** **

**SECURITIES AND EXCHANGECOMMISSION**

 

**WASHINGTON, D.C. 20549**

 

**FORM 10-Q**

 

**ý****  QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d)**

**OF THE SECURITIES EXCHANGE ACT OF1934**

 

**For the quarterly period ended March 31,2006**

 

**o****  TRANSITIONREPORT UNDER SECTION 13 OR 15(d) OF THE**

**EXCHANGE ACT**

 

**Commission File No. 0-51715**

 

**SPORT-HALEY, INC.**

(Exact name of small businessissuer as specified in its charter)

 

| **COLORADO**                                                     | ** ** | **84-1111669**                         |
|------------------------------------------------------------------|------------|----------------------------------------|
| (State of  other jurisdiction of  incorporation or organization) |       | (I.R.S.  Employer  Identification No.) |

 

**4600 E. 48th Avenue, Denver,Colorado 80216**

(Address of principal executiveoffices)

 

**(303)320-8800**

(Issuer’s telephone numberincluding area code)

 

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

 

Indicate by check mark whether the registrant is alarge accelerated filer, and accelerated filer, or a non-accelerated filer. Seedefinition of “accelerated filer and non-accelerated filer” in Rule 12b-2of the Exchange Act.

 
| Large accelerated filer |   | o |   | Accelerated filer |   | o |   | Non-accelerated filer |   | ý |
|-------------------------|--------|---|--------|-------------------|--------|---|--------|-----------------------|--------|--------|

 

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

 

Indicate the number of shares outstanding ineach of the issuer’s classes of common stock, as of the latest practicabledate.

 

| **Class**                      | ** ** | **Outstanding at May 15, 2006** |
|--------------------------------|------------|-----------------------------------------------------|
| **Common Stock, no par value** | ** ** | **2,770,252**                                       |

 

 

----

 

**TABLE OFCONTENTS**

 
| **PART 1 – FINANCIAL INFORMATION  (UNAUDITED)** |              |
|-----------------------------------------------------------|-------------------|
|                                                      |              |   |   |
| ITEM 1 –                                             |              | CONDENSED CONSOLIDATED FINANCIAL STATEMENTS |   |
|                                                      |              |   |   |
|                                                      | ** **        | CONDENSED CONSOLIDATED BALANCE SHEETS |   |
|                                                      |              |   |   |
|                                                      | ** **        | CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS |   |
|                                                      |              |   |   |
|                                                      | ** **        | CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS |   |
|                                                      |              |   |   |
|                                                      | ** **        | NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS |   |
|                                                      |              |   |   |
| ITEM 2 -                                                  |              | MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND  RESULTS OF OPERATIONS |   |
|                                                      |              |   |   |
| ITEM 3 -                                                  |              | QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT  MARKET RISK |   |
|                                                      |              |   |   |
| ITEM 4 -                                                  |              | CONTROLS AND PROCEDURES |   |
|                                                      |              |   |   |
| **PART II  - OTHER INFORMATION**                     |              |
|                                                      |              |   |   |
| ITEM 1                                                    | LEGAL PROCEEDINGS |   |
|                                                      |              |   |
| ITEM 5                                                    | OTHER INFORMATION |   |
|                                                      |              |   |
| ITEM 6                                                    | EXHIBITS          |   |
|                                                      |              |   |   |
| **SIGNATURES**                                            |              |
|                                                      |              |   |   |
| **EXHIBITS**                                              |              |
|                                                           |                   |  |  |  |  |  |  |

 

2

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**SPORT-HALEY, INC.**

**CONDENSED CONSOLIDATEDBALANCE SHEETS**

 
| ** **                                                                                                                      | ** ** | **March 31,** | ** ** | **June 30,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|-------------------|------------|
| ** **                                                                                                                      | ** ** | **2006**           | ** ** | **2005**          | ** ** |
| ** **                                                                                                                      | ** ** | **(Unaudited)**    | ** ** | **(***)**         | ** ** |
| **ASSETS**                                                                                                                      |       |               |       |              |       |
| Current  assets:                                                                                                                |       |               |       |              |       |
| Cash and  cash equivalents                                                                                                      |       | $                  | 7,107,000  |              | $          | 7,721,000 |   |
| Accounts  receivable, net of allowances of $441,000 and $691,000, respectively                                                  |       | 3,019,000          |       | 4,495,000         |       |
| Inventories                                                                                                                     |       | 7,156,000          |       | 4,153,000         |       |
| Prepaid  expenses and other                                                                                                     |       | 175,000            |       | 196,000           |       |
| Total  current assets                                                                                                           |       | 17,457,000         |       | 16,565,000        |       |
|                                                                                                                            |       |               |       |              |       |
| Property and  equipment, net                                                                                                    |       | 674,000            |       | 922,000           |       |
| Other assets                                                                                                                    |       | 3,000              |       | 3,000             |       |
|                                                                                                                            |       |               |       |              |       |
| Total Assets                                                                                                                    |       | $                  | 18,134,000 |              | $          | 17,490,000 |   |
|                                                                                                                            |       |               |       |              |       |
| **LIABILITIES  AND SHAREHOLDERS’ EQUITY**                                                                                  |       |               |       |              |       |
|                                                                                                                            |       |               |       |              |       |
| Current  liabilities:                                                                                                           |       |               |       |              |       |
| Accounts  payable                                                                                                               |       | $                  | 1,482,000  |              | $          | 582,000 |   |
| Accrued  royalties payable                                                                                                      |       | 206,000            |       | 294,000           |       |
| Accrued  commissions payable                                                                                                    |       | 193,000            |       | 249,000           |       |
| Accrued  payroll                                                                                                                |       | 389,000            |       | 533,000           |       |
| Other                                                                                                                           |       | 104,000            |       | 93,000            |       |
| Total  current liabilities                                                                                                      |       | 2,374,000          |       | 1,751,000         |       |
|                                                                                                                            |       |               |       |              |       |
| Long-Term  Liabilities:                                                                                                         |       |               |       |              |       |
| Minority  interest loan                                                                                                         |       | 256,000            |       | —            |       |
| Total  long-term liabilities                                                                                                    |       | 256,000            |       | —            |       |
|                                                                                                                            |       |               |       |              |       |
| Commitments  and Contingencies (Note 4)                                                                                         |       | —             |       | —            |       |
|                                                                                                                            |       |               |       |              |       |
| Shareholders’  equity:                                                                                                     |       |               |       |              |       |
| Preferred  stock, no par value; 1,500,000 shares authorized; none issued and outstanding                                        |       | —             |       | —            |       |
| Common  stock, no par value; 15,000,000 shares authorized; 2,770,252 and 2,645,252  shares issued and outstanding, respectively |       | 10,813,000         |       | 10,460,000        |       |
| Additional  paid-in capital                                                                                                     |       | 1,621,000          |       | 1,590,000         |       |
| Retained  earnings                                                                                                              |       | 3,070,000          |       | 3,689,000         |       |
| Total  shareholders’ equity                                                                                                |       | 15,504,000         |       | 15,739,000        |       |
|                                                                                                                            |       |               |       |              |       |
| Total  Liabilities and Shareholders’ Equity                                                                                |       | $                  | 18,134,000 |              | $          | 17,490,000 |   |

 

----

(***)  Taken from the auditedbalance sheet at that date.

 

See accompanying notes to condensedconsolidated financial statements.

 

3

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**SPORT-HALEY, INC.**

**CONDENSED CONSOLIDATEDSTATEMENTS OF OPERATIONS**

 
| ** **                                             | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|--------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                             | ** ** | **March 31,**               | ** ** | **March 31,**              | ** ** |
| ** **                                             | ** ** | **2006**                         | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                             | ** ** | **(Unaudited)**                  | ** ** | **(Unaudited)**                 | ** ** | **(Unaudited)** | ** ** | **(Unaudited)** | ** ** |
|                                                   |       |                             |       |                            |       |   |   |   |   |
| Net sales                                              |       | $                                | 4,656,000  |                            | $          | 4,455,000 |   | $ | 13,096,000 |   | $ | 15,025,000 |   |
|                                                   |       |                             |       |                            |       |   |   |   |   |
| Cost of  goods sold                                    |       | 2,828,000                        |       | 2,823,000                       |       | 8,132,000 |   | 9,927,000 |   |
| Impairments                                            |       | 91,000                           |       | —                          |       | 285,000 |   | 1,238,000 |   |
| Total cost  of goods sold                              |       | 2,919,000                        |       | 2,823,000                       |       | 8,417,000 |   | 11,165,000 |   |
|                                                   |       |                             |       |                            |       |   |   |   |   |
| Gross profit                                           |       | 1,737,000                        |       | 1,632,000                       |       | 4,679,000 |   | 3,860,000 |   |
|                                                   |       |                             |       |                            |       |   |   |   |   |
| Other  Operating Costs:                                |       |                             |       |                            |       |   |   |   |   |
| Selling,  general and administrative expenses          |       | 1,959,000                        |       | 2,134,000                       |       | 5,121,000 |   | 7,357,000 |   |
| Royalty  expense                                       |       | 203,000                          |       | 153,000                         |       | 541,000 |   | 503,000 |   |
| Total other  operating costs                           |       | 2,162,000                        |       | 2,287,000                       |       | 5,662,000 |   | 7,860,000 |   |
|                                                   |       |                             |       |                            |       |   |   |   |   |
| Loss from  operations                                  |       | (425,000                         | )          | (655,000                        | )          | (983,000 | ) | (4,000,000 | ) |
|                                                   |       |                             |       |                            |       |   |   |   |   |
| Other  income, net                                     |       | 237,000                          |       | 75,000                          |       | 367,000 |   | 138,000 |   |
|                                                   |       |                             |       |                            |       |   |   |   |   |
| Loss before  provision for income taxes                |       | (188,000                         | )          | (580,000                        | )          | (616,000 | ) | (3,862,000 | ) |
|                                                   |       |                             |       |                            |       |   |   |   |   |
| Provision  for income taxes                            |       | (2,000                           | )          | (6,000                          | )          | (3,000 | ) | (6,000 | ) |
|                                                   |       |                             |       |                            |       |   |   |   |   |
| Net loss                                               |       | $                                | (190,000   | )                               | $          | (586,000 | ) | $ | (619,000 | ) | $ | (3,868,000 | ) |
|                                                   |       |                             |       |                            |       |   |   |   |   |
| Basic and  diluted loss per common share               |       | $                                | (0.07      | )                               | $          | (0.23 | ) | $ | (0.23 | ) | $ | (1.52 | ) |
|                                                   |       |                             |       |                            |       |   |   |   |   |
| Basic and  diluted weighted average shares outstanding |       | 2,770,000                        |       | 2,545,000                       |       | 2,742,000 |   | 2,542,000 |   |

 

See accompanying notes to condensedconsolidated financial statements.

