10-K 1 hkfi20140201_10k.htm FORM 10-K hkfi20140201_10k.htm

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549


 

FORM 10-K

 

[X] Annual Report Pursuant to Section 13 or 15(d) of the

Securities Exchange Act of 1934

For the fiscal year ended January 25, 2014

or

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

Securities Exchange Act of 1934

 

Commission File Number 1 – 9482


 

HANCOCK FABRICS, INC.

(Exact name of registrant as specified in its charter)

 

Delaware 

 

64-0740905

(State or other jurisdiction

 

(I.R.S. Employer

of incorporation or organization)

 

Identification No.)

 

 

 

One Fashion Way, Baldwyn, MS

 

38824

(Address of principal executive offices)

 

(Zip Code)


 

  Registrant’s telephone number, including area code

(662) 365-6000

 

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

 

None.

 

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

 

 

Title of Class

 

Common stock ($.01 par value)

Purchase Rights

Warrants to Purchase Common Stock

 

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

 

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

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes   [X]    No [  ]

 

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

 

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

 

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

Large accelerated filer [ ] Accelerated filer [ ] Non-accelerated filer (Do not check if a smaller reporting company) [ ] Smaller reporting company [ X ]

 

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

 

Our common stock is traded through broker-to-broker exchanges on the OTC Markets (formerly known as the “Pink Sheets”), a centralized quotation service that collects and publishes market maker quotes for over-the-counter securities. The aggregate market value of Hancock Fabrics, Inc. $.01 par value common stock held by non-affiliates, based on 19,569,835 shares of common stock outstanding and the price of $0.99 per share on July 27, 2013 (the last business day of the Registrant’s most recently completed second quarter) was $19,374,137. Such aggregate market value was computed by reference to the closing sale price of our common stock as reported on the OTC Markets on such date. For purposes of making this calculation only, we have defined “affiliates” as all directors and executive officers. This determination of affiliate status is not a conclusive determination for any other purpose.

 

As of April 25, 2014, there were 21,642,853 shares of Hancock Fabrics, Inc. $.01 par value common stock outstanding.

 

 
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HANCOCK FABRICS, INC.

2013 ANNUAL REPORT ON FORM 10-K

 

 TABLE OF CONTENTS

 

PART 1

Page

   

 

Item 1.

Business

4

Item 1A.

Risk Factors

7

Item 1B.

Unresolved Staff Comments

15

Item 2.

Properties

16

Item 3.

Legal Proceedings

16

Item 4.

Mine Safety Disclosures

17

   

 

PART II

 

   

 

Item 5.

Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

17

Item 6.

Selected Financial Data

19

Item 7.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

20

Item 7A.

Quantitative and Qualitative Disclosures About Market Risk

36

Item 8.

Financial Statements and Supplementary Data

37

Item 9.

Changes in and Disagreements with Accountants on Accountin gand Financial Disclosure

66

Item 9A.

Controls and Procedures

66

Item 9B.

Other Information

67

   

 

PART III

 

   

 

Item 10.

Directors, Executive Officers and Corporate Governance

67

Item 11.

Executive Compensation

76

Item 12.

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

82

Item 13.

Certain Relationships and Related Transactions, and Director Independence

85

Item 14.

Principal Accountant Fees and Services

87

   

 

PART IV

 

   

 

Item 15.

Exhibits and Financial Statement Schedules

88

 

Forward-Looking Statements

 

This Annual Report on Form 10-K (“Annual Report”) contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Such statements are not historical facts and reflect our current views regarding matters such as operations and financial performance. In general, forward-looking statements are identified by such words or phrases as “anticipates,” “believes,” “could,” “approximates,” “estimates,” “expects,” “may,” “intends,” “predicts,” “projects,” “plans,” or “will” or the negative of those words or other terminology. Forward-looking statements involve inherent risks and uncertainties; our actual results could differ materially from those expressed in our forward-looking statements. The risks and uncertainties, either alone or in combination, that could cause our actual results to differ from those expressed in our forward-looking statements include, but are not limited to, those that are referred to in Item 1A. “Risk Factors” in this annual report on Form 10-K. Forward-looking statements speak only as of the date made, and we undertake no obligation to update or revise any forward-looking statement.

  

 

 

 

 

PART I

 

Except as otherwise stated, the information contained in this report is given as of January 25, 2014, the end of our latest fiscal year. The words “Hancock Fabrics, Inc.,” “Hancock,” the “Company,” “we,” “our” and “us” refer to Hancock Fabrics, Inc. and, unless the context requires otherwise, to our subsidiaries. During fiscal 2012 we changed the fiscal year end date from the Saturday closest to January 31, to the last Saturday in January. For 2013, 2012 and beyond our fiscal year now ends on the last Saturday in January  and refers to the calendar year ended immediately prior to such date, which contained the substantial majority of the fiscal period (e.g., “fiscal 2013” or “2013” refers to the fiscal year ended January 25, 2014). Fiscal years consist of 52 weeks, unless noted otherwise.

 

Item 1. BUSINESS

 

General

 

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

 

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

 

The Company is one of the largest fabric retailers in the United States, with 2013 sales of $276.0 million. We are a specialty retailer committed to nurturing creativity through a complete selection of fashion and home decorating textiles, sewing accessories, needlecraft supplies and sewing machines. We believe that providing a large assortment of fabric and other items, combined with expert in-store sewing advice, provides us with a competitive advantage. We operated 262 stores in 37 states and an internet store located on our website with the domain name www.hancockfabrics.com as of January 25, 2014.

 

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 2013, we opened three stores, closed two stores, remodeled nine stores, and relocated six existing stores.

 

 
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Merchandising/Marketing

 

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

 

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

 

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

 

Distribution and Supply

 

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

 

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

 

Bulk quantities of fabric are purchased from domestic and foreign mills, fabric jobbers and importers. We have no long-term contracts for the purchase of merchandise and did not purchase more than 4% of our merchandise from any one supplier during 2013. We purchased approximately 14.1% of our merchandise from our top five suppliers in fiscal year 2013.

 

Competition

 

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

 

Information Technology

 

Hancock Fabrics is committed to using information technology to improve operations and efficiency and to enhance the customer shopping experience.  Information obtained from our point-of-sale system enables us to identify important trends, increase in-stock levels of more popular stock keeping units (“SKUs”), eliminate less profitable SKUs, analyze product margins and generate data for the purpose of evaluating advertising and promotions.  A refresh of point-of-sale hardware improved the performance of store systems and provided us a new platform on which to build applications.  New systems to manage fabric cuts and coupons increased productivity at point-of-sale, thereby improving the overall checkout process.  In 2013, key systems were upgraded to increase capacity and performance.  This has provided the resources necessary to develop more sophisticated replenishment and distribution applications.  Additional capacity and performance has also allowed us to improve our reporting and data warehousing.  We continued to leverage our store network to improve perpetual inventory accuracy through new applications.  Our focus remains on inventory control and maximization, and labor management through the implementation and use of efficient systems.

 

 
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Service Mark

 

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

 

Seasonality

 

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

 

Employees

 

At January 25, 2014, we employed approximately 3,300 people on a full-time and part-time basis. Approximately 3,000 of those employees work in our retail stores. The remaining employees work in the Baldwyn headquarters, warehouse, and distribution facility. We do not have any employees covered under collective bargaining agreements.

 

Government Regulation

 

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

 

Environmental Law Compliance

 

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

 

Available Information

 

The Company’s internet address is www.hancockfabrics.com. The information on our website is not incorporated by reference into this report and should not be considered part of this or any other report we file with the Securities and Exchange Commission (“SEC”). Our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to reports filed pursuant to Sections 13(a) and 15(d) of the Securities Exchange Act of 1934, as amended, (the “Exchange Act”) are made available free of charge on our website as soon as practicable after these documents are filed with or furnished to the 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.

 

 
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Section 302 Certification

 

The Chief Executive Officer and Chief Financial Officer of the Company filed the certifications required by Section 302 of the Sarbanes-Oxley Act as exhibits to this Annual Report on Form 10-K for the fiscal year ended January 25, 2014.

 

Item 1A. RISK FACTORS

 

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

 

Risks Related to Our Business

 

Our business and operating results may be adversely affected by the general economic conditions and the ongoing slow economic recovery.

