** **

**SECURITIES AND EXCHANGECOMMISSION**

 

**WASHINGTON, D.C.  20549**

 

**FORM 10-Q**

 

**ý****  QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d)OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For the quarterly period ended September 30,2005**

 

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

 

**Commission File No. 33-74876-D**

 

**SPORT-HALEY, INC.**

(Exact name of small business issuer as specified in its charter)

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

 

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

(Address of principal executive offices)

 

**(303) 320-8800**

(Issuer’s telephone number including area code)

 

Indicate by check mark whether the registrant (1) filedall reports required to be filed by Section 13 or 15(d) of theSecurities 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 anaccelerated filer (as defined in Rule 12b-2 of the Exchange Act.  Yes  o   No  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 in each ofthe issuer’s classes of common stock, as of the latest practicable date.

 
| **Class**                      | ** ** | **Outstanding at November 14,  2005** |
|--------------------------------|------------|--------------------------------------------|
| **Common Stock, no par value** |       | **2,770,252**                              |

 

 

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**TABLE OF CONTENTS**

 
| **PART 1  –FINANCIAL INFORMATION (UNAUDITED)** |                                                                                        |
|----------------------------------------------------------|---------------------------------------------------------------------------------------------|
|                                                     |                                                                                        |   |
| ITEM 1                                                   | CONDENSED  FINANCIAL STATEMENTS                                                             |   |
|                                                     |                                                                                        |   |
|                                                     | CONDENSED  BALANCE SHEETS                                                                   |   |
|                                                     |                                                                                        |   |
|                                                     | CONDENSED  STATEMENTS OF OPERATIONS                                                         |   |
|                                                     |                                                                                        |   |
|                                                     | CONDENSED  STATEMENTS OF CASH FLOWS                                                         |   |
|                                                     |                                                                                        |   |
|                                                     | NOTES  TO CONDENSED 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**                                             |                                                                                        |

 

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**SPORT-HALEY, INC.**

**CONDENSEDBALANCE SHEETS**

 
| ** **                                                                                                                      | ** ** | **September 30,** | ** ** | **June 30,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-------------------|------------|
| ** **                                                                                                                      | ** ** | **2005**               | ** ** | **2005**          | ** ** |
| ** **                                                                                                                      | ** ** | **(Unaudited)**        | ** ** | **(***)**         | ** ** |
| **ASSETS**                                                                                                                      | ** ** | ** **             | ** ** | ** **        | ** ** |
| Current assets:                                                                                                                 |       |                   |       |              |       |
| Cash and cash equivalents                                                                                                       |       | $                      | 8,406,000  |              | $          | 7,721,000 |   |
| Accounts receivable, net of  allowances of $545,000 and $691,000, respectively                                                  |       | 2,807,000              |       | 4,495,000         |       |
| Inventories                                                                                                                     |       | 4,768,000              |       | 4,153,000         |       |
| Prepaid expenses and other                                                                                                      |       | 281,000                |       | 196,000           |       |
|                                                                                                                            |       |                   |       |              |       |
| Total current assets                                                                                                            |       | 16,262,000             |       | 16,565,000        |       |
|                                                                                                                            |       |                   |       |              |       |
| Property and equipment, net                                                                                                     |       | 843,000                |       | 922,000           |       |
| Other assets                                                                                                                    |       | 3,000                  |       | 3,000             |       |
|                                                                                                                            |       |                   |       |              |       |
|                                                                                                                            |       | $                      | 17,108,000 |              | $          | 17,490,000 |   |
|                                                                                                                            |       |                   |       |              |       |
| **LIABILITIES AND SHAREHOLDERS’ EQUITY**                                                                                   | ** ** | ** **             | ** ** | ** **        | ** ** |
|                                                                                                                            |       |                   |       |              |       |
| Current liabilities:                                                                                                            |       |                   |       |              |       |
| Accounts payable                                                                                                                |       | $                      | 539,000    |              | $          | 582,000 |   |
| Accrued royalties payable                                                                                                       |       | 161,000                |       | 294,000           |       |
| Accrued commissions payable                                                                                                     |       | 149,000                |       | 249,000           |       |
| Accrued payroll                                                                                                                 |       | 466,000                |       | 533,000           |       |
| Other                                                                                                                           |       | 96,000                 |       | 93,000            |       |
|                                                                                                                            |       |                   |       |              |       |
| Total current liabilities                                                                                                       |       | 1,411,000              |       | 1,751,000         |       |
|                                                                                                                            |       |                   |       |              |       |
| Commitments and  Contingencies (Notes 3 and 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 2,645,585 shares issued and  outstanding, respectively |       | 10,813,000             |       | 10,460,000        |       |
| Additional paid-in capital                                                                                                      |       | 1,621,000              |       | 1,590,000         |       |
| Retained earnings                                                                                                               |       | 3,263,000              |       | 3,689,000         |       |
| Total shareholders’ equity                                                                                                 |       | 15,697,000             |       | 15,739,000        |       |
|                                                                                                                            |       |                   |       |              |       |
|                                                                                                                            |       | $                      | 17,108,000 |              | $          | 17,490,000 |   |

 

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***  Taken from the audited balance sheet at thatdate

 

See accompanying notes to condensed financial statements.

 

3

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**SPORT-HALEY, INC.**

**CONDENSED STATEMENTS OFOPERATIONS**

 
| ** **                                             | ** ** | **Three Months Ended  September 30,** | ** ** |
|--------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                             | ** ** | **2005**                                   | ** ** | **2004** | ** ** |
| ** **                                             | ** ** | **(Unaudited)**                            | ** ** | **(Unaudited)** | ** ** |
|                                                   |       |                                       |       |   |   |
| Net sales                                              |       | $                                          | 4,011,000  |   | $ | 5,570,000 |   |
|                                                   |       |                                       |       |   |   |
| Cost of goods sold                                     |       | 2,641,000                                  |       | 3,257,000 |   |
| Impairments                                            |       | 65,000                                     |       | 543,000 |   |
| Total cost of goods sold                               |       | 2,706,000                                  |       | 3,800,000 |   |
|                                                   |       |                                       |       |   |   |
| Gross profit                                           |       | 1,305,000                                  |       | 1,770,000 |   |
|                                                   |       |                                       |       |   |   |
| Other Operating Costs:                                 |       |                                       |       |   |   |
| Selling, general and administrative expenses           |       | 1,633,000                                  |       | 2,859,000 |   |
| Royalty expense                                        |       | 163,000                                    |       | 198,000 |   |
| Total other operating costs                            |       | 1,796,000                                  |       | 3,057,000 |   |
|                                                   |       |                                       |       |   |   |
| Loss from operations                                   |       | (491,000                                   | )          | (1,287,000 | ) |
|                                                   |       |                                       |       |   |   |
| Other income, net                                      |       | 64,000                                     |       | 11,000 |   |
|                                                   |       |                                       |       |   |   |
| Loss before benefit from income taxes                  |       | (427,000                                   | )          | (1,276,000 | ) |
|                                                   |       |                                       |       |   |   |
| Benefit from income taxes                              |       | 1,000                                      |       | — |   |
|                                                   |       |                                       |       |   |   |
| Net loss                                               |       | $                                          | (426,000   | ) | $ | (1,276,000 | ) |
|                                                   |       |                                       |       |   |   |
| Basic and diluted loss per common share                |       | $                                          | (0.16      | ) | $ | (0.52 | ) |
|                                                   |       |                                       |       |   |   |
| Basic and diluted weighted average shares  outstanding |       | 2,685,000                                  |       | 2,456,000 |   |

 

See accompanying notes to condensed financial statements.

