Jo-Ann Stores, Inc. 10-Q

Jo-Ann Stores, Inc.

Consolidated Statements of Operations

(Unaudited)


	Thirteen Weeks Ended					Thirty-Nine Weeks Ended
	October 28,		October 29,			October 28,			October 29,
	2006		2005			2006			2005

	(Dollars in millions, except share and per share data)

Net sales	$	461.9	$	474.2		$	1,249.8		$	1,278.7
Cost of sales		242.8		257.9			660.4			672.8

Gross margin		219.1		216.3			589.4			605.9

Selling, general and administrative expenses		198.5		199.0			575.1			556.0
Store pre-opening and closing costs		3.0		8.5			11.1			17.4
Depreciation and amortization		12.6		10.5			36.5			31.1

Operating profit (loss)		5.0		(1.7	)		(33.3	)		1.4
Interest expense, net		4.9		4.1			12.3			8.7

Income (loss) before income taxes		0.1		(5.8	)		(45.6	)		(7.3	)
Income tax provision (benefit)		—		(1.7	)		(16.9	)		(2.3	)

Income (loss) before cumulative effect of accounting change		0.1		(4.1	)		(28.7	)		(5.0	)
Cumulative effect of change in accounting principle, net of tax		—		—			1.0			—

Net income (loss)	$	0.1	$	(4.1	)	$	(27.7	)	$	(5.0	)


Income (loss) per common share — basic:
Income (loss) before cumulative effect of accounting change	$	—	$	(0.18	)	$	(1.22	)	$	(0.22	)
Cumulative effect of change in accounting principle		—		—			0.04			—

Net income (loss)	$	—	$	(0.18	)	$	(1.18	)	$	(0.22	)

Income (loss) per common share — diluted:
Income (loss) before cumulative effect of accounting change	$	—	$	(0.18	)	$	(1.22	)	$	(0.22	)
Cumulative effect of change in accounting principle		—		—			0.04			—

Net income (loss)	$	—	$	(0.18	)	$	(1.18	)	$	(0.22	)


Weighted average shares outstanding (in thousands):
Basic		23,548		22,703			23,442			22,589

Diluted		23,986		22,703			23,442			22,589

See notes to unaudited consolidated financial statements

Jo-Ann Stores, Inc.

Consolidated Statements of Cash Flows

(Unaudited)


	Thirty-Nine Weeks Ended
	October 28,			October 29,
	2006			2005

	(Dollars in millions)
Net cash flows provided by (used for) operating activities:
Net loss	$	(27.7	)	$	(5.0	)
Adjustments to reconcile net loss to net cash provided by (used for) operating activities:
Depreciation and amortization		36.5			31.1
Stock-based compensation expense		5.5			1.2
Cumulative effect of change in accounting principle		(1.0	)		—
Tax benefit on stock-based compensation plan awards		—			1.0
Amortization of deferred financing costs		0.7			0.7
Loss on disposal of fixed assets		1.0			1.4
Changes in operating assets and liabilities:
Increase in inventories		(21.1	)		(214.4	)
Decrease (increase) in prepaid expenses and other current assets		9.7			(2.2	)
Increase in accounts payable		39.6			35.9
Decrease in accrued expenses		(25.4	)		(35.3	)
Increase in lease obligations, net		3.6			24.8
(Decrease) increase in other long-term liabilities		(0.1	)		1.2
Other, net		(1.0	)		(0.3	)

Net cash provided by (used for) operating activities		20.3			(159.9	)

Net cash flows used for investing activities:
Capital expenditures		(42.7	)		(91.8	)
Net proceeds from sale-leaseback transaction		24.7			—

Net cash used for investing activities		(18.0	)		(91.8	)

Net cash flows provided by financing activities:
Net change in revolving credit facility		(3.4	)		190.0
Proceeds from stock-based compensation plans		3.1			5.5
Other, net		1.0			0.7

Net cash provided by financing activities		0.7			196.2


Net increase (decrease) in cash and cash equivalents		3.0			(55.5	)
Cash and cash equivalents at beginning of period		17.9			79.6

Cash and cash equivalents at end of period	$	20.9		$	24.1


Supplemental disclosures of cash flow information:
Cash paid during the period for:
Interest	$	13.7		$	8.8
Income taxes, net of refunds		5.3			26.9

See notes to unaudited consolidated financial statements

Notes to Consolidated Financial Statements (Unaudited)

Jo-Ann Stores, Inc.

Note 1 — Basis of Presentation

Jo-Ann Stores, Inc. (the “Company”), an Ohio corporation, is the nation’s largest specialty retailer of fabrics and one of the largest specialty retailers of crafts operating 815 retail stores in 47 states at October 28, 2006. The 643 traditional stores and 172 superstores feature a variety of competitively priced merchandise used in sewing, crafting and home decorating projects, including fabrics, notions, yarn, crafts, frames, paper crafting material, artificial and dried flowers, home accents, finished seasonal and home décor merchandise.

The Company’s fiscal year ends on the Saturday closest to January 31. Fiscal years consist of 52 weeks, unless noted otherwise. The fiscal year refers to the year in which the period ends (e.g., fiscal 2007 refers to the year-ended February 3, 2007). Fiscal 2007 is a 53-week year.

The consolidated interim financial statements include the accounts of the Company and its subsidiaries and have been prepared without audit, pursuant to the rules of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted pursuant to those rules and regulations, although the Company believes that the disclosures herein are adequate to make the information not misleading. Certain amounts in the fiscal 2006 year-end and interim financial statements have been reclassified in order to conform to the current year presentation. The financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year-ended January 28, 2006.

Typical of most retail companies, the Company’s business is highly seasonal with the majority of revenues and operating profits generated in the second half of the fiscal year. Accordingly, earnings or losses for a particular interim period are not indicative of full year results. Due to the seasonal nature of the Company’s business, a comparable balance sheet as of October 29, 2005 has been provided. In the opinion of management, the consolidated financial statements contain all adjustments (consisting only of normal recurring accruals) necessary for a fair presentation of the financial position and results of operations for the interim periods presented.

Note 2 — Stock—Based Compensation

The Company administers its stock-based compensation award programs through its 1998 Incentive Compensation Plan (“1998 Plan”). The 1998 Plan provides for the grant of stock options, restricted stock, and stock equivalent units to employees and non-employee directors. It also allows for the operation of an employee stock purchase program and a deferred stock program for non-employee directors. The number of shares available for future awards under the 1998 Plan as of October 28, 2006 was 1,317,085. The Company has several other stock-based compensation award plans (“stock plans”) that have terminated, thus no new awards may be granted, but past awards remain outstanding under those plans. Full descriptions of the various plans are contained in Note 7 to the consolidated financial statements of the Company’s Annual Report on Form 10-K for the fiscal year-ended January 28, 2006.

In fiscal 2004, the Company adopted the fair value method of accounting as outlined in Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock-Based Compensation.”

Effective January 29, 2006, the Company adopted SFAS No. 123 (revised 2004), “Share-Based Payment,” (“SFAS No. 123R”), which replaces SFAS No. 123, using the modified prospective method. SFAS No. 123R requires stock-based compensation to be measured using the fair value method of accounting. The adoption of the new standard resulted in a cumulative after-tax adjustment related to estimated forfeitures, which is discussed below.

Among other things, SFAS No. 123R changed the manner of accounting for forfeitures of stock-based awards. Previously, the Company had accounted for forfeitures as they occurred, which is no longer permitted. The Company now estimates expected forfeitures as of the date the awards are granted and records compensation expense only for those awards that are ultimately expected to vest. Stock-based compensation expense is recognized over the vesting period of the awards.

