** **

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C.  20549**

 

**FORM 10-Q**

 

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

 

**For the quarterly period ended September 30, 2004**

 

**o****  TRANSITION REPORTUNDER SECTION 13 OR 15(d) OF THEEXCHANGE ACT**

 

**Commission File No. 1-12888**

 

**SPORT-HALEY,INC.**

(Exact name ofsmall business issuer 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 ofprincipal executive offices)

 

**(303)320-8800**

(Issuer’stelephone number including area code)

 

Indicateby check mark whether the registrant (1) filed all reports required to be filedby Section 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days:   Yes  ý   No  o

 

Indicateby check mark whether the registrant is an accelerated filer (as defined inRule 12b-2 of the Exchange Act:   Yes  o   No  ý

 

Indicatethe number of shares outstanding in each of the issuer’s classes of commonstock, as of the latest practicable date.

 

| **Class**                      | ** ** | **Outstanding at November 15, 2004** | ** ** |
|--------------------------------|------------|-------------------------------------------|------------|
| **Common Stock, no par value** | ** ** | **2,545,252**                             |       |

 

 

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**TABLE OFCONTENTS**

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

**BALANCE SHEETS**

 
| ** **                                                                                                                      | ** ** | **September 30,  2004** | ** ** | **June 30,  2004** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-------------------------|------------|
| ** **                                                                                                                      | ** ** | **(Unaudited)**              | ** ** | **(***)**               | ** ** |
| **ASSETS**                                                                                                                      |       |                         |       |                    |       |
| Current  assets:                                                                                                                |       |                         |       |                    |       |
| Cash  and cash equivalents                                                                                                      |       | $                            | 4,661,000  |                    | $          | 3,890,000 |   |
| Marketable  securities                                                                                                          |       | —                       |       | 539,000                 |       |
| Accounts  receivable, net of allowances of $1,354,000 and $542,000, respectively                                                |       | 4,243,000                    |       | 5,946,000               |       |
| Inventories                                                                                                                     |       | 8,827,000                    |       | 8,808,000               |       |
| Prepaid  expenses and other                                                                                                     |       | 432,000                      |       | 468,000                 |       |
|                                                                                                                            |       |                         |       |                    |       |
| Total  current assets                                                                                                           |       | 18,163,000                   |       | 19,651,000              |       |
|                                                                                                                            |       |                         |       |                    |       |
| Property  and equipment, net                                                                                                    |       | 1,038,000                    |       | 1,107,000               |       |
| Other  assets                                                                                                                   |       | 13,000                       |       | 13,000                  |       |
|                                                                                                                            |       |                         |       |                    |       |
|                                                                                                                            |       | $                            | 19,214,000 |                    | $          | 20,771,000 |   |
| **LIABILITIES  AND SHAREHOLDERS’ EQUITY**                                                                                  | ** ** | ** **                   | ** ** | ** **              | ** ** |
| ** **                                                                                                                      | ** ** | ** **                   | ** ** | ** **              | ** ** |
| Current  liabilities:                                                                                                           |       |                         |       |                    |       |
| Accounts  payable                                                                                                               |       | $                            | 1,064,000  |                    | $          | 1,461,000 |   |
| Accrued  commissions payable                                                                                                    |       | 271,000                      |       | 272,000                 |       |
| Accrued  payroll                                                                                                                |       | 112,000                      |       | 197,000                 |       |
| Other                                                                                                                           |       | 341,000                      |       | 218,000                 |       |
|                                                                                                                            |       |                         |       |                    |       |
| Total  current liabilities                                                                                                      |       | 1,788,000                    |       | 2,148,000               |       |
|                                                                                                                            |       |                         |       |                    |       |
| Commitments  and Contingencies (Note 3)                                                                                         |       |                         |       |                    |       |
|                                                                                                                            |       |                         |       |                    |       |
| 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; 2,545,252 and 2,444,585  shares issued and outstanding, respectively |       | 10,189,000                   |       | 10,126,000              |       |
| Additional  paid-in capital                                                                                                     |       | 1,543,000                    |       | 1,527,000               |       |
| Retained  earnings                                                                                                              |       | 5,694,000                    |       | 6,970,000               |       |
| Total  shareholders’ equity                                                                                                |       | 17,426,000                   |       | 18,623,000              |       |
|                                                                                                                            |       |                         |       |                    |       |
|                                                                                                                            |       | $                            | 19,214,000 |                    | $          | 20,771,000 |   |

 

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***  Taken from the audited balance sheet at thatdate

 

See accompanyingnotes to consolidated financial statements.

 

3

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**SPORT-HALEY,INC.**

**STATEMENTS OF OPERATIONS**

 
| ** **                                   | ** ** | **Three Months Ended  September 30,** | ** ** |
|----------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                   | ** ** | **2004**                                   | ** ** | **2003** | ** ** |
| ** **                                   | ** ** | **(Unaudited)**                            | ** ** | **(Unaudited)** | ** ** |
|                                         |       |                                       |       |   |   |
| Net  sales                                   |       | $                                          | 5,570,000  |   | $ | 4,312,000 |   |
|                                         |       |                                       |       |   |   |
| Cost  of goods sold                          |       | 3,800,000                                  |       | 2,672,000 |   |
|                                         |       |                                       |       |   |   |
| Gross  profit                                |       | 1,770,000                                  |       | 1,640,000 |   |
|                                         |       |                                       |       |   |   |
| Selling,  general and administrative expense |       | 3,057,000                                  |       | 1,945,000 |   |
|                                         |       |                                       |       |   |   |
| Loss  from operations                        |       | (1,287,000                                 | )          | (305,000 | ) |
|                                         |       |                                       |       |   |   |
| Other  income, net                           |       | 11,000                                     |       | 54,000 |   |
|                                         |       |                                       |       |   |   |
| Loss  before benefit from income taxes       |       | (1,276,000                                 | )          | (251,000 | ) |
|                                         |       |                                       |       |   |   |
| Benefit  from income taxes                   |       | —                                     |       | 90,000 |   |
|                                         |       |                                       |       |   |   |
| Net  loss                                    |       | $                                          | (1,276,000 | ) | $ | (161,000 | ) |
|                                         |       |                                       |       |   |   |
| Basic  and diluted loss per common share     |       | $                                          | (0.52      | ) | $ | (0.07 | ) |
|                                              |            |                                            |            |  |  |  |  |  |

 

See accompanyingnotes to consolidated financial statements.

