtor-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, 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 raises substantial doubts about its ability to continue as a going concern and could 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.

American Institute of Certified Public Accountant Statement of Position 90-7, “Financial Reporting by Entities in Reorganization under the Bankruptcy Code” (“SOP 90-7”) provides financial reporting guidance for entities that are reorganized under Bankruptcy Code. The Company implemented this guidance for the year ended February 2, 2008. Under Chapter 11, certain claims against the Company in existence prior to the filing of the petitions for relief under the federal bankruptcy laws are stayed while the Company continues business operations as debtor-in-possession. Per SOP 90-7, these estimated claims are reflected in the February 2, 2008 Consolidated Balance Sheet as Liabilities Subject to Compromise and are summarized in the table below. Such claims remain subject to future adjustments which may result from actions of the bankruptcy court, negotiations, rejection or acceptance of executory contracts, proofs of claim, or other events. Additional pre-petition claims (liabilities subject to compromise) may arise due to the rejection of executory contracts or as a result of the allowance of contingent or disputed claims. Claims are recorded at the amount of the expected allowed claim even if they may be settled for lesser amounts.

We have received approval from the bankruptcy court to pay or otherwise honor certain of our pre-petition obligations, including (i) certain pre-petition wages, salaries, and other compensation; (ii) employee medical and similar benefits; (iii) reimbursable employee expenses; (iv) insurance premiums; and (v) shipping and warehousing charges. Accordingly, these pre-petition items have been excluded from Liabilities Subject to Compromise as of February 2, 2008. Obligations arising post-petition are not classified as liabilities subject to compromise.

Liabilities Subject to Compromise as of February 2, 2008 (in thousands):


Accounts payable	$	28,483
Accrued liabilities:
Payroll and benefits		132
Rent liability		576
Capital lease obligations		67
Store closing liability		5,396
Customer liability and property claims		695
Deferred compensation		290
Other		167

Total accrued liabilities		7,323
Income taxes payable		1,500
Long term capital lease obligations		3,365
Post retirement benefits other than pensions		8,414
Pension and SERP liability		5,007
Other Liabilities:
Long Term Deferred Compensation		3,948
Long Term Stepped Rent		2,186
Unapplied Rent Credit		390
Other		19

Total other liabilities		6,543

Total liabilities subject to compromise	$	60,635

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. The Company maintains its financial records on a 52-53 week fiscal year ending on the Saturday closest to January 31. Fiscal years 2007, 2006 and 2005, as used herein, refer to the years ended February 2, 2008, February 3, 2007, and January 28, 2006, respectively. The fiscal years 2007 and 2005 contained 52 weeks. Fiscal year 2006 contained 53 weeks.

Financial statement presentation is in accordance with SOP 90-7. 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 are 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 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 reorganization or restructuring of the debtors’ business are reported separately as reorganization items. In addition, interest expense is 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. Cash used for reorganization items is disclosed separately in the consolidated statement of cash flows and on a going concern basis, which assumes the continuity of operations and reflects the realization of assets and satisfaction of liabilities in the ordinary course of business. However, as a result of the Chapter 11 bankruptcy proceeding, such realization of assets and liquidation of liabilities are subject to a significant number of uncertainties that have not been reflected in the consolidated financial statements.

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 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 the Securities and Exchange Commission (SEC) Staff Accounting Bulletin No. 104, “Revenue Recognition in Financial Statements.” Sales include the sale of merchandise at the Company’s retail stores and internet store, net of sales taxes collected. The Company allows customers to return merchandise under most circumstances. Sales returns were approximately $1.9 million in 2007, $2.4 million in 2006, and $2.5 million in 2005. The reserve for returns was $128,000 at February 2, 2008, and $194,000 at February 3, 2007, 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 as of February 2, 2008 and February 3, 2007. The provision for doubtful accounts is included in selling, general and administrative expenses and totaled $0, $5,000, and $4,000 for fiscal years 2007, 2006 and 2005, 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 $36.4 million at February 2, 2008 and $41.7 million at February 3, 2007. The LIFO reserve decreased by approximately $5.3 million during 2007, and increased $2.8 million during 2006. 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 2, 2008 and February 3, 2007, inventories included such capitalized costs for handling and distribution totaling $9.5 million and $13.3 million, respectively. During fiscal 2007, 2006 and 2005, the Company included in cost of goods sold $11.3 million, $13.5 million and $15.1 million, respectively, related to handling and distribution costs, and $2.3 million, $2.9 million and $2.4 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 2, 2008, and February 3, 2007, the amount of such reserves totaled $344,000 and $338,000, respectively. During April 2006, the Company modified agreements with two vendors that have and will continue to supply the majority of the Company’s consigned inventory. In connection with the new agreements, the Company recorded a charge of $5.7 million related to continuing operations, in 2006 to reflect additional obligations to the vendors related to future sales.

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

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

Assets under capital leases are amortized in accordance with the Company’s normal depreciation policy for owned assets or over the lease term (regardless of renewal options), if shorter, and the charge to earnings is included in depreciation expense in the Consolidated 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 2007, 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 $140,000 for stores deemed to be at least partially impaired, and the Company recorded total impairment charges of $70,000 due to the declining operations of the related stores and the impact on expected cash flows. 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 $1,365,000 for stores deemed to be at least partially impaired, 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. 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 evaluations of goodwill in 2007 and 2006 which resulted in goodwill impairment charges of $200,000 and $579,000, respectively. 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 $1.0 million.

Accounts Payable, as of February 2, 2008 and February 3, 2007, includes $4.6 million and $5.0 million, respectively 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.

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

Operating leases result in rent expense recorded on a straight-line basis over the expected life of the lease beginning with the point at which the Company obtains control and possession of the lease properties. The

expected life of the lease includes the build-out period where no rent payments are typically due under the terms of the lease; rent holidays; and available lease renewals and option periods reasonably assured of exercise due to economic penalties. Also, the leases often contain predetermined fixed escalations of the minimum rentals during the term of the lease, which are also recorded on a straight-line basis over the expected life of the lease. The difference between the lease payment and rent expense in any period is recorded as stepped rent accrual in 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 2007, 2006, and 2005, was $14.3 million, $17.3 million, and $16.3 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. For the fiscal years 2007, 2006 and 2005, basic and diluted earnings per share are the same because the Company is in a loss position and the effect of additional securities or contracts to additional common stock is antidilutive. Current equity interests will likely be diluted in the event the Company issues common stock or common stock equivalents in connection to its proceedings under bankruptcy.

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 the periods presented, Hancock did not have any financial derivative instruments outstanding.

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.

Uncertain Tax Positions are accounted for beginning the first day of fiscal 2007 (February 4, 2007) under the provisions of FASB Interpretation No. 48 (“FIN 48”), Accounting for Uncertainty in Income Taxes. This interpretation clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with SFAS No. 109 and prescribes a minimum recognition threshold of more-likely-

than-not to be sustained upon examination that a tax position must meet before being recognized in the financial statements. Under FIN 48, the impact of an uncertain income tax position on the income tax return must be recognized at the largest amount that is more-likely-than-not to be sustained upon audit by the relevant taxing authority. An uncertain income tax position will not be recognized if it has less than a 50% likelihood of being sustained. Additionally, FIN 48 provides guidance on de-recognition, measurement, classification, interest and penalties, accounting in interim periods, disclosure, and transition.

As a result of the Chapter 11 filing, which caused most eligible states to perform audits and file claims for the taxes owed, and recent audits performed by the Internal Revenue Service, the implementation of FIN 48 did not require the Company to recognize a liability for uncertain tax positions. The liabilities resulting from claims and an initial estimate of the Mississippi tax settlement were recorded in 2006 with an additional $1.0 million tax expense being reported in the fourth quarter of fiscal 2007.

We are subject to U.S. federal income tax as well as income tax in approximately 37 state jurisdictions. However, the Chapter 11 filing effectively precludes additional tax claims from being assessed by taxing authorities that were properly noticed of the filing.

Stock options, effective beginning 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).

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. The pro forma amount for fiscal year 2005 is as follows:


	2005
Net earnings (loss), as reported	$	(30,251	)
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects		(2,283	)

Pro forma net earnings (loss)	$	(32,534	)


Earnings (loss) per share:
Basic and diluted — as reported	$	(1.63	)

Basic and diluted — pro forma	$	(1.76	)

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.

The Company grants share-based compensation awards with terms that accelerate vesting upon retirement. Prior to the adoption of SFAS 123(R), the Company recognized compensation expense for these awards over the stated vesting period with adjustments recorded upon retirement or forfeiture. Upon the adoption of SFAS 123(R), the impact of these adjustments is estimated and expensed over the expected 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 2, 2008, and February 3, 2007, our cash deposits exceeded federally insured amounts by $1.7 million, and $3.1 million, respectively.

Recent Accounting Pronouncements

In September 2006, the Financial Accounting Standards Board (“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. However, the FASB agreed to defer for one year the effective date of SFAS No. 157 for all non-financial assets and non-financial liabilities, except those recognized or disclosed at fair value in the financial statements on a recurring basis.

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. 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 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 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.