Further, upon adoption, the Company estimated the forfeitures that are expected to occur on awards that were outstanding and reduced the previously recognized compensation expense for these awards. The after-tax amount of this reduction is presented on the statement of operations as a cumulative effect of a change in accounting principle. The Company estimated its forfeiture rates based on its historical experience during the preceding ten years and recorded a cumulative after-tax adjustment of $1.0 million, or $0.04 per diluted common share, in the first quarter of fiscal 2007.

Prior to the adoption of SFAS No. 123R, the Company presented all tax benefits of deductions resulting from the exercise of stock options or the issuance of shares under other stock-based compensation programs as operating cash flows in the statement of cash flows. SFAS No. 123R requires that cash flows resulting from the tax benefits of deductions in excess of the compensation cost recognized for stock-based awards be classified as financing cash flows. The gross excess tax benefit classified as a financing cash inflow for the third quarter year-to-date period was not significant.

The following table shows the expense recognized by the Company for stock-based compensation:


	Thirteen Weeks Ended					Thirty-Nine Weeks Ended
	October 28,		October 29,			October 28,		October 29,
Dollars in millions	2006		2005			2006		2005

Stock option compensation expense (a)	$	1.5	$	0.2		$	2.8	$	1.7
Restricted stock award amortization		0.7		(2.0	)		2.7		(0.5	)

	$	2.2	$	(1.8	)	$	5.5	$	1.2


(a)		Included within stock option compensation expense is expense related to the employee stock purchase plan (the Associate Stock Ownership Plan or “ASOP”). The associated expense is not significant.

Stock Options

The employee and non-employee director stock options granted under the 1998 Plan generally become exercisable to the extent of one-fourth of the optioned shares for each full year of continuous employment or service following the date of grant and generally expire seven to ten years after the date of the grant. Stock options granted under the 1998 Plan may become exercisable or expire under different terms as approved by the Compensation Committee of the Board of Directors.

The Company estimates the fair value of options granted using the Black-Scholes option-pricing model. The Black-Scholes model requires several assumptions, which management updates regularly based on historical trends and current market observations. The fair values of the options granted under the stock plans are determined at the date of grant. The Company does not pay dividends, thus, no dividend rate assumption is used.

The Company estimates expected volatility based on the historical volatility of the price of the common stock over the expected life of the awards. The Company believes its historical volatility is a reasonable expectation of future volatility. The Company also uses historical experience to estimate the expected life of stock-based compensation awards and employee terminations. The risk-free interest rate is based on applicable U.S. Treasury yields that approximate the expected life of stock-based awards granted.

The significant fair value assumptions were as follows:


	Thirty-Nine Weeks Ended
	October 28,		October 29,
	2006		2005

Weighted average fair value of options granted	$	5.68	$	11.88
Expected volatility of underlying stock		.436 to .584		.532 to .568
Risk-free interest rates	4.2% to 5.2%		3.5% to 4.4%
Expected life		2.2 to 5.2 years	4 years
Expected life — Employee Stock Purchase Program	6 months		6 months

The following table summarizes activity, pricing and other information for the Company’s stock options for the thirty-nine weeks ended October 28, 2006:


				Weighted-Average		Weighted-Average	Aggregate
	Number of			Exercise Price		Remaining	Intrinsic
	Options			Per Option		Contractual Term	Value^a

Outstanding at January 28, 2006		2,051,912		$	15.66
Granted		276,750			14.44
Exercised		(73,600	)		12.18
Cancelled		(456,302	)		16.36

Outstanding at October 28, 2006		1,798,760		$	15.43	4.2 years	$	7,544,456


Expected to vest		1,717,910		$	15.49	4.1 years	$	7,193,752


Exercisable at October 28, 2006		1,071,566		$	14.61	3.2 years	$	5,163,799


(a)		The intrinsic value of a stock option is the amount by which the fair value of the underlying stock exceeds the exercise price of the option.

The total intrinsic value of options exercised during the third quarter year-to-date period of fiscal 2007 and fiscal 2006 was $0.3 million and $3.3 million, respectively.

Restricted Stock Awards

The vesting periods for the restricted shares granted under the 1998 Plan are up to five years for employee restricted shares and up to six years for non-employee director restricted shares. Certain time-based and performance-based awards vest 50 percent at the end of three years, with the remaining 50 percent vesting at the end of the fourth year. These performance-based awards provide the potential to receive generally up to three times that amount in additional shares, dependent on the Company achieving certain net income performance criteria that are measured at the end of the third year. The expense for performance-based awards is recognized over the vesting period when the related criteria is probable of being achieved.

Restricted Stock — Time-Based Awards

As of October 28, 2006, 743,711 shares of restricted stock were outstanding in which the restrictions lapse upon the achievement of continued employment over a specified period of time (time-based restricted stock awards).

The following table summarizes activity for time-based restricted stock awards for the thirty-nine weeks ended October 28, 2006:


				Weighted-
	Number of			Average Grant
	Shares			Date Fair Value

Outstanding at January 28, 2006		661,910		$	20.83
Granted		410,920			13.95
Vested		(30,656	)		18.46
Cancelled		(298,463	)		20.36

Outstanding at October 28, 2006		743,711		$	17.31

The fair value of restricted shares is determined based on the closing trading price of the Company’s shares on the grant date.

During the third quarter year-to-date period of fiscal 2007 and fiscal 2006, the Company granted time-based restricted stock awards with weighted-average grant-date fair values of $13.95, and $29.44, respectively. As of October 28, 2006, there was $7.3 million of total unrecognized compensation cost related to restricted awards expected to vest, which is expected to be recognized over a weighted-average period of 1.6 years. During the third quarter year-to-date period of fiscal 2007 and fiscal 2006, the total fair value of shares fully vested was $0.4 million and $0.3 million, respectively.

Restricted Stock — Performance-Based Awards

The performance-based awards are issued only upon the achievement of specific measurable performance criteria. Performance can be achieved on three different levels, minimum (“Threshold”), midpoint (“Target”) or maximum (“Superior”). No expense was recognized during the third quarter year-to-date period of fiscal 2007 for performance awards based on the Company’s current and expected future performance. During the third quarter year-to-date period of fiscal 2006, an adjustment of $2.4 million was recognized to reduce previously recorded expense for performance awards due to a reduced expectation of operating performance.

The following table summarizes information about the performance-based restricted stock awards assuming the Superior performance level for the thirty-nine weeks ended October 28, 2006:


				Weighted-
	Number of			Average Grant
	Shares			Date Fair Value

Outstanding at January 28, 2006		801,600		$	29.00
Granted		134,500			14.05
Cancelled		(369,900	)		28.93

Outstanding at October 28, 2006		566,200		$	25.49

Expected to Vest		—		$	—

Based upon the Company’s current and expected performance, the Company does not expect to attain the Threshold performance level for either the fiscal 2006 or 2005 performance-based restricted stock awards.

Employee Stock Purchase Program

The employee stock purchase program enables employees to subscribe to purchase shares of the Company’s common stock on offering dates at six-month intervals, at a purchase price equal to 85 percent of the lesser of the fair market value of the common stock on the first or last day of the offering period. The total number of shares subject to stock purchase rights granted in any fiscal year for the ASOP may not exceed 1,000,000 shares. During the thirty-nine weeks ended October 28, 2006 and October 29, 2005, stock purchase rights of 197,850 shares and 132,787 shares, respectively, were granted and exercised under the ASOP. Related compensation expense was not significant.

Note 3 — Earnings Per Share

Basic earnings (loss) per common share are computed by dividing net income (loss) by the weighted average number of shares outstanding during the period. Diluted earnings per common share include the effect of the assumed exercise of dilutive stock-based awards under the treasury stock method.

