NITCHES INC - Quarter Report: 2006 November (Form 10-Q)

     Allowances for Sales Returns, Doubtful Accounts and Other. Sales are recorded net of estimated future returns, uncollectible accounts receivable and other customer related allowances. Management analyzes historical returns and bad debt expense, current economic trends, changes in customer demand and sell-through of our products when evaluating the adequacy of these allowances. In addition, the Company may provide warehousing credits and other allowances to certain customers in accordance with industry practice. These reserves are determined based on historical experience, budgeted customer allowances and existing commitments to customers. Although management believes it has established adequate reserves with respect to these items, actual activity could vary from management's estimates and such variances could have a material impact on reported results. At November 30, 2006, trade accounts receivable balance was $23.2 million, net of allowances of $921,000, as compared to the balance of $10.5 million, net of allowances of $643,000, at August 31, 2006. At November 30, 2005, the trade accounts receivable balance was $14.5 million, net of allowances of $624,000.

     Inventory. The Company marks down its inventory for estimated obsolescence or unmarketable inventory equal to the difference between the cost of inventory and the estimated net realizable value based on assumptions about age of the inventory, future demand and market conditions. This process provides for a new basis for the inventory until it is sold. If actual market conditions are less favorable than those projected by management, additional inventory markdowns may be required. The Company’s inventory balance was $7.4 million, net of inventory markdowns of $535,000, at November 30, 2006, as compared to an inventory balance of $12.4 million, net of inventory markdowns of $388,000, at August 31, 2006. At November 30, 2005, the inventory balance was $4.8 million, net of inventory markdowns of $276,000.

     Deferred Taxes. Deferred taxes are determined, based on differences between the financial statement and tax bases of assets and liabilities, as well as the future benefit of any net operating loss carryforward, using enacted tax rates in effect for the year in which the differences are expected to reverse. Valuation allowances are established when necessary to reduce deferred tax assets to the amounts expected to be realized. In assessing the need for a valuation allowance management considers estimates of future taxable income and ongoing prudent and feasible tax planning strategies.

     Valuation of Goodwill, Long-Lived Assets and Intangible Assets. The Company evaluates goodwill, long-lived assets and intangible assets for potential impairment on an annual basis during the fourth fiscal quarter, subsequent to the completion of financial projections for the following fiscal year. The Company may make an evaluation between annual tests in certain circumstances such as a significant change in business climate, unanticipated competition, loss of key personnel, or adverse action or assessment by a regulator such as import quotas or duties. Any of these circumstances could cause the Company to conclude that impairment exists and that the net book value of goodwill, long-lived assets and/or intangible assets is impaired. Any resulting impairment loss could have a material adverse impact on the Company’s financial condition and results of operations.

     Contingencies and Litigation. Management evaluates contingent liabilities including threatened or pending litigation in accordance with SFAS No. 5, “Accounting for Contingencies”, and records accruals when the outcome of these matters is deemed probable and the liability could be reasonably estimated.

Results of Operations

Three Months Ended November 30, 2006 Compared to the Three Months Ended November 30, 2005

     Net sales for the three months ended November 30, 2006, increased $20.7 million as compared to the three months ended November 30, 2005. This increase was attributable primarily to increased sales for the Company’s sleepwear and women’s private label apparel, as well as the addition of home décor revenues.

     Cost of sales as a percent of net sales increased 5.2%, generating a lower gross profit margin of 24.2% for the three months ended November 30, 2006 as compared to 29.4% for the year earlier period. The decrease in gross margin came as the result of increased private label sales and a high volume sale of branded product to a national retailer, both at a lower average gross margin. The Company’s product mix constantly changes to reflect customer mix, fashion trends and changing seasons. Consequently, gross margin is likely to vary on a quarter-to-quarter basis and in comparison to gross margins generated in the same period of prior fiscal years.

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     Selling, general and administrative expenses for the first quarter of fiscal 2006 increased $2.9 million as compared to a year ago, due primarily to the consolidation of selling, general and administrative costs for Designer Intimates and additional expenses related to the increased sales reported for the period. Expenses included $2.6 million of selling and merchandising expenses and $631,000 of shipping and warehousing expenses. This compares with $1.8 million of selling and merchandising expenses and $414,000 of shipping and warehousing expenses incurred during the quarter ended November 30, 2005. Expenses as a percent of net sales decreased to 16.9% from 20.6% in the prior period, due to the inclusion of higher sales from Designer Intimates and Home Décor at a correspondingly lower selling, general and administrative expense rate, as well as increased sales across the Company’s product lines.

     Interest expense increased to $300,000 in the current quarter as compared to $90,000 for the three months ended November 30, 2005. This increase was due to higher interest rates charged on increased advances under the Company’s factoring agreement.

     The Company’s income tax provision for the three months ended November 30, 2006 reflects a $998,000 tax expense accrued at an average 43.3% tax rate on income before the purchase accounting effect of a non-taxable increase in cost of goods to reflect the write up of Home Décor inventory of to fair market value, which reduced pretax income. The Company recognized a tax expense of $676,000 for the three months ended November 30, 2005. The Company utilized an estimated tax rate of 42% on income before the purchase accounting effect of a non-taxable increase in cost of goods to reflect the write up of the inventory of Designer Intimates to fair market value, which reduced pretax income.