 

4

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**SPORT-HALEY,INC.**

**STATEMENTS OF CASH FLOWS**

 
| ** **                                                                              | ** ** | **Three Months Ended  September 30,** | ** ** |
|-----------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                              | ** ** | **2004**                                   | ** ** | **2003** | ** ** |
| ** **                                                                              | ** ** | **(Unaudited)**                            | ** ** | **(Unaudited)** | ** ** |
| **Cash flows from operating activities:**                                               |       |                                       |       |   |   |
| Net  loss                                                                               |       | $                                          | (1,276,000 | ) | $ | (161,000 | ) |
| Adjustments  to reconcile net loss to net cash provided (used) by operating activities: |       |                                       |       |   |   |
| Depreciation  and amortization                                                          |       | 86,000                                     |       | 82,000 |   |
| Impairments  and write-downs                                                            |       | 543,000                                    |       | — |   |
| Deferred  taxes and other                                                               |       | —                                     |       | (90,000 | ) |
| Allowance  for doubtful accounts                                                        |       | 60,000                                     |       | 30,000 |   |
| Common  stock options                                                                   |       | 16,000                                     |       | 31,000 |   |
| Gain/Loss  on disposal of assets                                                        |       | 3,000                                      |       | — |   |
| Cash  provided (used) due to changes in assets and liabilities:                         |       |                                       |       |   |   |
| Accounts  receivable                                                                    |       | 1,643,000                                  |       | 824,000 |   |
| Inventory                                                                               |       | (562,000                                   | )          | (1,596,000 | ) |
| Other  assets                                                                           |       | 36,000                                     |       | 10,000 |   |
| Accounts  payable                                                                       |       | (397,000                                   | )          | 239,000 |   |
| Accrued  commissions and other expenses                                                 |       | 37,000                                     |       | 8,000 |   |
| Net  cash provided (used) by operating activities                                       |       | 189,000                                    |       | (623,000 | ) |
|                                                                                    |       |                                       |       |   |   |
| **Cash flows from investing activities:**                                               |       |                                       |       |   |   |
| Redemptions  of held to maturity investments                                            |       | 538,000                                    |       | 623,000 |   |
| Purchases  of held to maturity investments                                              |       | —                                     |       | (752,000 | ) |
| Purchase  of fixed assets                                                               |       | (19,000                                    | )          | (128,000 | ) |
| Net  cash provided (used) by investing activities                                       |       | 519,000                                    |       | (257,000 | ) |
|                                                                                    |       |                                       |       |   |   |
| **Cash flows from financing activities:**                                               |       |                                       |       |   |   |
| Issuance  of common stock                                                               |       | 63,000                                     |       | — |   |
| Net  cash provided by financing activities                                              |       | 63,000                                     |       | — |   |
|                                                                                    |       |                                       |       |   |   |
| **Net increase (decrease) in cash and cash  equivalents**                               |       | 771,000                                    |       | (880,000 | ) |
| ** **                                                                              |       |                                       |       |   |   |
| **Cash and cash equivalents, beginning**                                                |       | 3,890,000                                  |       | 4,304,000 |   |
| ** **                                                                              |       |                                       |       |   |   |
| **Cash and cash equivalents, ending**                                                   |       | $                                          | 4,661,000  |   | $ | 3,424,000 |   |
| ** **                                                                              |       |                                       |       |   |   |
| **Supplemental disclosure of cash flow  information:**                                  |       |                                       |       |   |   |
| Cash  received during the period for:                                                   |       |                                       |       |   |   |
| Income  taxes                                                                           |       | $                                          | —     |   | $ | — |   |
| Cash  paid during the period for:                                                       |       |                                       |       |   |   |
| Income  taxes                                                                           |       | $                                          | 7,000      |   | $ | — |   |
| Interest                                                                                |       | $                                          | —     |   | $ | — |   |

 

See accompanyingnotes to consolidated financial statements.

 

5

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**SPORT-HALEY,INC.**

**NOTES TO FINANCIAL STATEMENTS**

 

**NOTE 1****                                        CONDENSEDFINANCIAL STATEMENTS**

 

The unaudited financialstatements included herein have been prepared by Sport-Haley, Inc. (the “Company”),in accordance with accounting principles generally accepted in the UnitedStates of America for interim financial statements and in accordance with theinstructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly,they do not include all of the information and disclosures required bygenerally accepted accounting principles for complete financial statements. Inthe opinion of the Company’s management, all adjustments (consisting of normalrecurring accruals) necessary for fair presentation have been included. TheCompany’s revenues are seasonal, and therefore the results of operations forthe three months ended September 30, 2004 may not be indicative of theresults for the full fiscal year. For further information, refer to thefinancial statements and footnotes thereto for the year ended June 30,2004, included in the Company’s filing on Form 10-K.

 

**NOTE 2****                                        INVENTORIES**

 
| ** **                                         | ** ** | **September 30,  2004** | ** ** | **June 30,  2004** | ** ** |
|----------------------------------------------------|------------|------------------------------|------------|-------------------------|------------|
| Inventories  consisted of the following: Component |       | $                            | 315,000    |                    | $          | 470,000 |   |
| Finished  goods                                    |       | 8,512,000                    |       | 8,338,000               |       |
|                                               |       |                         |       |                    |       |
|                                               |       | $                            | 8,827,000  |                    | $          | 8,808,000 |   |

 

**NOTE 3****                                        COMMITMENTSAND CONTINGENCIES**

 

At September 30, 2004,the Company had $395,000 in outstanding letters of credit that were issued toforeign suppliers in accordance with finished goods inventory purchasecommitments.

 

In September 2004, theCompany’s Chairman died. The employment agreement between the Company and theChairman entitled the Chairman’s estate to receive, as a death benefit,severance compensation in a lump sum amount equal to three times the annualsalary and bonus paid to the Chairman in the twelve months preceding his death.The late Chairman received salary of $170,000 over the previous year and nobonus. A dispute with the Chairman’s estate ensued concerning the amount ofseverance and other matters relating to the Chairman’s employment agreement.The Chairman’s estate demanded a higher severance amount and other compensationwhich it claimed was also due under the agreement. The Board of Directorsnegotiated an agreement in compromise with the Chairman’s estate regarding thedeath benefit amount and the other disputed compensation. In accordance withthe terms of the settlement agreement for this matter, the Company paid thelump sum amount of $650,000 to the Chairman’s estate in October 2004.Accordingly, the Company recorded compensation expense in the amount of$650,000 during the fiscal quarter ended September 30, 2004.

 

6

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**NOTE 4****                                        REPURCHASEOF COMMON STOCK**

 

As of September 30, 2004,the Company’s Board of Directors had authorized the repurchase of up to 2,820,000shares of the Company’s issued and outstanding common stock. The shares may berepurchased from time to time in open market transactions at prevailing marketprices or in privately negotiated transactions. The Company has no commitmentto repurchase all or any portion of the shares. All shares repurchased by theCompany are required to be canceled and returned to the status of authorizedbut unissued common stock.

 

From the inception of therepurchase plan through September 30, 2004, the Company had repurchased atotal of 2,512,800 shares of its common stock at a cumulative cost of$13,488,000. The Company did not repurchase any shares of its common stockduring the quarter ended September 30, 2004.

 

**NOTE 5****                                        STOCK-BASEDCOMPENSATION**

 

The Company’s Stock OptionPlan (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 September 30, 2004, there were outstanding options to purchase1,074,515 shares of the Company’s common stock at exercise prices ranging from$2.71 to $9.78 per share and expiration dates between March 2005 and January 2013.