 

4

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**SPORT-HALEY, INC.**

**CONDENSED STATEMENTS OF CASHFLOWS**

 
| ** **                                                                       | ** ** | **Three Months Ended** | ** ** |
|----------------------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                                       | ** ** | **September 30,** | ** ** |
| ** **                                                                       | ** ** | **2005**               | ** ** | **2004** | ** ** |
| ** **                                                                       | ** ** | **(Unaudited)**        | ** ** | **(Unaudited)** | ** ** |
| **Cash flows from operating activities:**                                        | ** ** | ** **             | ** ** | ** ** | ** ** |
| Net loss                                                                         |       | $                      | (426,000   | ) | $ | (1,276,000 | ) |
| Adjustments to reconcile net loss to net cash  provided by operating activities: |       |                   |       |   |   |
| Depreciation and amortization                                                    |       | 84,000                 |       | 86,000 |   |
| Impairments and write-downs                                                      |       | 65,000                 |       | 543,000 |   |
| Allowance for doubtful accounts                                                  |       | 15,000                 |       | 60,000 |   |
| Common stock options                                                             |       | 31,000                 |       | 16,000 |   |
| Gain/Loss on disposal of assets                                                  |       | —                 |       | 3,000 |   |
| Cash provided (used) due to changes in assets and  liabilities:                  |       |                   |       |   |   |
| Accounts receivable                                                              |       | 1,673,000              |       | 1,643,000 |   |
| Inventory                                                                        |       | (680,000               | )          | (562,000 | ) |
| Other assets                                                                     |       | (85,000                | )          | 36,000 |   |
| Accounts payable                                                                 |       | (43,000                | )          | (397,000 | ) |
| Accrued commissions and other expenses                                           |       | (297,000               | )          | 37,000 |   |
| Net cash provided by operating activities                                        |       | 337,000                |       | 189,000 |   |
|                                                                             |       |                   |       |   |   |
| **Cash flows from investing activities:**                                        | ** ** | ** **             | ** ** | ** ** | ** ** |
| Redemptions of held to maturity investments                                      |       | —                 |       | 538,000 |   |
| Purchase of fixed assets                                                         |       | (5,000                 | )          | (19,000 | ) |
| Net cash provided (used) by investing activities                                 |       | (5,000                 | )          | 519,000 |   |
|                                                                             |       |                   |       |   |   |
| **Cash flows from financing activities:**                                        | ** ** | ** **             | ** ** | ** ** | ** ** |
| Issuance of common stock                                                         |       | 353,000                |       | 63,000 |   |
| Net cash provided by financing activities                                        |       | 353,000                |       | 63,000 |   |
|                                                                             |       |                   |       |   |   |
| **Net increase in cash and cash equivalents**                                    |       | 685,000                |       | 771,000 |   |
|                                                                             |       |                   |       |   |   |
| **Cash and cash equivalents, beginning**                                         |       | 7,721,000              |       | 3,890,000 |   |
|                                                                             |       |                   |       |   |   |
| **Cash and cash equivalents, ending**                                            |       | $                      | 8,406,000  |   | $ | 4,661,000 |   |
|                                                                             |       |                   |       |   |   |
| **Supplemental disclosure of cash flow  information:**                           |       |                   |       |   |   |
| Cash received during the period for:                                             |       |                   |       |   |   |
| Income taxes                                                                     |       | $                      | 1,000      |   | $ | — |   |
| Cash paid during the period for:                                                 |       |                   |       |   |   |
| Income taxes                                                                     |       | $                      | —     |   | $ | 7,000 |   |

 

See accompanying notes to condensed financial statements.

 

5

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**SPORT-HALEY, INC.**

**NOTES TO CONDENSED FINANCIALSTATEMENTS**

 

### **NOTE 1**                                                    SIGNIFICANT ACCOUNTING POLICIES:

 

*Condensed Financial Statements*- The accompanying condensed balance sheets and interim condensed statements ofoperations and cash flows include all adjustments (consisting only of normalrecurring items) necessary for their fair representation. 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. Ourrevenues are seasonal, and, therefore, interim results are not necessarilyindicative of results to be expected for the full year.

 

Certaininformation in footnote disclosures normally included in financial statementshas been condensed or omitted in accordance with the rules and regulationsof the Securities and Exchange Commission. The information included in this Form 10-Qshould be read in conjunction with financial statements and notes thereto andManagement’s Discussion and Analysis of Financial Condition and Results ofOperations for the year ended June 30, 2005, included in the Company’sfiling on Form 10-K.

 

*Stock-BasedCompensation* - Our Stock Option Plan (the “Plan”) expired by itsterms on February 28, 2003. Option agreements that were issued inaccordance with the Plan prior to February 28, 2003, generally remain inforce until the earlier of their exercise, the expiration of certain timeperiods after the termination of a grantee’s employment (or other relationshipwith the Company) or expiration by their terms.

 

AtSeptember 30, 2005, there were outstanding options to purchase 688,500shares of our common stock at exercise prices ranging from $2.71 to $9.78 pershare and expiration dates between November 2005 and January 2013. Inthe quarter ended September 30, 2005, 125,000 options were exercised and25,000 options expired. We received proceeds of $353,000 with respect tooptions exercised during the quarter ended September 30, 2005.

 

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 

 

6

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prospective method and also permits restatement ofprior periods based on amounts previously reported in pro forma disclosurespursuant to SFAS 123 for either all periods presented or for only prior interimperiods of the year of adoption. We adopted the modified prospective methodprescribed in SFAS 123R, effective July 1, 2005.

 

Previously, we accountedfor stock-based compensation using the intrinsic value method prescribed inAccounting Principles Board Opinion No. 25, “*Accounting for Stock Issued to Employees*,” and relatedinterpretations and elected to apply the disclosure-only provisions ofStatement of Financial Accounting Standards (SFAS) No. 123, “*Accounting for Stock-Based Compensation*,”as amended by SFAS No. 148, “*Accountingfor Stock-Based Compensation – Transition and Disclosure*.” Under theintrinsic value method, compensation expense for stock options was recognizedover the vesting period of the grant based on the excess, if any, of the marketprice of our common stock at the date of grant over the stock option exerciseprice. As governed by the Plan, stock options were generally granted at or nearfair market value on the date of grant.

