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                                  UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549
                                  -------------

                                    FORM 10-Q

[X]      QUARTERLY  REPORT  PURSUANT  TO SECTION  13 OR 15(d) OF THE  SECURITIES
         EXCHANGE ACT OF 1934.

                  For the quarterly period ended June 30, 2006.

                                       OR

[_]      TRANSITION  REPORT  PURSUANT  TO SECTION 13 OR 15(d) OF THE  SECURITIES
         EXCHANGE ACT OF 1934.

                         Commission file number 1-13669

                              TAG-IT PACIFIC, INC.
               (Exact Name of Issuer as Specified in its Charter)

                               DELAWARE 95-4654481
                (State or Other Jurisdiction of (I.R.S. Employer
               Incorporation or Organization) Identification No.)

                       21900 BURBANK BOULEVARD, SUITE 270
                        WOODLAND HILLS, CALIFORNIA 91367
                    (Address of Principal Executive Offices)

                                 (818) 444-4100
              (Registrant's Telephone Number, Including Area Code)




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

                                 Yes [X] No [ ]

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

   Large accelerated filer [ ]  Accelerated filer [ ]  Non-accelerated filer [X]

         Indicate by check mark whether the  registrant  is a shell  company (as
defined in Rule 12b-2 of the Act). Yes [ ] No X]

         AT AUGUST 14, 2006 THE ISSUER HAD  18,466,433  SHARES OF COMMON  STOCK,
$.001 PAR VALUE, ISSUED AND OUTSTANDING.

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<PAGE>


                              TAG-IT PACIFIC, INC.
                               INDEX TO FORM 10-Q



PART I   FINANCIAL INFORMATION                                              PAGE
                                                                            ----

Item 1.  Financial Statements..................................................3

         Consolidated Balance Sheets as of June 30, 2006
         and December 31, 2005 (unaudited).....................................3

         Consolidated Statements of Operations for the Three Months
         and the Six Months Ended June 30, 2006 and 2005 (unaudited)...........4

         Consolidated Statements of Cash Flows for the
         Six Months Ended June 30, 2006 and 2005 (unaudited)...................5

         Notes to the Consolidated Financial Statements........................6

Item 2.  Management's Discussion and Analysis of Financial Condition
         and Results of Operations............................................18

Item 3.  Quantitative and Qualitative Disclosures about Market Risk...........34

Item 4.  Controls and Procedures..............................................34

PART II  OTHER INFORMATION

Item 1.  Legal Proceedings....................................................37

Item 1A. Risk Factors ........................................................38

Item 6.  Exhibits.............................................................38


                                       2
<PAGE>


                              TAG-IT PACIFIC, INC.
                           CONSOLIDATED BALANCE SHEETS


                                                   (unaudited)
                                                     June 30,      December 31,
                                                       2006            2005
                                                   ------------    ------------
                       Assets
Current Assets:
   Cash and cash equivalents ...................   $  3,976,916    $  2,277,397
   Trade accounts receivable, net ..............      6,396,633       5,652,990
   Note receivable .............................      1,227,833         662,369
   Inventories .................................      3,553,133       5,573,099
   Prepaid expenses and other current assets ...        544,561         618,577
                                                   ------------    ------------
     Total current assets ......................     15,699,076      14,784,432

Property and equipment, net ....................      5,910,268       6,438,096
Fixed assets held for sale .....................        826,904         826,904
Note receivable, less current portion ..........      2,127,653       2,777,631
Due from related parties .......................        691,640         730,489
Other intangible assets, net ...................      4,202,626       4,255,125
Other assets ...................................        472,760         508,117
                                                   ------------    ------------
Total assets ...................................   $ 29,930,927    $ 30,320,794
                                                   ============    ============

      Liabilities and Stockholders' Equity
Current Liabilities:
   Accounts payable ............................   $  6,006,205    $  6,719,226
   Accrued legal costs .........................        874,131       2,520,111
   Other accrued expenses ......................      4,721,867       4,168,552
   Demand notes payable to related parties .....        664,971         664,971
   Current portion of capital lease obligations         386,327         590,884
   Current portion of notes payable ............      1,805,802         186,837
                                                   ------------    ------------
     Total current liabilities .................     14,459,303      14,850,581

Capital lease obligations, less current portion         663,146         856,495
Notes payable, less current portion ............      1,279,291       1,261,018
Secured convertible promissory notes ...........     12,456,491      12,440,623
                                                   ------------    ------------
     Total liabilities .........................     28,858,231      29,408,717
                                                   ------------    ------------

Contingencies and guarantees - (Note 5) ........           --              --

Stockholders' equity:
   Preferred stock, Series A $0.001 par value;
     250,000 shares authorized, no shares
     issued or outstanding .....................           --              --
   Common stock, $0.001 par value, 30,000,000
     shares authorized; 18,376,180 shares
     issued and outstanding at June 30, 2006;
     18,241,045 at December 31, 2005 ...........         18,376          18,241
   Common stock, issuable under grants, 90,253
     shares at June 30, 2006 ...................         50,000            --
   Additional paid-in capital ..................     51,513,120      51,327,878
   Accumulated deficit .........................    (50,508,800)    (50,434,042)
                                                   ------------    ------------
Total stockholders' equity .....................      1,072,696         912,077
                                                   ------------    ------------
Total liabilities and stockholders' equity .....   $ 29,930,927    $ 30,320,794
                                                   ============    ============


          See accompanying notes to consolidated financial statements.


                                       3
<PAGE>


<TABLE>
                              TAG-IT PACIFIC, INC.
                      CONSOLIDATED STATEMENTS OF OPERATIONS
                                   (unaudited)

<CAPTION>
                                       Three Months Ended June 30,      Six Months Ended June 30,
                                       ---------------------------    ----------------------------
                                           2006           2005            2006            2005
                                       ------------   ------------    ------------    ------------
<S>                                    <C>            <C>             <C>             <C>
Net sales ..........................   $ 14,246,087   $ 15,639,646    $ 24,884,303    $ 28,694,923
Cost of goods sold .................     10,118,850     14,883,526      17,914,341      24,686,980
                                       ------------   ------------    ------------    ------------
   Gross profit ....................      4,127,237        756,120       6,969,962       4,007,943

Selling expenses ...................        674,894        655,295       1,220,519       1,397,629
General and administrative expenses       2,634,622     11,008,446       5,451,753      14,735,706
                                       ------------   ------------    ------------    ------------
   Total operating expenses ........      3,309,516     11,663,741       6,672,272      16,133,335

Income (loss) from operations ......        817,721    (10,907,621)        297,690     (12,125,392)
Interest expense, net ..............        151,579        268,021         360,951         536,676
                                       ------------   ------------    ------------    ------------
Income (loss) before income taxes ..        666,142    (11,175,642)        (63,261)    (12,662,068)
Provision (benefit) for income taxes         11,500      1,300,996          11,500       1,463,013
                                       ------------   ------------    ------------    ------------
   Net Income (loss) ...............   $    654,642   $(12,476,638)   $    (74,761)   $(14,125,081)
                                       ============   ============    ============    ============

Basic income (loss) per share ......   $       0.04   $      (0.68)   $      (0.00)   $      (0.78)
                                       ============   ============    ============    ============
Diluted income (loss) per share ....   $       0.04   $      (0.68)   $      (0.00)   $      (0.78)
                                       ============   ============    ============    ============

Weighted average number of common
shares outstanding:
   Basic ...........................     18,358,360     18,241,045      18,300,027      18,210,406
                                       ============   ============    ============    ============
   Diluted .........................     18,598,442     18,241,045      18,300,027      18,210,406
                                       ============   ============    ============    ============
</TABLE>


          See accompanying notes to consolidated financial statements.


                                       4
<PAGE>


<TABLE>
                              TAG-IT PACIFIC, INC.
                      CONSOLIDATED STATEMENTS OF CASH FLOWS
                                   (unaudited)
<CAPTION>
                                                                      Six Months Ended June 30,
                                                                   ----------------------------
                                                                       2006            2005
                                                                   ------------    ------------
<S>                                                                <C>             <C>
Increase  (decrease) in cash and cash equivalents
Cash flows from operating activities:
   Net loss ....................................................   $    (74,761)   $(14,125,081)
Adjustments to reconcile net loss to net cash used
  by operating activities:
   Depreciation and amortization ...............................        614,077       1,127,169
   (Decrease) increase in allowance for doubtful accounts ......       (919,312)      6,120,691
   Increase in deferred tax asset valuation allowance ..........           --         1,000,000
   (Decrease) increase in inventory valuation reserves .........     (3,433,267)      1,550,000
   Disposal of asset ...........................................          8,502            --
   Stock based compensation ....................................        165,377            --
Changes in operating assets and liabilities:
      Receivables, including related party .....................        214,518       2,375,368
      Inventories ..............................................      5,453,233      (5,810,097)
      Prepaid expenses and other current assets ................         74,016         321,295
      Note Receivable ..........................................         84,514            --
      Other Assets .............................................         35,357          (4,445)
      Accounts payable and accrued expenses ....................         27,816       7,182,615
      Income taxes payable .....................................         11,500         114,651
                                                                   ------------    ------------
Net cash provided (used) by operating activities ...............      2,261,570        (147,834)
                                                                   ------------    ------------

Cash flows from investing activities:
   Acquisition of property and equipment .......................        (28,883)     (1,248,886)
   Proceeds from sale of equipment .............................          2,500            --
                                                                   ------------    ------------
Net cash used by investing activities ..........................        (26,383)     (1,248,886)
                                                                   ------------    ------------

Cash flows from financing activities:
   Proceeds of bank line of credit, net ........................           --           386,803
   Proceeds from exercise of stock options and warrants ........           --           254,541
   Repayment of capital leases .................................       (397,906)       (457,152)
   Repayment of notes payable ..................................       (137,762)     (1,286,052)
                                                                   ------------    ------------
Net cash (used) by financing activities ........................       (535,668)     (1,101,860)
                                                                   ------------    ------------

Net increase (decrease) in cash ................................      1,699,519      (2,498,580)
Cash at beginning of period ....................................      2,277,397       5,460,662
                                                                   ------------    ------------
Cash at end of period ..........................................   $  3,976,916    $  2,962,082
                                                                   ============    ============

Supplemental disclosures of cash flow information:
   Cash received (paid) during the period for:
     Interest paid .............................................   $   (520,825)   $   (655,032)
     Income taxes refunded (paid) ..............................   $       --      $    (47,560)
     Interest received .........................................   $    159,874    $     29,734
   Non-cash financing activities:
     Capital lease obligation ..................................   $       --      $    270,597
     Accounts payable & accrued legal converted to notes payable   $  1,775,000    $       --
</TABLE>


          See accompanying notes to consolidated financial statements.


                                       5
<PAGE>


                             TAG-IT PACIFIC, INC.
                 NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
                                   (UNAUDITED)

NOTE 1.  PRESENTATION OF INTERIM INFORMATION

         The accompanying  unaudited consolidated financial statements have been
prepared in accordance  with  accounting  principles  generally  accepted in the
United  States for interim  financial  information  and in  accordance  with the
instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do
not  include  all  of the  information  and  footnotes  required  by  accounting
principles  generally  accepted  in the  United  States for  complete  financial
statements. The accompanying unaudited consolidated financial statements reflect
all adjustments  that, in the opinion of the management of Tag-It Pacific,  Inc.
and its subsidiaries (collectively, the "Company"), are considered necessary for
a fair presentation of the financial position,  results of operations,  and cash
flows for the periods presented.  The results of operations for such periods are
not necessarily  indicative of the results  expected for the full fiscal year or
for any future period. The accompanying  financial  statements should be read in
conjunction with the audited  consolidated  financial  statements of the Company
included in the Company's  Form 10-K for the year ended  December 31, 2005.  The
balance  sheet  as of  December  31,  2005  has been  derived  from the  audited
financial statements as of that date but omits certain information and footnotes
required for complete financial statements.

         The accompanying  consolidated  financial statements have been prepared
assuming that the Company will continue as a going concern,  which  contemplates
the  realization  of assets and the  satisfaction  of  liabilities in the normal
course of business.  The Company has experienced  substantial  recurring  losses
from  operations on declining  revenues and has an accumulated  deficit of $50.5
million as of June 30, 2006.  These  matters,  among others,  raise  substantial
doubt about the Company's ability to continue as a going concern.  The Company's
continuation  as a  going  concern  is  dependent  on its  ability  to  generate
sufficient  cash  flow to meet its  obligations  on a timely  basis,  to  obtain
additional  financing as may be required,  and  ultimately to attain  profitable
operations.  In response  to these  matters,  during 2005 the Company  adopted a
restructuring  plan  designed to better align the Company's  organizational  and
cost  structures with its future growth  opportunities.  In connection with this
restructuring,  management's  operating plan for 2006 includes  increased sales,
higher margins on certain products, reduced expenses as a percentage of revenues
and improved cash flows sufficient to cover the Company's operating needs. There
can be no assurance  that the Company will be successful in these  matters.  The
financial  statements do not include any adjustments  that might result from the
outcome of this uncertainty.


                                       6
<PAGE>


NOTE 2.  EARNINGS (LOSS) PER SHARE

         The following is a reconciliation of the numerators and denominators of
the basic and diluted income (loss) per share computations:

<TABLE>
<CAPTION>
THREE MONTHS ENDED JUNE 30, 2006:         INCOME (LOSS)      SHARES        PER SHARE
---------------------------------------   ------------    ------------   ------------
<S>                                        <C>               <C>          <C>
Basic income per share:
Income available to common stockholders    $    654,642      18,358,360   $       0.04

Effect of Dilutive Securities:
Options ................................           --           240,082           --
Warrants ...............................           --              --             --
                                           ------------    ------------   ------------
Income available to common stockholders    $    654,642      18,598,442   $       0.04
                                           ============    ============   ============

THREE MONTHS ENDED JUNE 30, 2005:
---------------------------------------
Basic loss per share:
Loss available to common stockholders ..   $(12,476,638)     18,241,045   $      (0.68)

Effect of Dilutive Securities:
Options ................................           --              --             --
Warrants ...............................           --              --             --
                                           ------------    ------------   ------------
Loss available to common stockholders ..   $(12,476,638)     18,241,045   $      (0.68)
                                           ============    ============   ============

SIX MONTHS ENDED JUNE 30, 2006:
---------------------------------------
Basic loss per share:
Loss available to common stockholders ..   $    (74,761)     18,300,027   $      (0.00)

Effect of Dilutive Securities:
Options ................................           --              --             --
Warrants ...............................           --              --             --
                                           ------------    ------------   ------------
Loss available to common stockholders ..   $    (74,761)     18,300,027   $      (0.00)
                                           ============    ============   ============

SIX MONTHS ENDED JUNE 30, 2005:
---------------------------------------
Basic loss per share:
Loss available to common stockholders ..   $(14,125,081)     18,210,406   $      (0.78)

Effect of Dilutive Securities:
Options ................................           --              --             --
Warrants ...............................           --              --             --
                                           ------------    ------------   ------------
Loss available to common stockholders ..   $(14,125,081)     18,210,406   $      (0.78)
                                           ============    ============   ============
</TABLE>


        Warrants to purchase  1,243,813  shares of common stock  exercisable  at
between  $3.50 and $5.06 per share,  options  to  purchase  4,434,888  shares of
common stock exercisable at between $0.37 and $5.23 per share,  convertible debt
of $12,500,000  convertible at $3.65 per share,  and other  convertible  debt of
$500,000  convertible at $4.50 per share were  outstanding for the three and six
months ended June 30, 2006. In connection with the "Share-Based Payment," ("SFAS
123(R)")  calculation  (see  note  3),  240,082  shares  were  included  in  the
computation  of diluted  income per share for the three month  period ended June
30, 2006.  These shares were not included in the  computation  of diluted income
(loss) per share for the six months  ended June 30,  2006  because  exercise  or
conversion would have an antidilutive effect on earnings per share.


