NITCHES INC - Quarter Report: 2005 February (Form 10-Q)

          Selling, general and administrative expenses for the second quarter of fiscal 2005 declined $507,000 as compared to a year ago; due primarily to a decrease in sales commissions and selling related expenses in line with the reduced sales volume in the Company’s men’s wear product line.  Expenses included $1.1 million of selling and merchandising expenses and $308,000 of shipping and warehousing expenses.  This compares with $1.4 million of selling and merchandising expenses and $348,000 of shipping and warehousing expenses incurred during the quarter ended February 29, 2004.  Expenses increased as a percent of net sales to 29.9% from 25.4% in the year earlier period, due to the decrease in sales from the earlier period.

          Interest expense decreased $7,000 in the current quarter to $25,000 as compared to $32,000 for the three months ended February 29, 2004.  This decline was due to fewer advances made under the Company’s factoring agreement in line with sales and inventory levels.

          The Company’s income tax provision for the three months ended February 28, 2005, reflects a $275,000 tax benefit accrued at an estimated 39% tax rate on a pretax loss for the quarter of $713,000, which excludes the $86,000 loss on the investment in Designer Intimates.  The Company also utilized an estimated tax rate of 39% for the three months ended February 29, 2004.  There were no tax reserve write-offs or other tax adjustments in either period.

Investment in Unconsolidated Subsidiary

          In October 2002 the Company acquired a 28% interest in Designer Intimates, Inc., which owns 100% of NAP, Inc., a New York-based intimate apparel company.  Designer Intimates had acquired NAP from its founders and obtained a credit line of approximately $12 million from HSBC, later assumed by CIT, secured by the inventory and accounts receivable of NAP and the guarantees of shareholders of Designer Intimates.  Nitches guarantees $3 million of this credit line and this guarantee formed the consideration from Nitches for its 28% ownership interest in Designer Intimates. In the event of a call on this guaranty by CIT, Nitches has a contract with the remaining shareholders of Designer Intimates to limit Nitches’ exposure to 28% of the called value, subject to the maximum guaranty of $3.0 million.

          Nitches reports any income or loss from the ongoing operation of Designer Intimates using the equity method of accounting, whereby Nitches’ 28% interest in Designer Intimates is reported as a single line item on the Consolidated Statement of Income. For the three months ended February 28, 2005, the Company recognized a loss of $86,000 from the unconsolidated subsidiary. For that same period, Designer Intimates incurred a loss of $306,000 on sales of $9.3 million. For the three months ended February 29, 2004, the Company recognized a loss of $58,000 from the unconsolidated subsidiary, while for the same period Designer Intimates incurred a loss of $202,000 on sales of $12.1 million. For the six months ended February 28, 2005 the Company recognized $73,000 in income from the unconsolidated subsidiary.  This income is reported net of tax and is not taxable to the Company.  For that same period, Designer Intimates had net income of $262,000 on sales of $32.7 million.  Cumulative losses on this investment of $149,000 and $222,000 are shown as a liability on the consolidated balance sheet as of February 28, 2005 and August 31, 2004, respectively.

          Nitches has introduced Designers Intimates to the factories that Nitches uses for its own sleepwear product line. This provides access to a lower cost production base than Designer Intimates has had in Turkey where it has historically produced over ninety percent of it products which are predominantly robes and lounge wear.  In an agreement with Designer Intimates, Nitches produces a line of sleepwear under the Dockers® label.  This product contributed approximately $2.8 million dollars of sales for Nitches in the current period.  As of February 28, 2005, Nitches had a backlog of approximately $2.6 million for this product line.

Liquidity and Capital Resources

          Working capital decreased to $5.0 million at February 28, 2005, from $5.6 million at August 31, 2004.  The current ratio decreased to 2.84:1 at February 28, 2005 from 3.09:1 at August 31, 2004, due to a higher percentage increase in current liabilities of 39.1% versus a 1.3% rise in current assets.  Current liabilities increased in line with increased operating expenses for the current period and increased purchases that generated the higher inventory level at the period end.  Current assets increased due to a rise in inventory from $3.4 million to $5.7 million, offset by a lower current period accounts receivable balance of $802,000 versus $3.6 million at the end of the prior fiscal year.  Receivables were lower as of February 28, 2005 due to increased factor advances of $3.7 million versus advances of $1.9 million at the end of the prior fiscal year.  Receivables on the balance sheet are net of these factor advances.