 

The Company accounts for stock-based compensationusing the intrinsic value method prescribed in Accounting Principle BoardOpinion No. 25, “*Accounting for Stock Issuedto Employees*,” and related interpretations. The Company has electedto apply the disclosure-only provisions of Statement of Financial AccountingStandards (SFAS) No. 123, “*Accounting forStock-Based Compensation*,” as amended by SFAS No. 148, “*Accounting for Stock-Based Compensation – Transitionand Disclosure*.” Under the intrinsic value method, compensationexpense for stock options is recognized over the vesting period of the grantbased on the excess, if any, of the market price of the Company’s common stockat the date of grant over the stock option exercise price. As governed by thePlan, stock options were generally granted at or near fair market value on thedate of grant.

 

If the Company had accounted for stock-basedcompensation using the fair value method rather than the intrinsic valuemethod, the pro forma amounts of the Company’s net loss and loss per commonshare would have been reported as follows:

 

7

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| ** **                                                                            | ** ** | **Three Months Ended September 30,** | ** ** |
|---------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                            | ** ** | **2004**                                  | ** ** | **2003** | ** ** |
| ** **                                                                            | ** ** | ** **                                | ** ** | ** ** | ** ** |
| Net  loss - as reported                                                               |       | $                                         | (1,276,000 | ) | $ | (161,000 | ) |
| Effect  of employee stock-based compensation included in reported net loss            |       | 16,000                                    |       | 19,000 |   |
| Effect  of employee stock-based compensation per SFAS 123                             |       | (106,000                                  | )          | (66,000 | ) |
| Net  loss applicable to common stock - pro forma                                      |       | $                                         | (1,366,000 | ) | $ | (208,000 | ) |
|                                                                                  |       |                                      |       |   |   |   |   |
| Basic  and Diluted:                                                                   |       |                                      |       |   |   |
| Loss  per share - as reported                                                         |       | $                                         | (0.52      | ) | $ | (0.07 | ) |
| Per  share effect of employee stock-based compensation included in reported net  loss |       | 0.00                                      |       | 0.01 |   |
| Per  share effect of employee stock-based compensation per SFAS 123                   |       | (0.04                                     | )          | (0.03 | ) |
| Loss  per share applicable to common stock - pro forma                                |       | $                                         | (0.56      | ) | $ | (0.09 | ) |

 

**NOTE 6****                                        EARNINGSPER SHARE**

 

Effectivewith the year ended June 30, 1998, the Company adopted the provisions ofStatement of Financial Accounting Standards No. 128 (SFAS No. 128), *Earnings per Share*. SFAS No. 128 requires the presentationof basic and diluted earnings (loss) per common share. The following tableprovides a reconciliation of the numerator and denominator of basic and dilutedearnings (loss) per common share:

 
| ** **                             | ** ** | **Three Months ended September 30, 2004** | ** ** |
|----------------------------------------|------------|------------------------------------------------|------------|
|                                   | ** ** | **Net  Loss**                                  | ** ** | **Weighted  Average Shares** | ** ** | **Per Share** | ** ** |
| Loss  Per Common Share                 |       |                                           |       |   |   |   |   |
|                                   |       |                                           |       |   |   |   |   |
| Basic  loss per share                  |       | $                                              | (1,276,000 | ) | 2,456,215 |   | $ | (0.52 | ) |
|                                   |       |                                           |       |   |   |   |   |
| Effect  of dilutive securities options |       | —                                         |       | — |   | — |   |
|                                   |       |                                           |       |   |   |   |   |
| Diluted  loss per share                |       | $                                              | (1,276,000 | ) | 2,456,215 |   | $ | (0.52 | ) |

 

8

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| ** **                             | ** ** | **Three Months ended September 30, 2003** | ** ** |
|----------------------------------------|------------|------------------------------------------------|------------|
| ** **                             | ** ** | **Net  Loss**                                  | ** ** | **Weighted  Average Shares** | ** ** | **Per Share** | ** ** |
| Loss  Per Common Share                 |       |                                           |       |   |   |   |   |
|                                   |       |                                           |       |   |   |   |   |
| Basic  loss per share                  |       | $                                              | (161,000   | ) | 2,444,585 |   | $ | (0.07 | ) |
|                                   |       |                                           |       |   |   |   |   |
| Effect  of dilutive securities options |       | —                                         |       | — |   | — |   |
|                                   |       |                                           |       |   |   |   |   |
| Diluted  loss per share                |       | $                                              | (161,000   | ) | 2,444,585 |   | $ | (0.07 | ) |

 

Due to the Company’s netlosses, all options were antidilutive and therefore excluded from the loss pershare calculations.

 

9

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**SPORT-HALEY,INC.**

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

 

This Report on Form 10-Q contains certain forward-looking statements,within the 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 of these words or the negative of those words, and, anystatement regarding possible or assumed future results of operations of theCompany’s business, the markets for its products, anticipated expenditures,regulatory developments or competition, or other statements regarding mattersthat are not historical facts, are intended to identify forward-lookingstatements, although not all forward-looking statements contain suchidentifying words. The reader should be aware that our actual results coulddiffer materially from those contained in forward-looking statements. TheCompany’s financial condition and the results of its operations will depend ona number of factors, including, but not limited to, the following: our abilityto control costs and expenses; our ability to successfully anticipate fashiontrends, design favorably accepted fashion golf apparel, effectively advertiseand communicate within the marketplace, and penetrate our chosen distributionchannels; risks associated with the trend of increasing sales with respect tolicensed apparel, such as the Ben Hogan® apparel collections; relations withand performance of suppliers; competition within golf apparel markets; businessconditions and growth in the fashion golf apparel market and the generaleconomy; political and international trade relations; changes in internationaltrade quota systems for apparel; consumer spending on golf apparel; generalglobal economic and political conditions resulting from threats or acts of waror terrorism and responses thereto; timely performance of third parties, such asfreight forwarders, including risks of labor disputes and/or labor strikes;changes in product mix; inventory risks due to shifts in market and/or priceerosion of purchased apparel; lost or reduced manufacturing capacity ofsignificant suppliers; loss or delay of shipments from foreign suppliers;access to capital; maintaining satisfactory relationships with commercialbanking institutions; and, establishing controls with regard to and maintainingthe integrity of technology and information systems. Additional information onthese and other factors that could affect the Company’s financial results isincluded in the discussion below and in the Company’s Form 10-K for the yearended June 30, 2004. There may be other factors not mentioned above, inthe 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 the Company’s fiscalyear, which ends on June 30.

 

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##### **OVERVIEW**

##### ** **

##### **Sport-Haley, Inc. designs,purchases, contracts for the manufacture of and markets quality men’s and women’sfashion golf apparel and outerwear under the HALEY® label and premium men’sapparel under the Ben Hogan® label. HALEY® fashion golf apparel, known for itsinnovative design, quality fabrics, generous fit and classic style, isprimarily marketed in the premium and mid-priced markets through a network ofindependent sales representatives and distributors to golf professional shops,country clubs and resorts across the United States and internationally. BenHogan® apparel is primarily marketed to elite golf professional shops, upscaleresorts and exclusive department stores within the United States and by certaininternational distributors. The Company distributes Ben Hogan® apparel pursuantto a licensing agreement with Callaway Golf Company.**

##### ** **

The Company isrepresented by a network of independent wholesale sales representatives andemploys a vice-president of sales and two regional sales managers, each withresponsibilities for both of the Company’s branded labels of apparel. Most ofthe independent wholesale sales representatives solicit sales of both HALEY®and Ben Hogan® apparel on behalf of the Company.

