** **

**SECURITIES AND EXCHANGECOMMISSION**

** **

**WASHINGTON, D.C.  20549**

 

**FORM 10-Q**

 

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

 

**For the quarterly period ended December 31,2005**

 

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

 

**Commission File No. 0-51715**

 

**SPORT-HALEY, INC.**

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

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

 

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

(Address of principal executiveoffices)

 

**(303) 320-8800**

(Issuer’s telephone numberincluding area code)

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding 12months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements forthe past 90 days.                              ý Yeso  No

 

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

 
| Large accelerated filero |   | Accelerated  filero |   | Non-accelerated  filerý |
|--------------------------|--------|---------------------|--------|------------------------------|

 

Indicate by check mark whether the registrant is a shell company (asdefined in Rule 12b-2 of the Exchange Act).

o  Yes ý No

 

APPLICABLE ONLY TO ISSUERS INVOLVED INBANKRUPTCYPROCEEDINGS DURING THE PRECEDING FIVE YEARS:

 

Indicateby check mark whether the registrant has filed all documents and reportsrequired to be filed by Sections 12, 13 or 15(d) of the SecuritiesExchange Act of 1934 subsequent to the distribution of securities under a planconfirmed by a court.

o  Yes o No

 

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

 
| **Class**                      | ** ** | **Outstanding at February 14,  2006** |
|--------------------------------|------------|--------------------------------------------|
| **Common Stock, no par value** | ** ** | **2,770,252**                              |

 

 

----

 

**TABLE OFCONTENTS**

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

 

2

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**SPORT-HALEY,INC.**

**CONDENSED CONSOLIDATED BALANCE SHEETS**

 
| ** **                                                                                                                      | ** ** | **December 31,  2005** | ** ** | **June 30,  2005** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|-------------------------|------------|
| ** **                                                                                                                      | ** ** | **(Unaudited)**             | ** ** | **(***)**               | ** ** |
|                                                                                                                            |       |                        |       |                    |       |
| **ASSETS**                                                                                                                      |       |                        |       |                    |       |
|                                                                                                                            |       |                        |       |                    |       |
| Current  assets:                                                                                                                |       |                        |       |                    |       |
| Cash and  cash equivalents                                                                                                      |       | $                           | 8,387,000  |                    | $          | 7,721,000 |   |
| Accounts  receivable, net of allowances of $535,000 and $691,000, respectively                                                  |       | 2,723,000                   |       | 4,495,000               |       |
| Inventories                                                                                                                     |       | 5,110,000                   |       | 4,153,000               |       |
| Prepaid  expenses and other                                                                                                     |       | 336,000                     |       | 196,000                 |       |
| Total  current assets                                                                                                           |       | 16,556,000                  |       | 16,565,000              |       |
|                                                                                                                            |       |                        |       |                    |       |
| Property and  equipment, net                                                                                                    |       | 733,000                     |       | 922,000                 |       |
| Other assets                                                                                                                    |       | 3,000                       |       | 3,000                   |       |
|                                                                                                                            |       |                        |       |                    |       |
| Total Assets                                                                                                                    |       | $                           | 17,292,000 |                    | $          | 17,490,000 |   |
|                                                                                                                            |       |                        |       |                    |       |
| **LIABILITIES  AND SHAREHOLDERS’ EQUITY**                                                                                  |       |                        |       |                    |       |
|                                                                                                                            |       |                        |       |                    |       |
| Current  liabilities:                                                                                                           |       |                        |       |                    |       |
| Accounts  payable                                                                                                               |       | $                           | 705,000    |                    | $          | 582,000 |   |
| Accrued  royalties payable                                                                                                      |       | 175,000                     |       | 294,000                 |       |
| Accrued  commissions payable                                                                                                    |       | 155,000                     |       | 249,000                 |       |
| Accrued  payroll                                                                                                                |       | 464,000                     |       | 533,000                 |       |
| Other                                                                                                                           |       | 99,000                      |       | 93,000                  |       |
| Total  current liabilities                                                                                                      |       | 1,598,000                   |       | 1,751,000               |       |
|                                                                                                                            |       |                        |       |                    |       |
| Commitments  and Contingencies (Note 4)                                                                                         |       | —                      |       | —                  |       |
|                                                                                                                            |       |                        |       |                    |       |
| Shareholders’  equity:                                                                                                     |       |                        |       |                    |       |
| Preferred  stock, no par value; 1,500,000 shares authorized; none issued and outstanding                                        |       | —                      |       | —                  |       |
| Common  stock, no par value; 15,000,000 shares authorized; 2,770,252 and 2,645,252  shares issued and outstanding, respectively |       | 10,813,000                  |       | 10,460,000              |       |
| Additional  paid-in capital                                                                                                     |       | 1,621,000                   |       | 1,590,000               |       |
| Retained  earnings                                                                                                              |       | 3,260,000                   |       | 3,689,000               |       |
| Total  shareholders’ equity                                                                                                |       | 15,694,000                  |       | 15,739,000              |       |
|                                                                                                                            |       |                        |       |                    |       |
| Total  Liabilities and Shareholders’ Equity                                                                                |       | $                           | 17,292,000 |                    | $          | 17,490,000 |   |

 

----

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

 

See accompanying notes to condensedconsolidated financial statements.

 

3

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**SPORT-HALEY,INC.**

**CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**

 
| ** **                                       | ** ** | **Three Months Ended   December 31,** | ** ** | **Six Months Ended   December 31,** | ** ** |
|--------------------------------------------------|------------|--------------------------------------------|------------|------------------------------------------|------------|
| ** **                                       | ** ** | **2005**                                   | ** ** | **2004**                                 | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                       | ** ** | **(Unaudited)**                            | ** ** | **(Unaudited)**                          | ** ** | **(Unaudited)** | ** ** | **(Unaudited)** | ** ** |
|                                             |       |                                       |       |                                     |       |   |   |   |   |
| Net sales                                        |       | $                                          | 4,429,000  |                                     | $          | 5,000,000 |   | $ | 8,440,000 |   | $ | 10,570,000 |   |
|                                             |       |                                       |       |                                     |       |   |   |   |   |
| Cost of  goods sold                              |       | 2,663,000                                  |       | 3,847,000                                |       | 5,304,000 |   | 7,104,000 |   |
| Impairments                                      |       | 129,000                                    |       | 695,000                                  |       | 194,000 |   | 1,238,000 |   |
| Total cost  of goods sold                        |       | 2,792,000                                  |       | 4,542,000                                |       | 5,498,000 |   | 8,342,000 |   |
|                                             |       |                                       |       |                                     |       |   |   |   |   |
| Gross profit                                     |       | 1,637,000                                  |       | 458,000                                  |       | 2,942,000 |   | 2,228,000 |   |
|                                             |       |                                       |       |                                     |       |   |   |   |   |
| Other  Operating Costs:                          |       |                                       |       |                                     |       |   |   |   |   |
| Selling,  general and administrative expenses    |       | 1,438,000                                  |       | 2,364,000                                |       | 3,162,000 |   | 5,223,000 |   |
| Royalty  expense                                 |       | 175,000                                    |       | 152,000                                  |       | 338,000 |   | 350,000 |   |
| Total other  operating costs                     |       | 1,613,000                                  |       | 2,516,000                                |       | 3,500,000 |   | 5,573,000 |   |
|                                             |       |                                       |       |                                     |       |   |   |   |   |
| Income  (loss) from operations                   |       | 24,000                                     |       | (2,058,000                               | )          | (558,000 | ) | (3,345,000 | ) |
|                                             |       |                                       |       |                                     |       |   |   |   |   |
| Other  income, net                               |       | 77,000                                     |       | 52,000                                   |       | 130,000 |   | 63,000 |   |
|                                             |       |                                       |       |                                     |       |   |   |   |   |
| Income  (loss) before provision for income taxes |       | 101,000                                    |       | (2,006,000                               | )          | (428,000 | ) | (3,282,000 | ) |
|                                             |       |                                       |       |                                     |       |   |   |   |   |
| Provision  for income taxes                      |       | (2,000                                     | )          | —                                   |       | (1,000 | ) | — |   |
|                                             |       |                                       |       |                                     |       |   |   |   |   |
| Net income  (loss)                               |       | $                                          | 99,000     |                                     | $          | (2,006,000 | ) | $ | (429,000 | ) | $ | (3,282,000 | ) |
|                                             |       |                                       |       |                                     |       |   |   |   |   |
| Basic  earnings (loss) per common share          |       | $                                          | 0.04       |                                     | $          | (0.77 | ) | $ | (0.16 | ) | $ | (1.29 | ) |
|                                             |       |                                       |       |                                     |       |   |   |   |   |
| Diluted  earnings (loss) per common share        |       | $                                          | 0.03       |                                     | $          | (0.77 | ) | $ | (0.16 | ) | $ | (1.29 | ) |
|                                             |       |                                       |       |                                     |       |   |   |   |   |
| Basic  weighted average shares  outstanding      |       | 2,770,000                                  |       | 2,545,000                                |       | 2,728,000 |   | 2,541,000 |   |
|                                             |       |                                       |       |                                     |       |   |   |   |   |
| Diluted  weighted average shares  outstanding    |       | 2,968,000                                  |       | 2,545,000                                |       | 2,728,000 |   | 2,541,000 |   |

