HOUSE OF FABRICS INC/DE/
10-Q, 1997-09-10
MISCELLANEOUS SHOPPING GOODS STORES
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<PAGE>
 
                                 United States
                      Securities and Exchange Commission
                            Washington, D.C. 20549

                                   FORM 10-Q

                                  (Mark One)
[X] Quarterly Report Pursuant to Section 13 or 15 (d) of the Securities Exchange
                                  Act of 1934
                 For the quarterly period ended JULY 31, 1997.
                                                ------------- 

                                      or

[_] Transition Report Pursuant to Section 13 or 15(d) of the Securities
               Exchange Act of 1934  For the Transition period 
                    from _______________ to _____________.
                                        
                           Commission File No. 1-7927
                                               ------

                             HOUSE OF FABRICS, INC.
                             --------------------- 

             (Exact Name of Registrant as specified in its charter)


                Delaware                                   95-3426136
- ---------------------------------------           -----------------------------
    (State or other jurisdiction)                 (I.R.S. Employer I.D. Number)
 
13400 Riverside Drive, Sherman Oaks, CA                       91423
- ---------------------------------------                       -----
 
Post Office Box 9110, Van Nuys, CA                            91409
- ----------------------------------                            -----
(Address of principal executive offices)                    (Zip Code)

       Registrant's telephone number, including area code (818) 995-7000
                                                          --------------

                                   No Change
    _______________________________________________________________________
              Former name, former address and former fiscal year,
                         if changed since last report.

Indicate by check mark whether the Registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities & Exchange Act of 1934
during the preceding 12 months (or for such shorter period that the Registrant
was required to file such reports), and (2) has been the subject to such filing
requirements for the past 90 days. Yes   X       No __
                                        ---            
 
               APPLICABLE ONLY TO ISSUERS INVOLVED IN BANKRUPTCY
                  PROCEEDINGS DURING THE PRECEDING FIVE YEARS.

Indicate by check mark whether the Registrant has filed all documents and
reports required to be filed by Sections 12, 13, or 15(d) of the Securities
Exchange Act of 1934 subsequent to the distribution of securities under a plan
confirmed by a court.

                                                              Yes  X   No___
                                                                  ---           
<PAGE>
 
On November 2, 1994, the Registrant and four (4) of its former subsidiaries
filed separate voluntary petitions for reorganization under Chapter 11 of Title
11 of the United States Bankruptcy Code in the United States Bankruptcy Court of
the Central District of California (the "Bankruptcy Court").  On July 10, 1996,
the Bankruptcy Court confirmed the Third Amended Joint Plan of Reorganization,
(the "Plan"), of the Registrant and its subsidiaries.  On July 31, 1996, all
conditions to the effectiveness of the Plan were met, and the Plan became
effective ("Effective Date").

Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date.


       Class                                 Outstanding at September 5, 1997
     New Common Stock, par value                     5,331,830  Shares
     $.01 per share

                                                                               2
<PAGE>
 
                             HOUSE OF FABRICS, INC.

                                     INDEX
                                     -----

<TABLE> 
<CAPTION> 
                                                                                      Page No.
<S>                                                                                    <C> 
Part I.  Financial Information
 
         Item 1.     Financial Statements
 
                     Balance Sheets as of  July 31, 1997
                     and January 31, 1997                                              4 - 5
 
                     Statements of Operations
                     for the three months ended
                     July 31, 1997 and 1996                                            6
 
                     Statements of Operations                                          7
                     for the six months ended
                     July 31, 1997 and 1996
 
                     Statements of Cash Flows for the six months
                     ended July 31, 1997 and 1996                                      8 - 9
 
                     Notes to Financial Statements                                     10 - 12
 
         Item 2.     Management's Discussion and Analysis
                     of Financial Condition and Results of
                     Operations                                                        13-17
 
Part II. Other Information                                                             18
 
         Item 6.  Exhibits
 
                  (a)  Exhibits
                       10.   Amendment to Revolving Credit Agreement
                       27.   Financial Data Schedule
 
     Signature                                                                         19
</TABLE> 

                                                                               3
<PAGE>
 
HOUSE OF FABRICS, INC.
 
BALANCE SHEETS
(DOLLARS IN THOUSANDS)
- --------------------------------------------------------------------------------
<TABLE>
<CAPTION> 
                                                              (UNAUDITED)                    
ASSETS                                                      JULY 31, 1997    JANUARY 31, 1997 
<S>                                                         <C>              <C>
Current Assets:
  Cash                                                           $    375         $    767
  Receivables, net                                                  1,141            3,164
  Merchandise Inventories, net                                    103,423          104,576
  Prepaid Expenses and Other Current Assets                         2,628            3,686
                                                                 --------         --------
Total Current Assets                                              107,567          112,193
                                                                                  
Property                                                                          
  Land                                                                794            1,011
  Buildings                                                         1,394            1,473
  Furniture & Fixtures                                             18,437           16,055
  Leasehold Improvements                                            5,937            5,677
                                                                 --------         --------
                                                                   26,562           24,216
                                                                                  
  Less Accumulated Depreciation and Amortization                   (4,765)          (2,442)
                                                                 --------         --------
Property, net                                                      21,797           21,774
                                                                                  
                                                                                  
Other Assets                                                          539              675
Reorganization Value in Excess of Amounts Allocated                               
  to Net Assets, net                                                3,021            3,188
                                                                 --------         --------
                                                                 $132,924         $137,830
                                                                 ========         ========
</TABLE>


See accompanying notes to financial statements.

                                                                               4
<PAGE>
 
HOUSE OF FABRICS, INC.