                                       7
<PAGE>


         Warrants to purchase  1,510,479  shares of common stock  exercisable at
between  $3.50 and $5.06 per share,  options  to  purchase  1,942,000  shares of
common stock exercisable at between $1.30 and $5.23 per share,  convertible debt
of $500,000 convertible at $4.50 per share and convertible debt of $12.5 million
convertible  at $3.65 per share  were  outstanding  for the three and six months
ended  June 30,  2005,  but were not  included  in the  computation  of  diluted
earnings per share  because  exercise or conversion  would have an  antidilutive
effect on earnings per share.

NOTE 3.  STOCK BASED COMPENSATION

         On  January  1,  2006,  the  Company  adopted  Statement  of  Financial
Accounting  Standards  No. 123 (revised  2004),  "Share-Based  Payment,"  ("SFAS
123(R)") which requires the measurement and recognition of compensation  expense
for all  share-based  payment  awards made to employees and  directors  based on
estimated fair values.  SFAS 123(R) supersedes the Company's previous accounting
under Accounting  Principles Board Opinion No. 25,  "Accounting for Stock Issued
to  Employees"  ("APB 25") for periods  beginning in fiscal 2006. In March 2005,
the Securities and Exchange  Commission issued Staff Accounting Bulletin No. 107
("SAB 107")  relating to SFAS 123(R).  The Company has applied the provisions of
SAB 107 in its adoption of SFAS 123(R).

         The  Company  adopted  SFAS  123(R)  using  the  modified   prospective
transition method,  which requires the application of the accounting standard as
of January 1, 2006. The Company's  financial  statements as of and for the three
and six months  ended  June 30,  2006  reflect  the  impact of SFAS  123(R).  In
accordance  with the  modified  prospective  transition  method,  the  Company's
financial statements for prior periods have not been restated to reflect, and do
not include,  the impact of SFAS 123(R).  There was no stock-based  compensation
expense  related to employee or director  stock  options  recognized  during the
three and six  months  ended June 30,  2005.  Stock-based  compensation  expense
recognized  under SFAS 123(R) for employee and  directors  for the three and six
months  ended June 30, 2006 was $46,118 and  $165,377,  respectively.  Basic and
diluted  income per share for the  quarter  ended June 30,  2006 would have been
$0.04 per share,  if the  Company  had not  adopted  SFAS  123(R),  compared  to
reported basic and diluted income of $0.04 per share. Basic and diluted loss per
share for the six months  ended June 30, 2006 would have been $(0.00) per share,
if the Company  had not  adopted  SFAS  123(R),  compared to reported  basic and
diluted loss of $(0.00) per share.

         During the quarter  ended June 30, 2006,  the Company did not grant any
stock-based  awards to employees or  non-employees.  During the six months ended
June 30,  2006,  the Company  granted  awards of stock for 225,388  shares at an
average market price of $0.45 per share and options to acquire  2,685,135 shares
at an average  exercise  price of $0.42 per share.  Awards to acquire  1,625,000
shares  were  granted  to  employees  outside of the 1997 Plan (see Note 6), and
awards  of stock and  options  to  acquire  165,253  shares  were  granted  to a
consultant.  The estimated  fair value of all awards  granted during the quarter
was  $666,000,  of which  $70,000  was  accrued  for as of  December  31,  2005.
Assumptions used to value options granted to employees were expected  volatility
of 57%,  expected  term of 5.3 years to 6.1 years,  risk-free  interest  rate of
approximately 4.4%, and an expected dividend yield of zero.  Assumptions used to
value options granted to consultants were expected  volatility of 65%,  expected
term of 10 years  (contractual  life),  risk-free  interest  rate of  4.5%,  and
expected divided yield of zero.

         Options  issued to  consultants  are being  accounted for in accordance
with the provisions of Emerging Issues Task Force (EITF) No. 96-18,  "Accounting
for Equity  Instruments  That Are Issued to Others Than Employees for Acquiring,
or in Conjunction with Selling, Goods or Services."


                                       8
<PAGE>


         The  following  table  illustrates  the effect on net loss and loss per
share if the Company had applied the fair value  recognition  provisions of SFAS
123(R) to stock-based  awards granted under the Company's stock option plans for
the three  months  and six months  ended June 30,  2005.  For  purposes  of this
pro-forma  disclosure,  the fair  value of the  options is  estimated  using the
Black-Scholes-Merton   option-pricing   formula   ("Black-Scholes   model")  and
amortized to expense  generally  over the  options'  requisite  service  periods
(vesting periods).

                                                 Three Months        Six Months
                                                     Ended             Ended
                                                 June 30, 2005     June 30, 2005
                                                 ------------      ------------

Net loss as reported .......................     $(12,476,638)     $(14,125,081)
Plus: Stock-based expense recognized
   in the Statement of Operations,
   net of tax ..............................             --                --
Less:  Stock-based expense determined
   under fair-value based method,
   net of tax ..............................          (65,332)          (77,062)
                                                 ------------      ------------
Pro forma net loss .........................     $(12,541,970)     $(14,202,143)
                                                 ============      ============
--------------------------------------------
Net loss per share:
As reported -- basic and diluted ...........     $      (0.68)     $      (0.78)
Pro forma -- basic and diluted .............     $      (0.68)     $      (0.78)
                                                 ============      ============

        SFAS 123(R) requires companies to estimate the fair value of share-based
payment  awards  to  employees  and  directors  on the  date of  grant  using an
option-pricing  model.  The value of the portion of the award that is ultimately
expected to vest is recognized as expense over the requisite  service periods in
the  Company's  Statements  of  Operations.   Stock-based  compensation  expense
recognized in the  Statements  of Operations  for the three and six months ended
June 30, 2006  included  compensation  expense for  share-based  payment  awards
granted  prior to,  but not yet  vested as of January 1, 2006 based on the grant
date fair value  estimated in accordance  with the pro-forma  provisions of SFAS
123  and  compensation  expense  for  the  share-based  payment  awards  granted
subsequent  to January 1, 2006 based on the grant date fair value  estimated  in
accordance with the provisions of SFAS 123(R).  For stock-based awards issued to
employees and directors, stock-based compensation is attributed to expense using
the  straight-line  single  option  method,  which  is  consistent  with how the
prior-period  pro formas were  provided.  As  stock-based  compensation  expense
recognized in the Statements of Operations for 2006 is based on awards  expected
to vest, SFAS 123(R)  requires  forfeitures to be estimated at the time of grant
and revised,  if necessary,  in subsequent  periods if actual forfeitures differ
from those estimates. For the three and six months ended June 30, 2006, expected
forfeitures are immaterial and as such the Company is recognizing forfeitures as
they occur. In the pro-forma information provided under SFAS 123 for the periods
prior to fiscal 2006, the Company accounted for forfeitures as they occurred.

        Prior  to the  adoption  of  SFAS  123(R),  the  Company  accounted  for
stock-based  awards to employees and directors  using the intrinsic value method
in  accordance  with APB 25.  Under the  intrinsic  value  method,  the  Company
recognized share-based  compensation equal to the award's intrinsic value at the
time of grant over the requisite service periods using the straight-line method.
Forfeitures  were recognized as incurred.  During the three and six months ended
June, 30, 2005, there was no stock-based  compensation expense recognized in the
Statements  of  Operations  for awards  issued to employees and directors as the
awards had no intrinsic value at the time of grant because their exercise prices
equaled the fair values of the common stock at the time of grant.


                                       9
<PAGE>


        The Company's  determination of fair value of share-based payment awards
to employees  and directors on the date of grant uses the  Black-Scholes  model,
which is affected by the Company's stock price as well as assumptions  regarding
a number of complex and subjective  variables.  These variables include, but are
not limited to, the expected  stock price  volatility  over the expected term of
the awards, and actual and projected  employee stock option exercise  behaviors.
The Company  estimates  expected  volatility using historical data. The expected
term is estimated using the "safe harbor" provisions under SAB 107.

        The Company has elected to adopt the  detailed  method  provided in SFAS
123(R) for calculating the beginning  balance of the additional  paid-in capital
pool  ("APIC  pool")  related  to  the  tax  effects  of  employee   stock-based
compensation,  and to  determine  the  subsequent  impact  on the APIC  pool and
Statements of Cash Flows of the tax effects of employee stock-based compensation
awards that are outstanding upon adoption of SFAS 123(R).

NOTE 4.  INVENTORIES

         Inventories are stated at the lower of cost or market value and consist
of finished  goods  available  for sale.  Inventory  reserves  are  recorded for
damaged,  obsolete,  excess and  slow-moving  inventory.  Estimates  are used to
determine these reserves.  Slow-moving inventory is reviewed by category and may
be  partially  or fully  reserved  for  depending on the type of product and the
length of time the product has been included in inventory.  Reserve  adjustments
are made for the difference  between the cost of the inventory and the estimated
market  value,  if lower,  and charged to  operations in the period in which the
facts  that  give  rise to  these  adjustments  become  known.  Market  value of
inventory is estimated  based on the impact of market  trends,  an evaluation of
economic conditions and the value of current orders relating to the future sales
of this type of inventory.

         Inventories consist of the following:

                                             June 30,       December 31,
                                               2006             2005
                                           -----------      -----------

         Finished goods .............      $ 7,425,866      $12,879,100
         Less reserves ..............        3,872,733        7,306,000
                                           -----------      -----------
         Total inventories ..........      $ 3,553,133      $ 5,573,100
                                           ===========      ===========

NOTE 5.  CONTINGENCIES AND GUARANTEES

         On October 12, 2005, a shareholder class action complaint-- Huberman vs
Tag-It Pacific,  Inc., et al., Case No.  CV05-7352  R(Ex)--was filed against the
Company and certain of the Company's  current and former  officers and directors
in the United  States  District  Court for the Central  District  of  California
alleging  claims under Section 10(b) and Section 20 of the  Securities  Exchange
Act of 1934, as amended,  and Rule 10b-5 promulgated  thereunder.  The action is
brought on behalf of all purchasers of the Company's publicly-traded  securities
during the period from November 14, 2003 to August 12, 2005. On January 23, 2006
the court heard competing motions for appointment of lead  plaintiff/counsel and
appointed Seth Huberman as lead plaintiff.  The lead plaintiff  thereafter filed
an amended  complaint on March 13, 2006. The amended  complaint alleges that the
defendants made false and misleading  statements  about the Company's  financial
situation  and its  relationship  with certain of its large  customers  during a
purported  class  period  between  November  13,  2003 and August 12,  2005.  It
purports to state claims under Section 10(b)/Rule 10b-5 and Section 20(a) of the
Securities  Exchange  Act of 1934.  The  Company  filed a motion to dismiss  the
amended  complaint,  which  motion  was  denied by the  Court on July 17,  2006.
Although the Company  believes that it and the other defendants have meritorious
defenses  to the class  action  complaint  and  intend to  contest  the  lawsuit
vigorously,  if there is an adverse  resolution to the lawsuit the results could
have a material adverse effect on the Company's  financial  position and results
of operations. At this early stage of the litigation, the Company is not able to
reasonably  predict the outcome of this action or estimate  potential losses, if
any, related to the lawsuit.


                                       10
<PAGE>


         On April 16,  2004,  the Company  filed suit against  Pro-Fit  Holdings
Limited  ("Pro-Fit")  in the U.S.  District  Court for the  Central  District of
California - Tag-It Pacific,  Inc. v. Pro-Fit Holdings  Limited,  CV 04-2694 LGB
(RCx) - asserting various  contractual and tort claims relating to the Company's
exclusive  license and  intellectual  property  agreement with Pro-Fit,  seeking
declaratory relief,  injunctive relief and damages. It is the Company's position
that the  agreement  with  Pro-Fit  gives the  Company the  exclusive  rights in
certain geographic areas to Pro-Fit's stretch and rigid waistband technology. On
September 17, 2004, Pro-Fit filed an answer denying the material  allegations of
the complaint and filed  counterclaims  alleging  various  contractual  and tort
claims seeking injunctive relief and damages.  The Company filed a reply denying
the material  allegations of Pro-Fit's pleading.  Pro-Fit has since purported to
terminate the exclusive license and intellectual property agreement based on the
same  alleged  breaches of the  agreement  that are the subject of the  parties'
existing litigation, as well as on an additional basis. On February 9, 2005, and
again on June 16, 2005,  the Company  amended its pleadings in the litigation to
assert additional breaches by Pro-Fit of its obligations under the agreement and
under certain additional letter agreements,  and for a declaratory judgment that
Pro-Fit's  patent No.  5,987,721  is invalid and not  infringed  by the Company.
Thereafter,  Pro-Fit  filed an amended  answer  and  counterclaims  denying  the
material  allegations of the amended complaint and alleging various  contractual
and tort claims seeking injunctive relief and damages.  Pro-Fit further asserted
that  the  Company  infringed  its  United  States  Patent  Nos.  5,987,721  and
6,566,285.  The Company filed a reply denying the substantive allegations of the
amended counterclaims. At the Company's request, the Court bifurcated the breach
of contract issues for trial.  The parties have filed summary  judgment  motions
which may dispose of some of the issues in this case prior to trial.  On June 5,
2006 the Court denied one of the Company's motions for summary judgment, holding
that  the  issue of  whether  U.S.  Patent  No.  6,566,285  relating  to  curved
waistbands,  was  licensed  to the  Company  presented  a disputed  question  of
material  fact which  could not be  resolved  without a trial.  No trial date is
currently  set for trial of any  issues.  As the Company  derives a  significant
amount of revenue from the sale of products  incorporating the stretch waistband
technology,   the  Company's  business,  results  of  operations  and  financial
condition could be materially  adversely affected if the dispute with Pro-Fit is
not resolved in a manner favorable to the Company. Additionally, the Company has
incurred  significant  legal  fees in this  litigation,  and  unless the case is
settled will continue to incur  additional  legal fees in increasing  amounts as
the case accelerates to trial.