In December 2007, the FASB issued FASB Statement No. 160, “Non-controlling Interests in Consolidated Financial Statements” — An Amendment of ARB No. 51. Statement 160 establishes new accounting and reporting standards for the non-controlling interest in a subsidiary and for the deconsolidation of a subsidiary. Statement 160 is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008. Earlier adoption is prohibited. The Company is in the process of determining the effect, if any, that the adoption of FASB No. 160 will have on its results of operations or financial position.

In December 2007, the FASB issued Statement of Financial Accounting Standards No. 141 (Revised 2007) (“SFAS No. 141R”), Business Combinations. SFAS No. 141(R) will change accounting for business combinations. Under SFAS No. 141(R), an acquiring entity will be required to recognize all the assets acquired and liabilities assumed in a transaction at the acquisition-date fair value with limited exceptions. SFAS No. 141(R) also will change the accounting treatment and disclosures for certain specific items in a business combination. SFAS No. 141(R) applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 31, 2008. SFAS No. 141(R) will have an impact on accounting for business combinations once adopted, but the effect is dependent upon acquisitions effectuated after its effective date.

In March 2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities—an amendment of FASB Statement No. 133” (“FAS 161”). FAS 161 changes the disclosure requirements for derivative instruments and hedging activities. Entities are required to provide enhanced disclosures about (a) how and why an entity uses derivative instruments, (b) how derivative instruments and related hedged items are accounted for under Statement 133 and its related interpretations, and (c) how derivative instruments and related hedged items affect an entity’s financial position, financial performance, and cash flows. The guidance in FAS 161 is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008, with early application encouraged. This Statement encourages, but does not require, comparative disclosures for earlier periods at initial adoption. The Company does not believe the adoption of FAS 161 will have an effect on our Consolidated Financial Statements.

Several other new accounting standards became effective during the periods presented or will be effective subsequent to February 2, 2008. None of these new standards had or is expected to have a significant impact on Hancock’s Consolidated Financial Statements.

Note 4 — Discontinued Operations

During 2007 the Company closed 134 stores, of which 124 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 124 stores and the 26 stores that qualified for discontinued operations during 2006 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 (in thousands, except per share amounts)


								Per Common Share
								Net Earnings
	Sales		Gross Profit		Net Earnings (Loss)			Basic			Diluted

2007
Discontinued operations	$	61,158	$	16,498	$	(3,723	)	$	(0.20	)	$	(0.20	)

2006
As originally reported ¹	$	376,179	$	149,471	$	(46,394	)	$	(2.48	)	$	(2.48	)
Discontinued operations		86,695		34,415		(15,651	)		(0.84	)		(0.84	)

Continuing operations, as adjusted	$	289,484	$	115,056	$	(30,743	)	$	(1.64	)	$	(1.64	)

2005
As originally reported	$	403,237	$	164,575	$	(30,251	)	$	(1.63	)	$	(1.63	)
Discontinued operations		103,286		43,109		(10,290	)		(0.55	)		(0.55	)

Continuing operations, as adjusted	$	299,951	$	121,466	$	(19,961	)	$	(1.08	)	$	(1.08	)


¹		2006 net loss reported before cumulative effect of change in accounting principle

The inventories in the stores closed during the year 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 $4.1 million. Such amounts are included in the store closing liability at February 2, 2008.

Note 5 — Property and Equipment (in thousands)

Property and Equipment consists of the following:


	2007			2006

Buildings and improvements	$	25,801		$	28,356
Leasehold improvements		5,189			5,779
Fixtures and equipment		59,245			67,377
Assets held for sale		738			417

		90,973			101,929
Accumulated depreciation and amortization		(48,504	)		(54,248	)

		42,469			47,681
Land		1,214			3,362

Total property and equipment, at depreciated cost	$	43,683		$	51,043

The Company recorded $3.8 million, $3.2 million, and $3.6 million of depreciation expense for continuing operations for the years ended February 2, 2008, February 3, 2007, and January 28, 2006, 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.

Assets held under capital leases amounted to $3.6 million and $5.8 million as of February 2, 2008 and February 3, 2007, respectively. Accumulated depreciation related to these assets at February 2, 2008 and February 3, 2007 totaled $314,000 and $668,000, respectively. Related depreciation expense amounted to $203,000 and $205,000 for the years ended February 2, 2008 and February 3, 2007, respectively.

Note 6 — Accrued Liabilities (in thousands)

Accrued liabilities consist of the following:


	2007		2006

Payroll and benefits	$	1,821	$	3,546
Property taxes		3,088		3,797
Deferred credit on consigned inventory		2,272		3,241
Workers’ compensation and deferred compensation		1,458		1,994
Medical claims, customer liability claims and property claims		938		2,268
Accrued accounting, legal, and professional		1,682		1,426
Sales taxes		607		1,688
Current portion of reserve for store closings (Note 14)		—		1,388
Other		2,488		3,312

	$	14,354	$	22,660

Note 7 — Long-Term Debt Obligations

From June 29, 2005, to March 22, 2007, the Company operated under a senior collateralized revolving loan facility with Wachovia Bank and other lenders.

The Credit Facility was a five-year $110 million commitment, although there were minimum levels of availability that had to be maintained, which had the effect of limiting the amount that could be borrowed to less than $110 million. The level of borrowings was subject to a borrowing base as defined in the agreement. This agreement provided for an unused line fee, ranging from 0.25% to 0.35%, depending upon excess availability. The Company had the option of selecting either a “prime rate” or Eurodollar loan. Advances under the Credit Facility accrued 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 were made at the Applicable Margin plus the Adjusted Eurodollar Rate and were outstanding for 30 day periods. At February 3, 2007, Hancock had outstanding borrowings of approximately $59.6 million, under the Credit Facility. The estimated weighted average interest rate under the Credit Facility for the year ended February 3, 2007, was approximately 7.1%.

The Credit Facility was 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 contemplated the issuance of letters of credit aggregating up to $25 million, provided that all borrowings under the Credit Facility did not exceed $110 million.

The Credit Facility contained 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 was a financial covenant that required 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 a voluntary petition for reorganization under Chapter 11 of the United States Bankruptcy Code. On March 22, 2007, the Company received interim 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 $105 million 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 million. This agreement provides for an unused line fee of 0.25% to 0.35%. 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. At February 2, 2008, Hancock had outstanding borrowings under the DIP Credit Facility of $6.1 million. The estimated weighted average interest rate under the DIP Credit Facility for the year ended February 2, 2008, was approximately 8.4%.

Credit Facility, the Company is currently required to maintain at least $15 million of excess availability. 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.

Under the above DIP Credit Facility at February 2, 2008, and under the previously existing Credit Facility as of February 3, 2007, Hancock had commitments of $716,000 and $6.1 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 $5.8 million as of February 2, 2008, and $5.5 million as of February 3, 2007.

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 Company’s obligations under the Loan Agreement are collateralized, subject to the superior lien of the DIP Credit Facility lender, by substantially all of its 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, bankers’ 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 the Company 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 earliest to occur of (a) June 15, 2009, (b) the confirmation of a plan of reorganization for the Company in the previously disclosed Chapter 11 cases of the Company (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).

excess of the applicable rate for Eurodollar Rate Loans in certain circumstances. As of February 2, 2008, borrowings under the Loan Agreement were $17.5 million with an estimated weighted average interest rate of 10.25%.

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 the Company; (d) the occurrence of certain bankruptcy or insolvency events; (e) certain judgments against the Company; (f) any representation or warranty made by the Company 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. Four of the Company’s stores qualify for capital lease treatment. Two of the leases expire in 2020; the others expire in 2016 and 2021.

Rent expense consists of the following (in thousands):


	2007			2006			2005

Minimum rent	$	24,808		$	31,716		$	32,061
Common area maintenance		1,848			3,369			3,291
Stepped rent adjustment		(1,046	)		(437	)		(439	)
Equipment leases		594			625			689

	$	26,204		$	35,273		$	35,602


Additional rent based on sales	$	92		$	79		$	126


Taxes	$	4,083		$	5,742		$	6,133


Insurance	$	298		$	588		$	532

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.

Future minimum rental payments under all operating and capital leases as of February 2, 2008 are as follows (in thousands):


	Operating Leases
			Sublease			Capital
Fiscal Year	Payments		Rentals			Leases
2008	$	20,231	$	(502	)	$	478
2009		16,844		(415	)		478
2010		14,368		(349	)		478
2011		13,151		(278	)		482
2012		8,813		(152	)		488
Thereafter		17,893		(336	)		4,778

Total minimum lease payments (income)	$	91,300	$	(2,032	)		7,182


Less imputed interest							(3,750	)

Present value of capital lease obligations							3,432
Less current portion							(67	)

Long-term capital lease obligations						$	3,365

Note 9 — Income Taxes

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


	2007			2006			2005
Currently payable (refundable)
Federal	$	—		$	(2,989	)	$	(7,239	)
State		1,000			—			—

Total currently payable (refundable)	$	1,000		$	(2,989	)	$	(7,239	)


Deferred
Current
Federal	$	3,809		$	364		$	1,307
State		222			21			103

Total Current		4,031			385			1,410

Noncurrent
Federal		(2,871	)		(243	)		4,858
State		(1,160	)		(1,007	)		282

Total Noncurrent		(4,031	)		(1,250	)		5,140

Total Deferred	$	—		$	(865)	*	$	6,550


Continuing operations expense (benefit)	$	1,000		$	(3,854	)	$	(689	)
Discontinued operations (benefit)		—			—			—

	$	1,000		$	(3,854	)	$	(689	)


*		Includes current year adjustment for valuation allowance related to stock compensation expense of $403,000.