 

See accompanying notes to condensedconsolidated financial statements.

 

4

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**SPORT-HALEY, INC.**

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

 
| ** **                                                                       | ** ** | **Six Months Ended   December 31,** | ** ** |
|----------------------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                       | ** ** | **2005**                                 | ** ** | **2004** | ** ** |
| ** **                                                                       | ** ** | **(Unaudited)**                          | ** ** | **(Unaudited)** | ** ** |
| **Cash  flows from operating activities:**                                       |       |                                     |       |   |   |
| Net loss                                                                         |       | $                                        | (429,000   | ) | $ | (3,282,000 | ) |
|                                                                             |       |                                     |       |   |   |
| Adjustments  to reconcile net loss to net cash provided by operating activities: |       |                                     |       |   |   |
| Depreciation  and amortization                                                   |       | 170,000                                  |       | 170,000 |   |
| Impairments  and write-downs                                                     |       | 194,000                                  |       | 1,238,000 |   |
| Allowance  for doubtful accounts                                                 |       | 75,000                                   |       | 120,000 |   |
| Common stock  options                                                            |       | 31,000                                   |       | 31,000 |   |
| Gain/Loss on  sale of fixed assets                                               |       | 12,000                                   |       | 3,000 |   |
| Cash  provided (used) due to changes in assets and liabilities:                  |       |                                     |       |   |   |
| Accounts  receivable                                                             |       | 1,697,000                                |       | 2,410,000 |   |
| Inventories                                                                      |       | (1,151,000                               | )          | 1,434,000 |   |
| Other assets                                                                     |       | (140,000                                 | )          | 22,000 |   |
| Accounts  payable                                                                |       | 123,000                                  |       | (914,000 | ) |
| Accrued  commissions and other expenses                                          |       | (276,000                                 | )          | 356,000 |   |
| Net cash  provided by operating activities                                       |       | 306,000                                  |       | 1,588,000 |   |
|                                                                             |       |                                     |       |   |   |
| **Cash  flows from investing activities:**                                       |       |                                     |       |   |   |
| Redemption  of held-to-maturity investments                                      |       | —                                   |       | 538,000 |   |
| Proceeds  from sales of fixed assets                                             |       | 16,000                                   |       | — |   |
| Purchase of  fixed assets                                                        |       | (9,000                                   | )          | (67,000 | ) |
| Net cash  provided by investing activities                                       |       | 7,000                                    |       | 471,000 |   |
|                                                                             |       |                                     |       |   |   |
| **Cash  flows from financing activities:**                                       |       |                                     |       |   |   |
| Net proceeds  from issuance of common stock                                      |       | 353,000                                  |       | 63,000 |   |
| Net cash  provided by financing activities                                       |       | 353,000                                  |       | 63,000 |   |
|                                                                             |       |                                     |       |   |   |
| **Net  increase in cash and cash equivalents**                                   |       | 666,000                                  |       | 2,122,000 |   |
|                                                                             |       |                                     |       |   |   |
| **Cash and  cash equivalents, beginning**                                        |       | 7,721,000                                |       | 3,890,000 |   |
|                                                                             |       |                                     |       |   |   |
| **Cash and  cash equivalents, ending**                                           |       | $                                        | 8,387,000  |   | $ | 6,012,000 |   |
|                                                                             |       |                                     |       |   |   |
| **Supplemental  disclosure of cash flow information:**                           |       |                                     |       |   |   |
| Cash paid  during the period for:                                                |       |                                     |       |   |   |
| Income taxes                                                                     |       | $                                        | 2,000      |   | $ | 3,000 |   |

 

See accompanying notes to condensedconsolidated financial statements.

 

5

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**SPORT-HALEY, INC.**

**NOTESTO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

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

 

*Principlesof Consolidation* – Our fiscal year 2006 condensedconsolidated financial statements include the accounts of Sport-Haley, Inc.(“Sport-Haley”) and Reserve Apparel Group LLC (“Reserve Apparel”) (Sport-Haley, Inc.and Reserve Apparel Group LLC collectively referred to as the “Company”).Reserve Apparel was formed in November 2005 by Sport-Haley and ExplorerGear USA to manufacture and market Top-FliteTM branded apparel. Sport-Haley and Explorer Gear USA each own50% interests in Reserve Apparel. A licensing agreement between Callaway GolfCompany and Sport-Haley allows Reserve Apparel to market golf apparel bearingthe Top-FliteTM brand. Allsignificant inter-company accounts and transactions between Sport-Haley andReserve Apparel have been eliminated. In December 2005, Sport-Haleycontributed capital of $25,000 and advanced a loan of $189,000 to ReserveApparel. As of December 31, 2005, Reserve Apparel recorded no othermaterial transactions and Explorer Gear USA had contributed no capital toReserve Apparel. Accordingly, the condensed consolidated financial statementsof the Company do not reflect the minority interest of Explorer Gear USA inReserve Apparel at December 31, 2005.

 

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

 

Certain information in footnote disclosuresnormally included in financial statements has been condensed or omitted inaccordance with the rules and regulations of the Securities and ExchangeCommission. The information included in this Form 10-Q should be read inconjunction with financial statements and notes thereto and Management’sDiscussion and Analysis of Financial Condition and Results of Operations forthe year ended June 30, 2005, included in the Company’s filing on Form 10-K.

 

*Restatementof Previously Issued Interim Financial Statements*– The Audit Committee of our Board of Directors, along with senior management,determined that our statements of operations and cash flows for the periodended September 30, 2005, contained an error, which when corrected would resultin a material impact on our results of operations for the quarter endedSeptember 30, 2005.  The Audit Committeeand senior management have therefore determined that the statements ofoperations and cash flows for the period ended September 30, 2005, requirerestatement.  The error relates to ouraccounting for bonuses paid to certain executives and a key employee, which wehad recorded in October 2005.  The AuditCommittee and senior management determined that compensation expense relatingto the bonuses should have been recorded in the quarter ended September 30,2005.  We expect to file an amendedinterim report on Form 10-Q for the period ended September 30, 2005, to correctthis error, which we anticipate will increase the amount of reported net lossfor the quarterly period by $102,000, or 24%. The correction will not have a material effect on our statements ofoperations or cash flows for the six-month period ended December 31, 2005.

