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HANCOCK FABRICS INC - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Edgar Online "Glimpses"
The following discussion should be read in conjunction with the consolidated financial statements as of and for the thirteen and twenty-six weeks ended July 27, 2013 , including the notes to those statements, appearing elsewhere in this report. We also suggest that management's discussion and analysis appearing in this report be read in conjunction with the management's discussion and analysis and consolidated financial statements included in our Annual Report on Form 10-K for the fiscal year ended January 26, 2013 . Our fiscal year ends on the last Saturday in January and refers to the calendar year ended immediately prior to such date, which contained the substantial majority of the fiscal period (e.g., "fiscal 2012" or "2012" refers to the fiscal year ended January 26, 2013 ). Fiscal years consist of 52 weeks, comprised of four 13-week fiscal quarters, unless noted otherwise. References herein to second quarter 2013 and second quarter 2012 are for the 13 week periods ended July 27, 2013 and July 28, 2012 , respectively. References to twenty-six weeks 2013, first half 2013 or 2013, and twenty-six weeks 2012, first half 2012 or 2012 are for the 26 week periods ended July 27, 2013 and July 28, 2012 , respectively. Forward Looking Statements This Quarterly Report on Form 10-Q ("Quarterly Report") contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended and Section 21E of the Securities Exchange Act of 1934, as amended (the Exchange Act). Such statements are not historical facts and reflect our current views regarding matters such as operations and financial performance. In general, forward-looking statements are identified by such words or phrases as "anticipates," "believes," "approximates," "estimates," "expects," "intends" or "plans" or the negative of those words or other terminology. Forward-looking statements involve inherent risks and uncertainties; our actual results could differ materially from those expressed in our forward-looking statements. 11
-------------------------------------------------------------------------------- The risks and uncertainties, either alone or in combination, that could cause our actual results to differ from those expressed in our forward-looking statements include, but are not limited to, those that are discussed in our Annual Report on Form 10-K filed with the SEC on April 26, 2013 under Item 1A. Risk Factors. Forward-looking statements speak only as of the date made, and neither Hancock nor its management undertakes any obligation to update or revise any forward-looking statement. Our Business Hancock Fabrics, Inc. is a specialty retailer committed to nurturing creativity through a complete selection of fashion and home decorating textiles, sewing accessories, needlecraft supplies and sewing machines. We are one of the largest fabric retailers in the United States , operating as of July 27, 2013 , 261 stores in 37 states and an internet store under the domain name hancockfabrics.com. Our stores present a broad selection of fabrics and notions used in apparel sewing, home decorating and quilting projects. None of the information on the website referenced above is incorporated by reference into our reports filed with, or furnished to, the Securities and Exchange Commission . Overview Financial Summary:
? Sales for the second quarter of 2013 were $59.1 million compared to $60.5
million for the second quarter of 2012, and comparable store sales declined
1.7% in the second quarter of 2013 following an increase of 5.0% in the second
quarter of 2012. Sales for the first half of 2013 were $122.9 million compared
to $124.4 million for the first half of 2012 and comparable store sales decreased 0.8% following an increase of 4.3% in the first half of 2012.
? Our online sales for the second quarter of 2013, which are included in the
sales number and comparable sales percentage above, decreased 6.3% to $0.8
million compared to $0.9 million for the second quarter of 2012 and declined
by 7.2% to $1.7 million in the first half of 2013 compared to $1.9 million in
the first half of 2012.
? Gross profit for the second quarter and first half of 2013 was 44.9% and
45.2%, respectively, compared with 42.9% and 41.8% for the second quarter and
first half of 2012, respectively.
? Operating loss was $1.3 million for the second quarter of 2013 compared to a
loss of $2.0 million in the second quarter of 2012. For the first half of
2013, operating income was $32 thousand compared to a loss of $3.2 million for
the first half of 2012.
? Net loss was $2.6 million , or $0.13 per basic share, in the second quarter of
2013 compared to a net loss of $3.3 million , or $0.17 per basic share in the
second quarter of 2012. Net loss was $3.1 million or $0.15 per basic share in
the first half of 2013 compared to a net loss of $5.7 million or $0.29 per
basic share in the first half of 2012.