 

4

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**SPORT-HALEY, INC.**

**CONDENSED CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

 
| ** **                                                                             | ** ** | **Nine Months Ended** | ** ** |
|----------------------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                             | ** ** | **March 31,**              | ** ** |
| ** **                                                                             | ** ** | **2006**                        | ** ** | **2005** | ** ** |
| ** **                                                                             | ** ** | **(Unaudited)**                 | ** ** | **(Unaudited)** | ** ** |
| **Cash  flows from operating activities:**                                             |       |                            |       |   |   |
| Net loss                                                                               |       | $                               | (619,000   | ) | $ | (3,868,000 | ) |
| Adjustments  to reconcile net loss to net cash provided(used) by operating activities: |       |                            |       |   |   |
| Depreciation  and amortization                                                         |       | 247,000                         |       | 267,000 |   |
| Impairments  and write-downs                                                           |       | 285,000                         |       | 1,238,000 |   |
| Allowance  for doubtful accounts                                                       |       | 29,000                          |       | 180,000 |   |
| Common stock  options                                                                  |       | 31,000                          |       | 47,000 |   |
| Gain/Loss on  sale of fixed assets                                                     |       | 12,000                          |       | 22,000 |   |
| Cash  provided(used) due to changes in assets and liabilities:                         |       |                            |       |   |   |
| Accounts  receivable                                                                   |       | 1,447,000                       |       | 2,782,000 |   |
| Inventories                                                                            |       | (3,288,000                      | )          | 1,527,000 |   |
| Other assets                                                                           |       | 21,000                          |       | 82,000 |   |
| Accounts  payable                                                                      |       | 900,000                         |       | (671,000 | ) |
| Accrued  commissions and other expenses                                                |       | (277,000                        | )          | 427,000 |   |
| Net cash  provided(used) by operating activities                                       |       | (1,212,000                      | )          | 2,033,000 |   |
|                                                                                   |       |                            |       |   |   |
| **Cash  flows from investing activities:**                                             |       |                            |       |   |   |
| Redemption  of held-to-maturity investments                                            |       | —                          |       | 539,000 |   |
| Proceeds  from sale of fixed assets                                                    |       | 16,000                          |       | — |   |
| Purchase of  fixed assets                                                              |       | (27,000                         | )          | (106,000 | ) |
| Net cash  provided(used) by investing activities                                       |       | (11,000                         | )          | 433,000 |   |
|                                                                                   |       |                            |       |   |   |
| **Cash  flows from financing activities:**                                             |       |                            |       |   |   |
| Net proceeds  from minority interest loan                                              |       | 256,000                         |       | — |   |
| Net proceeds  from issuance of common stock                                            |       | 353,000                         |       | 63,000 |   |
| Net cash  provided by financing activities                                             |       | 609,000                         |       | 63,000 |   |
|                                                                                   |       |                            |       |   |   |
| **Net  increase(decrease) in cash and cash equivalents**                               |       | (614,000                        | )          | 2,529,000 |   |
|                                                                                   |       |                            |       |   |   |
| **Cash and  cash equivalents, beginning**                                              |       | 7,721,000                       |       | 3,890,000 |   |
|                                                                                   |       |                            |       |   |   |
| **Cash and  cash equivalents, ending**                                                 |       | $                               | 7,107,000  |   | $ | 6,419,000 |   |
|                                                                                   |       |                            |       |   |   |
| **Supplemental  disclosure of cash flow information:**                                 |       |                            |       |   |   |
| Cash paid  during the period for:                                                      |       |                            |       |   |   |
| Income taxes                                                                           |       | $                               | 3,000      |   | $ | 6,000 |   |

 

See accompanying notes to condensedconsolidated financial statements.

 

5

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**SPORT-HALEY, INC.**

**NOTES TO CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS**

 
| **NOTE 1** | ** ** | **SIGNIFICANT ACCOUNTING POLICIES** |
|------------|------------|-------------------------------------|

 

*Principlesof Consolidation* – Our fiscal year 2006 condensedconsolidated financial statements include the accounts of Sport-Haley, Inc.(“Sport-Haley”) and Reserve Apparel Group LLC (“Reserve Apparel”) (Sport-Haley, Inc.and Reserve Apparel Group LLC collectively referred to as the “Company”, “we”, “us”or “our”). Reserve Apparel was formed in November 2005 by Sport-Haley andExplorer Gear USA, Inc. (“Explorer Gear”) to manufacture and marketTop-FliteTM branded apparel. A licensing agreement between Callaway Golf Companyand Sport-Haley allows Reserve Apparel to market golf apparel bearing theTop-FliteTM brand. In accordance with the LLC operating agreement, as of March 2006,Sport-Haley owns a 51% interest in Reserve Apparel and Explorer Gear owns a 49%interest. At March 31, 2006, Sport-Haley had contributed equity capital of$25,000 and advanced loans of $897,000 to Reserve Apparel including accruedinterest of $2,000, and Explorer Gear had contributed equity capital of $0 andadvanced loans of $256,000 to Reserve Apparel. All significant inter-companyaccounts and transactions between Sport-Haley and Reserve Apparel have beeneliminated. Because Explorer Gear had contributed no equity capital to ReserveApparel as of March 31, 2006, our condensed consolidated financialstatements include the entire loss of Reserve Apparel for the three monthsended March 31, 2006, in accordance with ARB No. 51. Had ExplorerGear contributed sufficient equity capital to offset its proportionate share ofthe Reserve Apparel loss, $73,000 would have been allocated to Explorer Gear asits proportionate share of the loss for the three-month period, and theconsolidated loss reported by Sport-Haley would have been $73,000 less for thequarter and nine months ended March 31, 2006.

 

In April 2006, Explorer Gear’s equitycapital account within Reserve Apparel was credited upon the receipt of theircash contribution of $25,000. In May 2006, a majority of the members ofthe Management Committee of Reserve Apparel approved the reclassification toequity capital of certain amounts previously classified as member loans. Thereclassification increased the equity capital of Sport-Haley, Inc and reducedamounts classified as its member loans to Reserve Apparel by $79,000. Thereclassification also increased the equity capital of Explorer Gear and reducedamounts previously classified as its member loans to Reserve Apparel by$75,000, which brought their contributed capital balance to $100,000, inproportion with their respective 49% interest.

 

*CondensedFinancial Statements* – The accompanying condensedconsolidated balance sheets and interim condensed consolidated statements ofoperations and cash flows include all adjustments (consisting only of normalrecurring items) necessary for their fair presentation. The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States of America requires management to make estimatesand assumptions that affect the reported amounts of assets, liabilities,revenues and expenses and the disclosure of contingent assets and liabilities.Our revenues are seasonal and, therefore, interim results are not necessarilyindicative of results to be expected for the full year.

 

Certain information in footnote disclosuresnormally included in financial statements has been condensed or omitted inaccordance with the rules and regulations of the Securities and ExchangeCommission. The information included in this Form 10-Q should be read inconjunction with financial statements and notes thereto and Management’sDiscussion and

 

6

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Analysis of Financial Condition and Resultsof Operations for the year ended June 30, 2005, included in the Company’sfiling on Form 10-K.

 

*Reclassification* – Certainprior period amounts have been reclassified to conform to the year 2006presentation. Such reclassifications had no affect on net income(loss) in anyof the periods presented.

 

*Stock-Based Compensation* - Our StockOption Plan (the “Plan”) expired by its terms on February 28, 2003. Optionagreements that were issued in accordance with the Plan prior to February 28,2003, generally remain in force until the earlier of their exercise, theexpiration of certain time periods after the termination of a grantee’semployment (or other relationship with the Company) or expiration by theirterms.

 

At March 31, 2006,there were outstanding options to purchase 678,500 shares of our common stockat exercise prices ranging from $2.71 to $9.78 per share and expiration datesbetween July 2006 and January 2013. During the quarter ended March 31,2006, no options were exercised and no options expired.

 

In December 2004, the Financial AccountingStandards Board issued Statement of Financial Accounting Standards No. 123(R)(“SFAS 123R”), *“Share-Based Payment,”* which is arevision of Statement of Financial Accounting Standards No. 123, *“Accounting for Stock-Based Compensation.”* SFAS 123R iseffective for annual periods beginning after July 1, 2005, supersedesAccounting Principles Board Opinion No. 25, *“Accountingfor Stock Issued to Employees,”* and amends Statement of FinancialAccounting Standards No. 95, *“Statement of Cash Flows.”*SFAS 123R requires all share-based payments to employees, including grants ofemployee stock options, to be recognized in the statement of operations basedupon their fair values and rescinds the acceptance of pro forma disclosure.SFAS 123R permits two methods of adoption, a “modified prospective” method anda “modified retrospective” method. Under the modified prospective method,stock-based compensation cost is recognized, beginning with the effective date,based on the requirements of SFAS 123R for all share-based payments grantedafter the effective date and for all awards granted prior to the effective datethat remain unvested on the effective date. The modified retrospective methodincludes the requirements of the modified prospective method and also permitsrestatement of prior periods based on amounts previously reported in pro formadisclosures pursuant to SFAS 123 for either all periods presented or for onlyprior interim periods of the year of adoption. We adopted the modified prospectivemethod prescribed in SFAS 123R, effective July 1, 2005.

 

Previously, we accounted for stock-based compensationusing the intrinsic value method prescribed in Accounting Principles BoardOpinion No. 25, “*Accounting for StockIssued to Employees*,” and related interpretations and elected toapply the disclosure-only provisions of Statement of Financial AccountingStandards (“SFAS”) No. 123, “*Accountingfor Stock-Based Compensation*,” as amended by SFAS No. 148, “*Accounting for Stock-Based Compensation – Transitionand Disclosure*.” Under the intrinsic value method, compensationexpense for stock options was recognized over the vesting period of the grantbased on the excess, if any, of the market price of our common stock at thedate of grant over the stock option exercise price. As governed by the Plan,stock options were generally granted at or near fair market value on the dateof grant.