 

We believe that our saleson the more mature HALEY® brand have been negatively affected by the economicconditions and other market factors faced by our customers in the golfindustry. Per conversations with a few of the Company’s long-time customers,golf professional shops are currently placing less of an importance on stockingwomen’s golf apparel collections. A decline in the market for women’s fashiongolf apparel can affect us more than other companies in the golf apparelindustry, because, while, according to a recent industry-related survey, thegolf apparel market is basically comprised of 75% men’s apparel and 25% women’sapparel,  historically, sales of HALEY®apparel have typically been comprised of 30% men’s apparel and 70% women’sapparel.

 

The Company continues tofocus on stabilizing revenues associated with the HALEY® brand and growth ofrevenues associated with the Ben Hogan® brand. We recently discontinuedmarketing HALEY® men’s fashion apparel, in part, because we believe that thereare natural synergies common to Ben Hogan® men’s fashion apparel and HALEY®women’s fashion apparel. By marketing HALEY® women’s apparel in conjunctionwith Ben Hogan® men’s apparel, we are attempting to maintain our market sharewith current women’s apparel customers and expect to expand the distributionchannels for fashion women’s apparel into markets that we had previously onlybeen able to penetrate via the marketing of Ben Hogan® men’s apparel.

 

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##### **RECENT DEVELOPMENTS**

##### ** **

Aspreviously reported, the Company began utilizing a new comprehensive computersystem in January 2004 that was specifically designed for the garment industryand further tailored to our business operations. While each function of the newsystem was tested during the design and implementation phases of the project,certain design, implementation and operational deficiencies have beendiscovered since the system was first utilized. Certain of the operationaldeficiencies continued to affect our business operations throughout this fiscalquarter.

 

Previously,we reported that we discovered programming and human errors that had affectedthe system’s ability to properly compute the valuation of our finished goodsinventories. The computer system was designed and tailored to account for ourfinished goods inventories using a weighted average cost method. Due to thecomplexity of the transactions recorded within the functions of the computersystem and various human errors that we discovered, we were not able tospecifically quantify the financial effects at March 31 or June 30,2004, with regard to errors recorded in the system that affected the per itemcost valuations of our finished goods inventories. Therefore, we recomputed theestimated value of our finished goods inventories at March 31 and June 30,2004, using a standard cost assumption. We performed an analysis to compareactual landed costs of our finished goods inventories with their respectivestandard costs, and we believe that the standard cost valuations calculated at March 31and June 30, 2004, yielded fair estimations of our finished goodsinventories at those dates.

 

InOctober 2004, we discovered a malfunction in one of the computer systemprocedures we performed in September 2004 in an attempt to correct the peritem cost valuations of our finished goods inventories. Our softwareconsultants were requested to perform a review of the failed system procedureto determine the reason for the malfunction and to recommend how we shouldcorrect the problem. The software consultants have informed us that they cannotdetermine why the system malfunctioned during the procedure and have deferredthe problem to the software developers for advice.

 

Themalfunction affected the computer system’s ability to accurately compute peritem valuations of certain of our finished goods inventories. Therefore, at September 30,2004, we computed the estimated value of our finished goods inventories using astandard cost assumption. Because of the analysis we performed in September 2004to compare actual landed costs of our finished goods inventories with theirrespective standard costs as of June 30, 2004, we believe that thestandard cost valuation calculated at September 30, 2004, yielded a fairestimation of our finished goods inventories at that date.

 

Weconsider the system malfunction with respect to the computation of per itemvaluations of finished goods inventories to be an indication of a materialweakness in our internal control structure with respect to inventory valuation.Our software consultants have been informed that we consider this malfunctionto be a serious matter that requires immediate attention, and they appear to betaking the appropriate steps to correct the problem. However, because theconsultants referred the malfunction to the software developers, we cannotdetermine at this time how long it will take to correct this problem.

 

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Aspreviously reported, in September 2004, we authorized the softwareconsultants to perform a review and analysis of the processes performed withinthe new computer system. The consultants subsequently identified and adjustedcertain aspects of the system in order for us to operate more efficiently, andthe consultants prepared a written analysis of the major processes that weutilize, which included certain recommendations for future system enhancements.We plan to use the consultants’ written analysis and recommendations to planand coordinate the retraining of our management and employees as soon asadministratively feasible, thereby strengthening our internal controls withrespect to our business operations, including our controls with respect tofinished goods inventories.

 

**CRITICAL ACCOUNTING POLICIES ANDESTIMATES**

 

The Company’s interimfinancial statements have been prepared in accordance with accountingprinciples generally accepted in the United States of America, which requirethe Company to make estimates and judgments that affect the reported amounts ofassets, liabilities, revenues and expenses, and the related disclosures. Asummary of our significant accounting policies can be found in the Notes to ourConsolidated Financial Statements included in our Report on 10-K for the yearended June 30, 2004, which was filed with the SEC on October 13, 2004.The estimates used by management arebased upon the Company’s historical experiences combined with our understandingof current facts and circumstances. Certain of the Company’s 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 thefollowing critical accounting policies affect the more significant judgmentsand estimates used in the preparation of our financial statements.

 

Inventories,predominantly comprised of finished goods, are valued at the lower of cost ormarket. Excess finished goods inventories are a natural component of a seasonalapparel business. While certain finished goods items will sell out in anyparticular selling season, quantities of other finished goods items will remainat the end of each selling season. We market previous seasons’ finished goodsinventories at reduced wholesale prices to our customers in the normal courseof business. Remaining excess inventories are liquidated through other markets.Excess finished goods inventories may have more of an adverse effect on theresults of our operations than realized by other companies within the golfapparel industry. While, according to a recent industry-related survey, thegolf apparel market in total is generally comprised of 75% men’s apparel and25% women’s apparel, our sales for fiscal 2004 were generally comprised of 60%men’s apparel and 40% women’s apparel. A significant portion of our excessinventories are comprised of women’s apparel, which has a much smallerdistribution market than for men’s apparel.

 

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Weperform analyses on a quarterly basis to identify unsold discontinued or agingmerchandise and adjust our inventory valuation allowance to reduce the carryingvalue of discontinued or aging merchandise to its estimated net realizablevalue. The net realizable value of the discontinued or aging merchandise isestimated based on our disposition plans and historical experiences. In theordinary course of business, we maintain reserves for inventory write-downs dueto the obsolescence of discontinued or aging merchandise. We have a significantamount of prior seasons’ finished goods inventories, and, in October 2004,the Company set a goal to attempt to arrange for the disposal of a majority ofour prior seasons’ inventories by December 31, 2004. This goal caused usto accelerate our disposition plans and to revise our analysis with respect tothe valuation of discontinued or aging inventories, accordingly. Therefore, asof September 30, 2004, we recorded finished goods inventories write-downsof $543,000. We believe that our processes produce a fair valuation of obsoleteinventories, but, if actual market conditions are less favorable than those wehave projected, additional allowances may be required or losses on dispositionsmay be recorded.