         The Company  currently has pending a number of other claims,  suits and
complaints  that  arise in the  ordinary  course of its  business.  The  Company
believes  that it has  meritorious  defenses to these claims and that the claims
are either  covered by insurance  or, after taking into account the insurance in
place, would not have a material effect on the Company's  consolidated financial
condition if adversely determined against the Company.

         In  accordance  with the bylaws of the Company,  officers and directors
are  indemnified  for certain events or  occurrences  arising as a result of the
officer or director's serving in such capacity.  The term of the indemnification
period is for the  lifetime of the officer or  director.  The maximum  potential
amount of future  payments  the  Company  could be  required  to make  under the
indemnification provisions of its bylaws is unlimited.  However, the Company has
a director and officer liability  insurance policy that reduces its exposure and
enables it to recover a portion of any future  amounts  paid. As a result of its
insurance policy coverage,  the Company believes the estimated fair value of the
indemnification  provisions of its bylaws is minimal and therefore,  the Company
has not recorded any related liabilities.

         The Company enters into indemnification provisions under its agreements
with  investors  and its  agreements  with other parties in the normal course of
business,  typically  with  suppliers,  customers  and  landlords.  Under  these
provisions, the Company generally indemnifies and holds harmless the


                                       11
<PAGE>


indemnified  party for losses suffered or incurred by the indemnified party as a
result  of the  Company's  activities  or,  in some  cases,  as a result  of the
indemnified  party's  activities  under  the  agreement.  These  indemnification
provisions often include  indemnifications  relating to representations  made by
the Company with regard to intellectual  property rights. These  indemnification
provisions  generally  survive  termination  of the  underlying  agreement.  The
maximum  potential  amount of future  payments the Company  could be required to
make under these  indemnification  provisions is unlimited.  The Company has not
incurred  material  costs to defend  lawsuits or settle claims  related to these
indemnification agreements. As a result, the Company believes the estimated fair
value of these agreements is minimal.  Accordingly, the Company has not recorded
any related liabilities.

         Effective June 1, 2006 accrued legal fees for services  provided by the
Company's  counsel  in the  amount  of  $1,650,000  were  converted  into a note
payable. The note is payable over a fourteen-month  period,  bearing interest at
3% per annum,  and is secured with an assignment of a note receivable due from a
customer in substantially identical monthly payments.  Additionally,  during the
quarter  ended June 30, 2006 a trade  payable in the amount of $125,000 due to a
former supplier was converted into a non-interest  bearing note payable due over
three months.

NOTE  6. STOCK OPTIONS AND WARRANTS

         On October 1, 1997, the Company  adopted the 1997 Stock  Incentive Plan
("the 1997 Plan"),  which  authorized  the granting of a variety of  stock-based
incentive  awards.  The Board of Directors,  who  determines  the recipients and
terms of the awards granted, administers the 1997 Plan. As of June 30, 2006, the
Company may issue awards to acquire up to a total of 2,942,365  shares of common
stock under the 1997 Plan.  As of June 30,  2006,  there were awards  issued and
outstanding under the 1997 Plan to acquire a total of 2,809,888 shares of common
stock,  including  options  issued to a consultant  to acquire  75,000 shares of
common stock at $0.57 per share and a stock grant of 90,253  shares.  During the
six months ended June 30, 2006, the Company  issued options  outside the plan to
acquire  1,625,000  shares of common stock at an average exercise price of $0.46
per share.

         The  following  table  summarizes  all  options  and  grants  issued to
employees and directors including those issued outside the plan.

         The following table summarizes the activity for the periods:

                                                                      Weighted
                                                                      Average
                                                     Number of        Exercise
EMPLOYEE AND DIRECTOR                                  Shares           Price
                                                    ------------    ------------
Options outstanding - January 1, 2005 ...........      1,742,000    $       3.53
    Granted .....................................        425,000    $       3.22
    Exercised ...................................         (1,250)   $       3.63
    Canceled ....................................       (332,750)   $       3.50
                                                    ------------    ------------
Options outstanding - December 31, 2005 .........      1,833,000    $       3.46
    Granted .....................................      2,745,270    $       0.42
    Issued ......................................       (135,135)   $       0.37
    Canceled ....................................       (173,500)   $       3.26
                                                    ------------    ------------
Options outstanding - June 30, 2006 .............      4,269,635    $       1.61
                                                    ============    ============


        The  Company  has also  issued  certain  warrants,  stock and options to
non-employees.  As of June 30,  2006,  there were  warrants  issued to acquire a
total of 1,243,813  shares of common  stock,  a stock grant of 90,253 shares and
options to acquire 75,000 shares of common stock.


                                       12
<PAGE>


        The following table summarizes all stock-based awards (warrants,  grants
and options) to non- employees:

                                                               Weighted
                                                               Average
                                                Number of      Exercise
         NON-EMPLOYEE                             Shares         Price
                                                ----------    ----------

         Outstanding - January 1, 2005 ......    1,377,147    $     4.36
           Granted ..........................         --            --
                                                ----------    ----------
         Outstanding - December 31, 2005 ....    1,377,147    $     4.36
           Granted ..........................      165,253    $     0.57
           Cancelled ........................     (133,334)   $     4.54
                                                ----------    ----------
         Outstanding - June 30, 2006 ........    1,409,066    $     3.90
                                                ==========    ==========


         The weighted average exercise prices,  remaining  contractual lives and
aggregate intrinsic values for employee and director shares and options granted,
expected to vest, and exercisable as of December 31, 2005 and June 30, 2006 were
as follows:

<TABLE>
<CAPTION>
                                                 Weighted       Weighted
                                                 Weighted       Average
                                                  Average      Remaining
                                   Number of     Exercise     Contractual    Intrinsic
EMPLOYEE AND DIRECTOR                Shares        Price      Life (Years)     Value
                                   ---------     --------     -----------    ---------
<S>                                <C>             <C>            <C>        <C>
OPTIONS AS OF DECEMBER 31, 2005:
Outstanding                        1,833,000       $3.46          6.02         $0.00
Vested and Expected to Vest        1,809,000       $3.44          5.98         $0.00
Exercisable                        1,788,000       $3.44          5.97         $0.00

OPTIONS AS OF JUNE 30, 2006:
Outstanding                        4,269,635       $1.61          8.35       $679,191
Vested and Expected to Vest        4,267,000       $1.61          8.35       $678,535
Exercisable                        1,650,750       $3.48          5.49        $23,500
</TABLE>


         The aggregate  intrinsic  value excludes  options that have an exercise
price in excess of market  price of the common stock as of December 31, 2005 and
June  30,  2006,  respectively.  Awards  that are  expected  to vest  take  into
consideration, estimated forfeitures for awards not yet vested.

         The weighted average exercise prices,  remaining  contractual lives and
aggregate  intrinsic  values  for  non-employee  warrants,  shares  and  options
granted,  exercisable, and expected to vest as of December 31, 2005 and June 30,
2006 were as follows:


                                       13
<PAGE>


<TABLE>
<CAPTION>
                                                                 Weighted
                                                 Weighted        Average
                                                  Average       Remaining
                                    Number of    Exercise      Contractual   Intrinsic
NON-EMPLOYEE                          Shares       Price       Life (Years)    Value
                                   ---------     --------     -----------    ---------
<S>                                <C>             <C>             <C>        <C>
WARRANTS & OPTIONS AS OF
DECEMBER 31, 2005:
Outstanding                        1,377,147       $4.36           2.6         $0.00
Vested and Expected to Vest        1,377,147       $4.36           2.6         $0.00
Exercisable                        1,377,147       $4.36           2.6         $0.00

WARRANTS AS OF JUNE 30, 2006:
Outstanding                        1,409,066       $3.90           2.78       $7,500
Vested and Expected to Vest        1,409,066       $3.90           2.78       $7,500
Exercisable                        1,293,813       $4.20           2.65       $5,000
</TABLE>


         The aggregate  intrinsic value excludes  warrants and options that have
an  exercise  price in  excess of the  market  price of the  common  stock as of
December 31, 2005 and June 30, 2006,  respectively.  Awards that are expected to
vest take into consideration, estimated forfeitures for awards not yet vested.

         The intrinsic value of options  exercised in 2005,  2004, and 2003 were
$1,500;  $183,000;  and $261,000,  respectively.  The total fair value of awards
vested  during the years ended  December 31, 2005,  2004 and 2003 was  $220,000,
$55,000 and $140,000,  respectively.  The fair value of the awards  approximates
the values expensed for pro-forma purposes for these periods.

         As  of  June  30,  2006,  there  was  $542,894  of  total  unrecognized
compensation costs related to non-vested share-based  compensation  arrangements
granted,  including  warrants.  This cost is expected to be recognized  over the
weighted-average period of 1.9 years.

         When options are exercised, the Company's policy is to issue previously
registered,  unissued  shares of common stock.  As of June 30, 2006, the Company
had 132,477  registered  but unissued  shares of common  stock  available in its
plan. On July 31, 2006, at the annual  shareholders  meeting an amendment to the
1997 Stock  Incentive  Plan was  adopted to  increase  the number of  authorized
shares  under  the 1997  Plan to a total of  6,000,000  shares.  See  Subsequent
Events.

NOTE 7.  NEW ACCOUNTING PRONOUNCEMENTS

         Effective  January 1, 2006 the Company  implemented  FASB  Statement of
Financial  Accounting  Standards (SFAS) No. 154,  "Accounting  Changes and Error
Corrections",  an amendment to accounting  Principles Bulletin (APB) Opinion No.
20,  "Accounting  Changes",  and SFAS No. 3,  "Reporting  Accounting  Changes in
Interim Financial Statements".  Though SFAS No. 154 carries forward the guidance
in APB No.20 and SFAS No.3 with respect to accounting  for changes in estimates,
changes  in  reporting  entity,  and the  correction  of  errors,  SFAS No.  154
established  new standards on accounting  for changes in accounting  principles,
whereby all such changes must be accounted for by  retrospective  application to
the financial  statements of prior periods unless it is  impracticable to do so.
SFAS No. 154 was effective for accounting  changes and error corrections made in
fiscal  years  beginning  after  December  15,  2005.  The  adoption of this new
standard did not have a material impact upon the Company's  financial  position,
results of operations or cash flows.


                                       14
<PAGE>


         In February  2006,  the FASB issued  Statement of Financial  Accounting
Standards No. 155, "Accounting for Certain Hybrid Financial  Instruments" ("SFAS
155"),  which amends SFAS No. 133,  "Accounting for Derivatives  Instruments and
Hedging Activities" ("SFAS 133") and SFAS No. 140, "Accounting for Transfers and
Servicing of Financial Assets and  Extinguishment of Liabilities"  ("SFAS 140").
SFAS 155 amends SFAS 133 to narrow the scope  exception  for  interest-only  and
principal-only   strips  on  debt   instruments  to  include  only  such  strips
representing  rights to receive a specified portion of the contractual  interest
or  principle  cash flows.  SFAS 155 also  amends  SFAS 140 to allow  qualifying
special-purpose  entities  to hold a  passive  derivative  financial  instrument
pertaining to beneficial  interests that itself is a derivative  instrument.  We
are currently  evaluating  the impact of this new Standard,  but believe that it
will not have a material impact on the Company's financial position,  or results
of operations.

         In March 2006, the FASB issued SFAS No. 156,  "Accounting for Servicing
of Financial  Assets"  ("SFAS No. 156"),  which provides an approach to simplify
efforts to obtain  hedge-like  (offset)  accounting.  This Statement amends FASB
Statement No. 140,  "Accounting for Transfers and Servicing of Financial  Assets
and  Extinguishments  of  Liabilities",  with  respect  to  the  accounting  for
separately recognized servicing assets and servicing liabilities.  The Statement
(1)  requires an entity to recognize a servicing  asset or  servicing  liability
each time it undertakes  an obligation to service a financial  asset by entering
into a servicing contract in certain situations;  (2) requires that a separately
recognized  servicing asset or servicing liability be initially measured at fair
value, if practicable;  (3) permits an entity to choose either the  amortization
method or the fair value  method for  subsequent  measurement  for each class of
separately recognized servicing assets or servicing liabilities;  (4) permits at
initial adoption a one-time reclassification of available-for-sale securities to
trading securities by an entity with recognized  servicing rights,  provided the
securities  reclassified  offset the  entity's  exposure  to changes in the fair
value  of the  servicing  assets  or  liabilities;  and  (5)  requires  separate
presentation of servicing assets and servicing liabilities subsequently measured
at fair value in the balance sheet and additional disclosures for all separately
recognized servicing assets and servicing liabilities. SFAS No. 156 is effective
for  all  separately  recognized  servicing  assets  and  liabilities  as of the
beginning of an entity's  fiscal year that begins after September 15, 2006, with
earlier  adoption  permitted  in  certain  circumstances.   The  Statement  also
describes the manner in which it should be initially  applied.  We are currently
evaluating the impact of this Statement.

         In June 2006, the FASB issued  Interpretation  No. 48,  "Accounting for
Uncertainty  in Income Taxes -- An  Interpretation  of FASB  Statement No. 109",
(FIN 48).  FIN 48  clarifies  the  accounting  for  uncertainty  in income taxes
recognized in an  enterprise's  financial  statements  in  accordance  with FASB
Statement  No. 109,  "Accounting  for Income  Taxes".  FIN 48 also  prescribes a
recognition  threshold and  measurement  attribute  for the financial  statement
recognition and measurement of a tax position taken or expected to be taken in a
tax return that results in a tax benefit. Additionally, FIN 48 provides guidance
on  de-recognition,  income statement  classification of interest and penalties,
accounting in interim periods,  disclosure, and transition.  This interpretation
is effective for fiscal years  beginning after December 15, 2006. The Company is
currently  evaluating the effect that the application of FIN 48 will have on its
results of operations and financial condition


NOTE 8.  GEOGRAPHIC INFORMATION

         The Company  specializes in the distribution of a full range of apparel
zipper and trim items to manufacturers of fashion apparel,  specialty  retailers
and mass  merchandisers.  There is not enough  difference  between  the types of
products  developed and distributed by the Company to account for these products
separately or to justify segmented reporting by product type.


