** **

**SECURITIESAND EXCHANGE COMMISSION**

 

**WASHINGTON,D.C.  20549**

 

**FORM 10-Q**

 

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

**OF THESECURITIES EXCHANGE ACT OF 1934**

 

**For thequarterly period ended December 31, 2004**

 

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

**EXCHANGEACT**

 

**Commissionfile no. 1-12888**

 

**SPORT-HALEY,INC.**

(Exact name ofsmall 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 ofprincipal executive offices)

 

**(303)320-8800**

(Issuer’stelephone number including area code)

 

Indicate by check markwhether the registrant (1) filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months(or for such shorter period that the registrant was required to file suchreports), and (2) has been subject to such filing requirements for the past 90days:    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

 

Indicate the number ofshares outstanding in each of the issuer’s classes of common stock, as of thelatest practicable date.

 

| **Class**                       | ** ** | **Outstanding  at February 14, 2005** |
|---------------------------------|------------|---------------------------------------|
| **Common  Stock, no par value** | ** ** | **2,545,252**                         |

 

 

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**TABLE OF CONTENTS**

 
| **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**

 
| ** **                                                                                                                      | ** ** | **December 31,****2004** | ** ** | **June 30,****2004** |   |
|---------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|----------------------|--------|
| ** **                                                                                                                      | ** ** | **(Unaudited)**          | ** ** | **(***)**            |   |
|                                                                                                                            |       |                     |       |                 |   |
| **ASSETS**                                                                                                                      |       |                     |       |                 |   |
| Current assets:                                                                                                                 |       |                     |       |                 |   |
| Cash and cash  equivalents                                                                                                      |       | $                        | 6,012,000  |                 | $      | 3,890,000 |   |
| Marketable  securities                                                                                                          |       | —                   |       | 539,000              |   |
| Accounts  receivable, net of allowances of $1,318,000 and $1,128,000, respectively                                              |       | 3,416,000                |       | 5,946,000            |   |
| Inventories                                                                                                                     |       | 6,136,000                |       | 8,808,000            |   |
| Prepaid expenses  and other                                                                                                     |       | 447,000                  |       | 468,000              |   |
| Total current  assets                                                                                                           |       | 16,011,000               |       | 19,651,000           |   |
|                                                                                                                            |       |                     |       |                 |   |
| Property and  equipment, net                                                                                                    |       | 1,003,000                |       | 1,107,000            |   |
| Other assets                                                                                                                    |       | 12,000                   |       | 13,000               |   |
|                                                                                                                            |       |                     |       |                 |   |
| Total Assets                                                                                                                    |       | $                        | 17,026,000 |                 | $      | 20,771,000 |   |
| **LIABILITIES  AND SHAREHOLDERS’ EQUITY**                                                                                  |       |                     |       |                 |   |
| Current  liabilities:                                                                                                           |       |                     |       |                 |   |
| Accounts payable                                                                                                                |       | $                        | 547,000    |                 | $      | 1,461,000 |   |
| Accrued  commissions payable                                                                                                    |       | 170,000                  |       | 272,000              |   |
| Accrued payroll                                                                                                                 |       | 624,000                  |       | 197,000              |   |
| Other                                                                                                                           |       | 249,000                  |       | 218,000              |   |
| Total current  liabilities                                                                                                      |       | 1,590,000                |       | 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 2,525,252 shares issued  and outstanding, respectively |       | 10,189,000               |       | 10,126,000           |   |
| Additional  paid-in capital                                                                                                     |       | 1,559,000                |       | 1,527,000            |   |
| Retained  earnings                                                                                                              |       | 3,688,000                |       | 6,970,000            |   |
| Total  shareholders’ equity                                                                                                |       | 15,436,000               |       | 18,623,000           |   |
|                                                                                                                            |       |                     |       |                 |   |
| Total  Liabilities and Shareholders’ Equity                                                                                |       | $                        | 17,026,000 |                 | $      | 20,771,000 |   |

 

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*** Taken from theaudited balance sheet at that date.

 

See accompanyingnotes to financial statements.

 

3

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**SPORT-HALEY, INC.**

**STATEMENTS OF OPERATIONS**

 
| ** **                                       | ** ** | **Three  Months Ended  December 31,** |       | **Six  Months Ended  December 31,** |       |
|--------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                       | ** ** | **2004**                              | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** |   |
| ** **                                       | ** ** | **(Unaudited)**                       | ** ** | **(Unaudited)**                     | ** ** | **(Unaudited)** | ** ** | **(Unaudited)** |   |
|                                             |       |                                  |       |                                |       |   |   |   |   |
| Net sales                                        |       | $                                     | 5,000,000  |                                | $          | 4,763,000 |   | $ | 10,570,000 |   | $ | 9,075,000 |   |
|                                             |       |                                  |       |                                |       |   |   |   |   |
| Cost of goods  sold                              |       | 4,542,000                             |       | 2,905,000                           |       | 8,342,000 |   | 5,577,000 |   |
|                                             |       |                                  |       |                                |       |   |   |   |   |
| Gross profit                                     |       | 458,000                               |       | 1,858,000                           |       | 2,228,000 |   | 3,498,000 |   |
|                                             |       |                                  |       |                                |       |   |   |   |   |
| Selling, general  and administrative expenses    |       | 2,516,000                             |       | 1,901,000                           |       | 5,573,000 |   | 3,846,000 |   |
|                                             |       |                                  |       |                                |       |   |   |   |   |
| Loss from  operations                            |       | (2,058,000                            | )          | (43,000                             | )          | (3,345,000 | ) | (348,000 | ) |
|                                             |       |                                  |       |                                |       |   |   |   |   |
| Other income,  net                               |       | 52,000                                |       | 71,000                              |       | 63,000 |   | 125,000 |   |
|                                             |       |                                  |       |                                |       |   |   |   |   |
| Income (loss)  before provision for income taxes |       | (2,006,000                            | )          | 28,000                              |       | (3,282,000 | ) | (223,000 | ) |
|                                             |       |                                  |       |                                |       |   |   |   |   |
| (Provision for)  benefit from income taxes       |       | —                                |       | (17,000                             | )          | — |   | 73,000 |   |
|                                             |       |                                  |       |                                |       |   |   |   |   |
| Net income  (loss)                               |       | $                                     | (2,006,000 | )                                   | $          | 11,000 |   | $ | (3,282,000 | ) | $ | (150,000 | ) |
|                                             |       |                                  |       |                                |       |   |   |   |   |
| Basic earnings  (loss) per common share          |       | $                                     | (0.77      | )                                   | $          | 0.01 |   | $ | (1.29 | ) | $ | (0.06 | ) |
| Diluted earnings  (loss) per common share        |       | $                                     | (0.77      | )                                   | $          | 0.00 |   | $ | (1.29 | ) | $ | (0.06 | ) |
|                                             |       |                                  |       |                                |       |   |   |   |   |
| Basic weighted  average shares outstanding       |       | 2,545,252                             |       | 2,445,078                           |       | 2,541,067 |   | 2,444,831 |   |
| Diluted weighted  average shares outstanding     |       | 2,545,252                             |       | 2,705,511                           |       | 2,541,067 |   | 2,444,831 |   |

 

See accompanyingnotes to financial statements.

 