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):


	2007			2006
Current:
Deferred tax assets:
Other employee benefit costs	$	495		$	648
Insurance reserves		953			1,253
Deferred compensation		105			96
Store closing costs		1,953			504
Leases		124			176
Other		91			211
Valuation allowance established through statement of operations		(3,246	)		(5,283	)

		475			(2,395	)
Deferred tax liabilities — inventory valuation methods		(2,717	)		(3,878	)

Net current deferred tax liabilities		(2,242	)		(6,273	)

Noncurrent:
Deferred tax assets:
Other employee benefit costs		269			370
Insurance reserves		790			726
Postretirement benefits other than pensions		6,854			7,970
Deferred compensation		2,106			2,253
Pension liabilities		1,867			2,950
Valuation allowances established through other comprehensive loss		(5,392	)		(4,928	)
Store closing costs		6			173
NOL carryforward		22,170			14,877
NOL carryforward valuation allowance		(22,170	)		(14,877	)
Fixed asset impairment		25			284
Other		90			278
Valuation allowances established through statement of operations		(2,471	)		(1,021	)

		4,144			9,055

Deferred tax liabilities:
Accelerated depreciation		(1,837	)		(1,898	)
Lease accounting		(97	)		(493	)
Goodwill amortization		32			(391	)

		(1,902	)		(2,782	)

Net noncurrent deferred tax assets		2,242			6,273

Net deferred tax asset (liability)	$	—		$	—

As of February 2, 2008, the Company has federal net operating loss carry forwards totaling approximately $59.3 million, which expire beginning 2026. Additionally, the Company has net operating losses for state income tax purposes totaling $108.0 million which expire in various periods beginning 2016.

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


	2007			2006			2005

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		—			(8.6	)		—
Other permanent differences		—			0.2			—
State tax settlement		4.3			—			—
Valuation allowance		35.7			33.4			31.8
Other		0.6			0.2			1.2

Effective tax rate (benefit)		4.3	%		(11.1)	%		(3.3)	%

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 $7.3 million and $14.2 million in 2007 and 2006 respectively, and valuation allowances relating to benefit plans of $463,000 and $3.4 million in 2007 and 2006, respectively, through other comprehensive income (loss).

In June 2006, the Financial Accounting Standards Board (FASB) issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes “ (“FIN 48”). FIN 48 clarified the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with Statement of Financial Accounting Standards No. 109 “ Accounting for Income Taxes “ (“FAS 109”). This interpretation prescribes a recognition threshold and measurement attribute 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 of tax benefits, classification on the balance sheet, interest and penalties, accounting in interim periods, disclosure, and transition.

The Company adopted FIN 48 effective February 4, 2007. In accordance with FIN 48, the Company decided to classify interest and penalties as a component of tax expense. The Company recognized no material adjustment in the liability for unrecognized income tax benefits as a result of the implementation of FIN 48. At its adoption date of February 4, 2007, the Company had $500,000 of unrecognized tax benefits which was reclassified from accrued liabilities and had no impact on beginning retained earnings. To the extent these unrecognized tax benefits are ultimately recognized, they will impact the Company’s effective tax rate. At February 2, 2008 the Company had $1.5 million of unrecognized tax benefits of which $1.0 million impacted the effective tax rate in fiscal 2007. No interest and penalties were included in the balance sheet or statement of operations as of or for the year ended February 2, 2008.

A reconciliation of the beginning and ending amount of unrecognized tax benefits is as follows (in thousands):


Unrecognized tax benefit at beginning of year	$	500
Additions for tax positions related to the current year		1,000

Unrecognized tax benefit at end of year	$	1,500

Note 10 — Other Liabilities

Other Liabilities consisted of the following (in thousands):


	2007		2006
Long-term workers’ compensation and deferred compensation	$	2,239	$	6,235
Long-term stepped rent accrual		—		2,345
Deferred fixed cost liability		512		640
Unapplied rent credit		—		629
Reserve for store closing		—		476
Asset retirement obligations		319		476
Other		1		36

	$	3,071	$	10,837

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.

Stock Repurchase Plan. In prior years and continuing in fiscal 2007, Hancock has repurchased approximately 13 million shares. As of February 2, 2008, 243,617 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 or shares reacquired and not reserved for any other purpose. As of February 3, 2007, all of the shares available in the 2005 Plan had been issued.

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 $1.4 million, $2.7 million, and $0.8 million for 2007, 2006, and 2005, 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 the preceding 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. In March 2006, the 2001 Plan was amended by the Long-Term Incentive Compensation Restricted Stock Program, which provides for shares to be issued without restriction upon achieving predetermined performance goals. As of February 2, 2008, a total of 1,330,950 shares remain available for grant under the 2001 Plan, including 497,450 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 2, 2008, all of the shares available in the 2004 Plan had been issued.

A summary of stock option activity in the plans for the years ended February 2, 2008, February 3, 2007, and January 28, 2006 follows:


	2007					2006					2005
				Weighted					Weighted					Weighted
				Average					Average					Average
				Exercise					Exercise					Exercise
	Options			Price		Options			Price		Options			Price

Outstanding at beginning of year		1,795,275		$	11.65		1,959,475		$	12.21		2,436,125		$	12.37
Granted		108,500		$	1.63		126,000		$	3.63		13,500		$	5.77
Canceled		(766,475	)	$	11.67		(290,200	)	$	11.93		(485,275	)	$	12.88
Exercised		—		$	—		—		$	—		(4,875	)	$	5.00

Outstanding at end of year		1,137,300		$	10.68		1,795,275		$	11.65		1,959,475		$	12.21

Exercisable at end of year		890,825		$	12.20		1,394,025		$	12.25		1,361,775		$	11.69

The weighted average remaining contractual life of all outstanding options was 5.43 years at February 2, 2008.

The weighted average grant-date fair value of options granted during 2007, 2006, and 2005 was $0.93, $1.91, and $2.07, 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 2007, 2006, and

2005, respectively: dividend yields of 0%, 0% and 2.82%; average expected volatility of 0.54, 0.47, and 0.48; risk-free interest rates of 4.22%, 4.77% and 4.08%; and an average expected life of 6.25 years in 2007, 6.25 years in 2006, and 4.5 years in 2005.

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 2, 2008 follows:


	Options Outstanding						Options Exercisable
			Weighted		Weighted				Weighted
	Number		Average		Average		Number		Average
Range of	Outstanding		Remaining		Exercise		Exercisable		Exercise
Exercise Prices	at 2/2/08		Life (Years)		Price		2/2/2008		Price

$0.925 to $3.16		154,500		9.13	$	2.12		12,500	$	3.16
$3.27 to $6.43		112,900		4.11	$	4.54		87,400	$	4.69
$7.50 to $7.50		152,100		3.36	$	7.50		152,100	$	7.50
$9.44 to $9.44		100,000		6.87	$	9.44		75,000	$	9.44
$12.20 to $12.22		216,100		6.36	$	12.20		162,125	$	12.20
$12.22 to $15.34		51,000		0.45	$	12.68		51,000	$	12.68
$15.84 to $15.84		178,800		5.35	$	15.84		178,800	$	15.84
$18.09 to $18.09		171,900		4.36	$	18.09		171,900	$	18.09

$0.925 to $18.09		1,137,300		5.43	$	10.68		890,825	$	12.20

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 1,000,000 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 2007, 2006, and 2005, restricted shares totaling 58,000, 148,500, and 137,000, 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 2, 2008, and changes during the year ended February 2, 2008, is presented below:


				Weighted-Average
Nonvested Shares	Shares			Grant-Date Fair Value

Nonvested Shares at February 3, 2007		485,900		$	10.84
Granted		58,000		$	1.55
Vested		(120,025	)	$	11.03
Forfeited		(85,350	)	$	9.05

Nonvested Shares at February 2, 2008		338,525		$	7.01

As of February 2, 2008, there was $1.5 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 1.6 years. The total fair value of shares vested during the year ended February 2, 2008, was $1.3 million.

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 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 (in thousands).



	Before Application						After Application
	of Statement 158			Adjustments			of Statement 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 2007, the Company recognized $419,000 of expense for its 401(k) contribution and match.