 

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

 

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

 

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

 

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

 

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

 

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

 

Changes in customer demands and failure to manage inventory effectively could adversely affect our operating results.

 

Our financial condition and operating results are dependent upon our ability to anticipate and respond in a timely manner to changing customer demands and preferences for our products. A miscalculation in the anticipated demands of our customers could result in a significant overstock of unpopular products which could lead to major inventory markdowns, resulting in negative consequences to our operating results and cash flow. Likewise, a shortage of popular products could lead to negative operating results and cash flow. In addition, inventory shrink (inventory theft or loss) rates and failure to manage such rates could adversely affect our business, financial condition and operating results.

 

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

 

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

 

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

 

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

 

 
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Interest rate increases could negatively impact profitability.

 

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

 

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

 

At January 25, 2014, we had outstanding long-term indebtedness of $81.3 million. Our significant indebtedness could have important negative consequences to us, including:

 

 

making it more difficult for us to satisfy our obligations with respect to such indebtedness;

 

increasing our vulnerability to adverse general economic and industry conditions;

 

exhausting the amount available to borrow under our current credit lines if operating results do not improve;

 

limiting our ability to obtain additional financing to fund capital expenditures or other growth initiatives, and other general corporate requirements;

 

requiring us to dedicate a significant portion of our cash flow from operations to interest and principal payments on our indebtedness, thereby reducing the availability of our cash flow to fund capital expenditures or other growth initiatives, and other general corporate requirements;

 

limiting our flexibility in planning for, or reacting to, changes in our business and the industry in which we operate;  

 

placing us at a competitive disadvantage compared to our less leveraged competitors;

 

limiting our ability to fund the required cash contributions to the defined benefit pension plan; and

 

limiting our ability to refinance our existing indebtedness as it matures.

 

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

 

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

 

Our business is dependent on the availability of credit to fund working capital, capital expenditures and other general corporate requirements. Our credit facilities are scheduled to expire on November 15, 2016 and our floating rate secured notes mature on November 20, 2017. We can provide no assurance that we will be able to obtain replacement financing at that time on acceptable terms or at all. While we believe we can meet our capital requirements from our operations and our available sources of financing for the next twelve months, we can provide no assurances that we will be able to do so for the long-term. If we are unable to access financial markets at competitive rates, our ability to implement our business plan and strategy will be negatively affected.

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

Approximately 91% of our store shipments pass through our distribution center. The remainder of merchandise is drop-shipped by our vendors directly to our store locations. Damage or interruption to our distribution center from factors such as fire, power loss, storm damage or unanticipated supplier shipment delays could cause a disruption in our operations. The occurrence of unanticipated problems at our distribution center would likely result in increased operating expenses and reduced sales that would negatively impact our operating results.

 

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

 

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

 

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

 

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

 

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

 

Due to our history of losses over the three year period ended January 25, 2014, we have not generated positive operating cash flow during such period. If we do not generate positive cash flow from operations, we will need to develop and implement alternative strategies. These alternative strategies could include seeking improvements in working capital management, reducing or delaying capital expenditures, restructuring or refinancing our indebtedness, seeking additional debt or financing, and selling assets. There can be no assurance that any of these strategies could be implemented on satisfactory terms, on a timely basis, or at all.

 

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

 

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

 

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

 

We have become more dependent upon automated information technology processes, including use of the internet for conducting a portion of our business. The regulatory environment surrounding information security and privacy is increasingly demanding, with the frequent imposition of new and constantly changing requirements. In connection with credit card sales, we transmit confidential credit card information. Information may be compromised through various means, including penetration of our network security, hardware tampering, and misappropriation of confidential information. We have a program in place to detect and respond to data security incidents. However, because the techniques used to obtain unauthorized access, disable or degrade service, or sabotage systems changes frequently and may be difficult to detect for long periods of time, we may be unable to anticipate these techniques or implement adequate preventive measures. In addition, hardware, software or applications we develop or procure from third parties may contain defects in design or manufacture or other problems that could unexpectedly compromise information security. Unauthorized parties may also attempt to gain access to our systems or facilities through fraud, trickery or other forms of deceiving our team members, contractors and temporary staff. Failure to maintain the security of confidential information could result in deterioration in our employees’ and customers’ confidence in us, expose us to litigation and liability, and any breach in the security and integrity of other business information could put us at a competitive disadvantage, resulting in a material adverse impact on our financial condition and results of operations.

 

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

 

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

 

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

 

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

 

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

 

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

 

Our results may be adversely affected by serious disruptions or catastrophic events, including geo-political events and weather.

 

Unforeseen public health issues, such as pandemics and epidemics, and geo-political events, such as civil unrest in a country in which our suppliers are located or terrorist or military activities disrupting transportation, communication or utility systems, as well as natural disasters such as hurricanes, typhoons, tornadoes, floods, earthquakes and other adverse weather and climate conditions, whether occurring in the U.S. or abroad, particularly during peak seasonal periods, could disrupt our operations or the operations of one or more of our vendors or could severely damage or destroy one or more of our stores or distribution facilities located in the affected areas. Day to day operations, particularly our ability to receive products from our vendors or transport products to our stores could be adversely affected, or we could be required to close stores or distribution centers in the affected areas or in areas served by the affected distribution center. These factors could also cause consumer confidence and spending to decrease or result in increased volatility in the U.S. and global financial markets and economy. Such occurrences could significantly impact our operating results and financial performance. As a result, our business could be adversely affected.

 

Changes in newspaper subscription rates may result in reduced exposure to our circular advertisements.

 

A substantial portion of our promotional activities utilize circular advertisements in local newspapers. A continued decline in consumer subscriptions of these newspapers could reduce the frequency with which consumers receive our circular advertisements, thereby negatively affecting sales, results of operations and cash flow.

 

Unexpected or unfavorable consumer responses to our promotional or merchandising programs could materially adversely affect our sales, results of operations, cash flow and financial condition.

 

Brand recognition, quality and price have a significant influence on consumers’ choices among competing products and brands. Advertising, promotion, merchandising and new product introductions also have a significant impact on consumers’ buying decisions. If we misjudge consumer responses to our existing or future promotional activities, this could have a material adverse impact on our sales, results of operations, cash flow and financial condition.

 

We believe improvements in our merchandise offering help drive sales at our stores. We could be materially adversely affected by poor execution of changes to our merchandise offering or by unexpected consumer responses to changes in our merchandise offering.

 

 
13

 

 

New regulations related to “conflict minerals” may force us to incur additional expenses, may make our supply chain more complex and may result in damage to our reputation with customers.

 

On August 22, 2012, under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, or the Dodd-Frank Act, the SEC adopted new requirements for companies that use certain minerals and metals, known as conflict minerals, in their products, whether or not these products are manufactured by third parties. These requirements will require companies to diligence, disclose and report whether or not such minerals originate from the Democratic Republic of Congo and adjoining countries. We will have to diligence whether such minerals are used in the manufacture of our products. However, the implementation of these new requirements could adversely affect the sourcing, availability and pricing of such minerals if they are found to be used in the manufacture of our products. In addition, we will incur additional costs to comply with the disclosure requirements, including costs related to determining the source of any of the relevant minerals and metals used in our products. Since our supply chain is complex, we may not be able to sufficiently verify the origins for these minerals and metals used in our products through the due diligence procedures that we implement, which may harm our reputation. In such event, we may also face difficulties in satisfying customers who require that all of the components of our products are certified as conflict mineral free. The first report is due on May 31, 2014 for the 2013 calendar year.

 

Risks Related to Our Common Stock

 

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

 

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

 

Our stock price has been volatile and could decrease in value.

 

There has been significant volatility in the market price and trading volume of equity securities, in many cases unrelated to the financial performance of the companies. These broad market fluctuations may negatively affect the market price of shares of our common stock. Fluctuations in the market price of our common stock may be caused by changes in our operating performance or prospects and other factors, including, among others:

 

 

actual or anticipated fluctuations in our operating results or future prospects;

 

 

our announcements or our competitors’ announcements of new products;

 

 

public reaction to our press releases, our other public announcements and our filings with the SEC;

 

 

strategic actions by us or our competitors;

 

 

changes in financial markets or general economic conditions;

 

 
14

 

 

 

our ability to raise additional capital as needed;

 

 

developments regarding our patents or proprietary rights or those of our competitors; and

 

 

changes in stock market analyst recommendations or earnings estimates regarding shares of our common stock, other comparable companies or our industry generally.