4

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**SPORT-HALEY, INC.**

**STATEMENTS OF CASH FLOWS**

 
| ** **                                                                              | ** ** | **Six Months Ended  December 31,** | ** ** |
|-----------------------------------------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                                                              | ** ** | **2004**                           | ** ** | **2003** | ** ** |
| ** **                                                                              | ** ** | **(Unaudited)**                    | ** ** | **(Unaudited)** |   |
|                                                                                    |       |                               |       |   |   |
| **Cash  flows from operating activities:**                                              |       |                               |       |   |   |
| Net loss                                                                                |       | $                                  | (3,282,000 | ) | $ | (150,000 | ) |
| Adjustments to  reconcile net loss to net cash provided (used) by operating activities: |       |                               |       |   |   |
| Depreciation and  amortization                                                          |       | 170,000                            |       | 149,000 |   |
| Deferred taxes  and other                                                               |       | —                             |       | (73,000 | ) |
| Allowance for  doubtful accounts                                                        |       | 120,000                            |       | 60,000 |   |
| Common stock  options                                                                   |       | 31,000                             |       | 63,000 |   |
| Gain/Loss on  sale of fixed assets                                                      |       | 3,000                              |       | — |   |
| Cash provided  (used) due to changes in assets and liabilities:                         |       |                               |       |   |   |
| Accounts receivable                                                                     |       | 2,410,000                          |       | 926,000 |   |
| Inventories                                                                             |       | 2,672,000                          |       | (1,650,000 | ) |
| Other assets                                                                            |       | 22,000                             |       | (22,000 | ) |
| Accounts payable                                                                        |       | (914,000                           | )          | 485,000 |   |
| Accrued  commissions and other expenses                                                 |       | 356,000                            |       | 33,000 |   |
| Net cash  provided (used) by operating activities                                       |       | 1,588,000                          |       | (179,000 | ) |
| ** **                                                                              |       |                               |       |   |   |
| **Cash  flows from investing activities:**                                              |       |                               |       |   |   |
| Redemption of  held-to-maturity investments                                             |       | 538,000                            |       | 1,653,000 |   |
| Purchases of  held-to-maturity investments                                              |       | —                             |       | (1,752,000 | ) |
| Purchase of  fixed assets                                                               |       | (67,000                            | )          | (234,000 | ) |
| Net cash  provided (used) by investing activities                                       |       | 471,000                            |       | (333,000 | ) |
| ** **                                                                              |       |                               |       |   |   |
| **Cash  flows from financing activities:**                                              |       |                               |       |   |   |
| Net proceeds  from issuance of common stock                                             |       | 63,000                             |       | 18,000 |   |
| Net cash  provided by financing activities                                              |       | 63,000                             |       | 18,000 |   |
|                                                                                    |       |                               |       |   |   |
| **Net increase  (decrease) in cash and cash equivalents**                               |       | 2,122,000                          |       | (494,000 | ) |
| ** **                                                                              |       |                               |       |   |   |
| **Cash  and cash equivalents, beginning**                                               |       | 3,890,000                          |       | 4,304,000 |   |
| ** **                                                                              |       |                               |       |   |   |
| **Cash  and cash equivalents, ending**                                                  |       | $                                  | 6,012,000  |   | $ | 3,810,000 |   |
| ** **                                                                              |       |                               |       |   |   |   |   |
| **Supplemental  disclosure of cash flow information:**                                  |       |                               |       |   |   |
| Cash paid during  the period for:                                                       |       |                               |       |   |   |
| Income taxes                                                                            |       | $                                  | 3,000      |   | $ | — |   |

 

See accompanyingnotes to financial statements.

 

5

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**SPORT-HALEY, INC.**

**NOTES TO FINANCIAL STATEMENTS**

 

**NOTE 1****             SIGNIFICANTACCOUNTING POLICIES**

 

*CondensedFinancial Statements* - The unaudited financial statementsincluded herein have been prepared by Sport-Haley, Inc. (the “Company”), inaccordance with accounting principles generally accepted in the United Statesof America for interim financial statements and in accordance with theinstructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, theydo not include all of the information and disclosures required by generallyaccepted accounting principles for complete financial statements. In theopinion 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 six months ended December 30, 2004, may not be indicative of the resultsfor the full fiscal year. For further information, refer to the financialstatements and footnotes thereto for the year ended June 30, 2004, included inthe Company’s filing on Form 10-K.

 

*Stock-Based Compensation* - The Company’sStock Option Plan (the “Plan”) expired by its terms on February 28, 2003.Option agreements that were issued in accordance with the Plan prior toFebruary 28, 2003, generally remain in force until the earlier of theirexercise, the expiration of certain time periods after the termination of agrantee’s employment (or other relationship with the Company) or expiration bytheir terms. At December 31, 2004, there were outstanding options to purchase1,072,015 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 January2013.

 

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:

 

6

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| ** **                                                                           | ** ** | **Six Months Ended December 31,** | ** ** |
|--------------------------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                           | ** ** | **2004**                          | ** ** | **2003** | ** ** |
| Net loss - as  reported                                                              |       | $                                 | (3,282,000 | ) | $ | (150,000 | ) |
| Effect of  employee stock-based compensation included in reported net loss           |       | 31,000                            |       | 39,000 |   |
| Effect of  employee stock-based compensation per SFAS 123                            |       | (211,000                          | )          | (133,000 | ) |
| Net loss  applicable to common stock - pro forma                                     |       | $                                 | (3,462,000 | ) | $ | (244,000 | ) |
|                                                                                 |       |                              |       |   |   |
| Basic and  Diluted:                                                                  |       |                              |       |   |   |
| Loss per share -  as reported                                                        |       | $                                 | (1.29      | ) | $ | (0.06 | ) |
| Per share effect  of employee stock-based compensation included in reported net loss |       | 0.01                              |       | 0.02 |   |
| Per share effect  of employee stock-based compensation per SFAS 123                  |       | (0.08                             | )          | (0.06 | ) |
| Loss per share  applicable to common stock - pro forma                               |       | $                                 | (1.36      | ) | $ | (0.10 | ) |

 

| ** **                                                                           | ** ** | **Three Months Ended December 31,** | ** ** |
|--------------------------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                           | ** ** | **2004**                            | ** ** | **2003** | ** ** |
| Net income  (loss) - as reported                                                     |       | $                                   | (2,006,000 | ) | $ | 11,000 |   |
| 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 income  (loss) applicable to common stock - pro forma                            |       | $                                   | (2,096,000 | ) | $ | (36,000 | ) |
|                                                                                 |       |                                |       |   |   |
| Basic:                                                                               |       |                                |       |   |   |
| Income (loss per  share) - as reported                                               |       | $                                   | (0.77      | ) | $ | 0.01 |   |
| Per share effect  of employee stock-based compensation included in reported net loss |       | 0.01                                |       | 0.01 |   |
| Per share effect  of employee stock-based compensation per SFAS 123                  |       | (0.04                               | )          | (0.03 | ) |
| Income (loss)  per share applicable to common stock - pro forma                      |       | $                                   | (0.80      | ) | $ | (0.01 | ) |
|                                                                                 |       |                                |       |   |   |
| Diluted:                                                                             |       |                                |       |   |   |
| Income (loss per  share) - as reported                                               |       | $                                   | (0.77      | ) | $ | 0.00 |   |
| Per share effect  of employee stock-based compensation included in reported net loss |       | 0.01                                |       | 0.01 |   |
| Per share effect  of employee stock-based compensation per SFAS 123                  |       | (0.04                               | )          | (0.02 | ) |
| Income (loss)  per share applicable to common stock - pro forma                      |       | $                                   | (0.80      | ) | $ | (0.01 | ) |

 

7

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InDecember 2004, the Financial Accounting Standards Board issued Statement ofFinancial Accounting Standards No. 123(R) (“SFAS 123R”), *“Share-BasedPayment,”* which is a revision of Statement of Financial AccountingStandards No. 123, *“Accounting forStock-Based Compensation.”* SFAS 123R is effective forpublicly-traded companies for interim or annual periods beginning after June15, 2005, supersedes Accounting Principles Board Opinion No. 25, *“Accounting for Stock Issued to Employees,”*and amendsStatement of Financial Accounting Standards No. 95, *“Statementof Cash Flows.”*

 

SFAS123R requires all share-based payments to employees, including grants ofemployee stock options, to be recognized in the income statement based on theirfair values and will rescind the acceptance of pro forma disclosure. SFAS 123Rwill be effective for the Company beginning with the quarter ended September30, 2005. The Company has not yet completed an evaluation but expects theadoption of SFAS 123R to have an effect on its financial statements similar tothe pro forma effects reported above.

 

*Segments*– The Company has one operating segment: designing, purchasing, contracting forthe manufacture of and marketing women’s and men’s fashion golf apparel andouterwear. The information for this segment is the information used by theCompany’s chief decision maker to evaluate operating performance.

 

**NOTE 2****             INVENTORIES**

 

| ** **                               | ** ** | **December 31,  2004** | ** ** | **June 30,  2004** | ** ** |
|------------------------------------------|------------|------------------------|------------|--------------------|------------|
| Inventories  consisted of the following: |       | $                      | 319,000    |               | $          | 470,000 |   |
| Component                                |       | 5,817,000              |       | 8,338,000          |       |
| Finished goods                           |       | $                      | 6,136,000  |               | $          | 8,808,000 |   |

 

8

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

 

At December 31, 2004, theCompany had $1,758,000 in outstanding letters of credit that were issued toforeign suppliers in accordance with finished goods inventory purchasecommitments.

 

In October 2004, the Board of Directors decided not torenew the executive employment agreement of Kevin M. Tomlinson, appointedDonald W. Jewell to act as Interim Chief Executive Officer and relieved Mr.Tomlinson of his duties as Chief Executive Officer and President. Mr. Tomlinsonresigned as a Director in November 2004, and his employment will cease upon theeffective date of termination of the agreement in March 2005. The terms of theexecutive employment agreement between the Company and Mr. Tomlinson requirethe Company to pay Mr. Tomlinson severance and other compensation as a resultof the Board’s decision not to renew the agreement. Upon the effective date of terminationof the agreement, Mr. Tomlinson is entitled to receive severance compensation,payable monthly, for a term of 36 months based upon his salary and incentivebonus 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, during the time he is receivingseverance compensation, and for reimbursement from the Company for legalexpenses Mr. Tomlinson incurred with respect to exercising his right to obtainprofessional counsel regarding termination of the contract. Accordingly, theCompany recorded severance and other compensation expense in the amount of$520,000 during the fiscal quarter ended December 31, 2004. Mr. Tomlinson willreceive salary payments through March 17, 2005 and will receive monthlyseverance payments thereafter.