BALANCE SHEETS (CONTINUED)
(DOLLARS IN THOUSANDS)
- --------------------------------------------------------------------------------
<TABLE>
<CAPTION>
                                                                                (UNAUDITED)
                                                                           JULY 31, 1997  JANUARY 31, 1997            
                                                                                                                      
LIABILITIES AND STOCKHOLDERS' EQUITY                                                                                  
                                                                                                                      
<S>                                                                             <C>                <C>                
Current Liabilities:                                                                                                  
  Accounts payable                                                              $ 14,570           $ 18,250           
  Accrued liabilities                                                             12,598             12,505           
  Bank loan                                                                       51,432             42,621           
  Current portion of long-term debt                                                   28                 28           
                                                                                --------           --------           
      Total Current Liabilities                                                   78,628             73,404           
                                                                                                                      
Deferred income taxes                                                                634                634           
Long-term liabilities                                                             22,502             22,502           
Long-term debt                                                                       566                903           
                                                                                                                      
                                                                                                                      
Stockholders' Equity:                                                                                                 
                                                                                                                      
  New Preferred stock,  $.01 par value                                                                                
    authorized 1,000,000 shares; outstanding, none                                     -                  -           
                                                                                                                      
  New Common stock, $.01 par value; authorized 7,000,000 shares;                                                      
    issued and outstanding, 5,332,217 and 4,201,034 shares, respectively,             53                 51           
  Paid-in capital                                                                 39,960             39,411           
  Retained earnings (deficit)                                                     (9,419)               925           
                                                                                --------           --------           
      Total Stockholders' Equity                                                  30,594             40,387           
                                                                                --------           --------           
                                                                                $132,924           $137,830           
                                                                                ========           ========           
</TABLE>

See accompanying notes to financial statements.

                                                                               5
<PAGE>
 
HOUSE OF FABRICS, INC.

STATEMENTS OF OPERATIONS
(DOLLARS IN THOUSANDS EXCEPT PER SHARE AMOUNTS AND SHARES)
(UNAUDITED)
- --------------------------------------------------------------------------------
<TABLE>
<CAPTION>
 
                                                              THREE MONTHS ENDED
                                                      JULY 31, 1997         JULY 31, 1996                  
                                                      SUCCESSOR CO.         PREDECESSOR CO.                 
<S>                                                    <C>                   <C>                 
Sales                                                   $   50,238               $  54,840                 
                                                                                                           
Expenses:                                                                                                  
  Cost of Sales                                             29,010                  30,826                 
  Selling, General and Administrative                       25,618                  27,071                 
  Interest                                                   1,550                   2,402                 
                                                        ----------               ---------                 
                                                                                                           
Total Expenses                                              56,178                  60,299                 
                                                        ----------               ---------                 
                                                                                                           
Loss Before Income Taxes, Reorganization                                                                   
  and Extraordinary Items                                   (5,940)                 (5,459)                
                                                                                                           
Reorganization Items:                                                                                      
  Fresh-Start adjustments (a)                                    -                  26,370                 
  Reorganization Costs                                           -                    (458)                
                                                        ----------               ---------                 
                                                                                                           
Loss Before Income Taxes and Extraordinary Item             (5,940)                (31,371)                
                                                                                                           
Income Taxes                                                    24                      24                 
                                                        ----------               ---------                 
                                                                                                           
Loss Before Extraordinary Item                              (5,964)                (31,395)                
                                                                                                           
Extraordinary Item:                                                                                        
Gain on Forgiveness of Debt (a)                                  -                (100,959)                
                                                        ----------               ---------                 
                                                                                                           
Net Income (Loss)                                       $  (5,964)               $  69,564                 
                                                        ==========               =========                 
                                                                                                           
Net Loss Per Share (b)                                  $   (1.12)                     N/A                 
                                                        ==========               =========                 
                                                                                                           
Weighted Average Number of                                                                                 
  Shares Outstanding (b)                                 5,330,377                     N/A                 
                                                        ==========               =========                 
</TABLE>



(a) These adjustments are the result of the adoption of Fresh-Start Reporting
upon the emergence from Chapter 11 proceedings.  All assets and liabilities were
restated and the accumulated deficit of $74,589,000 was eliminated.

(b) The net income per common share and the weighted average number of common
shares for the Predecessor Company have not been presented because, due to the
Reorganization and implementation of Fresh-Start accounting, they are not
comparable to the current period.

See accompanying notes to financial statements.

                                                                               6
<PAGE>
 
HOUSE OF FABRICS, INC.

STATEMENTS OF OPERATIONS
(DOLLARS IN THOUSANDS EXCEPT PER SHARE AMOUNTS AND SHARES)
(UNAUDITED)
- --------------------------------------------------------------------------------
<TABLE>
<CAPTION>
 
 
                                                               SIX MONTHS ENDED
                                                       JULY 31, 1997      JULY 31, 1996        
                                                       SUCCESSOR CO.     PREDECESSOR CO.       
                                                                                               
<S>                                                        <C>               <C>               
Sales                                                   $  104,311           $ 111,355         
                                                                                               
Expenses:                                                                                      
  Cost of Sales                                             59,636              62,000         
  Selling, General and Administrative                       52,253              53,952         
  Interest                                                   2,718               4,911         
                                                        ----------           ---------         
                                                                                               
Total Expenses                                             114,607             120,863         
                                                        ----------           ---------         
                                                                                               
Loss Before Income Taxes, Reorganization                                                       
  and Extraordinary Items                                  (10,296)             (9,508)        
                                                                                               
Reorganization Items:                                                                          
  Fresh-Start adjustments (a)                                    -              26,370         
  Reorganization Costs                                           -               1,440         
                                                        ----------           ---------         
                                                                                               
Loss Before Income Taxes and Extraordinary Item            (10,296)            (37,318)        
                                                                                               
Income Taxes                                                    48                  48         
                                                        ----------           ---------         
                                                                                               
Loss Before Extraordinary Item                             (10,344)            (37,366)        
                                                                                               
Extraordinary Item:                                                                            
Gain on Forgiveness of Debt (a)                                  -            (100,959)        
                                                        ----------           ---------         
                                                                                               
Net Income (Loss)                                       $ (10,344)           $  63,593         
                                                        ==========           =========         
                                                                                               
Net Loss Per Share (b)                                  $   (1.96)                 N/A         
                                                        ==========           =========         
                                                                                               
Weighted Average Number of                                                                     
  Shares Outstanding (b)                                 5,264,742                 N/A         
                                                        ==========           =========         
</TABLE>

(a) These adjustments are the result of the adoption of Fresh-Start Reporting
upon the emergence from Chapter 11 proceedings.  All assets and liabilities were
restated and the accumulated deficit of $74,589,000 was eliminated.