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


	Retirement Plan						SERP
	2007			2006			2007			2006
Change in benefit obligation
Benefit obligation at beginning of year	$	74,861		$	75,172		$	1,031		$	1,133
Service cost		1,642			2,310			3			11
Interest cost		4,308			4,104			61			57
Benefits paid		(3,988	)		(3,345	)		(11	)		(50	)
Plan amendments		—			6			—			(9	)
Actuarial loss (gain)		(5,195	)		(3,386	)		(12	)		(111	)
Liability (gain) loss due to curtailment		(488	)		—			—

Benefit obligation at end of year	$	71,140		$	74,861		$	1,072		$	1,031


Change in plan assets
Fair value of plan assets at beginning of year	$	67,775		$	64,671
Actual return on plan assets		3,147			6,449
Benefits paid		(3,987	)		(3,345	)

Fair value of plan assets at end of year	$	66,935		$	67,775


Amounts recognized in the consolidated balance sheets
Current liabilities	$	—		$	—		$	134		$	75
Non-current liabilities		4,205			7,086			938			955

Net Liability at end of year	$	4,205		$	7,086		$	1,072		$	1,030


Amounts recognized in accumulated other comprehensive income
Prior service credit	$	(640	)	$	(873	)	$	(9	)	$	(10	)
Net actuarial (gain) loss		11,747			15,851			198			229

Net Liability at end of year	$	11,107		$	14,978		$	189		$	219

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
	2007			2006			2007			2006

Funded status	$	(4,205	)	$	(7,095	)	$	(1,072	)	$	(1,031	)

Recorded Pension Liability

In accordance with SFAS No. 87, Employers’ Accounting for Pensions, a liability was required in 2007 and 2006 as the accumulated benefit obligation exceeded the fair value of pension plan assets for both plans as of the measurement date. The liability, totaling $11.3 million and $15.2 million at February 2, 2008, and

February 3, 2007, 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
	2007			2006			2005			2007			2006		2005

Service cost	$	1,642		$	2,310		$	2,486		$	3		$	11	$	21
Interest cost		4,308			4,104			4,053			61			58		62
Expected return on plan assets		(5,578	)		(5,361	)		(5,633	)		—			—		—
Amortization of prior service cost		(97	)		(98	)		(98	)		(1	)		—		—
Actuarial (gain)/loss		852			1,356			862			23			24		25
Curtailment expense		(136	)		—			—			—			—		—

Net periodic benefit cost	$	991		$	2,311		$	1,670		$	86		$	93	$	108

Other Changes in Plan Assets and Benefit Obligation
Recognized in Other Comprehensive Income (in thousands)


	Retirement Plan			SERP
	2007			2007

Net actuarial (gain)/loss	$	(2,764	)	$	(12	)
Curtailment — recognition of net actuarial (gain)/loss		(488	)
Curtailment — recognition of prior service (cost)/credit		136
Reversal of amortization — net actuarial gain/loss		(851	)		(19	)
Reversal of amortization — prior service cost/credit		97			1

Total recognized in other comprehensive income	$	(3,870	)	$	(30	)


Total recognized in net periodic benefit cost and other comprehensive income	$	(2,880	)	$	56

Accumulated Benefit Obligation

The accumulated benefit obligation for the retirement plan was $70.0 million and $72.8 million at the measurement dates of December 31, 2007 and 2006, respectively. The accumulated benefit obligation for the SERP was $1.1 million and $987,000 at December 31, 2007 and 2006, respectively.

Assumptions

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


	2007			2006

Discount rate		6.55	%		5.90	%
Rate of increase in compensation levels		2.50	%		4.00	%

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


	2007			2006			2005

Discount rate		5.90	%		5.60	%		6.00	%
Rate of increase in compensation levels		4.00	%		4.00	%		4.00	%
Expected long-term rate of return on assets		8.50	%		8.50	%		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 2,			February 3,			Target
Asset Category	2008			2007			Allocation
Equity securities		81.0	%		65.9	%		65	%
Fixed income securities		19.0	%		34.1	%		35	%

		100.0	%		100.0	%		100	%

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 2008. Contributions to the SERP are made as benefits are paid.

Estimated Future Benefit Payments (in thousands)


	Retirement
	Plan		SERP
2008	$	3,995	$	134
2009		4,119		80
2010		4,258		80
2011		4,394		80
2012		4,581		80
Years 2013 through 2017		25,531		396

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)


	2007			2006
Change in benefit obligation
Benefit obligation at beginning of year	$	9,160		$	9,261
Service cost		263			309
Interest cost		490			496
Benefits paid		(629	)		(607	)
Actuarial (gain) loss		(398	)		(515	)
Liability (gain)/loss due to curtailment		(399	)		—
Plan participant contributions		242			216

Benefit obligation at end of year	$	8,729		$	9,160

Funded Status (in thousands)

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):


	2007			2006

Funded status	$	(8,729	)	$	(9,160	)

Components of Net Periodic Benefit Cost (in thousands)


	2007			2006			2005

Service costs	$	263		$	309		$	600
Interest costs		490			496			937
Amortization of prior service cost		(1,174	)		(1,178	)		(405	)
Amortization of net actuarial (gain)/loss		(231	)		(151	)		(156	)
Curtailment expense (income)		(2,040	)		—			—

Net periodic postretirement costs	$	(2,692	)	$	(524	)	$	976

Other Changes in Plan Assets and Benefit Obligation

Recognized in Other Comprehensive Income (in thousands)


	2007

Net actuarial (gain)/loss	$	(398	)
Net actuarial (gain)/loss adjustment to match (accrued)/prepaid		(6	)
Curtailment — recognition of prior service (cost)/credit		1,642
Reversal of amortization — net actuarial gain/loss		231
Reversal of amortization — prior service cost/credit		1,174

Total recognized in other comprehensive income	$	2,643


Total recognized in net periodic benefit cost and other comprehensive income	$	(49	)

Assumptions

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


	2007			2006

Discount rate		6.55	%		5.90	%
Rate of increase in compensation levels		2.50	%		4.00	%

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


	2007			2006			2005

Discount rate		5.90	%		5.60	%		6.00	%
Expected return on plan assets		N/A			N/A			N/A
Rate of increase in compensation levels		4.00	%		4.00	%		4.00	%

Assumed Health Care Cost Trend Rates


	2007						2006
	Employees			Employees			Employees			Employees
	under age 65			age 65 or older			under age 65			age 65 or older
Health care cost trend rate assumed for next year		8.25	%		7.50	%		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		2012			2013			2013			2013


	One-Percentage Point		One-Percentage Point
	Increase		Decrease

Effect on total service and interest costs	$	112	$	(94	)
Effect on postretirement benefit obligation	$	1,100	$	(949	)

Contributions

Hancock currently contributes to the plan as medical and dental benefits are paid and expects to continue to do so in 2008. Claims paid in 2007, 2006, and 2005, net of employee contributions, totaled $388,000, $392,000, and $861,000, 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.

Estimated Future Benefit Payments (in thousands)


	Net
	Payments
2008	$	447
2009		475
2010		469
2011		555
2012		568
Years 2013 through 2017		3,309

Note 13 — Commitments and Contingencies

Litigation. As more fully described in Note 2, Proceedings under Chapter 11 and Related Going Concern Considerations, the Company currently operates the business as debtor-in-possession pursuant to the Bankruptcy Code. Under the Bankruptcy Code, actions to collect pre-petition indebtedness, as well as most other pending litigation, are stayed and other contractual obligations against the Debtor generally may not be enforced. At this time, it is not possible to predict the outcome of the Chapter 11 case or their effect on the Company’s business. The rights of creditors and the ultimate recovery by creditors of pre-petition indebtedness will not be determined until confirmation and implementation of a plan of reorganization. Until that time, no assurance can be given as to what recoveries, if any, will be assigned in the bankruptcy proceedings to each of these constituencies.

In addition, 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 indebtedness by and between the Company and its subsidiaries is properly classified as taxable capital rather

than debt. The Company has agreed in principal with the Tax Commission on a settlement and this amount has been accrued at year end.

Note 14 — Reserve for Store Closings

The reserve for store closings is based on estimates of net lease obligations and other store closing costs. The reserve was increased by $637,000 in 2005, $1.6 million in 2006, and $4.5 million in 2007 due to store closings and changes in prospects for sub-leasing properties.

The 2006 and 2007 activity in the reserve is as follows (in thousands):


	2007 Lease Obligations			2006 Lease Obligations
Beginning of Year	$	1,864		$	1,179
Addition to (Reduction in) Reserve		4,455			1,623
Interest		22			52
Payments		(945	)		(990	)

End of Year	$	5,396		$	1,864

Note 15 — 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 2, 2008 and February 3, 2007, 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):


	2007			2006
Asset retirement obligation, beginning of period	$	476		$	523
Asset retirement obligation incurred and accretion expense		(157	)		(47	)

Asset retirement obligation, end of period	$	319		$	476


Related capitalized property and equipment, net of accumulated depreciation	$	69		$	137

Note 16 — Subsequent Event

On April 9, 2008, the Company entered into a commitment letter for a senior secured revolving line of credit for $100 million (the “Exit Facility”) with General Electric Capital Corporation. The facility includes a $20 million letter of credit sub-facility and has a five-year term. It will be collateralized by senior liens on substantially all assets of the Company and will replace the $105 million DIP Credit Facility and the $17.5 million Loan Agreement on the effective date of a Plan of Reorganization. This financing has yet to be approved by the Court, and the closing for the Exit Facility remains subject to a number of conditions, including but not limited to Court confirmation of a Plan. The Exit Facility will include customary covenants for these types of financings. The preceding description is qualified in its entirety by reference to the Exit Facility commitment letter (filed as Exhibit 99.1 to the Current Report on Form 8-K filed on April 10, 2008).