 

7

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If we had previously accounted for stock-basedcompensation in interim periods using the fair value method rather than theintrinsic value method, the pro forma amounts of our net loss and loss percommon share would have been reported as follows:

 

| ** **                                                                                     | ** ** | **Three Months Ended March 31,** | ** ** |
|------------------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                                     | ** ** | **2006**                                             | ** ** | **2005** | ** ** |
| Net loss -  as reported                                                                        |       | $                                                    | (190,000   | ) | $ | (586,000 | ) |
| Effect of  employee stock-based compensation included in reported net loss                     |       | —                                               |       | 16,000 |   |
| Effect of  employee stock-based compensation per SFAS 123                                      |       | —                                               |       | (106,000 | ) |
| Net loss  applicable to common stock (2004 pro forma)                                          |       | $                                                    | (190,000   | ) | $ | (676,000 | ) |
|                                                                                           |       |                                                 |       |   |   |
| Basic and  Diluted:                                                                            |       |                                                 |       |   |   |
| Loss per  share - as reported                                                                  |       | $                                                    | (0.07      | ) | $ | (0.23 | ) |
| Per share  effect of employee stock-based compensation included in reported net income  (loss) |       | —                                               |       | 0.01 |   |
| Per share  effect of employee stock-based compensation per SFAS 123                            |       | —                                               |       | (0.04 | ) |
| Loss per  share applicable to common stock (2004 pro forma)                                    |       | $                                                    | (0.07      | ) | $ | (0.26 | ) |

 

| ** **                                                                           | ** ** | **Nine Months Ended March 31,** | ** ** |
|--------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                           | ** ** | **2006**                                            | ** ** | **2005** | ** ** |
| Net loss -  as reported                                                              |       | $                                                   | (619,000   | ) | $ | (3,868,000 | ) |
| Effect of  employee stock-based compensation included in reported net loss           |       | 31,000                                              |       | 47,000 |   |
| Effect of  employee stock-based compensation per SFAS 123                            |       | (31,000                                             | )          | (317,000 | ) |
| Net loss  applicable to common stock (2005 pro forma)                                |       | $                                                   | (619,000   | ) | $ | (4,138,000 | ) |
|                                                                                 |       |                                                |       |   |   |
| Basic and  Diluted:                                                                  |       |                                                |       |   |   |
| Loss per  share - as reported                                                        |       | $                                                   | (0.23      | ) | $ | (1.52 | ) |
| Per share  effect of employee stock-based compensation included in reported net loss |       | 0.01                                                |       | 0.02 |   |
| Per share  effect of employee stock-based compensation per SFAS 123                  |       | (0.01                                               | )          | (0.13 | ) |
| Loss per  share applicable to common stock (2005 pro forma)                          |       | $                                                   | (0.23      | ) | $ | (1.63 | ) |

 

8

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| **NOTE 2** | ** ** | **INVENTORIES** |
|------------|------------|-----------------|

 
| ** **                                                  | ** ** | **March 31,  2006** | ** **   | **June 30,  2005** | ** ** |
|-------------------------------------------------------------|------------|--------------------------|--------------|-------------------------|------------|
| Inventories consisted of the following: |       |                     |         |                    |       |
| Component                                                   |       | $                        |  73,000 |                    | $          |  387,000 |   |
| Finished goods                                         |       | 7,229,000                |         | 3,766,000               |       |
|                                                        |       |                     |         |                    |       |
|                                                        |       | $                        | 7,156,000    |                    | $          | 4,153,000 |   |

 
| **NOTE 3** | ** ** | **LINE OF CREDIT AGREEMENT** |
|------------|------------|------------------------------|

 

We maintain a revolving line of creditagreement with a commercial bank. The revolving line of credit agreement,renewed by amendment through December 5, 2006, provides for a maximum loanamount of $5,000,000, collateralized by a lien on substantially all of ourassets, and for interest at the bank’s prime rate. In accordance with theamendment agreement, we must maintain minimum tangible net worth of $14,000,000and liquidity of $4,000,000. We generally maintain the line of credit tofacilitate the issuance of letters of credit for inventory purchases fromoffshore suppliers and, if necessary, to fund any temporary working capitalneeds. We did not have any balances due on the line of credit at March 31,2006, or June 30, 2005, respectively.

 
| **NOTE 4** | ** ** | **COMMITMENTS AND CONTINGENCIES** |
|------------|------------|-----------------------------------|

 

At March 31, 2006, wehad $445,000 in outstanding letters of credit that were issued to foreignsuppliers in accordance with finished goods inventory purchase commitments.Outstanding letters of credit reduce the amount available for borrowing underthe line of credit agreement.

** **
| **NOTE 5** | ** ** | **EARNINGS PER SHARE** |
|------------|------------|------------------------|

 

Effectivewith the year ended June 30, 1998, we adopted the provisions of Statementof Financial Accounting Standards No. 128 (“SFAS No. 128”), *Earnings per Share*. SFAS No. 128 requires thepresentation of basic and diluted earnings(loss) per common share. Thefollowing table provides a reconciliation of the numerator and denominator ofbasic and diluted earnings(loss) per common share:

 
| ** **                                     | ** ** | **Three Months ended March 31, 2006** | ** ** |
|------------------------------------------------|------------|----------------------------------------------------------------|------------|
| ** **                                     | ** ** | **Net**                                                        | ** ** | **Weighted** | ** ** | ** ** | ** ** |
| ** **                                     | ** ** | **Income**                                                     | ** ** | **Average** | ** ** | ** ** | ** ** |
| ** **                                     | ** ** | **(Loss)**                                                     | ** ** | **Shares** | ** ** | **Per Share** | ** ** |
|                                           |       |                                                           |       |   |   |   |   |
| Loss Per  Common Share                         |       |                                                           |       |   |   |   |   |
|                                           |       |                                                           |       |   |   |   |   |
| Basic loss  per share                          |       | $                                                              | (190,000   | ) | 2,770,000 |   | $ | (0.07 | ) |
|                                           |       |                                                           |       |   |   |   |   |
| Effect of  dilutive securities options **[A]** |       | —                                                         |       | — |   | — |   |
| ** **                                     |       |                                                           |       |   |   |   |   |
| Diluted loss  per share                        |       | $                                                              | (190,000   | ) | 2,770,000 |   | $ | (0.07 | ) |

 

9

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| ** **                                     | ** ** | **Nine Months ended March 31, 2006** | ** ** |
|------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                     | ** ** | **Net**                                                       | ** ** | **Weighted** | ** ** | ** ** | ** ** |
| ** **                                     | ** ** | **Income**                                                    | ** ** | **Average** | ** ** | ** ** | ** ** |
| ** **                                     | ** ** | **(Loss)**                                                    | ** ** | **Shares** | ** ** | **Per Share** | ** ** |
|                                           |       |                                                          |       |   |   |   |   |
| Loss Per  Common Share                         |       |                                                          |       |   |   |   |   |
|                                           |       |                                                          |       |   |   |   |   |
| Basic loss  per share                          |       | $                                                             | (619,000   | ) | 2,742,000 |   | $ | (0.23 | ) |
|                                           |       |                                                          |       |   |   |   |   |
| Effect of  dilutive securities options **[A]** |       | —                                                        |       | — |   | — |   |
|                                           |       |                                                          |       |   |   |   |   |
| Diluted loss  per share                        |       | $                                                             | (619,000   | ) | 2,742,000 |   | $ | (0.23 | ) |

 
| ** **                                     | ** ** | **Three Months ended March 31, 2005** | ** ** |
|------------------------------------------------|------------|----------------------------------------------------------------|------------|
| ** **                                     | ** ** | **Net**                                                        | ** ** | **Weighted** | ** ** | ** ** | ** ** |
| ** **                                     | ** ** | **Income**                                                     | ** ** | **Average** | ** ** | ** ** | ** ** |
| ** **                                     | ** ** | **(Loss)**                                                     | ** ** | **Shares** | ** ** | **Per Share** | ** ** |
|                                           |       |                                                           |       |   |   |   |   |
| Loss Per  Common Share                         |       |                                                           |       |   |   |   |   |
|                                           |       |                                                           |       |   |   |   |   |
| Basic loss  per share                          |       | $                                                              | (586,000   | ) | 2,545,000 |   | $ | (0.23 | ) |
|                                           |       |                                                           |       |   |   |   |   |
| Effect of  dilutive securities options **[A]** |       | —                                                         |       | — |   | — |   |
|                                           |       |                                                           |       |   |   |   |   |
| Diluted loss  per share                        |       | $                                                              | (586,000   | ) | 2,545,000 |   | $ | (0.23 | ) |

 
| ** **                                     | ** ** | **Nine Months ended March 31, 2005** | ** ** |
|------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                     | ** ** | **Net**                                                       | ** ** | **Weighted** | ** ** | ** ** | ** ** |
| ** **                                     | ** ** | **Income**                                                    | ** ** | **Average** | ** ** | ** ** | ** ** |
| ** **                                     | ** ** | **(Loss)**                                                    | ** ** | **Shares** | ** ** | **Per Share** | ** ** |
|                                           |       |                                                          |       |   |   |   |   |
| Loss Per  Common Share                         |       |                                                          |       |   |   |   |   |
|                                           |       |                                                          |       |   |   |   |   |
| Basic loss  per share                          |       | $                                                             | (3,868,000 | ) | 2,542,000 |   | $ | (1.52 | ) |
|                                           |       |                                                          |       |   |   |   |   |
| Effect of  dilutive securities options **[A]** |       | —                                                        |       | — |   | — |   |
|                                           |       |                                                          |       |   |   |   |   |
| Diluted loss  per share                        |       | $                                                             | (3,868,000 | ) | 2,542,000 |   | $ | (1.52 | ) |

 

----

**[A]** Due to theCompany’s net losses, all options were anti-dilutive and therefore excludedfrom the loss per share calculations.

 

** **
| **NOTE 6** | ** ** | **SEGMENT INFORMATION:** |
|------------|------------|--------------------------|

 

The consolidated Companyhas two operating segments: designing, purchasing or contracting for themanufacture of and wholesale sales of men’s and women’s (1) fashion golfapparel and outerwear****and (2) brandedapparel. Our Ben Hogan® and SPORT HALEYTM fashion golf apparel and outerwearcollections are marketed by Sport-Haley,

 

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Inc. in the premium andmid-priced markets through a network of independent wholesale salesrepresentatives and distributors to golf professional shops, country clubs,resorts and exclusive department stores within the United States and on alimited basis by certain distributors within international markets. Currently,we distribute Top-FliteTM men’s branded apparel exclusively though Wal-MartStores, Inc. in the United States within the operations of Reserve ApparelGroup LLC.****Ben Hogan® and Top-FliteTM apparel are distributedpursuant to a licensing agreement with Callaway Golf Company.

 

Statements of operationsinformation for each of our segments is presented in the table below. The firstshipments of Top-FliteTM branded apparel were made in March 2006.Therefore, the table below only includes segment information for the quarterand nine months ended March 31, 2006.