(b) The net income per common share and the weighted average number of common
shares for the Predecessor Company have not been presented because, due to the
Reorganization and implementation of Fresh-Start accounting, they are not
comparable to the current  period.

See accompanying notes to financial statements.

                                                                               7
<PAGE>
 
HOUSE OF FABRICS, INC.

STATEMENTS OF CASH FLOWS
(DOLLARS IN THOUSANDS)
(UNAUDITED)
- --------------------------------------------------------------------------------

<TABLE>
<CAPTION>
                                                                                   SIX MONTHS ENDED
                                                                         JULY 31, 1997          JULY 31, 1996
                                                                         SUCCESSOR CO.         PREDECESSOR CO.
<S>                                                                        <C>                   <C> 
CASH FLOWS FROM OPERATING ACTIVITIES:
Net Income (Loss)                                                          $(10,344)             $  63,593                
Adjustments to Reconcile Net Income (Loss) to Net                                                                         
 Cash Provided by (Used In) Operating Activities:                                                                         
  Fresh-Start adjustments                                                         -                 26,370                
  Extraordinary item - Gain on Forgiveness of Debt                                -               (100,959)               
  Depreciation and Amortization                                               2,545                  2,895                
  Loss (Gain) on Disposal of Fixed Assets                                       111                 (3,191)               
                                                                                                                          
Changes in Assets and Liabilities:                                                                                        
  Receivables                                                                 2,023                 15,246                
  Merchandise Inventories                                                     1,153                 12,287                
  Prepaid Expenses and Other Assets                                           1,194                 (1,008)               
  Accounts Payable and Accrued Liabilities                                   (3,587)                (4,719)               
  Operating Payables subject to compromise under                                                                          
   reorganization proceedings                                                     -                    843                
  Long Term Liabilities                                                                             21,513                
                                                                          ---------              ---------                
   Total Adjustments                                                          3,439                (30,723)               
                                                                          ---------              ---------                        
  Net Cash Provided by (Used In) Operating Activities                        (6,905)                32,870                
                                                                          ---------              ---------  
                                                                                                                          
CASH FLOWS FROM INVESTING ACTIVITIES:                                                                                     
Capital Expenditures                                                         (2,837)                (2,687)               
Proceeds from Sale of Property                                                  325                  5,050                
                                                                          ---------              ---------                
                                                                                                                          
 Net Cash Provided by (Used In) Investing Activities                         (2,512)                 2,363                
                                                                                                                          
CASH FLOWS FROM FINANCING ACTIVITIES:                                                                                     
                                                                                                                          
Repayments Under Line of Credit Agreements, net                                   -                (45,945)               
Borrowings Under Revolving Line, net                                          8,811                      -                
Repayment of Long-Term Debt                                                    (337)                     -                
Exercise of Series A Warrants                                                   551                      -                
                                                                          ---------              ---------                
                                                                                                                          
 Net Cash Provided by (Used in) Financing Activities                          9,025                (45,945)               
                                                                          ---------              ---------                 
                                                                                                                          
NET DECREASE IN CASH                                                           (392)               (10,712)               
CASH AT BEGINNING OF PERIOD                                                     767                 16,634                
                                                                          ---------              ---------                
CASH AT END OF PERIOD                                                     $     375              $   5,922                
                                                                          =========              =========                
</TABLE>

                SEE ACCOMPANYING NOTES TO FINANCIAL STATEMENTS.

                                                                               8
<PAGE>
 
HOUSE OF FABRICS,  INC.

STATEMENTS OF CASH FLOWS (CONTINUED)
(DOLLARS IN THOUSANDS)
(UNAUDITED)
_______________________________________________________________________________
<TABLE> 
<CAPTION> 
 
                                                            SIX MONTHS ENDED
                                                     JULY 31, 1997    JULY 31, 1996                     
                                                     SUCCESSOR CO.    PREDECESSOR CO.
<S>                                                  <C>              <C> 
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:

Interest Paid                                           $2,405            $  4,933
Income Taxes Paid (Refunded)                            $    1            $(21,285)
</TABLE> 

SUPPLEMENTAL DISCLOSURE OF NONCASH FINANCING ACTIVITIES:

During the six months ended July 31, 1997 and 1996, loss on disposal of property
charged to accrued reserves amounted to $ -0-  and $5,222, respectively.

See accompanying notes to financial statements.

                                                                               9
<PAGE>
 
HOUSE OF FABRICS, INC.


NOTES TO FINANCIAL STATEMENTS (UNAUDITED)
- --------------------------------------------------------------------------------

NOTE 1:  REORGANIZATION AND BASIS OF REPORTING

House of Fabrics, Inc. (the "Company") is one of the largest home sewing/craft
retailers in the United States, operating 262 stores in 27 states as of July 31,
1997.  The Company's stores are located throughout the United States and operate
under the names "House of Fabrics," "So-Fro Fabrics," "Fabricland" or "Fabric
King."  The Company operates most of its stores in leased premises principally
in neighborhood shopping centers or stand-alone locations.

On November 2, 1994 (the "Petition Date"), the Company and four (4) of its then
existing subsidiaries filed separate voluntary petitions for reorganization
under Chapter 11 of the United States Bankruptcy Code ("Chapter 11") in the
United States Bankruptcy Court for the Central District of California (the
"Bankruptcy Court").  On July 10, 1996, the Bankruptcy Court confirmed the Third
Amended Joint Plan of Reorganization, (the "Plan"), of the Company and its
subsidiaries.  On July 31, 1996, all conditions required for the effectiveness
of the Plan were met, and the Plan became effective ("Effective Date").