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 sheets of Hancock Fabrics, Inc. (Debtor-in-Possession) (the “Company”) as of February 2, 2008 (fiscal 2007) and February 3, 2007, and the related statements of operations, shareholders’ equity, and cash flows for the years then ended. Our audits also included the financial statement schedules listed in the Index to the Annual Report on Form 10-K at Part IV, Item 15(a) 2 as of and for the years ended February 2, 2008 and February 3, 2007. These Consolidated Financial Statements and financial statement schedules 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 audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor have we been engaged to perform, an audit of the Company’s internal control over financial reporting for fiscal 2007. An audit includes consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion on fiscal 2007. 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 audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of February 2, 2008 and February 3, 2007, and the results of their operations and their cash flows for the years then ended in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the related financial statement schedules as of and for the years ended February 2, 2008 and 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 financial statements to retrospectively apply the change in accounting for discontinued operations, as described in Notes 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 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 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 2 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 2007, 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 3 to the consolidated financial statements, the Company changed its method of accounting for stock-based compensation as a result of adopting Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment”, as of January 29, 2006 applying the modified prospective method.

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-An Amendment of FASB Statements 87,88,106 and 132(r),” as of February 3, 2007.

As discussed in Note 2 to the consolidated financial statements, effective February 4, 2007, the Company adopted the provisions of Financial Accounting Standards Board Interpretation No. 48, “Accounting for Uncertainty in Income Taxes — An Interpretation of FASB Statement No. 109.”

/s/ BURR, PILGER & MAYER LLP

San Francisco, California
April 15, 2008

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

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

In our opinion, the consolidated statement of operations, cash flows and shareholders’ equity and comprehensive income for the year 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 results of their operations and their cash flows for the year 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 the year 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 audit. We conducted our audit, 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 audit provides 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

QUARTERLY FINANCIAL DATA (unaudited)
Years ended February 2, 2008 and February 3, 2007
(in thousands, except per share amounts)


	First			Second			Third			Fourth
	Quarter			Quarter			Quarter			Quarter
	2007			2007			2007			2007
Sales	$	69,182		$	58,031		$	69,650		$	79,384

Gross profit		31,056			24,649			31,073			31,852

Selling, general and administrative expense		28,725			24,800			31,059			33,231
Depreciation and amortization		742			1,034			874			1,165

Reorganization expense, net		4,125			3,759			4,164			2,891
Interest expense		2,044			1,133			1,113			1,030

Income tax expense		—			—			—			1,000

Loss from continuing operations, net of tax		(4,580	)		(6,077	)		(6,137	)		(7,465	)

Earnings (loss) from discontinued operations, net of tax		3,369			(7,257	)		—			165

Net loss	$	(1,211	)	$	(13,334	)	$	(6,137	)	$	(7,300	)


Basic and dilutive loss per share⁽¹⁾	$	(0.06	)	$	(0.71	)	$	(0.32	)	$	(0.39	)


	First			Second			Third			Fourth
	Quarter			Quarter			Quarter			Quarter
	2006			2006			2006			2006 *
Sales	$	67,841		$	61,606		$	74,264		$	85,773

Gross profit		23,040			24,555			31,653			35,808

Selling, general and administrative expense		34,212			31,393			36,962			38,772
Depreciation and amortization		821			783			792			838

Interest expense		997			1,065			1,377			1,641

Income tax benefit		(1,479	)		(970	)		(822	)		(583	)

Net loss from continuing operations before cumulative effect of change in accounting principle		(11,511	)		(7,716	)		(6,656	)		(4,860	)

Loss from discontinued operations, net of tax		(5,337	)		(5,373	)		(3,201	)		(1,740	)

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	)	$	(0.53	)	$	(0.35	)


⁽¹⁾		Per share amounts are based on average shares outstanding during each quarter and may not add to the total for the year.

*		The fourth quarter of 2007 contains 13 weeks whereas the fourth quarter of 2006 contains 14 weeks.

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

None.

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 Senior Vice President and Chief Financial Officer (principal financial officer), as appropriate, to allow timely decisions regarding the required disclosures.

As of the end of the period covered by this report (February 2, 2008), the Company’s management, under the supervision and with the participation of the Company’s President and Chief Executive Officer (principal executive officer) and Senior Vice President and Chief Financial Officer (principal financial officer), performed an evaluation of the effectiveness of our disclosure controls and procedures (as such term is defined in the Rules 13a-15(e) and 15d-15(e) under the Exchange Act). Based upon this evaluation and as a result of the material weakness discussed in Management’s Annual Report on Internal Control Over Financial Reporting in Item 9A, the Company’s principal executive officer and principal financial officer, concluded that the Company’s disclosure controls and procedures were not effective as of February 2, 2008. 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 and Related Matters

Changes were made during the fiscal year and fourth quarter ended February 2, 2008, 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 help remediate material weaknesses identified in the prior year and to improve internal controls.

The Company reported two material weaknesses in internal control in Form 10-K for the fiscal year ended February 3, 2007. The Company reported one of the material weaknesses because 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. Management has taken actions to begin remediating the material weakness by engaging a third party consulting firm to assist with accounting and disclosure matters related to the financial reporting and accounting requirements. We will utilize the third party 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 our financial reporting and accounting processes, we are providing additional information to our audit committee on the progress of accounting matters on a routine basis. Management believes that the recent changes made have allowed them to improve internal controls over financial reporting but did not enable them to thoroughly evaluate such controls, especially those over the quarterly financial close process.

Management will continue to assess the complement of personnel needed to assist with accounting and disclosure matters related to the financial reporting and accounting requirements in the upcoming quarters, and additional changes are expected to be made. One such change made subsequent to year end is represented by the February 2008 hiring of a new Senior Vice President and Chief Financial Officer to supplement the existing financial executive team.

Additionally, the Company reported a material weakness in internal control in Form 10-K for the fiscal year ended February 3, 2007, because the Company did not maintain effective management controls over the completeness and accuracy of reconciliations of certain financial statement accounts, journal entries, and spreadsheets. Management took actions in the third and fourth quarters of 2007 to remediate this material weakness by engaging 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 will continue to assess the complement of personnel needed to assist with preparing account reconciliations and account documentation in the upcoming quarters, and additional changes are expected to be made.

There were no other changes in our internal control over financial reporting that occurred during the year ended February 2, 2008 that have materially affected or are reasonably likely to materially affect our internal control over financial reporting.

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’s 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.

Hancock’s management conducted an assessment of the effectiveness of the Company’s internal control over financial reporting as of February 2, 2008. 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 deficiency, or combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the company’s 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 2, 2008:

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 and resulted in the Company’s inability to file its Forms 10-Q for the quarterly periods May 5, 2007, August 4, 2007, and November 3, 2007, within the timelines established by the Securities and Exchange Commission.

Because of the material weaknesses described above, management concluded that the Company did not maintain effective internal control over financial reporting as of February 2, 2008, based on the criteria established in Internal Control — Integrated Framework issued by the COSO.

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

Item 9B. OTHER INFORMATION

None.

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 (64)	Chairman, MxSecure, Inc., Scottsdale, Arizona (an Internet based medical transcription services company). Director, member of the Audit Committee, and Chair of the Nominating and Corporate Governance 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. Chairman of Hardy Reed Frugé Capital Advisors, LLC, Tupelo and Oxford, Mississippi (an independent registered investment advisory firm).		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 does not anticipate holding a 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”), 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.

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 during the year ended February 2, 2008.


			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 1993 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.

Larry D. Fair		50	Vice President — Finance since 1996 and Corporate Controller from 1989 to 1996.

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.

William A. Sheffield		61	Senior Vice President — Distribution since December 2000 and Vice-President — Distribution from June 1996 to December 2000. Mr. Sheffield has held various leadership roles since joining the Company in 1974.

William D. Smothers		60	Senior Vice President — Real Estate since February 1997 and Vice President — Real Estate from 1980 to 1997. Since joining the Company in 1966, Mr. Smothers has held various positions within the real estate function.

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, the Company’s compliance with laws and regulations, and with the Code of Business Conduct and Ethics for both employees and 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 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 2, 2008, 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, and principal financial officer. 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 a manner consistent with that of the other corporate officers.

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 Principal Financial and Accounting Officers, 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	• Communicate key financial and operating objectives.
	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.
	• Our current stock option plans prohibit repricing.	• Opportunities for significant wealth accumulation by executives are tightly linked to stockholder returns.

Retirement plans	The Company maintains three retirement plans:	• Provide competitive executive retirement benefits.
	• 401(k) defined contribution plan; and
	• Defined benefit pension plan
	• Supplemental executive retirement plan. (Both pension plans are frozen to new participants.)

Health and other benefits	Executives are eligible for a variety of benefits, including:	• Provide competitive benefits.
	• Medical, dental, and vision plans; and	• Minimize perquisites while ensuring a competitive
	• Life and disability insurance plans.	overall rewards package.

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 during 2006 or 2007.

Incentive Compensation

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”).

All salaried employees at the Senior Manager level and above located 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 for 2006 and 2007, the Company must have achieved at least one of three specified Cash Flow from Operations goals (Minimum, Target, and Maximum) for the year. No bonuses were paid for 2006 or 2007 under the Bonus Program as the performance goals were not achieved.

For 2008, the Board of Directors has modified the Bonus Program goal to FIFO EBITDA before reorganization costs. Minimum, Target, and Maximum goals have been set, based on the Company’s business plan for the year. In addition, 50% of the bonus opportunity at each level will be paid based on the participants’ achievement of individual operating goals. The individual performance component is only payable if one of the FIFO EBITDA before reorganization costs goals is reached.