                                       15
<PAGE>


         The Company distributes its products  internationally and has reporting
requirements  based on geographic  regions.  Long-lived assets are attributed to
countries  based on the location of the assets and revenues  are  attributed  to
countries based on customer delivery locations, as follows:

                               Three Months Ended          Six Months Ended
                                    June 30,                    June 30,
                           -------------------------   -------------------------
Country / Region               2006          2005          2006          2005
                           -----------   -----------   -----------   -----------

United States ..........   $ 1,025,100   $ 2,540,200   $ 1,938,400   $ 3,127,700
Asia ...................     8,418,400     6,035,000    14,738,800    10,330,200
Mexico .................     1,444,200     4,417,300     2,579,700     9,038,900
Dominican Republic .....     2,631,300     1,683,100     4,272,100     3,902,500
Other ..................       727,100       964,000     1,355,300     2,295,600
                           -----------   -----------   -----------   -----------

                           $14,246,100   $15,639,600   $24,884,300   $28,694,900
                           ===========   ===========   ===========   ===========


                                                   June 30,         December 31,
                                                     2006               2005
                                                 -----------         -----------
Long-lived Assets:
     United States .....................         $ 9,984,200         $10,493,900
     Asia ..............................             218,800             226,200
     Mexico ............................              14,300              23,700
     Dominican Republic ................             722,700             776,300
                                                 -----------         -----------

                                                 $10,940,000         $11,520,100
                                                 ===========         ===========


NOTE 9.  SUBSEQUENT EVENTS

         On August 3, 2006 the Company received  notification  from the American
Stock Exchange  ("AMEX") that the Company's plan to regain  compliance  with the
minimum  shareholders'  equity  requirements  of the AMEX Company Guide had been
accepted and the Company has been granted an extension  until  November 16, 2007
to achieve  the AMEX  continued  listing  requirements.  During  this period the
Company will be subject to periodic review by the AMEX Staff and failure to make
progress consistent with the plan or to regain compliance with continued listing
standards by the end of the extension period could result in being delisted from
the American Stock Exchange.

         In May,  2006,  the  Company  had  received  notice  that it was not in
compliance with certain of the continued  listing  standards as set forth in the
AMEX  Company  Guide due to the failure to comply with  Section  1003(a)(i)  and
Section  1003(a)(ii) of the Company Guide,  which effectively  required that the
Company  maintain  shareholders'  equity of at least  $4,000,000.  Following the
notice from AMEX the Company was afforded the  opportunity  to submit a "plan of
compliance" to AMEX outlining in detail how the Company  expected to achieve the
minimum  equity  requirements  and to  regain  compliance,  and in June  2006 we
submitted the plan that has been accepted by AMEX.

         Effective July 31, 2006, concurrent with the appointment of Mr. William
Sweedler to the Company's  Board of Directors and its Audit  Committee,  and the
resignation  of Mr.  Kevin  Bermeister  from the Board,  the Company has met the
governance  requirements of the AMEX Company Guidelines requiring that the board
consist of a majority of independent  directors and that the audit  committee be
comprised of at least three independent directors.


                                       16
<PAGE>


         The  Company  has  adopted  an   amendment   to  its   Certificate   of
Incorporation,  effective  as of August 3, 2006 to increase the number of shares
of  common  stock  the  Company  is  authorized  to  issue  from  30,000,000  to
100,000,000. This amendment was approved by the Company's Board of Directors and
by a  vote  of  the  Company's  stockholders  at  the  2006  annual  meeting  of
stockholders.

         On July 31, 2006 at the Company's annual meeting of  stockholder's  two
amendments to the 1997 Stock Plan were approved  which (1) increased the maximum
number of shares of common stock that may be issued  pursuant to awards  granted
under the 1997 Plan from 3,077,500 shares to 6,000,000 shares, and (2) increased
the  number  of shares of common  stock  that may be issued  pursuant  to awards
granted to any  individual  under the plan in a single  year to 50% of the total
number of shares available under the plan.


                                       17
<PAGE>


ITEM 2.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
         OF OPERATIONS.

FORWARD LOOKING STATEMENTS

         This report and other  documents  we file with the SEC contain  forward
looking statements that are based on current expectations,  estimates, forecasts
and projections about us, our future performance,  our business or others on our
behalf, our beliefs and our management's  assumptions.  These statements are not
guarantees of future performance and involve certain risks,  uncertainties,  and
assumptions  that are difficult to predict.  We describe our  respective  risks,
uncertainties,  and  assumptions  that could  affect  the  outcome or results of
operations  below.  We  have  based  our  forward  looking   statements  on  our
management's  beliefs and  assumptions  based on  information  available  to our
management  at the time the  statements  are made.  We caution  you that  actual
outcomes and results may differ materially from what is expressed,  implied,  or
forecast by our forward looking  statements.  Reference is made in particular to
forward looking  statements  regarding  projections or estimates  concerning our
business,  including  demand  for our  products  and  services,  mix of  revenue
streams, ability to control and/or reduce operating expenses,  anticipated gross
margins and  operating  results,  cost  savings,  product  development  efforts,
general  outlook  of  our  business  and  industry,   international  businesses,
competitive  position,  adequate  liquidity to fund our  operations and meet our
other cash requirements.

OVERVIEW

         The  following  management's  discussion  and  analysis  is intended to
assist the reader in understanding our consolidated  financial statements.  This
management's  discussion and analysis is provided as a supplement to, and should
be  read  in  conjunction  with,  our  consolidated   financial  statements  and
accompanying notes.

         Tag-It Pacific,  Inc. designs,  sells and distributes  apparel zippers,
specialty  waistbands  and various  apparel trim  products to  manufacturers  of
fashion apparel, specialty retailers and mass merchandisers.  We sell and market
these products  under various  branded names  including  Talon,  and Tekfit.  We
operate the business globally under three product groups.

         We plan to increase our global  expansion of Talon zippers  through the
establishment of a network of Talon locations,  distribution relationships,  and
joint ventures. Our distribution partners will be required to maintain excellent
zipper   manufacturing   capabilities  and  will  adopt  quality   manufacturing
procedures  to meet our  high  manufacturing  standards.  The  network  of these
manufacturers under the Talon brand is expected to improve the time-to-market by
eliminating the typical setup and build-out phase for new manufacturing capacity
throughout the world.

         During the third quarter of 2005 we  restructured  our trim business to
focus as an outsourced product development, sourcing and sampling department for
the  most  demanding   brands  and  retailers.   We  believe  that  trim  design
differentiation  among brands and retailers has become a critical marketing tool
for our  customers.  By assisting our customers in the  development,  design and
sourcing of trim,  we expect to achieve  higher  margins for our trim  products,
create  long-term  relationships  with  our  customers,  grow  our  sales  to  a
particular  customer by supplying trim for a larger  proportion of their brands,
and  better  differentiate  our  trim  sales  and  services  from  those  of our
competitors.  The  restructuring  (described more fully below)  discontinued the
supply of trim products in preassembled kits. We will continue to supply trim to
customers however we will not provide the trim components in a preassembled kit.

         Our Tekfit services provide manufacturers with the patented technology,
manufacturing  know-how and materials required to produce pants incorporating an
expandable   waistband.   These  products  are  currently  produced  by  several
manufacturers  for one single  brand.  We intend to expand this product to other
brands;  however  our  expansion  has been  limited  to date due to a  licensing
dispute.  As  described  more  fully  in this  report  under  Contingencies  and
Guarantees (see Note 5 to our unaudited consolidated


                                       18
<PAGE>


financial  statements),  we are  presently in litigation  with Pro-Fit  Holdings
Limited related to our exclusively licensed rights to sell or sublicense stretch
waistbands  manufactured  under Pro-Fit's  patented  technology.  As we derive a
significant  amount  of  revenue  from the sale of  products  incorporating  the
stretch waistband technology,  our business, results of operations and financial
condition could be materially  adversely affected if our dispute with Pro-Fit is
not resolved in a manner favorable to us.

         In an effort to better  align our  organizational  and cost  structures
with its future  growth  opportunities,  in August  2005 our Board of  Directors
adopted a restructuring  plan that was  substantially  completed by December 31,
2005.  The plan included  restructuring  our global  operations  by  eliminating
redundancies in our Hong Kong operation,  closing our facilities in Mexico,  and
closing our North Carolina  manufacturing  facility.  We have also refocused our
sales  efforts on higher  margin  products,  which may result in lower net sales
over the next twelve months as we focus on acquiring high quality customers, and
decrease our customer concentration.  As a result of this restructuring, we will
operate  with fewer  employees  and will have  lower  associated  operating  and
distribution expenses.

         RESULTS OF OPERATIONS

         The following  table sets forth selected  statements of operations data
shown as a percentage of net sales for the periods indicated:

                                       THREE MONTHS ENDED     SIX MONTHS ENDED
                                             JUNE 30,             JUNE 30,
                                        ----------------     ------------------
                                         2006      2005       2006       2005
                                        ------    ------     ------     ------
Net sales ............................   100.0 %   100.0 %    100.0 %    100.0 %
Cost of goods sold ...................    71.0      95.2       72.0       86.0
                                        ------    ------     ------     ------
Gross profit .........................    29.0       4.8       28.0       14.0
Selling expenses .....................     4.7       4.2        4.9        4.9
General and administrative expenses ..    18.5      70.4       21.9       51.4
Interest & Taxes .....................     1.1      10.0        1.5        7.0
                                        ------    ------     ------     ------
Operating (loss) income ..............     4.7 %   (79.8)%     (0.3)%    (49.3)%
                                        ------    ------     ------     ------

         SALES

         For the three months ended June 30, 2006 and 2005,  sales by geographic
region based on the location of the customer as a percentage of sales:

                                       THREE MONTHS ENDED     SIX MONTHS ENDED
                                             JUNE 30,             JUNE 30,
                                        -----------------     -----------------
COUNTRY / REGION                         2006       2005       2006       2005
                                        ------     ------     ------     ------
United States ......................       7.2%      16.2%       7.8%      10.9%
Asia ...............................      59.1%      38.6%      59.2%      36.0%
Mexico .............................      10.1%      28.2%      10.4%      31.5%
Dominican Republic .................      18.5%      10.8%      17.2%      13.6%
Other ..............................       5.1%       6.2%       5.4%       8.0%
                                        ------     ------     ------     ------
                                         100.0%     100.0%     100.0%     100.0%
                                        ======     ======     ======     ======

         Sales for the three  months  ended June 30, 2006 were $14.2  million or
$1.4  million  (8.9%) less than sales for the three  months ended June 30, 2005.
Sales for the six months ended June 30, 2006 were $24.9  million or $3.8 million
(13.3%) less than sales for the same period in 2005.  The reduction in sales for
the three and six months  ended June 30,  2006 as compared to the same period in
2005 is primarily


                                       19
<PAGE>


attributable  to the  discontinuance  of sales of thread  products in the fourth
quarter of 2005. For the three and six months ended June 30, 2005 sales included
$1.2 million and $2.7 million,  respectively  of thread  products,  whereas only
liquidation  sales of these  products  existed  in 2006.  For the  three and six
months ended June 30, 2006 sales of thread  products  were $53,000 and $300,000,
respectively. Thread products were lower margin sales, and the discontinuance of
this product  offering allows more focus on other market  opportunities  such as
zippers and trim that we believe will add more value.

         Sales  for the three  months  and six  months  ended  June 30,  2006 as
compared to the same periods in 2005 also declined as a result of lower sales of
trim products to our customers in Mexico and the U.S. as production shifted from
these areas to Asia and other worldwide markets.  Sales within the Asian markets
for the three and six months ended June 30, 2006 increased $2.4 million and $4.4
million,  respectively  over the same periods in 2005. Sales within the U.S. and
Mexico for the three and six months  ended June 30, 2006  declined  $4.5 million
and $7.6 million,  respectively, compared with the same periods in 2005. The net
decrease is primarily the result of the shift of apparel  production  from Latin
America  to Asia and  other  worldwide  markets  that  began  in  2004,  and the
resulting  decrease in sales to our  customers in Mexico of trim  products.  The
Company responded to this shift with our growth and expansion  activities in the
Asian markets and with the  restructuring  plans implemented in 2005 closing the
Mexican assembly and U.S. manufacturing facilities.

         COST OF SALES

         Cost of sales  for the  three  months  ended  June 30,  2006 was  $10.1
million or $4.7  million  (32%)  less than cost of sales for the same  period in
2005, and cost of sales for the six months ended June 30, 2006 was $17.9 million
or $6.8 million  (27%) less than cost of sales for the same period in 2005.  The
reduction  in cost of sales for the three and six months  ended June 30, 2006 as
compared to the same periods in 2005 was  attributable to costs  associated with
lower overall sales volumes,  improved product margins  resulting from our focus
on higher margin sales, reduced distribution charges since more products are now
sourced and delivered within the same  marketplace,  reduced  manufacturing  and
assembly  overhead costs as these operations were closed in the third quarter of
2005,  and lower  provisions  for  obsolescence  as  inventory  levels have been
reduced and turns  accelerated.  A brief  recap of the change in sales,  cost of
sales and gross  margin  for the three and six  months  ended  June 30,  2006 as
compared with the same periods in 2005 is as follows:

                                                (Amounts in thousands)
                                          THREE MONTHS           SIX MONTHS
                                       -----------------     -----------------
                                       AMOUNT       %(1)     AMOUNT       %(1)
                                       ------     ------     ------     ------
Sales increase (decrease) ..........   $(1,394)     (8.9)%   $(3,810)    (13.3)%

Cost of sales decrease (increase):
Improved margin on current sales ...    1,396        9.4      1,792        7.3
Reduced freight and duty costs .....      695        4.7      1,299        5.3
Lower manufacturing & assembly costs      400        2.7        602        2.4
Reduced obsolescence ...............    1,490       10.0        960        3.9
Lower volumes ......................      563        3.8      1,543        6.3
Other cost of sales charges ........      221        1.4        576        2.2
                                       ------     ------     ------     ------
                                        4,765       32.0%     6,772       27.4%
                                       ------                ------
Gross margin increase (decrease) ...   $3,371                $2,962
                                       ======                ======

(1) Represents the percentage change in the 2006 period, as compared to the same
    period in 2005.


                                       20
<PAGE>


         SELLING EXPENSES

         Selling  expenses  for the three  months  ended June 30, 2006 were $0.7
million, or 4.7% of sales compared to $0.6 million or 4.2% of sales for the same
period in 2005.  The increase in selling  expense is due to a  commission  based
compensation  program  implemented in 2006, offset by employee reductions in the
U.S. and Mexico associated with the restructuring plan adopted in 2005.

         Selling  expenses  for the six  months  ended  June 30,  2006 were $1.2
million or 4.9% of sales  compared to $1.4 million or 4.9% of sales for the same
period  in 2005.  Increased  costs of $0.2  million  associated  with a shift to
commission based compensation was offset by employee  reductions in the U.S. and
Mexico  associated with the  restructuring  plan adopted in the third quarter of
2005.

         GENERAL AND ADMINISTRATIVE EXPENSES

         General and administrative expenses for the three months ended June 30,
2006 were $2.6  million or $8.4  million  (76%) less than for the same period in
2005. General and administrative expenses for the six months ended June 30, 2006
were $5.5 million or $9.3 million (63%) less than for the same period in 2005.