? The amount of cash used in operating activities was $5.3 million during the
first half of 2013 compared to $13.8 million of cash used in operating activities for the first half of 2012. 12
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We use a number of key performance measures to evaluate our financial performance, including the following:
Thirteen Weeks Ended Twenty-six Weeks Ended July 27, July 28, July 27, July 28, 2013 2012 2013 2012 Net sales (in thousands) $ 59,134 $ 60,455 $ 122,875 $ 124,399 Gross margin percentage 44.9 % 42.9 % 45.2 % 41.8 % Number of stores Open at end of period (1) 261 263 261 263 Comparable stores at period end (2) 259 263 259 263 Sales growth All retail outlets (2.2 )% 4.6 % (1.2 )% 3.9 % Comparable retail outlets (3) (1.7 )% 5.0 %
(0.8 )% 4.3 %
Total store square footage at period end (in thousands) 3,692 3,747
3,692 3,747
Net sales per total square footage $ 16.02 $ 16.13 $ 33.28 $ 33.20
(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. Comparable sales computation also includes
net sales derived from e-commerce. 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) Comparable sales growth computation also includes net sales derived from
e-commerce. Results of Operations The following table sets forth, for the periods indicated selected statement of operations data expressed as a percentage of sales. This table should be read in conjunction with the following discussion and with our Consolidated Financial Statements, including the related notes. Thirteen Weeks Ended Twenty-six Weeks Ended July 27, July 28, July 27, July 28, 2013 2012 2013 2012 Net sales 100.0 % 100.0 % 100.0 % 100.0 % Cost of goods sold 55.1 57.1 54.8 58.2 Gross profit 44.9 42.9 45.2 41.8 Selling, general and administrative expense 45.5 44.7 43.7 42.9 Depreciation and amortization 1.5 1.6 1.5 1.5 Operating (loss) income (2.1 ) (3.4 ) 0.0 (2.6 ) Interest expense, net 2.3 2.1 2.5 2.0 Loss before income taxes (4.4 ) (5.5 ) (2.5 ) (4.6 ) Income taxes 0.0 0.0 0.0 0.0 Net loss (4.4 )% (5.5 )% (2.5 )% (4.6 )% 13
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Net Sales Thirteen Weeks Ended Twenty-six Weeks Ended (in thousands) July 27, July 28, July 27, July 28, 2013 2012 2013 2012 Retail comparable store base $ 57,869 $ 58,836 $ 120,343 $ 121,245 E-Commerce 828 884 1,734 1,869 Comparable sales 58,697 59,720 122,077 123,114 New stores 437 - 798 - Closed stores - 735 - 1,285 Total net sales $ 59,134 $ 60,455 $ 122,875 $ 124,399 The retail comparable store base above consists of the stores which were included in the comparable sales computation for the current period. The second quarter 2013 comparable sales (excluding e-commerce) decrease of 1.6% was the result of a 7.8% decrease in transaction count partially offset by a 6.2% improvement in average ticket evidencing higher sales volumes for each individual transaction. The first half 2013 retail comparable sales decline of 0.7% resulted from a 6.8% decline in transaction count partially offset by a 6.1% increase in average ticket. Sales provided by our e-commerce channel decreased 6.3% and 7.2% in the second quarter and first twenty-six weeks of fiscal 2013, respectively. The sales decline can be primarily attributed to year over year adjustments to our pricing strategy. Two new stores opened and four stores, where we chose not to stay in the market, have closed since the second quarter of 2012. The sales from these locations are included in net sales. During the current quarter, the Company relocated two stores and ended the quarter with 261 stores. Our merchandise mix has had minimal change year over year, as reflected in the table below. Thirteen Weeks Ended Twenty-six Weeks Ended July 27, July 28, July 27, July 28, 2013 2012 2013 2012 Apparel and Craft Fabrics 42 % 40 % 42 % 40 % Home Decorating Fabrics 14 % 14 % 13 % 14 % Sewing Accessories 32 % 33 % 33 % 33 % Non-Sewing Products 12 % 13 % 12 % 13 % 100 % 100 % 100 % 100 % 14
-------------------------------------------------------------------------------- Gross Margin Costs of goods sold include: ? the cost of merchandise ? inventory rebates and allowances including term discounts ? inventory shrinkage and valuation adjustments ? 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.