 

If we had previously accountedfor stock-based compensation in interim periods using the fair value methodrather than the intrinsic value method, the pro forma amounts of our net lossand loss per common share would have been reported as follows:

 
| ** **                                                                           | ** ** | **Three Months Ended September 30,** | ** ** |
|--------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                           | ** ** | **2005**                                  | ** ** | **2004** | ** ** |
|                                                                                 |       |                                      |       |   |   |
| Net income (loss) - as reported                                                      |       | $                                         | (426,000   | ) | $ | (1,276,000 | ) |
| Effect of employee stock-based compensation included  in reported net loss           |       | 31,000                                    |       | 16,000 |   |
| Effect of employee stock-based compensation per SFAS 123                        |       | (31,000                                   | )          | (106,000 | ) |
| Net income (loss) applicable to common stock  (pro forma 2004)             |       | $                                         | (426,000   | ) | $ | (1,366,000 | ) |
|                                                                                 |       |                                      |       |   |   |
| Basic and Diluted:                                                                   |       |                                      |       |   |   |
| Income (loss per share) - as reported                                                |       | $                                         | (0.16      | ) | $ | (0.52 | ) |
| Per share effect of employee stock-based  compensation included in reported net loss |       | 0.01                                      |       | 0.00 |   |
| Per share effect of employee stock-based compensation  per SFAS 123                  |       | (0.01                                     | )          | (0.04 | ) |
| Income (loss) per share applicable to common stock  (pro forma 2004)                 |       | $                                         | (0.16      | ) | $ | (0.56 | ) |

 

In December 2004, the Financial AccountingStandards Board issued Statement of Financial Accounting Standards No. 153(“SFAS 153”), *“Exchanges of Nonmonetary Assets,”*which changes the guidance in Accounting Principles Board Opinion No. 29 (“APB29”), *“Accounting for Nonmonetary Transactions.”*  SFAS 153 amends APB 29 to 

 

7

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eliminate the exception for nonmonetary exchanges ofsimilar productive assets and replaces it with a general exception forexchanges on nonmonetary assets that do not have commercial substance. Anonmonetary exchange has commercial substance if the future cash flows of theentity are expected to change significantly as a result of the exchange. SFAS153 is effective during fiscal years beginning after June 15, 2005. We donot believe the adoption of SFAS 153 will have a material impact on the resultsof our operations and financial condition.

 

*Segments* – We have one operating segment: designing,purchasing, contracting for the manufacture of and marketing and distributing men’sand women’s fashion golf apparel and outerwear. The information for thissegment is the information used by our chief decision maker to evaluateoperating performance.

 

### **NOTE 2**                                                 INVENTORIES:

 
| ** **                               | ** ** | **September 30,** | ** ** | **June 30,** | ** ** |
|------------------------------------------|------------|------------------------|------------|-------------------|------------|
| ** **                               | ** ** | **2005**               | ** ** | **2005**          | ** ** |
| Inventories consisted of  the following: |       |                   |       |              |       |
| Component                                |       | $                      | 85,000     |              | $          | 387,000 |   |
| Finished goods                           |       | 4,683,000              |       | 3,766,000         |       |
|                                     |       |                   |       |              |       |
|                                     |       | $                      | 4,768,000  |              | $          | 4,153,000 |   |

 

### **NOTE 3**                                                 LINE OF CREDIT AGREEMENT:

 

Wemaintain a revolving line of credit agreement with a commercial bank. Therevolving line of credit agreement, renewed by amendment through December 5,2005, provides for a maximum loan amount of $5,000,000, collateralized by alien on substantially all of the our assets, and for interest at the bank’sprime rate. In accordance with the amendment agreement, we must maintainminimum tangible net worth of $14,000,000. 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. We did not have any balances due on the line of credit at September 30,2005, or June 30, 2005, respectively.

 

### **NOTE 4**                                                 COMMITMENTS AND CONTINGENCIES:

 

At September 30, 2005, we had $818,000 inoutstanding letters of credit that were issued to foreign suppliers inaccordance with finished goods inventory purchase commitments. Outstandingletters of credit reduce the amount available for borrowing under the line ofcredit agreement.

 

### **NOTE 5**                                                 EARNINGS PER SHARE:

 

Effective with the year ended June 30,1998, we adopted the provisions of Statement of Financial Accounting Standards No. 128(SFAS No. 128), *Earnings per Share*.SFAS No. 128 requires the presentation of basic and diluted earnings(loss) per common share. The 

 

8

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followingtable provides a reconciliation of the numerator and denominator of basic anddiluted earnings (loss) per common share:

 
| ** **                                    | ** ** | **Three Months ended September 30,  2005** | ** ** |
|-----------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                    | ** ** | **Net**                                         | ** ** | **Weighted** | ** ** | ** ** | ** ** |
| ** **                                    | ** ** | **Loss**                                        | ** ** | **Average Shares** | ** ** | **Per Share** | ** ** |
| Loss Per Common Share                         |       |                                            |       |   |   |   |   |
|                                          |       |                                            |       |   |   |   |   |
| Basic loss per share                          |       | $                                               | (426,000   | ) | 2,685,000 |   | $ | (0.16 | ) |
|                                          |       |                                            |       |   |   |   |   |
| Effect of dilutive securities options **[A]** |       | —                                          |       | — |   | — |   |
|                                          |       |                                            |       |   |   |   |   |
| Diluted loss per share                        |       | $                                               | (426,000   | ) | 2,685,000 |   | $ | (0.16 | ) |

 
| ** **                                    | ** ** | **Three Months ended September 30,  2004** | ** ** |
|-----------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                    | ** ** | **Net**                                         | ** ** | **Weighted** | ** ** | ** ** | ** ** |
| ** **                                    | ** ** | **Loss**                                        | ** ** | **Average Shares** | ** ** | **Per Share** | ** ** |
| Loss Per Common Share                         |       |                                            |       |   |   |   |   |
|                                          |       |                                            |       |   |   |   |   |
| Basic loss per share                          |       | $                                               | (1,276,000 | ) | 2,456,000 |   | $ | (0.52 | ) |
|                                          |       |                                            |       |   |   |   |   |
| Effect of dilutive securities options **[A]** |       | —                                          |       | — |   | — |   |
|                                          |       |                                            |       |   |   |   |   |
| Diluted loss per share                        |       | $                                               | (1,276,000 | ) | 2,456,000 |   | $ | (0.52 | ) |

 

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

 

### **NOTE 6**                                               SUBSEQUENT EVENTS:

 

On November 8,2005, we announced that we entered into a joint venture with Explorer Gear USA,which will be operated as a separate Colorado limited liability company (“LLC”).The LLC intends to use our license with Callaway to manufacture and marketTop-FliteTM branded apparel to Wal-Mart Stores, Inc. in the United States.The license, previously granted to us by Callaway, allows us to manufacture anddistribute Top-FliteTM branded apparel in the United States and certain othercountries. Callaway has given us its consent to use the Top-FliteTM license inconnection with the LLC, subject to certain conditions.

 

ExplorerGear USA is affiliated by ownership with Explorer Headgear, Inc., aCanadan corporation located in Markham, Ontario. Explorer Headgear, Inc.is licensed by Callaway to manufacture and market Top-FliteTM apparel in Canada.Explorer Headgear, Inc. and Explorer Gear USA are affiliated with certainmanufacturing plants in China, which are expected to manufacture Top-FliteTMapparel for the LLC. We anticipate that the first significant deliveries ofTop-FliteTM apparel to Wal-Mart Stores, Inc., in the United States will bemade in approximately January 2006.