 

 

Future sales of our common stock could adversely affect the market price of our common stock and our future capital-raising activities could involve the issuance of equity securities, which could result in a decline in the trading price of shares of our common stock.

 

We may sell securities in the public or private equity markets if and when conditions are favorable, even if we do not have an immediate need for additional capital at that time. Sales of substantial amounts of common stock, or the perception that such sales could occur, could adversely affect the prevailing market price of shares of our common stock and our ability to raise capital. We currently have outstanding warrants to purchase an aggregate of up to 9,838,000 shares of the Company’s common stock for an exercise price of $0.59 per share that are exercisable at any time until November 20, 2019 on a cashless basis pursuant to the terms of the warrants. We may issue additional shares of our common stock in future financing transactions or as incentive compensation for our executive management and other key personnel, consultants and advisors. Issuing any equity securities would be dilutive to the equity interests represented by our-then-outstanding shares of our common stock. The market price for shares of our common stock could decrease as the market takes into account the dilutive effect of any of these issuances.

 

We do not expect to pay cash dividends on shares of our common stock for the foreseeable future.

 

We do not anticipate that any cash dividends will be paid on shares of our common stock in the foreseeable future. Any future determination relating to our dividend policy will be made at the discretion of our board of directors and will depend on a number of factors, including future earnings, capital requirements, financial conditions, future prospects, contractual restrictions and other factors that our board of directors may deem relevant. The Company’s credit facilities also contain covenants restricting the ability of the Company and its subsidiaries to pay dividends or distributions.

 

 

Item 1B. UNRESOLVED STAFF COMMENTS

 

None.

 

 
15

 

 

Item 2. PROPERTIES

 

As of January 25, 2014, the Company operated 262 stores in 37 states. The number of store locations in each state is shown in the following table:

 

 

Number

 

Number

State

of Stores

State

of Stores

           

Alabama

11

 

Nebraska

4

 

Arizona

2

 

Nevada

3

 

Arkansas

9

 

New Mexico

2

 

California

10

 

North Carolina

14

 

Colorado

3

 

North Dakota

1

 

Florida

5

 

Ohio

5

 

Georgia

15

 

Oklahoma

10

 

Idaho

4

 

Oregon

2

 

Illinois

12

 

Pennsylvania

1

 

Indiana

5

 

South Carolina

 

Iowa

7

 

South Dakota

2

 

Kansas

4

 

Tennessee

11

 

Kentucky

8

 

Texas

29

 

Louisiana

12

 

Utah

5

 

Maryland

5

 

Virginia

10

 

Minnesota

10

 

Washington

7

 

Mississippi

6

 

Wisconsin

8

 

Missouri

9

 

Wyoming

1

 

Montana

1

       

 

 

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

 

Store Development Program

 

Year

 

Opened

 

Closed

 

Net Change

 

Year-end Stores

 

Relocated

2009

 

3

 

(1)

 

2

 

265

 

2

2010

 

1

 

(1)

 

-

 

265

 

7

2011

 

1

 

(3)

 

(2)

 

263

 

5

2012

 

1

 

(3)

 

(2)

 

261

 

8

2013

 

3

 

(2)

 

1

 

262

 

6

 

The Company’s 262 retail stores average 13,995 square feet and are located principally in strip shopping centers.

 

With the exception of one owned location, the Company’s retail stores are leased. The original lease terms generally are ten years in length and most leases contain one or more renewal options, usually of five years in length. During fiscal 2014, thirty-four store leases are scheduled to expire. We currently have negotiated or are in the process of negotiating renewals on certain leases.

 

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

 

Reference is made to the information contained in Note 6 to the accompanying Consolidated Financial Statements for information concerning our long-term obligations under leases.

 

Item 3. LEGAL PROCEEDINGS

 

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

  

 
16 

 

 

Item 4. MINE SAFETY DISLOSURES          

 

Not applicable.

 

PART II

 

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

 

There is currently no established public trading market for our common stock. Our common stock is currently quoted on the OTC Markets, formerly known as the “Pink Sheets”, under the symbol “HKFI.PK”. The OTC Markets is a centralized quotation service that collects and publishes market maker quotes for over-the-counter securities in real time. Over-the-counter market quotations, like those on the OTC Markets, reflect inter-dealer prices, without retail mark-up, mark-down, or commission and may not necessarily represent actual transactions. The following table sets forth the high and low closing prices of our common stock for the year and during each quarter in fiscal 2012 and 2013, as reported by the OTC Markets:

 

   

High

   

Low

 

2012

               

First Quarter

  $ 1.01     $ 0.70  

Second Quarter

    0.87       0.45  

Third Quarter

    0.70       0.35  

Fourth Quarter

    0.70       0.46  
                 

Year Ended

               

January 26, 2013

  $ 1.01     $ 0.35  
                 

2013

               

First Quarter

  $ 0.73     $ 0.47  

Second Quarter

    1.10       0.72  

Third Quarter

    1.33       0.81  

Fourth Quarter

    1.10       0.82  
                 

Year Ended

               

January 25, 2014

  $ 1.33     $ 0.47  

 

As of January 25, 2014, there were 3,363 record holders of our common stock.

 

We did not pay any cash dividends during fiscal 2013 or 2012. We do not currently anticipate declaring or paying cash dividends on shares of our common stock in the foreseeable future. We currently intend to retain all of our future earnings, if any, to finance operations. Any future determination relating to our dividend policy will be made at the discretion of our board of directors and will depend on a number of factors, including future earnings, capital requirements, financial conditions, future prospects, contractual restrictions and other factors that our board of directors may deem relevant. The Company’s credit facilities also contain covenants restricting the ability of the Company and its subsidiaries to pay dividends or distributions.

 

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

 

 
17

 

 

Issuer Purchases of Equity Securities

 

This table provides information with respect to purchases by the Company of shares of our common stock during the year ended January 25, 2014:

 

 

Issuer Purchases of Equity Securities

 

Period

 

Total number of

Shares Purchased (1)

   

Average Price

Paid Per Share

   

Total Number of

Shares Purchased as

Part of Publicly

Announced Plans (2)

   

Maximum

Number of Shares That

May Yet Be Purchased

Under the Plans (2)

 

January 27, 2013 through

                               

February 23, 2013

    27,108     $ 0.50       -       243,327  

February 24,2013 through

                               

March 30, 2013

    2,034       0.55       -       243,327  

March 31, 2013 through

                               

April 27, 2013

    -       -       -       243,327  

April 28, 2013 through

                               

May 25, 2013

    -       -       -       243,327  

May 26, 2013 through

                               

June 29, 2013

    830       0.91       -       243,327  

June 30, 2013 through

                               

July 27, 2013

    -       -       -       243,327  

July 28, 2013 through

                               

August 24, 2013

    -       -       -       243,327  

August 25, 2013 through

                               

September 28, 2013

    1,610       1.02       -       243,327  

September 29, 2013 through

                               

October 26, 2013

    1,350       0.99       -       243,327  

October 27, 2013 through

                               

November 23, 2013

    -       -       -       243,327  

November 24, 2013 through

                               

December 28, 2013

    151       0.91       -       243,327  

December 29, 2013 through

                               

January 25, 2014

    34,936       1.01       82       243,245  

Total January 27, 2013 through

                               

January 25, 2014

    68,019     $ 0.79       82       243,245  

  

 

(1)

The number of shares purchased during the year includes 67,937 shares deemed surrendered to the Company to satisfy tax withholding obligations arising from the lapse of restrictions on shares.

 

 

(2)

In June of 2000, the Board of Directors authorized the repurchase of up to 2,000,000 shares of the Company’s Common Stock from time to time when warranted by market conditions. There have been 1,756,755 shares purchased under this authorization through January 25, 2014. The shares discussed in footnote (1) are excluded from this column.