The following table presents information necessary to calculate basic and diluted earnings (loss) per common share (shares in thousands):


	Thirteen Weeks Ended				Thirty-Nine Weeks Ended
	October 28,		October 29,		October 28,		October 29,
	2006		2005		2006		2005

Weighted average shares outstanding:
Basic common shares		23,548		22,703		23,442		22,589
Incremental shares from assumed exercise of stock options		150		—		—		—
Incremental restricted shares		288		—		—		—

Diluted common shares		23,986		22,703		23,442		22,589

For the third quarter of fiscal 2007, the above calculation reflects the impact of stock options that had exercise prices below the average market price of the Company’s common shares. For the year-to-date period of fiscal 2007, all outstanding stock options were excluded from the calculation of diluted net loss per common share, because they would have an anti-dilutive effect due to the Company’s net loss for the period. For the third quarter, an average of 981,692 stock options had exercise prices above the average market price of the Company’s common shares. For the year-to-date period of fiscal 2007, an average of 571,985 stock options had exercise prices below the average market price of the Company’s common shares and an average of 1,235,892 stock options had exercise prices above the average market price of the Company’s common shares. As of October 28, 2006, the Company had 743,711 time-based restricted stock awards issued and not yet vested, which were excluded from the calculation of diluted common shares for the year-to-date period.

For the third quarter and year-to-date period of fiscal 2006, all outstanding stock options were excluded from the calculation of diluted net loss per common share because they would have had an anti-dilutive effect due to the Company’s net loss for both periods. For the third quarter, an average of 1,585,405 stock options had exercise prices below the average market price of the Company’s common shares and an average of 528,990 stock options had exercise prices above the average market price of the Company’s common shares. For the year-to-date period, an average of 1,957,242 stock option awards had exercise prices below the average market price of the Company’s common shares and an average of 235,992 stock option awards had exercise prices above the average market price of the Company’s common shares. As of October 29, 2005, the Company had 444,260 time-based restricted stock awards issued and not yet vested, which were excluded from the calculation of diluted common shares.

Note 4 — Shareholders’ Equity

During the first thirty-nine weeks of fiscal 2007, shares outstanding increased by 322,000 as follows:


							Common
	Net						Stock		Additional
	Common			Treasury			Stated		Paid-In			Treasury
	Shares			Shares			Value		Capital			Stock

	(Shares in thousands)						(Dollars in millions)
Balance, January 28, 2006		23,375			3,675		$	1.4	$	165.4		$	(44.0	)
Exercise of stock options		73			(12	)		—		0.8			0.1
Purchase of common stock		(7	)		7			—		—			(0.1	)
Issuance of treasury shares		96			(96	)		—		0.7			0.6
Associate stock ownership plan		198			—			—		2.2			—
Stock-based compensation		(38	)		—			—		5.5			—
Cumulative effect of change in accounting principle		—			—			—		(1.6	)		—

Year-to-date activity		322			(101	)		—		7.6			0.6

Balance, October 28, 2006		23,697			3,574		$	1.4	$	173.0		$	(43.4	)

As of October 28, 2006, the Company had 1,798,760 stock options outstanding and 743,711 restricted stock awards issued and not yet vested, none of which are included in shares outstanding.

Note 5 — Sale-Leaseback Transaction

On October 19, 2006, the Company completed a sale-leaseback transaction of its distribution center located in Visalia, California (the “Facility”). The Company sold the Facility to an independent third party for approximately $24.7 million, net of expenses borne by the Company in connection with the sale. The Company has leased the Facility back from the purchaser and the Company is treating the lease as an operating lease.

The lease has an initial term of twenty years and will be automatically renewed for eight consecutive five-year renewal terms unless the Company provides notice of non-renewal prior to the commencement of any renewal term. A gain of $1.5 million in connection with the sale of the Facility was deferred, and is being amortized as a reduction of rent expense over the minimum lease term of 20 years. Rent payments under the lease will be payable monthly in advance. During each of the first five years of the term of the lease, annual rent payments will total $1.8 million. Thereafter, the annual rent payments will increase by 6% for each subsequent five-year period (whether during the initial term or with respect to a renewal term), subject to either parties’ right to have rent payments adjusted to a fair market rent, based on one or more appraisals, as necessary, in year 41. Total scheduled rent payments during the initial term of the lease will be approximately $38.8 million.

Note 6 — Recent Accounting Pronouncements

Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements”

In September 2006, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” (“SAB 108”), which provides interpretive guidance on the consideration of the effects of prior year misstatements in quantifying current year misstatements for the purpose of a materiality assessment. The cumulative effect of the initial application, if any, should be reported in the carrying amount of assets and liabilities as of the beginning of the fiscal year and the offsetting adjustment to the opening balance of retained earnings. SAB 108 is effective for the Company in fiscal 2007. The Company

does not expect the adoption of SAB No. 108 to have a material impact on its consolidated financial statements; however, the Company is still in the process of evaluating the potential impact, if any.

Statement of Financial Accounting Standards No. 157, “Fair Value Measurements”

In September 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 157, “Fair Value Measurements.” SFAS No. 157 defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting principles and expands disclosures about fair value measurements. SFAS No. 157 does not require any new fair value measurements but provides guidance in determining fair value measurements presently used in the preparation of financial statements. SFAS No. 157 is effective for the Company in fiscal 2009. The Company is currently assessing the impact that SFAS No. 157 will have on its consolidated financial statements upon adoption.

FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes — An Interpretation of FASB Statement No. 109”

In July 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes — An Interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with SFAS No. 109, “Accounting for Income Taxes.” FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition associated with tax positions. The provisions of FIN 48 are effective for the Company in fiscal 2008. The Company is currently evaluating the impact that FIN 48 will have on its consolidated financial statements upon adoption.

Note 7 — Consolidating Financial Statements (Unaudited)

The Company’s 7.5 percent senior subordinated notes and credit facility are fully and unconditionally guaranteed, on a joint and several basis, by the wholly-owned subsidiaries of the Company. The senior subordinated notes are subordinated to the Company’s credit facility.

Summarized consolidating financial information of the Company (excluding its subsidiaries) and the guarantor subsidiaries as of October 28, 2006 and January 28, 2006 and for the thirteen and thirty-nine weeks ended October 28, 2006 and October 29, 2005 are as follows:

Consolidating Balance Sheets
October 28, 2006


				Guarantor
	Parent			Subsidiaries			Eliminations			Consolidated

	(Dollars in millions)
Assets
Current assets:
Cash and cash equivalents	$	18.0		$	2.9		$	—		$	20.9
Inventories		231.2			304.6						535.8
Deferred income taxes		27.6			10.4						38.0
Prepaid expenses and other current assets		16.2			9.3						25.5

Total current assets		293.0			327.2			—			620.2

Property, equipment and leasehold improvements, net		146.7			167.0						313.7
Other assets		8.3			1.5						9.8
Investment in subsidiaries		45.6			—			(45.6	)		—
Intercompany receivable		404.3			—			(404.3	)		—

Total assets	$	897.9		$	495.7		$	(449.9	)	$	943.7


Liabilities and Shareholders’ Equity
Current liabilities:
Accounts payable	$	172.7		$	13.5		$	—		$	186.2
Accrued expenses		83.0			(13.7	)					69.3

Total current liabilities		255.7			(0.2	)		—			255.5

Long-term debt		200.3			—						200.3
Deferred income taxes		6.5			16.7						23.2
Lease obligations and other long-term liabilities		55.5			29.3						84.8
Intercompany payable		—			404.3			(404.3	)		—