 

9

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**ITEM 2 MANAGEMENT’S DISCUSSIONAND ANALYSIS OF**

**FINANCIAL 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,” 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 fromthreats or acts of war or terrorism and responses thereto; timely performanceof third parties, such as freight forwarders, including risks of labor disputesand/or labor strikes; changes in product mix; inventory risks due to shifts inmarket and/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 mentioned above,in the discussion below or included in our Securities and Exchange Commission (“SEC”)filings that may cause actual results to differ materially from anyforward-looking statements. The reader should not place undue reliance on anyforward-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 to theCompany’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 SPORT HALEYTMand Ben Hogan® labels. Our fashion golf apparel collections, known for their innovativedesigns, quality fabrics, generous fits and classic styles, are primarilymarketed in the premium and mid-priced markets through a network of independentwholesale sales representatives and distributors to golf professional shops,country clubs and resorts  and exclusivedepartment stores within the United States and by certain distributors withininternational markets. We distribute Ben Hogan® apparel pursuant to a licensingagreement with Callaway Golf Company (“Callaway”).**

##### ** **

We are represented by anetwork of independent wholesale sales representatives and employ a 

 

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vice-president of salesand a regional sales manager, each with responsibilities for both of ourbranded labels of apparel. Most of the independent wholesale salesrepresentatives solicit sales of both SPORT HALEYTM and Ben Hogan® apparel on ourbehalf.

 

We continue to focus onstabilizing revenues associated with our SPORT HALEYTM label and growth ofrevenues associated with our Ben Hogan® label. We previously discontinuedmarketing SPORT HALEYTM men’s fashion apparel, in part, because we believe thatthere are natural synergies common to Ben Hogan® men’s fashion apparel and SPORTHALEYTM women’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, weannounced that we plan to introduce initial collections of Top-FliteTM men’sapparel in approximately January 2006. Top-FliteTM apparel will bedistributed via a vendor agreement with Wal-Mart Stores through a joint venturewith Explorer Gear USA. We will distribute Top-FliteTM apparel pursuant to ourlicensing agreement with Callaway.

 

##### **RECENTDEVELOPMENTS**

##### ** **

OnNovember 8, 2005, we announced that we entered into a joint venture withExplorer Gear USA, which will be operated as a separate Colorado limitedliability company (“LLC”). The LLC intends to use our license with Callaway tomanufacture and market Top-FliteTM branded apparel to Wal-Mart Stores, Inc.in the United States. The license, previously granted to us by Callaway, allowsus to manufacture and distribute Top-FliteTM branded apparel in the UnitedStates and certain other countries. Callaway has given us its consent to usethe Top-FliteTM license in connection with the LLC, subject to certainconditions.

 

ExplorerGear USA is affiliated by ownership with Explorer Headgear, Inc., aCanadian corporation located in Markham, Ontario. Explorer Headgear, Inc.is licensed by Callaway to manufacture and market Top-FliteTM apparel in Canada.Explorer Headgear, Inc. and Explorer Gear USA are affiliated with certainmanufacturing plants in China, which are expected to manufacture Top-FliteTMapparel for the LLC. We anticipate that the first significant deliveries ofTop-FliteTM apparel to Wal-Mart Stores, Inc., in the United States will bemade in approximately January 2006.

 

**CRITICALACCOUNTING POLICIES AND ESTIMATES**

 

Our financial statementshave been prepared in accordance with standards of the Public CompanyAccounting Oversight Board (United States), which require us to make estimatesand judgments that affect the reported amounts of assets, liabilities, revenuesand expenses, and the related disclosures. A summary of those significantaccounting policies can be found in the Footnotes to the Financial Statementsincluded in our Report on Form 10-K for the fiscal year ended June 30,2005. The estimates used by managementare based upon our historical experiences combined with management’sunderstanding of current facts and circumstances. Certain of our accountingpolicies are considered critical as they are both important to the portrayal ofour financial condition and the results of our operations and requiresignificant or complex judgments on the part of management. We believe that the

 

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followingcritical accounting policies affect the more significant judgments andestimates used in the preparation of our financial statements.

 

*Inventories*

 

Inventories,predominately comprised of finished goods, are generally valued at the lower ofcost (weighted average) or market. Costs include amounts paid to suppliers forpackaged apparel and/or materials and labor, import costs, such as customsduties, freight-in and other miscellaneous costs, and allocated overhead. Afterwe implemented our operations software in January 2004, we discoveredcertain programming and human errors within the new system that adverselyaffected the software’s ability to accurately compute the valuation of ourfinished goods inventories using a weighted average method. We consider theprogramming and human errors, which caused us to use a standard cost method inprior periods, to be a material weakness in our internal controls overfinancial reporting with respect to inventory valuation. This weakness in ourcontrols prevented us from relying upon the system-recorded transactions withrespect to inventory valuations during fiscal 2005. During the 2005 fiscal year,we concluded with reasonable assurance that recomputing the value of ourfinished goods inventories using a standard cost method yielded a fairestimation of the value of our finished goods inventories. We used the standardcost method to value our finished goods inventories from the fiscal quarterended March 31, 2004, through the fiscal quarter ended March 31,2005. Had we been able to rely upon the system to properly compute the cost ofour finished goods inventories using the weighted average method, we believethat the weighted average method would not have yielded a materially differentcomputation of the value than the standard cost method that we applied.

 

AtSeptember 30, 2005, a relatively small percentage our inventory itemsremained on hand that had been valued in prior periods using the standard costmethod. Based upon tests we performed during the quarter ended September 30,2005, we believe that the computer software has been properly programmed, andemployees have been adequately trained to utilize the proscribed systemprocedures, so that prospectively we may rely upon the computer system toaccurately compute our finished goods inventory valuations using a weightedaverage cost assumption. During the quarter ending December 31, 2005, weplan to design and implement additional controls to periodically test theaccuracy of the system-generated valuation entries that comprise the weightedaverage cost components of our finished goods inventories to conclude whetherthe material weakness has been mitigated.

 

Thematerial weakness in our internal controls over financial reporting withrespect to inventory valuation also impaired our ability to rely uponinformation created by our computer system to fairly present, in all materialrespects, our financial condition, results of operations and cash flows inperiods during the periods covered by this report. The inability of our computersystem to properly calculate the valuation of our finished goods inventoriesusing a weighted average cost assumption also affected the system-recordedamounts within our cost of goods sold in periods in the periods covered by thisreport. Because we concluded with reasonable assurance that our using astandard cost assumption yielded a fair estimation of our finished goodsinventories, and because we consistently recorded adjustments to inventories ascomponents of cost of goods sold, we believe with reasonable assurance that ourcost of goods sold are fairly stated for the periods covered by this report.Therefore, we believe that the procedures we applied to value our finishedgoods inventories for the periods covered by this report provide us with reasonableassurance that our condensed financial statements and the notes thereto fairlystate, in all material respects, our financial condition, the results of ouroperations and our cash flows.

