NITCHES INC - Quarter Report: 2004 November (Form 10-Q)

Inventory

          The Company’s inventory increased 32.4% to $4.5 million at November 30, 2004, from $3.4 million at August 31, 2004.  Compared to inventories of $4.9 million at November 30, 2003, inventories ending the current period decreased 8%, primarily because the Company is holding less inventory for near-term order fulfillment due to a shift in sales mix and related shorter lead times required by key suppliers.  The Company believes that its current inventory mix and unit levels are appropriate to respond to anticipated market demand.

          In its ordinary course of operations, the Company generally makes some sales below its normal selling prices or below cost.  Based on prior experience, management believes this will be true for some inventory held on or acquired after November 30, 2004.  The amount of such sales depends on several factors, including general economic conditions, market conditions within the apparel industry, the desirability of the styles held in inventory and competitive pressures from other garment suppliers.

          The Company has established an inventory markdown reserve as of November 30, 2004, which management believes will be sufficient for current inventory that is expected to sell below cost in the future.  There can be no assurance that the Company will realize its expected selling prices, or that the inventory markdown reserve will be adequate, for items in inventory as of November 30, 2004 for which customer sales orders have not yet been received.  The inventory markdown reserve is calculated based on specific identification of aged goods and styles that are slow-moving or selling off-price.

Backlog

          As of November 30, 2004, the Company had on-hand unfilled customer orders of $13.0 million as compared to $15.3 million at November 30, 2003, with such orders generally scheduled for delivery by May 2005 and 2004, respectively.  The decrease in backlog is due primarily to the inability of the Company to secure a renewal of $7.9 million in men’s wear orders from Sam’s Club, offset partially by increased orders from other men’s wear and sleepwear customers.

          Backlog amounts include both confirmed and unconfirmed orders that the Company believes, based on industry practice and past experience, will be confirmed.  While cancellations, rejections and returns have generally not been material in the past, there can be no assurance that cancellations, rejections and returns will not reduce the amount of sales realized from the backlog of orders at November 30, 2004.  Because of the Company’s reliance upon a few major accounts, any deteriorating financial performance by one or more of these customers could lead to the cancellation of existing orders and/or an inability to secure future orders, which would have a material adverse financial effect on the Company.

Impact of Exchange Rates

          While the Company purchases over 85% of its products from foreign manufacturers, all of its purchases are denominated in United States dollars.  Because the Company’s products are sold primarily in the United States, in dollar denominated transactions, the Company does not engage in hedging or other arbitrage to reduce currency risk.  An increase in the value of the dollar versus foreign currencies could enhance the Company’s purchasing power for new purchase orders and reduce its cost of goods sold.  Conversely, a decrease in the value of the dollar relative to foreign currencies could result in an increase in the Company’s cost of manufacturing for new purchase orders and costs of goods sold.

Impact of Inflation and Deflation

          Management does not believe that inflation has had any material impact upon the Company’s revenues or income from operations to date.  Management believes that the apparel sector in which the Company operates has been in a period of deflation, contrary to the modest inflation experienced in the economy in general.  The persistence of the consumer to buy “on sale” merchandise has put pressure on retail gross margins, which in turn has led to downward pressure from retailers on wholesale gross margins, in the form of selling cost adjustments taken as deductions against invoices issued by the Company.  In the apparel industry, these are commonly referred to as markdown allowances or chargebacks.  Without a corresponding decrease in fabric and labor prices, these markdown allowances have led to a decline in wholesale gross margins.  Management believes these modest deflationary pressures will persist into the foreseeable future.

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Future Operating Results

          Business conditions in the apparel sector continue to be characterized by limited consumer demand and persistent discounting of merchandise by retailers.  The continuing conflict in Iraq, coupled with the propensity of consumers to seek “on sale” merchandise has sustained the use of significant discounting by most retailers to stimulate sales.  In general, retailers have to sell more units in order to achieve sales equal to last year.  The Company does not expect significant improvement in business conditions in the apparel sector for the upcoming fiscal year.  Furthermore, the Company expects to incur significant expense related to internal controls documentation, testing and remediation requirements as mandated by Sarbanes-Oxley legislation with which the Company must be in compliance by August 31, 2005.  In view of the market uncertainties and economic pressures facing the Company, management remains conservative in its approach to the upcoming fiscal year.