 

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

 

As of December 31, 2004, theCompany’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 December 31, 2004, the Company had repurchased a totalof 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 stock during thequarter ended December 31, 2004.

 

**NOTE 5****             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:

 

9

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| ** **                                    | ** ** | **Three Months ended December 31, 2004** | ** ** |
|-----------------------------------------------|------------|------------------------------------------|------------|
| ** **                                    | ** ** | **Net  Income  (Loss)**                  | ** ** | **Weighted  Average  Shares** | ** ** | **Per  Share** | ** ** |
| Loss Per Common  Share                        |       |                                     |       |   |   |   |   |
|                                          |       |                                     |       |   |   |   |   |
| Basic earnings  per share                     |       | $                                        | (2,006,000 | ) | 2,545,252 |   | $ | (0.77 | ) |
|                                          |       |                                     |       |   |   |   |   |
| Effect of  dilutive securities options**[A]** |       | —                                   |       | — |   | — |   |
|                                          |       |                                     |       |   |   |   |   |
| Diluted loss per  share                       |       | $                                        | (2,006,000 | ) | 2,545,252 |   | $ | (0.77 | ) |
|                                               |            |                                          |            |  |  |  |  |  |  |  |

 

| ** **                                    |       | **Six  Months ended December 31, 2004** |       |
|-----------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                    | ** ** | **Net  Income  (Loss)**                 | ** ** | **Weighted  Average  Shares** | ** ** | **Per  Share** | ** ** |
| Loss Per Common  Share                        |       |                                    |       |   |   |   |   |
|                                          |       |                                    |       |   |   |   |   |
| Basic loss per  share                         |       | $                                       | (3,282,000 | ) | 2,541,067 |   | $ | (1.29 | ) |
|                                          |       |                                    |       |   |   |   |   |
| Effect of  dilutive securities options**[A]** |       | —                                  |       | — |   | — |   |
|                                          |       |                                    |       |   |   |   |   |
| Diluted loss per  share                       |       | $                                       | (3,282,000 | ) | 2,541,067 |   | $ | (1.29 | ) |
|                                               |            |                                         |            |  |  |  |  |  |  |  |  |

 

| ** **                             |       | **Three  Months ended December 31, 2003** |       |
|----------------------------------------|------------|-------------------------------------------|------------|
| ** **                             | ** ** | **Net  Income  (Loss)**                   | ** ** | **Weighted  Average  Shares** | ** ** | **Per  Share** | ** ** |
| Earnings Per  Common Share             |       |                                      |       |   |   |   |   |
|                                   |       |                                      |       |   |   |   |   |
| Basic earnings  per share              |       | $                                         | 11,000     |   | 2,445,078 |   | $ | 0.01 |   |
|                                   |       |                                      |       |   |   |   |   |
| Effect of  dilutive securities options |       | —                                    |       | 260,433 |   | (0.01 | ) |
|                                   |       |                                      |       |   |   |   |   |
| Diluted earnings  per share            |       | $                                         | 11,000     |   | 2,705,511 |   | $ | 0.00 |   |
|                                        |            |                                           |            |  |  |  |  |  |  |  |  |  |

 

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| ** **                                    | ** ** | **Six Months ended December 31, 2003** | ** ** |
|-----------------------------------------------|------------|----------------------------------------|------------|
|                                          |       | **Net  Income  (Loss)**                | ** ** | **Weighted  Average  Shares** | ** ** | **Per  Share** | ** ** |
| Loss Per Common  Share                        |       |                                   |       |   |   |   |   |
|                                          |       |                                   |       |   |   |   |   |
| Basic loss per  share                         |       | $                                      | (150,000   | ) | 2,444,831 |   | $ | (0.06 | ) |
|                                          |       |                                   |       |   |   |   |   |
| Effect of  dilutive securities options**[A]** |       | —                                 |       | — |   | — |   |
|                                          |       |                                   |       |   |   |   |   |
| Diluted loss per  share                       |       | $                                      | (150,000   | ) | 2,444,831 |   | $ | (0.06 | ) |

** **

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

 

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**SPORT-HALEY, INC.**

**ITEM 2MANAGEMENT’S DISCUSSION AND ANALYSIS OF**

**FINANCIAL 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 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 the yearended June 30, 2004. There may be other factors not mentioned above, in thediscussion 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.

 

##### **OVERVIEW**

##### ** **

##### **Sport-Haley, Inc. designs,purchases, contracts for the manufacture of and markets women’s and men’s fashiongolf apparel and outerwear under the SPORT HALEY and Ben Hogan® labels. Ourfashion golf apparel collections, known for their innovative designs, qualityfabrics, generous fit and classic styles, are primarily marketed in the premiumand mid-priced markets, through a network of independent sales representativesand distributors, to golf professional shops, country clubs, resorts andexclusive department stores within the United States and by certaindistributors within international markets. The Company distributes Ben Hogan®apparel pursuant to a licensing agreement with Callaway Golf Company (“Callaway”).**

 

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

 

We believe that our salesmay have been more negatively affected by recent economic conditions and othermarket factors faced by our customers in the golf industry. A few of ourlong-time customers have indicated that they are now placing less of animportance on stocking women’s golf apparel collections in their shops. Adecline in the market for women’s fashion golf apparel can affect us more thanother companies in the golf apparel industry, because, while, according to anindustry-related survey, the golf apparel market is basically comprised of 75%men’s apparel and 25% women’s apparel, our sales for 2004 were generallycomprised of 40% men’s apparel and 60% women’s apparel. We discontinued ourHALEY RESERVE men’s fashion golf apparel collections beginning with the spring2005 season. Therefore, our current product mix is now even more heavilyweighted by our SPORT HALEY women’s apparel.

 

The Company continues tofocus on stabilizing revenues associated with the SPORT HALEY women’s apparel brandand growth of revenues associated with the Ben Hogan® men’s apparel brand. Our decisionto discontinue marketing HALEY RESERVE men’s fashion apparel was due, in part,because we believe that there are natural synergies common to Ben Hogan® men’sfashion apparel and SPORT HALEY women’s fashion apparel, and in part, becausewe had anticipated introducing a line of men’s apparel under the Top Flite®label to bolster our sales with respect to men’s apparel. In 2004, Callawayreached an agreement in principle with us to indefinitely delay theintroduction of Top Flite® branded apparel. While we have no immediate plans tointroduce apparel under the Top Flite® label, we maintain the licensing rightsto Top Flite® branded apparel granted to us under the licensing agreement thatwe maintain with Callaway. By marketing SPORT HALEY women’s apparel inconjunction with Ben Hogan® men’s apparel, we are attempting to retain ourmarket share with current women’s apparel customers, and we expect to expandthe distribution channels for fashion women’s apparel into markets that we hadpreviously only been able to penetrate via the marketing of Ben Hogan® men’sapparel, which has a broader market acceptance due to its inherent brand appealwithin golf markets.

 

##### **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. Certain design, implementationand operational deficiencies of the computer system have affected our businessoperations for the last four consecutive fiscal quarters.

 

Previously,we reported that we discovered programming and human errors that had affectedthe comprehensive computer system’s ability to properly compute the valuationof our finished goods inventories. The comprehensive system was designed toaccount for our finished goods inventories using a weighted average costingmethod. Due to the complexity of the transactions recorded within the functionsof the computer system and various human errors that we discovered, we were notable to specifically quantify the financial effects at March 31, June 30 orSeptember 30, 2004, with regard to errors recorded in the system that affectedthe per-item cost valuations of our finished goods inventories. Therefore, werecomputed the estimated value of our finished goods inventories at March 31,June 30, and September 30, 2004, using a standard cost assumption. We performedan analysis to compare the actual landed cost components of our finished goodsinventories with their respective standard cost

 

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components.We also performed an analysis of the allocated overhead portion of our standardcosts. Because our analyses indicated that our standard costs approximatedactual costs, we believe that our standard cost valuations calculated at March31, June 30 and September 30, 2004, yielded fair estimations of our finishedgoods inventories at those dates. We considered the system malfunction withrespect to the computation of per-item valuation of finished goods inventoriesto be an indication of a material weakness in our internal controls overfinancial reporting with respect to inventory valuation during the periodsended March 31, June 30 and September 30, 2004.