 

 
18

 

 

Item 6. SELECTED FINANCIAL DATA

 

Set forth below is selected financial information of the Company for each fiscal year in the 5-year period ended January 25, 2014. 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)

 

2013

   

2012

   

2011

   

2010

   

2009

 
                                         

Results of Operations Data:

                                       

Sales

  $ 276,030     $ 277,989     $ 271,993     $ 275,465     $ 274,058  

Gross profit

    118,755       112,137       112,725       114,645       121,717  

(Loss) income from continuing operations before income taxes

    (1,942 )     (8,510 )     (11,298 )     (10,258 )     1,838  

Income from discontinued operations, net of tax

    -       -       -       29       150  

Net (loss) income

    (1,942 )     (8,510 )     (11,298 )     (10,461 )     1,788  

As a percentage of sales

    (0.7

)%

    (3.1

)%

    (4.2

)%

    (3.8

)%

    0.6

%

As a percentage of average shareholders' equity

    (69.7

)%

    (104.0

)%

    (46.4

)%

    (25.5

)%

    3.8

%

                                         

Financial Position Data:

                                       

Total assets

  $ 155,072     $ 150,532     $ 146,387     $ 140,923     $ 148,546  

Capital expenditures

    4,509       2,698       4,934       5,392       3,084  

Long-term indebtedness

    81,296       72,181       52,320       31,856       30,126  

Common shareholders' equity

    3,082       2,491       13,871       34,837       47,212  

Current ratio

    3.4       3.4       3.0       2.9       2.8  
                                         

Per Share Data:

                                       

Basic (loss) earnings per share

  $ (0.09 )   $ (0.42 )   $ (0.57 )   $ (0.53 )   $ 0.09  

Diluted (loss) earnings per share

    (0.09 )     (0.42 )     (0.57 )     (0.53 )     0.09  

Cash dividends per share

    -       -       -       -       -  

Shareholders' equity per share

    0.14       0.12       0.68       1.74       2.37  
                                         

Other Data:

                                       

Number of states

    37       37       37       37       37  

Number of stores

    262       261       263       265       265  

Number of shareholders

    3,363       3,448       3,489       3,561       3,676  

Number of shares outstanding, net of treasury shares

    21,641,004       21,570,797       20,511,123       20,068,327       19,902,148  

Comparable sales change

    (0.1

)%

    2.9

%

    (0.8

)%

    (0.1

)%

    0.2

%

Total selling square footage

    3,149,495       3,194,594       3,217,307       3,250,427       3,036,444  

 

 
19

 

 

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

 

Overview

 

Hancock Fabrics, Inc. is a specialty retailer committed to nurturing creativity through a complete selection of fashion and home decorating textiles, sewing accessories, needlecraft supplies and sewing machines. We are one of the largest fabric retailers in the United States, operating 262 stores in 37 states as of January 25, 2014. Our stores present a broad selection of fabrics and notions used in apparel sewing, home decorating and quilting projects. The stores average 13,995 total square feet, of which 12,021 are on the sales floor. During 2013, the average annual sales per store were approximately $1.0 million.

 

Significant financial items during fiscal 2013 include:

 

 

Sales for fiscal 2013 were $276.0 million compared with $278.0 million in fiscal 2012, and comparable store sales decreased by 0.1% in 2013 compared to an increase of 2.9% in 2012.

 

 

Our online sales for 2013, which are included in the sales and comparable sales results above, decreased 0.8% to $5.1 million.

 

 

Operating results and net loss for 2013, 2012 and 2011 as adjusted for one-time and non-comparable items are summarized in the table below.

 

The Company has presented normalized operating income (loss) and normalized net loss to provide investors with additional information to evaluate our operating performance and our ability to service our debt. The Company uses these measurements, among other metrics to evaluate operating performance and to plan and forecast future periods’ operating performance.

 

Normalized operating income (loss) and normalized net loss are not measures of operating performance calculated in accordance with GAAP and should not be considered in isolation of, or as a substitute for operating income (loss) or net loss, as an indicator of operating performance. Since the computation of normalized operating income (loss) and normalized net loss may differ from similarly titled measures used by other companies and industries, it should not be used as a measure of performance among companies. The table below shows a reconciliation of normalized operating income (loss) to operating income (loss) and a reconciliation of normalized net loss to net loss, the most directly comparable GAAP financial measures.

 

 
20

 

 

   

Fiscal Year

 
   

2013

   

2012

   

2011

 
                         

Operating income (loss)

  $ 4,025     $ (1,233 )   $ (6,462 )
                         

One-time, non-comparable items

                       

Asset impairment

    -       -       1,666  

Contract arbitration professional fees

    -       413       1,614  

Severance related costs

    -       -       401  

CEO relocation costs

    -       -       300  

Total one-time, non-comparable items

    -       413       3,981  
                         

Normalized operating income (loss)

  $ 4,025     $ (820 )   $ (2,481 )
                         

Net loss

  $ (1,942 )   $ (8,510 )   $ (11,298 )

Items above

    -       413       3,981  

W/O unamortized discount, 2008 facility

    -       806       -  

W/O unamortized loan cost, 2008 facility

    -       175       -  

Financing breakup fees

    -       507       -  

Total one-time, non-comparable items

    -       1,901       3,981  
                         

Normalized net loss

  $ (1,942 )   $ (6,609 )   $ (7,317 )

 

During 2012 and 2011, the Company had to defend itself related to a disputed consulting agreement. The professional fees incurred for this defense were $413,000 and $1.6 million, respectively.

 

As a result of the debt restructuring the Company undertook during 2012 it incurred additional or non-recurring cost which were charged to interest expense. Those costs include $0.8 million of discount written-off related to the early retirement of a portion of the Company’s Floating Rate Series A secured notes, $175,000 of unamortized loan cost related to the revolver under the Company’s loan and security agreement dated as of August 1, 2008, which was amended and restated on November 15, 2012 and $0.5 million of legal and breakup fees paid to Wells Fargo Capital Finance for an uncompleted financing arrangement.

 

For 2011, the asset impairment charge of $1.4 million is the difference between asset values and projected future cash flows related to specific store locations plus $259,000 of goodwill impairment.

 

For 2011, severance costs of $401,000 related to the departure of one Senior Vice-President and three Vice-Presidents of the Company during the prior fiscal year. The relocation costs of $300,000 cover the relocation payment and reimbursements as provided in the Company CEO’s employment agreement.

 

 
21

 

 

Excluding the one-time charges outlined above, which total approximately $1.9 million in 2012, the net loss for 2012 would have been $6.6 million or $0.33 per basic share, excluding the $4.0 million in 2011, the net loss for 2011 would have been $7.3 million or $0.37 per basic share.

 

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

 

   

Fiscal Year

 
   

2013

   

2012

   

2011

 
                         

Sales (in thousands)

  $ 276,030     $ 277,989     $ 271,993  
                         

Gross margin percentage

    43.0

%

    40.3

%

    41.4

%

                         

Number of stores

                       

Open at end of period(1)

    262       261       263  

Comparable stores at year end (2)

    259       260       262  
                         

Sales growth

                       

All retail outlets

    (0.7

)%

    2.2

%

    (1.3

)%

Comparable retail outlets (3)

    (0.1

)%

    2.9

%

    (0.8

)%

                         

Total store square footage at year end (in thousands)

    3,667       3,723       3,751  
                         

Net sales per total square footage

  $ 75     $ 75     $ 73  

 

 

(1)

Open store count does not include the internet store.

   

(2)

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

   

(3)

Sales growth for comparable retail outlets also includes net sales derived from E-commerce.

 

 
22

 

 

Results of Operations

 

The following table sets forth, for the periods indicated, selected statement of operations data expressed as a percentage of sales. This table includes the $1.9 million, and $4.0 million of one-time and non-comparable charges occurring in 2012 and 2011 respectively, and should be read in conjunction with the following discussion and with our Consolidated Financial Statements, including the related notes.