 

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Excessfinished goods inventories are a natural component of a seasonal apparelbusiness. While certain finished goods items will sell out in any particularselling season, quantities of other finished goods items will remain at the endof each selling season. We market previous seasons’ finished goods inventoriesat reduced wholesale prices to our customers in the normal course of business.Remaining excess inventories are liquidated through other markets. In theordinary course of business, we maintain reserves for inventory write downs dueto the obsolescence of discontinued or aging merchandise. We perform analyseson a quarterly basis to identify unsold discontinued or aging merchandise andadjust our reserves 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 September 30, 2005, we recorded finished goods inventorieswrite-downs of $65,000. 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.

 

*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 September 30, 2005, 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 thegeneration of future profits. Because the recoverability of deferred tax assetsis directly dependent upon future operating results, actual recoverability ofdeferred tax assets may differ materially from our estimates.

 

*Allowancefor Doubtful Accounts*

 

Our allowance fordoubtful accounts reflects a reserve that reduces our customer accountsreceivable to the net amount estimated to be collectible. Estimating the creditworthiness of customers and the recoverability of customer accounts requires usto exercise considerable judgment. In estimating the reserve for uncollectibleaccounts, we consider factors such as general economic and industry-specificconditions, historical customer performance and anticipated customerperformance. From time to time, we also identify delinquent customer accounts forwhich a specific reserve is required. Our allowance for doubtful accountstotaled $259,000 at September 30, 2005, including specific reservesapproximating $18,000 with respect to certain delinquent customer accounts.While we consider our processes to be adequate to effectively quantify ourexposure to doubtful accounts, changes in economic, industry or specificcustomer conditions may result in recoverability of our doubtful accounts thatdiffers materially from our estimates.

 

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*Allowancefor Sales Returns*

 

We record allowances forsales returns as net adjustments to customer accounts receivable. Whenrecording an allowance, the net method reduces customer accounts receivable andnet sales by the estimated gross margin effect of the anticipated sales return.Generally, our selling terms preclude return of our products subsequent to thesale. However, we have traditionally maintained limited programs that offersome customers the right to return certain finished goods items underpredefined conditions, which we include as a component within our estimate ofallowance for sales returns. We review historical data and consider factorssuch as general economic and industry-specific conditions and anticipated customerperformance when evaluating the adequacy of our allowance for sales returns. AtSeptember 30, 2005, the Company’s allowance for sales returns was$286,000. Significant changes in general economic or industry conditions mayyield sales returns that differ materially from our estimates

 

### **LIQUIDITY ANDCAPITAL RESOURCES**

### ** **

Because the golf apparelbusiness is highly seasonal in nature, our balance sheet amounts as of September 30,2005, may be more meaningful when compared with the balance sheet amounts as ofSeptember 30, 2004, rather than with the balance sheet amounts at June 30,2005.

 

Our primary sources ofliquidity are comprised of available cash and cash equivalents, cash flows fromoperations and a working capital line of credit with a commercial bank. Werequire cash for general working capital purposes. We do not anticipate therequirements of material amounts of cash for capital expenditures over theremainder of the current fiscal year. Our working capital requirements arehighly seasonal in nature, with greater requirements from approximately August throughOctober and February through April of each fiscal year, due tothe purchases of finished goods inventories for the spring/summer andfall/holiday selling seasons, respectively.

 

Our net accountsreceivable decreased by $1,688,000 to $2,807,000 at September 30, 2005,from $4,495,000 at June 30, 2005. When compared with the September 30,2004, balance, the net accounts receivable balance at September 30, 2005, decreasedby $1,436,000, or 34%. Historically, our net sales are weakest during our firstfiscal quarter, and our net accounts receivable balance generally declinesduring our first fiscal quarter when compared with the balance at the previousfiscal year end. While a large portion of our fourth fiscal quarter sales areshipped in the month of June each year, sales are generally shipped moreevenly throughout our first fiscal quarter. Because a large portion of oursales are shipped with Net 30 payment terms, our collections are generally greaterthan our sales during our first fiscal quarter, because a significant portionof our June sales are generally collected by September 30 each year. Changesin our accounts receivable balances provided operating cash of $1,673,000 and $1,643,000for the fiscal quarters ended September 30, 2005 and 2004, respectively.

 

The balances of our inventorieshave increased slightly since June 30, 2005. Inventories increased by$615,000, or 15%, to $4,768,000 at September 30, 2005, from $4,153,000 at June 30,2005. When compared with the balance at September 30, 2004, ourinventories decreased by $4,059,000, or 46%, from $8,827,000. The comparativedecreases are attributable to several separate factors. Near the end of fiscal2004, we established initiatives designed to reduce excess inventories and toset target thresholds for expected future levels of finished goods inventories.One of our initiatives reduced the number of items offered for sale in each ofthe SPORT HALEY® and Ben Hogan® apparel collections, thereby reducinginventories related to the initial purchases of finished goods items at thebeginning of each

 

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season. Anotherinitiative was enacted to identify and dispose of excess obsolete or agingfinished goods inventories. In fiscal 2005, we sold substantially all of ourexcess obsolete or aging finished goods inventories. During fiscal 2005, wedeveloped new methods that we believe provide us with better information totimely identify and value excess amounts of finished goods inventories from acurrent selling season. In fiscal 2005,we also developed new methods to optimize reorders of finished goodsinventories based upon the anticipated required future delivery dates ofpre-booked customer orders. We believe that the new reorder methods haveallowed us to minimize the quantities of finished goods inventories expected toremain at the end of each selling season. The differences between theperiods in pending ocean deliveries of finished goods also contributed to thecomparative differences in total finished goods inventories. Pending oceandeliveries of finished goods were $824,000, $459,000 and $317,000 at September 30,2005, June 30, 2005, and September 30, 2004, respectively. Changes inour inventory balances provided operating cash of $2,765,000 and used operatingcash of $3,092,000 for the nine-month periods ended March 31, 2005 and2004, respectively. Changes in our inventory balances used operating cash of$615,000 and $19,000 for the quarters ended September 30, 2005 and 2004,respectively.

 

Our continued reliance onforeign suppliers sustains the risk that our revenues could be adverselyaffected if a foreign shipment or shipments were received late or lost. Wemaintain insurance for risk of loss relating to goods shipped from its foreignand domestic suppliers. However, our predominant reliance upon foreignsuppliers, and significant reliance on six separate foreign suppliers, alsosustains the risk that we would be left with inadequate or unsatisfactoryrecourse should the goods received from a foreign supplier be nonconforming.

 

Accounts payable andaccrued expenses decreased by $340,000 to $1,411,000 at September 30, 2005,from $1,751,000 at June 30, 2005. Accounts payable and accrued expensesdecreased by $377,000, or 21%, from $1,788,000 at September 30, 2004. Thecomparative decreases in accounts payable and accrued expenses are indicativeof management’s efforts to reduce overall operating expenses.