         General and  administrative  expense for the three month  period  ended
June 30, 2005 included $6.4 million in reserve  provisions  for bad debts;  $1.3
million in legal &  professional  costs  primarily  associated  with the Pro-Fit
Holdings litigation;  and $0.5 million in travel & related costs associated with
expanding  operations  in Asia.  For the three month  period ended June 30, 2006
comparable items included in general and  administrative  expense  reflected net
bad debt recoveries of $164,000;  $0.7 million in legal and professional  costs;
and $130,000 in travel and related costs.  These items  represent  approximately
$7.5  million or (90%) of the decrease in general and  administrative  costs for
the three months ended June 30, 2006 as compared to the same period of 2005 with
the  balance  of the  reduction  resulting  from cost  savings  associated  with
employee  reductions in the U.S.,  Mexico and Hong Kong implemented as a part of
our  restructuring  plan in the third  quarter  of fiscal  year  2005.  This was
partially offset by non-cash  compensation costs associated with the adoption of
FAS 123(R) effective January 1, 2006.

         For the six month  period  ended June 30,  2006 as compared to the same
period of 2005,  the general and  administrative  costs  declined from the prior
year by $9.3 million.  The reduction was  principally the result of $6.5 million
in  provisions  for bad  debts  in 2005 as  compared  to  $400,000  in bad  debt
recoveries in 2006; a $0.7 million  decrease in travel & related costs, and cost
reductions associated with employee reductions in the U.S., Mexico and Hong Kong
that we implemented  with our  restructuring  plan in 2005,  partially offset by
non-cash compensation costs recorded with the adoption of FAS 123R.

         Effective  January 1,  2006,  we adopted  FAS 123R which  requires  the
company to  recognize a non-cash  expense  associated  with options and warrants
issued to  employees,  directors and  consultants.  For the three and six months
ended June 30, 2006 we  incurred  $46,000 and  $165,000,  respectively  of costs
associated with the implementation of this accounting requirement.  The majority
of the  recognized  cost is  associated  with the  option  grants  issued to the
executive management team in the first quarter of 2006.

         INTEREST EXPENSE

         Interest expense  decreased by  approximately  $117,000 to $152,000 for
the three months  ended June 30,  2006,  as compared to the same period in 2005.
Interest  expense  decreased by  approximately  $176,000 to $361,000 for the six
months ended June 30, 2006,  as compared to the same period in 2005.  The change
for both the three  and six month  period  from 2005 is due  primarily  to lower
borrowings under a bank line of credit and certain notes.


                                       21
<PAGE>


         INCOME TAXES

         Income tax expense for the three and six months  ended June 30 2006 was
$11,500  associated  with foreign  income taxes from  earnings  within our Asian
facilities.  Due to prior  operating  losses incurred within the year no benefit
for  domestic  income  taxes has been  recorded  since  there is not  sufficient
evidence to  determine  that we will be able to utilize our net  operating  loss
carryforwards to offset future taxable income.

         Income tax expense for the three and six months  ended June 30 2005 was
$1.3 million and $1.5 million  respectfully.  Income taxes for 2005  included an
increase of $1.0 million in the deferred tax asset  valuation  allowance,  and a
provision for earned income within our foreign subsidiary.

LIQUIDITY AND CAPITAL RESOURCES

         The following table summarizes selected financial data at:

                                              JUNE 30,      DECEMBER 31,
                                                2006            2005
                                            -----------     -----------
         Cash and cash equivalents ....     $ 3,976,900     $ 2,277,400
         Total assets .................     $29,930,900     $30,320,800
         Current debt .................     $14,459,300     $14,850,600
         Non-current debt .............     $14,398,900     $14,558,100
         Stockholders' equity .........     $ 1,072,700     $   912,100


         CASH AND CASH EQUIVALENTS

         Cash  and cash  equivalents  for the six  months  ended  June 30,  2006
increased  $1,700,000  from  December  31, 2005  principally  arising  from cash
generated by operating activities.

         Cash provided by operating  activities is our only recurring  source of
funds,  and was  approximately  $2.3  million for the six months  ended June 30,
2006. The cash provided by operating  activities  during the six months resulted
principally  from a net  decrease in  inventory  of $2.0 million (a $5.4 million
reduction in inventory  levels,  net of  established  reserves of $3.4 million),
plus  non-cash  charges to income of $0.7 million from stock based  compensation
and depreciation, partially offset by an increase in current receivables of $0.7
million (before consideration of accounts  written-off),  and a net loss of $0.1
million.  During the six months  ended June 30, 2006  established  reserves  for
uncollectible  accounts receivable were applied to approximately $0.6 million of
accounts written-off, and approximately $0.3 million in reserves were eliminated
following the collection of previously reserved accounts. Cash used by operating
activities for the six months ended June 30, 2005 was $148,000.

         Net cash used in investing activities for the six months ended June 30,
2006 was $26,000 as compared to $1.2  million for the six months  ended June 30,
2005.  The  cash  used  in  investing  activities  in  2006  represents  capital
expenditures  for  leasehold  improvements  in China.  In 2005 the cash used for
investing  activities  consisted  primarily of capital  expenditures  for zipper
equipment and leasehold  improvements  for the  manufacturing  facility in North
Carolina.

         Net cash used in financing activities for the six months ended June 30,
2006  was  approximately  $536,000  and  primarily  reflects  the  repayment  of
borrowings under capital leases and notes payable. For the six months ended June
30, 2005 the cash used by financing  activities was $1.1 million and represented
the repayment of notes  payable and capital  leases,  partially  offset by funds
raised from the exercise of stock options and warrants and increased utilization
of the bank line of credit.


                                       22
<PAGE>


         We currently satisfy our working capital requirements primarily through
cash flows generated from  operations.  As we continue to respond to the current
industry  trend of large retail  brands to outsource  apparel  manufacturing  to
offshore  locations,  our foreign  customers,  though backed by U.S.  brands and
retailers,   are  increasing.   This  makes  receivables  based  financing  with
traditional  U.S. banks more difficult.  Our current  borrowings may not provide
the level of financing we may need to expand into additional foreign markets. As
a result, we are continuing to evaluate non-traditional financing of our foreign
assets.

         We have incurred  significant legal fees in our litigation with Pro-Fit
Holdings  Limited.  Unless  the  case is  settled,  we will  continue  to  incur
additional legal fees in increasing amounts as the case accelerates to trial.

         We believe that our existing cash and cash  equivalents and anticipated
cash flows from our operating  activities will be sufficient to fund our minimum
working  capital  and  capital  expenditure  needs for at least the next  twelve
months. This conclusion is based on the assumption that we will be successful in
restructuring our operations in accordance with the  restructuring  plan adopted
in 2005, and that we will collect our note and accounts receivable in accordance
to  existing  terms.  If we are  unable  to  successfully  fully  implement  our
restructuring  initiative or collect the note receivable,  or experience greater
than anticipated reductions in sales, we may need to raise additional capital or
further  reduce the scope of our  business in order to fully  satisfy our future
short-term  liquidity  requirements.  If we cannot raise  additional  capital or
reduce the scope of our  business in response  to our failure to  implement  our
restructuring  initiative in accordance with our plan,  there may be substantial
doubt  about our  ability to  continue as a going  concern.  Our  auditors  have
included in their report on our financial statements for the year ended December
31, 2005 an explanatory paragraph expressing substantial doubt about our ability
to  continue  as a  going  concern  if we  fail to  successfully  implement  our
restructuring initiative.

         The extent of our future long-term capital  requirements will depend on
many  factors,  including  our  results  of  operations,  future  demand for our
products,  the size and  timing  of  future  acquisitions,  our  borrowing  base
availability limitations related to eligible accounts receivable and inventories
and our  expansion  into  foreign  markets.  Our need for  additional  long-term
financing  includes the  integration  and expansion of our operations to exploit
our rights under our Talon trade name,  the  expansion of our  operations in the
Asian,  Central  and  South  American  and  Caribbean  markets  and the  further
development  of our waistband  technology.  If our cash from  operations is less
than anticipated or our working capital  requirements  and capital  expenditures
are  greater  than we  expect,  we may need to raise  additional  debt or equity
financing in order to provide for our operations.  We are continually evaluating
various  financing  strategies to be used to expand our business and fund future
growth or acquisitions. There can be no assurance that additional debt or equity
financing  will be available on acceptable  terms or at all. If we are unable to
secure  additional  financing,  we may not be  able to  execute  our  plans  for
expansion,  including  expansion into foreign markets to promote our Talon brand
tradename, and we may need to implement additional cost savings initiatives.


                                       23
<PAGE>


CONTRACTUAL OBLIGATIONS AND OFF-BALANCE SHEET ARRANGEMENTS

         The following  summarizes our contractual  obligations at June 30, 2006
and the effects such obligations are expected to have on liquidity and cash flow
in future periods:

<TABLE>
<CAPTION>
                                                        PAYMENTS DUE BY PERIOD
                                  -------------------------------------------------------------------
                                                 LESS THAN      1 TO 3        4 TO 5         AFTER
     CONTRACTUAL OBLIGATIONS         TOTAL        1 YEAR         YEARS         YEARS        5 YEARS
-------------------------------   -----------   -----------   -----------   -----------   -----------

<S>                               <C>           <C>           <C>           <C>           <C>
Demand notes payable to related   $   664,971   $   664,971   $         0   $         0   $         0
  parties (1)
Capital lease obligations .....   $ 1,049,500   $   193,000   $   856,000   $       500   $         0
Operating leases ..............   $ 1,717,000   $   563,000   $ 1,088,000   $    66,000   $         0
Notes payable .................   $ 3,085,100   $   916,400   $ 1,530,500   $   638,200   $         0
Convertible notes payable .....   $12,456,500   $         0   $12,456,500   $         0   $         0
</TABLE>

(1)      The majority of notes payable to related parties are due on demand with
         the  remainder  due and payable on the fifteenth day following the date
         of delivery of written demand for payment, and include accrued interest
         payable through June 30, 2006.

         At June 30,  2006 and  2005,  we did not  have any  relationships  with
unconsolidated  entities  or  financial  partnerships,  such as  entities  often
referred to as structured finance or special purpose entities,  which would have
been established for the purpose of facilitating  off-balance sheet arrangements
or other contractually  narrow or limited purposes.  As such, we are not exposed
to any  financing,  liquidity,  market or credit risk that could arise if we had
engaged in such relationships.

RELATED PARTY TRANSACTIONS

         Prior to 2005 the  company  operated an apparel  trim supply  agreement
with Tarrant Apparel Group. Two of Tarrant's  executive officers and significant
shareholders  are also  significant  shareholders  of our  company.  The  supply
agreement  was  terminated  in  December  2004;  however we  continue to conduct
business with Tarrant Apparel Group on a limited basis.  Sales to Tarrant or its
affiliates for the six months ended June 30, 2005 were $27,000.

         As of June 30,  2006  accounts  receivable  included  $13.000  due from
Tarrant,  of which  $10,000 has been  subsequently  collected.  At June 30, 2005
accounts  receivable,  related party  included  $3.4 million due from  Tarrant's
affiliate,  United Apparel  Ventures.  United Apparel Ventures paid this balance
over a nine-month period and it was fully paid as of December 31, 2005.

         As of  June  30,  2006  and  December  31,  2005,  we  had  outstanding
related-party  notes payable of $665,000,  at interest  rates ranging from 0% to
11%. The majority of related-party debt is due on demand, with the remainder due
and payable within 15 days of demand.  Accrued  interest  associated  with these
notes is included in other accrued liabilities.

         As of June 30, 2006 and December 31, 2005, we had  receivables due from
related parties of $691,000 and $730,000,  respectively. The receivables consist
of unsecured  notes,  advances  and accrued  interest  receivable  from a former
officer and  stockholder  of the Company who is related to or affiliated  with a
director of the Company.  The notes and advances  bear  interest at 0%, 8.5% and
prime and, together with accrued interest, are due on demand.


                                       24
<PAGE>


         Consulting fees paid to Diversified  Investments,  a company owned by a
member of our Board of Directors,  amounted to $37,500 and $75,000 for the three
and six months ended June 30, 2006, respectively.

         APPLICATION OF CRITICAL ACCOUNTING POLICIES AND ESTIMATES

         The  preparation of financial  statements in conformity with accounting
principles   generally  accepted  in  the  United  States  of  America  requires
management to make estimates and assumptions for the reporting  period and as of
the financial statement date. We base our estimates on historical experience and
on various  other  assumptions  that are  believed  to be  reasonable  under the
circumstances,  the results of which form the basis for making  judgments  about
the carrying values of assets and liabilities that are not readily apparent from
other sources.  These estimates and assumptions  affect the reported  amounts of
assets  and  liabilities,  the  disclosure  of  contingent  liabilities  and the
reported amounts of revenue and expense.  Actual results could differ from those
estimates.

         Critical  accounting  policies  are  those  that are  important  to the
portrayal of our financial  condition and results,  and which require us to make
difficult,  subjective and/or complex judgments.  Critical  accounting  policies
cover  accounting  matters  that are  inherently  uncertain  because  the future
resolution  of such  matters is  unknown.  We  believe  the  following  critical
accounting policies affect our more significant  judgments and estimates used in
the preparation of our consolidated financial statements:

         o        Accounts  receivable  balances  are  evaluated  on a continual
                  basis   and   allowances   are   provided   for    potentially
                  uncollectible  accounts based on management's  estimate of the
                  collectibility   of  customer   accounts.   If  the  financial
                  condition  of  a  customer   deteriorates,   resulting  in  an
                  impairment  of its  ability to make  payments,  an  additional
                  allowance may be required.  Allowance  adjustments are charged
                  to  operations in the period in which the facts that give rise
                  to the adjustments become known.

         o        Inventories  are stated at the lower of cost or market  value.
                  Inventory  is  evaluated  on a  continual  basis  and  reserve
                  adjustments are made based on management's  estimate of future
                  sales value, if any, of specific  inventory  items.  Inventory
                  reserves  are  recorded  for  damaged,  obsolete,  excess  and
                  slow-moving  inventory.  We  use  estimates  to  record  these
                  reserves.  Slow-moving  inventory  is reviewed by category and
                  may be partially or fully  reserved for  depending on the type
                  of  product  and the  length  of time  the  product  has  been
                  included in inventory.  Reserve  adjustments  are made for the
                  difference between the cost of the inventory and the estimated
                  market  value,  if lower,  and  charged to  operations  in the
                  period in which the facts that give rise to these  adjustments
                  become known.  Market value of inventory is estimated based on
                  the  impact  of  market  trends,  an  evaluation  of  economic
                  conditions  and the value of current  orders  relating  to the
                  future sales of this type of inventory.

         o        We record  deferred tax assets arising from  temporary  timing
                  differences between recorded net income and taxable net income
                  when and if we believe that future earnings will be sufficient
                  to realize the tax benefit.  For those jurisdictions where the
                  expiration date of tax benefit carry-forwards or the projected
                  taxable  earnings  indicate that  realization is not likely, a
                  valuation  allowance is provided.  If we determine that we may
                  not realize all of our deferred  tax assets in the future,  we
                  will make an adjustment to the carrying  value of the deferred
                  tax asset,  which would be reflected as an income tax expense.
                  Conversely,  if we  determine  that we will realize a deferred
                  tax asset, which currently has a valuation allowance, we would
                  be required to reverse the valuation allowance, which would be
                  reflected  as an  income  tax  benefit.  We  believe  that our
                  estimate of deferred tax assets and  determination to record a
                  valuation allowance against