 

   

Fiscal Year

 
                         
   

2013

   

2012

   

2011

 

Sales

    100.0

%

    100.0

%

    100.0

%

Cost of goods sold

    57.0       59.7       58.6  

Gross profit

    43.0       40.3       41.4  

Selling, general and administrative expenses

    40.2       39.4       42.3  

Depreciation and amortization

    1.3       1.3       1.5  

Operating income (loss)

    1.5       (0.4 )     (2.4 )

Interest expense, net

    2.2       2.6       1.8  

Loss before income taxes

    (0.7 )     (3.0 )     (4.2 )

Income taxes

    -       -       -  

Net loss

    (0.7

)%

    (3.0

)%

    (4.2

)%

 

Sales

 

(in thousands)

 

Fiscal Year

 
   

2013

   

2012

   

2011

 

Retail comparable store base

  $ 267,668     $ 269,559     $ 264,687  

E-Commerce

    5,121       5,164       4,782  

Comparable sales

    272,789       274,723       269,469  

New stores

    2,115       649       616  

Closed stores

    1,126       2,617       1,908  

Total sales

  $ 276,030     $ 277,989     $ 271,993  

 

The retail comparable store base above consists of sales which were included in the comparable sales computation for the year. Retail comparable store sales decreased by 0.1% in 2013, increased by 2.8% in 2012, and declined 0.7% in 2011. This resulted from a 5.2% increase in average ticket and a 5.3% decrease in transactions in fiscal 2013, and a 6.5% increase in average ticket and a 3.7% decrease in transactions in fiscal 2012.

 

Sales provided by our E-commerce channel decreased by 0.8% in 2013, increased by 8.0% in 2012 and decreased by 7.9% in 2011. We believe the downturn in 2011 was attributable to merchandising issues which were recognized during the year, but could not be fully corrected.

 

New stores for 2013 include the results for four locations, one which was not comparable until it reached its 53rd week of operation and three which opened during the year. Two stores closed in 2013 and three stores closed in each of 2012 and 2011, none of which qualified as discontinued operations.

 

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

 

 
23

 

 

Our sales by merchandise category is reflected for the last three years in the table below:

 

   

Fiscal Year

 
   

January 25,

2014

   

January 26,

2013

   

January 28,

2012

 
                         

Apparel and Craft Fabrics

    44 %     43 %     43 %

Home Decorating Fabrics

    11 %     11 %     12 %

Sewing Accessories

    32 %     32 %     31 %

Non-Sewing Products

    13 %     14 %     14 %
      100 %     100 %     100 %

 

We are constantly making adjustments to our merchandise mix based on anticipated consumer demand and current sales trends. As shown by the results, only minor changes have occurred in our product mix over the last three years. Apparel and craft fabrics improved slightly, due to strong demand for products within this category. Non-sewing products have declined slightly as the Company has reduced its focus on adding craft products.

 

Gross Margin

 

Costs of goods sold include:

 

 

the cost of merchandise

 

 

inventory rebates and allowances including term discounts

 

 

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

 

 

freight charges

 

 

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

 

 

costs associated with receiving, processing, and warehousing merchandise

 

The classification of these expenses varies across the retail industry.

 

 
24

 

 

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

 

(in thousands)

 

2013

   

% of Sales

   

2012

   

% of Sales

   

2011

   

% of Sales

 
                                                 

Total sales

  $ 276,030       100.0 %   $ 277,989       100.0 %   $ 271,993       100.0 %
                                                 

Merchandise cost

    135,351       49.1 %     142,141       51.2 %     135,570       49.9 %

Freight

    9,190       3.3 %     9,805       3.5 %     9,506       3.5 %

Sourcing and warehousing

    12,734       4.6 %     13,906       5.0 %     14,192       5.2 %
                                                 

Gross Profit

  $ 118,755       43.0 %   $ 112,137       40.3 %   $ 112,725       41.4 %

 

Merchandise cost declined by 210 basis points for 2013 as compared to 2012 primarily due to adjustments to our pricing strategy which were implemented in the fourth quarter of 2012 and inventory shrink improvement. Merchandise cost increased for 2012 over 2011 primarily due to aggressive promotional activity during the first three quarters of the year which was necessary to be competitive. Merchandising issues in our core product lines during 2011 required aggressive promotions late in 2011 to regain customer traffic lost earlier in the year.

 

Freight costs have benefited from stable fuel cost during the years presented and continued improvements in our shipping process.

 

Sourcing and warehousing costs expensed through costs of goods sold is impacted by both the volume of inventory received and shipped during any period, and the rate at which inventory turns. For 2013, the sourcing and warehousing cost capitalized into inventory was relatively constant as compared to 2012, but reduced from 2011 and inventory turns have declined in each of the three years presented.

 

In total, 2013 gross profit improved by 270 basis points after a decline of 110 basis points in 2012 as compared to 2011. Our business continues to be highly promotional but management believes the current pricing strategy will allow it to maintain the 2013 gross profit levels for 2014 while offering consumers price events necessary to drive sales volume.

 

Selling, General and Administrative Expenses

 

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

 

 

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

 

 

advertising

 

 

general and administrative expenses

 

 

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

 

 

operating costs of our headquarter facilities

 

 

other expense (income)

 

 
25

 

 

Specific components of selling, general and administrative expenses include:

 

(in thousands)

 

2013

   

% of Sales

   

2012

   

% of Sales

   

2011

   

% of Sales

 
                                                 

Retail store labor costs

  $ 40,228       14.6 %   $ 39,647       14.3 %   $ 41,291       15.2 %

Advertising

    11,139       4.0 %     10,018       3.6 %     9,618       3.5 %

Store occupancy

    30,068       10.9 %     29,916       10.8 %     30,325       11.1 %

Retail SG&A

    18,662       6.8 %     19,685       7.1 %     20,953       7.7 %

Corp SG&A

    11,010       3.9 %     10,387       3.6 %     12,860       4.8 %
                                                 

Total SG&A

  $ 111,107       40.2 %   $ 109,653       39.4 %   $ 115,047       42.3 %

 

Retail Store Labor Costs – Store labor costs were allowed to increase slightly in 2013 to ensure customer service levels were maintained after a significant reduction in 2012 as compared to 2011, as a result of greater corporate oversight. We will continue to leverage our technology investment in store infrastructure to improve labor efficiency and enhance store performance.

 

Advertising – Our advertising medium is primarily direct mail and newspaper inserts, and for the near term we believe this combination is the most effective, although we will continue to explore the effectiveness of other advertising channels. Advertising cost has increased in each of the three years presented as we’ve expanded or added events to drive customer traffic. For 2014, we have made improvements to our marketing program which management believes will allow us to expand the reach of our advertising events without significantly impacting costs.

 

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

 

Retail SG&A – Retail selling, general and administrative expenses declined in 2013 primarily due to commission income from a third party loyalty program being promoted by store associates. This category also benefited from reduced insurance claims and a reduction in expenditures for store supplies. The decline in costs for 2012 can be attributed to a reduction in outside janitorial services, lower insurance related costs and a decline in credit card fees.

 

Corporate SG&A – These are costs related primarily to staffing and operation of the Company’s headquarters. The increase for 2013 over 2012, occurred from additional payroll and relocation costs for corporate personnel, increased contract labor and incentive compensation, partially offset by reduced professional fees. In addition to normal recurring expenses, which include the write-off of the one remaining pre-petition obligation in 2011, this category includes the following one-time or non-comparable expenses for 2012 and 2011. For 2012 and 2011 respectively, $413,000 and $1.6 million related to contract arbitration professional fees. For 2011, relocation charges of $300,000 were recorded which relate to the Company CEO’s relocation payment and expenses, severance expenses of $401,000 and an asset impairment charge of $1.7 million was recorded. Excluding these one-time, non-comparable items, 2012 and 2011 corporate SG&A would have been $10.0 million and $8.9 million, respectively.

 

 
26

 

 

Interest Expense, Net

 

(in thousands)

 

2013

   

% of Sales

   

2012

   

% of Sales

   

2011

   

% of Sales

 
                                                 

Interest expense, net

  $ 5,967       2.2 %   $ 7,277       2.6 %   $ 4,836       1.8 %

 

Our interest costs are driven by borrowings on our credit facilities. Our current credit facilities consist of both an asset based facility and a subordinated debt facility. In addition to the one-time, non-recurring items included in 2012 interest expense as a result of the debt restructuring discussed above, both 2013 and 2012 were impacted by higher average outstanding borrowings and the higher interest rates under the amended and restated revolving credit agreement. Interest expense includes non-cash bond discount amortization costs of $379,000 for 2013, $3.1 million for 2012 and $2.3 million for 2011.