 

Deferred income taxes are recognized for the expected tax consequencesin future years for differences between the tax bases of assets and liabilitiesand their financial reporting amounts, based upon enacted tax laws andstatutory tax rates applicable to the periods in which the differences areexpected to affect taxable income. Our significant deferred tax assets arerelated to net operating loss carryforwards for federal and state income taxpurposes, a change in accounting methods for federal income tax purposes, stockoptions compensation and an unrealized loss for tax purposes on a common stockinvestment. Governing tax regulations require that our operating losses be carriedforward for state income tax purposes. We have established a valuationallowance to reduce deferred tax assets to the net amount expected to berecovered in future periods. The estimates for deferred tax assets and thecorresponding valuation allowance require us to exercise complex judgments. Weperiodically review and adjust those estimates based upon the most currentinformation available. Because of the Company’s trend of net losses in thecurrent and most recent prior years, we believe that it is more probable thannot that none of our net deferred tax assets will be recovered. Therefore, weadopted a policy at June 30, 2004, to maintain a valuation allowance that effectivelyreduces our net deferred tax assets to zero. However, because the recoverabilityof deferred tax assets is directly dependent upon future operating results,actual recoverability of deferred tax assets may differ materially from ourestimates.

 

The Company’s allowancefor doubtful accounts reflects a reserve that reduces 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. Analyses of our accounts receivable that we performed throughoutfiscal 2004 indicated an increase in the percentage of doubtful accounts.Therefore, we increased our estimates for the percentage of doubtful accountsaccordingly. From time to time, we also identify delinquent customer accountsfor which a specific reserve is required. At June 30, 2004, we establishedspecific reserves approximating $175,000 with respect to two separatedelinquent customer accounts. At September 30, 2004, our allowance fordoubtful accounts was approximately $450,000, including the two specificreserves. While we consider our processes to be adequate to effectivelyquantify our exposure to doubtful accounts, changes in economic, industry orspecific customer conditions may result in a recoverability of doubtfulaccounts that differs materially from our estimates.

 

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We record an allowance for sales returns as a net adjustment tocustomer accounts receivable. When recording an allowance, the net methodreduces customer accounts receivable and net sales by the estimated grossmargin effect of the anticipated sales return. Generally, our selling termspreclude the return of our products subsequent to the sale. However, we havetraditionally maintained limited programs that offer some customers the rightto return certain finished goods items under predefined conditions, and,historically, a relatively small percentage of our customers refuse receipt ofmerchandise at the time of delivery. We review historical data and considerfactors such as general economic and industry-specific conditions andanticipated customer performance when evaluating our allowance for salesreturns. At September 30, 2004, our allowance for sales returns wasapproximately $342,000. Beginning with the fall 2004 selling season, theCompany began offering its independent wholesale sales representatives theright to return sample garments to the Company at no charge to the salesrepresentative. Previously, the Company invoiced the sales representatives forsample garments at discounted wholesale prices. Because of the right of returnoffered to the sales representatives with regard to sample garments, we electedto record invoiced sales of sample garments to sales representatives in amanner consistent with consigned inventories. Therefore, beginning with thefall 2004 selling season, we include the cost of sample garments in finishedgoods inventories as consigned inventories and record an allowance tocompletely offset the revenue effect of the sale of sample garments. The salesrepresentative’s accounts receivable balance, the related allowance for salesrepresentative samples and the related inventory costs are adjusted when eitherthe sales representative reimburses the Company for the cost of sample garmentsor the garments are returned to the Company. At September 30, 2004, the Company’sallowance for returns of sales representatives sample garments wasapproximately $561,000. Significant changes in general economic or industryconditions may yield sales returns that differ materially from management’sestimates.

### ** **

### **LIQUIDITY AND CAPITAL RESOURCES**

 

The golf apparel business is highly seasonalin nature. Therefore, the balance sheet amounts as of September 30, 2004 may bemore meaningful when compared with the balance sheet amounts as of September30, 2003, rather than with the balance sheet amounts at June 30, 2004.

 

Our primary sources of liquidity arecomprised of available cash and cash equivalents, cash flows from operationsand a working capital line of credit with a commercial bank. We require cashfor general working capital purposes. We do not anticipate the requirements ofmaterial amounts of cash for capital expenditures over the remainder of thecurrent fiscal year. Our working capital requirements are highly seasonal innature, with greater requirements from approximately August through October andFebruary through April of each fiscal year, due to the purchases of finishedgoods inventories for the spring/summer and fall/holiday selling seasons,respectively.

 

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Our net accounts receivable decreased by$1,703,000 to $4,243,000 at September 30, 2004, from $5,946,000 at June 30,2004. Because of the seasonal nature of the ourbusiness, the net accounts receivable balance at September 30, 2004 may be moremeaningfully compared with the September 30, 2003, balance of $3,880,000,rather than with the June 30, 2004, balance. When compared with the September30, 2003, balance, the net accounts receivable balance at September 30, 2004,increased by $363,000, or 9%, as compared with an increase of approximately$1,258,000, or 29%, in net sales for the comparative fiscal quarters.Historically, our net sales are weakest during our first fiscal quarter, andour net accounts receivable balance generally declines during our first fiscalquarter when compared with the balance at the previous fiscal year end. While alarge portion of our fourth fiscal quarter sales are shipped in the month ofJune each year, sales are generally shipped more evenly throughout our firstfiscal quarter. Because a large portion of our sales are shipped with Net 30payment terms, our collections are generally greater than our sales during ourfirst fiscal quarter, because a significant portion of our June sales aregenerally collected by September 30 each year. Changes in our accountsreceivable balances provided operating cash of $1,643,000 and $824,000 for thefiscal quarters ended September 30, 2004 and 2003, respectively.

 

The balances of our inventories have remainedrelatively the same since June 30, 2004. As discussed in “Recent Developments”above, we recomputed the valuation of our finished goods inventories atSeptember 30, 2004, using a standard cost assumption. Because of the seasonalnature of our business, the inventories balance at September 30, 2004, may bemore meaningfully compared with the balance at September 30, 2003, rather thanwith the June 30, 2004 balance. Our finished goods inventory levels generallyincrease during our first fiscal quarter, because we generally receive a largepercentage of our initial orders for the following spring seasons’ merchandiseby September 30 each year. We generally begin shipping spring seasonmerchandise in November of each year. When compared with the balance atSeptember 30, 2003, our finished goods inventories decreased by $420,000, or5%, to $8,512,000 at September 30, 2004, from $8,932,000. The decrease isprimarily attributable to the $543,000 adjustment to our allowance forinventory obsolescence that we recorded at September 30, 2004, combined withthe difference between the periods in pending ocean deliveries of finishedgoods. Pending ocean deliveries of finished goods approximated $317,000 atSeptember 30, 2004, and $1,488,000 at September 30, 2003, respectively. Changesin our inventory balances used operating cash of $550,000 and $1,596,000 forthe fiscal quarters ended September 30, 2004 and 2003, respectively.