 

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

 

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

 

At December 31, 2005,there were outstanding options to purchase 678,500 shares of our common stockat exercise prices ranging from $2.71 to $9.78 per share and expiration

 

6

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dates between July 2006and January 2013. During the quarter ended December 31, 2005, nooptions were exercised and 10,000 options expired.

 

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

 

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

 

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

 
| ** **                                                                           | ** ** | **Six Months Ended December 31,** | ** ** |
|--------------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                           | ** ** | **2005**                               | ** ** | **2004** | ** ** |
| Net loss -  as reported                                                              |       | $                                      | (429,000   | ) | $ | (3,282,000 | ) |
| Effect of  employee stock-based compensation included in reported net loss           |       | 31,000                                 |       | 31,000 |   |
| Effect of  employee stock-based compensation per SFAS 123                            |       | (31,000                                | )          | (211,000 | ) |
| Net loss  applicable to common stock (2004 pro forma)                                |       | $                                      | (429,000   | ) | $ | (3,462,000 | ) |
| Basic and  Diluted:                                                                  |       |                                   |       |   |   |
| Loss per  share - as reported                                                        |       | $                                      | (0.16      | ) | $ | (1.29 | ) |
| 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                  |       | (0.01                                  | )          | (0.08 | ) |
| Loss per  share applicable to common stock (2004 pro forma)                          |       | $                                      | (0.16      | ) | $ | (1.36 | ) |

 

7

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| ** **                                                                                     | ** ** | **Three Months Ended December 31,** |
|------------------------------------------------------------------------------------------------|------------|------------------------------------------|
| ** **                                                                                     | ** ** | **2005**                                 | ** ** | **2004** | ** ** |
| Net income  (loss) - as reported                                                               |       | $                                        | 99,000 |   | $ | (2,006,000 | ) |
| Effect of  employee stock-based compensation included in reported net loss                     |       | —                                   |   | 16,000 |   |
| Effect of  employee stock-based compensation per SFAS 123                                      |       | —                                   |   | (106,000 | ) |
| Net income  (loss) applicable to common stock (2004 pro forma)                                 |       | $                                        | 99,000 |   | $ | (2,096,000 | ) |
|                                                                                           |       |                                     |   |   |   |
| Basic:                                                                                         |       |                                     |   |   |   |
| Income  (loss) per share - as reported                                                         |       | $                                        | 0.04 |   | $ | (0.77 | ) |
| Per share  effect of employee stock-based compensation included in reported net income  (loss) |       | —                                   |   | 0.01 |   |
| Per share  effect of employee stock-based compensation per SFAS 123                            |       | —                                   |   | (0.04 | ) |
| Income  (loss) per share applicable to common stock (2004 pro forma)                           |       | $                                        | 0.04 |   | $ | (0.80 | ) |
|                                                                                           |       |                                     |   |   |   |
| Diluted:                                                                                       |       |                                     |   |   |   |
| Income  (loss) per share - as reported                                                         |       | $                                        | 0.03 |   | $ | (0.77 | ) |
| Per share  effect of employee stock-based compensation included in reported net income  (loss) |       | —                                   |   | 0.01 |   |
| Per share  effect of employee stock-based compensation per SFAS 123                            |       | —                                   |   | (0.04 | ) |
| Income  (loss) per share applicable to common stock (2004 pro forma)                           |       | $                                        | 0.03 |   | $ | (0.80 | ) |

 

*Segments* – The consolidated Company has two operatingsegments: (1) designing, purchasing, contracting for the manufacture ofand marketing women’s and men’s fashion

 

8

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golf apparel and outerwear; and, (2) wholesalesales of branded apparel to large, discount store chains and other mass marketoutlets. The information for these segments is the information used by theCompany’s chief decision maker to evaluate operating performance. Segmentinformation for wholesale sales of branded apparel to large, discount storechains and other mass market outlets has not been presented in this report,because there was no material business activity for this segment as of December 31,2005.

 

**NOTE 2****             INVENTORIES**

 
| ** **                              | ** ** | **December 31,  2005** | ** ** | **June 30,  2005** | ** ** |
|-----------------------------------------|------------|-----------------------------|------------|-------------------------|------------|
| Inventories consisted of the following: |       |                        |       |                    |       |
| Component                               |       | $                           | 319,000    |                    | $          | 387,000 |   |
| Finished  goods                         |       | 4,791,000                   |       | 3,766,000               |       |
|                                    |       |                        |       |                    |       |
|                                    |       | $                           | 5,110,000  |                    | $          | 4,153,000 |   |

 

**NOTE 3****             LINEOF CREDIT AGREEMENT**

 

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

 

**NOTE 4****             COMMITMENTSAND CONTINGENCIES**

 

At December 31, 2005,we had $985,000 in outstanding letters of credit that were issued to foreignsuppliers in accordance with finished goods inventory purchase commitments.Outstanding letters of credit reduce the amount available for borrowing underthe line of credit agreement.

 

**NOTE 5****             EARNINGSPER SHARE**

 

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

 

9

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| ** **                             | ** ** | **Three Months ended December 31,  2005** | ** ** |
|----------------------------------------|------------|------------------------------------------------|------------|
| ** **                             | ** ** | **Net  Income  (Loss)**                        | ** ** | **Weighted  Average  Shares** | ** ** | **Per Share** | ** ** |
| Income  (Loss) Per Common Share        |       |                                           |       |   |   |   |   |
|                                   |       |                                           |       |   |   |   |   |
| Basic income  (loss) per share         |       | $                                              | 99,000     |   | 2,770,000 |   | $ | 0.04 |   |
|                                   |       |                                           |       |   |   |   |   |
| Effect of  dilutive securities options |       | —                                         |       | 198,000 |   | (0.01 | ) |
|                                   |       |                                           |       |   |   |   |   |
| Diluted  income (loss) per share       |       | $                                              | 99,000     |   | 2,968,000 |   | $ | 0.03 |   |

 
| ** **                                     | ** ** | **Six Months ended December 31,  2005** | ** ** |
|------------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                     | ** ** | **Net  Income  (Loss)**                      | ** ** | **Weighted  Average  Shares** | ** ** | **Per Share** | ** ** |
| Loss Per  Common Share                         |       |                                         |       |   |   |   |   |
|                                           |       |                                         |       |   |   |   |   |
| Basic loss  per share                          |       | $                                            | (429,000   | ) | 2,728,000 |   | $ | (0.16 | ) |
|                                           |       |                                         |       |   |   |   |   |
| Effect of  dilutive securities options **[A]** |       | —                                       |       | — |   | — |   |
|                                           |       |                                         |       |   |   |   |   |
| Diluted loss  per share                        |       | $                                            | (429,000   | ) | 2,728,000 |   | $ | (0.16 | ) |

 
| ** **                                     | ** ** | **Three Months ended December 31,  2004** | ** ** |
|------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                     | ** ** | **Net  Income  (Loss)**                        | ** ** | **Weighted  Average  Shares** | ** ** | **Per Share** | ** ** |
| Loss Per  Common Share                         |       |                                           |       |   |   |   |   |
|                                           |       |                                           |       |   |   |   |   |
| Basic loss  per share                          |       | $                                              | (2,006,000 | ) | 2,545,000 |   | $ | (0.77 | ) |
|                                           |       |                                           |       |   |   |   |   |
| Effect of  dilutive securities options **[A]** |       | —                                         |       | — |   | — |   |
|                                           |       |                                           |       |   |   |   |   |
| Diluted loss  per share                        |       | $                                              | (2,006,000 | ) | 2,545,000 |   | $ | (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 | ) | 2,541,000 |   | $ | (1.29 | ) |
|                                           |       |                                         |       |   |   |   |   |
| Effect of  dilutive securities options **[A]** |       | —                                       |       | — |   | — |   |
|                                           |       |                                         |       |   |   |   |   |
| Diluted loss  per share                        |       | $                                            | (3,282,000 | ) | 2,541,000 |   | $ | (1.29 | ) |

 

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

 

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

 

On February 13, 2006, we entered into asettlement agreement to resolve all pending claims between Sport-Haley, Inc.,our former auditors and certain of our former auditors’ current and formermembers. Pursuant to the terms of the settlement agreement and a sharingagreement between Sport-Haley, Inc. and one of our director and officerliability insurance carriers, we will receive a net payment of approximately$173,000 from the total settlement with the former auditors.