Under the Plan, the Company has issued approximately 5,332,000 shares of newly
reorganized House of Fabrics, Inc. common stock ("New Common Stock") including
shares issuable upon resolution of claims.  As of July 31 1997,  5,332,217
shares were issued, including 188,079 shares issued upon the exercise of Series
A Warrants.  The secured bank group received $76,500,000 (discounted based on
debt outstanding as of May 1, 1996) plus approximately 257,000 shares (or 5%) of
New Common Stock and an additional $1,157,000 to satisfy a requirement to bring
the aggregate market value of the approximately 257,000 shares up to $2,000,000.
Generally, defaults under other secured obligations were cured and the
maturities reinstated or converted to longer term obligations at market rates of
interest.  Reclamation claims received 25% in cash shortly after the effective
date of the Plan and will receive the balance in 12 equal monthly installments.
Holders of general unsecured claims that are not covered by insurance will
receive a pro rata distribution of approximately 4,776,000 shares (or 93%) of
New Common Stock.  A portion of the approximately 4,776,000 shares of New Common
Stock to be issued to holders of unsecured claims was placed in a claims reserve
based on the percentage of disputed claims to total claims (total claims include
both allowed claims and disputed claims).  Holders of existing House of Fabrics,
Inc., common stock received a pro-rata distribution of approximately 103,000
shares (or 2%) of New Common Stock (subject to dilution) plus warrants to
purchase additional shares of New Common Stock.  A total of 188,079 Series A
Warrants were exercised by the deadline of April 29, 1997, out of 257,381
issued.  Each warrant exercised was converted to one share of New Common Stock
for a price of $3.02 per share and entitles the holder to a Series B Warrant
which may be exercised at a later date for a different price.  Warrants not
exercised have no further rights.

On July 31, 1996, and effective August 1, 1996, the Company restructured its
corporate organization by merging Fabricland, Inc., So-Fro Fabrics, Inc., House
of Fabrics of South Carolina, Inc., and Metrolina Express, Inc. into House of
Fabrics, Inc..

                                                                              10
<PAGE>
 
The reorganization value of the Company's common equity of $39,446,000 was
determined after consideration of several factors and by reliance on independent
financial specialists using various valuation methods, including discounted
projected cash flows, price/earnings ratios, and other applicable ratios and
economic and industry information relevant to the operations of the Company. The
reorganization value of the Company has been allocated to specific asset
categories pursuant to Fresh-Start Reporting.  Reorganization Value in Excess of
Amounts Allocated to Net Assets reflects the difference in the Company's stock
valuation and the Company's net assets.

Upon emergence from its Chapter 11 proceedings, the Company (referred to as
"Successor Company" when compared to periods prior to August 1, 1996) adopted
the provisions of Statement of Position No. 90-7, "Financial Reporting by
Entities in Reorganization Under the Bankruptcy Code" ("Fresh-Start Reporting")
as promulgated by the American Institute of Certified Public Accountants.
Accordingly, all assets and liabilities have been restated to reflect their
reorganization value, which approximates their fair value at the Effective Date.
The adjustment to eliminate the accumulated deficit totaled $74,589,000 of which
$100,959,000 was forgiveness of debt reduced by $26,370,000 of Fresh-Start
adjustments.  The capital structure was recast in conformity with the Plan, and
as such, the Company has recorded the effects of the Plan and Fresh-Start
Reporting as of August 1, 1996.  The results of operations and cash flows for
the six months ended July 31, 1996 include operations prior to the Company's
emergence from Chapter 11 proceedings (referred to as "Predecessor Company") and
prior to the effects of Fresh-Start Reporting.  The results of operations and
cash flows for the six months ended July 31, 1997 include operations subsequent
to the Company's emergence from Chapter 11 proceedings and reflect the on-going
effects of Fresh-Start Reporting.  As a result, the net loss for the three and
six month periods ended July 31, 1997 is not comparable with prior periods.

The financial statements included herein do not include all the information and
footnote disclosures normally included in financial statements prepared in
accordance with generally accepted accounting principles, although the Company
believes that disclosures are adequate to make the information not misleading.
In the opinion of management, all adjustments, consisting of normal recurring
accruals, considered necessary for a fair presentation for the interim periods
have been included in the financial statements.

The results of operations for  the interim periods presented, are not
necessarily indicative of the operating results to be expected for the full
fiscal year.

NOTE 2: NET LOSS PER SHARE

Net loss per share is computed based on the weighted average number of
outstanding common and common equivalent shares, if dilutive, during the period.
As of July 31, 1997, 5,332,217  shares were issued, including 188,079 shares
issued upon exercise of Series A Warrants.  As of September 5, 1997, 5,331,830
shares were issued including 188,079 shares issued upon exercise of Series A
Warrants.  Per share data for periods prior to August 1, 1996 have been omitted
as these amounts do not reflect the current capital structure.  In February
1997, the Financial Accounting Standards Board issued Statement of Financial
Accounting Standards No. 128, "Earnings Per Share" ("SFAS No. 128") which is
effective for financial statements issued for periods ending after December 15,
1997.  SFAS No. 128 requires the disclosure of basic and diluted earnings per
share.  For the three and six month periods ended July 31, 1997, the amounts
reported as net loss per common and common equivalent share are not materially
different from that which would have been reported for basic and diluted
earnings per share in accordance with SFAS No. 128.