 

Thematerial weakness persisted during the quarter ended December 31, 2004, andimpaired our ability to rely upon information created by our computer system tofairly present, in all material respects, our financial condition, results ofoperations and cash flows for the period covered by this report. As previously reported, in October 2004 wediscovered a malfunction in the operation of one of the computer systemprocedures that we performed in September 2004 in an attempt to correct errors previouslydiscovered in the per-item cost valuations of our finished goods inventories. Werequested that our former software consultants perform a review of the failedsystem procedure to determine the reason for the malfunction and to recommendhow we should correct the problem. The former consultants informed us that theycould not determine why the system malfunctioned during the system procedureand deferred the problem to the software developers for advice. The softwaredevelopers suggested that we zero out all finished goods inventory balances,reverse other pending inventory-related system procedures and re-enter finishedgoods inventory quantities into the system in order to correct errors caused bythe system malfunction. To ensure the integrity of the finished goods inventorydata within the computer system, at the end of December 2004, we performed aphysical inventory of our finished goods apparel. Because of the complexity of theerrors discussed above, we have not been able to re-compute the per-item weightedaverage costs of our numerous individual finished goods items. The standardcosts of our finished goods inventories have not changed since the previousanalyses were performed. Therefore, at the conclusion of our December physicalinventory, we entered the quantities of finished goods inventory items, asdetermined by the results of the physical count, back into our computer systemusing their respective standard costs. After applying the recommendedprocedures, we compared the per-item costs of several of our finished goodsinventory items with their respective standard costs and noted nodiscrepancies. Had we analyzed the standard cost components of all of ourfinished inventory items on hand at December 31, 2004, we believe that theprobability of reaching a materially different conclusion is remote. Therefore,we concluded that our analyses provide reasonable assurance that our standardcosts approximate the actual costs of our finished goods inventories atDecember 31, 2004.

 

The inability of ourcomputer system to properly calculate the per-item valuations of our finishedgoods inventories also affected the system-recorded amounts within our cost of goodssold during the period covered by this report. Costs associated with invoicedsales and returns as well as inventory adjustments are natural components ofour cost of goods sold. Because we concluded with reasonable assurance that ourusing a standard cost assumption yielded a fair estimation of our finishedgoods inventories and we consistently recorded adjustments to inventories ascomponents of cost of goods sold during the periods covered by this report, webelieve with reasonable assurance that our cost of goods sold are fairly statedduring the periods covered by this report. Therefore, we believe that astandard cost valuation of our finished goods inventories provides us withreasonable assurance that our report fairly presents, in all material respects,our financial condition, results of operations and cash flows.

 

Wehave not performed a detailed analysis of the inventory costing functionswithin the computer system since the procedures suggested by the softwaredevelopers were applied and the physical inventory

 

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procedureswere performed, but our former software consultants have advised us that thevaluation problem caused by the system malfunction was corrected by thecompletion of those procedures. During our third fiscal quarter, we plan toclosely monitor the costing functions within our computer system to determinewhether we will be able to begin to rely upon the system to properly value ourfinished goods inventories without further modifications to the systemfunctions.

 

Aspreviously reported, in September 2004, we authorized our former softwareconsultants to perform a review and analysis of the processes performed withinthe new computer system. The former consultants subsequently identified andadjusted certain aspects of the system in order for us to operate moreefficiently, and they prepared a written analysis of the major processes thatwe utilize, which included certain recommendations for future systemenhancements. In January 2005, we contracted with another software consultantto use the written analysis to further analyze and adjust certain of thecomputer system’s functionality. The new software consultants are currentlyevaluating other alternatives to improve functions within the system that wehave requested to strengthen our internal controls with respect to our businessoperations, including our controls over finished goods inventories.

 

##### **CRITICAL ACCOUNTING POLICIESAND ESTIMATES**

##### ** **

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 are basedupon the Company’s historical experiences combined with our understanding ofcurrent facts and circumstances. Certain of the Company’s accounting policiesare considered critical as they are both important to the portrayal of ourfinancial condition and the results of our operations and require significantor complex judgments on the part of management. We believe that the followingcritical accounting policies affect the more significant judgments and estimatesused in the preparation of our financial statements.

 

*Inventories*

 

Inventories,predominantly comprised of finished goods, are generally valued at the lower ofcost or market. As discussed above in *“Recent Developments,”*a material weakness in our internals has caused us to value our finished goodsinventories using a standard cost assumption for the last four consecutivefiscal quarters. Excess finished goods inventories are a natural component of aseasonal apparel business. While certain finished goods items will sell out inany particular selling season, quantities of other finished goods items willremain at the end of each selling season. We market previous seasons’ finishedgoods inventories 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 an industry-related survey, the golfapparel market in total is generally comprised of 75% men’s apparel and 25%women’s apparel, our sales for fiscal 2004 were generally comprised of 40% men’sapparel and 60% women’s apparel. Historically, a significant portion of ourexcess inventories have been comprised of women’s apparel, which has fewerchannels of distribution than are available within the men’s apparel market.

 

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Weperform analyses on a quarterly basis to identify 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 regardingthe dispositions of excess inventories. In the ordinary course of business, wemaintain reserves for inventory write-downs due to the obsolescence ofdiscontinued or aging merchandise. In October 2004, the Company set a goal toattempt to arrange for the disposal of a majority of our prior seasons’inventories by December 31, 2004. That goal caused us to accelerate ourdisposition plans and to revise our analysis with respect to the valuation ofdiscontinued or aging inventories, accordingly. Our analysis of those excessinventories and expected methods to be used for their disposition dictated thatwe increase our reserve for finished goods inventory write-downs at September30, 2004. In December 2004, we sold substantially all of our discontinued oraging merchandise to a major retailer for approximately $713,000. We soldapproximately 98,000 units of women’s apparel and 36,000 units of men’s apparelin the December sale, which was comprised of essentially all of ourdiscontinued or aging merchandise from the spring 2004 and earlier sellingseasons. The goal we established for disposition of those inventories prior toDecember 31, 2004, may have weakened our bargaining position with respect tothe amount we could recover through their disposition. Thus, after accountingfor the reserve previously recorded on our finished goods inventories aged fromspring 2004 and earlier, we recorded an additional loss of approximately$179,000 on the sale in December 2004.

 

AtDecember 31, 2004, we improved the methods that we use to assess therecoverability of our finished goods inventories. We developed a system tobetter estimate the anticipated future sales of our finished goods inventoriesin order to better forecast inventories expected to remain at the end of acurrent or future distribution period. Having better information available toforecast quantities and mix of unsold inventories allows us to better estimateexcess inventories expected to be on hand in a future period. Having suchinformation also allows us to better plan marketing strategies for the sales ofsuch inventories through existing marketing channels and to better estimate theoverall recoverability of our finished goods inventories. The use of the newmethod at December 31, 2004, revealed that we expect to incur a significantamount of excess finished goods inventories remaining from the fall 2004 andspring 2005 selling seasons. Accordingly, we increased our reserve for inventorywrite-downs by $695,000 at December 31, 2004. We estimated the recoverabilityof the fall 2004 and spring 2005 inventories based upon our expectations forthe success of future marketing plans and our historical experience regardingthe disposition of such apparel. We believe that the methods we now use to identifyand evaluate obsolete and aging finished goods inventories produce a fairvaluation of obsolete inventories, but, if actual market conditions are lessfavorable than those we have projected, additional allowances may be requiredor losses on dispositions may be recorded.

 

As discussed above in *“Recent Developments,”* we performed a physical count toverify the quantities of our finished goods inventories on hand at December 31,2004. Accordingly, we reduced our finished goods inventories by $53,000.Subsequently, we performed a detailed review of our component inventories as ofDecember 31, 2004. In the detailed review, we identified that, in certaininstances, the consumption of fabric inventories was being incorrectly applied withinfinished goods production orders. Additionally, our review included revisingour estimates regarding the recoverability of certain fabric inventories thatwe intend to consume in future production orders. As a result of our detailedreview, we reduced our component inventories by $300,000 at December 31, 2004. Werecently instructed our new software consultants to assist us with simplifyingthe processes we currently utilize to account for the consumption of componentinventories within finished goods production orders in order to strengthen ourinternal controls with respect to component inventories.

 

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*Deferred Income Taxes*

 

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 becarried forward 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 thateffectively reduces our net deferred tax assets to zero. While we areattempting to streamline our business operations to return the Company toprofitability, we cannot be certain that our efforts will result in thegeneration of future profits. Therefore, because the recoverability of deferredtax assets is directly dependent upon future operating results, actualrecoverability of deferred tax assets may differ materially from our estimates.