 

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

 

During a mediation session in November 2005,we reached an agreement in principle with the former auditors to settle alldisputed claims between the parties and their affiliates. The parties have nowfinalized a written settlement agreement, which provides for payment toSport-Haley, Inc. of $525,000. In accordance with a sharing agreementbetween Sport-Haley, Inc. and one of its carriers for director and officerliability insurance, we will receive 33% of these settlement proceeds, orapproximately $173,000, and the insurance carrier will receive the remainder topartially recover amounts the carrier paid in connection with a previouslysettled class action securities lawsuit and defense costs the carrier hasreimbursed to us relating to the civil action lawsuit filed by the SEC.

 

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

 

On January 17, 2006, the Court entered aFinal Judgment, pursuant to a settlement reached with the Securities andExchange Commission (the “Commission” or the “SEC”), to resolve the pendingclaims in the civil action brought by the SEC against Sport-Haley, Inc.and our former Controller. The settlement had been considered by the Commissionin Washington D.C. and thereby approved on December 8, 2005. Thesettlement did not call for Sport-Haley, Inc. to pay any fine, civilpenalty or disgorgement. Pursuant to a written Consent entered into bySport-Haley, Inc. as part of the settlement, Sport-Haley, Inc.consented, without admitting or denying the allegations of the Complaint orAmended Complaint, to the entry of an injunction enjoining the Company fromviolating §17(a)(2) and §17(a)(3) of the Securities Act of 1933 (the “SecuritiesAct”), which do not require proof of scienter (an intent to deceive, manipulateor defraud), but may be based upon a showing of negligence, §13(b)(2) and§15(d) of the Securities Exchange Act of 1934 (the “Exchange Act”), and Rules 12b-20,15d-1 and 15d-13 promulgated thereunder. The

 

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settlement resulted in no injunction oradjudication against Sport-Haley, Inc. with respect to the claims allegingviolations of §17(a)(1) of the Securities Act, §10(b) of the ExchangeAct and Rule 10b-5 promulgated thereunder, which each require proof ofscienter.

 

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**SPORT-HALEY,INC.**

**ITEM 2 MANAGEMENT’S DISCUSSION AND ANALYSISOF**

**FINANCIALCONDITION AND RESULTS OF OPERATIONS**

 

ThisReport on Form 10-Q contains certain forward-looking statements, withinthe meaning of Section 27A of the Securities Act of 1933 and Section 21Eof the Securities Exchange Act of 1934. The words “may,” “will,” “expect,” “anticipate,”“continue,” “estimate,” “project,” “intend,” “believe,” “appear” and similarexpressions, variations or the negative of these words, and any statementregarding possible or assumed future results of operations of the Company’sbusiness, the markets for its products, anticipated expenditures, regulatorydevelopments or competition, or other statements regarding matters that are nothistorical facts, are intended to identify forward-looking statements, althoughnot all forward-looking statements contain such identifying words. The readershould be aware that our actual results could differ materially from thosecontained in forward-looking statements. The Company’s financial condition andthe results of its operations will depend on a number of factors, including,but not limited to, the following: our ability to control costs and expenses;our ability to successfully anticipate fashion trends, design favorablyaccepted fashion golf apparel, effectively advertise and communicate within themarketplace, and penetrate our chosen distribution channels; our ability tosuccessfully forecast sales and optimize inventory levels; our ability tosuccessfully manage risks associated with the trend of increasing sales withrespect to licensed apparel, such as the Ben Hogan® apparel collections;relations with and performance of suppliers; competition within golf apparelmarkets; business conditions and growth in the fashion golf apparel market andthe general economy; political and international trade relations; changes ininternational trade quota systems for apparel; consumer spending on golfapparel; general global economic and political conditions resulting fromthreats or acts of war or terrorism and responses thereto; timely performanceof third parties, such as freight forwarders, including risks of labor disputesand/or labor strikes; changes in product mix; inventory risks due to shifts inmarket and/or price erosion of purchased apparel; lost or reduced manufacturingcapacity of significant suppliers; loss or delay of shipments from foreignsuppliers; access to capital; maintaining satisfactory relationships withcommercial banking institutions; and, establishing controls with regard to andmaintaining the integrity of technology and information systems. Additionalinformation on these and other factors that could affect our financial resultsis included in the discussion below and in the Company’s Form 10-K for theyear ended June 30, 2005. There may be other factors not mentioned above,in the discussion below or included in our Securities and Exchange Commissionfilings 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 toSport-Haley’s fiscal year, which ends on June 30.

 

##### **OVERVIEW**

##### ** **

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

##### ** **

We are represented by a network of independent wholesale salesrepresentatives and employ a regional sales manager, with responsibilities forboth our SPORT HALEYTMand Ben Hogan**®** labels ofapparel.

 

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Most of the independent wholesale sales representatives solicit salesof both SPORT HALEYTM and Ben Hogan® apparel on our behalf.

 

We continue to focus on stabilizing revenues associated with our SPORTHALEYTM label and growth of revenues associated with our Ben Hogan® label. Wepreviously discontinued marketing SPORT HALEYTM men’s fashion apparel, in part,because we believe that there are natural synergies common to Ben Hogan® men’sfashion apparel and SPORT HALEYTM women’s fashion apparel. By marketing SPORTHALEYTM women’s apparel in conjunction with Ben Hogan® men’s apparel, we areattempting to maintain our market share with current women’s apparel customersand expect to expand the distribution channels for fashion women’s apparel intomarkets that we had previously only been able to penetrate via the marketing ofBen Hogan® men’s apparel.

 

In November 2005, we previously announced that Top-FliteTM apparelwill be distributed in the United States in accordance with a vendor agreementwith Wal-Mart Stores through Reserve Apparel Group LLC, a joint venture betweenSport-Haley, Inc. and Explorer Gear USA. Top-FliteTM apparel will bedistributed pursuant to our licensing agreement with Callaway. We anticipatethe first sales of Top-FliteTM apparel to Wal-Mart Stores will be made in late February 2006.

 

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

##### ** **

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

 

*Inventories*

 

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

 

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

 

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

 

The material weakness in our internalcontrols over financial reporting with respect to inventory valuation alsoimpaired our ability to rely upon information created by our computer system tofairly present, in all material respects, our financial condition, results ofoperations and cash flows in the periods covered by this report. The inabilityof our computer system to properly calculate the valuation of our finishedgoods inventories using a weighted average cost assumption also affected thesystem-recorded amounts within our cost of goods sold in certain periodscovered by this report. Because (1) we concluded with reasonable assurance thatour using a standard cost assumption yielded a fair estimation of our finishedgoods inventories from the fiscal quarter ended March 31, 2004, throughthe fiscal quarter ended March 31, 2005, (2) we determined thatdifferences between the system-calculated values (average cost) of our finishedgoods inventories versus the values of our finished goods inventories using astandard cost method subsequent to March 31, 2005, were immaterial and (3)we consistently recorded adjustments to inventories as components of cost ofgoods sold, we believe with reasonable assurance that our cost of goods soldare fairly stated for the periods covered by this report. Therefore, we believethat the procedures we applied to value our finished goods inventories for theperiods covered by this report provide us with reasonable assurance that ourcondensed consolidated financial statements and the notes thereto fairly state,in all material respects, our financial condition, the results of ouroperations and our cash flows.