NOTE 3: FINANCING

At July 31, 1996, the Company entered into a  Financing Agreement with CIT
Group/Business Credit, Inc. ("CITBC"),  to provide a $65,000,000 line of credit,
as amended, having a term of  3 years, with automatic annual renewals unless  90
days written notice is provided prior to the anniversary date of the agreement.
Cash borrowings bear interest at prime (based on the Chase Manhattan Bank Rate)
plus 1% or Libor plus 3 1/4% and a commitment fee of .5% per annum on unused
availability.  Fees for letters of credit are generally 1 1/2% per 

                                                                              11
<PAGE>
 
annum based on the amount of letters of credit issued. The Financing Agreement
provides for a combination of cash borrowings and the issuance of up to
$20,000,000 in letters of credit. The Financing Agreement is collateralized by a
first priority lien on generally all assets of the Company, as defined,
excluding up to $10,000,000 for Point of Sale equipment which may be secured by
the purchased Point of Sale equipment. Loan availability is determined by an
advance rate on eligible inventory as defined. The Financing Agreement includes
certain restrictive covenants, which have been amended, including net worth, a
fixed charge covenant which is computed quarterly, and others which are computed
annually (operating leases, and capital expenditures). As of July 31, 1997, the
Company had direct borrowings of $51,432,000 and letters of credit of $1,488,000
outstanding with additional credit available of approximately $9,795,000. During
the quarter, the Financing Agreement was amended, giving the Company an
additional, seasonal credit of $5 million.

As of July 31, 1997, the Company was in compliance with all terms of the amended
Financing Agreement.

In March 1995, the Company entered into, with Bankruptcy Court approval, an
agreement with Bank of America NT & SA, acting as agent bank, to provide
Debtors-in-Possession financing in the form of a $20,000,000 line of credit (The
"D.I.P. Financing") that expired on January 31, 1996 and was extended through
April 30, 1996, with Bankruptcy Court approval.  On May 1, 1996, the amended and
restated D.I.P. Financing agreement was reduced to $17,300,000 and extended
through June 28, 1996, and subsequently through July 31, 1996, when the Company
retired the D.I.P. Financing agreement and replaced it with a new Financing
Agreement with CITBC as explained above.

NOTE 4:  REORGANIZATION COSTS

Prior to emergence from bankruptcy, professional fees and expenditures directly
related to the Chapter 11 filing were classified as reorganization costs and
expensed as incurred.  There were no reorganization costs for the six months
ended July 31, 1997, as the Company emerged from bankruptcy on August 1, 1996.
Reorganization costs with respect to the six months ended July 31, 1996
consisted primarily of professional fees and lease termination expenses offset
by the gain on the sale of the Sherman Oaks, California office building.

NOTE 5:  STOCK OPTIONS

During the six months ended July 31, 1997, the Company granted 230,000 new stock
options to newly employed officers.  The options have a term of ten years and
vest 33 1/3% after 12 months, an additional 33 1/3% after 24 months, and the
final 33 1/3% after 36 months. The exercise prices range from $3.625 to $3.6875
with various grant dates.

NOTE 6:  INCOME TAXES

During the year ended January 31, 1997, the Company received $22,502,000
pursuant to carrybacks of certain net operating losses on claims for refund
filed with the Internal Revenue Service on Forms 1139.  The Company's claims for
refund are currently being examined by the Internal Revenue Service.  Although
the Company believes that the positions taken on the claims for refund are
supportable, it is uncertain at this time as to their ultimate resolution.
Therefore, the Company has recorded reserves on its balance sheet as of January
31, 1997 equal to the refunds received.  To the extent that the Internal Revenue
Service disallows the claims for refund in whole or part and ultimately prevails
with respect to the disallowance, the Company will be required to repay the
Internal Revenue Service the refund attributable to the disallowance.  As set
forth in the Plan of Reorganization, a deficiency notice issued by the Internal
Revenue Service requesting repayment of the refund is allowed to be treated as a
Priority Tax Claim, as defined in the Plan.  Subject to exhaustion of the
Company's right to contest, the claim would become payable in quarterly
installments of principal and interest over six years.  A future demand by the
Internal Revenue Service for repayment would adversely impact the Company's
liquidity.

                                                                              12
<PAGE>
 
HOUSE OF FABRICS, INC.


MANAGEMENT'S DISCUSSION AND ANALYSIS OF
RESULTS OF OPERATIONS AND FINANCIAL CONDITION
________________________________________________________________________________

The Company is one of the largest home sewing/craft retailers in the United
States, operating 262 stores in 27 states as of July 31, 1997.  The following
discussion explains material changes in the results of operations for the second
quarter of fiscal years 1998 and 1997 and significant developments affecting
financial condition since the end of fiscal 1997.


CHAPTER 11 REORGANIZATION
- -------------------------

On November 2, 1994 (the "Petition Date"), the Company and four (4) of its
former subsidiaries filed separate voluntary petitions for reorganization under
Chapter 11 of the United States Bankruptcy Code ("Chapter 11") in the United
States Bankruptcy Court for the Central District of California (the "Bankruptcy
Court").  On July 10, 1996, the Bankruptcy Court confirmed the Third Amended
Joint Plan of Reorganization, (the "Plan"), of the Company and its subsidiaries.
On July 31, 1996, all conditions required for the effectiveness of the Plan were
achieved, and the Plan became effective ("Effective Date").

Under the Plan, the Company has issued approximately 5,332,000 shares of newly
reorganized House of Fabrics, Inc. common stock ("New Common Stock") including
shares issued upon resolution of claims.  As of July 31, 1997, 5,332,217 shares
were issued, including 188,079 shares issued upon the exercise of Series A
Warrants.  The secured bank group received $76,500,000 (discounted based on debt
outstanding as of May 1, 1996) plus approximately 257,000 shares (or 5%) of New
Common Stock and an additional $1,157,000 to satisfy a requirement to bring the
aggregate market value of the approximately 257,000 shares up to $2,000,000.
Generally, defaults under other secured  obligations were cured and the
maturities reinstated or converted to longer term obligations at market rates of
interest.  Reclamation claims received 25% in cash shortly after the effective
date of the Plan and are receiving the balance in 12 equal monthly installments.
Holders of general unsecured claims that are not covered by insurance received a
pro rata distribution of approximately 4,776,000 shares (or 93%) of New Common
Stock.  A portion of the approximately 4,776,000 shares of New Common Stock to
be issued to holders of unsecured claims was placed in a claims reserve based on
the percentage of disputed claims to total claims (total claims include both
allowed claims and disputed claims).  Holders of existing House of Fabrics,
Inc., common stock received a pro rata distribution of approximately 103,000
shares (or 2%) of New Common Stock (subject to dilution) plus warrants to
purchase additional shares of New Common Stock.  A total of 188,079 Series A
Warrants were exercised by the deadline of April 29, 1997 out of 257,381 issued.
Each warrant exercised was converted to one share of New Common Stock for a
price of $3.02 per share and entitles the holder to a Series B Warrant which may
be exercised at a later date for a different price.  Warrants not exercised have
no further rights.