Payouts, if any, cap at 30%, 60%, and 90%, respectively, of salary at the CEO level, depending on whether the Minimum, Target or Maximum goal is reached. The caps are at 20%, 40%, and 60%, respectively, for the Senior Vice President position, 15%, 30%, and 40%, respectively, for the Vice President position, and 7.5%, 15%, and 20%, respectively, for the Senior Manager position.

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.

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 four 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 specific metrics determined by the Board of Directors each year (the “Performance Award”). The performance award goal, as established at the time of the base award, provided a minimum, target, and maximum award at one, two, or three times the base shares. If earned, such shares will vest immediately upon achieving the goal.

Due to restructuring efforts that occurred in 2007, the Board approved converting to the utilization of FIFO EBITDAR from continuing operations for the purpose of qualification for the performance award for 2007. Based on this criteria, participants in the Long-Term Program who achieve the target would receive two times the Base Award shares. Accordingly, shares were issued to Ms. Aggers, Mr. Fair, Ms. Moore, Mr. Sheffield, and Mr. Smothers under the Long-Term Program as Performance Awards subsequent to year end. The awards were for 30,000, 6,000, 5,000, 10,000, and 10,000 shares, respectively and vested immediately upon issuance. The closing price of the common stock on the date of issuance April 4, 2008 was $1.23. Restricted shares may be issued to Ms. Aggers under the Long-Term Program in 2008, but only if the Company achieves certain goals which have not yet been determined.

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. 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. No incentive compensation was paid to Ms. Aggers in 2006. Ms. Aggers was awarded 30,000 shares of Common Stock based on 2007 results under the Company’s Long-Term Program.

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.

The Compensation Committee approves awards of stock options to all 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 2007. 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 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. Fair, Mr. Sheffield, and Mr. Smothers (the “Executives”). The Severance Agreements were to be effective until May 4, 2008 (Mr. Smith’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 Executive is 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 Executive 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 a participant in the Retirement Plan, the Executive is 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.

With respect to the Company’s 1996 Stock Option Plan, 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. Fair, Mr. Sheffield, and Mr. Smothers.

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.

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 Ms. Aggers 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.

The following table sets forth the amounts payable to the Named Executive Officers in the event of a Change In Control as of February 2, 2008:


									Market Value of		Total Value of
									Equity Vesting		Severence
Name	Salary		Bonus		Benefits		SERP		(2)		Agreements⁽¹⁾
Jane F. Aggers	$	1,350,000	$	—	$	62,640	$	—	$	76,775	$	1,489,415
Larry D. Fair	$	125,000	$	45,780	$	15,132	$	—	$	10,707	$	196,619
L. Gail Moore	$	190,000	$	—	$	9,588	$	—	$	16,600	$	216,188
William A. Sheffield	$	140,000	$	51,972	$	10,800	$	—	$	13,197	$	215,969
William D. Smothers	$	140,000	$	55,428	$	15,132	$	108	$	14,193	$	224,861


⁽¹⁾		The tax benefits provided for in the Severance Agreements and the Agreement have not been determined.

⁽²⁾		Based on closing market value of $.83 on February 1, 2008.

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 have been officers or employees of the Company or any of its subsidiaries. In addition, no executive officer of the Company served during 2007 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.

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
											Compen-		tion		Compen-
Name and Principal			Salary		Bonus		Stock Awards		Option Awards		sation		Earnings		sation		Total
Position	Year		($)		($)		($)⁽¹⁾		($)⁽¹⁾		($)⁽²⁾		($)⁽³⁾		($)⁽⁴⁾		($)
(a)	(b)		(c)		(d)		(e)		(f)		(g)		(h)		(i)		(j)
Jane F. Aggers, Chief Executive		2007	$	450,000		—	$	278,133	$	85,872	$	36,900		—	$	31,665	$	882,570
Officer		2006	$	450,000		—	$	281,448	$	87,556		—		—	$	20,790	$	839,794
Bruce D. Smith, Chief Financial		2007	$	59,712		—	$	1,812	$	4,081		—		—	$	1,870	$	67,475
Officer		2006	$	230,000		—	$	85,175	$	33,833		—	$	9,133	$	12,614	$	370,755
Larry D. Fair, Vice President —		2007	$	121,538		—	$	29,445	$	6,670	$	7,380		—	$	10,356	$	175,389
Finance		2006	$	102,500		—	$	54,573	$	13,533		—	$	3,272	$	11,059	$	184,937
L. Gail Moore, Senior Vice President —		2007	$	190,000		—	$	15,718	$	20,657	$	6,150		—	$	4,165	$	236,690
Merchandising		2006	$	116,923		—	$	10,210	$	13,416		—		—	$	7,348	$	147,897
William D. Smothers, Senior Vice President —		2007	$	138,460		—	$	37,165	$	10,005	$	12,300	$	11,079	$	10,176	$	219,185
Real Estate		2006	$	130,000		—	$	68,423	$	20,300		—	$	13,509	$	11,991	$	244,223
William A. Sheffield, Senior Vice President —		2007	$	137,076		—	$	34,508	$	10,005	$	12,300	$	6,009		—	$	219,185
Distribution		2006	$	121,000		—	$	59,660	$	20,300		—	$	13,073	$	13,711	$	227,744


⁽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 years ended February 2, 2008 and February 3, 2007, respectively 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⁾		The bonus shown is the closing market value of stock awarded under the Long-Term Incentive Compensation Plan on April 4, 2008.

⁽³⁾		See the table below captioned “Pension Benefits.”

⁽⁴⁾		All Other Compensation includes the following:


							Company
							Contributions to
							Defined
			Perquisites and		Life Insurance		Contribution
Name	Year		Personal Benefits		Premiums		Plans^(A)		Other^(B)
Jane F. Aggers		2007	$	9,000		—	$	22,665		—
		2006	$	9,000	$	540	$	11,250		—
Bruce D. Smith		2007		—		—		—	$	1,870
		2006		—		—		—	$	12,614
Larry D. Fair		2007		—		—		—	$	10,356
		2006		—	$	504		—	$	10,555
L. Gail Moore		2007		—		—	$	4,165		—
		2006	$	7,348		—		—		—
William D. Smothers		2007		—		—		—	$	10,176
		2006		—	$	1,620		—	$	10,371
William A. Sheffield		2007		—		—		—		—
		2006		—	$	1,620		—	$	12,091


^(A)		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.

^(B)		Represents amortized amounts of net present value under deferred compensation agreements between the Company and the eligible Named Executive Officers. Upon termination, Mr. Smith’s rights to payment under this agreement were forfeited.

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


	Option Awards												Stock Awards
																			Equity
																			Incentive
																			Plan
																	Equity		Awards:
																	Incentive		Market or
							Equity										Plan		Payout
							Incentive										Awards:		Value
							Plan										Number		Of
							Awards:								Market		Of		Unearned
	Number			Number			Number								Value of		Unearned		Shares,
	Of			Of			Of						Number		Shares of		Shares,		Units or
	Securities			Securities			Securities						Of Shares		Units of		Units or		Other
	Underlying			Underlying			Underlying						Or Units		Stock		Other		Rights
	Unexercised			Unexercised			Unexercised		Option				Of Stock		That Have		Rights		That Have
	Options			Options			Unearned		Exercise		Option		That Have		Not		That Have		Not
	(#)			(#)			Options		Price		Expiration		Not Vested		Vested		Not Vested		Vested
Name	Exercisable			Unexercisable			(#)		($)		Date		(#)		($)		(#)		($)
(a)	(b)			(c)			(d)		(e)		(f)		(g)		(h)		(i)		(j)
Jane F. Aggers		75,000	⁽¹⁾		25,000	⁽¹⁾		—	$	9.44		12/15/14		92,500	$	76,775		—		—
Larry D. Fair		4,000	⁽²⁾		—			—	$	12.63		6/11/08		12,900	$	10,707		—		—
		2,000	⁽²⁾		—			—	$	4.25		6/15/10		—		—		—		—
		4,000	⁽³⁾		—			—	$	7.50		6/14/11		—		—		—		—
		4,000	⁽⁴⁾		—			—	$	18.09		6/13/12		—		—		—		—
		4,000	⁽⁴⁾		—			—	$	15.84		6/11/13		—		—		—		—
		3,000	⁽⁴⁾		1,000	⁽⁴⁾		—	$	12.20		6/9/14		—		—		—		—
William A. Sheffield		2,000	⁽²⁾		—			—	$	4.25		6/15/10		15,900	$	13,197		—		—
		6,000	⁽³⁾		—			—	$	7.50		6/14/11		—		—		—		—
		6,000	⁽⁴⁾		—			—	$	18.09		6/13/12		—		—		—		—
		6,000	⁽⁴⁾		—			—	$	15.84		6/11/13		—		—		—		—
		4,500	⁽⁴⁾		1,500	⁽⁴⁾		—	$	12.20		6/9/14		—		—		—		—
L. Gail Moore		12,500	⁽⁴⁾		37,500			—	$	3.16		6/12/16		20,000	$	16,600		—		—
WilliamD. Smothers		4,500	⁽³⁾		—			—	$	7.50		6/14/11		17,100	$	14,193		—		—
		6,000	⁽⁴⁾		—			—	$	18.09		6/13/12		—		—		—		—
		6,000	⁽⁴⁾		—			—	$	15.84		6/11/13		—		—		—		—
		4,500	⁽⁴⁾		1,500	⁽⁴⁾		—	$	12.20		6/9/14		—		—		—		—


⁽¹⁾		Stock options were granted under the 2004 Special Stock Plan, vest in equal installments on the first four anniversaries of the grant date, with a 10 year life.