Shareholders’ equity:
Preferred stock		—			—						—
Common stock		1.4			—						1.4
Additional paid-in capital		173.0			—						173.0
Retained earnings		248.9			45.6			(45.6	)		248.9

		423.3			45.6			(45.6	)		423.3
Treasury stock, at cost		(43.4	)		—						(43.4	)

Total shareholders’ equity		379.9			45.6			(45.6	)		379.9

Total liabilities and shareholders’ equity	$	897.9		$	495.7		$	(449.9	)	$	943.7

Note 7 — Consolidating Financial Statements (Unaudited) — CONTINUED

Consolidating Statements of Operations
Thirty-Nine Weeks Ended October 28, 2006 and October 29, 2005


	October 28, 2006
				Guarantor
	Parent			Subsidiaries			Eliminations			Consolidated
	(Dollars in millions)

Net sales	$	692.2		$	943.2		$	(385.6	)	$	1,249.8
Cost of sales		389.6			656.4			(385.6	)		660.4

Gross margin		302.6			286.8			—			589.4
Selling, general and administrative expenses		292.6			282.5						575.1
Store pre-opening and closing costs		5.1			6.0						11.1
Depreciation and amortization		18.3			18.2						36.5

Operating loss		(13.4	)		(19.9	)		—			(33.3	)
Interest expense, net		5.1			7.2						12.3

Loss before income taxes		(18.5	)		(27.1	)		—			(45.6	)
Income tax benefit		(6.9	)		(10.0	)					(16.9	)

Loss before equity loss & cumulative effect		(11.6	)		(17.1	)		—			(28.7	)
Equity loss from subsidiaries		(17.1	)		—			17.1			—

Loss before cumulative effect		(28.7	)		(17.1	)		17.1			(28.7	)
Cumulative effect of accounting change, net of tax		1.0			—			—			1.0

Net loss	$	(27.7	)	$	(17.1	)	$	17.1		$	(27.7	)


	October 29, 2005
				Guarantor
	Parent			Subsidiaries		Eliminations			Consolidated
	(Dollars in millions)

Net sales	$	699.9		$	1,084.4	$	(505.6	)	$	1,278.7
Cost of sales		447.1			731.3		(505.6	)		672.8

Gross margin		252.8			353.1		—			605.9
Selling, general and administrative expenses		273.3			282.7					556.0
Store pre-opening and closing costs		12.2			5.2					17.4
Depreciation and amortization		15.1			16.0					31.1

Operating (loss) profit		(47.8	)		49.2		—			1.4
Interest expense, net		3.1			5.6					8.7

(Loss) income before income taxes		(50.9	)		43.6		—			(7.3	)
Income tax (benefit) provision		(16.0	)		13.7					(2.3	)

(Loss) income before equity income		(34.9	)		29.9		—			(5.0	)
Equity income from subsidiaries		29.9			—		(29.9	)		—

Net (loss) income	$	(5.0	)	$	29.9	$	(29.9	)	$	(5.0	)

Note 7 — Consolidating Financial Statements (Unaudited) — CONTINUED

Consolidating Statements of Cash Flows
Thirty-Nine Weeks Ended October 28, 2006 and October 29, 2005


	October 28, 2006
				Guarantor
	Parent			Subsidiaries			Eliminations		Consolidated
	(Dollars in millions)

Net cash provided by operating activities	$	14.8		$	5.5		$	—	$	20.3

Net cash flows used for investing activities:
Capital expenditures		(13.0	)		(29.7	)				(42.7	)
Net proceeds from sale-leaseback transaction		—			24.7					24.7

Net cash used for investing activities		(13.0	)		(5.0	)		—		(18.0	)

Net cash flows provided by financing activities:
Net change in revolving credit facility		(3.4	)		—					(3.4	)
Proceeds from stock-based compensation plans		3.1			—					3.1
Other, net		1.0			—					1.0

Net cash provided by financing activities		0.7			—			—		0.7


Net increase in cash and cash equivalents		2.5			0.5			—		3.0
Cash and cash equivalents at beginning of period		15.5			2.4			—		17.9

Cash and cash equivalents at end of period	$	18.0		$	2.9		$	—	$	20.9


	October 29, 2005
				Guarantor
	Parent			Subsidiaries			Eliminations		Consolidated
	(Dollars in millions)

Net cash (used for) provided by operating activities	$	(206.2	)	$	46.3		$	—	$	(159.9	)

Net cash flows used for investing activities:
Capital expenditures		(45.9	)		(45.9	)				(91.8	)

Net cash used for investing activities		(45.9	)		(45.9	)		—		(91.8	)

Net cash flows provided by financing activities:
Net change in revolving credit facility		190.0			—					190.0
Proceeds from stock-based compensation plans		5.5			—					5.5
Other, net		0.7			—					0.7

Net cash provided by financing activities		196.2			—			—		196.2


Net (decrease) increase in cash and cash equivalents		(55.9	)		0.4			—		(55.5	)
Cash and cash equivalents at beginning of period		76.6			3.0			—		79.6

Cash and cash equivalents at end of period	$	20.7		$	3.4		$	—	$	24.1

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

This discussion is intended to provide the reader with information that will assist in an overall understanding of our financial statements, changes in certain key indicators in those financial statements from year to year, the factors that account for those changes and how certain accounting principles have impacted our financial statements. This discussion should be read in conjunction with the audited consolidated financial statements and notes to the consolidated financial statements presented in our Annual Report on Form 10-K. The financial information presented for the interim period of fiscal 2006 has been reclassified for certain amounts to conform to the fiscal 2007 presentation.

General Overview

We are the nation’s largest specialty retailer of fabrics and one of the largest specialty retailers of crafts, serving customers in their pursuit of apparel and craft sewing, crafting, home decorating and other creative endeavors. Our retail stores (operating as Jo-Ann Fabric and Craft traditional stores and Jo-Ann superstores) feature a variety of competitively priced merchandise used in sewing, crafting and home decorating projects, including fabrics, notions, yarn, crafts, frames, paper crafting material, artificial and dried flowers, home accents, finished seasonal and home décor merchandise.

We continue to transition our store base by replacing our existing traditional stores with superstores. During fiscal 2007 we expect to open 26 stores, 21 of which will be new superstores, compared with 40 superstore openings during fiscal 2006. During the third quarter year-to-date period of fiscal 2007, we opened 20 superstores and five traditional stores and closed 46 traditional stores and two superstores. We believe that our prototype 35,000 square foot superstore gives us a competitive advantage in the industry. Our superstores provide a unique shopping experience by offering a full creative selection — sewing, crafting, framing, seasonal, floral and home décor accessories — all under one roof. On average, we close approximately 1.1 traditional stores for every superstore that we open. Our superstores typically average over three times the revenues of the traditional stores they replace. In markets where we have opened multiple superstores, we have grown our revenues significantly and, we believe, expanded the market size and our market share.

As of October 28, 2006, we operated 815 stores in 47 states (643 traditional stores and 172 superstores — 101 of which are the prototype superstore format). Our traditional stores offer a complete selection of fabric and a convenience assortment of crafts, floral, finished seasonal and home décor merchandise. Our traditional stores average approximately 14,650 square feet and generated net sales per store of approximately $1.6 million in fiscal 2006. Our superstores offer an expanded and more comprehensive product assortment than our traditional stores. Our superstores also offer custom framing and educational programs that our traditional stores do not. Our superstores that opened prior to fiscal 2003 average approximately 45,000 square feet and generated net sales per store of approximately $6.3 million in fiscal 2006. Our current superstore prototype is 35,000 square feet, and stores open at least one year generated average net sales per store of approximately $5.0 million in fiscal 2006.