                                       25
<PAGE>


                  such assets are critical accounting estimates because they are
                  subject to, among other things,  an estimate of future taxable
                  income,  which is  susceptible  to change and  dependent  upon
                  events  that may or may not occur,  and  because the impact of
                  recording a valuation  allowance may be material to the assets
                  reported on the balance sheet and results of operations.

         o        We record  impairment  charges  when the  carrying  amounts of
                  long-lived  assets  are  determined  not  to  be  recoverable.
                  Impairment is measured by assessing the usefulness of an asset
                  or by  comparing  the  carrying  value of an asset to its fair
                  value. Fair value is typically  determined using quoted market
                  prices,  if available,  or an estimate of undiscounted  future
                  cash flows  expected  to result  from the use of the asset and
                  its eventual  disposition.  The amount of  impairment  loss is
                  calculated  as the excess of the carrying  value over the fair
                  value.  Changes in market  conditions and management  strategy
                  have historically caused us to reassess the carrying amount of
                  our long-lived  assets.  Long-lived  assets are evaluated on a
                  continual basis and impairment adjustments are made based upon
                  management's  valuations.  As part of our  2005  restructuring
                  plan,  certain  long-lived  assets,  primarily  machinery  and
                  equipment,   were   impaired   and   their   values   adjusted
                  accordingly.

         o        Sales  are   recognized   when   persuasive   evidence  of  an
                  arrangement exists, product delivery has occurred,  pricing is
                  fixed or determinable,  and collection is reasonably  assured.
                  Sales  resulting  from  customer   buy-back   agreements,   or
                  associated  inventory storage arrangements are recognized upon
                  delivery  of the  products  to the  customer,  the  customer's
                  designated  manufacturer,  or upon notice from the customer to
                  destroy  or  dispose  of  the  goods.  Sales,  provisions  for
                  estimated  sales  returns,  and the cost of products  sold are
                  recorded  at the time title  transfers  to  customers.  Actual
                  product  returns are charged  against  estimated  sales return
                  allowances.

         o        We are  currently  involved  in various  lawsuits,  claims and
                  inquiries,  most of which  are  routine  to the  nature of the
                  business,  and in accordance with SFAS No. 5,  "Accounting for
                  Contingencies,"  we  accrue  estimates  of  the  probable  and
                  estimable  losses  for the  resolution  of these  claims.  The
                  ultimate  resolution  of these  claims could affect our future
                  results of operations for any  particular  quarterly or annual
                  period  should our exposure be materially  different  from our
                  earlier estimates or should  liabilities be incurred that were
                  not previously accrued.

NEW ACCOUNTING PRONOUNCEMENTS

         Effective  January 1, 2006 the Company  implemented  FASB  Statement of
Financial  Accounting  Standards (SFAS) No. 154,  "Accounting  Changes and Error
Corrections",  an amendment to accounting  Principles Bulletin (APB) Opinion No.
20,  "Accounting  Changes",  and SFAS No. 3,  "Reporting  Accounting  Changes in
Interim Financial Statements".  Though SFAS No. 154 carries forward the guidance
in APB No.20 and SFAS No.3 with respect to accounting  for changes in estimates,
changes  in  reporting  entity,  and the  correction  of  errors,  SFAS No.  154
established  new standards on accounting  for changes in accounting  principles,
whereby all such changes must be accounted for by  retrospective  application to
the financial  statements of prior periods unless it is  impracticable to do so.
SFAS No. 154 was effective for accounting  changes and error corrections made in
fiscal  years  beginning  after  December  15,  2005.  The  adoption of this new
standard did not have a material impact upon the Company's  financial  position,
or results of operations.


                                       26
<PAGE>


         In February  2006,  the FASB issued  Statement of Financial  Accounting
Standards No. 155, "Accounting for Certain Hybrid Financial  Instruments" ("SFAS
155"),  which amends SFAS No. 133,  "Accounting for Derivatives  Instruments and
Hedging Activities" ("SFAS 133") and SFAS No. 140, "Accounting for Transfers and
Servicing of Financial Assets and  Extinguishment of Liabilities"  ("SFAS 140").
SFAS 155 amends SFAS 133 to narrow the scope  exception  for  interest-only  and
principal-only   strips  on  debt   instruments  to  include  only  such  strips
representing  rights to receive a specified portion of the contractual  interest
or  principle  cash flows.  SFAS 155 also  amends  SFAS 140 to allow  qualifying
special-purpose  entities  to hold a  passive  derivative  financial  instrument
pertaining to beneficial  interests that itself is a derivative  instrument.  We
are currently evaluating the impact this new Standard,  but believe that it will
not have a material  impact on the  Company's  financial  position or results of
operations.

         In March 2006, the FASB issued SFAS No. 156,  "Accounting for Servicing
of Financial  Assets"  ("SFAS No. 156"),  which provides an approach to simplify
efforts to obtain  hedge-like  (offset)  accounting.  This Statement amends FASB
Statement No. 140,  "Accounting for Transfers and Servicing of Financial  Assets
and  Extinguishments  of  Liabilities",  with  respect  to  the  accounting  for
separately recognized servicing assets and servicing liabilities.  The Statement
(1)  requires an entity to recognize a servicing  asset or  servicing  liability
each time it undertakes  an obligation to service a financial  asset by entering
into a servicing contract in certain situations;  (2) requires that a separately
recognized  servicing asset or servicing liability be initially measured at fair
value, if practicable;  (3) permits an entity to choose either the  amortization
method or the fair value  method for  subsequent  measurement  for each class of
separately recognized servicing assets or servicing liabilities;  (4) permits at
initial adoption a one-time reclassification of available-for-sale securities to
trading securities by an entity with recognized  servicing rights,  provided the
securities  reclassified  offset the  entity's  exposure  to changes in the fair
value  of the  servicing  assets  or  liabilities;  and  (5)  requires  separate
presentation of servicing assets and servicing liabilities subsequently measured
at fair value in the balance sheet and additional disclosures for all separately
recognized servicing assets and servicing liabilities. SFAS No. 156 is effective
for  all  separately  recognized  servicing  assets  and  liabilities  as of the
beginning of an entity's  fiscal year that begins after September 15, 2006, with
earlier  adoption  permitted  in  certain  circumstances.   The  Statement  also
describes the manner in which it should be initially  applied.  We are currently
evaluating the impact of this Statement.

         In June 2006, the FASB issued  Interpretation  No. 48,  "Accounting for
Uncertainty  in Income Taxes -- An  Interpretation  of FASB  Statement No. 109",
(FIN 48).  FIN 48  clarifies  the  accounting  for  uncertainty  in income taxes
recognized in an  enterprise's  financial  statements  in  accordance  with FASB
Statement  No. 109,  "Accounting  for Income  Taxes".  FIN 48 also  prescribes a
recognition  threshold and  measurement  attribute  for the financial  statement
recognition and measurement of a tax position taken or expected to be taken in a
tax return that results in a tax benefit. Additionally, FIN 48 provides guidance
on  de-recognition,  income statement  classification of interest and penalties,
accounting in interim periods,  disclosure, and transition.  This interpretation
is effective for fiscal years  beginning after December 15, 2006. The Company is
currently  evaluating the effect that the application of FIN 48 will have on its
results of operations and financial condition

CAUTIONARY STATEMENTS AND RISK FACTORS

         Several   of  the   matters   discussed   in  this   document   contain
forward-looking  statements  that  involve  risks  and  uncertainties.   Factors
associated with the  forward-looking  statements that could cause actual results
to differ from those projected or forecast are included in the statements below.
In  addition to other  information  contained  in this  report,  readers  should
carefully consider the following cautionary statements and risk factors.


                                       27
<PAGE>


         OUR  GROWTH  AND  OPERATING  RESULTS  COULD  BE  MATERIALLY,  ADVERSELY
AFFECTED IF WE ARE UNSUCCESSFUL IN RESOLVING A DISPUTE THAT NOW EXISTS REGARDING
OUR RIGHTS  UNDER OUR  EXCLUSIVE  LICENSE AND  INTELLECTUAL  PROPERTY  AGREEMENT
("AGREEMENT")  WITH PRO-FIT.  Pursuant to our agreement  with Pro-Fit  Holdings,
Limited,  we have  exclusive  rights in certain  geographic  areas to  Pro-Fit's
stretch  and rigid  waistband  technology.  We are in  litigation  with  Pro-Fit
regarding our rights. See Part II, Item 1, "Legal Proceedings" for discussion of
this  litigation.  We derive a  significant  amount of revenues from the sale of
products incorporating the stretch waistband technology.  Our business,  results
of operations and financial condition could be materially  adversely affected if
we are unable to conclude our present  negotiations in a manner acceptable to us
and  ensuing   litigation  is  not  resolved  in  a  manner   favorable  to  us.
Additionally,  we have incurred  significant legal fees in this litigation,  and
unless the case is settled,  we will continue to incur  additional legal fees in
increasing amounts as the case accelerates to trial.

         WHILE WE EXPECT THAT THE RESTRUCTURING WILL RESULT IN REDUCED OPERATING
COSTS AND IMPROVED  OPERATING RESULTS AND CASH FLOWS,  THERE CAN BE NO ASSURANCE
THAT THESE RESULTS WILL BE ACHIEVED. We recorded restructuring costs during 2005
of $6.4 million.  We face many  challenges  related to our decision to implement
this  restructuring  plan,  including that we may not execute the  restructuring
effectively,  and our expectation that we will benefit from greater efficiencies
may not be  realized.  Any  failure  on our part to  successfully  manage  these
challenges  or  other  unanticipated  consequences  may  result  in the  loss of
customers and sales, which could cause our results to differ materially from our
current expectations. The challenges we face include:

         o        Our ability to execute  successfully  through  business cycles
                  while we continue to implement the restructuring plan and cost
                  reductions;

         o        Our  ability  to  meet  and   achieve  the   benefits  of  our
                  cost-reduction goals and otherwise successfully adapt our cost
                  structures to continuing changes in business conditions;

         o        The risk that our  cost-cutting  initiatives  will  impair our
                  ability to develop  products  and  remain  competitive  and to
                  operate effectively;

         o        We may experience  delays in  implementing  our  restructuring
                  plan and incur additional costs;

         o        We may experience decreases in employee morale; and

         o        We  may  experience   unanticipated   expenses   winding  down
                  manufacturing  operations,  including  labor costs,  which may
                  adversely affect our results of operations in the short term.

         WE  MAY  BE  UNABLE  TO  CONTINUE  AS A  GOING  CONCERN  IF WE  DO  NOT
SUCCESSFULLY ACHIEVE CERTAIN OBJECTIVES.  If we are unable to successfully fully
implement  our  restructuring  initiative,  or collect the note  receivable,  or
experience  greater than  anticipated  reductions in sales, we may need to raise
additional  capital or further reduce the scope of our business to fully satisfy
our future  short-term  liquidity  requirements.  If we cannot raise  additional
capital,  or reduce the scope of our  business  in  response  to our  failure to
implement our  restructuring  initiative in accordance with our plan, or fail to
achieve  other  operating  objectives,  the Company may be  otherwise  unable to
achieve its goals or continue  its  operations.  Our auditors  have  included in
their report on our financial  statements for the year ending  December 31, 2005
an  explanatory  paragraph  expressing  substantial  doubt  about our ability to
continue as a going concern.

         IF WE LOSE OUR LARGER CUSTOMERS OR THEY FAIL TO PURCHASE AT ANTICIPATED
LEVELS, OUR SALES AND OPERATING RESULTS WILL BE ADVERSELY AFFECTED.  Our results
of operations will depend to a significant extent upon the commercial success of
our larger  customers.  If these  customers  fail to  purchase  our  products at
anticipated levels, or our relationship with these customers terminates,  it may
have an adverse affect on our results because:


                                       28
<PAGE>


         o        We will lose a primary  source of revenue  if these  customers
                  choose not to purchase our products or services;

         o        We  may  not  be  able  to  reduce  fixed  costs  incurred  in
                  developing the  relationship  with these customers in a timely
                  manner;

         o        We may not be able to recoup setup and inventory costs;

         o        We may be left holding  inventory that cannot be sold to other
                  customers; and

         o        We may not be able to collect our receivables from them.

         CONCENTRATION OF RECEIVABLES FROM OUR LARGER CUSTOMERS MAKES RECEIVABLE
BASED  FINANCING  DIFFICULT AND INCREASES THE RISK THAT IF OUR LARGER  CUSTOMERS
FAIL TO PAY US, OUR CASH FLOW COULD BE SEVERELY  AFFECTED.  Our business  relies
heavily on a relatively  small number of customers.  This  concentration  of our
business  reduces the amount we can borrow from our  lenders  under  receivables
based financing  agreements.  If we are unable to collect any large  receivables
due us, our cash flow would be severely impacted.

         IF CUSTOMERS DEFAULT ON INVENTORY PURCHASE COMMITMENTS WITH US, WE WILL
BE LEFT HOLDING  NON-SALABLE  INVENTORY.  We hold  significant  inventories  for
specific customer programs,  which the customers have committed to purchase.  If
any customer  defaults on these  commitments,  or insists on  markdowns,  we may
incur a charge in connection with our holding significant amounts of non-salable
inventory and this would have a negative impact on our operations and cash flow.

         OUR REVENUES MAY BE HARMED IF GENERAL ECONOMIC  CONDITIONS  WORSEN. OUR
REVENUES DEPEND ON THE HEALTH OF THE ECONOMY AND THE GROWTH OF OUR CUSTOMERS AND
POTENTIAL FUTURE CUSTOMERS.  When economic  conditions  weaken,  certain apparel
manufacturers  and  retailers,  including  some of our customers may  experience
financial  difficulties  that  increase  the risk of  extending  credit  to such
customers.  Customers  adversely  affected  by  economic  conditions  have  also
attempted to improve their own operating  efficiencies  by  concentrating  their
purchasing  power among a narrowing group of vendors.  There can be no assurance
that we will remain a preferred vendor to our existing customers.  A decrease in
business from or loss of a major customer  could have a material  adverse effect
on our results of operations.  Further, if the economic conditions in the United
States  worsen  or if a  wider  or  global  economic  slowdown  occurs,  we  may
experience a material  adverse impact on our business,  operating  results,  and
financial condition.