⁽²⁾		Stock options were granted under the 1996 Stock Option Plan and vest in equal installments on the first two anniversaries of the grant date, with a 10 year life.

⁽³⁾		Stock options were granted under the 1996 Stock Option Plan and vest in equal installments on the first four anniversaries of the grant date, with a 10 year life.

⁽⁴⁾		Stock options were granted under the 2001 Stock Incentive Plan and vest in equal installments on the first four anniversaries of the grant date, with a 10 year life.

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 F. Aggers		—		—		38,750	$	34,738	⁽²⁾
Bruce D. Smith		—		—		—		^--
Larry D. Fair		—		—		3,700	$	10,508	⁽³⁾
L. Gail Moore		—		—		5,000	$	14,250	⁽⁴⁾
William A. Sheffield		—		—		3,900	$	11,076	⁽³⁾
William D. Smothers		—		—		4,600	$	13,064	⁽³⁾


(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, 2007, and 20,000 shares vested on December 16, 2007.

(3)		These restricted shares vested on June 14, 2007.

(4)		These restricted shares vested on June 13, 2007.

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, Mr. Fair, Mr. Sheffield, and Mr. Smothers 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 Mr. Smith, Mr. Fair, Mr. Sheffield, and Mr. Smothers, 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.

PENSION BENEFITS


		Number of Years		Present Value of
		Credited Service		Accumulated Benefit		Payments During
Name⁽¹⁾	Plan Name	(#)		($)⁽²⁾		Last Fiscal Year($)
(a)	(b)	(c)		(d)		(e)
Bruce D. Smith	Hancock Fabrics, Inc. Consolidated Retirement Plan		10.16	$	79,682	—
	Hancock Fabrics, Inc. Supplemental Retirement Plan		10.16	$	9,297	—
Larry D. Fair	Hancock Fabrics, Inc. Consolidated Retirement Plan		22.0	$	77,716	—
	Hancock Fabrics, Inc. Supplemental Retirement Plan		22.0		—	—
William A. Sheffield	Hancock Fabrics, Inc. Consolidated Retirement Plan		33.0	$	237,409	—
	Hancock Fabrics, Inc. Supplemental Retirement Plan		33.0		—	—
William D. Smothers	Hancock Fabrics, Inc. Consolidated Retirement Plan		39.0	$	369,972	—
	Hancock Fabrics, Inc. Supplemental Retirement Plan		39.0	$	995	—


⁽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 and Ms. Moore are ineligible for this benefit.

⁽²⁾		As of February 2, 2008.

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 2007 fiscal year. No amounts were paid to our non-employee directors during the 2007 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	$	45,000	$	15,000	$	5,438	$	65,438
Roger T. Knox	$	51,000	$	9,000	$	5,438	$	65,438
Wellford L. Sanders	$	45,000	$	15,000	$	12,378	$	72,378
Donna L. Weaver	$	45,000	$	15,000	$	5,438	$	65,438
Bernard J. Wein	$	45,000	$	15,000	$	12,351	$	72,351


⁽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 2007; therefore, stock options were not granted to directors during 2007. 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 2, 2008, 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 2, 2008, each non-employee director held the following aggregate number of outstanding stock options:


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


*		Includes vested and unvested stock options.

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. Each eligible director receives a fee of $15,000 quarterly, in either stock or cash at each director’s discretion. Subsequent to March 21, 2007, the eligible directors elected to receive all of their quarterly fees in cash. 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). This amendment is pending shareholder approval. Annual meetings were not held in 2006 and 2007; therefore, stock options were not granted to non-employee directors.


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

Securities Authorized for Issuance Under Equity Compensation Plans

The following table provides certain information as of February 2, 2008, with respect to compensation plans under which shares of the Company’s common stock may be issued.

(a)

(b)

(c)

Number of

Number of securities

securities to be

remaining available for

issued upon

Weighted-average

future issuance under

exercise of

exercise price of

equity compensation

outstanding

plans (excluding

options, warrants,

securities reflected

Plan Category

and rights

in column (a) (3)

Equity compensation plans approved by security holders (1)

1,037,300

10.80

1,330,950

Equity compensation plans not approved by security holders (2)

100,000

9.44

—

1,137,300

10.68

1,330,950


(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.

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 April 5, 2008:


Name and Address of	Number of Shares		Percent of
Beneficial Owner	Beneficially Owned		Class⁽¹⁾
Aspen Advisors LLC ⁽²⁾ 152 West 57^th Street New York, NY, 10019		508,460		2.6	%
Sopris Capital Advisors, LLC ⁽²⁾ 314 S. Galena Street, Suite 300 Aspen, CO 81611		2,423,140		12.5	%
Sopris Capital, LLC ⁽²⁾ 314 S. Galena Street, Suite 300 Aspen, CO 81611		1,736,790		8.9	%
EnterAspen Ltd. First Caribbean House, 4^th Floor, P.O. Box 487 Grand Caymen, Cayman Islands, KY1-1106		1,194,810		6.2	%
Nikos Hecht ⁽²⁾ 314 S. Galena Street, Suite 300 Aspen, CO 81611		2,931,600		15.1	%
Berg & Berg Enterprises, LLC ⁽³⁾ 10050 Brandley Drive Cupertino, CA 94014		2,717,000		14.0	%
Dimensional Fund Advisors LP ⁽⁴⁾ 1299 Ocean Avenue, Santa Monica, CA 90401		5,600		0.0	%
Warren B. Kandars⁽⁵⁾ C/o Kanders & Company, Inc. One Landmark Square, 22^nd Floor Stamford, CT 06901		1,930,000		9.9	%


⁽¹⁾		Based on 19,402,012 shares of common stock outstanding as of April 5, 2008.

⁽²⁾		The information as to beneficial ownership is based on a Schedule 13G/A filed with the SEC on February 13, 2008, 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”)
EnterAspen Ltd. (“EnterAspen”)
Nikos Hecht


		Of the shares reported as beneficially owned in this Schedule 13G, 1,736,790 shares are owned directly by Sopris Partners and 508,460 shares are owned by private clients of Aspen Advisors and 686,350 are owned by private clients of Sopris Advisors. Of the shares reported as owned by private clients of


		Aspen Advisors and Sopris Advisors, 1,194,810 are owned by EnterAspen, 508,460 are owned through an account managed by Aspen Advisors, and 686,350 are owned through an account managed by 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. Each of Aspen Advisors and Sopris Advisors is an Attorney-in-Fact for EnterAspen. Mr. Hecht is the managing member of each of Aspen Advisors and of Sopris Advisors 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 February 6, 2008, 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.

⁽⁵⁾		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 April 5, 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		295,000		1.5	%

Bruce D. Smith⁽⁴⁾		150,658		*

LarryD.Fair		56,419		*

L. Gail Moore		38,810		*

WilliamD. Smothers		146,470		*

William A. Sheffield		52,683		*

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 (11 persons)		1,112,522		5.7	%


*		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 June 4, 2008 (60 days from April 5, 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		—
• Mr. Fair:		21,000		12,900
• Ms. Moore:		12,500		20,000
• Mr. Smothers:		21,000		17,100
• Mr. Sheffield:		24,500		15,900
• Mr. Frugé:		18,125		—
• Mr. Knox:		18,125		—
• Mr. Sanders:		8,750		—
• Ms. Weaver:		18,125		—
• Mr. Wein:		8,750		—


⁽³⁾		Based on 19,402,012 shares of common stock outstanding as of April 5, 2008.

⁽⁴⁾		Mr. Smith resigned from the Company effective March 30, 2007. Shares are reflected for this individual as of his termination date.

Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

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

Item 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES

Aggregate fees for professional services rendered for the Company by Burr Pilger & Mayer LLP in 2007 and 2006 were as follows (in thousands):


	Year Ended		Year Ended
	February 2, 2008		February 3, 2007
Audit Fees⁽¹⁾	$	600	$	1,564
Audit-Related Fees⁽¹⁾		—		—
Tax Fees		—		—
All Other Fees		—		—

Total	$	600	$	1,564


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

For purposes of 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.

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 35 of this Report.