Executive Overview

Our overall performance represented an improvement over last year’s third quarter. While net sales from stores open one year or more (“same-store sales”) declined 5.4% during the quarter, our gross margin rate improved 180 basis points and we generated more gross margin dollars than we did in the prior year third quarter. We have successfully completed our Repair Plan, resulting in a more stable business. We made meaningful progress in the areas that the Repair Plan was designed to address, including inventory management and the reduction of selling, general and administrative expenses (“SG&A”), leaving us with a stronger balance sheet.

Highlights of our third quarter performance are as follows:

•

Net sales decreased 2.6% to $461.9 million from $474.2 million in the prior year. Same-store sales decreased 5.4% versus a 0.7% same-store sales increase for the third quarter last year. The decline in same-store sales was related to a decrease in customer transactions, as average ticket was consistent with the prior year. The decrease in customer transactions was driven by lower customer traffic, in part, due to reduced newspaper ad inserts compared with last year. The conversion rate for the quarter was consistent with the prior year third quarter, which is an improvement over the negative trend we experienced in the first half of the year.

•

Our gross margin rate increased by 180 basis points, to 47.4% of net sales this quarter versus 45.6% for the third quarter last year. The increase is due to a less promotional pricing strategy, better sell-through on seasonal goods and reduced sales of clearance inventory.

•

Our SG&A, excluding those expenses separately identified in the statement of operations, increased 100 basis points to 43.0% of net sales from 42.0% of net sales in the third quarter last year. While total SG&A expense dollars are below last year spending levels, the increase as a percentage of net sales is due to the lack of leverage resulting from lower sales. SG&A expenses also include $2.0 million of severance-related costs associated with 40 additional head count reductions at our store support center.

SG&A includes stock-based compensation expense of $2.2 million, net of estimated forfeitures, in the third quarter of fiscal 2007, compared with a credit of $1.8 million in the third quarter last year. The credit in the prior year quarter was the result of executive departures and an adjustment of $2.0 million to reverse previously recorded expense for performance awards due to a decline in business conditions at that time.

•

Store pre-opening and closing costs decreased $5.5 million for the third quarter of fiscal 2007 to $3.0 million, compared with $8.5 million in the third quarter last year, due to fewer store openings and closings year-over-year.

•

Third quarter net income was $0.1 million or $0.00 per diluted share, versus a net loss of $4.1 million or $(0.18) per diluted share in the third quarter last year.

•

During the third quarter, we completed a sale-leaseback transaction of our distribution center located in Visalia, California. We sold the facility to an independent third party for approximately $24.7 million, and have leased the facility back from the purchaser. The initial term of the lease is for 20 years and can be automatically renewed for eight consecutive five-year renewal terms unless we provide notice of non-renewal. A gain of $1.5 million on the sale of the facility was deferred and is being amortized as a reduction of rent expense over the initial term of 20 years.

Results of Operations

The following table sets forth our results of operations through operating profit, expressed as a percentage of net sales. The following discussion should be read in conjunction with our consolidated interim financial statements and related notes thereto.


	Percentage of Net Sales
	Thirteen						Thirty-Nine
	Weeks Ended						Weeks Ended
	October 28,			October 29,			October 28,			October 29,
	2006			2005			2006			2005
Net sales		100.0	%		100.0	%		100.0	%		100.0	%
Gross margin		47.4	%		45.6	%		47.2	%		47.4	%
Selling, general and administrative expenses		43.0	%		42.0	%		46.0	%		43.5	%
Store pre-opening and closing costs		0.6	%		1.8	%		0.9	%		1.4	%
Depreciation and amortization		2.7	%		2.2	%		3.0	%		2.4	%

Operating profit (loss)		1.1	%		(0.4	)%		(2.7	)%		0.1	%

Comparison of the Thirteen Weeks Ended October 28, 2006 to October 29, 2005

Net Sales. Net sales for the third quarter of fiscal 2007 decreased 2.6% to $461.9 million from $474.2 million in the prior year. Same-store sales decreased 5.4% during the quarter versus a 0.7% same-store sales increase in the third quarter last year. Although our total store count at the end of the quarter decreased by 27 units from last year’s third quarter, the number of superstores in operation increased to 172 at the quarter end from 142 at the end of last year’s third quarter. Total store square footage increased approximately 2.5% over last year’s third quarter. Superstores accounted for 47% of total net sales for the third quarter of fiscal 2007, compared with approximately 42% of total net sales in the third quarter last year.

The decline in sales was related to a decrease in customer transactions, as average ticket was consistent with the prior year. The decrease in customer transactions was driven by lower customer traffic, in part, due to reduced newspaper ad inserts compared with last year. The conversion rate for the quarter was consistent with the prior year third quarter, which is an improvement over the negative trend we experienced in the first half of the year. By store format, our same-store sales performance for traditional stores decreased 3.5% versus a same-store sales increase of 0.6% for the prior year third quarter. Same-store sales for superstores decreased 7.7% for the quarter versus a same-store sales increase of 0.8% for the prior year third quarter. Superstore sales performance, compared with traditional store sales performance, were influenced by three distinct factors. These included less fall and Halloween seasonal merchandise offerings, significantly less clearance merchandise available and reduced newspaper ad inserts compared with last year.

On a category basis, our hardlines, defined as all of our non-sewing categories, represented 46% of our third quarter sales volume and decreased approximately 6.8% on a same-store sales basis. The primary source of the decrease in this category was a decline in yarn sales, paper crafting, seasonal and floral, partially offset by increases in jewelry and kids’ crafts. Our softlines, or sewing related businesses, represented 54% of our third quarter sales volume and decreased approximately 4.3% on a same-store sales basis for the quarter. The decrease in softlines primarily was the result of weakening sales trends in home decorating textiles and fleece, which is consistent with previous trends we have identified.

Gross Margin. Gross margins may not be comparable to those of our competitors and other retailers. For instance, some retailers include all of the costs related to their distribution network and/or occupancy costs in cost of sales, while we exclude a portion of them from gross margin, including those costs instead within SG&A. As a percent of net sales, gross margin increased 180 basis points to 47.4% for the third quarter of fiscal 2007 compared with 45.6% for the same quarter last year. The increase is due to a less promotional pricing strategy, better sell-through on seasonal goods and reduced sales of clearance inventory.

Selling, general and administrative expenses. SG&A expenses include store and administrative payroll, employee benefits, stock-based compensation, distribution costs, store occupancy costs, advertising expenses and administrative expenses. SG&A expenses, excluding other expenses separately identified in the statement of operations, were $198.5 million in the third quarter compared with $199.0 million in the prior year third quarter. As a percentage of net sales, SG&A expenses increased 100 basis points to 43.0% of net sales, from 42.0% of net sales in the third quarter of last year. SG&A expenses also include $2.0 million of severance related costs associated with 40 additional head count reductions at our store support center. While total SG&A expenses are below last year spending levels, the increase as a percentage of net sales is due to the lack of leverage resulting from lower sales.

Under Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment,” (“SFAS No. 123R”), stock-based compensation includes the expensing of stock options and the amortization of the value of restricted stock granted to employees, net of estimated forfeitures. Stock-based compensation expense was $2.2 million, net of estimated forfeitures, for the third quarter of fiscal 2007, compared with a credit of $1.8 million in the same period last year. The reduced expense in the third quarter of the prior year is attributable to an adjustment of $2.0 million that was recognized to reduce previously recorded expense for performance awards due to a decline in business conditions at that time. In addition, in the prior year third quarter, stock-based compensation expense was credited for $1.1 million for expense that had been previously recognized for executives who left the company during that quarter.