 

*Allowance for Doubtful Accounts*

 

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 December 31, 2004, our allowance for doubtfulaccounts was approximately $489,000, including the two specific reserves. Whilewe consider our processes to be adequate to effectively quantify our exposureto doubtful accounts, changes in economic, industry or specific customerconditions may result in a recoverability of doubtful accounts that differsmaterially from our estimates.

 

*Allowance for Sales Returns*

 

We record an allowancefor sales returns as a net adjustment 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 the return of our products subsequent tothe sale. However, we have traditionally maintained limited programs that offersome customers the right to return certain finished goods items underpredefined conditions, and, historically, a relatively small percentage of ourcustomers refuse receipt of merchandise at the time of delivery. We reviewhistorical data and consider factors such as general economic andindustry-specific conditions and anticipated customer performance whenevaluating our allowance for

 

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sales returns. At December31, 2004, our allowance for sales returns was $342,000. Significant changes ingeneral economic or industry conditions may yield sales returns that differmaterially from our estimates.

 

*Allowance for Return of SalesRepresentative Sample Garments*

 

Beginning with the fall2004 selling season, we initiated a policy that granted our independentwholesale sales representatives the right to return sample garments to theCompany at no charge to the sales representative. Previously, we invoiced thesales representatives for sample garments at discounted wholesale prices.Because of the right of return offered to the sales representatives with regardto sample garments, we elected to record invoiced shipments of sample garmentsto sales representatives in a manner consistent with consigned inventories. Beginningwith the fall 2004 selling season, we included the cost of sample garments infinished goods inventories as consigned inventories and reversed the cost ofsale components of the invoiced shipments. We also recorded an accountsreceivable allowance and reversed the revenue effect of the sale of samplegarments. The sales representative’s accounts receivable balance, the relatedallowance for sales representative samples and the related inventory costs areadjusted and a sale is recorded when the sales representative reimburses theCompany for the cost of sample garments or the term, for which the right ofreturn was granted, expires. Upon return of the garments to the Company, thesales representative’s accounts receivable balance and the related allowancefor sales representative samples are adjusted accordingly, the corresponding revenueeffect of the return is reversed, and the inventory items are returned to stock.At December 31, 2004, the Company’s allowance for returns of salesrepresentatives sample garments was $487,000. We discontinued the policy thatallowed our sales representatives to return selling samples effective withsample garments shipped for the fall 2005 selling season. Because the shipmentsand returns of sample garments made under the right to return policy must betracked and adjusted manually, actual shipments and returns made in accordancewith that policy may differ from our estimates.

 

### **RECENT PRONOUNCEMENTS**

### ** **

InDecember 2004, the Financial Accounting Standards Board issued Statement ofFinancial Accounting Standards No. 123(R) (“SFAS 123R”), *“Share-BasedPayment,”* which is a revision of Statement of Financial AccountingStandards No. 123, *“Accounting forStock-Based Compensation.”* SFAS 123R is effective forpublicly-traded companies for interim or annual periods beginning after June15, 2005, supersedes Accounting Principles Board Opinion No. 25, *“Accounting for Stock Issued to Employees,”*and amendsStatement of Financial Accounting Standards No. 95, *“Statementof Cash Flows.”*

 

SFAS123R requires all share-based payments to employees, including grants ofemployee stock options, to be recognized in the income statement based on theirfair values and will rescind the acceptance of pro forma disclosure. SFAS 123Rwill be effective for the Company beginning with the quarter ended September30, 2005. The Company has not yet completed an evaluation but expects theadoption of SFAS 123R to have an effect on its financial statements similar tothe pro forma effects reported above.

 

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### **LIQUIDITY AND CAPITALRESOURCES**

### ** **

The golf apparel businessis highly seasonal in nature. Therefore, the balance sheet amounts as ofDecember 31, 2004 may be more meaningful when compared with the balance sheetamounts as of December 31, 2003, rather than with the balance sheet amounts atJune 30, 2004.

 

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 Augustthrough October and February through April of each fiscal year, due to thepurchases of finished goods inventories for the spring/summer and fall/holidayselling seasons, respectively.

 

Our net accountsreceivable decreased by $2,530,000 to $3,416,000 at December 31, 2004, from$5,946,000 at June 30, 2004. Because of the seasonal nature of the ourbusiness, the net accounts receivable balance at December 31, 2004, may be moremeaningfully compared with the December 31, 2003, balance of $3,733,000, ratherthan with the June 30, 2004, balance. When compared with the December 31, 2003,balance, the net accounts receivable balance at December 31, 2004, decreased by$317,000, or 8%. Historically, a significant number of our customers closetheir business for the winter months, beginning in October or November of eachyear. Because many of those business owners prefer to settle their outstandingaccount balances prior to closing up shop for the winter, our net accountsreceivable balance generally declines during our second fiscal quarter. Changesin our accounts receivable balances and related allowances provided operatingcash of $2,530,000 and $986,000 for the six-month periods ended December 31,2004 and 2003, respectively.

 

The balance of ourinventories has declined significantly since June 30, 2004. Inventoriesdeclined by $2,672,000, or 30%, to $6,136,000 at December 31, 2004, from $8,808,000at June 30, 2004. Because of the seasonal nature of our business, theinventories balance at December 31, 2004, may be more meaningfully comparedwith the balance at September 30, 2004 or at December 31, 2003, rather thanwith the June 30, 2004 balance. When compared with the balance at September 30,2004, our finished goods inventories decreased by $2,691,000, or 30%, from$8,727,000. When compared with the balance at December 31, 2003, our finishedgoods inventories decreased by $3,342,000, or 35%, from $9,478,000. Thedecrease is attributable to several separate factors. In 2004, we establishedinitiatives designed to reduce excess inventories and to set target thresholdsfor expected future levels of finished goods inventories. One of our initiativesreduced the number of items offered for sale in each of the SPORT HALEY and BenHogan® apparel collections, beginning with the spring 2005 selling season, therebyreducing inventories related to the initial purchases of finished goods itemsat the beginning of each season. Another initiative was enacted to identify anddispose of excess obsolete or aging finished goods inventories. As discussedabove in *“Critical Accounting Policies and Estimates,”*during December 2004, we disposed of substantially all of our excess obsoleteor aging finished goods inventories dating from the spring 2004 and earlierselling seasons. $892,000 of the decrease since September 30, 2004, relates tothe December 2004 disposition. As also discussed above in *“CriticalAccounting Policies and Estimates,”*we recently developed revisedmethods that we believe provide us with better information that we use toidentify and value excess amounts of finished goods inventories from a currentselling season. The use of the newmethod at December 31, 2004, revealed that we expect to incur a significantamount of excess finished goods inventories remaining from the fall 2004 andspring 2005 selling seasons. Accordingly, we increased our reserve forinventory write-downs at

 

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December31, 2004, resulting in a $695,000 reduction in the value of our finished goodsinventories on hand at December 31, 2004. The differences between theperiods in pending ocean deliveries of finished goods also contributed to thedecrease. Pending ocean deliveries of finished goods were $293,000, $317,000,$360,000 and $2,501,000 at December 31, 2004, September 30, 2004, June 30,2004, and December 31, 2003, respectively. Changes in our inventory balances providedoperating cash of $2,672,000 and used operating cash of $1,650,000 for the six-monthperiods ended December 31, 2004 and 2003, 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 our foreignand domestic suppliers. However, our predominant reliance upon foreignsuppliers, and significant reliance on four 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 $558,000, or 26%, to $1,590,000 at December 31,2004, from $2,148,000 at June 30, 2004. Because of the seasonal nature of theCompany’s business, the accounts payable and accrued expenses balance at December31, 2004, may be more meaningfully compared with the balance of $1,636,000 at December31, 2003, rather than with the June 30, 2004, balance. The decrease of $46,000,or 3%, in current liabilities when comparing the balance at December 31, 2004,with the balance at December 31, 2003, primarily related to the differences inpending ocean deliveries of finished apparel between the periods discussedabove. Included in the December 31, 2004, balance is an accrual of severanceand other compensation payable to our former chief executive officer. As discussedin Note 3 and in *“Item 5 Other Information,”* inaccordance with the terms of an executive employment agreement between theCompany and the former officer, we accrued severance and other compensation of$520,000, primarily payable to executive on a monthly basis subsequent to the effectivedate of termination of the employment agreement on March 17, 2005.

 

Due to the combination ofthe factors discussed above, and others, during the six months ended December31, 2004, our operating activities provided cash of $1,588,000. Comparatively,during the six months ended December 31, 2003, our operating activities usedcash of $179,000.

 

For the six months ended December 31, 2004, investing activitiesprovided cash of $471,000. Comparatively, for the six months ended December 31,2003, investing activities used cash of $333,000. 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 six months endedDecember 31, 2004, we expended $67,000 for the purchase of property andequipment, and $170,000 in depreciation and amortization was charged to currentoperations.