 

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Excess finished goods inventories are anatural component of a seasonal apparel business. While certain finished goodsitems will sell out in any particular selling season, quantities of otherfinished goods items will remain at the end of each selling season. We marketprevious seasons’ finished goods inventories at reduced wholesale prices to ourcustomers in the normal course of business. Remaining excess inventories areliquidated through other markets. In the ordinary course of business, wemaintain reserves for inventory write downs due to the obsolescence ofdiscontinued or aging merchandise. We perform analyses on a quarterly basis toidentify unsold discontinued or aging merchandise and adjust our reserves forinventory obsolescence to reduce the carrying value of discontinued or agingmerchandise to its estimated net realizable value. The net realizable value ofthe discontinued or aging merchandise is estimated based on management’sdisposition plans and historical experiences. During the quarter ended December 31,2005, we recorded finished goods inventories write-downs of $129,000. Whilemanagement believes that our processes produce fair valuations of obsoleteinventories, if actual market conditions are less favorable than thoseprojected by management, additional allowances may be required or we mayrecognize losses on the disposition of obsolete inventories.

 

*Deferred Income Taxes*

 

Deferred income taxes are recognized for the expectedtax consequences in future years for differences between the tax bases ofassets and liabilities and their financial reporting amounts, based uponenacted tax laws and statutory tax rates applicable to the periods in which thedifferences are expected to affect taxable income. Our significant deferred taxassets are related to net operating loss carry forwards for federal and stateincome tax purposes, stock-based compensation and an unrealized loss for taxpurposes on a common stock investment. Governing regulations require that ouroperating losses be carried forward for income tax purposes. We haveestablished a valuation allowance to reduce deferred tax assets to the netamount expected to be recovered in future periods. The estimates for deferredtax assets and the corresponding valuation allowance require us to exercisecomplex judgments. We periodically review and adjust those estimates based uponthe most current information available. In accordance with SFAS 109 and basedupon a review at December 31, 2005, of our utilization of deferred taxassets, we maintained a valuation allowance that effectively reduces our netdeferred tax assets to zero. While we continue to explore various strategies toreturn the Company to profitability, including the introduction of Top-FliteTMbranded apparel, we cannot be certain that our efforts will result in thegeneration of future profits. Because the recoverability of deferred tax assetsis directly dependent upon future operating results, actual recoverability ofdeferred tax assets may differ materially from our estimates.

 

*Allowance for Doubtful Accounts*

 

Our allowance for doubtful accounts reflects a reserve that reduces ourcustomer accounts receivable to the net amount estimated to be collectible.Estimating the credit worthiness of customers and the recoverability of customeraccounts requires us to exercise considerable judgment. In estimating thereserve for uncollectible accounts, we consider factors such as generaleconomic and industry-specific conditions, historical customer performance andanticipated customer performance. From time to time, we also identifydelinquent customer accounts for which a specific reserve is required. Ourallowance for doubtful accounts totaled $249,000 at December 31, 2005,including specific reserves approximating $18,000 with respect to certaindelinquent customer accounts. While we consider our processes to be adequate toeffectively quantify our exposure to doubtful accounts, changes in economic,industry or specific customer conditions may result in recoverability of ourdoubtful accounts that differs materially from our estimates.

 

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*Allowance for Sales Returns*

 

We record allowances for sales returns as net adjustments to customeraccounts receivable. When recording an allowance, the net method reducescustomer accounts receivable and net sales by the estimated gross margin effectof the anticipated sales return. Generally, our selling terms preclude returnof our products subsequent to the sale. However, we have traditionally maintainedlimited programs that offer some customers the right to return certain finishedgoods items under predefined conditions, which we include as a component withinour estimate of allowance for sales returns. We review historical data andconsider factors such as general economic and industry-specific conditions andanticipated customer performance when evaluating the adequacy of our allowancefor sales returns. At December 31, 2005, the Company’s allowance for salesreturns was $286,000. Significant changes in general economic or industryconditions may yield sales returns that differ materially from our estimates.

 

### **RECENTPRONOUNCEMENTS**

 

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

### ** **

InMay 2005, the Financial Accounting Standards Board issued Statement ofFinancial Accounting Standards No. 154 (“SFAS 154”), *“Accountingfor Changes and Error Corrections – A Replacement of APB Opinion No. 20and FASB Statement No. 3.”* SFAS 154 changes the requirements for the accounting for and reportingof a change in accounting principle. The provisions of SFAS 154 require, unlessimpracticable, retrospective application to prior periods’ financial statementsof: (1) all voluntary changes in principles; and, (2) changesrequired by a new accounting pronouncement, if a specific transition period is notprovided. SFAS 154 also requires that a change in depreciation, amortization ordepletion method for long-lived, non-financial assets be accounted for as achange in accounting estimate, which requires prospective application of thenew method. SFAS 154 is effective for all accounting changes made in fiscalyears beginning after December 15, 2005. Because SFAS 154 isdirectly dependent upon future events, we cannot determine what effect, if any,adoption of SFAS 154 will have on our financial condition or the results of ouroperations.

 

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

 

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### **LIQUIDITY ANDCAPITAL RESOURCES**

 

The golf apparel business is highly seasonal in nature. Therefore, thebalance sheet amounts as of December 31, 2005, may be more meaningful whencompared with the balance sheet amounts as of December 31, 2004, ratherthan with the balance sheet amounts at June 30, 2005.

 

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

 

Our net accounts receivable decreased by $1,772,000 to $2,723,000 at December 31,2005, from $4,495,000 at June 30, 2005. When compared with the December 31,2004, balance, the net accounts receivable balance at December 31, 2005,decreased by $693,000, or 20%. Historically, a significant number of ourcustomers close their businesses for the winter months, beginning in October orNovember of each year. Because many of those business owners prefer tosettle their outstanding account balances prior to closing up shop for thewinter, our net accounts receivable balance generally declines during oursecond fiscal quarter. Changes in our accounts receivable balances and relatedallowances provided operating cash of $1,772,000 and $2,530,000 for thesix-month periods ended December 31, 2005 and 2004, respectively.

 

Our inventories increased from $4,153,000 at June 30, 2005, to$5,110,000 at December 31, 2005. However, our inventory requirements arehighly cyclical in nature, and, when compared with the balance of $6,136,000 atDecember 31, 2004, our inventories at December 31, 2005, declined by$1,026,000, or 17%. The differences in our inventory balances between therespective periods are attributable to a few separately identifiable factors.In fiscal 2005, we developed new methods to optimize reorders of finished goodsinventories based upon the anticipated required future delivery dates forpre-booked customer orders. We believe that the new reorder methods haveallowed us to optimize the quantities of finished goods inventories on hand atany point in time and to minimize the amount of excess inventories remaining atthe end of each selling season. Infiscal 2005, we also developed new methods that we believe provide us withbetter information to timely identify and value excess finished goodsinventories relating to a current selling season. Having better information toidentify excess inventories allows us to more quickly develop marketingstrategies to reduce the amount of inventories remaining at the end of aselling season and to maximize recovery associated with excess inventories. Differencesbetween the periods in pending ocean deliveries of finished goods also factoredinto the overall decrease. Pending ocean deliveries of finished goodsapproximated $750,000, $459,000 and $293,000 at December 31, 2005, June 30,2005, and December 31, 2004, respectively. Changes in our inventorybalances provided (used) operating cash of ($957,000) and $2,672,000 for thesix-month periods ended December 31, 2005 and 2004, respectively.