Store pre-opening and closing costs. Pre-opening costs are expensed as incurred and relate to the costs incurred prior to a new store opening, which includes lease costs recognized prior to the store opening, hiring and training costs for new employees and processing of initial merchandise. Store closing costs consist of lease termination costs, lease costs for closed locations, loss on disposal of fixtures and equipment, severance for store employees, third-party inventory liquidation costs and other costs incidental to store closings.

Store pre-opening and closing costs decreased $5.5 million during the third quarter of fiscal 2007 to $3.0 million, compared with $8.5 million in the third quarter last year, due to fewer store openings and closings compared with the prior year. Store pre-opening costs decreased $4.3 million during the quarter to $1.3 million compared with $5.6 million in last year’s third quarter. Store closing costs decreased $1.2 million during the quarter to $1.7 million compared with $2.9 million in last year’s third quarter.

Depreciation and amortization. Depreciation and amortization expense in the third quarter increased $2.1 million to $12.6 million from $10.5 million in the prior year. The increase is due to the new superstore growth, as well as the opening of our new distribution center during the first quarter.

Interest expense. Interest expense in the third quarter of fiscal 2007 increased $0.8 million to $4.9 million from $4.1 million in the third quarter last year, primarily due to a higher average borrowing rate on our bank credit facility. Although our average debt levels during the third quarter of fiscal 2007 of $249 million were down from the prior year of $260 million, our average interest rate on credit facility borrowings was higher than the prior year third quarter due to an increase in the London Interbank Offered Rate (“LIBOR”) versus last year.

Income taxes. Our effective income tax rate for the third quarter of fiscal 2007 was approximately 37% compared with 30% for the same period in the prior year. The effective rate for the prior year quarter was lower due to the effect of recording certain period or discrete items during the quarter. Our effective tax rate is subject to change based on the mix of income from different state jurisdictions that tax at different rates, as well as the change in status or outcome of uncertain tax positions. We evaluate our effective rate on a quarterly basis and update our estimate of the full-year effective rate as necessary.

Comparison of the Thirty-Nine Weeks Ended October 28, 2006 to October 29, 2005

Net Sales. Net sales for the first three quarters of fiscal 2007 decreased 2.3% to $1.250 billion from $1.279 billion in the prior year. Year-to-date same-store sales decreased 5.8% versus a same-store sales increase of 0.3% last year. Superstores accounted for 46% of total net sales year-to-date versus 40% of total net sales in the prior year period.

The decline in sales was due to fewer customer transactions resulting from less traffic and lower conversion rates. Average ticket was consistent with the prior year. By store format, our same-store sales performance for traditional stores decreased 3.8% year-to-date versus a same-store sales decrease of 0.5% in the prior year period. Same-store sales for superstores decreased 8.5% year-to-date versus a same-store sales increase of 1.8% in the prior year period. Superstores sales were impacted by the decrease in newspaper ad inserts that ran in the superstore markets last year that were not repeated this year, as well as an adjustment of store merchandise assortments that more significantly impacted superstores.

On a category basis, our hardlines, defined as all of our non-sewing categories, represented 47% of our year-to-date sales volume and decreased approximately 6.4% on a same-store sales basis. The primary causes of the decrease in this category were negative results in yarn, paper crafting, seasonal, home accent categories, and floral, partially offset by increases in jewelry and kids’ crafts. Our softlines, or sewing related businesses, represented 53% of our year-to-date sales volume, and decreased approximately 5.9% on a same-store sales basis for the first nine months. The decrease in softlines primarily was the result of weakening sales trends in home decorating fabric and fleece, which continue to be slowing categories.

Gross Margin. Gross margins may not be comparable to those of our competitors and other retailers. Some retailers include all of the costs related to their distribution network in cost of sales, while we exclude a portion of them from gross margin, including those costs instead within SG&A. As a percent of net sales, gross margin decreased 20 basis points to 47.2% for the first three quarters of fiscal 2007 compared with 47.4% for the same period a year earlier. The decrease is attributable to steps we have taken to reduce inventory and is primarily due to higher markdowns related to clearance activity, substantially offset by a less promotional pricing strategy and better sell-through on seasonal goods in the third quarter.

Selling, general and administrative expenses. SG&A expenses include store and administrative payroll, employee benefits, stock-based compensation, distribution costs, store occupancy costs, advertising expenses and administrative expenses. SG&A expenses, excluding other expenses separately identified in the statement of operations, were $575.1 million for the first three quarters of fiscal 2007 compared with $556.0 million in the prior year. As a percentage of net sales, SG&A expenses increased 250 basis points to 46.0% of net sales, from 43.5% of net sales last year. The increase as a percentage of net sales is due to negative same-store sales performance, increases in logistics costs related to the opening of our new distribution center, and increases in fixed store expenses, primarily caused by costs related to the new superstores and the larger year-over-year superstore base. On a year-to-date basis, we have incurred $4.4 million of separation costs related to the former chief executive officer and $3.5 million related to the recruitment and relocation of executive officers, as well as severance related to the reduction of 75 positions at our store support center.

Under SFAS No. 123R, stock-based compensation includes the expensing of stock options and the amortization of the value of restricted stock granted to employees, net of estimated forfeitures. Stock-based compensation expense was $5.5 million, net of estimated forfeitures, for the first three quarters of fiscal 2007, compared with $1.2 million in the same period last year. The reduced expense in the prior year-to-date period is primarily attributable to a reduced expectation regarding the level of performance-based shares that may be earned under the restricted stock program. Our revised expectation in the third quarter of fiscal 2006 was based on our operating performance, and resulted in a reversal of $2.4 million of performance-based expense that had been previously recorded. In addition, stock based compensation

expense was credited for $1.1 million of expense that had been previously recognized for executives that left the Company in the prior year third quarter.

Store pre-opening and closing costs decreased $6.3 million year-to-date to $11.1 million, due to fewer store openings compared with the prior year. Store pre-opening costs decreased $6.8 million during the year-to-date period to $4.7 million compared with $11.5 million in last year’s year-to-date period. Store closing costs increased $0.5 million during the year-to-date period to $6.4 million compared with $5.9 million in the same period of the prior year, as year-over-year closings increased from 40 to 48 in fiscal 2007.

Depreciation and amortization. Depreciation and amortization increased $5.4 million to $36.5 million in the first three quarters of fiscal 2007 from $31.1 million last year. The increase is due to the new superstore growth, as well as the opening of our new distribution center, which we began depreciating during the first quarter this year. Fiscal 2007 depreciation is estimated to be approximately $48 to $50 million, primarily as a result of incremental depreciation related to new stores and the opening of the new distribution center.

Interest expense. Interest expense in the first three quarters of fiscal 2007 increased $3.6 million to $12.3 million from $8.7 million in the same period in the prior year, primarily due to an increase in our average debt levels, as well as a higher borrowing rate on our bank credit facility. Our average debt levels year-to-date in fiscal 2007 were $218 million, versus $162 million last year.

Income taxes. Our effective income tax rate for the third quarter year-to-date of fiscal 2007 was approximately 37.0%. The effective income tax rate for the same period in fiscal 2006 was approximately 31.5%. The effective rate for the prior year-to-date period was lower than the current year-to-date period due to the effect of recording certain period or discrete items during the third quarter of fiscal 2006. Our effective tax rate is subject to change based on the mix of income from different state jurisdictions that tax at different rates, as well as the change in status or outcome of uncertain tax positions. We evaluate our effective rate on a quarterly basis and update our estimate of the full-year effective rate as necessary.