 

The Company maintains aline of credit with a commercial bank, primarily to facilitate the issuance ofletters of credit for inventory purchases from offshore suppliers. Outstandingletters of credit reduce the amount available for borrowing under the line ofcredit agreement. The line of credit agreement expired on December 5, 2004, andwe are currently negotiating with the bank for its renewal. Since theexpiration date of the line of credit, the bank has continued without fail toissue letters of credit on our behalf, and we have been told by the bankrepresentative assigned to our accounts that the bank intends to renew theagreement. Therefore, we believe, but can give no assurance, that the bank willrenew the line of credit in the near future. We did not have any outstandingborrowings under the line of credit at December 31,

 

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2004. We had outstandingletters of credit of approximately $1,758,000 at December 31, 2004. Outstandingletters of credit reduce the amount available for borrowing under the line ofcredit. As of December 31, 2004, the Company was in violation of a loancovenant for this debt instrument, which requires the Company to maintain totalcapital of at least $18,500,000. We have spoken with the bank representative,and we believe, but can give no assurance, that the bank will issue a waiver ofthis breach.

 

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 2005. 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 2005. 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 OF OPERATIONS**

 

The Company’s business isseasonal in nature, and sales occurring from January through June, whichcomprise the Company’s third and fourth quarters of each fiscal year, aregenerally disproportionately higher than sales occurring from July throughDecember.

 

Net sales for the sixmonths ended December 31, 2004, were $10,570,000, an increase of $1,495,000, or16%, from net sales of $9,075,000 for the same six-month period in the priorfiscal year. We attribute the increase in net sales to factors such as thecontinued growth in sales of Ben Hogan® apparel collections combined with acontinued decrease in sales of HALEY® branded apparel. A significantdisposition of obsolete and aging finished goods inventories also contributedto the increase in sales. As discussed above in *“CriticalAccounting Policies and Estimates,”* we recorded net sales of$713,000 relating to the disposition of finished goods inventories in December2004. We did not record a similar significant disposition during the six monthsended December 31, 2003. The decline in sales of SPORT HALEY women’s apparel andHALEY RESERVE men’s apparel has concerned us for the last several quarters.Historically, sales of our HALEY® branded apparel have been disproportionatelycomprised of greater sales of women’s apparel than of men’s apparel. Thedecline in HALEY® brand sales appears to be related to a shrinking market forwomen’s golf apparel combined with our inability to maintain our previousmarket share with respect to our HALEY RESERVE men’s apparel. As we previouslyreported, declining sales of our HALEY RESERVE men’s apparel caused us, inpart, to decide to discontinue marketing fashion golf apparel under that labeleffective with the spring 2005 selling season. We began shipping spring 2005apparel during November 2004.

 

Net sales of Ben Hogan®apparel collections were $2,010,000 and $1,416,000 for the fiscal quartersended December 31, 2004 and 2003, respectively. Net sales of Ben Hogan® apparelcollections were $4,709,000 and $2,471,000 for the six months ended December 31,2004 and 2003, respectively. The increase of $594,000, or 42%, in the fiscalperiod and the increase of $2,238,000, or 91%, in the six-month period are indicativeof our continued efforts to maximize revenues with regard to licensed apparel.Ben Hogan® apparel is marketed in accordance with a licensing agreement wemaintain with Callaway Golf Company (“Callaway”) for such apparel. We considerthe licensing 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

 

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of licensed apparel,sustains a risk of loss, should the licensing agreement with Callaway beterminated by either party.

 

Grossprofit, as a percentage of net sales, was 9% for the quarter ended December 31,2004, and 39% for the same quarter in the prior fiscal year. Gross profit, as apercentage of net sales, was 21% for the six-month period ended December 31,2004, and 39% for the same six-month period in the prior fiscal year. Thedecrease in gross profit percentages was primarily attributable to the followingfactors: (i) As discussed above in *“Critical AccountingPolicies and Estimates,”* we assessed the recoverability of ourfinished goods inventories using an improved method that calculates theestimated sales value based upon the quantities and mix of inventories that areavailable for sale, rather than an estimate based upon total units on hand. Therecoverability assessment indicated that we should expect to have aconsiderable number of units left over at the end of the fall 2004 and spring2005 delivery periods, and, accordingly, we increased our reserve for inventorywrite-downs by $695,000 at December 31, 2004. The increase was in addition tothe $543,000 increase in our reserve that was recorded at September 30, 2004,and negatively impacted our gross margin for the December quarter by 16%. (ii) Asdiscussed above in *“Critical AccountingPolicies and Estimates,”* in December 2004, we sold substantially allof our discontinued or aging finished goods inventories from the spring 2004and earlier selling seasons to a major retailer. Those inventories had beenwritten down at September 30, 2004, to the net amount we expected to recover ina mass disposition of them. The disposal of closeout inventories negativelyimpacts our gross margins, because the valuation of such inventories to thelower of cost or market causes a zero margin relating to their sale. The actualsales price we obtained for the substantial sale to the major retailer resultedin our recording a loss of $179,000 on the sale in December 2004, which negativelyimpacted our margin by 6% in the December quarter. (iii) As discussed above in *“Recent Developments,”* in conjunction with performingprocedures recommended by the developer of our software that were designed tocorrect a prior system malfunction, we performed a physical count of ourfinished goods inventories at December 31, 2004. As discussed above in *“Critical Accounting Policies and Estimates,”* along with thephysical count we also performed a detailed review of our component inventoriesas of December 31, 2004. The physical inventory caused us to reduce ourfinished goods inventories by $53,000 and the detailed review caused us toreduce our component inventories by $300,000, which in total negativelyimpacted our gross margin by 8%. Without the increase in reserve for inventorywrite-downs, the loss on the sale of closeout inventories, the finished goodsphysical inventory adjustment and the adjustment to component inventories, ourgross margins for the quarter and six months ended December 31, 2004 would havebeen 39% and 35%, respectively.

 

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 certain 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. We also include royalty payments, relating to sales oflicensed apparel, in selling, general and administrative expenses.

 

Selling, general andadministrative expenses increased by $615,000, or 32%, to $2,516,000 for thefiscal quarter ended December 31, 2004, from $1,901,000 for the same quarter inthe prior fiscal year. Selling, general and administrative expenses increasedby $1,727,000, or 45%, to $5,573,000 for the six-month period ended December31, 2004, from $3,846,000 for the same six-month period in the prior fiscalyear. The increase for the fiscal quarter was primarily due to the $520,000 inseverance compensation payable to our former chief executive officer that wasaccrued during our fiscal quarter ended December 31,

 

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2004, which is describedabove in our discussion of *“Liquidity and CapitalResources.”* The increase for the six-month period includes the$650,000 in severance and other compensation paid to our late Chairman’s estateduring our fiscal quarter ended September 30, 2004, the $520,000 in severanceand other compensation payable to our former chief executive officer, andincreases in sales commissions and royalties payable on higher net sales. Salescommissions were $482,000 and $991,000 for the quarter and six months endedDecember 31, 2004, and were $496,000 and $872,000 for the quarter and six-monthperiod in the prior fiscal year, respectively. Royalty expense was $152,000 and$350,000 for the quarter and six months ended December 31, 2004, and was$121,000 and $217,000 for the quarter and six-month period in the prior fiscalyear, respectively. We are concerned by the trend that indicates a continuingincrease in our selling, general and administrative expenses and we performed adetailed analysis of individual categories of such expenses during the end of oursecond fiscal quarter. We are currently evaluating our operational structure,and plan to use our evaluation as a tool to help streamline our operationsfurther in order to reduce our operating expenses. As a percentage of netsales, selling, general and administrative expenditures were 50% and 42% forthe quarters and were 53% and 42% for the six-month periods ended December 31,2004 and 2003, respectively. Had we not recorded severance compensation for ourlate Chairman and former Chief Executive Officer, as a percentage of net sales,selling, general and administrative expenses would have been 40% and 42% forthe quarter and six months ended December 31, 2004, respectively. As apercentage of net sales, selling, general and administrative expenses were 40%and 42% for the quarter and six months ended December 31, 2003, respectively.