Specific components of cost of goods sold for the second quarters and first twenty-six weeks of fiscal 2013 and 2012 are as follows:
Thirteen Weeks Ended Twenty-six Weeks Ended July 27, % of July 28, % of July 27, % of July 28, % of (dollars in thousands) 2013 Sales 2012 Sales
2013 Sales 2012 Sales
Total net sales $ 59,134 100.0 % $ 60,455 100.0 % $ 122,875 100.0 % $ 124,399 100.0 %
Merchandise cost 27,368 46.3 % 29,482 48.8 % 57,489 46.8 % 62,010 49.9 % Freight 2,035 3.4 % 2,265 3.7 % 3,991 3.2 % 4,357 3.5 % Sourcing and warehousing 3,190 5.4 % 2,783 4.6 % 5,877 4.8 % 6,006 4.8 % Gross Profit $ 26,541 44.9 % $ 25,925 42.9 % $ 55,518 45.2 % $ 52,026 41.8 % Merchandise cost declined as a percentage of sales for the second quarter of 2013 as compared to the same period of 2012 by 250 basis points. For the first twenty-six weeks of 2013 compared to the first twenty-six weeks of 2012, merchandise cost decreased by 310 basis points. This improvement resulted primarily from adjustments to our pricing strategy which we believe will allow us to be more competitive while maintaining acceptable margin levels. The other factor influencing merchandise cost for the periods discussed above is the inventory valuation reserve. Excluding the impact of the reserve merchandise cost decreased by 460 basis points and 410 basis points for the quarter and twenty-six week of 2013 as compared to 2012, respectively. Freight expense is 30 basis points lower as a percentage of sales for the second quarter and twenty-six weeks of 2013 as compared to the same periods of 2012. This decrease was the result of a shift in the freight capitalized into inventory, which is affected by inventory turns and a reduction in overall freight expense. Sourcing and warehousing costs for the Company vary based on both the volume of inventory received during any period and the rate at which inventory is shipped out, or inventory turns. The cost difference for the second quarter and twenty-six weeks of 2013 compared to the same periods in 2012 is primarily due to changes in inventory turns during those periods, which influence the amount of sourcing and warehousing costs capitalized into inventory. In total, gross margin increased by 200 basis points in the second quarter 2013 from second quarter 2012 levels and by 340 basis points for the first twenty-six weeks of 2013 as compared to the same period of 2012. 15
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Selling, General and Administrative Expenses
Selling, general and administrative 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) Specific components of selling, general and administrative expenses (SG&A) include: Thirteen Weeks Ended Twenty-six Weeks Ended July 27, % of July 28, % of July 27, % of July 28, % of (dollars in thousands) 2013 Sales 2012 Sales
2013 Sales 2012 Sales
Retail store labor costs $ 9,376 15.9 % $ 9,218 15.2 % $ 19,072 15.5 % $ 18,830 15.1 % Advertising 2,608 4.4 % 2,561 4.2 % 4,952 4.0 % 4,684 3.8 % Store occupancy 7,506 12.7 % 7,549 12.5 % 15,015 12.2 % 15,045 12.1 % Retail SG&A 4,859 8.2 % 5,520 9.1 % 9,365 7.7 % 10,240 8.2 % Corp SG&A 2,562 4.3 % 2,162 3.7 %
5,306 4.3 % 4,562 3.7 %
Total SG&A $ 26,911 45.5 % $ 27,010 44.7 % $ 53,710 43.7 % $ 53,361 42.9 %
Retail Store Labor Costs - The Company store labor costs increased slightly during the second quarter of 2013 as compared to the same period in 2012. The increase was the result of increased benefit costs for medical claims as compared to 2012 and addition store payroll costs. For the twenty-six weeks of 2013, labor costs increased due to medical claims, partially offset by reductions in labor related taxes and payroll costs. Advertising - The variance in advertising expense for the second quarter of 2013 compared to the same period of 2012 is related to additional advertising incurred for the online store. For the first twenty-six weeks of 2013 compared to the same period in 2012 the increase in advertising cost is primarily due to a postage rate increase, an expanded circulation test which affected the cost of an inserted promotional piece and additional advertising for the online store. Store Occupancy - The Company's store occupancy expense was basically unchanged as compared to the same period of the prior year for both the second quarter and twenty-six weeks of 2013. Reductions in occupancy related expenses were primarily offset by increased maintenance and repair expense. Retail SG&A - The reductions in retail selling, general and administrative for the second quarter and first twenty-six weeks of 2013 compared to same periods of 2012 decreased primarily due to reductions in insurance cost, which are claims driven and reduced expenditures for store supplies. 16