On July 31, 1996, and effective August 1, 1996, the Company restructured its
corporate organization by merging Fabricland, Inc., So-Fro Fabrics, Inc., House
of Fabrics of South Carolina, Inc., and Metrolina Express, Inc. into House of
Fabrics, Inc..

STORE OPENINGS AND CLOSURES:

The Company opened 1 store during the six month period for fiscal 1998 and none
for fiscal 1997.  No stores were closed during the six month period for either
year.

                                                                              13
<PAGE>
 
RESULTS OF OPERATIONS
- ---------------------

                              THREE MONTHS ENDED
                              ------------------

Although the adoption of Fresh-Start Reporting significantly affected
comparability, certain Pre- and Post-reorganization period income and expense
items remain comparable and are addressed in the following analysis of results
of operations for the quarter ended July 31, 1997.

Sales for the quarter ended July 31, 1997 decreased 8.4% to $50,238,000 for the
Successor Company from $54,840,000 for the Predecessor Company.  Of the
$4,602,000 sales decrease, $986,000 was due to the closing of underperforming
stores. Store for store sales decreased by 6.6% as the Company moves away from
deep store-wide discounting towards item merchandising and value pricing as it
continues the process of refining its product mix.

Gross profit as a percentage of sales decreased to 42.3% for the quarter ended
July 31, 1997 from 43.8% for the quarter ended July 31, 1996.  The decease is
primarily due to aggressive markdowns in certain product categories and
clearance items as the Company adjusts its product mix.

Selling, general and administrative expenses as a percent of sales increased to
51.0%  for the quarter ended July 31, 1997 from 49.4% for the quarter ended July
31, 1996. Through improved cost controls, including reduced head count and
expense reductions, the Company achieved a decrease of $1,453,000 in expenses
from the prior year, however, expenses as a percent of sales increased due to
lower sales volume.

Interest expense for the quarter ended July 31, 1997 decreased by $852,000 from
$2,402,000 for the quarter ended July 31, 1996, to $1,550,000 for the quarter
ended July 31, 1997, primarily as a result of a decrease in the Company's
average loan balance and a decrease in the Company's average effective borrowing
rate from 10.75% in the quarter ended July 31, 1996 to 9.5% in the quarter ended
July 31, 1997.  This decrease was partially offset by fees paid to CITBC for
amendments to the Financing Agreement.

There were no reorganization costs for the quarter ended July 31, 1997, as the
Company had emerged from Chapter 11 bankruptcy protection effective August 1,
1996.  While still in the bankruptcy process in the prior comparable period,
there were credits to reorganization costs of $458,000, which includes a gain on
the sale of the Sherman Oaks, California office building partially offset by
lease termination costs, asset write-offs and professional fees.  In addition,
for the quarter ended July 31, 1996, there were adjustments due to Fresh-Start
Reporting of $26,370,000 related to the emergence from Chapter 11 proceedings.

The Company recorded a tax expense of $24,000 for the three months ended July
31, 1997 and 1996, for minimum state income taxes.

An extraordinary item resulting in a gain of $100,959,000 was recognized for the
quarter ended July 31, 1996. This was a gain due to the forgiveness of debt upon
emergence from Chapter 11 proceedings.

                                                                              14
<PAGE>
 
RESULTS OF OPERATIONS
- ---------------------

                               SIX MONTHS ENDED
                               ----------------

Although the adoption of Fresh-Start Reporting significantly affected
comparability, certain Pre- and Post-reorganization period income and expense
items remain comparable and are addressed in the following analysis of results
of operations for the six months ended July 31, 1997.

Sales for the six months ended July 31, 1997 decreased 6.3% to $104,311,000 for
the Successor Company from $111,355,000 for the Predecessor Company.  Of the
$7,044,000 sales decrease, $2,123,000 was due to the closing of underperforming
stores. Store for store sales decreased by 4.6% as the Company moves away from
deep store-wide discounting towards item merchandising and value pricing as it
continues the process of refining its product mix.

Gross profit as a percentage of sales decreased to 42.8% for the six months
ended July 31, 1997 from 44.3% for the quarter ended July 31, 1996.  The decease
is primarily due to aggressive markdowns in certain product categories and
clearance items as the Company adjusts its product mix.

Selling, general and administrative expenses as a percent of sales increased to
50.1%  for the six months ended July 31, 1997 from 48.5% for the six months
ended July 31, 1996. Through improved cost controls, including reduced head
count and expense reductions, the Company achieved a decrease of  $1,699,000 in
expenses from the prior year, however, expenses as a percent of sales increased
due to lower sales volume.

Interest expense for the six months ended July 31, 1997 decreased by $2,193,000
from $4,911,000 for the six months ended July 31, 1996, to $2,718,000 for the
six months ended July 31, 1997, primarily as a result of a decrease in the
Company's average loan balance and a decrease in the Company's average effective
borrowing rate.  This decrease was partially offset by fees paid to CITBC for
amendments to the Financing Agreement during fiscal 1998.

There were no reorganization costs for the six months ended July 31, 1997, as
the Company had emerged from Chapter 11 bankruptcy protection effective August
1, 1996.  While still in the bankruptcy process in the prior comparable period,
there were reorganization costs of $1,440,000, which were primarily for
professional fees and lease termination costs partially offset by the gain on
the sale of the Sherman Oaks, California office building.  In addition, for the
six months ended July 31, 1996, there were adjustments due to Fresh-Start
Reporting of $26,370,000 related to the emergence from Chapter 11 proceedings.