 

*Statements of Operations SegmentInformation for the Quarter and Nine Months Ended March 31, 2006:*

 
| ** **                                    | ** ** | **Quarter Ended**       | ** ** | **Nine Months Ended** | ** ** |
|-----------------------------------------------|------------|------------------------------|------------|---------------------------------|------------|
| ** **                                    | ** ** | **March 31, 2006** | ** ** | **March 31, 2006**    | ** ** |
| ** **                                    | ** ** | **Fashion**                  | ** ** | **Branded**                     | ** ** | **Fashion** | ** ** | **Branded** | ** ** |
| ** **                                    | ** ** | **Apparel**                  | ** ** | **Apparel**                     | ** ** | **Apparel** | ** ** | **Apparel** | ** ** |
| ** **                                    | ** ** | **(Unaudited)**              | ** ** | **(Unaudited)**                 | ** ** | **(Unaudited)** | ** ** | **(Unaudited)** | ** ** |
| ** **                                    | ** ** | ** **                   | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net sales                                     |       | 4,210,000                    |       | 446,000                         |       | 12,650,000 |   | 446,000 |   |
| Cost of  goods sold                           |       | 2,400,000                    |       | 428,000                         |       | 7,704,000 |   | 428,000 |   |
| Impairments                                   |       | 91,000                       |       | —                          |       | 91,000 |   | — |   |
| Gross profit                                  |       | 1,719,000                    |       | 18,000                          |       | 4,661,000 |   | 18,000 |   |
| Selling,  general and administrative expenses |       | 1,821,000                    |       | 138,000                         |       | 4,983,000 |   | 138,000 |   |
| Royalty  expense                              |       | 176,000                      |       | 27,000                          |       | 514,000 |   | 27,000 |   |
| Loss from  operations                         |       | (278,000                     | )          | (147,000                        | )          | (836,000 | ) | (147,000 | ) |

 

*Financial information aboutgeographic areas*- Currently, the Company’s revenues, from either operating segment, derivedfrom sales to customers outside the United States are immaterial.

** **
| **NOTE 7** | ** ** | **SUBSEQUENT EVENTS:** |
|------------|------------|------------------------|

 

In May 2006, an executive from ExplorerGear informed the management of Reserve Apparel that an amount previouslypurported by Explorer Gear to have been paid on behalf of Reserve Apparel hadnot been paid. The amount in question related to finished goods inventorieswhich were purchased through a Canadian apparel broker, received by ReserveApparel and shipped to Wal-Mart Stores, Inc. in March 2006. While wehave not been able to ascertain with certainty that the broker has not beenpaid for this inventory purchase, we reclassified the amount from a long-termloan payable to Explorer Gear to a current liability of Reserve Apparel. At March 31,2006, we reduced Explorer Gear’s loan balance with respect to Reserve Appareland increased Reserve Apparel’s trade accounts payable by $236,000. TheCanadian apparel broker also informed Reserve Apparel that the broker hadapplied a $291,000 prepayment from Reserve Apparel to satisfy a debt ofExplorer Headgear, Inc. (a Canadian Company related to Explorer Gear bycommon ownership)

 

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instead of applying the amount as a deposittoward finished goods inventories which were planned to be provided to ReserveApparel by the broker. At March 31, 2006, the $291,000 amount wasclassified as an inventory deposit on the books of Reserve Apparel. We believethat the Canadian broker inappropriately misapplied these funds, and we havedemanded that the funds be applied toward their intended purpose as a depositfor the future purchase of finished goods inventories. Reserve Apparel expectsto fully recover the $291,000 deposit.

 

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**SPORT-HALEY, INC.**

**ITEM 2MANAGEMENT’S DISCUSSION AND ANALYSIS OFFINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

ThisReport on Form 10-Q contains certain forward-looking statements, withinthe meaning of Section 27A of the Securities Act of 1933 and Section 21Eof the Securities Exchange Act of 1934. The words “may,” “will,” “expect,” “anticipate,”“continue,” “estimate,” “project,” “intend,” “believe,” “appear” and similarexpressions, variations or the negative of these words, and any statementregarding possible or assumed future results of operations of the Company’sbusiness, the markets for its products, anticipated expenditures, regulatorydevelopments or competition, or other statements regarding matters that are nothistorical facts, are intended to identify forward-looking statements, althoughnot all forward-looking statements contain such identifying words. The readershould be aware that our actual results could differ materially from thosecontained in forward-looking statements. The Company’s financial condition andthe results of its operations will depend on a number of factors, including,but not limited to, the following: our ability to control costs and expenses;our ability to successfully anticipate fashion trends, design favorablyaccepted fashion golf apparel, effectively advertise and communicate within themarketplace, and penetrate our chosen distribution channels; our ability tosuccessfully forecast sales and optimize inventory levels; our ability tosuccessfully manage risks associated with the trend of increasing sales withrespect to licensed apparel, such as the Ben Hogan® apparel collections;relations with and performance of suppliers; competition within golf apparelmarkets; business conditions and growth in the fashion golf apparel market andthe general economy; political and international trade relations; changes ininternational trade quota systems for apparel; consumer spending on golfapparel; general global economic and political conditions resulting from threatsor acts of war or terrorism and responses thereto; timely performance of thirdparties, such as freight forwarders, including risks of labor disputes and/orlabor strikes; changes in product mix; inventory risks due to shifts in marketand/or price erosion of purchased apparel; lost or reduced manufacturingcapacity of significant suppliers; loss or delay of shipments from foreignsuppliers; access to capital; maintaining satisfactory relationships withcommercial banking institutions; and, establishing controls with regard to andmaintaining the integrity of technology and information systems. Additionalinformation on these and other factors that could affect our financial resultsis included in the discussion below and in the Company’s Form 10-K for theyear ended June 30, 2005. There may be other factors not mentionedabove, in the discussion below or included in our Securities and ExchangeCommission filings that may cause actual results to differ materially fromany forward-looking statements. The reader should not place undue reliance onany forward-looking statements. Neither the Company nor any of its corporateofficers or key employees assumes any obligation to update any forward-lookingstatements as a result of new information, future events or developments,except as required by securities laws.

 

All references to fiscal years are references toSport-Haley’s fiscal year, which ends on June 30.

 

##### **OVERVIEW**

##### ** **

##### **Sport-Haley, Inc.designs, purchases, contracts for the manufacture of, markets and distributesquality women’s and men’s fashion golf apparel and outerwear under the SPORTHALEYTM and Ben Hogan® labels. Our fashion golf apparel collections, known fortheir innovative designs, quality fabrics, generous fits and classic styles,are primarily marketed in the premium and mid-priced markets through a networkof independent wholesale sales representatives and distributors to golfprofessional shops, country clubs, resorts and exclusive department storeswithin the United States and by certain distributors within internationalmarkets. Sport-Haley distributes Ben Hogan® apparel pursuant to a licensingagreement with Callaway Golf Company (“Callaway”).**

##### ** **

Sport-Haley is represented by a network of independent wholesale salesrepresentatives and employ two regional sales managers, with responsibilitiesincluding supervising the sales representatives in the

 

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eastern and western regions of the United States, respectively. Most ofthe independent wholesale sales representatives solicit sales of both SPORTHALEYTM and Ben Hogan® apparel on our behalf.

 

Sport-Haley continues to focus on stabilizing revenues associated withour SPORT HALEYTM women’s fashion apparel and growth of revenues associated withour Ben Hogan® men’s fashion apparel. We previously discontinued marketingSPORT HALEYTM men’s fashion apparel, in part, because we believe that there arenatural synergies common to Ben Hogan® men’s fashion apparel and SPORT HALEYTMwomen’s fashion apparel. By marketing SPORT HALEYTM women’s apparel inconjunction with Ben Hogan® men’s apparel, we are attempting to maintain ourmarket share with current women’s apparel customers and expect to expand thedistribution channels for fashion women’s apparel into markets that we hadpreviously only been able to penetrate via the marketing of Ben Hogan® men’sapparel.

 

In November 2005, we previously announced that Top-FliteTM apparelwill be distributed in the United States in accordance with a vendor agreementwith Wal-Mart Stores through Reserve Apparel Group LLC, a joint venture betweenSport-Haley, Inc. and Explorer Gear. Top-FliteTM apparel is distributedpursuant to a licensing agreement between Callaway and Sport-Haley. The firstsales of Top-FliteTM apparel to Wal-Mart Stores were made in March 2006.

 

##### **CRITICALACCOUNTING POLICIES AND ESTIMATES**

##### ** **

Our financial statements have been prepared in accordance withstandards of the Public Company Accounting Oversight Board (United States),which require us to make estimates and judgments that affect the reportedamounts of assets, liabilities, revenues and expenses, and the relateddisclosures. A summary of those significant accounting policies can be found inthe Footnotes to the Financial Statements included in our Report on Form 10-Kfor the fiscal year ended June 30, 2005. The estimates used by management are based upon our historicalexperiences combined with management’s understanding of current facts andcircumstances. Certain of our accounting policies are considered critical asthey are both important to the portrayal of our financial condition and theresults of our operations and require significant or complex judgments on the part ofmanagement. We believe that the following critical accounting policies affectthe more significant judgments and estimates used in the preparation of ourfinancial statements.

 

*Inventories*

 

Inventories, predominately comprised offinished goods, are generally valued at the lower of cost (weighted average) ormarket. Costs include amounts paid to suppliers for packaged apparel and/ormaterials and labor, import costs, such as customs duties, freight-in and othermiscellaneous costs, and allocated overhead. After we implemented ouroperations software in January 2004, we discovered certain programming andhuman errors within the new system that adversely affected the software’sability to accurately compute the valuation of our finished goods inventoriesusing a weighted average method. In prior periods we considered the programmingand human errors, which caused us to use a standard cost method in the priorperiods, to be a material weakness in our internal controls over financialreporting with respect to inventory valuation. This weakness in our controlsprevented us from relying upon the system-recorded transactions with respect toinventory valuations during fiscal 2005. During the 2005 fiscal year, weconcluded with reasonable assurance that recomputing the value of our finishedgoods inventories using a standard cost method yielded a fair estimation of thevalue of our finished goods inventories. We used the standard cost method tovalue our finished goods inventories from the fiscal quarter ended March 31,2004, through the fiscal quarter ended March 31, 2005. Had we

 

14

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been able to rely upon the system to properlycompute the cost of our finished goods inventories using the weighted averagemethod, we believe that the weighted average method would not have yielded amaterially different computation of the value than the standard cost methodthat we applied. For periods subsequent to March 31, 2005, we determinedthat differences between the system-calculated values (average cost) of ourfinished goods inventories versus the values of our finished goods inventoriesusing a standard cost method were immaterial. At March 31, 2006, inventories ofapproximately $102,000 remained on hand that had been valued in prior periodsusing the standard cost method.