Item 4.  Controls and Procedures

          In October 2004, our management concluded that that there were certain material weaknesses in our internal controls and procedures.  The material weaknesses noted related to segregation of duties in the payroll process and in the monthly closing process; inadequate review and approval of management-level adjustments and entries.  We have discussed these material weaknesses with our auditors, Moss Adams, LLP, who have recommended taking steps to alleviate the inadequate segregation of duties within these areas. 

          The Company and our Audit Committee are committed to remediation of the material weaknesses.  We plan to implement appropriate mitigating factors in order to reduce the likelihood of material misstatements or improper disclosure. 

          During the period beginning in October 2004, we began to implement steps to address our internal controls and procedures.  The following remediation actions have been completed:

	•	We began requiring the Accounting Manager to review, approve and maintain back-up for all accounting entries.  We began requiring the President to then document his review of the adequacy and completeness of the closing process.
	•	The Audit Committee began reviewing and approving all officer expense reimbursements.

          We are in the process of developing and implementing the following remediation steps.  We expect to be able to fully implement these actions by the end of the second quarter 2005.

	•	We are in a search for a Controller.
	•	We are evaluating the effectiveness of our current control structure.
	•	We will place the payroll duties with the Controller, when hired.
	•	We will remove the payroll clerk, who is a related party, from the authorized check signer list.

          Within 90 days prior to the date of this report, the Chief Executive and Financial Officer evaluated the effectiveness of the design and operation of the Company’s disclosure controls and procedures pursuant to Exchange Act Rule 13a-14.  Based upon that evaluation, he concluded that the disclosure controls and procedures of the Company are effective in timely alerting of the material information required to be included in the periodic filings with the Securities and Exchange Commission and that the information required to be disclosed in these filings is recorded, processed, summarized, and reported within the time periods specified in the rules and forms of the Commission.

Cautionary Statement under the Private Securities Litigation Reform Act of 1995

          Statements in the quarterly report on Form 10-Q under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, as well as oral statements that may be made by the Company or by officers, directors or employees of the Company acting on the Company’s behalf, that are not historical fact constitute “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and

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Section 21E of the Securities Exchange Act of 1934, as amended.  Forward-looking statements involve known and unknown risks and uncertainties that may cause the Company’s actual results in future periods to differ materially from forecasted results.  Those risks include a softening of retailer or consumer acceptance of the Company’s products, pricing pressures and other competitive forces, or unanticipated loss of a major customer.  In addition, the Company’s business, operations and financial condition are subject to reports and statements filed from time to time with the Securities and Exchange Commission.

PART II.   OTHER INFORMATION

Item 1.          Legal Proceedings

          By letter dated December 6, 2004, the Company, together with Steve Wyandt and Paul Wyandt, were served notice by the U.S. Department of Labor that a complaint has been filed with the office of Occupational Safety & Health Administration by Angel Martin Aquino alleging discriminatory employment practices in violation of Section 806 of the Corporate and Criminal Fraud Accountability Act of 2002 (also known as the Sarbanes-Oxley Act). OSHA has not yet spoken with, or received any information from, the Company or Messrs. Steve or Paul Wyandt, and the December 6 letter indicates that OSHA has not yet determined whether an investigation of this matter is appropriate. Mr. Aquino was retained by the Company earlier this year to provide consulting services to the Company. Mr. Aquino is seeking alleged actual and compensatory damages of $43,000 and $300,000, respectively.  The Company believes that the claims asserted by Mr. Aquino are without merit and intends to vigorously defend against such claims.

Item 6.          Exhibits and Reports on Form 8-K

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SIGNATURES

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

	NITCHES, INC.
	Registrant

January 14, 2005	By:	/s/ STEVEN P. WYANDT
		Steven P. Wyandt
		As Principal Financial Officer and on behalf of the Registrant

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EXHIBIT INDEX

Exhibit Number		Exhibit
31		Certification required under Section 302
32		Certification required under Section 906

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