 

Due to the combination ofthe factors discussed above, and others, our operating activities provided cashof $337,000 for the three months ended September 30, 2005. Comparatively,for the quarter ended September 30, 2004, our operating activitiesprovided cash of $189,000.

 

For the three months ended September 30, 2005,investing activities used cash of $5,000. Comparatively, for the three monthsended September 30, 2004, investing activities provided cash of $519,000.Our cash flows from investing activities are primarily derived from purchases andredemptions of held-to-maturity investments. Generally, our held-to-maturityinvestments consist of short-term federal agency securities. During the threemonths ended September 30, 2005, we expended $5,000 for the purchase ofproperty and equipment, and $84,000 in depreciation and amortization wascharged to current operations.

 

We maintain a revolvingline of credit agreement with a commercial bank. The revolving line of creditagreement, renewed by amendment through December 5, 2005, provides for a maximumloan amount 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 tangible net worth of $14,000,000. Wegenerally maintain the line of credit to facilitate the issuance of letters ofcredit for inventory purchases from offshore suppliers and, if necessary, tofund any temporary working capital needs. Outstanding letters of credit reducethe amount available for borrowing under the line of credit 

 

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agreement. At September 30,2005, we had $818,000 in outstanding letters of credit that were issued toforeign suppliers in accordance with finished goods inventory purchase commitments.

 

We believe that cash onhand and cash generated from operations, as well as the ability to borrow underthe bank line of credit, will be sufficient to meet our cash requirementsduring the remainder of fiscal 2006. We also have alternative sources offinancing, including the factoring of customer accounts receivable. Althoughthey are available to the Company, we do not anticipate using alternativesources of financing during the remainder of fiscal 2006. However, our capitalneeds will depend on many factors, including the Company’s growth rate, theneed to finance required inventory levels, the success of various sales andmarketing programs, expenses related to the defense of pending law suits andvarious other factors.

 

### **RESULTS OFOPERATIONS**

### ** **

Our business is seasonalin nature, and sales occurring from January through June, which compriseour third and fourth quarters of each fiscal year, are generallydisproportionately higher than sales occurring from July through December.

 

Net sales for the threemonths ended September 30, 2005, were $4,011,000, a decrease of $1,559,000,or 28%, from net sales of $5,570,000 for the comparable period in the priorfiscal year. We attribute the decrease in net sales to factors such as the previouslyreported discontinuance of our HALEY RESERVE men’s fashion apparel anddifferences between the periods with the timing of shipments relating to ourrespective fall seasons. The difference caused by our discontinuance of theHALEY RESERVE men’s collections totaled slightly over $1,000,000, the amount ofnet HALEY RESERVE sales recorded during the three months ended September 30,2004. While net sales of our SPORT HALEYTM women’s collections weresubstantially similar between the comparable three-month periods, sales of ourBen Hogan® men’s collections declined between the periods by approximately$349,000. We attribute the decline in Ben Hogan® net sales to differencesbetween the periods with the timing of shipments relating to our respectivefall seasons. While we have not specifically quantified sales differencesbetween the respective periods, we believe that the decrease in Ben Hogan®sales primarily relates to our shipping a larger percentage of our fallcollections prior to June 30 this year as compared with the same periodlast year. Net sales of Ben Hogan® apparel collections were $2,349,000 and $2,698,000for the three months ended September 30, 2005 and 2004, respectively. BenHogan® apparel is marketed in accordance with a licensing agreement we maintainwith Callaway Golf Company (“Callaway”) for such apparel. We consider thelicensing agreement with Callaway to be a key component of our businessstrategies. While we strive to maintain a good working relationship withCallaway, the trend for the last several periods, reflecting a continuedincrease in sales of licensed apparel, sustains a risk of loss, should the licensingagreement with Callaway be terminated by either party.

 

Grossprofit, as a percentage of net sales, was 33% for the quarter ended September 30,2005, and 32% for the same quarter in the prior fiscal year. Our gross profitis 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 three months ended September 30, 2005, we recorded net sales of$539,000 and gross profit of $15,000 with respect to sales

 

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ofexcess inventories. The valuation of inventories to the lower of cost or marketalso negatively 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 $65,000 for thethree months ended September 30, 2005, by the adjustment of our finishedgoods inventories to the lower of cost or market. Comparatively, our grossprofit was negatively impacted by $543,000 for the three months ended September 30,2004, by a similar lower of cost or market adjustment. We believe that thesubstantially lower adjustment recorded in the September 2005 period isindicative of our successful efforts to minimize the amount of our finishedgoods inventories expected to remain on hand at the end of each selling seasonand to better estimate the recoverable value of our excess finished goodsinventories.

 

Ourgross margins may not be comparable to other companies within the golf apparelindustry. We have consistently included the cost of merchandise sold, includingimport charges, in-bound freight, allocated overhead, freight-out, embroiderycosts and other charges in our cost of goods sold. Our overhead allocationincludes a portion of our distribution costs, such as receiving, inspection andshipping costs, but we include some of the other costs of distribution, such asa portion of our warehousing and other handling costs, in selling, general andadministrative expenses.

 

Selling, general andadministrative expenses decreased by $1,196,000, or 42%, to $1,663,000 for thequarter ended September 30, 2005, from $2,859,000 for the same quarter inthe prior fiscal year. The decrease was primarily attributable to the accrual atSeptember 30, 2004, of $650,000 in severance and other compensationpayable to our late Chairman’s estate subsequent to his death combined with ageneral decrease in selling, general and administrative expenses. As previouslyreported, shortly after December 30, 2004, we performed a detailed reviewof our selling, general and administrative costs and formed a plan to reducecosts in several categories. The comparative decrease at September 30,2005, is indicative of the cost reductions that have been achieved as a resultof implementing cost reduction initiatives. As a percentage of net sales,selling, general and administrative expenditures were approximately 41% and 51%for the quarters ended September 30, 2005 and 2004, respectively.

 

Werecorded royalty expense of $163,000 and $198,000 for the quarters ended September 30,2005 and 2004, respectively. Royalty expense is due to Callaway in accordancewith the license they previously granted us to market men’s apparel bearing theBen Hogan® label.

 

Netloss for the three months ended September 30, 2005, was ($426,000), adifference of $850,000, or 67%, as compared with the net loss of ($1,276,000)for the same period in the prior fiscal year. At September 30, 2005, wehad federal and state net operating loss carry forwards of $5,850,000 and $8,522,000that we estimated may be recoverable at income tax rates of 34% and 5%,respectively. Because of our continued trend of net losses in the current andmost recent prior fiscal years, we determined that it was more probable thannot that none of our net deferred tax assets will be recovered, and wemaintained our valuation allowance that effectively reduced our net deferredtax assets to zero. While we are attempting 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 quarterly periods ended September 30,2005 and 2004, we did not record a benefit from income taxes associated withthe corresponding losses for the respective nine-month periods.

 

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Both the basic anddiluted losses per share were ($0.16) for the quarter ended September 30,2005. Both the basic and diluted losses per share were ($0.52) for the samequarter in the prior fiscal year. Due to our net losses for the respectiveperiods, all options were anti-dilutive and therefore excluded from the lossper share calculations.