The Company recorded a tax expense of $48,000 for the six months ended July 31,
1997 and 1996, for minimum state income taxes.

An extraordinary item resulting in a gain of $100,959,000 was recognized for the
six months ended July 31, 1996. This was a gain due to the forgiveness of debt
upon emergence from Chapter 11 proceedings.

                                                                              15
<PAGE>
 
LIQUIDITY AND CAPITAL RESOURCES
- -------------------------------

Upon emergence from Chapter 11 bankruptcy proceedings, the DIP Financing
Agreement with Bank of America was paid off (see following).  In addition, new
common stock was issued, pre-petition bank group debt was settled and settlement
of all other pre-petition claims was commenced.

To replace the DIP Financing agreement and provide for longer term financing as
of  July 31, 1996, the Company entered into a  Financing Agreement with CIT
Group/Business Credit, Inc. ("CITBC"),  to provide a $65,000,000 line of credit,
as amended, having a term of 3 years, with automatic annual renewals unless  90
days written notice is provided prior to the anniversary date of the agreement.
Cash borrowings bear interest at prime (based on the Chase Manhattan Bank Rate)
plus 1% or Libor plus 3 1/4% and a commitment fee of .5% per annum on unused
availability.  Fees for letters of credit are generally 1 1/2% per annum based
on the amount of letters of credit issued.  The Financing Agreement provides for
a combination of cash borrowings and the issuance of up to $20,000,000 in
letters of credit.  The Financing Agreement is collateralized by a first
priority lien on generally all assets of the Company, as defined, excluding up
to $10,000,000 for Point of Sale equipment which may be secured by the purchased
Point of Sale equipment.   Loan availability is determined by an advance rate on
eligible inventory as defined. The Financing Agreement includes certain
restrictive covenants, which have been amended, including net worth, a fixed
charge covenant which is computed quarterly, and others which are computed
annually (operating leases and capital expenditures).  As of July 31, 1997, the
Company had direct borrowings of $51,432,000 and letters of credit of
$1,488,000 outstanding with additional credit available of approximately
$9,795,000.  During the quarter, the Financing Agreement was amended, giving the
Company an additional, seasonal credit of $5 million.

As of July 31, 1997, the Company was in compliance with all terms of the amended
Financing Agreement.

In March 1995, the Company entered into, with Bankruptcy Court approval, an
agreement with Bank of America NT & SA, acting as agent bank, to provide
Debtors-in-Possession financing in the form of a $20,000,000  line of credit
(The "D.I.P. Financing") that expired on January 31, 1996 and was extended
through April 30, 1996, with Bankruptcy Court approval.  On May 1, 1996, the
amended and restated D.I.P. Financing agreement was reduced to $17,300,000 and
extended through June 28, 1996 and subsequently through July 31, 1996 when the
Company retired the D.I.P. Financing agreement and replaced it with a new
Financing Agreement with CITBC as explained above.

One new store was opened during the six months ended July 31, 1997 compared to
none for the same period of  1996.  Capital expenditures were $2,837,000 for the
six months ended July 31, 1997 compared to $2,687,000 for the prior comparable
period and were primarily for POS systems in the stores and other MIS equipment.

The Company finances its operations from short-term borrowings and internally
generated cash flow.  The Company's primary capital requirements have been the
financing of inventory and MIS systems.

The Company's working capital was approximately $28,939,000 as of July 31, 1997,
and its current ratio was approximately 1.4 to 1.

Net cash used in operating activities was approximately $6,905,000 for the six
months ended July 31, 1997. The decrease was primarily attributable to the
seasonal operating loss and lower accounts payable balances partially offset by
lower inventory levels and receivables.

Net cash provided by financing activities was approximately $9,025,000 for the
six months ended July 31, 1997.  The increase is primarily attributable to
borrowings under the Company's Revolving Line.

The Company believes that the CITBC Financing Agreement and its ongoing
operating cash flow should enable the Company to meet liquidity requirements for
the reasonably foreseeable future.

                                                                              16
<PAGE>
 
NEW ACCOUNTING PRONOUNCEMENTS
- -----------------------------

In February 1997, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 128, "Earnings Per Share" ("SFAS No. 128")
which is effective for financial statements issued for periods ending after
December 15, 1997.  SFAS No. 128 requires the disclosure of basic and diluted
earnings per share.  For the three and six months ended July 31, 1997, the
amount reported as net loss per common and common equivalent share is not
materially different from that which would have been reported for basic and
diluted earnings per share in accordance with SFAS No. 128.

STATEMENT REGARDING FORWARD LOOKING DISCLOSURE
- ----------------------------------------------

The preceding Management's Discussion and Analysis contains various "forward
looking statements" within the meaning of Section 27A of the Securities Act of
1933, as amended, and Section 21E of the Securities and Exchange Act of 1934, as
amended, which represent the Company's expectations or beliefs concerning future
events.  The Company cautions that these statements are further qualified by
important factors that could cause actual results to differ materially from
those in the forward looking statements, including without limitation, those
associated with the ability of  Company to reduce the current expense levels and
increase the sales volumes.  In addition, these statements are further qualified
by important factors that could cause actual results to differ materially from
those in the forward looking statements, including without limitation, decline
in demand for the merchandise offered by the Company, the ability of the Company
to obtain adequate merchandise supply and hire and train employees, management's
ability to manage the Company's return to profitability and the effect of
economic conditions.

The foregoing discussion is designed to comply with interim reporting standards
and should be read in conjunction with the more detailed discussion in the
Company's 1997 Annual Report.

                                                                              17
<PAGE>
 
Part II.  OTHER INFORMATION


Item 6.  EXHIBITS AND REPORTS ON FORM 8-K

         (a)  Exhibits.

              10.  Amendment to Revolving Credit Agreement

              27.  Financial Data Schedule

         (b) No reports on Form 8-K were filed during the quarter ended July 31,
1997.

                                                                              18
<PAGE>
 
                                   SIGNATURE
                                   ---------

Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf  by the
undersigned thereunto duly authorized.