 

Duringthe quarter ended December 31, 2005, we revised employee guidelines andprocedures for recording inventory-related transactions within our softwaresystem, and shortly after December 31, 2005, we prepared a detailedanalysis of the weighted average cost calculations recorded within our softwarefor several of our finished goods inventory items. Our guidelines andprocedures are designed to ensure that only qualified personnel may recordinventory-related transactions. During the quarter ended December 31,2005, those persons received additional training in how to properly recordfinished goods inventory transactions within the system. Our detailed analysisconcluded with reasonable assurance that the software system has been properlyconfigured within a level of accuracy that provides us with reasonableassurance to now rely upon the system to properly compute the weighted averageunit costs of our finished goods inventories. Therefore, we now believe, withreasonable assurance, that the programming errors related to our operationssoftware no longer cause a material weakness in our internal controls overfinancial reporting with respect to inventory valuation. However, human errorshave continued to cause a material weakness in our internal controls overfinancial reporting with respect to inventory valuation. Our detailed analysisrevealed that certain variances in the unit costs of our finished goodsinventories have occurred, because procedures were not properly followed in allinstances. Ongoing training and management supervision are inherentrequirements within any software system and all errors cannot be prevented inall instances. In order to achieve reasonable assurance that human errors nolonger cause a material weakness, we will continue to educate and supervise ourpersonnel responsible for recording inventory-related transactions, and we willalso continue to refine our periodic testing model used to determine theaccuracy of inventory-related transactions which have been recorded within thesystem.

 

The material weakness in our internalcontrols over financial reporting with respect to inventory valuation alsoimpaired our ability to rely upon information created by our computer system tofairly present, in all material respects, our financial condition, results ofoperations and cash flows in the periods covered by this report. The inabilityof our computer system to properly calculate the valuation of our finishedgoods inventories using a weighted average cost assumption also affected thesystem-recorded amounts within our cost of goods sold in certain periodscovered by this report. Because (1) we concluded with reasonable assurancethat our using a standard cost assumption yielded a fair estimation of ourfinished goods inventories from the fiscal quarter ended March 31, 2004,through the fiscal quarter ended March 31, 2005, (2) we determinedthat differences between the system-calculated values (average cost) of ourfinished goods inventories versus the values of our finished goods inventoriesusing a standard cost method subsequent to March 31, 2005, were immaterialand (3) we consistently recorded adjustments to inventories as componentsof cost of goods sold, we believe with reasonable assurance that our cost ofgoods sold are fairly stated for the periods covered by this report. Therefore,we believe that the procedures we applied to value our finished goodsinventories for the periods covered by this report provide us with reasonableassurance that our condensed consolidated financial statements and the notesthereto fairly state, in all material respects, our financial condition, theresults of our operations and our cash flows.

 

15

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Excess finished goods inventories are anatural component of a seasonal apparel business. While certain finished goodsitems will sell out in any particular selling season, quantities of otherfinished goods items will remain at the end of each selling season. We marketprevious seasons’ finished goods inventories at reduced wholesale prices to ourcustomers in the normal course of business. Remaining excess inventories areliquidated through other markets. In the ordinary course of business, wemaintain reserves for inventory write downs due to the obsolescence ofdiscontinued or aging merchandise. We perform analyses on a quarterlybasis to identify unsold discontinued or aging merchandise and adjust ourreserves for inventory obsolescence to reduce the carrying value ofdiscontinued or aging merchandise to its estimated net realizable value. Thenet realizable value of the discontinued or aging merchandise is estimatedbased on management’s disposition plans and historical experiences. During thequarter ended March 31, 2006, we recorded finished goods inventorieswrite-downs of $91,000. While management believes that our processes producefair valuations of obsolete inventories, if actual market conditions are lessfavorable than those projected by management, additional allowances may berequired or we may recognize losses on the disposition of obsoleteinventories.

 

*Deferred Income Taxes*

 

Deferred income taxes are recognized for the expectedtax consequences in future years for differences between the tax bases ofassets and liabilities and their financial reporting amounts, based uponenacted tax laws and statutory tax rates applicable to the periods in which thedifferences are expected to affect taxable income. Our significant deferred taxassets are related to net operating loss carry forwards for federal and stateincome tax purposes, stock-based compensation and an unrealized loss for taxpurposes on a common stock investment. Governing regulations require that ouroperating losses be carried forward for income tax purposes. We haveestablished a valuation allowance to reduce deferred tax assets to the netamount expected to be recovered in future periods. The estimates for deferredtax assets and the corresponding valuation allowance require us to exercisecomplex judgments. We periodically review and adjust those estimates based uponthe most current information available. In accordance with SFAS 109 and basedupon a review at March 31, 2006, of our utilization of deferred taxassets, we maintained a valuation allowance that effectively reduces our netdeferred tax assets to zero. While we continue to explore various strategies toreturn the Company to profitability, including the introduction of Top-FliteTMbranded apparel, we cannot be certain that our efforts will result in the generationof future profits. Because the recoverability of deferred tax assets isdirectly dependent upon future operating results, actual recoverability ofdeferred tax assets may differ materially from our estimates.

 

*Allowance for Doubtful Accounts*

 

Our allowance for doubtful accounts reflects a reserve that reduces ourcustomer accounts receivable to the net amount estimated to be collectible.Estimating the credit worthiness of customers and the recoverability ofcustomer accounts requires us to exercise considerable judgment. In estimatingthe reserve for uncollectible accounts, we consider factors such as generaleconomic and industry-specific conditions, historical customer performance andanticipated customer performance. From time to time, we also identifydelinquent customer accounts for which a specific reserve is required. Ourallowance for doubtful accounts totaled $155,000 at March 31, 2006. Whilewe consider our processes to be adequate to effectively quantify our exposureto doubtful accounts, changes in economic, industry or specific customerconditions may result in recoverability of our doubtful accounts thatdiffers materially from our estimates.

 

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*Allowance for Sales Returns*

 

We record allowances for sales returns as net adjustments to customeraccounts receivable. When recording an allowance, the net method reducescustomer accounts receivable and net sales by the estimated gross margin effectof the anticipated sales return. Generally, our selling terms preclude returnof our products subsequent to the sale. However, we have traditionallymaintained limited programs that offer some customers the right to returncertain finished goods items under predefined conditions, which we include as acomponent within our estimate of allowance for sales returns. We reviewhistorical data and consider factors such as general economic andindustry-specific conditions and anticipated customer performance when evaluatingthe adequacy of our allowance for sales returns. At March 31, 2006, ourallowance for sales returns was $286,000. Significant changes in generaleconomic or industry conditions may yield sales returns that differmaterially from our estimates.

 

### **RECENTPRONOUNCEMENTS**

### ** **

### **In June 2005, the EmergingIssues Task Force of the Financial Accounting Standards Board reached aconsensus on Issue No. 05-6 (“EITF 05-6”), *“Determiningthe Amortization Period for Leasehold Improvements.”* The guidanceprovided by EITF 05-6 requires that leasehold improvements acquired in abusiness combination or purchased subsequent to the inception of a lease beamortized over the lesser of the useful life of the assets or a term thatincludes renewals of the lease that are reasonably assured at the date of thebusiness combination or purchase of the leasehold improvement. EITF 05-6 iseffective for periods beginning after June 29, 2005. We do not believe theadoption of EITF 05-6 will have a material impact on our financial condition orthe results of our operations.**

### ** **

InMay 2005, the Financial Accounting Standards Board issued Statement ofFinancial Accounting Standards No. 154 (“SFAS 154”), *“Accountingfor Changes and Error Corrections – A Replacement of APB Opinion No. 20and FASB Statement No. 3.”* SFAS 154 changes the requirements for the accounting for and reportingof a change in accounting principle. The provisions of SFAS 154 require, unlessimpracticable, retrospective application to prior periods’ financial statementsof: (1) all voluntary changes in principles; and, (2) changesrequired by a new accounting pronouncement, if a specific transition period isnot provided. SFAS 154 also requires that a change in depreciation,amortization or depletion method for long-lived, non-financial assets beaccounted for as a change in accounting estimate, which requires prospectiveapplication of the new method. SFAS 154 is effective for all accounting changesmade in fiscal years beginning after December 15, 2005. BecauseSFAS 154 is directly dependent upon future events, we cannot determine whateffect, if any, adoption of SFAS 154 will have on our financial condition orthe results of our operations.

 

InMarch 2005, the Financial Accounting Standards Board issued InterpretationNo. 47 (“FIN 47”), *“Accounting forConditional Asset Retirement Obligations”* to clarify the guidanceincluded in Statement of Financial Accounting Standards No. 143, *“Accounting for Asset Retirement Obligations.”* FIN 47requires companies to recognize a liability for the fair value of a legalobligation to perform asset retirement activities that are conditional ona future event if the amount can be reasonably determined. If amounts cannot bereasonably estimated, FIN 47 requires certain disclosures about the unrecognizedasset retirement obligations. FIN 47 is effective no later than the end offiscal years ending after December 15, 2005. We do not anticipate thatadoption of FIN 47 will have a material impact on our financial condition orthe results of our operations.

 

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### **LIQUIDITY ANDCAPITAL RESOURCES**

### ** **

The golf apparel business is highly seasonal in nature, and the balancesheet amounts as of March 31, 2006, may be more meaningful whencompared with the balance sheet amounts as of March 31, 2005, rather thanwith the balance sheet amounts at June 30, 2005.

 

Our primary sources of liquidity are comprised of available cash andcash equivalents, cash flows from operations and a working capital line ofcredit with a commercial bank. We require cash for general working capitalpurposes. We do not anticipate the requirements of material amounts of cash forcapital expenditures over the remainder of the current fiscal year. Our workingcapital requirements are highly seasonal in nature, with greater requirementsfrom approximately August through October and February through April ofeach fiscal year, due to the purchases of finished goods inventories for thespring/summer and fall/holiday selling seasons, respectively.

 

Our net accounts receivable decreased by $1,476,000 to $3,019,000 at March 31,2006, from $4,495,000 at June 30, 2005. When compared with the March 31,2005, balance, the net accounts receivable balance at March 31, 2006,increased by $35,000, or 1%, while net sales for the comparable periodsincreased by 5%, from $4,455,000 for the three months ended March 31,2005, to $4,656,000 for the three months ended March 31, 2006. Changes inour accounts receivable balances and related allowances provided operating cashof $1,476,000 and $2,962,000 for the nine-month periods ended March 31,2006 and 2005, respectively.

 

Our inventories increased from $4,153,000 at June 30, 2005, to$7,156,000 at March 31, 2006. However, our inventory requirements arehighly cyclical in nature, and, when compared with the balance of $6,143,000 atMarch 31, 2005, our inventories at March 31, 2006, increased by$1,113,000, or 18%. Our finished goods inventories generally increase duringour fiscal quarter ended March 31 when compared with the June 30balance in the previous fiscal year. Wegenerally receive a substantial amount of inventory at or near the end of our March 31fiscal quarter in order to fulfill orders for fall merchandise which we beginshipping in early May of each year. The 2006 consolidation of financialstatement amounts for Sport-Haley and Reserve Apparel as well as differencesbetween the periods with respect to amounts and timing of pending oceandeliveries of finished goods also factored into the respective differences. At March 31,2006 Reserve Apparel had recorded inventory deposits of $518,000. Pending oceandeliveries of finished goods approximated $1,086,000, $459,000 and $824,000 at March 31,2006, June 30, 2005, and March 31, 2005, respectively. Changes in ourinventory balances used operating cash of $3,288,000 and provided operatingcash of $2,765,000 for the nine-month periods ended March 31, 2006 and2005, respectively.