 

Our book value per sharewas $5.67 at September 30, 2005, $5.95 at June 30, 2005, and $6.85 atSeptember 30, 2004.

 

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**ITEM 3 QUALITATIVE ANDQUANTITATIVE**

**DISCLOSURES ABOUT MARKET RISK**

 

Market risk representsthe risk of loss that may impact the financial position, results of operationsor cash flows due to adverse changes in financial and commodity market pricesand rates. We are exposed to market risk with regard to changes in UnitedStates interest rates. This exposure is directly related to our normaloperating and funding activities. Historically, and as of September 30,2005, we have not used derivative instruments or engaged in hedging activities.Our market risk has not changed significantly from June 30, 2005.

 

**InterestRate Risk**

 

We maintain a revolvingline of credit agreement with a commercial bank that provides for interest atthe bank’s prime rate. The agreement provides for a maximum loan amount of $5,000,000collateralized by a lien on substantially all of our assets. We generallymaintain the line of credit to facilitate the issuance of letters of credit forinventory purchases from offshore suppliers, and, if necessary, to fund anytemporary working capital needs. At September 30, 2005, we did not haveany outstanding borrowings under the line of credit. Increases in the bank’sprime rate could, however, increase the interest expense with respect to futureborrowings, including borrowings under the line of credit. Outstanding lettersof credit reduce the amount available for borrowing under the line of credit.We had outstanding letters of credit of $818,000 at September 30, 2005. Wedo not use derivative financial instruments to manage interest rate risk.

 

From time to time, wemaintain short-term investments in low risk and no risk financial instruments,readily convertible into cash, which earn interest at variable rates.Periodically, our cash balances held at financial institutions exceed federallyinsured limits.

 

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**ITEM 4 CONTROLS AND PROCEDURES**

 

**(a)     Evaluation ofDisclosure Controls and Procedures**

 

Ourmanagement, with the participation of our Interim Chief Executive Officer andour Chief Financial Officer, conducted an evaluation of the effectiveness ofour disclosure 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, our disclosure controls and procedures wereeffective in reaching a reasonable level of assurance that:  (a) all material information relating tothe Company, required to be disclosed in this report, was made known tomanagement in a timely manner; and (b) information was recorded,processed, summarized and reported within the time periods specified in the SEC’srules and regulations.

 

Asdiscussed in Part II, Item 2, in *“Management’s Discussionand Analysis of Financial Condition and Results of Operations”*, in *“Critical Accounting Policies and Estimates,”* we considerthe programming and human computational errors, which caused us to use astandard cost method in prior periods, to be a material weakness in ourinternals control over financial reporting with respect to inventory valuationduring the periods covered by this report. After we implemented our operationssoftware in January 2004, we discovered certain programming and humanerrors within the new system that adversely affected the software’s ability toaccurately compute the valuation of our finished goods inventories using aweighted average method. This weakness in our controls prevented us fromrelying upon the system-recorded transactions with respect to finished goodsinventory valuation. 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, the Interim Chief Executive Officer and the ChiefFinancial Officer believe that the weighted average method would not haveyielded a materially different computation of the value than the standard costmethod that we applied.

 

At September 30,2005, a relatively small percentage of our inventory items remained on handthat had been valued in prior periods using the standard cost method. Basedupon tests we performed during the quarter ended September 30, 2005, theInterim Chief Executive Officer and the Chief Financial Officer believe thatthe computer software has been properly programmed, and employees have beenadequately trained to utilize the proscribed system procedures, so that prospectivelywe may rely upon the computer system to accurately compute our finished goodsinventory valuations using a weighted average cost assumption. The InterimChief Executive Officer and the Chief Financial Officer believe that theprocedures we applied to value our finished goods inventories for the periodscovered by this report provide us with reasonable assurance that the Company’sdisclosure controls and procedures were effective as of the end of the periodcovered by this report.

 

Thematerial weakness in our internal controls over financial reporting withrespect to inventory valuation also impaired our ability to rely uponinformation created by our computer system to fairly present, in all materialrespects, our financial condition, results of operations and cash flows for theperiods covered by this report. The inability of our computer system toproperly calculate

 

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thevaluation of our finished goods inventories also affected the system-recordedamounts within our cost of goods sold during the periods covered by thisreport. Because we concluded with reasonable assurance that our using astandard cost assumption yielded a fair estimation of our finished goodsinventories for the periods covered by this report, and because we consistentlyrecorded adjustments to inventories as components of cost of goods sold duringthe periods covered by this report, we believe with reasonable assurance thatour cost of goods sold are fairly stated during the periods covered by this report.Therefore, the Interim Chief Executive Officer and Chief Financial Officerbelieve that the procedures we applied to value our finished goods inventoriesfor the periods covered by this report provide us with reasonable assurancethat our report fairly states, in all material respects, our financialcondition, results of operations and cash flows.

 

**(b)****               Changesin Internal Controls Over Financial Reporting**

 

During the first quarterof fiscal 2006, we did not institute any significant changes in internalcontrols over financial reporting that materially affected, or are reasonablylikely to materially affect, our internal controls over financial reporting.

 

During the quarter endingDecember 31, 2005, we plan to design and implement additional controls toperiodically test the accuracy of the system-generated valuation entries thatcomprise the weighted average cost components of our finished goods inventoriesto conclude whether the material weakness has been mitigated.

 

Our management, includingthe Interim Chief Executive Officer and the Chief Financial Officer, does notexpect that our disclosure controls and procedures or our internal controlsover financial reporting will, in all instances, prevent all errors and allfraud. A control system, no matter how well conceived or operated, can onlyprovide reasonable, not absolute, assurance that the objectives of the controlsystem are met. While our control systems provide a reasonable assurance level,the design of our control systems reflects the fact that there are resourceconstraints, and the benefits of such controls were considered relative totheir costs. Because of the inherent limitations in all control systems, noevaluation of controls can provide absolute assurance that all control issuesand instances of fraud, if any, within the financial reports of Sport-Haley, Inc.have been detected. These inherent limitations include the realities thatjudgments in decision-making can be faulty, and that breakdowns can occurbecause of 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.Because of the inherent limitations in a cost-effective control system,misstatements due to error or fraud may occur and not be detected.