 

Our continued reliance on foreign supplierssustains the risk that our revenues could be adversely affected if a foreignshipment or shipments were received late or lost. We maintain insurance forrisk of loss relating to goods shipped from its foreign and domestic suppliers.However, our predominant reliance upon foreign suppliers, and significantreliance on two separate foreign suppliers, also sustains the risk that wewould be left with inadequate or unsatisfactory recourse should the goodsreceived from a foreign supplier be nonconforming. Due to a combination ofseveral factors, during the three months ended September 30, 2004, ouroperating activities provided cash of $189,000. Comparatively, during the threemonths ended September 30, 2003, our operating activities used cash of$623,000.

 

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For the threemonths ended September 30, 2004, investing activities provided cash of$519,000. Comparatively, for the three months ended September 30, 2003,investing activities used cash of $257,000. Our cash flows from investingactivities are primarily derived from purchases and redemptions ofheld-to-maturity investments. Generally, our held-to-maturity investmentsconsist of short-term federal agency securities. During the three months endedSeptember 30, 2004, we expended $19,000 for the purchase of property andequipment, and $86,000 in depreciation and amortization was charged to currentoperations.

 

Accounts payable and accrued expensesdecreased by $360,000 to $1,788,000 at September 30, 2004, from $2,148,000 atJune 30, 2004. Because of the seasonal nature of the Company’s business, theaccounts payable and accrued expenses balance at September 30, 2004, may bemore meaningfully compared with the balance of $1,365,000 at September 30,2003, rather than with the June 30, 2004, balance. The increase of $423,000 incurrent liabilities when comparing the balance at September 30, 2004, with thebalance at September 30, 2003, primarily related to the accrual of severanceand other compensation payable to the estate of our deceased Chairman. Aspreviously reported, in accordance with the terms of a settlement agreement, wepaid the lump sum of $650,000 to the Chairman’s estate in October 2004.Accordingly, we recorded compensation expense in the amount of $650,000 duringour fiscal quarter ended September 30, 2004.

 

The Company maintains a line of credit with acommercial bank, primarily to facilitate the issuance of letters of credit forinventory purchases from offshore suppliers. Outstanding letters of creditreduce the amount available for borrowing under the line of credit agreement.As of September 30, 2004, the Company was in violation of a loan covenant forthis debt instrument, which requires the Company to maintain total capital ofat least $18,500,000. We have spoken with the bank representative assigned toour accounts, and we believe, but can give no assurance, that the bank willissue a waiver of this breach.

 

We believe that cash on hand and cashgenerated from operations, as well as the ability to borrow under the bank lineof credit, will be sufficient to meet our cash requirements during theremainder of fiscal 2005. We also have alternative sources of financing,including the factoring of customer accounts receivable. Although they areavailable to the Company, we do not anticipate using alternative sources offinancing during the remainder of fiscal 2005. However, our capital needs willdepend on many factors, including the Company’s growth rate, the need tofinance required inventory levels, the success of various sales and marketingprograms, expenses related to the defense of pending law suits and variousother factors.

 

### **RESULTS OF OPERATIONS**

 

The Company’s business is seasonal in nature,with disproportionately higher sales occurring from January through June, whichare the Company’s third and fourth quarters of each fiscal year.

 

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Net sales for the first fiscal quarter endedSeptember 30, 2004, were approximately $5,570,000, an increase of approximately$1,258,000, or 29%, from net sales of $4,312,000 for the same quarter in theprior fiscal year. We attribute the increase in net sales to factors such asthe continued growth of Ben Hogan® apparel collections within upscale golfapparel markets combined with a continued decrease in sales of HALEY® brandedapparel. The decline in sales of HALEY® branded apparel has been a concern forthe last several quarters. Historically, sales of our HALEY® apparel have beendisproportionately comprised of greater sales of women’s apparel than of men’sapparel. The decline in HALEY® sales appears to be a result of a shrinkingmarket for women’s golf apparel combined with our inability to maintain ourprevious market share within men’s golf apparel markets. As we previouslyreported, declining sales of our HALEY® branded men’s apparel caused us, inpart, to decide to discontinue marketing fashion golf apparel under the HALEY®label effective with the spring 2005 selling season.

 

Net sales of Ben Hogan® apparel collectionswere $2,698,000 and $1,326,000 for the three months ended September 30, 2004and 2003, respectively. The increase of $1,372,000, or 103%, is indicative ofour efforts to maximize revenues with regard to licensed apparel. Ben Hogan®apparel is marketed in accordance with a licensing agreement we maintain withCallaway Golf Company (“Callaway”) for such apparel. We consider the licensingagreement with Callaway to be a key component of our business strategies. Whilewe strive to maintain a good working relationship with Callaway, the trend forthe last several periods, reflecting a continued increase in sales of licensedapparel, sustains a risk of loss, should the licensing agreement with Callawaybe terminated by either party.

 

The Company’s gross profit, as a percentage of net sales, was 32% forthe quarter ended September 30, 2004, and 38% for the same quarter in the priorfiscal year. The decrease in gross profit percentages is primarily attributableto the buildup in closeout inventories that must be sold at reduced prices. Asdiscussed above, the buildup in closeout inventories caused our gross margin inthe fiscal quarter ended September 30, 2004, to be impacted by thecorresponding increase of $543,000 in an inventory valuation allowance fordiscontinued and aging merchandise. We did not record an inventory valuationcharge during the fiscal quarter ended September 30, 2003. The disposal ofcloseout inventories negatively impacts our gross margins, because even if thecloseout inventories are properly valued to the lower of cost or market, salesof large quantities of closeout inventories are normally marketed for sale atzero margins. Similarly, our second quarter margins may also be negativelyimpacted, because we anticipate that a material amount of closeout inventoriesmay be disposed within that fiscal quarter.

 

Our gross margins may not be comparable to other companies within thegolf apparel industry. We have consistently included the cost of merchandisesold, including import charges, in-bound freight, allocated overhead,freight-out, embroidery costs and other charges in our cost of goods sold. We includeother costs of distribution in selling, general and administrative expenses. Wealso include royalty payments, relating to sales of licensed apparel, inselling, general and administrative expenses.

 

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Selling, general and administrative expensesincreased by $1,112,000, or 57%, to $3,057,000 for the fiscal quarter endedSeptember 30, 2004, from $1,945,000 for the same quarter in the prior fiscalyear. The increase was primarily attributable to the accrual of $650,000 inseverance and other compensation payable to our late Chairman’s estate andincreasing selling, general and administrative expenses with respect to BenHogan® apparel which included increases in sales commissions and royaltiespayable on higher net sales. We are concerned by the trend that indicates acontinuing increase in our selling, general and administrative expenses andplan to perform a detailed analysis of individual categories of such expensesduring our second fiscal quarter. As a percentage of net sales, selling,general and administrative expenditures were approximately 55% and 45% for thequarters ended September 30, 2004 and 2003, respectively.

 

Loss before benefit from income taxes for thethree months ended September 30, 2004, was ($1,276,000), a difference of($1,025,000), or 408%, as compared with ($251,000) for the same period in theprior fiscal year. Benefit from income taxes was $0 for the three months endedSeptember 30, 2004, a difference of ($90,000) from $90,000 for the same periodin the prior fiscal year. Net loss for the three months ended September 30,2004, was ($1,276,000), a difference of ($1,115,000), or 693%, as compared with($161,000) for the same period in the prior fiscal year. The difference in benefitsfrom income taxes between the fiscal periods arose primarily because of achange in estimates between the periods with regard to the recoverability ofdeferred tax assets. Because of our continued trend of net losses in the 2004and most recent prior fiscal years, at June 30, 2004, we determined that it wasmore probable than not that none of our net deferredtax assets would be recovered, and we increased our valuation allowance toeffectively reduce our net deferred tax assets to zero. Therefore, at September30, 2004, we did not record a benefit from income taxes associated with thecorresponding loss for the three-month period.