Cumulative effect of change in accounting principle. Effective January 29, 2006, we adopted SFAS No. 123R, which, among other things, changes the method of accounting for forfeited share-based awards. Under the new standard, we are required to estimate forfeitures at the time of the award grant, rather than accounting for them as they occur. We had been expensing share-based awards without estimating forfeitures, and reduced the expense recognized as forfeitures actually occurred. Accordingly, as of the adoption date, we are required to reduce our previously recognized expense based on estimated forfeitures of existing awards, which have not yet vested. The amount of this reduction is presented on the statement of operations as a cumulative effect of change in accounting principle, net of tax. The cumulative adjustment increased fiscal 2007 net earnings by $1.0 million, or $0.04 per diluted common share.

Liquidity and Capital Resources

Our capital requirements are primarily for capital expenditures in connection with new store openings, the construction of our third distribution center, other infrastructure investments and working capital requirements for seasonal inventory builds and new store inventory purchases. Working capital requirements fluctuate during the year and reach their highest levels during the third fiscal quarter as we increase our inventory in preparation for our peak selling season during the months of September through December. These requirements are funded through a combination of internally generated cash flows from operations, credit extended by suppliers and borrowings under our bank credit facility.

We believe that our bank credit facility, coupled with cash on hand and cash from operations, will be sufficient to cover our working capital, capital expenditure and debt service requirement needs for the foreseeable future.

Our liquidity is based, in part, on our corporate and unsecured debt ratings. As of October 28, 2006, our corporate and unsecured debt ratings were rated “B1” and “B3” with Moody’s Investors Service and “B-” and “CCC” with Standard & Poor’s, respectively. In November 2006, Moody’s Investors Service downgraded our corporate debt rating to“B3” and our unsecured debt rating to “Caa2.” This downgrade by Moody’s Investors Service is consistent with that initiated by Standard & Poor’s in April and reflects their view of the deterioration of our business through the second quarter of fiscal 2007 and the longer term impact this deterioration may have on our liquidity should these trends continue. Both Moody’s Investors Service and Standard & Poor’s have the Company on credit watch for possible future downgrade. In assessing our credit strength, both Moody’s Investors Service and Standard & Poor’s consider our capital structure and financial policies, as well as our consolidated balance sheet and other financial information. Our credit ratings could adversely impact, among other things, our future borrowing costs, access to capital markets and new store operating lease costs, although we anticipate no short-term effect under our current credit arrangements.

The following table provides cash flow related information for the first three quarters of fiscal 2007 and 2006:


Dollars in millions	2007			2006

Net cash provided by (used for) operating activities	$	20.3		$	(159.9	)
Net cash used for investing activities		(18.0	)		(91.8	)
Net cash provided by financing activities		0.7			196.2

Net increase (decrease) in cash and cash equivalents	$	3.0		$	(55.5	)

Ending cash and cash equivalents	$	20.9		$	24.1

Net cash provided by (used for) operating activities

Net cash provided by operations was $20.3 million in the first three quarters of fiscal 2007 compared with net cash used for operating activities of $159.9 million in the first three quarters of fiscal 2006, an increase of $180.2 million. The increase was generated by changes in operating assets and liabilities, which in the first three quarters of fiscal 2007 represented a $5.3 million source of cash versus a $190.3 million use of cash in the same period last year. Cash flows provided by operating activities, before changes in operating assets and liabilities, were $15.0 million in fiscal 2007 versus $30.4 million generated in fiscal 2006. The decrease in cash flows from operating activities, before changes in operating assets and liabilities, was caused primarily by our lower earnings in the first three quarters of fiscal 2007.

Inventories, net of payable support, were an $18.5 million net source of cash in the first three quarters of fiscal 2007, compared with a $178.5 million net use of cash in fiscal 2006. Total inventories

decreased $118.3 million, or 18.1%, year-over-year. Inventory levels on a same-store basis were down approximately 17% in our traditional stores and 23% in our superstores, respectively. Inventory reductions have occurred in categories primarily related to seasonal, fashion and clearance merchandise.

We are currently undergoing an Internal Revenue Service examination of our returns for the fiscal 2003 through fiscal 2005 tax years. As a result of the examination, we anticipate a payment in the range of $14.0 million to $16.0 million, related to temporary differences and interest thereon. We believe that adequate amounts have been reserved for any adjustments which may ultimately result from these examinations.

Net cash used for investing activities

Net cash used for investing activities totaled $18.0 million in the first three quarters of fiscal 2007, which was comprised of capital expenditures of $42.7 million, partially offset by proceeds of $24.7 million from the sale-leaseback of our distribution center in Visalia, California. Net cash used for investing activities of $91.8 million in fiscal 2006 consisted entirely of capital spending. Capital expenditures consist of cash expenditures and cash expenditures reimbursed by landlords. Landlord reimbursed capital expenditures represent the cost of assets acquired with landlord lease incentives. Capital expenditures are summarized as follows:


	Thirty-Nine Weeks Ended
	October 28,		October 29,
Dollars in millions	2006		2005

Cash	$	30.8	$	76.5
Cash — landlord reimbursed		11.9		15.3

Total	$	42.7	$	91.8

We anticipate capital expenditures for the full fiscal year 2007 to be approximately $43 to $45 million, which is net of expected landlord allowances of approximately $15 million. During the first three quarters of fiscal 2007, we opened 20 superstores and five traditional stores and closed 46 traditional stores and two superstores. Traditional store closings are related to superstore openings in traditional store markets, as well as normal performance related closings for stores that do not meet minimum performance requirements. Store related expenditures, including the 25 new store openings, represented the majority of the capital spending, net of the landlord allowances received. The remaining capital related primarily to the opening of the new distribution center.

For the balance of the fiscal year, we expect to open one additional superstore and close approximately 14 traditional stores. Our 815 stores at the end of the third quarter consisted of 643 traditional stores and 172 superstores.

Net cash provided by financing activities

Net cash provided by financing activities was $0.7 million during the first three quarters of fiscal 2007 compared with $190.0 million during the same period in fiscal 2006. The cash flows provided from the increased borrowings on the bank credit facility were primarily used to increase inventory levels in fiscal 2006, which did not recur in fiscal 2007. Debt borrowings were $200 million at the end of the third quarter of fiscal 2007, which was a decrease of $3.4 million from the beginning of the year and a decrease of $90 million from the same period in the prior year. Our debt levels are projected to peak at the end of the third quarter, as they historically have, and then be paid down in the fourth quarter.

As of October 28, 2006, we had the ability to borrow $221.8 million under our bank credit facility, subject to the borrowing base calculation, as defined. Our debt-to-capitalization ratio was 34.5% at October 28, 2006, 33.8% at January 28, 2006 and 41.3% at October 29, 2005.

Off-Balance Sheet Transactions

Our liquidity is not currently dependent on the use of off-balance sheet transactions other than letters of credit and operating leases, which are typical in a retail environment.

In October 2006, we completed a sale-leaseback transaction of our distribution center located in Visalia, California. For more information regarding that transaction, see Note 5 in our notes to unaudited consolidated financial statements included in this Form 10-Q.

Business Outlook

Previously, we had communicated that our outlook for the current year was for a difficult first half of the year, with year-over-year improvement in the back half of the year. Our current outlook is consistent with our previous communications. Based upon our operating and industry assumptions, along with the completion of the Repair Plan initiatives, we expect year-over-year improvement in our business performance in the fourth quarter of this year. The key considerations for understanding this outlook for fiscal 2007 include:

	•		Same-store sales decline in the fourth quarter, improving slightly from year-to-date results;

	•		Gross margin rate improvement for the full year of 70 to 90 basis points in fiscal 2007 from fiscal 2006;

	•		Selling, general and administrative expenses for the full year, excluding the former chief executive officer separation expenses, to increase 95 to 110 basis points as a percentage of net sales from fiscal 2006;

	•		Capital spending for the full year of $43 to $45 million, net of the landlord allowances received, primarily related to the opening of the 26 new stores; and

	•		Strengthening of the balance sheet through inventory reduction of $50 to $55 million as of the end of the fiscal year, and a resulting debt reduction by fiscal year end of $75 to $85 million, which includes $25 million of proceeds received from our sale-leaseback of our Visalia distribution center completed during the third quarter this year.