         BECAUSE WE DEPEND ON A LIMITED NUMBER OF SUPPLIERS,  WE MAY NOT BE ABLE
TO  ALWAYS  OBTAIN  MATERIALS  WHEN WE  NEED  THEM  AND WE MAY  LOSE  SALES  AND
CUSTOMERS.  Lead times for materials we order can vary  significantly and depend
on many factors,  including the specific  supplier,  the contract  terms and the
demand for  particular  materials  at a given  time.  From time to time,  we may
experience  fluctuations  in the  prices,  and  disruptions  in the  supply,  of
materials. Shortages or disruptions in the supply of materials, or our inability
to procure  materials  from alternate  sources at acceptable  prices in a timely
manner, could lead us to miss deadlines for orders and lose sales and customers.

         WE OPERATE IN AN INDUSTRY THAT IS SUBJECT TO  SIGNIFICANT  FLUCTUATIONS
IN OPERATING  RESULTS THAT MAY RESULT IN  UNEXPECTED  REDUCTIONS  IN REVENUE AND
STOCK PRICE VOLATILITY. We operate in an industry that is subject to significant
fluctuations  in operating  results  from quarter to quarter,  which may lead to
unexpected  reductions in revenues and stock price volatility.  Factors that may
influence our quarterly operating results include:

         o        The volume and timing of customer  orders  received during the
                  quarter;

         o        The timing and magnitude of customers' marketing campaigns;


                                       29
<PAGE>


         o        The loss or addition of a major customer;

         o        The availability and pricing of materials for our products;

         o        The  increased   expenses  incurred  in  connection  with  the
                  introduction of new products;

         o        Currency fluctuations;

         o        Delays caused by third parties; and

         o        Changes in our product mix or in the relative  contribution to
                  sales of our subsidiaries.

         Due to  these  factors,  it is  possible  that  in  some  quarters  our
operating  results  may be below  our  stockholders'  expectations  and those of
public market analysts.  If this occurs,  the price of our common stock could be
adversely affected.  In the past,  following periods of volatility in the market
price of a company's  securities,  securities class action  litigation has often
been  instituted  against such a company.  In October  2005, a securities  class
action  lawsuit  was  filed  against  us.  See  footnote  4,  Contingencies  and
Guarantees for a detailed description of this lawsuit.

         THE OUTCOME OF LITIGATION  IN WHICH WE HAVE BEEN NAMED,  AS A DEFENDANT
IS  UNPREDICTABLE  AND AN  ADVERSE  DECISION  IN ANY SUCH  MATTER  COULD  HAVE A
MATERIAL ADVERSE AFFECT ON OUR FINANCIAL POSITION AND RESULTS OF OPERATIONS.  We
are  defendants  in a number of  litigation  matters.  These  claims  may divert
financial and management  resources that would  otherwise be used to benefit our
operations.  Although we believe that we have meritorious defenses to the claims
made in each and all of the  litigation  matters  to which we have been  named a
party, and intend to contest each lawsuit vigorously, no assurances can be given
that the results of these matters will be favorable to us. An adverse resolution
of any of these lawsuits  could have a material  adverse affect on our financial
position and results of operations.

         We maintain product  liability and director and officer  insurance that
we regard as reasonably adequate to protect us from potential claims; however we
cannot  assure you that it will be adequate to cover any  losses.  Further,  the
costs  of  insurance  have  increased  dramatically  in  recent  years,  and the
availability of coverage has decreased.  As a result,  we cannot assure you that
we will be able to maintain  our current  levels of  insurance  at a  reasonable
cost, or at all.

         OUR CUSTOMERS HAVE CYCLICAL  BUYING PATTERNS WHICH MAY CAUSE US TO HAVE
PERIODS OF LOW SALES VOLUME.  Most of our customers are in the apparel industry.
The apparel  industry  historically  has been  subject to  substantial  cyclical
variations. Our business has experienced, and we expect our business to continue
to  experience,  significant  cyclical  fluctuations  due, in part,  to customer
buying  patterns,  which may result in periods of low sales usually in the first
and fourth quarters of our financial year.

         OUR BUSINESS MODEL IS DEPENDENT ON  INTEGRATION OF INFORMATION  SYSTEMS
ON A GLOBAL  BASIS AND, TO THE EXTENT  THAT WE FAIL TO MAINTAIN  AND SUPPORT OUR
INFORMATION  SYSTEMS,  IT CAN RESULT IN LOST REVENUES.  We must  consolidate and
centralize  the  management of our  subsidiaries  and  significantly  expand and
improve our financial and operating controls.  Additionally, we must effectively
integrate the information systems of our Hong Kong facility with the information
systems of our  principal  offices  in  California.  Our  failure to do so could
result  in  lost  revenues,   delay  financial  reporting  or  adversely  affect
availability of funds under our credit facilities.

         THE LOSS OF KEY MANAGEMENT AND SALES PERSONNEL  COULD ADVERSELY  AFFECT
OUR BUSINESS,  INCLUDING OUR ABILITY TO OBTAIN AND SECURE  ACCOUNTS AND GENERATE
SALES. Our success has and will continue to depend to a significant  extent upon
key management and sales personnel,  many of whom would be difficult to replace.
In connection with our  restructuring,  we  significantly  reduced the number of
employees  within  our  company,  which  has  increased  our  reliance  on those
employees  that have remained with the company.  The loss of the services of key
employees  could have a material  adverse effect on our business,  including our
ability to establish and maintain client relationships.  Our future success will
depend in large part upon our  ability to attract  and retain  personnel  with a
variety of sales, operating and managerial skills.


                                       30
<PAGE>


         IF WE EXPERIENCE DISRUPTIONS AT ANY OF OUR FOREIGN FACILITIES,  WE WILL
NOT BE ABLE TO MEET OUR OBLIGATIONS AND MAY LOSE SALES AND CUSTOMERS. Currently,
we do not operate duplicate facilities in different geographic areas. Therefore,
in the  event of a  regional  disruption  where we  maintain  one or more of our
facilities,  it is unlikely  that we could shift our  operations  to a different
geographic  region and we may have to cease or curtail our operations.  This may
cause us to lose sales and customers.  The types of  disruptions  that may occur
include:

         o        Foreign trade disruptions;

         o        Import restrictions;

         o        Labor disruptions;

         o        Embargoes;

         o        Government intervention;

         o        Natural disasters; or

         o        Regional pandemics.

         INTERNET-BASED   SYSTEMS  THAT  HOST  OUR  MANAGED  TRIM  SOLUTION  MAY
EXPERIENCE  DISRUPTIONS AND AS A RESULT WE MAY LOSE REVENUES AND CUSTOMERS.  Our
Managed  Trim  Solution  is an  Internet-based  business-to-business  e-commerce
system. To the extent that we fail to adequately continue to update and maintain
the hardware and software  implementing the system, our customers may experience
interruptions  in service due to defects in our hardware or our source code.  In
addition,  since our  software  is  Internet-based,  interruptions  in  Internet
service  generally  can  negatively  impact  our  customers'  ability to use the
Managed Trim Solution to monitor and manage various aspects of their trim needs.
Such defects or interruptions could result in lost revenues and lost customers.

         THERE ARE MANY  COMPANIES  THAT OFFER SOME OR ALL OF THE  PRODUCTS  AND
SERVICES WE SELL AND IF WE ARE UNABLE TO SUCCESSFULLY  COMPETE OUR BUSINESS WILL
BE  ADVERSELY  AFFECTED.   We  compete  in  highly  competitive  and  fragmented
industries  with numerous local and regional  companies that provide some or all
of  the  products  and  services  we  offer.   We  compete  with   national  and
international   design  companies,   distributors  and  manufacturers  of  tags,
packaging  products,  zippers and other trim items. Some of our competitors have
greater name recognition,  longer operating  histories and greater financial and
other resources than we do.

         UNAUTHORIZED  USE  OF  OUR  PROPRIETARY  TECHNOLOGY  MAY  INCREASE  OUR
LITIGATION  COSTS AND ADVERSELY  AFFECT OUR SALES.  We rely on trademark,  trade
secret and copyright laws to protect our designs and other proprietary  property
worldwide.  We cannot be certain that these laws will be  sufficient  to protect
our property.  In  particular,  the laws of some countries in which our products
are distributed or may be distributed in the future may not protect our products
and intellectual  rights to the same extent as the laws of the United States. If
litigation  is  necessary  in the future to enforce  our  intellectual  property
rights,  to protect our trade  secrets or to determine the validity and scope of
the proprietary  rights of others,  such litigation  could result in substantial
costs and diversion of resources.  This could have a material  adverse effect on
our operating results and financial condition. Ultimately, we may be unable, for
financial or other reasons,  to enforce our rights under  intellectual  property
laws, which could result in lost sales.

         IF OUR PRODUCTS INFRINGE ANY OTHER PERSON'S  PROPRIETARY RIGHTS, WE MAY
BE SUED AND HAVE TO PAY LEGAL EXPENSES AND JUDGMENTS AND REDESIGN OR DISCONTINUE
SELLING OUR PRODUCTS.  From time to time in our industry,  third parties  allege
infringement of their proprietary  rights. Any infringement  claims,  whether or
not meritorious,  could result in costly  litigation or require us to enter into
royalty or licensing


                                       31
<PAGE>


agreements  as a means of  settlement.  If we are  found to have  infringed  the
proprietary  rights of others, we could be required to pay damages,  cease sales
of the infringing  products and redesign the products or discontinue their sale.
Any of these  outcomes,  individually  or  collectively,  could  have a material
adverse effect on our operating results and financial condition.

         OUR STOCK PRICE MAY DECREASE, WHICH COULD ADVERSELY AFFECT OUR BUSINESS
AND CAUSE OUR STOCKHOLDERS TO SUFFER  SIGNIFICANT  LOSSES. The following factors
could  cause  the  market  price  of  our  common  stock  to  decrease,  perhaps
substantially:

         o        The  failure  of  our  quarterly  operating  results  to  meet
                  expectations of investors or securities analysts;

         o        Adverse  developments  in the financial  markets,  the apparel
                  industry and the worldwide or regional economies;

         o        Interest rates;

         o        Changes in accounting principles;

         o        Intellectual property and legal matters;

         o        Sales of common stock by existing  shareholders  or holders of
                  options;

         o        Announcements of key developments by our competitors; and

         o        The   reaction   of  markets   and   securities   analysts  to
                  announcements and developments involving our company.

         IF WE NEED TO SELL OR ISSUE ADDITIONAL SHARES OF COMMON STOCK OR ASSUME
ADDITIONAL DEBT TO FINANCE FUTURE GROWTH,  OUR STOCKHOLDERS'  OWNERSHIP COULD BE
DILUTED OR OUR EARNINGS COULD BE ADVERSELY  IMPACTED.  Our business strategy may
include expansion through internal growth, by acquiring complementary businesses
or  by  establishing   strategic   relationships  with  targeted  customers  and
suppliers.  In order  to do so or to fund our  other  activities,  we may  issue
additional equity  securities that could dilute our stockholders'  value. We may
also assume additional debt and incur impairment losses to our intangible assets
if we acquire another company.

         IF WE ARE NOT ABLE TO REGAIN COMPLIANCE WITH LISTING REQUIREMENTS,  OUR
SHARES MAY BE REMOVED FROM LISTING ON AMEX.  In May 2006 we were advised by AMEX
that we were non-compliant with the minimum net equity listing  requirements and
we were  afforded  an  opportunity  to submit a plan to AMEX that  provides  for
increases  in our equity  beyond  the  minimum  $4.0  million  equity  within an
eighteen-month  timeframe  from the date of the notice  from AMEX.  On August 3,
2006 AMEX accepted our plan to regain  compliance  and has given us an extension
until  November 16, 2007 to become  compliant  with the AMEX  continued  listing
standards. During this period, we will be subject to periodic review by the AMEX
staff  and  failure  to make  progress  consistent  with the  plan or to  regain
compliance with continued  listing  standards by the end of the extension period
could result in being delisted from the American Stock Exchange.  In addition we
have  suffered  substantial  recurring  losses and may fail to comply with other
listing requirements of AMEX. We may not be able to regain compliance with these
matters within the time allowed by the exchange,  and our shares of common stock
may be removed from the listing on AMEX.

         WE MAY NOT BE ABLE TO REALIZE THE ANTICIPATED BENEFITS OF ACQUISITIONS.
We may consider strategic  acquisitions as opportunities  arise,  subject to the
obtaining of any  necessary  financing.  Acquisitions  involve  numerous  risks,
including  diversion  of our  management's  attention  away  from our  operating
activities.  We  cannot  assure  you  that we will not  encounter  unanticipated
problems or liabilities  relating to the  integration  of an acquired  company's
operations,  nor can we assure you that we will realize the anticipated benefits
of any future acquisitions.


                                       32
<PAGE>


         OUR ACTUAL TAX  LIABILITIES  MAY DIFFER FROM ESTIMATED TAX RESULTING IN
UNFAVORABLE ADJUSTMENTS TO OUR FUTURE RESULTS. The amount of income taxes we pay
is subject to ongoing audits by federal, state and foreign tax authorities.  Our
estimate  of the  potential  outcome of  uncertain  tax issues is subject to our
assessment of relevant risks,  facts, and  circumstances  existing at that time.
Our future  results may include  favorable  or  unfavorable  adjustments  to our
estimated tax  liabilities in the period the  assessments  are made or resolved,
which may impact our effective tax rate and our  financial  results.  See Item 3
"Legal Proceedings" for discussion of certain tax claims.

         WE HAVE ADOPTED A NUMBER OF ANTI-TAKEOVER MEASURES THAT MAY DEPRESS THE
PRICE OF OUR COMMON STOCK. Our  stockholders'  rights plan, our ability to issue
additional  shares of preferred  stock and some provisions of our certificate of
incorporation  and bylaws and of Delaware law could make it more difficult for a
third party to make an unsolicited  takeover attempt of us. These  anti-takeover
measures may depress the price of our common  stock by making it more  difficult
for third parties to acquire us by offering to purchase shares of our stock at a
premium to its market price.

         INSIDERS OWN A  SIGNIFICANT  PORTION OF OUR COMMON  STOCK,  WHICH COULD
LIMIT OUR STOCKHOLDERS' ABILITY TO INFLUENCE THE OUTCOME OF KEY TRANSACTIONS. As
of June 30, 2006, our officers and directors and their  affiliates  beneficially
owned  approximately 18% of the outstanding shares of our common stock. The Dyne
family,  which includes Mark Dyne,  Colin Dyne, and Jonathan  Burstein,  who are
also our directors; Larry Dyne and the estate of Harold Dyne; beneficially owned
approximately  13% of the  outstanding  shares of our  common  stock at June 30,
2006.  As a result,  our officers and  directors and the Dyne family are able to
exert considerable influence over the outcome of any matters submitted to a vote
of the  holders of our common  stock,  including  the  election  of our Board of
Directors.  The voting power of these  stockholders could also discourage others
from seeking to acquire  control of us through the purchase of our common stock,
which might depress the price of our common stock.