          The Company sells substantially all of its trade receivables to a factor (CIT) on a pre-approved, non-recourse basis. The Company attempts to make any recourse shipments on a COD basis or ensure that the customers’ payments are backed by a commercial or standby letter of credit issued by the customers’ bank.  The amount of the Company’s receivables that were recourse and were not made on a COD basis or supported by commercial or standby letters of credit at February 28, 2005 was approximately $199,000, of which approximately $48,000 had been collected through March 31, 2005.

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          Payment for non-recourse factored receivables is made at the time customers make payment to CIT or, if a customer is financially unable to make payment, within approximately 180 days of the invoice due date.  Under the factoring agreement, the Company can request advances in anticipation of customer collections at the prime rate (currently 5.25%) less one and one-half percent (1.5%).  The amount of advances available to the Company is limited to eighty-five percent (85%) of non-recourse factored receivables.

          The Company may issue import letters of credit through CIT for the purchase of inventory in the normal course of its operations.  Letters of credit are subjected to a limit of $6 million.  At February 28, 2005, the Company had outstanding letters of credit of approximately $2.2 million for the purchase of finished goods, which had been opened through CIT.

          The factoring agreement does not contain any financial covenants to which the Company must adhere.  Advances are collateralized by all of the assets of the Company as well as a personal guaranty of the Company’s Chairman.  The factoring agreement can be terminated by CIT on 30-days written notice.  The company believes the factoring agreement with CIT, along with expected cash flow from operating activities and current levels of working capital are adequate to fulfill the Company’s liquidity needs for the foreseeable future.

Contractual Obligations and Commercial Commitments

Payments due/Commitments expiring per period

		Total Amounts Committed			Less than 1 year			1-3 years			4-5 years			Over 5 years
Operating leases		$	540,000		$	362,000		$	178,000
Letters of credit			2,244,000			2,244,000
Guarantees			3,000,000									3,000,000	*
Total obligations & commitments		$	5,784,000		$	2,606,000		$	178,000		$	3,000,000		$	—

* Due on demand

Inventory

          The Company’s inventory increased 67.9% to $5.7 million at February 28, 2005, from $3.4 million at August 31, 2004.  Compared to inventories of $6.0 million at February 29, 2004, inventories ending the current period decreased 5.5%, 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 February 28, 2005.  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 February 28, 2005, 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 February 28, 2005 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.

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Backlog

          As of February 28, 2005, the Company had on-hand unfilled customer orders of $10.7 million as compared to $8.8 million at February 29, 2004, with such orders generally scheduled for delivery by August 2005 and 2004, respectively.  The increase in backlog is due primarily to an increase in orders for the Company’s sleepwear line, offset partially by decreased orders from men’s wear 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 February 28, 2005.  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.

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 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 or exceeding prior years.  The Company does not expect significant improvement in business conditions in the apparel sector for the remainder of this fiscal year.  Furthermore, the Company has begun incurring 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, 2006.  In view of the market uncertainties and economic pressures facing the Company, management remains conservative in its approach to the current 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 discussed these material weaknesses with our auditors, Moss Adams, LLP, who recommended taking steps to alleviate the inadequate segregation of duties within these areas. 

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          The Company and our Audit Committee are committed to remediation of the material weaknesses.  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 have retained a Controller.
	•	We have removed 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 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).  Mr. Aquino was seeking alleged actual and compensatory damages of $43,000 and $300,000, respectively.  On or about January 13, 2005, the Company responded to a detailed request for information from OSHA.  Subsequently OSHA issued a letter dated February 25, 2005, finding that the Company, together with Steve Wyandt and Paul Wyandt, did not commit any violations of the Sarbanes-Oxley Act and dismissed Mr. Aquino’s complaint.

Item 6.     Exhibits

          See Exhibit Index.

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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
April  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		Description
31		Certification of the principal executive and financial officer, Steven P. Wyandt, pursuant to 15 U.S.C. Section 10A, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32		Certification of the principal executive and financial officer, Steven P. Wyandt, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

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