 

Our continued reliance on foreign suppliers sustains the risk that ourrevenues could be adversely affected if a foreign shipment or shipments werereceived late or lost. We maintain insurance for risk of loss relating to goodsshipped from our foreign and domestic suppliers. However, our predominantreliance upon foreign suppliers, and significant reliance on six separateforeign suppliers, also sustains

 

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the risk that we would be left with inadequate or unsatisfactoryrecourse should the goods received from a foreign supplier be nonconforming.

 

Accounts payable and accrued expenses decreased by $153,000, or 9%, to$1,598,000 at December 31, 2005, from $1,751,000 at June 30, 2005.Accounts payable and accrued expenses increased by $8,000, or 1%, from $1,590,000at December 31, 2004. The increase of $8,000 when comparing the balance atDecember 31, 2005, with the balance at December 31, 2004, primarilyrelated to the differences in pending ocean deliveries of finished apparelbetween the periods discussed above combined with a decrease in accrued payrollexpenses. Included in accrued payroll expenses at December 31, 2004, wasthe balance of $490,000 in severance and other compensation payable to ourformer chief executive officer. Comparatively, at December 31, 2005,accrued payroll expenses included the balance of $367,000 in severance andother compensation payable to our former chief executive officer.

 

Due to the combination of the factors discussed above, and others,during the six months ended December 31, 2005, our operating activitiesprovided cash of $306,000. Comparatively, during the six months ended December 31,2004, our operating activities provided cash of $1,588,000.

 

For the six months ended December 31, 2005,investing activities provided cash of $7,000. Comparatively, for the six monthsended December 31, 2004, investing activities provided cash of $471,000.Our cash flows from investing activities are primarily derived from purchasesand redemptions of held-to-maturity investments. Generally, ourheld-to-maturity investments consist of short-term federal agency securities.During the six months ended December 31, 2005, we expended $9,000 for thepurchase of property and equipment, and $170,000 in depreciation andamortization was charged to current operations.

 

We maintain a revolving line of credit agreement with a commercialbank. The revolving line of credit agreement, renewed by amendment through December 5,2006, provides for a maximum loan amount of $5,000,000, collateralized by alien on substantially all of our assets, and for interest at the bank’s primerate. In accordance with the amended agreement, we must maintain tangible networth of $14,000,000 and liquidity of $4,000,000. We generally maintain theline of credit to facilitate the issuance of letters of credit for inventorypurchases from offshore suppliers and, if necessary, to fund any temporaryworking capital needs. Outstanding letters of credit reduce the amountavailable for borrowing under the line of credit agreement. At December 31,2005, we had $985,000 in outstanding letters of credit that were issued toforeign suppliers in accordance with finished goods inventory purchasecommitments.

 

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

 

**RESULTS OF OPERATIONS**

 

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

 

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Net sales for the three months ended December 31, 2005, were$4,429,000, a decrease of $571,000, or 11%, from net sales of $5,000,000 forthe comparable quarterly period in the prior fiscal year. Net sales for the sixmonths ended December 31, 2005, were $8,440,000, a decrease of $2,130,000,or 20%, from net sales of $10,570,000 for the comparable six-month period inthe prior fiscal year. We attribute the decreases in net sales to factors suchas the previously reported discontinuance of our HALEY RESERVE men’s fashionapparel and a significant decrease in SPORT HALEYTM women’s apparel between therespective periods. The decreases in net sales associated with ourdiscontinuance of the HALEY RESERVE men’s collections totaled $200,000 and$900,000, the approximate amount of HALEY RESERVE net sales recorded during thequarter and six months ended December 31, 2004, respectively. Net sales ofour SPORT HALEYTM women’s collections decreased substantially between thecomparable quarterly and six-month periods. Net sales of SPORT HALEYTM women’sapparel totaled approximately $1,400,000 and $2,900,000, for the quarter andsix months ended December 31, 2005, decreases of approximately $1,100,000,or 44%, and $1,500,000, or 34%, when compared with the respective quarterly andsix-month periods in the prior fiscal year. The overall market for women’sfashion golf apparel appears to be shrinking, as evidenced by the recent exitfrom the women’s market by certain of our competitors. While the dramaticdecline in sales of women’s apparel greatly concerns our management, SPORTHALEYTM continues to be a highly recognized brand within the women’s golfapparel market, and we are currently developing strategies to improve thestrategic position of the SPORT HALEYTM brand within the women’s market.

 

Net sales of our Ben Hogan® men’s collections continued to increasebetween the comparative periods. Net sales of Ben Hogan® approximated$2,800,000 and $5,200,000 for the quarter and six-months ended December 31,2005, increases of approximately $800,000, or 40%, and $480,000, or 10%, fromnet sales of approximately $2,000,000 and $4,700,000 for the quarter and sixmonths ended December 31, 2004. We believe that the increase in Ben Hogan®sales is indicative of the highly-respected reputation we have built for theBen Hogan® apparel brand within golf apparel markets. Ben Hogan® apparel ismarketed in accordance with a licensing agreement we maintain with CallawayGolf Company (“Callaway”) for such apparel. We consider the licensing agreementwith Callaway to be a key component of our business strategies. While we striveto maintain a good working relationship with Callaway, the trend for the lastseveral periods, reflecting a continued increase in sales 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 37% for the quarter ended December 31,2005, and 9% for the same quarter in the prior fiscal year. Gross profit, as apercentage of net sales, was 35% for the six-month period ended December 31,2005, and 21% for the same six-month period in the prior fiscal year. Our grossprofit is generally affected by sales discounts offered to customers on variousmarketing programs, payment discounts offered to certain customers,dispositions of excess inventories at reduced sales prices and the valuation ofexcess inventories to the lower of cost or market. The disposition of excessinventories negatively impacts our gross profit percentage even when suchinventories are properly valued to the lower of cost or market, because suchvaluation causes sales to be recorded with gross profit at or near zero. Forthe six months ended December 31, 2005, we recorded net sales of $539,000and gross profit of $15,000 with respect to sales of excess inventories, whichwe believe is indicative of our successful efforts to better estimate therecoverable value of our excess finished goods inventories. The valuation ofinventories to the lower of cost or market negatively impacts our gross profitpercentage, because a reduction of inventory value causes an increase in ourcost of goods sold, thereby reducing our gross profit. Our gross profit wasnegatively impacted by $129,000 and $194,000

 

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forthe quarter and six months ended December 31, 2005, respectively, by theadjustment of our finished goods inventories to the lower of cost or market.Comparatively, our gross profit was negatively impacted by $695,000 and$1,238,000 for the quarter and six months ended December 31, 2004, bysimilar lower of cost or market adjustments. We believe that the substantiallylower adjustments recorded during the quarter and six-month period ended December 31,2005, are indicative of our successful efforts to minimize the amount of ourfinished goods inventories remaining on hand at the end of each selling season.