	(a)(2)		Financial Statement Schedules

			Schedule II — Valuation and qualifying accounts. (see page 105 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	a		Certificate of Incorporation.
3.2	d		By-Laws.
3.3	s		Amended and Restated By-Laws, effective July 3, 2007.
4.1	g		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	b		Agreement with Continental Stock and Transfer Company (as Rights Agent) dated July 16, 1992.
10.1	d		Form of Indemnification Agreement, dated June 8, 1995, for each of Don L. Frugé and Donna L. Weaver.
10.2	e		Form of Indemnification Agreements for Bruce D. Smith dated December 10, 1996, Larry D. Fair dated June 8, 1995, William A. Sheffield, Jr. dated June 13, 1996, and William D. Smothers dated July 8, 1995.
10.3	e	•	Form of Agreements (deferred compensation) with Bruce D. Smith dated December 10, 1996, Larry D. Fair dated June 13, 1996, William A. Sheffield, Jr. dated June 13, 1996, and William D. Smothers dated June 9, 1988.
10.4	e	•	Form of Severance Agreements with Bruce D. Smith dated December 10, 1996 and Larry D. Fair, William A. Sheffield, Jr., and William D. Smothers dated May 4, 2002.
10.5	e	•	Form of Agreements to Secure Certain Contingent Payments with Bruce D. Smith dated December 10, 1996.
10.6	c	•	Supplemental Retirement Plan, as amended.
10.7	e	•	1996 Stock Option Plan.
10.8	a	•	Extra Compensation Plan.
10.9	f		Indemnification Agreement for Roger T. Knox dated June 21, 1999.
10.10	f	•	Form of Agreement and Renewal of Severance Agreement for Bruce D. Smith dated May 4, 1999.
10.11	h	•	2001 Stock Incentive Plan.
10.12	i	•	Officer Incentive Compensation Plan as amended.
10.13	i	•	Amended and Restated 1995 Restricted Stock Plan and Deferred Stock Unit Plan.
10.14	j	•	Employment Agreement with Jane F. Aggers, dated as of December 15, 2004.
10.15	k	•	2004 Special Stock Plan.
10.16	j	•	Amendment to Agreement and Agreement to secure Certain Contingent Payments with Bruce D. Smith, dated as of March 15, 2005.
10.17	j		Form of Indemnification Agreement, dated September 23, 2004 for Wellford L. Sanders, Jr. and June 10, 2004 for Bernard J. Wein.

100


10.18	l		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.
10.19	l		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.
10.20	l		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.
10.21	l		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.
10.22	l		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.
10.23	l		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.
10.24	l		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.
10.25	l		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.
10.26	l		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.
10.27	m		First Amendment to Wachovia Credit Facility dated July 26, 2005.
10.28	n	•	2005 Stock Compensation Plan for Non-Employee Directors.
10.29	o	•	Amendment to Employment Agreement with Jane F. Aggers, dated December 15, 2004.
10.30	o	•	Amendment No. 1, dated December 9, 2005, to the Amended and Restated Rights Agreement.
10.31	t	•	Severance agreement with Kathleen Kennedy, dated March 15, 2006.
10.32	p	•	Amendment No. 2, dated March 20, 2006, to the Amended and Restated Rights Agreement.
10.33	p	•	Amended and Restated Rights Agreement with Continental Stock Transfer and Trust Company as amended through March 20, 2006.
10.34	t	•	2001 Stock Incentive Plan, as amended.
10.35	t	•	Severance agreement with Gail Moore, dated June 12, 2006.
10.36	q		Fifth Amendment to Wachovia Credit Facility dated October 31, 2006.
10.37	t		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.
10.38	t		Amendment No. 1 to Ratification and Amendment Agreement, and Amendment No. 7 to Wachovia Credit Facility, dated April 19, 2007.
10.39	t	•	Severance agreement with Kathleen Kennedy, dated May 9, 2007.
10.40	t		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.
10.41	s		Loan and Security Agreement (Ableco Facility), dated June 15, 2007.
10.42	*	•	Form of Amendments and Renewals of Severance Agreements for Larry D. Fair, William A. Sheffield and William D. Smothers, Jr. dated March 16, 2005.
10.43	*	•	Form of Amendments to the Deferred Compensation Agreements for Larry D. Fair, William A. Sheffield, Jr. and William D. Smothers dated December 22, 2005.
10.44	u		GE Capital Commitment letter date April 9, 2008.

101


21	*	Subsidiaries of the Registrant.
23.1	*	Consent of Burr, Pilger & Mayer LLP.
31.1	*	Certification of Chief Executive Officer.
31.2	*	Certification of Chief Financial Officer.
32	*	Certification of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. Section 1350.


*		Filed herewith.

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


a		Form 10—K dated April 27, 1992.
b		Form 10—K dated April 26, 1993.
c		Form 10—K dated April 24, 1995.
d		Form 10—K dated April 22, 1996.
e		Form 10—K dated April 22, 1997.
f		Form 10—K dated April 25, 2000.
g		Form 8—K dated April 6, 2001.
h		Form S-8 dated September 7, 2001.
i		Form 10-K dated April 28, 2003.
j		Form 10-K dated April 15, 2005.
k		Form S-8 dated April 14, 2005.
l		Form 8—K dated July 6, 2005.
m		Form 10—Q dated September 8, 2005.
n		Form S-8 (File No. 333-128432) dated September 20, 2005.
o		Form 8—K dated December 9, 2005.
p		Form 8-K dated March 20, 2006.
q		Form 8-K dated November 1, 2006.
r		Form 8-K dated June 20, 2007.
s		Form 8-K dated July 5, 2007.
t		Form 10-K dated February 19, 2008
u		Form 8-K dated April 10, 2008.
•		Denotes management contract or compensatory plan or arrangement.

102

HANCOCK FABRICS, INC.
SCHEDULE II — VALUATION AND QUALIFYING ACCOUNTS
FOR FISCAL YEARS 2007, 2006, AND 2005
(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 2, 2008
Allowance for doubtful accounts	$	56	$	—	$	—		$	—		$	56
Reserve for sales returns		194		62		—			(128	)		128
Reserve for lower of cost or market inventory		338		118		—			(112	)		344
Reserves for store closings		1,864		4,477		—			(945	)		5,396
Asset retirement obligations		476		—		—			(157	)		319
Deferred tax asset valuation allowance		26,109		6,706		464			—			33,279

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


(a)		- Recorded as a component of other comprehensive income (loss) related to minimum pension, SERP, and OPEB liabilities.

105


		Page
PART 1

Item 1.	Business		4
Item 1A.	Risk Factors		9
Item 1B.	Unresolved Staff Comments		15
Item 2.	Properties		16
Item 3.	Legal Proceedings		17
Item 4.	Submission of Matters to a Vote of Security Holders		17

PART II

Item 5.	Market for Registrant’s Common Equity and Related Stockholder Matters and Issuer Purchases of Equity Securities		18
Item 6.	Selected Financial Data		20
Item 7.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		21
Item 7A.	Quantitative and Qualitative Disclosures About Market Risk		34
Item 8.	Consolidated Financial Statements and Supplementary Data		35
Item 9.	Changes in and Disagreements with Accountants on Accounting and Financial Disclosure		74
Item 9A.	Controls and Procedures		74
Item 9B.	Other Information		76

PART III

Item 10.	Directors, Executive Officers and Corporate Governance		77
Item 11.	Executive Compensation		80
Item 12.	Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters		95
Item 13.	Certain Relationships and Related Transactions		99
Item 14.	Principal Accountant Fees and Services		99

PART IV

Item 15.	Exhibits and Financial Statement Schedules		100
Signatures			103
Ex-10.42 Form of Amendments and Renewals of Severance Agreements
Ex-10.43 Form of Amendments to the Deferred Compensation Agreements
Ex-21 Subsidiaries of the Registrant
Ex-23.1 Consent of Burr, Pilger & Mayer LLP
Ex-31.1 Section 302 Certification of the CEO
Ex-31.2 Section 302 Certification of the CFO
Ex-32 Section 906 Certification of the CEO & CFO


	Page

Consolidated Balance Sheets as of February 2, 2008 and February 3, 2007		36

Consolidated Statements of Operations for each of the three years in the period ended February 2, 2008		37

Consolidated Statements of Shareholders’ Equity for each of the three years in the period ended February 2, 2008		38

Consolidated Statements of Cash Flows for each of the three years in the period ended February 2, 2008		39

Notes to Consolidated Financial Statements		40

Reports of Independent Registered Public Accounting Firms		70

Quarterly Financial Data (unaudited)		73


	HANCOCK FABRICS, INC.
	By	/s/ Jane F. Aggers
		Jane F. Aggers
		President, Director and Chief Executive Officer (Principal Executive Officer)


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


Signature				Date

/s/ Jane F. Aggers Jane F. Aggers President, Director and Chief Executive Officer (Principal Executive Officer)				April 17, 2008

/s/ Robert W. Driskell Robert W. Driskell Senior Vice President and Chief Financial Officer (Principal Financial and Accounting Officer)				April 17, 2008

/s/ Don L. Frugé Don L. Frugé Director				April 17, 2008

/s/ Roger T. Knox Roger T. Knox Director				April 17, 2008

/s/ Wellford L. Sanders, Jr. Wellford L. Sanders, Jr. Director				April 17, 2008

/s/ Donna L. Weaver Donna L. Weaver Director				April 17, 2008

/s/ Bernard J. Wein Bernard J. Wein Director				April 17, 2008


	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%



/s/ BURR, PILGER & MAYER LLP San Francisco, California April 17, 2008

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

	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.


/s/ Jane F. Aggers Jane F. Aggers
President and Chief Executive Officer


/s/ Robert W. Driskell Robert W. Driskell
Senior Vice President and
Chief Financial Officer