 

Both the basic and diluted losses per share were ($0.52) for thequarter ended September 30, 2004. Both the basic and diluted losses per sharewere ($0.07) for the same quarter in the prior fiscal year.

 

Our book value per share was $6.85 at September 30, 2004, $7.37 at June30, 2004, and $8.30 at September 30, 2003.

 

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**SPORT-HALEY, INC.**

**ITEM 3QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK**

 

Market risk represents the risk of loss that may impact the financialposition, results of operations or cash flows due to adverse changes infinancial and commodity market prices and rates. We are exposed to market riskwith regard to changes in United States interest rates. This exposure isdirectly related to our normal operating and funding activities. Historically,and as of September 30, 2004, we have not used derivative instruments orengaged in hedging activities. Our market risk has not changed significantlyfrom June 30, 2004.

 

**Interest Rate Risk**

 

The Company maintains a revolving line of credit agreement with acommercial bank. The revolving line of credit agreement provides for interestat 1⁄2% below the bank’s prime rate. The agreement provides for a maximum loanamount of $9,000,000 to Sport-Haley collateralized by a lien on substantiallyall of our assets. We generally maintain the line of credit to facilitate theissuance of letters of credit for inventory purchases from offshore suppliers,and, if necessary, to fund any temporary working capital needs. We did not haveany outstanding borrowings under the line of credit at September 30, 2004. Wehad outstanding letters of credit of approximately $395,000 at September 30,2004. Outstanding letters of credit reduce the amount available for borrowingunder the line of credit. Increases in the bank’s prime rate could, however,increase the interest expense with respect to future borrowings, includingborrowings under the line of credit. We do not use derivative financialinstruments 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****CONTOLS AND PROCEDURES**

 

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

 

Management of the Company, with the participation ofthe Interim Chief Executive Officer and the Chief Financial Officer, conductedan evaluation of the effectiveness of the Company’s disclosure controls andprocedures pursuant to Rule 13a-15 under the Securities Exchange Act of 1934 asof the end of the period covered by this report. Based on that evaluation,management, including the Interim Chief Executive Officer and the ChiefFinancial Officer, concluded that, as of the date of this report, the Company’sdisclosure controls and procedures were effective in ensuring 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)information was recorded, processed, summarized and reported within the timeperiods specified in the Securities and Exchange Commission’s rules andregulations.

 

**(b)  Changes in Internal Controls Over Financial Reporting**

 

During the first quarter of fiscal 2005, we did notinstitute any significant changes in internal controls over financial reportingthat materially affected, or are reasonably likely to materially affect, theCompany’s internal controls over financial reporting, except that certaindifficulties which were encountered in the prior two fiscal quarters relatingto the implementation and utilization of our new software system continuedduring the first fiscal quarter of 2005. The implementation and utilizationdifficulties encountered in this fiscal quarter related to errors recorded inthe system that affected the per unit cost valuations of our finished goodsinventories.

 

InOctober 2004, we discovered a malfunction in one of the computer systemprocedures we performed in September 2004 in an attempt to correct the per itemcost valuations of our finished goods inventories. Our software consultantswere requested to perform a review of the failed system procedure to determinethe reason for the malfunction and to recommend how we should correct theproblem. The software consultants have informed us that they cannot determinewhy the system malfunctioned during the procedure and have deferred the problemto the software developer for advice.

 

Themalfunction affected the computer system’s ability to accurately compute peritem valuations of certain of our finished goods inventories. Therefore, atSeptember 30, 2004, we computed the estimated value of our finished goodsinventories using a standard cost assumption. Because of the analysis weperformed in September 2004 to compare actual landed costs of our finishedgoods inventories with their respective standard costs as of June 30, 2004, webelieve that the standard cost valuation calculated at September 30, 2004, yieldeda fair estimation of our finished goods inventories at that date.

 

Weconsider the system malfunction with respect to the computation of per itemvaluations of finished goods inventories to be an indication of a materialweakness in our internal control structure with respect to inventory valuation.Our software consultants have been informed that we consider this malfunctionto be a serious matter that requires immediate attention, and they appear to betaking the appropriate steps to correct the problem. However, because theconsultants referred the malfunction to the software developer, we cannotdetermine at this time how long it will take to correct this problem.

 

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As previously reported, inSeptember 2004, we authorized the software consultants to perform a review andanalysis of the processes performed within the new computer system. Theconsultants subsequently identified and adjusted certain aspects of the systemin order for us to operate more efficiently, and the consultants prepared awritten analysis of the major processes that we utilize, which included certainrecommendations for future system enhancements. We plan to use the consultants’written analysis and recommendations to plan and coordinate the retraining ofour management and employees as soon as administratively feasible, therebystrengthening our internal controls with respect to our business operations,including our controls with respect to finished goods inventories.

 

As discussed in Part II, Item 5 - Other Information,in October 2004, the Board of Directors decided not to renew the executiveemployment agreement of Kevin M. Tomlinson, appointed Donald W. Jewell to actas Interim Chief Executive Officer and relieved Mr. Tomlinson of his duties asour Chief Executive Officer and President. Mr. Tomlinson subsequently resignedas a Director. As our Chief Executive Officer, Mr. Tomlinson was a primarydecision maker within the Company’s internal control structure. Because of hisdeparture, we are currently reassigning those portions of our internal controlprocedures, previously supervised by Mr. Tomlinson, to other of the Company’sofficers and key employees. In addition, we expect to redefine and strengthenour internal controls over financial reporting policies and procedures over thenext fiscal quarter.

 

The Company’s management, including the Interim ChiefExecutive Officer and the Chief Financial Officer, does not expect that theCompany’s disclosure controls and procedures or its internal controls overfinancial reporting will, in all instances, prevent all errors and all fraud. Acontrol system, no matter how well conceived or operated, can only providereasonable, not absolute, assurance that the objectives of the control systemare met. While the Company’s control systems provide a reasonable assurancelevel, the design of its control systems reflects the fact that there areresource constraints, and the benefits of such controls were consideredrelative to their costs. Because of the inherent limitations in all controlsystems, no evaluation of controls can provide absolute assurance that allcontrol issues and instances of fraud, if any, within the Company have beendetected. These inherent limitations include the realities that judgments indecision-making can be faulty, and that breakdowns can occur because of simpleerrors or mistakes. Additionally, a control may be circumvented by theindividual act of some person, by collusion of two or more persons, or bymanagement’s override of a specific control. The design of any system ofcontrols is also based in part on certain assumptions about the likelihood offuture events, and there can be no assurance that any design will succeed inachieving its stated goals under all potential future conditions. Because ofthe inherent limitations in a cost-effective control system, misstatements dueto error or fraud may occur and not be detected.