 

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

 

Selling, general and administrative expenses decreased by $926,000, or39%, to $1,438,000 for the quarter ended December 31, 2005, from$2,364,000 for the same quarter in the prior fiscal year. Selling, general and administrativeexpenses decreased by $2,061,000, or 39%, to $3,162,000 for the six-monthperiod ended December 31, 2005, from $5,223,000 for the same six-monthperiod in the prior fiscal year. The comparative decreases in selling, generaland administrative expenses are attributable to several factors. During thequarter ended December 31, 2004, we recorded $520,000 in severancecompensation relating to the departure of our former chief executive officer.Similarly, during the six months ended December 31, 2004, we recorded$650,000 in severance and other compensation subsequent to the death of ourformer Chairman. Differences in sales commission, payroll expenses and ageneral reduction in general and administrative expenses also contributed tothe respective decreases in overall selling, general and administrativeexpenses. Sales commissions were $352,000 and $644,000 for the quarter and sixmonths ended December 31, 2005, and were $482,000 and $991,000 for thequarter and six months ended December 31, 2004, respectively. Afterexcluding the severance and other compensation expenses from total payrollexpenses recorded during the quarter and six months ended December 31,2004, payroll expenses decreased by $131,000 and $199,000 for the quarterly andsix-month periods ended December 31, 2005, respectively. Payroll expensesfor the six months ended December 31, 2005, included bonuses and relatedemployer payroll taxes totaling $91,000 paid in October 2005 to certain ofthe Company’s executives, including the Interim Chief Executive Officer whoreceived a cash bonus of $50,000 and title to a Company vehicle with anestimated value of $14,000. The remainders of the comparative decreases aregenerally attributable to overall comparative decreases in general and administrativeexpenses between the periods, which are indicative of cost reductions that havebeen achieved as a result of implementing cost reduction initiatives in fiscal2005. As a percentage of net sales, selling, general and administrativeexpenses were 32% and 37% for the quarter and six months ended December 31,2005, and 47% and 49% for the quarter and six months ended December 31,2004, respectively.

 

We recorded royalty expense of $175,000 ad$152,000 for the quarters ended December 31, 2005 and 2004, respectively.We recorded royalty expense of $338,000 ad $350,000 for the six months ended December 31,2005 and 2004, respectively. Royalty expense is due to Callaway in accordancewith the license they previously granted to us to market men’s apparel bearingthe Ben Hogan® label.

 

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Other income, net, was $77,000 for thequarter ended December 31, 2005, an increase of $25,000, or 48%, from$52,000 for the same quarter in the prior fiscal year. Other income, net, was$130,000 for the six months ended December 31, 2005, an increase of$67,000, or 106%, from $63,000 for the same six-month period in the priorfiscal year. Other income, net, was primarily derived from interest earned oncash and cash equivalent balances held at various financial institutions. Theincreases for the quareterly and six-month periods are generally attributableto higher rates of interest earned during the respective periods ended December 31,2005, than had been earned during the comparable periods in the prior fiscalyear.

 

Income (loss) before provision for incometaxes for the quarter ended December 31, 2005, was $101,000, a differenceof $2,107,000, or 105%, as compared with ($2,006,000) for the same period inthe prior fiscal year. Loss before provision for income taxes for the sixmonths ended December 31, 2005, was ($428,000), a difference of$2,854,000, or 87%, as compared with ($3,282,000) for the same period in theprior fiscal year. At December 31, 2005, we had federal and state netoperating loss carry forwards of $5,600,000 and $8,300,000 that we estimatedmay be recoverable at income tax rates of 34% and 5%, respectively. Because ofour continued trend of net losses in fiscal 2006 and the most recent priorfiscal years, we determined that it was more probable than not that none of ournet deferred tax assets will be recovered, and we maintained our valuationallowance that effectively reduced our net deferred tax assets to zero. Whilewe continue to search for ways to streamline our business operations and toinitiate other improvements to return the Company to profitability, such as theintroduction of Top-FliteTM branded apparel, we cannot be certain that ourefforts will result in the generation of future profits sufficient to offsetour significant net operating loss carry forwards prior to their expirations.Accordingly, during the six-month periods ended December 31, 2005 and2004, we did not record a benefit from income taxes associated with thecorresponding losses for the respective six-month periods.

 

Basic earnings (loss) per common share were $0.04 and ($0.77) for thequarters and were ($0.16) and ($1.29) for the six-month periods ended December 31,2005 and 2004, respectively. Diluted earnings (loss) per common share were$0.03 and ($0.77) for the quarters and were ($0.16) and ($1.29) for thesix-month periods ended December 31, 2005 and 2004, respectively.

 

Our book value per outstanding common share was $5.67 at December 31,2005, $5.95 at June 30, 2005, and $6.06 at December 31, 2004.

 

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**SPORT-HALEY, INC.**

**ITEM 3QUALITATIVE AND QUANTITATIVE DISCLOSURES**

**ABOUT MARKET RISK**

 

Market risk represents the risk of loss that may impact the financialposition, results of operations or cash flows due to adverse changes infinancial and commodity market prices and rates. We are exposed to market riskwith regard to changes in United States interest rates. This exposure isdirectly related to our normal operating and funding activities. Historically,and as of December 31, 2005, we have not used derivative instruments orengaged in hedging activities. Our market risk has not changed significantlyfrom September 30, 2005.

 

**Interest Rate Risk**

 

We maintain a revolving line of credit agreement with a commercial bankthat provides for interest at the bank’s prime rate. The agreement provides fora maximum loan amount of $5,000,000 collateralized by a lien on substantiallyall of our assets. We generally maintain the line of credit to facilitate theissuance of letters of credit for inventory purchases from offshore suppliers,and, if necessary, to fund any temporary working capital needs. At December 31,2005, we did not have any outstanding borrowings under the line of credit.Increases in the bank’s prime rate could, however, increase the interestexpense with respect to future borrowings, including borrowings under the lineof credit. Outstanding letters of credit reduce the amount available forborrowing under the line of credit. We had outstanding letters of credit of$985,000 at December 31, 2005. We do not use derivative financial instrumentsto manage interest rate risk.

 

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

 

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**SPORT-HALEY, INC.**

**ITEM 4CONTROLS AND PROCEDURES**

 

**(a)****   Evaluation of Disclosure Controls and Procedures**

 

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

 

As discussed in *“CriticalAccounting Policies and Estimates - Inventories,”* after we implemented our operations softwarein January 2004, we discovered certain programming and human errors withinthe new system that adversely affected the software’s ability to accuratelycompute the valuation of our finished goods inventories using a weightedaverage method. In prior periods we considered the programming and humanerrors, which caused us to use a standard cost method in the prior periods, tobe a material weakness in our internal controls over financial reporting withrespect to inventory valuation. This weakness in our controls prevented us fromrelying upon the system-recorded transactions with respect to inventoryvaluations during fiscal 2005. During the 2005 fiscal year, we concluded withreasonable assurance that recomputing the value of our finished goods inventoriesusing a standard cost method yielded a fair estimation of the value of ourfinished goods inventories. We used the standard cost method to value ourfinished goods inventories from the fiscal quarter ended March 31, 2004,through the fiscal quarter ended March 31, 2005. Had we been able to relyupon the system to properly compute the cost of our finished goods inventoriesusing the weighted average method, we believe that the weighted average methodwould not have yielded a materially different computation of the value than thestandard cost method that we applied. For periods subsequent to March 31,2005, we determined that differences between the system-calculated values(average cost) of our finished goods inventories versus the values of ourfinished goods inventories using a standard cost method were immaterial. A relatively small percentage our inventoryitems remained on hand at December 31, 2005, that had been valued in priorperiods using the standard cost method.