-------------------------------------------------------------------------------- Corporate SG&A - The variance in corporate selling, general and administrative expense for both periods of 2013 presented above as compared to those periods of 2012, reflect higher corporate overhead partially offset by lower capitalizable cost related to warehousing and distribution. In addition, both periods of 2012 presented included the benefit of a real estate settlement gain of $156,000 and the twenty-six week comparison includes a 2012 gain from the settlement of an insurance claim of $238,000 . Interest Expense Thirteen Weeks Ended Twenty-six Weeks Ended (dollars in thousands) July 27, % of July 28, % of July 27, % of July 28, % of 2013 Sales 2012 Sales 2013 Sales 2012 Sales Interest expense, net $ 1,369 2.3 % $ 1,286 2.1 %
$ 3,125 2.5 % $ 2,509 2.0 % The Company's interest costs are driven by borrowings on our credit facilities and a small number of capital leases. Interest expense for the second quarter of 2012 includes $0.6 million of non-cash expense for note discount amortization and the twenty-six week amounts for 2013 and 2012 include $379,000 and $1.2 million , respectively. Excluding these non-cash items, interest expense was $1.4 million for the first quarter of 2013, $0.7 million for the second quarter of 2012, and $2.7 million and $1.3 million for the twenty-six weeks of 2013 and 2012, respectively. Income Taxes The Company did not recognize any income tax benefit during the periods of fiscal 2013 or 2012 presented in this report given the uncertainty in realizing the future benefit. As of July 27, 2013 , January 26, 2013 , and July 28, 2012 the Company has established a 100% valuation allowance to offset the net deferred tax assets related to net operating loss carryforwards and other book-tax timing differences.
Liquidity and Capital Resources
Hancock's primary capital requirements are for the financing of inventories and, to a lesser extent, for capital expenditures relating to store locations and its distribution facility. Funds for such purposes have historically been generated from Hancock's operations, short-term trade credit in the form of extended payment terms from suppliers for inventory purchases, and long-term borrowings from commercial lenders. We anticipate that we will be able to satisfy our working capital requirements, planned capital expenditures, required cash contributions to retirement plans, and debt service requirements through the next twelve months with available cash, proceeds from cash flows from operations, short-term trade credit, borrowings under our revolving credit facility and other sources of financing. Hancock's cash flow related information as of the first twenty-six weeks of fiscal 2013 and 2012 follows: Twenty-six Weeks Ended July 27, July 28, 2013 2012 Net cash flows provided by (used in): Operating activites $ (5,308 ) $ (13,798 ) Investing activities (1,790 ) (1,188 ) Financing activites 5,199 14,753 17
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Operating Activities Net cash from operating activities, before changes in assets and liabilities, improved by $2.8 million during the first twenty-six weeks of 2013 compared to the first twenty-six weeks of 2012. This can be primarily attributed to an improvement in gross profit which reduced the net loss as compared to the prior year. An inventory increase of $7.7 million less accounts payable support of $4.7 million and a $1.4 million decrease in pension related liabilities primarily resulted in the $5.3 million of net cash used in operating activities for 2013. Investing Activities Cash used for investing activities consists primarily of purchases of property and equipment. Capital expenditures during the first twenty-six weeks of 2013 consisted primarily of store fixtures for one new store, three relocated units, and maintenance capital expenditures for the Corporate headquarters and distribution center. Capital expenditures in the prior year consisted primarily of store fixtures related to five relocations reduced by the proceeds from a sale of surplus property. Financing Activities During the first twenty-six weeks of 2013, the seasonal build up of inventory and fixtures for four units drove up net debt obligations by $5.3 million , excluding the remainder of the discount on notes of $379 thousand , which has been fully amortized. This change in debt obligations and a reduction in the amount outstanding for capital leases produced a net increase in cash provided by financing activities of $5.2 million . Long-Term Debt Obligations
The following should be read in conjunction with Note 4 to the Consolidated Financial Statements included in this report and Note 7 to the Company's Consolidated Financial Statements included in the Company's Annual Report on Form 10-K filed with the SEC on April 26, 2013 .