 

Income Taxes

 

(in thousands)

 

2013

   

% of Sales

   

2012

   

% of Sales

   

2011

   

% of Sales

 
                                                 

Income taxes

  $ -       0.0 %   $ -       0.0 %   $ -       0.0 %

 

No income tax expense was recognized in 2013, 2012, or 2011. Total net deferred tax assets and liabilities are fully reserved with a valuation allowance.

 

 

Liquidity and Capital Resources

 

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

 

Due to our history of losses over the three year period ended January 25, 2014, we have not generated positive operating cash flow during such period. During the years ended January 25, 2014, January 26, 2013 and January 28, 2012, the Company had a net loss of $1.9 million, $8.5 million and $11.3 million, respectively and net cash used in operating activities for the corresponding periods was $5.7 million, $11.3 million and $13.3 million, respectively. As a result, since fiscal 2011, we have increasingly relied on bank borrowings for our capital needs to fund the Company’s working capital needs, its required cash contribution to the Company’s defined benefit pension plan, for capital expenditures, and losses from operations.

 

At January 25, 2014, the Company had outstanding long-term indebtedness of $81.3 million compared to $31.9 million as of January 29, 2011. As a consequence of our significant amount of indebtedness as of January 25, 2014, a significant portion of our cash flow from operations must be dedicated to interest and principal payments on our indebtedness, thereby reducing the availability of our cash flow to fund capital expenditures or other growth initiatives and other general corporate requirements, see “Item 1A. Risk Factors − Risks Related to Our Business − We have a significant amount of indebtedness, which could have important negative consequences to us.” In addition, at January 25, 2014, the Company had limited cash resources, with cash of $1.8 million, see “Item 1A. Risk Factors − Risks Related to Our Business − Our current cash resources might not be sufficient to meet our expected near-term cash needs.

 

 
27

 

 

Our short-term and long-term liquidity needs arise primarily from our working capital requirements, required cash contributions to the defined benefit pension plan, planned capital expenditures and debt service requirements. We anticipate that capital expenditures for the fiscal year ending January 31, 2015 will be approximately $3.8 to $4.2 million, primarily for store and technology upgrades. We anticipate that we will be able to satisfy our short-term and long-term liquidity needs highlighted above through the next twelve months with available cash, proceeds from cash flows from operations, short-term trade credit, borrowings under our revolving credit facility (the “Revolver”) and other sources of financing. As of January 25, 2014, we have $16.6 million available to borrow under the Revolver. We consolidate our daily cash receipts into a centralized account. In accordance with the terms of our $100.0 million Revolver, on a daily basis, all collected and available funds are applied to the outstanding loan balance. We then determine our daily cash requirements and request those funds from the Revolver availability.

 

Our ability to improve our liquidity in future periods will depend on generating positive operating cash flow, primarily through comparable store sales increases, improved gross margin and controlling our expenses, which in turn, may be impacted by prevailing economic conditions and other financial and business factors, some of which are beyond our control, see “Item 1A. Risk Factors” in this report.”     

 

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

 

   

2013

   

2012

   

2011

 
                         

Net cash flows provided by (used in):

                       

Operating activities

  $ (5,700 )   $ (11,278 )   $ (13,255 )

Investing activities

    (4,487 )     (2,439 )     (4,586 )

Financing activities

    7,931       15,131       18,117  

 

Operating Activities

 

In 2013, the net loss plus non-cash adjustments to reconcile net loss to cash flow from operations, provided $5.2 million compared to $0.9 million for 2012; inventory increased $6.6 million, accounts payable increased by $1.7 million and a cash contribution of $5.4 million was made to the defined benefit pension plan.

 

In 2012, the net loss plus non-cash adjustments to reconcile net loss to cash flow from operations, provided $0.9 million compared to a loss of $5.2 million for 2011; inventory increased by $5.0 million, accrued liabilities declined by $2.4 million and a cash contribution of $5.0 million was made to the defined benefit pension plan.

 

We believe future inventory reductions can be obtained as we refine our supply chain management systems, but this additional efficiency did not occur in 2013, 2012 or 2011 and may not occur in the near-term as we continue to modify our product offering to drive sales growth.

 

Accounts payable as a percentage of inventory was 19.1%, 18.5% and 20.2% at year-end 2013, 2012 and 2011, respectively.

 

 
28

 

 

The Company expects to make contributions to its defined benefit pension plan during 2014 of $4.9 million.

 

Investing Activities

 

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

 

During 2013, expenditures for investing activities consisted of store fixtures for three new stores, nine remodels and six relocations, store leasehold improvements and maintenance capital expenditures at the distribution center. Expenditures for 2012 consisted of store fixtures for one new store and eight relocations, and leasehold improvements. Expenditures for 2011 consist primarily of store fixtures for one new store, five relocations and the expanded craft assortment introduced in numerous locations, and IT equipment upgrades. These activities totaled approximately $4.5 million, $2.7 million and $4.9 million for 2013, 2012 and 2011, respectively.

 

Financing Activities

 

During the three years presented outstanding borrowings have increased by $8.9 million, $16.9 million and $18.3 million for 2013, 2012 and 2011, respectively. This growth in outstanding debt has been used primarily to fund working capital needs, pay the required cash contribution to the defined benefit pension plan and for capital expenditures in each of those years.

 

General

 

We do not currently anticipate declaring or paying cash dividends on shares of our common stock in the foreseeable future. We currently intend to retain all of our future earnings, if any, to finance operations. Any future determination relating to our dividend policy will be made at the discretion of our board of directors and will depend on a number of factors, including future earnings, capital requirements, financial conditions, future prospects, contractual restrictions and other factors that our board of directors may deem relevant. Stock repurchases in 2013 were minor, consisting of insignificant purchases from odd-lot shareholders and small amounts surrendered by employees to satisfy tax withholding obligations arising from the lapse of restrictions on shares of stock.

 

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

 

Credit Facilities

 

The following should be read in conjunction with Note 5 to the accompanying Consolidated Financial Statements – Long-Term Debt Obligations.

 

On November 15, 2012, the Company entered into an amended and restated loan and security agreement with its direct and indirect subsidiaries, General Electric Capital Corporation, as working capital agent, GA Capital, LLC, as term loan agent, and the lenders party thereto, which expires on November 15, 2016. The amended and restated loan and security agreement amended and restated the Company’s loan and security agreement dated as of August 1, 2008, and provides senior secured financing of $115 million, consisting of (a) an up to $100 million revolving credit facility (the "Revolver"), which includes a letter of credit sub-facility of up to $20.0 million, and (b) an up to $15 million term loan facility (the "Term Loan"). The level of borrowings available is subject to a borrowing base computation, as defined in the amended and restated loan and security agreement, which includes credit card receivables, inventory, and real property. Principal amounts outstanding under both the Revolver and the Term Loan bear interest at a rate equal to, at the option of the borrowers, either (a) a LIBOR rate determined by reference to the offered rate for deposits in dollars for the interest period relevant to such borrowing (the “Eurodollar Rate”), or (b) a prime rate, in each case plus an applicable margin and adjusted for certain additional costs and fees. As of January 25, 2014, the applicable margin for Revolver borrowings was 2.25% with respect to the Eurodollar Rate and 1.25% with respect to the prime rate loans; and for Term Loan borrowings 10.0% with respect to the Eurodollar Rate and 9.00% with respect to prime rate loans.

 

 
29

 

 

The Revolver and Term Loan is collateralized by a fully perfected first priority security interest in all of the existing and after acquired real and personal tangible and intangible assets of the Company.

 

As of January 25, 2014, the Company had outstanding borrowings under the Revolver of $55.5 million and $15.0 million under the Term Loan, and amounts available to borrow of $16.6 million.

 

At January 25, 2014, Hancock had commitments under the above credit facility of $0.8 million, under documentary letters of credit, which support purchase orders for merchandise. Hancock also has standby letters of credit primarily to guarantee payment of potential insurance claims totaling $5.6 million.