Our actual results in the fourth quarter are highly dependent on the same-store sales performance and gross margin rate we are ultimately able to achieve during the year.

Seasonality and Inflation

Our business exhibits seasonality, which is typical for most retail companies. Our net sales are much stronger in the second half of the year than the first half of the year. Net earnings are highest during the months of September through December when sales volumes provide significant operating leverage. 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.

We believe that inflation has not had a significant effect on net sales or on our earnings performance. There can be no assurance, however, that our operating results will not be affected by inflation in the future.

Critical Accounting Policies

Our condensed consolidated interim financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America. Preparation of these statements requires management to make judgments and estimates. Some accounting policies have a significant impact on amounts reported in these financial statements. A summary of significant accounting policies and a description of accounting policies that are considered critical may be found in our fiscal 2006 Annual Report on Form 10-K in the notes to the consolidated financial statements, Note 1 and the “Critical Accounting Policies and Estimates” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations.

Cautionary Statement Concerning Forward-Looking Statements

Certain statements contained in this report that are not historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements, which reflect the Company’s current views of future events and financial performance, involve certain risks and uncertainties. When used herein, the terms “anticipates,” “plans,” “estimates,” “expects,” “believes,” and similar expressions as they relate to us or future or conditional verbs such as “will,” “should,” “would,” “may,” and “could” are intended to identify such forward-looking statements. Our actual results, performance or achievements may differ materially from those expressed or implied in the forward-looking statements. Risks and uncertainties that could cause or contribute to such material differences include, but are not limited to, general economic conditions, changes in customer demand, changes in trends in the fabric and craft industry, seasonality, failure to manage new store growth and the store transition strategy, the availability of merchandise, changes in the competitive pricing for products, the impact of competitors’ store openings and closings, longer-term unseasonable weather or wide spread severe weather, our ability to effectively manage our distribution network, our ability to recruit and retain highly qualified personnel, our ability to sell-through our inventory at acceptable prices, energy costs, increases in transportation costs, our indebtedness and limits on obtaining additional financing, failure to maintain the security of our electronic and other confidential information, failure to comply with various laws and regulations, consumer confidence and debt levels, and other capital market and geo-political conditions. We caution readers not to place undue reliance on these forward-looking statements. We assume no obligation to update any of the forward-looking statements.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

In the normal course of business, the Company employs established policies and procedures to manage exposure to changes in interest rates. The Company’s objective in managing the exposure to interest rate changes is to limit the volatility and impact of interest rate changes on earnings and cash flows. This is accomplished through our debt structure, which consists of fixed rate senior subordinated notes and a variable rate senior bank credit facility that is designed to be a working capital facility. In the past, the Company also utilized interest rate swaps to achieve this objective. The Company utilized interest rate swaps to manage net exposure to interest rate changes related to the Company’s variable rate bank credit facilities. The interest rate swap agreements required the Company to pay a fixed interest rate while receiving a floating interest rate based on London Interbank Offered Rate (''LIBOR’’). The Company does not enter into financial instruments for trading purposes. The Company had a $40.0 million interest rate swap with a fixed LIBOR rate of 6.72 percent that expired on April 30, 2005. The Company has not entered into any new interest rate swap agreements.

Item 4. Controls and Procedures

As of the end of the period covered by this report, the Company conducted an evaluation, under the supervision and with the participation of the principal executive officer and principal financial officer of the effectiveness of the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”)). Based on this evaluation, the principal executive officer and principal financial officer concluded that the Company’s disclosure controls and procedures are effective to ensure that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms.

There have been no changes in our internal control over financial reporting identified in connection with the evaluation required by Rule 13a-15(d) of the Exchange Act that occurred during our last fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

We are involved in various litigation matters in the ordinary course of our business. We are not currently involved in any litigation which we expect, either individually or in the aggregate, will have a material adverse effect on our financial condition or results of operations.

Item 1A. Risk Factors

None.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

Purchases of Equity Securities by Jo-Ann Stores, Inc.


					Total Number of		Maximum Number
					Shares Purchased		of Shares that May
	Total Number		Average		as Part of Publicly		Yet Be Purchased
	of Shares		Price Paid		Announced Plans or		Under the Plans or
	Purchased		per Share		Programs		Programs
July 30 — August 26, 2006		—	$	—		905,544		1,244,456
August 27 — Sept. 30, 2006		472	$	15.94		906,016		1,243,984
October 1—28, 2006		—	$	—		906,016		1,243,984

Total		472	$	15.94		906,016		1,243,984

In December 1998, the Company’s Board of Directors authorized a discretionary program that allowed the Company to buy back 2,150,000 common shares. That program does not have a stated expiration date. In the table above, the total number of shares purchased represents shares purchased directly from the market, as well as shares purchased from employees related to the lapse of restricted shares and exercise of employee stock options which were provided to the Company to satisfy related tax withholding requirements.


	Page Numbers
Part I. Financial Information

Item 1. Financial Statements

Consolidated Balance Sheets — October 28, 2006 (Unaudited), January 28, 2006 and October 29, 2005 (Unaudited)		1

Unaudited Consolidated Statements of Operations for the Thirteen and Thirty-Nine Weeks Ended October 28, 2006 and October 29, 2005		2

Unaudited Consolidated Statements of Cash Flows for the Thirty-Nine Weeks Ended October 28, 2006 and October 29, 2005		3

Notes to Unaudited Consolidated Financial Statements		4

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		16

Item 3. Quantitative and Qualitative Disclosures about Market Risk		25

Item 4. Controls and Procedures		26

Part II. Other Information

Item 1. Legal Proceedings		26

Item 1A. Risk Factors		26

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds		26

Item 3. Defaults Upon Senior Securities		27

Item 4. Submission of Matters to a Vote of Security Holders		27

Item 5. Other Information		27

Item 6. Exhibits		27

Signatures		28
EX-31.1
EX-31.2
EX-32.1


No.		Exhibit Description
	10.1	Lease Agreement, dated as of October 19, 2006, between BPVisalia LLC, as Landlord, and Jo-Ann Stores Supply Chain Management, Inc., as Tenant (incorporated by reference to Exhibit 10.1 of Form 8-K, filed with the Securities and Exchange Commission on October 25, 2006)

	31.1	Section 302 Certification By Chief Executive Officer

	31.2	Section 302 Certification By Chief Financial Officer

	32.1	Section 906 Certification of Principal Executive Officer and Principal Financial Officer


	JO-ANN STORES, INC.
DATE: December 7, 2006	/s/ Darrell Webb
	Darrell Webb,
	President and Chief Executive Officer


	/s/ James Kerr
	James Kerr,
	Executive Vice President and Chief Financial Officer

	(a)		Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

	(b)		Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

	(c)		Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

	(d)		Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

	(a)		All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

	(b)		Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

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Ohio (State or other jurisdiction of incorporation or organization)		34-0720629 (I.R.S. Employer Identification No.)


5555 Darrow Road, Hudson, Ohio (Address of principal executive offices)		44236 (Zip Code)



	/s/ Darrell Webb
	By: Darrell Webb
	President and Chief Executive Officer



	/s/ James Kerr
	By: James Kerr
	Executive Vice President and Chief Financial Officer



	/s/ Darrell Webb
	Darrell Webb
	President and Chief Executive Officer


	/s/ James Kerr
	James Kerr
	Executive Vice President and Chief Financial Officer