 

During the quarter ended December 31, 2005, werevised employee guidelines and procedures for recording inventory-relatedtransactions within our software system, and shortly after December 31,2005, we prepared a detailed analysis of the weighted average cost calculationsrecorded within our software for several of our finished goods inventory items.Our guidelines and procedures are designed to ensure that only qualifiedpersonnel may record inventory-related transactions During the quarter ended December 31,2005, those persons received additional training in how to properly recordfinished goods transactions within the system. Our detailed analysis concludedwith reasonable assurance that the software system has been properly configuredwithin a level of accuracy that provides us with reasonable assurance to nowrely upon the system to properly compute the weighted average unit costs of ourfinished goods inventories. Therefore, we now believe, with reasonableassurance, that the programming errors related to our operations software no longercause a material weakness in our internal controls over financial reportingwith respect to inventory valuation. However,

 

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

 

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

 

**(b)****   Changes in Internal Controls**

 

During the secondquarter of fiscal 2005, we instituted a change in internal controls overfinancial reporting that materially affected, or is reasonably likely tomaterially affect, the Company’s internal controls over financial reporting. Asdiscussed in *“Critical Accounting Policies and Estimates- Inventories,”*during the quarter ended December 31,2005, we revised employee guidelines and procedures for recordinginventory-related transactions within our software system, and shortly after December 31,2005, we prepared a detailed analysis of the weighted average cost calculationsrecorded within our software for several of our finished goods inventory items.Our guidelines and procedures are designed to ensure that only qualifiedpersonnel may record inventory-related transactions, and during the quarterended December 31, 2005, those persons received additional training withregard to recording such transactions within the system. Our detailed analysisconcluded with reasonable assurance that the software system has been properlyconfigured within a level of accuracy that provides us with reasonableassurance to now rely upon the system to properly compute the weighted averageunit costs of our finished goods inventories. Therefore, we now believe, withreasonable assurance, that the programming errors related to our operationssoftware no longer cause a material weakness in our internal controls overfinancial reporting with respect to

 

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inventory valuation. However, human errors have continued to cause amaterial weakness in our internal controls over financial reporting withrespect to inventory valuation. Our detailed analysis revealed that certainvariances in the unit costs of our finished goods inventories have occurred,because procedures were not properly followed in all instances. Ongoingtraining and management supervision are inherent requirements within anysoftware system, and all errors cannot be prevented in all instances. In orderto achieve reasonable assurance that human errors no longer cause a materialweakness, we will continue to educate and supervise our personnel responsiblefor recording inventory-related transactions, and we will also refine ourperiodic testing model used to determine the accuracy of inventory-relatedtransactions which have been recorded within the system.

 

Our management, including the Interim Chief ExecutiveOfficer and the Chief Financial Officer, does not expect that our disclosurecontrols and procedures or our internal controls over financial reporting will,in all instances, prevent all errors and all fraud. A control system, no matterhow well conceived or operated, can only provide reasonable, not absolute,assurance that the objectives of the control system are met. While our controlsystems provide a reasonable assurance level, the design of its control systemsreflects the fact that there are resource constraints, and the benefits of suchcontrols were considered relative to their costs. Because of the inherentlimitations in all control systems, no evaluation of controls can provideabsolute assurance that all control issues and instances of fraud, if any,within the financial reports of Sport-Haley, Inc. have been detected.These inherent limitations include the realities that judgments indecision-making can be faulty, and that breakdowns can occur because of simpleerrors or mistakes. Additionally, a control may be circumvented by theindividual act of some person, by collusion of two or more persons, or bymanagement’s override of a specific control. The design of any system ofcontrols is also based in part on certain assumptions about the likelihood offuture events, and there can be no assurance that any design will succeed inachieving its stated goals under all potential future conditions. Because ofthe inherent limitations in a cost-effective control system, misstatements dueto error or fraud may occur and not be detected.

 

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**SPORT-HALEY, INC.**

**PART II**

**OTHER INFORMATION**

 

### **ITEM 1**        LEGAL PROCEEDINGS

### ** **

As previously reported, in September 2003,the United States Securities and Exchange Commission (the “Commission” or the “SEC”)filed suit in the United States District Court for the District of Coloradoagainst Sport-Haley, Inc., Robert G. Tomlinson, our late Chairman andformer Chief Executive Officer, and Steve S. Auger, our former Controller (the “Defendants”).The Commission filed an amended complaint in October 2003, which added oneof our former auditors to the action as a Defendant.

 

On January 17, 2006, the Court entered aFinal Judgment, pursuant to a settlement reached with the Commission, toresolve the pending claims in the civil action brought by the SEC againstSport-Haley, Inc. and our former Controller. The settlement had beenconsidered by the Commission in Washington D.C. and thereby approved on December 8,2005. The settlement did not call for Sport-Haley, Inc. to pay any fine,civil penalty or disgorgement. Pursuant to a written Consent entered into bySport-Haley, Inc. as part of the settlement, Sport-Haley, Inc.consented, without admitting or denying the allegations of the Complaint orAmended Complaint, to the entry of an injunction enjoining the Company fromviolating §17(a)(2) and §17(a)(3) of the Securities Act of 1933 (the “SecuritiesAct”), which do not require proof of scienter (an intent to deceive, manipulateor defraud), but may be based upon a showing of negligence, §13(b)(2) and§15(d) of the Securities Exchange Act of 1934 (the “Exchange Act”), and Rules 12b-20,15d-1 and 15d-13 promulgated thereunder. The settlement resulted in noinjunction or adjudication against Sport-Haley, Inc. with respect to theclaims alleging violations of §17(a)(1) of the Securities Act, §10(b) ofthe Exchange Act and Rule 10b-5 promulgated thereunder, which each requireproof of scienter.

 

Pursuant to a separate settlement with theSEC, the Court also entered a Final Judgment with respect to Mr. Auger, inwhich Mr. Auger consented, without admitting or denying the allegations ofthe Complaint or Amended Complaint, to the entry of an injunction enjoining himfrom violating various provisions of the federal securities laws andregulations and other relief.

 

On February 13, 2006, we entered into asettlement agreement to resolve all pending claims between Sport-Haley, Inc.,our former auditors and certain of our former auditors’ current and formermembers. Pursuant to the terms of the settlement agreement and a sharingagreement between Sport-Haley, Inc. and one of our director and officerliability insurance carriers, we will receive a net payment of approximately$173,000 from the total settlement with the former auditors.

 

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

 

During a mediation session in November 2005,we reached an agreement in principle with the former auditors to settle alldisputed claims between the parties and their affiliates. The

 

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parties have now finalized a writtensettlement agreement, which provides for payment to Sport-Haley, Inc. of$525,000. In accordance with a sharing agreement between Sport-Haley, Inc.and one of its carriers for director and officer liability insurance, we willreceive 33% of these settlement proceeds, or approximately $173,000, and theinsurance carrier will receive the remainder to partially recover amounts thecarrier paid in connection with a previously settled class action securitieslawsuit and defense costs the carrier has reimbursed to us relating to thecivil action lawsuit filed by the SEC.

 

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

 

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

 

### **ITEM 5**       OTHERINFORMATION

 

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

 

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

 

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

 

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

 

On January 4, 2006, we announced that theCompany had notified the Nasdaq Stock Market, Inc., upon which the Company’scommon stock is listed on the National Market, that the Company had recentlybecome aware that our common shares were not properly registered under §12(g) ofthe Securities Exchange Act of 1934 (the “Exchange Act”), as amended.

 

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Therefore, we were not in compliance with NASDMarketplace Rule 4440(a), which requires an issue of securities to beregistered under §12(g) of the Exchange Act in order to be listed on theNasdaq National Market. We also announced that, in order to register our commonstock pursuant to §12(g) of the Exchange Act, we would be filing aregistration statement on Form 10.

 

### **ITEM 6**       EXHIBITS

### ** **

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

 

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

 

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

 

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**SPORT-HALEY, INC.**

**SIGNATURES**

 

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

 

 
| ** ** | **SPORT-HALEY, INC.**                           | ** ** |
|------------|-------------------------------------------------|------------|
|       | (Registrant)                                    |       |
|       |                                            |       |
|       |                                            |       |
| Date:      | February 21, 2006                          |       | /s/ PATRICK W. HURLEY |   |
|       | Patrick W. Hurley                               |       |
|       | Chief Financial Officer                         |       |
| * *   | *(Principal Financial and Accounting  Officer)* | * *   |
|            |                                                 |            |  |  |  |

 

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