 

On November 20, 2012, the Company exchanged approximately $16.4 million aggregate principal amount of the Company’s outstanding $21.6 million of Floating Rate Series A Secured Notes (the “Existing Notes”) originally issued pursuant to an Indenture dated as of June 17, 2008 (the “2008 Indenture”) between the Company and Deutsche Bank National Trust Company (“DBNTC”), as trustee thereunder, for (a) the Company’s Floating Rate Series A Secured Notes Due 2017 in an aggregate principal amount of approximately $8.2 million (the “New Notes”) issued pursuant to an indenture dated as of November 20, 2012 between the Company and DBNTC, as trustee thereunder (the “New Indenture”), and (b) cash consideration in the aggregate amount of approximately $8.2 million. After completion of the exchange, approximately $5.1 million aggregate principal amount of Existing Notes remained outstanding under the 2008 Indenture and the unamortized warrant discount on the Existing Notes was $379,000 as of January 26, 2013.

 

The New Notes bear interest at a variable rate, adjusted quarterly, equal to a LIBOR rate plus 12% per annum until maturity on November 20, 2017. The New Notes and the related guarantees provided by certain subsidiaries of the Company are secured by a lien on substantially all of the Company’s and the subsidiary guarantors’ assets, in each case, subject to certain prior liens and other exceptions, but the New Notes are subordinated in right of payment in certain circumstances to all of the Company’s existing and future senior indebtedness, including the Company’s Amended and Restated Loan and Security Agreement, dated as of November 15, 2012.

 

On January 31, 2013, the Company used funds from the Revolver to retire the remaining $5.1 million of Existing Notes outstanding and wrote off the related unamortized discount of $379,000. The Existing Notes would have matured on August 1, 2013, were subordinated to the Revolver, and were secured by a junior lien on all of the Company’s assets.

 

As of January 25, 2014, the outstanding balance on the New Notes was $8.2 million.

 

Off-Balance Sheet Arrangements

 

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

 

 
30

 

 

Contractual Obligations and Commercial Commitments

 

The following is a summary of our contractual obligations and commercial commitments as of January 25, 2014 that will require the use of funds:

 

Contractual Obligations (in thousands)

                                 
   

Note Reference

   

Total

   

Less than 1 Year

   

1-3 Years

   

4-5 Years

   

More than 5 Years

 
                                                 

Long-term debt (1)

    5     $ 78,691     $ -     $ 70,487     $ 8,204     $ -  

Minimum lease payments (2)

    6       84,219       21,068       32,999       18,460       11,692  

Standby letters of credit

    5       5,600       5,600       -       -       -  

Capital lease obligations (3)

    6       4,236       472       902       742       2,120  

Trade letters of credit

            751       751       -       -       -  

Open purchase orders

            23,152       23,152       -       -       -  

Total

          $ 196,649     $ 51,043     $ 104,388     $ 27,406     $ 13,812  

 

(1) The calculation of interest on the Revolver, the Term Loan and the New Notes is dependent on the average borrowings during the year and a variable interest rate. The interest rates on the Revolver, the Term Loan and the New Notes were approximately 2.66%, 11.50%, and 12.27% at January 25, 2014.  Interest payments are excluded from the table because of their subjectivity and the estimation required.

 

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

 

(3) Capital lease obligations include related interest.

 

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

 

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

 

Critical Accounting Policies and Estimates

 

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

 

 
31

 

 

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

 

Inventories. We value inventory using the lower of weighted average cost or market method. Market price is generally based on the projected selling price of the merchandise. We regularly review inventories to determine if the carrying value of the inventory exceeds market value and we record a reserve to reduce the carrying value to its market price, as necessary. This policy is not expected to have a material impact on future earnings as product is sold. As of January 25, 2014, and January 26, 2013, we had recorded reserves totaling $2.3 million and $1.9 million, respectively.

 

As with other retailers, it is not practical to perform physical inventory counts for all stores on the last day of a period. Therefore, certain assumptions must be made in order to record cost of sales for the period of time from each store's most recent physical count to the end of the period. For the periods between the date of the last physical count and the end of the applicable reporting period, we include these assumptions as we record cost of goods sold, including certain estimates for shrinkage of inventory due to theft, miscuts of fabric and other matters. These estimates are based on previous experience and could fluctuate from period-to-period and from actual results at the date of the next physical inventory count.

 

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

 

We capitalize costs related to the acquisition, distribution, and handling of inventory as well as freight, duties and fees related to import purchases of inventory as a component of inventory each period. In determining the amount of costs to be allocated to inventory each period, we must estimate the amount of costs related to the inventory, based on inventory turnover ratios and the ratio of inventory flowing through the warehouse. Changes in these estimates from period-to-period could significantly change the reported amounts for inventory and cost of goods sold. As of January 25, 2014, we had capitalized costs related to acquisition, distribution, and handling in inventory of $9.9 million compared to $8.9 million as of January 26, 2013, and expensed $12.7 million as cost of sales during 2013 compared to $13.9 million during 2012.

 

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

 

 
32

 

 

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

 

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

 

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

 

Revenue Recognition. Sales are recorded at the time customers provide a satisfactory form of payment and take ownership of the merchandise. We allow customers to return merchandise under most circumstances. The reserve for returns was $134,000 at January 25, 2014 and $137,000 at January 26, 2013, and is included in accrued liabilities in the accompanying Consolidated Balance Sheet. The reserve is estimated based on our prior experience of returns made by customers after period end.

 

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

 

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

 

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

 

 
33

 

 

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 Increase

   

One-Percentage

Point Decrease

 

Effect on total service and interest costs

  $ 10     $ (9 )

Effect on postretirement benefit obligation

    129       (115 )

 

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, a qualitative test is performed to determine if it is more likely than not that impairment has occurred. If the qualitative test yields a 50% or greater probability that impairment has occurred then a two-step quantitative test is performed. For the first step of the quantitative test, the fair value of our reporting units are estimated using the discounted present value of future cash flows approach and then compared with their carrying values. If the carrying value of a reporting unit exceeds its fair value, a second step is performed to measure the amount of the impairment loss, if any. In the second step, the implied fair value of the goodwill is estimated as the fair value of the reporting unit used in the first step less the fair values of all other net tangible and intangible assets of the reporting unit. If the carrying amount of the goodwill exceeds its implied fair value, an impairment loss is recognized in an amount equal to that excess, not to exceed the carrying amount of the goodwill.

 

Each of the 34 remaining stores acquired in two separate transactions that resulted in the recognition of goodwill represents a reporting unit. We performed a qualitative and quantitative test of goodwill for 2013 and determined that goodwill was not impaired. Impairment charges may be required in the future based on changes in the fair value of reporting units which will be evaluated, when events arise indicating potential impairment, and during the annual goodwill impairment evaluation performed in the fourth quarter of each fiscal year.

 

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

 

At the present time, we do not anticipate recognizing any portion of our deferred income tax benefit in fiscal year 2014.

 

 
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Deferred taxes are summarized in Note 7 to the accompanying Consolidated Financial Statements.

 

Stock-based Compensation. The Company applies Accounting Standard Codification (“ASC”) 718, Compensation-Stock Compensation, (“ASC 718”) and expenses the fair value for any unvested stock options over the remaining service (vesting) period. The amounts of future stock compensation expense may vary based on the types of awards, vesting periods, estimated fair values of the awards using various assumptions regarding future dividends, interest rates and volatility of the trading prices of our stock.

 

Related Party Transactions

 

On November 20, 2012, we completed a warrant exchange with certain warrant holders pursuant to which the exchanging holders exchanged warrants to purchase an aggregate of up to 7,385,200 shares of our common stock (the “Old Warrants”) issued pursuant to the master warrant agreement, dated as of June 17, 2008 for new warrants (the “New Warrants”) to purchase an aggregate of up to 9,838,000 shares of our common stock for an exercise price per share of $0.59. The New Warrants are exercisable at any time until November 20, 2019 on a cashless basis pursuant to the terms of the New Warrants.

 

Carl E. Berg (a former non-executive Chairman of our Board of Directors) is the beneficial owner of more than 5% of our common stock through either controlling or majority interest and/or controlling investment management in Berg & Berg Enterprises, LLC and Lightpointe Communications, Inc. (“Lightpointe”). In the warrant exchange, Lightpointe exchanged Old Warrants for a New Warrant to purchase 4,860,400 shares of our common stock.