 

Our continued reliance on foreign suppliers sustains the risk that ourrevenues could be adversely affected if a foreign shipment or shipments werereceived late or lost. We maintain insurance for risk of loss relating to goodsshipped from our foreign and domestic suppliers. However, our predominantreliance upon foreign suppliers, and significant reliance on six separateforeign suppliers, also sustains the risk that we would be left with inadequateor unsatisfactory recourse should the goods received from a foreign supplier benonconforming.

 

Accounts payable and accrued expenses increased by $623,000, or 36%, to$2,374,000 at March 31, 2006, from $1,751,000 at June 30, 2005.Accounts payable and accrued expenses increased by $470,000, or 25%, from$1,904,000 at March 31, 2005. The increase of $470,000 when comparing thebalance at March 31, 2006, with the balance at March 31, 2005,primarily related to accrued expenses with regard to

 

18

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Reserve Apparel in the March 31, 2006, period combined with adecrease in accrued payroll expenses between the comparative periods. At March 31,2006, Reserve Apparel had an accounts payable balance of $270,000. Included inaccrued payroll expenses at March 31, 2006, was the balance of $326,000 inseverance and other compensation payable to our former chief executive officer.Comparatively, at March 31, 2005, accrued payroll expenses included thebalance of $490,000 in severance and other compensation payable to our formerchief executive officer.

 

Due to the combination of the factors discussed above and others, ouroperating activities used cash of $1,212,000 during the nine months ended March 31,2006. Comparatively, during the nine months ended March 31, 2005, ouroperating activities provided cash of $2,033,000.

 

For the nine months ended March 31, 2006,investing activities used cash of $11,000. Comparatively, for the nine monthsended March 31, 2005, investing activities provided cash of $433,000. Ourcash flows from investing activities are primarily derived from purchases andredemptions of held-to-maturity investments. Historically, our held-to-maturityinvestments have consisted of short-term federal agency securities. During thenine months ended March 31, 2005, redemptions of held-to-maturityinvestments provided cash of $539,000. We have not maintained material amountsin held-to-maturity investments since September 2004. During the ninemonths ended March 31, 2006, we received $16,000 in proceeds from sales offixed assets, expended $27,000 for the purchase of property and equipment, and$247,000 in depreciation and amortization was charged to current operations.

 

We maintain a revolving line of credit agreement with a commercialbank. The revolving line of credit agreement, renewed by amendment through December 5,2006, provides for a maximum loan amount of $5,000,000, collateralized by alien on substantially all of our assets, and for interest at the bank’s primerate. In accordance with the amended agreement, we must maintain tangible networth of $14,000,000 and liquidity of $4,000,000. We generally maintain theline of credit to facilitate the issuance of letters of credit for inventorypurchases from offshore suppliers and, if necessary, to fund any temporaryworking capital needs. Outstanding letters of credit reduce the amountavailable for borrowing under the line of credit agreement. At March 31,2006, we had $445,000 in outstanding letters of credit that were issued toforeign suppliers in accordance with finished goods inventory purchasecommitments.

 

We believe that cash on hand and cash generated from operations, aswell as the ability to borrow under the bank line of credit, will be sufficientto meet our cash requirements during the remainder of fiscal 2006. We also havealternative sources of financing, including the factoring of customer accountsreceivable. We do not anticipate drawing on the line of credit or usingalternative sources of financing during the remainder of fiscal 2006. However,our capital needs will depend on many factors, including the Company’s growthrate, the need to finance required inventory levels, the success of currentsales and marketing programs, the cash requirements of the operations ofReserve Apparel and various other factors.

 

**RESULTS OF OPERATIONS**

 

Our business is seasonal in nature, and sales occurring from January throughJune, which comprise our third and fourth quarters of each fiscal year, aregenerally disproportionately higher than sales occurring from July throughDecember.

 

Net sales for the three months ended March 31, 2006, were$4,656,000, an increase of $201,000, or 5%, from net sales of $4,455,000 forthe comparable quarterly period in the prior fiscal year. Net sales for the

 

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nine months ended March 31, 2006, were $13,096,000, a decrease of$1,929,000, or 13%, from net sales of $15,025,000 for the comparable nine-monthperiod in the prior fiscal year. We attribute the differences in net sales tofactors such as the previously reported discontinuance of our HALEY RESERVE men’sfashion apparel and a significant decrease in SPORT HALEYTM women’s apparelbetween the respective periods combined with Reserve Apparel’s sales ofTop-FliteTM branded apparel. The decrease in net sales for the nine-month periodassociated with our discontinuance of the HALEY RESERVE men’s collectionstotaled $1,200,000, the approximate amount of HALEY RESERVE net sales recordedduring the nine months ended March 31, 2005. Net sales of our SPORT HALEYTMwomen’s collections decreased substantially between the comparable quarterlyand nine-month periods. Net sales of SPORT HALEYTM women’s apparel totaledapproximately $1,607,000 and $4,526,000, for the quarter and nine months ended March 31,2006, decreases of approximately $334,000, or 17%, and $2,764,000, or 35%, whencompared with the respective quarterly and nine-month periods in the priorfiscal year. The comparative quarterly decrease in net sales of SPORT HALEYTMwomen’s apparel reflects the fact that net sales for the quarterly period endedMarch 31, 2005, included $395,000 in sales of prior seasons women’sinventories to a major retailer, while no such sales were recorded during thequarterly period ended March 31, 2006. The shrinking market for women’sfashion golf apparel appears to have bottomed out, and we anticipate that oursales of women’s apparel will begin to increase slightly in future periods.SPORT HALEYTM continues to be a highly recognized brand within the women’s golfapparel market, and we are continuing to develop plans to improve the strategicposition of the SPORT HALEYTM brand within the women’s market.

 

Net sales of our Ben Hogan® men’s collections continued to increaseslightly between the comparative periods. Net sales of Ben Hogan® approximated$2,420,000 and $7,609,000 for the quarter and nine-months ended March 31,2006, increases of $104,000, or 4%, and $584,000, or 8%, from net sales of$2,316,000 and $7,025,000 for the quarter and nine months ended December 31,2005. We believe that the increase in Ben Hogan® sales is indicative of thehighly-respected reputation we have built for the Ben Hogan® apparel brandwithin golf apparel markets. Ben Hogan® apparel is marketed in accordance witha licensing agreement we maintain with Callaway Golf Company (“Callaway”) forsuch apparel. We consider the licensing agreement with Callaway to be a keycomponent of our business strategies. While we strive to maintain a goodworking relationship with Callaway, the trend for the last several periods,reflecting a continued increasing reliance on sales of licensed apparel,sustains a risk of loss, should the licensing agreement with Callaway beterminated by either party.

 

ReserveApparel began shipping Top-FliteTM branded men’s golf apparel to Wal-Mart Storesin March 2006. Net sales of Top-FliteTM apparel for the quarter ended March 31,2006, totaled $446,000. A licensing agreement between Callaway and Sport-Haleyallows Reserve Apparel to market golf apparel bearing the Top-FliteTM brand.

 

Grossprofit, as a percentage of net sales, was 37% for the quarter ended March 31,2006, and 37% for the same quarter in the prior fiscal year. Gross profit, as apercentage of net sales, was 36% for the nine-month period ended March 31,2006, and 26% for the same six-month period in the prior fiscal year. Our grossprofit is generally affected by sales discounts offered to customers on variousmarketing programs, payment discounts offered to certain customers,dispositions of excess inventories at reduced sales prices and the valuation ofexcess inventories to the lower of cost or market. The disposition of excessinventories negatively impacts our gross profit percentage even when suchinventories are properly valued to the lower of cost or market, because suchvaluation causes sales to be recorded with gross profit at or near zero. Forthe nine months ended March 31, 2006, we recorded net sales of $539,000and gross profit of $15,000 with respect to sales of excess inventories, whichwe believe is indicative of our

 

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successfulefforts to better estimate the recoverable value of our excess finished goodsinventories. The valuation of inventories to the lower of cost or marketnegatively impacts our gross profit percentage, because a reduction ofinventory value causes an increase in our cost of goods sold, thereby reducingour gross profit. Our gross profit was negatively impacted by $91,000 and$285,000 for the quarter and nine months ended March 31, 2006,respectively, by the adjustment of our finished goods inventories to the lowerof cost or market. Comparatively, our gross profit was negatively impacted by$0 and $1,238,000 for the quarter and nine months ended March 31, 2005, bysimilar lower of cost or market adjustments. We believe that the substantiallysmaller negative impact for the nine-month period ended March 31, 2006,when compared with the same nine month period in the prior fiscal year, isindicative of our successful efforts to minimize the amount of our finishedgoods inventories remaining on hand at the end of each selling season.

 

Gross profit, as a percentage of sales with respect to Top-FliteTMbranded apparel, was 4% for the quarter ended March 31, 2006. Gross profitrelating to Top-FliteTM sales during the quarter was negatively impacted byproduction delays and extraordinary shipping charges. Production delays with aforeign supplier caused us to incur inbound air freight charges of $70,000 andadditional shipping charges of $45,000 in order to deliver the merchandise toWal-Mart Stores, Inc., within their acceptable range of receipt dates forthe merchandise which was sold to them in March 2006. Achieving only a 4%gross margin on sales of Top-FliteTM branded apparel concerns us greatly. Toachieve higher margins in the future and to operate more efficiently, in April 2006,we began reorganizing the operations of Reserve Apparel to move substantiallyall of its operations to our Denver, Colorado facility by late July 2006.Initially, the product development, sourcing and logistics operations ofReserve Apparel were performed by employees of Explorer Headgear, Inc. inToronto, Ontario. We expect that sales of Top-FliteTM branded apparel shouldproduce gross margins of 25% or greater. However, because of continuedproduction and other delays relating to deliveries and shipments after March 31,2006, gross margins with respect to Top-FliteTM branded apparel may notimprove dramatically until after June 30, 2006.

 

Ourgross margins may not be comparable to other companies within the golfapparel industry. We have consistently included the cost of merchandise sold,including import charges, in-bound freight, allocated overhead, freight-out,embroidery costs and other charges in our cost of goods sold. Our overheadallocation includes a portion of our distribution costs, such as receiving,inspection and shipping costs, but we include some of the other costs ofdistribution, such as a portion of our warehousing and other handling costs, inselling, general and administrative expenses. Our gross margins also include,on a consolidated basis, the operations of Reserve Apparel, which distributesTop-FliteTM apparel to the mass retail market at much lower price points andgross margins than those expected to be achieved in the premium and mid-pricemarkets where we distribute our SPORT HALEYTM and Ben Hogan® apparel brands.Other companies within the golf apparel industry may or may notoperate within the lower price markets. We include royalty payments, relatingto sales of licensed apparel, in selling, general and administrative expenses.