As of July 27, 2013 , the Company had outstanding borrowings under the Revolver of $51.8 million and $15.0 million under the Term Loan, and amounts available to borrow of $19.6 million . At July 27, 2013 , Hancock had commitments under the above credit facility of $2.0 million , under documentary letters of credit, which support purchase orders for merchandise. Hancock also has standby letters of credit to guarantee payment of potential insurance claims. These letters of credit amounted to $6.3 million as of July 27, 2013 .
As of July 27, 2013 , the Company had an outstanding balance of $8.2 million on the New Notes.
Off-Balance Sheet Arrangements
Hancock has no off-balance sheet financing arrangements. Hancock leases its retail fabric store locations mainly under non-cancelable operating leases. Four of the Company's store leases qualified for capital lease treatment and are reflected on the Company's balance sheet. Future payments under the operating leases are excluded from the Company's balance sheet.
Contractual Obligations and Commercial Commitments
Hancock has an arrangement within its Revolver that provides up to $20.0 million in letters of credit. At July 27, 2013 , Hancock had commitments of $2.0 million on documentary letters of credit under the facility, which support purchase orders for merchandise. Hancock also has $6.3 million on standby letters of credit to guarantee payment of potential insurance claims. Hancock leases its retail fabric store locations under operating leases expiring at various dates through 2024. 18
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The Company has no standby repurchase obligations or guarantees of other entities' debt.
For further information on our contractual obligations, please refer to Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations - Contractual Obligations and Commercial Commitments" as presented in our Annual Report on Form 10-K for the fiscal year ended January 26, 2013 .
Critical Accounting Policies and Estimates
The preparation of financial statements in accordance with accounting principles generally accepted in the United States of America requires management to adopt accounting policies and make significant judgments and estimates to develop amounts reflected and disclosed in the financial statements. In many cases, there are alternative policies or estimation techniques that could be used. We maintain a process to review the application of our accounting policies and to evaluate the appropriateness of the many estimates that are required to prepare the financial statements of a large corporation. However, even under optimal circumstances, estimates routinely require adjustment based on changing circumstances and the receipt of new or better information. There have been no significant changes to our accounting policies and estimates as discussed under Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations - Critical Accounting Policies and Estimates" in our Annual Report on Form 10-K for the fiscal year ended January 26, 2013 . Related Party Transactions See Note 16 to the Company's Consolidated Financial Statements included in the Company's Annual Report on Form 10-K for the fiscal year ended January 26, 2013 filed with the SEC on April 26, 2013 , for details regarding the related party transactions that the Company has entered into. The Company has no other balances with related parties, nor has it had any other material transactions with related parties during the twenty-six week period ended July 27, 2013 . Effects of Inflation Inflation in labor and occupancy costs could significantly affect Hancock's operations. Many of Hancock's employees are paid hourly rates related to federal and state minimum wage requirements; accordingly, any increases in those requirements will affect Hancock. In addition, payroll taxes, employee benefits, and other employee costs continue to increase, and the full impact of the recently enacted health care reform legislation will not be known for several years. Health insurance costs, in particular, continue to rise at a high rate in the United States each year, and higher employer contributions to Hancock's pension plan could be necessary if investment returns are weak. Costs of leases for new store locations remain stable, but renewal costs of older leases continue to increase. Hancock believes the practice of maintaining adequate operating margins through a combination of price adjustments and cost controls, careful evaluation of occupancy needs, and efficient purchasing practices are the most effective tools for coping with increased costs and expenses. Seasonality Hancock's business is seasonal. Peak sales periods occur during the fall and early spring weeks, while the lowest sales periods occur during the summer. Working capital requirements needed to finance our operations fluctuate during the year and reach their highest levels during the second and third fiscal quarters as we increase our inventory in preparation for our peak selling season during the fourth quarter. 19
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