 

Income(loss) before (provision for) benefit from income taxes for the six monthsended December 31, 2004, was ($3,282,000), a difference of ($3,059,000), or 1372%,as compared with ($223,000) for the same period in the prior fiscal year.Benefit from income taxes was $0 for the six months ended December 31, 2004, adifference of ($73,000) from $73,000 for the same period in the prior fiscalyear. Net loss for the three months ended December 31, 2004, was ($3,282,000),a difference of ($3,132,000), or 2088%, as compared with ($150,000) for thesame period in the prior fiscal year. The difference in benefits from incometaxes between the fiscal periods arose primarily because of a change inestimates between the periods with regard to the recoverability of deferred taxassets. Because of our continued trend of net losses in the 2004 and mostrecent prior fiscal years, at June 30, 2004, we determined that it was moreprobable than not that none of our net deferred tax assets would be recovered,and we increased our valuation allowance to effectively reduce our net deferredtax assets to zero. While we are attempting to streamline our businessoperations and to initiate other improvements to return the Company toprofitability, we cannot be certain that our efforts will result in thegeneration of future profits sufficient to offset our significant net operatingloss carryforwards prior to their expirations. Therefore, during the six monthsended December 31, 2004, we did not record a benefit from income taxesassociated with the corresponding loss for the six-month period.

 

Basic earnings (loss) pershare were ($0.77) and $0.01 for the quarters and were ($1.29) and ($0.06) forthe six-month periods ended December 31, 2004 and 2003, respectively. Diluted earnings(loss) per share were ($0.77) and $0.00 for the quarters and ($1.29) and($0.06) for the six month periods ended December 31, 2004 and 2003,respectively.

 

Our book value per sharewas $6.06 at December 31, 2004, $7.37 at June 30, 2004, and $8.31 at December 31,2003.

 

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**SPORT-HALEY, INC.**

**ITEM 3QUALITATIVE AND QUANTITATIVE 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 December 31, 2004, wehave not used derivative instruments or engaged in hedging activities. Ourmarket risk has not changed significantly from September 30, 2004.

 

**Interest Rate Risk**

 

The Company maintains arevolving line of credit agreement with a commercial bank. The revolving lineof credit agreement provides for interest at 1⁄2% below the bank’s prime rate.The agreement provides for a maximum loan amount of $9,000,000 to Sport-Haleycollateralized 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. The line of credit agreement expired onDecember 5, 2004, and we are currently negotiating with the bank for itsrenewal. Since the expiration date of the line of credit, the bank hascontinued to issue letters of credit without fail on our behalf, and we havebeen told by the bank representative assigned to our accounts that the bankintends to renew the agreement. We did not have any outstanding borrowingsunder the line of credit at December 31, 2004. We had outstanding letters ofcredit of approximately $1,758,000 at December 31, 2004. Outstanding letters ofcredit reduce the amount available for borrowing under the line of credit.Increases in the bank’s prime rate and/or a renewal at a higher rate could,however, increase the interest expense with respect to future borrowings,including borrowings under the line of credit. We do not use derivativefinancial 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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**SPORT-HALEY, INC.**

**ITEM 4 CONTROLS AND PROCEDURES**

 

**(a)****               Evaluationof Disclosure Controls and Procedures**

 

Management of theCompany, with the participation of the Interim Chief Executive Officer and theChief Financial Officer, conducted an evaluation of the effectiveness of theCompany’s 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, the Company’s disclosure controls andprocedures were effective in reaching a reasonable level of assurance that: (a)all material information relating to the Company, required to be disclosed inthis report, 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.

 

As discussed in *“Recent Developments,”* we consider programming and humanerrors and a system malfunction that had previously affected our computersystem’s ability to properly compute the per-item valuations of our finishedgoods inventories using a weighted average costing method to be an indicationof a material weakness in our internal controls over financial reporting withrespect to inventory valuation throughout the period covered by this report.This weakness in our controls prevented us from relying upon the system-recordedtransactions with respect to finished goods inventories during the periodcovered by this report. During the period covered by this report, we recomputedthe estimated value of our finished goods inventories using a standard costassumption. We previously performed an analysis to compare the landed costcomponents of our finished goods inventories with our respective standard costcomponents, and we performed an analysis of the allocated overhead portion ofour standard costs. We concluded that valuations using a standard cost assumptionyielded a fair estimation of our finished goods inventories. In December 2004,we performed certain procedures recommended by the developer of our software inorder to correct errors caused by the system malfunction. In conjunction withperforming the suggested procedures, we also performed a physical inventory ofour finished goods apparel at December 31, 2004. The standard costs of ourfinished goods inventories have not changed since the analyses of such costswere performed. Therefore, at the conclusion of our December 31, 2004, physicalinventory, we valued our finished goods inventories, as determined by theresults of the physical count, using a standard cost assumption. Upon applyingthe procedures recommended by our software developers, taking the physicalinventory of finished goods apparel and valuing our correspondingquantification of finished goods inventory items using a standard costassumption, the Interim Chief Executive Officer and Chief Financial Officerbelieve that the procedures we applied to quantify and value our finished goodsinventories at December 31, 2004, provide us with reasonable assurance that theCompany’s disclosure controls and procedures were effective as of the end ofthe period covered by this report.

 

The material weakness,discussed above, impaired our ability to rely upon information created by ourcomputer system to fairly present, in all material respects, our financialcondition, results of operations and cash flows for the period covered by thisreport. Our analyses with respect to the standard cost components of ourfinished goods inventories caused us to conclude with reasonable assurance thatour using a standard cost assumption yielded a fair estimation of our finishedgoods inventories during the periods covered by this report. The inability ofour computer system to properly calculate the per-item valuations of ourfinished goods inventories also affected the system-recorded amounts within ourcost of goods sold

 

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during the period coveredby this report. Costs associated with invoiced sales and returns as well asinventory adjustments are natural components of our cost of goods sold. Becausewe concluded with reasonable assurance that our using a standard costassumption yielded a fair estimation of our finished goods inventories and weconsistently recorded adjustments to inventories as components of cost of goodssold during the periods covered by this report, we believe with reasonableassurance that our cost of goods sold are fairly stated during the periodscovered by this report. Therefore, the Interim Chief Executive Officer andChief Financial Officer believe that a standard cost valuation of our finishedgoods inventories provides us with reasonable assurance that our report fairlypresents, in all material respects, our financial condition, results ofoperations and cash flows.

 

**(b)****               Changesin Internal Controls**

 

During the second quarterof fiscal 2005, we instituted two changes in internal controls over financialreporting that materially affected, or are reasonably likely to materiallyaffect, the Company’s internal controls over financial reporting: *(i)* As discussed in *“Recent Developments,”*we previously discovered a malfunction in the operation of one of our computersystem procedures with respect to finished goods inventory valuations that wasreferred to the software developers for advice. The software developersrecommended zeroing out and then re-entering all finished goods inventories andrelated pending transactions to correct the problem. We performed the suggestedprocedures in conjunction with a physical inventory at December 31, 2004, andhave been advised by our former software consultants that the valuation problemcaused by the system malfunction has now been corrected. After applying therecommended procedures, we compared the per-item costs of several of ourfinished goods inventory items with their respective standard costs and notedno discrepancies. We plan to closely monitor the costing functions within ourcomputer system to determine whether we will be able to begin to rely upon thesystem to properly value our finished goods inventories without furthermodifications to the system functions. *(ii)* Asdiscussed in *“Critical Accounting Policies and Estimates,”*at December 31, 2004, we improved the methods that we use to assess therecoverability of our finished goods inventories. We developed a system to helpus better forecast finished goods inventories expected to remain at the end ofa selling season, which allows us to better estimate the recoverability offinished goods inventories, thereby strengthening our controls with respect toinventory valuation.

 

TheCompany’s management, including the Interim Chief Executive Officer and the ChiefFinancial Officer, does not expect that our disclosure controls and proceduresor our internal controls over financial reporting will, in all instances,prevent all errors and all fraud. A control system, no matter how wellconceived or operated, can only provide reasonable, not absolute, assurancethat the objectives of the control system are met. While the Company’s controlsystems provide a reasonable assurance level, the design of its control systemsreflects the fact that there are resource constraints, and the benefits of suchcontrols were considered relative to their costs. Because of the inherentlimitations in all control systems, no evaluation of controls can provideabsolute assurance that all control issues and instances of fraud, if any,within the Company have been detected. These inherent limitations include therealities that judgments in decision-making can be faulty, and that breakdownscan occur because 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

 

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achievingits stated goals under all potential future conditions. Because of the inherentlimitations in a cost-effective control system, misstatements due to error orfraud may occur and not be detected.