 

Selling, general and administrative expenses decreased by $176,000, or8%, to $1,959,000 for the quarter ended March 31, 2006, from $2,134,000for the same quarter in the prior fiscal year. Selling, general andadministrative expenses decreased by $2,236,000, or 30%, to $5,121,000 for thenine-month period ended March 31, 2006, from $7,357,000 for the samesix-month period in the prior fiscal year. The comparative decreases inselling, general and administrative expenses are attributable to severalfactors. During the quarter ended December 31, 2004, we recorded $520,000in severance compensation relating to the departure of our former chiefexecutive officer, and during the six months ended December 31, 2004, werecorded $650,000 in severance and other compensation subsequent to the deathof our former

 

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Chairman. We did not record any severance compensation expense duringany of the periods in the nine-months ended March 31, 2006. Differences insales commission, payroll expenses and a general reduction in general andadministrative expenses also contributed to the respective decreases in overallselling, general and administrative expenses. Sales commissions were $361,000and $1,005,000 for the quarter and nine months ended March 31, 2006, andwere $362,000 and $1,353,000 for the quarter and nine months ended March 31,2005, respectively. After excluding the severance and other compensationexpenses from total payroll expenses recorded during the quarter and ninemonths ended March 31, 2005, payroll expenses decreased by $74,000 and$267,000 for the quarterly and nine-month periods ended March 31, 2006,respectively. Payroll expenses for the nine months ended March 31, 2006,included bonuses and related employer payroll taxes totaling $91,000 paid in October 2005to certain of the Company’s executives. No executive bonuses were recorded forthe comparative nine-month period in the previous fiscal year. Our selling,general and administrative expenses for the quarter and nine months ended March 31,2006, also include $138,000 from the operations of Reserve Apparel, including$20,000 in legal fees incurred by Sport-Haley relating to the formation ofReserve Apparel. The balance of the Reserve Apparel operating expenses for thethree-month period generally related to amounts allocated by Explorer Gear forpersonnel costs incurred in the business operations of Reserve Apparel duringthe quarterly period. The remainders of the comparative decreases are generallyattributable to overall comparative decreases in general and administrative expensesbetween the periods, which are indicative of cost reductions that have beenachieved as a result of implementing cost reduction initiatives in fiscal 2005.As a percentage of net sales, selling, general and administrative expenses were43% and 39% for the quarter and nine months ended March 31, 2006, and 48%and 49% for the quarter and nine months ended March 31, 2005,respectively.

 

We recorded Ben Hogan® royalty expense of$176,000 and $514,000, and $153,000 and $503,000, for the quarters and nine-monthperiods ended March 31, 2006 and 2005, respectively. We recordedTop-FliteTM royalty expense of $27,000 for the quarter and nine-months ended March 31,2006. Royalty expense is due to Callaway in accordance with the license theypreviously granted to us to market men’s apparel bearing the Ben Hogan® andTop-FliteTM labels.

 

Other income, net, was $237,000 for thequarter ended March 31, 2006, an increase of $162,000, or 216%, from$75,000 for the same quarter in the prior fiscal year. Other income, net, was$367,000 for the nine months ended March 31, 2006, an increase of$229,000, or 166%, from $138,000 for the same nine-month period in the priorfiscal year. Our other income, net, is generally comprised of interest earnedon cash and cash equivalent balances held at various financial institutions.The increases for the quarterly and nine-month periods are partiallyattributable to slightly higher rates of interest earned during the respectiveperiods ended March 31, 2006, than had been earned during the comparableperiods in the prior fiscal year. Other income for the quarter and nine-monthsended March 31, 2006, also includes $157,000 of the $173,000 recovered inthe settlement we reached with our former auditors. We offset related legalexpenses for the nine-month period with the remainder of the settlement in theamount of $16,000.

 

Loss before minority interest in loss andprovision for income taxes for the quarter ended March 31, 2006, was($188,000), a difference of $392,000, or 68%, as compared with ($580,000) forthe same period in the prior fiscal year. Loss before minority interest in lossand provision for income taxes for the nine months ended March 31, 2006,was ($616,000), a difference of $3,246,000, or 84%, as compared with($3,862,000) for the same period in the prior fiscal year. At March 31,2006, we had federal and state net operating loss carry forwards of $6,000,000and $8,700,000 that we estimated may be recoverable at income tax rates of34% and 5%, respectively. Because of our continued trend of net

 

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losses in fiscal 2006 and the most recentprior fiscal years, we determined that it was more probable than not that noneof our net deferred tax assets will be recovered, and we maintained ourvaluation allowance that effectively reduced our net deferred tax assets tozero. While we continue to search for ways to streamline our businessoperations and to initiate other improvements to return the Company toprofitability, such as the introduction of Top-FliteTM branded apparel, wecannot be certain that our efforts will result in the generation of futureprofits sufficient to offset our significant net operating loss carry forwardsprior to their expirations. Accordingly, during the nine-month periods ended March 31,2006 and 2005, we did not record a benefit from income taxes associated withthe corresponding losses for the respective nine-month periods.

 

Basic and diluted loss per common share were ($0.07) and ($0.23) forthe quarters and were ($0.23) and ($1.52) for the nine-month periods ended March 31,2006 and 2005, respectively. Due to the Company’s net losses, all outstandingstock options were anti-dilutive and therefore excluded from the loss per sharecalculations.

 

Our book value per outstanding common share was $5.60 at March 31,2006, $5.95 at June 30, 2005, and $5.95 at March 31, 2005.

 

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**SPORT-HALEY, INC.**

**ITEM 3 QUALITATIVE AND QUANTITATIVE DISCLOSURESABOUT MARKET RISK**

 

Market risk represents the risk of loss that may impact thefinancial position, results of operations or cash flows due to adverse changesin financial and commodity market prices and rates. We are exposed to marketrisk with regard to changes in United States interest rates. This exposure isdirectly related to our normal operating and funding activities. Historically,and as of March 31, 2006, we have not used derivative instruments orengaged in hedging activities. Our market risk has not changed significantlyfrom December 31, 2005.

 

**Interest Rate Risk**

 

We maintain a revolving line of credit agreement with a commercial bankthat provides for interest at the bank’s prime rate. The agreement provides fora maximum loan amount of $5,000,000 collateralized by a lien on substantiallyall of our assets. The bank also requires that we maintain tangible net worthof $14,000,000 and liquidity of $4,000,000. We generally maintain the line ofcredit to facilitate the issuance of letters of credit for inventory purchasesfrom offshore suppliers, and, if necessary, to fund any temporary workingcapital needs. At March 31, 2006, we did not have any outstandingborrowings under the line of credit. Increases in the bank’s prime rate could,however, increase the interest expense with respect to future borrowings,including borrowings under the line of credit. Outstanding letters of creditreduce the amount available for borrowing under the line of credit. We hadoutstanding letters of credit of $445,000 at March 31, 2006. We do not usederivative financial instruments to manage interest rate risk.

 

From time to time, we maintain short-term investments in low risk andno risk financial instruments, readily convertible into cash, which earninterest at variable rates. Periodically, our cash balances held at financialinstitutions exceed federally insured limits.

 

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**SPORT-HALEY, INC.**

**ITEM 4 CONTROLS ANDPROCEDURES**

 

**(a)****          Evaluation of DisclosureControls and Procedures**

 

Management of the Company, with theparticipation of the Interim Chief Executive Officer and the Chief FinancialOfficer, conducted an evaluation of the effectiveness of the Company’sdisclosure controls and procedures pursuant to Rule 13a-15 under theSecurities Exchange Act of 1934 as of the end of the period covered by thisreport. Based on that evaluation, management, including the Interim ChiefExecutive Officer and Chief Financial Officer, concluded that, as of the end ofthe period covered by this report, the Company’s disclosure controls andprocedures were effective in reaching a reasonable level of assurance that: (a) allmaterial information relating to the Company, required to be disclosed in thisreport, has been made known to management in a timely manner; and, (b) informationwas recorded, processed, summarized and reported within the time periodsspecified in the Securities and Exchange Commission’s rules andregulations.

 

As discussed in *“CriticalAccounting Policies and Estimates - Inventories,”* after we implemented our operations softwarein January 2004, we discovered certain programming and human errors withinthe new system that adversely affected the software’s ability to accuratelycompute the valuation of our finished goods inventories using a weightedaverage method. In prior periods we considered the programming and humanerrors, which caused us to use a standard cost method in the prior periods, tobe a material weakness in our internal controls over financial reporting withrespect to inventory valuation. This weakness in our controls prevented us fromrelying upon the system-recorded transactions with respect to inventoryvaluations during fiscal 2005. During the 2005 fiscal year, we concluded with reasonableassurance that recomputing the value of our finished goods inventories using astandard cost method yielded a fair estimation of the value of our finishedgoods inventories. We used the standard cost method to value our finished goodsinventories from the fiscal quarter ended March 31, 2004, through thefiscal quarter ended March 31, 2005. Had we been able to rely upon thesystem to properly compute the cost of our finished goods inventories using theweighted average method, we believe that the weighted average method would nothave yielded a materially different computation of the value than the standardcost method that we applied. For periods subsequent to March 31, 2005, wedetermined that differences between the system-calculated values (average cost)of our finished goods inventories versus the values of our finished goodsinventories using a standard cost method were immaterial. A relatively small percentage our inventoryitems remained on hand at March 31, 2006, that had been valued in priorperiods using the standard cost method.

 

During the quarter ended December 31, 2005, werevised employee guidelines and procedures for recording inventory-relatedtransactions within our software system, and shortly after December 31,2005, we prepared a detailed analysis of the weighted average cost calculationsrecorded within our software for several of our finished goods inventory items.Our guidelines and procedures are designed to ensure that only qualifiedpersonnel may record inventory-related transactions During the quarterended December 31, 2005, those persons received additional training in howto properly record finished goods transactions within the system. Our detailedanalysis concluded with reasonable assurance that the software system has beenproperly configured within a level of accuracy that provides us with reasonableassurance to now rely upon the system to properly compute the weighted averageunit costs of our finished goods inventories. Therefore, we now believe, withreasonable assurance, that the programming errors related to our operationssoftware no longer cause a material weakness in our internal controls overfinancial reporting with respect to inventory valuation. However,

 

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human errors have continued to cause a materialweakness in our internal controls over financial reporting with respect toinventory valuation. Our detailed analysis revealed that certain variances inthe unit costs of our finished goods inventories have occurred, becauseprocedures were not properly followed in all instances. Ongoing training andmanagement supervision are inherent requirements within any software system,and all errors cannot be prevented in all instances. In order to achievereasonable assurance that human errors no longer cause a material weakness, wewill continue to educate and supervise our personnel responsible for recordinginventory-related transactions, and we will also refine our periodic testingmodel used to determine the accuracy of inventory-related transactions whichhave been recorded within the system.