         WE MAY FACE  INTERRUPTION  OF PRODUCTION  AND SERVICES DUE TO INCREASED
SECURITY  MEASURES IN RESPONSE TO  TERRORISM.  Our business  depends on the free
flow of products and services  through the channels of commerce.  In response to
terrorists'  activities and threats aimed at the United States,  transportation,
mail,  financial  and  other  services  may be  slowed  or  stopped  altogether.
Extensive  delays or  stoppages  in  transportation,  mail,  financial  or other
services  could  have a  material  adverse  effect on our  business,  results of
operations and financial condition.  Furthermore,  we may experience an increase
in operating costs, such as costs for transportation,  insurance and security as
a result of the activities and potential  delays.  We may also experience delays
in  receiving  payments  from  payers that have been  affected by the  terrorist
activities.  The United States  economy in general may be adversely  affected by
the terrorist  activities and any economic  downturn could adversely  impact our
results  of  operations,  impair  our  ability  to raise  capital  or  otherwise
adversely affect our ability to grow our business.


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<PAGE>


ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

         All of our  sales  are  denominated  in United  States  dollars  or the
currency  of the  country in which our  products  originate.  We are  exposed to
market risk for fluctuations in the foreign currency  exchange rates for certain
product purchases that are denominated in British Pounds.  There were no hedging
contracts  outstanding as of June 30, 2006.  Currency  fluctuations can increase
the price of our products to foreign  customers  which can adversely  impact the
level  of our  export  sales  from  time  to  time.  The  majority  of our  cash
equivalents  are held in United  States bank  accounts  and we do not believe we
have significant market risk exposure with regard to our investments.

ITEM 4.  CONTROLS AND PROCEDURES

EVALUATION OF CONTROLS AND PROCEDURES

         We  conducted  an  evaluation,  with  the  participation  of our  Chief
Executive  Officer and Chief  Financial  Officer,  of the  effectiveness  of the
design and operation of our disclosure  controls and  procedures,  as defined in
Rules  13a-15(e) and  15d-15(e)  under the  Securities  Exchange Act of 1934, as
amended,  or the Exchange Act, as of June 30, 2006,  to ensure that  information
required to be disclosed by us in the reports filed or submitted by us under the
Exchange Act is recorded,  processed,  summarized and reported,  within the time
periods  specified  in the  Securities  Exchange  Commission's  rules and forms,
including  to ensure  that  information  required to be  disclosed  by us in the
reports  filed or  submitted by us under the  Exchange  Act is  accumulated  and
communicated to our management,  including our principal executive and principal
financial officers,  or persons performing similar functions,  as appropriate to
allow timely decisions regarding required disclosure.  Based on that evaluation,
our Chief Executive  Officer and Chief Financial  Officer have concluded that as
of June 30, 2006, our internal  controls and  procedures,  and as a consequence,
our  disclosure  controls and  procedures  were not effective at the  reasonable
assurance level.

         The  ineffectiveness  of our disclosure  controls and procedures arises
principally  from the material  weaknesses  in internal  control  identified  in
conjunction  with the  preparation  of our  Annual  Report  on Form 10-K for the
fiscal year ended December 31, 2005.  Additional  internal control processes and
controls  have been  implemented  since  the  identification  of these  material
weaknesses;  however,  given  that some of the  weaknesses  are with  respect to
processes  that are conducted  annually or  periodically,  it is not possible to
adequately  test  these  controls  on an  interim  basis to ensure  that the new
controls are effective.  Accordingly we have not relied on these  controls,  but
have performed  additional analysis and other post-closing  procedures to ensure
that our  consolidated  financial  statements  were prepared in accordance  with
generally  accepted  accounting  principles.  Accordingly,  we believe  that the
consolidated financial statements included in this report fairly present, in all
material respects, our financial condition, results of operations and cash flows
for the periods presented.

         A brief  summary  of the  material  weaknesses  identified  during  the
preparation of our Annual Report on Form 10-K for the fiscal year ended December
31, 2005 is described  below. The additional  analysis and remediation  steps we
have  implemented in our disclosure  controls and procedures also are summarized
below.

MATERIAL WEAKNESSES

         A material weakness is a control  deficiency (within the meaning of the
Public Company  Accounting  Oversight Board (PCAOB) Auditing  Standard No. 2) or
combination of control deficiencies that result in more than a remote likelihood
that a material  misstatement of the annual or interim financial statements will
not be prevented or detected.  Management  previously  identified  the following
deficiencies  that  represented  material  weaknesses  in internal  control over
financial reporting which have caused management to conclude that our disclosure
controls and procedures were not effective at the reasonable assurance level:


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<PAGE>


         In  conjunction  with  preparing our Annual Report on Form 10-K for the
fiscal year ended December 31, 2005, management reviewed our revenue recognition
practices  as they relate to the  recognition  of  revenues on certain  sale and
inventory storage transactions. As a result of this review, management concluded
that our controls over the  identification  and  monitoring of  assumptions  and
factors affecting the recording of revenue were not in accordance with generally
accepted accounting  principles and that our revenue for the quarters ended June
30, 2005 and September 30, 2005 had been misstated.  Based upon this conclusion,
management  with  concurrence  of our Audit  Committee,  restated our  financial
statements  as of and for those  quarters  to  reflect  the  corrections  in the
application  of our  revenue  recognition  policies.  We  believe  this  control
weakness has been corrected and did not result in a material misstatement of our
consolidated financial statements for this interim period.

         In fiscal  year 2005 we  previously  reported  the  failure to maintain
sufficient  documentation  supporting  inventory  costs necessary to effectively
analyze our  inventory for  lower-of-cost  or market  reserves.  We believe this
control   weakness  has  been  corrected  and  did  not  result  in  a  material
misstatement of our consolidated financial statements.

         In fiscal  year 2005 we failed  to  maintain  sufficient  documentation
supporting our perpetual inventory counts and our year end physical  inventories
were not effectively  controlled,  requiring a recount of our inventory balances
at year end. We believe we have  implemented  appropriate  procedures  to ensure
this weakness is remedied;  however as of June 30, 2006 we have not tested these
procedures. This control deficiency did not result in a material misstatement of
our consolidated financial statements.

         To address these material  weaknesses,  management performed additional
analyses and other procedures to ensure that the financial  statements  included
herein fairly present, in all material respects, our financial position, results
of operations and cash flows for the periods presented.

REMEDIATION OF MATERIAL WEAKNESSES

         To remediate  the material  weaknesses in our  disclosure  controls and
procedures  identified above, we have done the following which correspond to the
material weaknesses identified above:

         We have  revised  our review  procedures  over the  application  of our
revenue recognition practices,  particularly as they relate to inventory storage
transactions. We have instituted additional control and disclosure procedures to
effectively  and timely  identify  such  transactions  including a review of all
major sale transactions by our disclosure committee.

         We have implemented  additional  documentation  control procedures over
the assumptions and factors affecting our inventory costs and reserves to ensure
that  inventory  balances are  appropriately  supported and reduced to their net
realizable values on a timely basis.  These controls include the segregation and
review of selected inventory adjustment  transactions and management analysis of
inventory cost and reserve changes during the reporting period.

         We  have  modified  our  physical   inventory  process  procedures  and
instructions to ensure that the  appropriate  documentation  regarding  physical
inventories  is maintained  and  controlled,  and that the physical  counting of
inventories is performed at regular intervals.



                                       35
<PAGE>


CHANGES IN INTERNAL CONTROLS OVER FINANCIAL REPORTING

         There  were  no  significant  changes  in our  internal  controls  over
financial reporting that occurred during the six months ended June 30, 2006 that
have materially  affected,  or are reasonably likely to materially  affect,  our
internal control over financial reporting, other than the changes we implemented
as discussed above to address the material weaknesses.


                                       36
<PAGE>


                                     PART II
                                OTHER INFORMATION

ITEM 1.  LEGAL PROCEEDINGS

         On October 12, 2005, a shareholder class action complaint-- Huberman vs
Tag-It Pacific,  Inc., et al., Case No.  CV05-7352  R(Ex)--was filed against the
Company  and certain of our current and former  officers  and  directors  in the
United States  District  Court for the Central  District of California  alleging
claims  under  Section  10(b) and Section 20 of the  Securities  Exchange Act of
1934, as amended, and Rule 10b-5 promulgated  thereunder.  The action is brought
on behalf of all purchasers of the Company's  publicly-traded  securities during
the period from  November 14, 2003 to August 12,  2005.  On January 23, 2006 the
court heard  competing  motions for  appointment of lead  plaintiff/counsel  and
appointed Seth Huberman as lead plaintiff.  The lead plaintiff  thereafter filed
an amended  complaint on March 13, 2006. The amended  complaint alleges that the
defendants made false and misleading  statements  about our financial  situation
and our  relationship  with  certain of its large  customers  during a purported
class period between November 13, 2003 and August 12, 2005. It purports to state
claims  under  Section  10(b)/Rule  10b-5 and  Section  20(a) of the  Securities
Exchange Act of 1934. We filed a motion to dismiss the amended complaint,  which
motion was denied by the Court on July 17, 2006. Although we believe that we and
the other defendants have meritorious defenses to the class action complaint and
intend to contest the lawsuit  vigorously,  an adverse resolution of the lawsuit
could have a material  adverse  affect on our financial  position and results of
operations. At this early stage of the litigation, we are not able to reasonably
predict the outcome of this action or estimate potential losses, if any, related
to the lawsuit.

         On April 16,  2004,  we filed suit  against  Pro-Fit  Holdings  Limited
("Pro-Fit") in the U.S.  District Court for the Central District of California -
Tag-It  Pacific,  Inc.  v.  Pro-Fit  Holdings  Limited,  CV 04-2694  LGB (RCx) -
asserting various  contractual and tort claims relating to our exclusive license
and intellectual  property agreement with Pro-Fit,  seeking  declaratory relief,
injunctive  relief and  damages.  It is our  position  that the  agreement  with
Pro-Fit gives us the exclusive  rights in certain  geographic areas to Pro-Fit's
stretch and rigid waistband technology.  On September 17, 2004, Pro-Fit filed an
answer denying the material allegations of the complaint and filed counterclaims
alleging  various  contractual  and tort claims  seeking  injunctive  relief and
damages.  We  filed  a reply  denying  the  material  allegations  of  Pro-Fit's
pleading.  Pro-Fit has since  purported to terminate the  exclusive  license and
intellectual  property  agreement  based on the  same  alleged  breaches  of the
agreement that are the subject of the parties' existing  litigation,  as well as
on an  additional  basis.  On February 9, 2005,  and again on June 16, 2005,  we
amended our pleadings in the litigation to assert additional breaches by Pro-Fit
of its  obligations  under the  agreement and under  certain  additional  letter
agreements,  and for a declaratory  judgment that Pro-Fit's patent No. 5,987,721
is invalid and not infringed by us. Thereafter,  Pro-Fit filed an amended answer
and counterclaims  denying the material allegations of the amended complaint and
alleging  various  contractual  and tort claims  seeking  injunctive  relief and
damages.  Pro-Fit  further  asserted  that we infringed its United States Patent
Nos.  5,987,721  and  6,566,285.  We  filed  a  reply  denying  the  substantive
allegations of the amended  counterclaims.  At our request, the Court bifurcated
the breach of contract issues for trial. The parties have filed summary judgment
motions which may dispose of some of the issues in this case prior to trial.  On
June 5, 2006 the Court denied one of our motions for summary  judgment,  holding
that  the  issue of  whether  U.S.  Patent  No.  6,566,285  relating  to  curved
waistbands,  was licensed to us presented a disputed  question of material  fact
which could not be resolved  without a trial. No trial date is currently set for
trial of any issues. As we derive a significant  amount of revenue from the sale
of  products  incorporating  the stretch  waistband  technology,  our  business,
results of operations  and  financial  condition  could be materially  adversely
affected if the dispute with  Pro-Fit is not  resolved in a manner  favorable to
us.  Additionally,  we have incurred  significant legal fees in this litigation,
and unless the case is settled will continue to incur  additional  legal fees in
increasing amounts as the case accelerates to trial.


                                       37
<PAGE>


         We  currently  have  pending  a  number  of  other  claims,  suits  and
complaints that arise in the ordinary course of its business. We believe that we
have meritorious defenses to these claims and that the claims are either covered
by insurance  or, after  taking into account the  insurance in place,  would not
have a material  affect on our  consolidated  financial  condition  if adversely
determined against us.

ITEM 1A. RISK FACTORS

         A restated  description of the risk factors associated with the Company
is included  under  "Cautionary  Statements  and Risk  Factors" in  Management's
Discussion  and  Analysis of  Financial  Condition  and Results of  Operations,"
contained  in Item 2 of Part I of this  report.  This  description  includes any
material  changes  to  and  supersedes  the  description  of  the  risk  factors
associated  with the Company  previously  disclosed in the Company's 2005 Annual
Report on Form 10-K and is incorporated herein by reference.

ITEM 6.  EXHIBITS

         3.1      Certificate of  Incorporation  of Registrant.  Incorporated by
                  reference  to Exhibit  3.1 to Form SB-2  filed on October  21,
                  1997, and the amendments thereto.

         3.1.1    Certificate  of  Designation   of  Rights,   Preferences   and
                  Privileges  of  Series  A  Preferred  Stock.  Incorporated  by
                  reference  to  Exhibit  A to the  Rights  Agreement  filed  as
                  Exhibit 4.1 to Current Report on Form 8-K filed on November 4,
                  1998.

         3.1.2    Certificate of Amendment of Certificate  of  Incorporation  of
                  Registrant. Incorporated by reference to Exhibit 3.4 to Annual
                  Report on Form 10-KSB, filed on March 28, 2000.

         3.1.3    Certificate of Amendment of Certificate  of  Incorporation  of
                  Registrant.  Incorporated  by  reference  to Exhibit  3.1.3 to
                  Current Report on Form 8-K filed on August 4, 2006.

         31.1     Certificate  of  Chief  Executive  Officer  pursuant  to  Rule
                  13a-14(a)  under the  Securities  and Exchange Act of 1934, as
                  amended

         31.2     Certificate  of  Chief  Financial  Officer  pursuant  to  Rule
                  13a-14(a)  under the  Securities  and Exchange Act of 1934, as
                  amended

         32.1     Certificate  of Chief  Executive  Officer and Chief  Financial
                  Officer  pursuant to Rule  13a-14(b)  under the Securities and
                  Exchange Act of 1934, as amended.


                                       38
<PAGE>


                                   SIGNATURES

         Pursuant to the  requirements  of the Securities  Exchange Act of 1934,
the  registrant  has duly  caused  this report to be signed on its behalf by the
undersigned thereunto duly authorized.





Dated:   August 14, 2006          TAG-IT PACIFIC, INC.

                                  /S/  LONNIE D. SCHNELL
                                  ----------------------------------------------
                                  By:  Lonnie D. Schnell
                                  Its: Chief Financial Officer


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