 

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** **

**SPORT-HALEY, INC.**

**PART II**

**OTHER INFORMATION**

 

**ITEM 1**      **LEGAL PROCEEDINGS**

 

As previously reported,on September 26, 2003, the United States Securities and Exchange Commission(the “Commission”) filed suit in the United States District Court for theDistrict of Colorado (the “Action”) against Sport-Haley, its late Chairman andformer Chief Executive Officer, Robert G. Tomlinson, and its former controller,Steve S. Auger (the “Defendants”). The Commission filed an amended complaint inOctober 2003, which added one of the Company’s former auditors to the Action asa Defendant. The suit seeks an injunction against future violations and otherrelief, including disgorgement, civil penalties and an order barring Mr.Tomlinson and Mr. Auger from serving as a director or officer of any publiclyheld company. The suit alleges that the Defendants misrepresented inventories,period costs and losses on the sale of headwear equipment in annual and/orquarterly financial statements for our fiscal years 2000, 1999 and 1998. Thecomplaint alleges that the Company violated §17(a) of the Securities Act of1933 (the “Securities Act”), §10(b), §13(b)(2) and §15(d) of the SecuritiesExchange Act of 1934 (the “Exchange Act”) and various other rules promulgatedthereunder. The amended complaint further alleges that Mr. Tomlinson and Mr.Auger violated §17(a) of the Securities Act, §10(b) and §13(b)(5) of theExchange Act and Rules 10b-5 and 13b-2 thereunder. Finally, the suit allegesthat 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 rules promulgated thereunder.The Commission’s suit primarily relates to errors in our previously issuedfinancial statements that we previously reported when we voluntarily restatedour financial statements for fiscal years 1999 and 1998 and subsequentlycorrected material financial information for the quarterly periods of fiscalyears 2000, 1999 and 1998. The Defendants have answered the allegations of theamended complaint, denying the substantive allegations and asserting variousdefenses. Discovery in the Action has concluded. No trial date has yet beendetermined. The Company, subject to its Bylaws and Colorado law, agreed toindemnify Mr. Tomlinson and Mr. Auger, and we have advanced the costs of theirdefenses, pending final adjudication of the Action. The costs of defense of theAction by the Defendants are covered by our applicable liability insurance,subject to a retention amount, which has been satisfied, and other limitations.After Mr. Tomlinson’s death in September 2004, the Commission advised hiscounsel that it would dismiss Mr. Tomlinson from the case and would not seekany relief against Mr. Tomlinson’s estate. However, the Commission has not yetdismissed Mr. Tomlinson from the action. 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 unrecoverable future costs that we will incurdefending the Action. However, if the suit were determined in favor of theCommission and against the Defendants, the possible monetary penalties andother relief that we might be required to pay could negatively impact ourfinancial position and the results of our operations.

 

As of December 31, 2004,we had cumulatively incurred approximately $915,000 in potentially recoverable costsrelated to the restatements of our financial statements and material quarterlyinformation, the investigation by the Commission and a class action lawsuitthat has been settled. The policy retention for such costs has been satisfied,and one of our insurance carriers had reimbursed us $289,000 as of December 31,2004, of which $85,000 was received during the six months ended December 31,2004. Amounts recovered from our insurance carriers are

 

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generally offset againstother related legal expenses in the period in which they are recovered. However,amounts recovered from our insurance carriers are generally included in otherincome to the extent that such recovery exceeds legal expenses for relatedmatters incurred in the period in which the recovery is received. For the sixmonths ended December 31, 2004, we offset $53,000 in related legal expenses andrecorded $32,000 in other income with respect to reimbursements received duringthat period. Subsequent to December 31, 2004, one of our insurance carriersreimbursed us an additional $68,000.

 

As previously reported,we retained legal counsel to possibly pursue claims against our former auditorsin connection with damages suffered as a result of the restatements of ourfinancial statements for the fiscal years ended June 30, 1999 and 1998 and thecorrections of material financial information for the quarterly periods of thefiscal years ended June 30, 2000, 1999 and 1998. Further, counsel to the formerauditors has advised us that the former auditors may bring certain claimsagainst us. We believe that the claims threatened by the former auditors relateto allegations of unpaid fees. Each party continues to deny any liability tothe other party. Neither the Company nor the former auditors have yet filed anylegal action to assert any of these claims.

 

We are subject to variousother legal proceedings and claims which arise in the ordinary course of business.Based upon information that is currently available, we do not believe that thetotal impact of the other legal proceedings will materially affect ourfinancial position or the results of our operations.

 

**ITEM 5**      **OTHER INFORMATION**

 

Aspreviously reported, in October 2004, our Board of Directors approved aresolution not to renew the executive employment agreement of Kevin M.Tomlinson, our Chief Executive Officer, President and Director, beyond the endof the term of the agreement on March 17, 2005. The Board and Mr. Tomlinsonagreed that he would continue to act as Chief Executive Officer and Presidentuntil a new or interim chief executive officer was appointed or the end of theterm of his employment agreement, whichever occurred first. In accordance withthe 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. In November 2004, Mr.Tomlinson resigned as a Director. In January 2005, Mr. Jewell entered into anemployment agreement, effective November 1, 2004, to serve as Interim ChiefExecutive Officer through June 30, 2005, subject to automatic monthlyextensions. The agreement provides for salary of $50,000 per year in additionto the salary Mr. Jewell is entitled to receive under his employment agreementfor serving as Senior Vice President, in which capacity he will continue toserve. Once a permanent Chief Executive Officer is appointed, we expect thatMr. Jewell will remain with us as our Senior Vice President.

 

Theterms of an executive employment agreement with Mr. Tomlinson require thepayment of severance and other compensation as a result of the Company’snon-renewal of the agreement, as described above. Under the terms of theagreement, Mr. Tomlinson is entitled to severance compensation for a term of 36months equal to his salary and incentive bonus payments as

 

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shallhave been paid to him during the most recent twelve-month period. In addition,the agreement provides for Mr. Tomlinson’s participation in all employeebenefit plans, during the time he is receiving severance compensation, and forreimbursement from the Company for legal expenses Mr. Tomlinson incurred withrespect to exercising his right to obtain professional counsel regardingtermination of the contract. We estimated the severance and other compensation dueto Mr. Tomlinson upon the expiration of his employment contract andreimbursement for legal fees. Accordingly, we recorded the severance and other compensationestimate of $520,000 during the quarter ended December 31, 2004.

 

InDecember 2004, effective December 1, 2004, we entered into an amendment to theemployment agreement with Patrick W. Hurley, our Chief Financial Officer. Theamended agreement increases Mr. Hurley’s annual salary to $110,000 and amendsthe provisions of his prior agreement, which otherwise continue to apply,regarding termination by the executive without cause.

 

InDecember 2004, effective January 1, 2005, we entered into an amended employmentagreement with Mark Maley to continue to serve as our Vice President – Sales.The amended agreement provides for a term of one year, with automaticextensions of one year unless terminated earlier. The amendment provides foradditional compensation in the form of an override commission of 0.2% on theCompany’s gross annualized sales (excluding discounted sales of more than 50%from original suggested wholesale prices), returns and credits.

 

InDecember 2004, effective December 20, 2004, we entered into an employmentagreement with Barry L. Hyman to serve as our Regional Sales Manager. Theemployment agreement provides for a term of one year, subject to automaticone-year extensions unless otherwise terminated, at an annual salary of$95,000, plus an override commission of 0.2% on the Company’s gross annualizedsales (excluding discounted sales of more than 50% from original suggestedwholesale prices), returns and credits.

 

InDecember 2004, effective December 20, 2004, we entered into an employmentagreement with George E. Tomlinson to serve as our Director – Operations andProduction. Mr. Tomlinson has served the Company substantially in that positionfor more than a year, but without a written employment agreement. Theemployment agreement provides for a term of one year, subject to automaticone-year extensions unless otherwise terminated, at an annual salary of$95,000.

 

**ITEM 6**      **EXHIBITS**

 

Exhibit 10.1 – Amendmentto Executive Employment Agreement of Patrick W. Hurley, effective December 1,2004

 

Exhibit 10.2 – Letteragreement amending Executive Employment Agreement of Donald W. Jewell,effective November 1, 2004

 

Exhibit 10.3 – ExecutiveEmployment Agreement between the Company and Mark Maley, effective January 1,2005

 

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Exhibit 10.4 – EmploymentAgreement between the Company and George E. Tomlinson, effective December 20,2004

 

Exhibit 10.5 – EmploymentAgreement between the Company and Barry L. Hyman, effective December 20, 2004

 

Exhibit 31.1 –Certification of Donald W. Jewell pursuant to Exchange Act Rule13a-14(a)/15d-14(a)

 

Exhibit 31.2 –Certification of Patrick W. Hurley pursuant to Exchange Act Rule13a-14(a)/15d-14(a)

 

Exhibit 32.1 –Certifications of Donald W. Jewell and Patrick W. Hurley pursuant to 18 U.S.C.§1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 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: February 22, 2005 |   | /s/ PATRICK W. HURLEY                           |   |
|                    |   | Patrick W. Hurley                               |
|                    |   | Chief Financial Officer                         |
|                    |   | *(Principal Financial and  Accounting Officer)* |

 

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