 

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**PART II**

**OTHER INFORMATION**

 

### **ITEM 1**             LEGALPROCEEDINGS

### ** **

Aspreviously reported, in September 2003, the United States Securities andExchange Commission (the “Commission”) filed suit in the United States DistrictCourt for the District of Colorado against Sport-Haley, Inc., Robert G.Tomlinson, our late Chairman and former Chief Executive Officer, and Steve S.Auger, our former Controller (the “Defendants”). The Commission filed anamended complaint in October 2003, which added one of our former auditorsto the action as a Defendant. The suit seeks an injunction against futureviolations and other relief, including disgorgement, civil penalties and anorder barring Mr. Tomlinson and Mr. Auger from serving as director orofficer of any publicly held company. The suit alleges that the Defendantsmisrepresented inventories, period costs and losses on the sale of headwearequipment in annual and/or quarterly financial statements for Sport-Haley’sfiscal years 2000, 1999 and 1998. The amended complaint alleges thatSport-Haley, Inc. violated §17(a) of the Securities Act of 1933 (the “SecuritiesAct”), §10(b), §13(b)(2) and §15(d) of the Securities Exchange Act of1934 (the “Exchange Act”) and various other rules promulgated thereunder.The amended complaint further alleges that Mr. Tomlinson and Mr. Augerviolated §17(a) of the Securities Act, §10(b) and §13(b)(5) ofthe Exchange Act and Rules 10b-5 and 13b-2 thereunder. Finally, the suitalleges that Mr. Tomlinson and Mr. Auger aided and abettedSport-Haley, Inc. in violation of §13(b)(2) and §15(d) of theExchange Act and various rules promulgated thereunder. The Commission’ssuit primarily relates to errors in our previously issued financial statementsthat we previously reported when we voluntarily restated our financialstatements for fiscal years 1999 and 1998 and subsequently corrected materialfinancial information for the quarterly periods of fiscal years 2000, 1999 and1998. The Defendants have answered the allegations of the amended complaint,denying the substantive allegations and asserting various defenses. Discoveryin the action has concluded. No trial date has yet been determined. Subject toour Bylaws and Colorado law, we agreed to indemnify Mr. Tomlinson and Mr. Auger,and we have advanced the costs of their defenses, pending final adjudication ofthe Action. The costs of defense of the action by the Defendants are covered bythe applicable liability insurance, subject to a policy retention, which hasbeen satisfied, and other limitations. After Mr. Tomlinson’s death in September 2004,the Commission filed a motion to dismiss Mr. Tomlinson from the actionwithout prejudice, and the Court granted the motion. In July 2005, wesubmitted a settlement proposal to the Commission’s Denver regional office,which the parties agreed to amend in September 2005. If the amendedsettlement proposal is approved by the full Commission in Washington D.C., thelitigation against us would end, without further material impact on ourfinancial position or the results of our operations. Counsel to Mr. Augerhas informed us that a settlement proposal has also been submitted to theDenver office on his behalf, which, if approved, would also end the litigationagainst him. The Court issued an Order requiring the settlements, if approvedby the full Commission, be submitted to the Court by no later than November 30,2005. Based upon the information that is currently available, management cannotreasonably estimate the amount of future costs that we will incur defending theCommission’s allegations if our amended settlement offer is not accepted.However, if the suit were determined in favor of the Commission and against theDefendants, the possible monetary penalties and other relief that we might berequired to pay could further negatively impact our financial position and theresults of our operations.

 

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Infiling our annual report on Form 10-K for fiscal 2000, we restatedpreviously issued financial statements. In March 2001, we retained legalcounsel to possibly pursue claims against our former auditors in connectionwith damages suffered as a result of the restatements of our financialstatements for fiscal years 1999 and 1998 and the corrections of materialinformation for the quarterly periods of fiscal years 2000, 1999 and 1998.Also, counsel to the former auditors previously advised us that the formerauditors may file certain claims against us, possibly including allegations ofunpaid fees. Neither have we nor our former auditors filed any legal action toassert any of these claims. Based upon the information that is currentlyavailable, we do not believe the impact, if any, of an award to the formerauditors, if they were to initiate a formal action against us, would materiallyaffect our financial position or the results of our operations. The partieshave scheduled a non-binding mediation session before a neutral party in November 2005.

 

As of September 30,2005, we had cumulatively incurred $1,104,000 in potentially recoverable costsrelated to the restatements of our fiscal year 1999 and 1998 financialstatements and the correction of material information for the fiscal quartersof years 2000, 1999 and 1998, an investigation and subsequent civil actioninitiated by the Commission and a class action lawsuit that has been settled.The policy retention for such costs has been satisfied, and one of ourinsurance carriers had reimbursed us $409,000 as of September 30, 2005.Amounts recovered from our insurance carriers are generally offset againstother related legal expenses in the period within which they are recovered, orrecoverability is reasonably assured, except that amounts recovered areincluded in other income to the extent that such recovery exceeds legal expensesfor related matters incurred within the period for which the recovery isrecorded.

 

We aresubject to various other legal proceedings and claims which arise in theordinary course of our business. Based upon information that is currentlyavailable, management does not believe that the total impact of the variousother legal proceedings will materially affect our financial position or theresults of our operations.

 

### **ITEM 5**             OTHERINFORMATION

### ** **

On October 19, 2005, Mark Maley,Vice-President, Sales of Sport-Haley, Inc., submitted a letter ofresignation, dated and effective October 18, 2005. Pursuant to the letter ofresignation and Mr. Maley’s executive employment agreement, Mr. Maleyprovided notice of his intended resignation ninety days before such resignationwill become effective on January 16, 2006. The Board of Directors has notappointed anyone to act as Vice-President, Sales upon Mr. Maley’sdeparture. Barry L. Hyman, our Regional Sales Manager, has agreed to serve asNational Sales Manager on an interim basis.

 

On November 8, 2005, we announced that weentered into a joint venture with Explorer Gear USA, which will be operated asa separate Colorado limited liability company (“LLC”). The LLC intends to useour license with Callaway to manufacture and market Top-FliteTM branded apparelto Wal-Mart Stores, Inc. in the United States. The license, previouslygranted to us by Callaway, allows us to manufacture and distribute Top-FliteTMbranded apparel in the United States and certain other countries. Callaway hasgiven us its consent to use the Top-FliteTM license in connection with the LLC,subject to certain conditions.

 

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Explorer Gear USA is affiliated by ownership withExplorer Headgear, Inc., a Canadian corporation located in Markham,Ontario. Explorer Headgear, Inc. is licensed by Callaway to manufactureand market Top-FliteTM apparel in Canada. Explorer Headgear, Inc. andExplorer Gear USA are affiliated with certain manufacturing plants in China,which are expected to manufacture Top-FliteTM apparel for the LLC. We anticipatethat the first significant deliveries of Top-FliteTM apparel to Wal-Mart Stores, Inc.,in the United States will be made in approximately January 2006.

 

### **ITEM 6**             EXHIBITS

### ** **

Exhibit 31.1– Certification of Donald W. Jewell pursuant to Exchange Act Rule 13a-14(a)/15d-14(a)

 

Exhibit 31.2– Certification of Patrick W. Hurley pursuant to Exchange Act Rule 13a-14(a)/15d-14(a)

 

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

 

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**SIGNATURES**

 

In accordance with therequirements of the Securities Exchange Act of 1934, the Registrant caused thisreport to be signed on its behalf by the undersigned thereunto duly authorized.

 

 
|   | **SPORT-HALEY,  INC.**                                |
|--------|-------------------------------------------------------|
|   | (Registrant)                                          |
|   |                                                  |
|   |                                                  |
| Date:  | November 21,  2005                               | ** ** | /s/ PATRICK W.  HURLEY |   |
|   | Patrick W.  Hurley                                    |
|   | Chief Financial  Officer                              |
|   | * (Principal Financial and Accounting  Officer)* |
|        |                                                       |  |  |  |

 

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