 

The materialweakness in our internal controls over financial reporting with respect toinventory valuation also impaired our ability to rely upon information createdby our computer system to fairly present, in all material respects, ourfinancial condition, results of operations and cash flows in the periodscovered by this report. The inability of our computer system to properlycalculate the valuation of our finished goods inventories using a weightedaverage cost assumption also affected the system-recorded amounts within ourcost of goods sold in certain periods covered by this report. Because (1) weconcluded with reasonable assurance that our using a standard cost assumptionyielded a fair estimation of our finished goods inventories from the fiscalquarter ended March 31, 2004, through the fiscal quarter ended March 31,2005, (2) we determined that differences between the system-calculatedvalues (average cost) of our finished goods inventories versus the values ofour finished goods inventories using a standard cost method subsequent to March 31,2005, were immaterial and (3) we consistently recorded adjustments toinventories as components of cost of goods sold, we believe with reasonableassurance that our cost of goods sold are fairly stated for the periods coveredby this report. Therefore, we believe that the procedures we applied to valueour finished goods inventories for the periods covered by this report provideus with reasonable assurance that our condensed consolidated financialstatements and the notes thereto fairly state, in all material respects, ourfinancial condition, the results of our operations and our cash flows.

 

**(b)****          Changes in InternalControls**

 

During the thirdquarter of fiscal 2006, we did not institute any changes in internal controlsover financial reporting that materially affected, or are reasonably likely tomaterially affect, the Company’s internal controls over financial reporting.

 

Our management, including the Interim Chief ExecutiveOfficer and the Chief Financial Officer, does not expect that our disclosurecontrols and procedures or our internal controls over financial reporting will,in all instances, prevent all errors and all fraud. A control system, no matterhow well conceived or operated, can only provide reasonable, not absolute,assurance that the objectives of the control system are met. While our controlsystems provide a reasonable assurance level, the design of its control systemsreflects the fact that there are resource constraints, and the benefits of suchcontrols were considered relative to their costs. Because of the inherentlimitations in all control systems, no evaluation of controls can provideabsolute assurance that all control issues and instances of fraud, if any,within the financial reports of Sport-Haley, Inc. have been detected.These inherent limitations include the realities that judgments indecision-making can be faulty, and that breakdowns can occur because of

 

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simple errors or mistakes. Additionally, a control may becircumvented by the individual act of some person, by collusion of two or morepersons, or by management’s override of a specific control. The design of anysystem of controls is also based in part on certain assumptions about thelikelihood of future events, and there can be no assurance that any design willsucceed in achieving its stated goals under all potential future conditions. Becauseof the inherent limitations in a cost-effective control system, misstatementsdue to error or fraud may occur and not be detected.

 

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**SPORT-HALEY, INC.**

**PART IIOTHER INFORMATION**

 
| **ITEM 1** | ** ** | **LEGAL PROCEEDINGS** |
|------------|------------|-----------------------|

### ** **

On February 13, 2006, we entered into asettlement agreement to resolve all pending claims between Sport-Haley, Inc.,our former auditors and certain of our former auditors’ current and formermembers. Pursuant to the terms of the settlement agreement and a sharingagreement between Sport-Haley, Inc. and one of our director and officerliability insurance carriers, in February 2006, we received a net paymentof $173,000 from the total settlement with the former auditors, of which$157,000 was included in other income and $16,000 was offset against relatedlegal expenses for the nine-month period ended March 31, 2006.

 

In March 2001, as we previouslyannounced, we retained legal counsel to possibly pursue claims against ourformer auditors in connection with damages we claimed were suffered as a resultof the restatements of our financial statements for fiscal years 1999 and 1998and the corrections of material information for the quarterly periods of fiscalyears 2000, 1999 and 1998. Also, we were previously advised that the formerauditors asserted certain claims against us, including allegations of unpaidfees. Neither Sport-Haley, Inc. nor the former auditors filed any legalaction to assert any of these disputed claims.

 

During a mediation session in November 2005,we reached an agreement in principle with the former auditors to settle alldisputed claims between the parties and their affiliates. The parties executeda written settlement agreement, which provided for payment to Sport-Haley, Inc.of $525,000. In accordance with a sharing agreement between Sport-Haley, Inc.and one of its carriers for director and officer liability insurance, wereceived $173,000 of these settlement proceeds, or 33%, and the insurancecarrier received the remainder to partially recover amounts the carrier paid inconnection with a previously settled class action securities lawsuit anddefense costs the carrier reimbursed to us relating to the civil action lawsuitfiled by the SEC.

 

Among other terms of the settlement agreement,the parties have agreed to mutual releases of all claims asserted against eachother and each party has continued to deny the merits of those claims assertedagainst it by the other party.

 

We are subject to various other legalproceedings or claims which arise in the ordinary course of our business. Basedupon information that is currently available, management does not believe thatthe total impact of other legal proceedings or claims will materially affectour financial position or the results of our operations.

 
| **ITEM 5** | ** ** | **OTHER INFORMATION** |
|------------|------------|-----------------------|

### ** **

On May 8, 2006, we announced theappointment of Jan Beemer to the newly created position of Customer RelationsLiaison for our SPORT HALEYTM and Ben Hogan® apparel lines.

 

On April 28, 2006, we announced that weprovided notice to Caymus Partners LLC (“Caymus”) of our intent to terminateCaymus’ engagement as the Company’s investment banking firm, which had beenassisting the Company since December 2004 in exploring strategicalternatives to maximize shareholder value. Since the expiration of theoriginal agreement with Caymus in July 2005, the parties had continued theengagement on a month to month basis. The termination of the engagement waseffective on May 14, 2006.

 

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On April 26, 2006, we announced theissuance of a cash dividend $0.25 per share, payable to our common shareholdersof record as of May 5, 2006. The dividend was distributed to shareholdersby May 19, 2006.

 

On February 20, 2006, we announced thatour Audit Committee, along with senior management, determined that the Company’sstatements of operations and cash flows for the quarterly period ended September 30,2005, contained an error which, when corrected, would result in a materialimpact on results of our operation for the quarter ended September 30,2005. The Audit Committee and senior management determined that the statementsof operations and cash flows for the quarter ended September 30, 2005,required restatement. The error related to the Company’s accounting for bonusespaid to certain executive officers and a key employee of the Company in October 2005.On February 28, 2006, we filed an amended interim report on Form 10-Qfor the quarterly period ended September 30, 2005, to correct this error.

 

On February 14, 2006, we announced thaton February 13, 2005, we entered into a settlement agreement to resolveall pending claims between Sport-Haley, Inc., our former auditors andcertain of our former auditors’ current and former members. Pursuant to theterms of the settlement agreement and a sharing agreement between Sport-Haley, Inc.and one of our director and officer liability insurance carriers, in February 2006,we received a net payment of $173,000 from the total settlement with the formerauditors.

 

In February 2006, effective February 7,2006, we entered into an employment agreement with Michael D. Doris to serve asour Western Regional Sales Manager. The agreement provides for a term of oneyear, subject to automatic one-year extensions unless otherwise terminated, atan annual salary of $110,000, plus an override commission of 0.2% on theCompany’s gross annualized sales (excluding discounted sales of more than 50%from original suggested wholesale prices), returns and credits.

 

On February 3, 2006, we announced that wereceived a letter from the Nasdaq Stock Market, Inc. (“Nasdaq”), uponwhich our common stock trades, advising that, after filing our application forregistration of our common stock on Form 10 and the registration becomingeffective on January 24, 2006, we have regained compliance with theregistration requirement for continuing listing on the Nasdaq National Market,as stated in NASD Marketplace Rule 4440(a). We were further advised that,subject to making a public disclosure concerning the receipt of the letter,Nasdaq considered this matter to be closed.

 

On January 25, 2006, we announced that theSecurities and Exchange Commission declared our recently filed application forregistration of our common stock on Form 10, pursuant to §12(g) ofthe Securities Exchange Act of 1934, effective as of January 24, 2006.

 

On January 17, 2006, we announced that theUnited States District Court for the District of Colorado entered a FinalJudgment, pursuant to a settlement reached with the Securities and ExchangeCommission (the “SEC”), to resolve the pending claims in the civil actionbrought by the SEC against Sport-Haley, Inc. and our former Controller.The settlement did not call for the Company to pay any fine, civil penalty ordisgorgement.

 

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On January 4, 2006, we announced that theCompany had notified the Nasdaq Stock Market, Inc., upon which the Company’scommon stock is listed on the National Market, that the Company had recentlybecome aware that our common shares were not properly registered under §12(g) ofthe Securities Exchange Act of 1934 (the “Exchange Act”), as amended.Therefore, we were not in compliance with NASD Marketplace Rule 4440(a),which requires an issue of securities to be registered under §12(g) of theExchange Act in order to be listed on the Nasdaq National Market. We alsoannounced that, in order to register our common stock pursuant to §12(g) ofthe Exchange Act, we would be filing a registration statement on Form 10.

 
| **ITEM 6** | ** ** | **EXHIBITS** |
|------------|------------|--------------|

### ** **

Exhibit 10.1 – Executive EmploymentAgreement of Michael D. Doris, effective February 7, 2006

 

Exhibit 31.1 – Certification of DonaldW. Jewell pursuant to Exchange Act Rule 13a-14(a)

 

Exhibit 31.2 – Certification of PatrickW. Hurley pursuant to Exchange Act Rule 13a-14(a)

 

Exhibit 32.1 – Certifications of DonaldW. Jewell and Patrick W. Hurley pursuant to 18 U.S.C. §1350, as adoptedpursuant to Section 906 of the Sarbanes-Oxley Act of 2002

 

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**SPORT-HALEY, INC.**

**SIGNATURES**

 

In accordance with the requirements of the Securities Exchange Act of1934, the Registrant caused this report to be signed on its behalf by theundersigned thereunto duly authorized.

 

 
|   | **SPORT-HALEY, INC.**                      |
|--------|-------------------------------------------------|
|   | (Registrant)                                    |
|   |                                            |
|   |                                            |
| Date:  | May 22, 2006                               |   | /s/ PATRICK W. HURLEY |   |
|   | Patrick W. Hurley                               |
|   | Chief Financial Officer                         |
|   | *(Principal Financial and Accounting  Officer)* |
|        |                                                 |  |  |  |

 

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