 

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**SPORT-HALEY, INC.**

**PART II**

**OTHER INFORMATION**

 

### **ITEM1**       LEGAL PROCEEDINGS

 

As previously reported, on September 26, 2003, the United StatesSecurities and Exchange Commission (the “Commission”) filed suit in the UnitedStates District Court for the District of Colorado (the “Action”) againstSport-Haley, its late Chairman and former Chief Executive Officer, Robert G.Tomlinson, and its former controller, Steve S. Auger (the “Defendants”). TheCommission filed an amended complaint in October 2003, which added one of theCompany’s former auditors to the Action as a Defendant. The suit seeks aninjunction against future violations and other relief, including disgorgement,civil penalties and an order barring Mr. Tomlinson and Mr. Auger from servingas a director or officer of any publicly held company. The suit alleges thatthe Defendants misrepresented inventories, period costs and losses on the saleof headwear equipment in annual and/or quarterly financial statements for ourfiscal years 2000, 1999 and 1998. The complaint alleges that the Company violated§17(a) of the Securities Act of 1933 (the “Securities Act”), §10(b), §13(b)(2) and §15(d) of the Securities Exchange Act of 1934 (the “ExchangeAct”) and various other rules promulgated thereunder. The amended complaintfurther alleges that Mr. Tomlinson and Mr. Auger violated §17(a) of theSecurities Act, §10(b) and §13(b)(5) of the ExchangeAct and Rules 10b-5 and 13b-2 thereunder. Finally, the suit alleges that Mr.Tomlinson and Mr. Auger aided and abetted the Company’s violations of §13(b)(2) and §15(d) of the Exchange Act and various rulespromulgated thereunder. The Commission’s suit primarily relates to errors inour previously issued financial statements that we previously reported when wevoluntarily restated our financial statements for fiscal years 1999 and 1998and subsequently corrected material financial information for the quarterlyperiods of fiscal years 2000, 1999 and 1998. The Defendants have answered theallegations of the amended complaint, denying the substantive allegations andasserting various defenses. Discovery in the Action has concluded. No trialdate has yet been determined. The Company, subject to its Bylaws and Coloradolaw, agreed to indemnify Mr. Tomlinson and Mr. Auger, and we have advanced thecosts of their defenses, pending final adjudication of the Action. The costs ofdefense of the Action by the Defendants are covered by our applicable liabilityinsurance, subject to a retention amount, which has beensatisfied, and other limitations. The Defendants intend to vigorouslydefend the Commission’s allegations, which the Defendants believe are withoutmerit. Based upon the information that is currently available, we cannotreasonably estimate the amount of future costs that we will incur defending theAction. However, if the suit were determined in favor of the Commission andagainst the Defendants, the possible monetary penalties and other relief thatwe might be required to pay could negatively impact our financial position andthe results of our operations.

 

As of September 30, 2004, we had cumulatively incurred approximately$1,060,000 in expenses related to the restatements of our financial statementsand material quarterly information, the investigation by the Commission and aclass action lawsuit that has been settled. The policy retention for such costshas been satisfied, and one of our insurance carriers had reimbursed usapproximately $287,000 as of September 30, 2004. Amounts recovered from ourinsurance carriers are either offset against other legal expenses or includedas other income in the period(s) in which they are recovered.

 

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As previously reported, we retained legal counsel to possibly pursueclaims against our former auditors in connection with damages suffered as aresult of the restatements of our financial statements for the fiscal yearsended June 30, 1999 and 1998 and the corrections of material financialinformation for the quarterly periods of the fiscal years ended June 30, 2000,1999 and 1998. Further, counsel to the former auditors has advised us that theformer auditors may bring certain claims against us. We believe that the claimsthreatened by the former auditors relate to allegations of unpaid fees. Eachparty continues to deny any liability to the other party. Neither the Companynor the former auditors have yet filed any legal action to assert any of theseclaims.

 

We are subject to various other legal proceedings and claims whicharise in the ordinary course of business. Based upon information that iscurrently available, we do not believe that the total impact of the other legalproceedings will materially affect our financial position or the results of ouroperations.

 

### **ITEM5**       OTHER INFORMATION

 

OnOctober 18, 2004, our Board of Directors approved a resolution not to renew theexecutive employment agreement of Kevin M. Tomlinson, our Chief ExecutiveOfficer, President and Director, beyond the end of the term of the agreement onMarch 17, 2005. The Board and Mr. Tomlinson agreed that he would continue toact as Chief Executive Officer and President until a new or interim chiefexecutive officer was appointed or the end of the term of his employmentagreement, whichever occurred first. In accordance with the resolution, Mr.Tomlinson was to continue to serve as a Director.

 

OnOctober 29, 2004, our Board of Directors appointed Donald W. Jewell, our SeniorVice President, to act as our Interim Chief Executive Officer until a permanentchief executive officer is appointed. Accordingly, Mr. Jewell assumed theposition of Interim Chief Executive Officer and Mr. Tomlinson stepped down fromhis duties as Chief Executive Officer and President. The terms of an executiveemployment agreement with Mr. Tomlinson require the payment of severance andother compensation as a result of the Company’s non-renewal of the agreement,as described above. Under the terms of the agreement, Mr. Tomlinson is entitledto severance compensation for a term of 36 months equal to his salary andincentive bonus payments as shall have been paid to him during the most recenttwelve-month period. In addition, the agreement provides for Mr. Tomlinson’sparticipation in all employee benefit plans, at the Company’s expense, duringthe time he is receiving severance compensation. We anticipate recording theobligation and related expense for severance and other compensation in oursecond fiscal quarter ending December 31, 2004. At this time, we estimate thatthe severance and other compensation will be approximately within the range of $480,000to $550,000. Mr. Jewell will continue to serve as our Senior Vice President andwill also in the interim assume the duties of our Chief Executive Officer. Oncea permanent Chief Executive Officer is appointed, we expect that Mr. Jewellwill remain with us as our Senior Vice President.

 

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On November 1, 2004, Mr. Tomlinson informed us that he was resigningfrom his position as a Director, effective October 29, 2004. The vacancy on theBoard created by Mr. Tomlinson’s resignation has not been filled. The Board ofDirectors is currently comprised of four independent persons.

 

### **ITEM6**       EXHIBITS

 

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

 

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

 

Exhibit 32.1 – Certifications of Donald W. Jewell and Patrick W. Hurleypursuant to 18 U.S.C. §1350, as adopted pursuant to Section 906 of theSarbanes-Oxley Act of 2002

 

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#### **SIGNATURES**

 

In accordance with the requirements of theSecurities Exchange Act of 1934, the Registrant caused this report to be signedon its behalf by the undersigned thereunto duly authorized.

 

 
| ** ** | ** **        | **SPORT-HALEY, INC.**                           |
|------------|-------------------|-------------------------------------------------|
|       |              | (Registrant)                                    |
|       |              |                                            |
|       |              |                                            |
| Date:      | November 19, 2004 |                                            | /s/ PATRICK W. HURLEY |   |
|       |              | Patrick W. Hurley                               |
|       |              | Chief Financial Officer                         |
|       |              | *(Principal  Financial and Accounting Officer)* |
|            |                   |                                                 |  |  |

 

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