                                                 House of Fabrics, Inc.
                                                 ----------------------
                                                 Registrant


        
                                                 /s/ John E. Labbett
                                                 -------------------
Date:  September 10, 1997                        John E. Labbett
                                                 Executive Vice President-Chief
                                                 Financial Officer

                                                                              19

<PAGE>
 
THE CIT GROUP                                                        EXHIBIT 10

July 7, 1997



House of Fabrics, Inc.
13400 Riverside Drive
Sherman Oaks, CA 91423

Gentlemen:

Reference is made to the Financing Agreement, dated July 23, 1996, between House
of Fabrics, Inc. (the "Company") and The CIT Group/Business Credit, Inc.
("CIT/BC") as Agent and Lender, as the same may be amended from time to time
(the "Financing Agreement").  Capitalized terms not otherwise defined herein
shall have the meaning ascribed thereto in the Financing Agreement.

The Company has requested and CIT/BC, as Agent and Lender, hereby agrees to
amend the Financing Agreement, effective the date of this Letter Amendment, as
follows:

1.   Paragraph 8 of Section 6 of the Financing Agreement is hereby amended by
     deleting said paragraph in its entirety and inserting the following in lieu
     thereof:

     8.   The Company and its Subsidiaries shall have, at all times, on a
          consolidated basis, a Net Worth, as defined herein, of not less than
          the amount set forth below for the applicable time period:
<TABLE> 
<CAPTION> 
               Period                       Minimum Net Worth
               ------                       -----------------
<S>                                         <C> 
               July 1997                    $29,000,000
               August 1997                  $28,000,000
               September 1997               $28,000,000
               October 1997 and at
               all times thereafter         $30,000,000
</TABLE>

2.   The definition of Inventory Advance Percentage set forth in Section 1 of
     the Financing Agreement is hereby amended by deleting said definition in
     its entirety, and inserting the following in lieu thereof:

     Inventory Advance Percentage shall mean:

     (i)   sixty percent (60%) from the date hereof through and including August
           14, 1997;

     (ii)  fifty-nine percent (59%) from August 15, 1997 through and including
           September 14, 1997;

     (iii) fifty-eight percent (58%) from September 15, 1997 through and
           including October 14, 1997;

     (iv)  fifty-seven percent (57%) from October 15, 1997 through and including
           November 14, 1997;

     (v)   fifty-six percent (56%) from November 15, 1997 through and including
           December 14, 1997; and

     (vi)  fifty-five percent (55%) at all times thereafter.

                                                                              20
<PAGE>
 
3.   In consideration of this Letter Agreement you hereby agree to pay the Agent
     on behalf of the Lenders a $500,000 facility fee, due upon execution of
     this Letter Agreement. You hereby authorize the Agent to charge your
     Revolving Loan Account with the Agent for such facility fee.

Except as set forth herein no other change in the terms or provisions of the
Financing Agreement is intended or implied.  If the foregoing is in accordance
with your understanding of our agreement, please so indicated by signing and
returning to us the enclosed copy of this Letter Agreement.  It is agreed with
respect to this Letter Amendment that signed faxed copies shall be deemed of the
same force and effect as an original manually signed copy, provided further that
the Company hereby confirms that it shall promptly deliver original signature
pages to the undersigned.

                                     Very truly yours,

                                     THE CIT GROUP/BUSINESS CREDIT, INC.,
                                     (as Agent and Lender)

                                     By: /s/ Guy Fuchs
                                        --------------
                                     Title: Vice President

                                     WELLS FARGO BANK, N.A., (As Lender)
                                     By: /s/ Scott James Lorimer
                                        ------------------------
                                     Title: Vice President
 
                                     LA SALLE BUSINESS CREDIT, INC., (As Lender)
                                     By: /s/ Larry Magkamit
                                        -------------------
                                     Title: Assistant Vice President
 
                                     FINOVA CAPITAL CORPORATION, (As Lender)
                                     By: /s/ Ron Ornstein
                                        -----------------
                                     Title: Vice President

                                     FREMONT FINANCIAL CORPORATION, (As Lender)
                                     By: /s/ Cheri Rittan
                                        -----------------
                                     Title: Vice President


Read and Agreed to:

HOUSE OF FABRICS, INC.

By: /s/ John E. Labbett
   --------------------
Title: EVP/CFO


                                                                              21

<TABLE> <S> <C>

<PAGE>
 
<ARTICLE> 5
<MULTIPLIER> 1,000
       
<S>                             <C>
<PERIOD-TYPE>                   6-MOS
<FISCAL-YEAR-END>                          JAN-31-1997
<PERIOD-END>                               JUL-31-1997
<CASH>                                             375
<SECURITIES>                                         0
<RECEIVABLES>                                    1,141
<ALLOWANCES>                                         0
<INVENTORY>                                    103,423
<CURRENT-ASSETS>                               107,567
<PP&E>                                          26,562
<DEPRECIATION>                                   4,765
<TOTAL-ASSETS>                                 132,924
<CURRENT-LIABILITIES>                           78,628
<BONDS>                                            566
                                0
                                          0
<COMMON>                                            53
<OTHER-SE>                                      30,541
<TOTAL-LIABILITY-AND-EQUITY>                   132,924
<SALES>                                        104,311
<TOTAL-REVENUES>                               104,311
<CGS>                                           59,636
<TOTAL-COSTS>                                   59,636
<OTHER-EXPENSES>                                52,253
<LOSS-PROVISION>                                     0
<INTEREST-EXPENSE>                               2,718
<INCOME-PRETAX>                               (10,296)
<INCOME-TAX>                                        48
<INCOME-CONTINUING>                           (10,344)
<DISCONTINUED>                                       0
<EXTRAORDINARY>                                      0
<CHANGES>                                            0
<NET-INCOME>                                  (10,344)
<EPS-PRIMARY>                                   (1.96)
<EPS-DILUTED>                                   (1.96)
        

</TABLE>


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