Acquisition of Saguaro LLC

     On October 24, 2006, Nitches completed its acquisition of the Saguaro® mark and related trademarks from Impex Inc., a leading manufacturer of branded and non-branded specialty, western and private-label women’s apparel. Nitches paid consideration of $3,030,000 to Impex in the form of 600,000 shares of Nitches common stock valued at $4.55 per share (based on the average closing price for the common stock for the ten trading days between June 7 and June 20, 2006, inclusive) and a $300,000 promissory note. Since January 2005, the Company had been manufacturing and distributing Saguaro® apparel products to specialty and catalog retailers under the terms of a strategic alliance with Impex. Under this alliance, Nitches recorded the revenue from such sales and remitted royalties and design fees to Impex as part of its operating expenses. Due to the closing of the Acquisition Agreement, Nitches is not required to pay such fees to Impex as of January 1, 2006. Accordingly, profit margins for Saguaro® products are expected to increase.

Liquidity and Capital Resources

     For the quarter ended November 30, 2006 cash used by operating activities was approximately $9,485,000 whereas for the prior quarter ended November 30, 2005 cash used by operating activities was approximately $8,986,000. For the period ended November 30, 2006, the increase in cash used by operating activities was due primarily to an increase in accounts receivable as a result of higher sales in the current period and a decrease in accounts payable, offset partially by a decrease in inventories. Similarly for the quarter ended November 30, 2005, cash used by operating activities was due primarily to an increase in accounts receivable as a result of higher sales in the current period and a decrease in accounts payable, offset partially by a decrease in inventories.

     For the quarter ended November 30, 2006, net cash used by investing activities of $317,000 included cash used in the Saguaro acquisition. For the quarter ended November 30, 2005, net cash provided by investing activities of $107,000 derived from the acquisition of cash balances of Designer Intimates, offset partially by capital expenditures on equipment and leasehold improvements.

     Cash provided by financing activities of $10,298,000 for the quarter ended November 30, 2006 included advances from the factor offset slightly by partial repayment of a note payable. Cash provided by financing activities in the prior period of $9,109,000 also consisted of advances from the factor.

     Working capital increased to $4.8 million at November 30, 2006 from $3.6 million at August 31, 2006 primarily due to the net income in the quarter. The increase in working capital coincides with increased accounts receivable and payable in conjunction with the increased revenue reported for the period. The current ratio remained constant at 1.2:1 at November 30, 2006 as compared to August 31, 2006.

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     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 November 30, 2006 was approximately $939,000 of which approximately $247,000 had been collected through December 31, 2006.

     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 8.25%) 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 November 30, 2006, the Company had outstanding letters of credit of approximately $2.6 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			Less than										Over
		Committed			1 year			1-3 years				4-5  years			5 years
Operating leases		$	6,315,000		$	945,000		$	1,311,000		$	1,082,000			$	2,977,000
Employment agreement			693,000			120,000			320,000			253,000
Letters of credit			2,610,000			2,610,000			-			-				-
Note payable			250,000			250,000
Guarantees			3,000,000			-			-			3,000,000	*			-
Total obligations & commitments		$	12,868,000		$	3,925,000		$	1,631,000		$	4,335,000			$	2,977,000
*  Due on demand

Inventory

     The Company's inventory decreased 40% to $7.4 million at November 30, 2006, from $12.4 million at August 31, 2006. Compared to inventories of $4.9 million at November 30, 2005, inventories ending the current period increased 51%, primarily because the Company is holding additional inventory to meet the increased backlog for the coming period, including home décor inventory. 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, 2006. 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, 2006, 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, 2006 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 November 30, 2006, the Company had on-hand unfilled customer orders of $35.1 million as compared to $23.4 million at November 30, 2005, with such orders generally scheduled for delivery by May 2007 and 2006, respectively. The increase in backlog is due primarily to an increase in sleepwear orders and the inclusion of home décor orders.

     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, 2006. 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 98% 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 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, 2008. 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

     (a) Disclosure Controls and Procedures. Disclosure controls and procedures are controls and other procedures that are designed to ensure that the information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed in the reports that a company files or submits under the Exchange Act is accumulated and communicated to the company’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure.

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     We conducted an evaluation, under the supervision and with the participation of our Chief Executive and Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the end of the period covered by this report. Based on such evaluation, our Chief Executive and Financial Officer concluded that as of November 30, 2006, the design and operation of our disclosure controls and procedures were not effective as of November 30, 2006. This conclusion was based on identification of a weakness with regard to our ability to timely process and report information during the period. That weakness was exacerbated by disclosure requirements associated with our acquisitions of Saguaro LLC and the assets of Taresha LLC.

     (b) Changes In Internal Controls Over Financial Reporting. No changes were made in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) of the Exchange Act) during our most recent fiscal quarter that has materially affected, or is likely to materially affect, our internal control over financial reporting.

     (c) Limitations On Disclosure Controls And Procedures. Our management, including our Chief Executive and Financial Officer, does not expect that our disclosure controls or internal controls over financial reporting will prevent all errors or all instances of fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within our company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Controls can also be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of controls is based in part upon certain assumptions about the likelihood of future events, and any design may not succeed in achieving its stated goals under all potential future conditions. Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with policies or procedures. Because of the inherent limitation of a cost-effective control system, misstatements due to error or fraud may occur and not be detected.

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.

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PART II - OTHER INFORMATION

ITEM 6. Exhibits

31.1      Certification required under Section 302

32.1      Certification required under Section 906

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 22, 2007	By:		/s/ Steven P. Wyandt
			Steven P. Wyandt
			As Principal Financial Officer and on
			behalf of the Registrant

EXHIBIT INDEX

Exhibit
Number		Exhibit
31.1		Certification required under Section 302
32.1		Certification required under Section 906

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