 

As the managing member of Lenado Capital Advisors, LLC (“Lenado Advisors”); SPV UNO, LLC (“SPV Uno”); and SPV Quatro, LLC (“SPV Quatro”); the sole member of the managing member of Lenado Capital, LLC (“Lenado Capital”); and the owner, directly or indirectly, of a majority of the membership interests in each of Lenado Advisors, Lenado Capital, SPV UNO and SPV Quatro, Nikos Heckt may be deemed to be the controlling person of Lenado Advisors, Lenado Capital, SPV UNO and SPV Quatro and, through Lenado Capital, Series A of Lenado Capital Partners, L.P. (“Lenado Partners”) and Lenado DP, Series A of Lenado DP, L.P. (“Lenado DP”). Mr. Hecht, Lenado Advisors, Lenado Capital, Lenado Partners and SPV Quatro are each the beneficial owners of more than 5% of our common stock. In the warrant exchange, Lenado DP exchanged Old Warrants for a New Warrant to purchase 566,400 shares of our common stock; SPV Uno exchanged Old Warrants for a New Warrant to purchase 232,000 shares of our common stock; SPV Quatro exchanged Old Warrants for a New Warrant to purchase 1,984,800 shares of our common stock; and Lenado Partners exchanged Old Warrants for a New Warrant to purchase 2,194,400 shares of our common stock.

 

On November 20, 2012, we also exchanged approximately $16.4 million aggregate principal amount of the Floating Rate Series A Secured Notes held by the related parties for approximately $8.2 million of our Floating Rate Series A Secured Notes Due 2017 and cash consideration of approximately $8.2 million.

 

We did not enter into any other material transactions with related parties during fiscal years 2013, 2012, or 2011.

 

 
35

 

 

Effects of Inflation

 

Inflation in labor and occupancy costs could significantly affect our operations. Many of our employees are paid hourly rates related to federal and state minimum wage requirements; accordingly, any increases in those requirements will affect us. In addition, payroll taxes, employee benefits, and other employee costs continue to increase. Health insurance costs, in particular, continue to rise at a high rate in the United States each year, and higher employer contributions to our pension plan could be necessary if investment returns are weak. Cost of leases for new store locations remain stable, but renewal costs of older leases continue to increase. We believe the practice of maintaining adequate operating margins through a combination of price adjustments and cost controls, careful evaluation of occupancy needs, and efficient purchasing practices are the most effective tools for coping with increased costs and expenses.

 

Seasonality

 

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

 

 

Item 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

We did not hold derivative financial or commodity instruments at January 25, 2014.

 

Interest Rate Risk

 

We are exposed to financial market risks, including changes in interest rates. At our option, all loans under the Revolver and the Term Loan bear interest at either (a) a floating interest rate plus the applicable margins or (b) absent a default, a fixed interest rate for periods of one, two or three months equal to the reserve adjusted London Interbank Offered Rate, or LIBOR, plus the applicable margins. As of January 25, 2014, we had borrowings outstanding of approximately $55.5 million under the Revolver and $15.0 million under the Term Loan. If interest rates increased 100 basis points, our annual interest expense would increase approximately $705,000, assuming borrowings under the Revolver and Term Loan as existed at January 25, 2014.

 

In addition to the Revolver and Term Loan, as of January 25, 2014 the Company has outstanding New Notes for $8.2 million on which interest is payable quarterly in arrears on February 20, May 20, August 20 and November 20 of each year. The quarterly interest is payable at LIBOR plus 12.0% on the New Notes. If interest rates increased 100 basis points, our annual interest expense would increase $82,000, assuming borrowings under the New Notes as existed at January 25, 2014.

 

 

Foreign Currency Risk

 

All of our business is transacted in U.S. dollars and, accordingly, fluctuations in the valuation of the dollar against other currencies will affect product costs. No significant impact was experienced on 2013 results. As of January 25, 2014, we had no financial instruments outstanding that were sensitive to changes in foreign currency rates.

 

 
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Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

 

Hancock Fabrics, Inc.

Consolidated Balance Sheets


January 25, 2014 and January 26, 2013

 

2013

   

2012

 

(in thousands, except for share and per share amounts)

               

Assets

               

Current assets:

               

Cash

  $ 1,806     $ 4,062  

Receivables

    5,259       3,817  

Inventories, net

    107,180       101,245  

Prepaid expenses

    2,107       2,552  

Total current assets

    116,352       111,676  
                 

Property and equipment, net

    33,409       33,571  

Goodwill

    2,880       2,880  

Other assets

    2,431       2,405  

Total assets

  $ 155,072     $ 150,532  
                 

Liabilities and Shareholders' Equity

               

Current liabilities:

               

Accounts payable

  $ 20,466     $ 18,702  

Accrued liabilities

    13,742       13,995  

Total current liabilities

    34,208       32,697  
                 

Long-term debt obligations

    78,691       69,374  

Capital lease obligations

    2,605       2,807  

Postretirement benefits other than pensions

    2,728       2,481  

Pension and SERP liabilities

    28,407       35,115  

Other liabilities

    5,351       5,567  

Total liabilities

    151,990       148,041  
                 

Commitments and contingencies (See Note 7 and 13)

               
                 

Shareholders' equity:

               

Common stock, $.01 par value; 80,000,000 shares authorized; 35,116,436 and 34,978,210 issued and 21,641,004 and 21,570,797 outstanding, respectively

    351       350  

Additional paid-in capital

    91,360       90,720  

Retained earnings

    94,484       96,426  

Treasury stock, at cost, 13,475,432 and 13,407,413 shares held, respectively

    (153,793 )     (153,740 )

Accumulated other comprehensive loss

    (29,320 )     (31,265 )

Total shareholders' equity

    3,082       2,491  

Total liabilities and shareholders' equity

  $ 155,072     $ 150,532  

 

The accompanying notes are an integral part of these consolidated statements.

 

 
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Hancock Fabrics, Inc.

Consolidated Statements of Operations and Comprehensive Income (Loss)


Years Ended January 25, 2014, January 26, 2013, and January 28, 2012

 

2013

   

2012

   

2011

 

(in thousands, except per share amounts)

                       
                         

Sales

  $ 276,030     $ 277,989     $ 271,993  

Cost of goods sold

    157,275       165,852       159,268  
                         

Gross profit

    118,755       112,137       112,725  
                         

Selling, general and administrative expenses

    111,107       109,653       115,047  

Depreciation and amortization

    3,623       3,717       4,140  
                         

Operating income (loss)

    4,025       (1,233 )     (6,462 )
                         

Interest expense, net

    5,967       7,277       4,836  
                         

Loss before income taxes

    (1,942 )     (8,510 )     (11,298 )

Income taxes

    -       -       -  
                         

Net loss

  $ (1,942 )   $ (8,510 )   $ (11,298 )
                         

Other comprehensive income (loss):

                       

Changes in minimum pension, SERP and postretirement liabilities (net of taxes of $0)

    1,945       (3,585 )     (10,008 )
                         

Comprehensive income (loss)

  $ 3     $ (12,095 )   $ (21,306 )
                         
                         

Net loss per share, basic and diluted

  $ (0.09 )   $ (0.42 )   $ (0.57 )
                         

Weighted average shares outstanding

                       

Basic and diluted

    20,562       20,046       19,846  

 

The accompanying notes are an integral part of these consolidated statements.

 

 
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Hancock Fabrics, Inc.

Consolidated Statements of Shareholders' Equity

 


Years Ended January 25, 2014, January 26, 2013, and January 28, 2012

 
(in thousands, except number of shares)  
   

Common Stock

   

Additional

Paid-in

   

Retained

   

Treasury Stock

   

Accumulated Other Comprehensive

   

Total

Shareholders'

 
   

Shares

   

Amount

   

Capital

   

Earnings

   

Shares

   

Amount

   

(Loss)

   

Equity

 

Balance January 29, 2011

    33,466,455     $ 335     $ 89,671     $ 116,234       (13,398,128 )   $ (153,731 )   $ (17,672 )   $ 34,837  

Net loss

                            (11,298 )                             (11,298 )

Minimum pension, SERP and postretirement

                                                               

liabilities, net of taxes of $0