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

          Cost of sales as a percent of net sales decreased 9.5%, generating a higher gross profit margin of 28.9% for the three months ended February 28, 2006 as compared to 19.4% for the year earlier period.  The increase in gross margin came primarily as the result of the addition of higher gross margin sales from Designer Intimates.  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.

          Selling, general and administrative expenses for the three months ended February 28, 2006 increased $1.3 million as compared to a year ago, due to the consolidation of selling, general and administrative costs for Designer Intimates.   Expenses included $1.2 million of selling and merchandising expenses and $509,000 of shipping and warehousing expenses.  This compares with $1.1 million of selling and merchandising expenses and $308,000 of shipping and warehousing expenses incurred during the three months ended February 28, 2005.  Expenses as a percent of net sales decreased to 26.4% from 29.9% in the prior period, due to the inclusion of higher sales from Designer Intimates at a correspondingly lower selling, general and administrative expense rate.

          Interest expense increased $108,000 in the current period to $133,000 as compared to $25,000 for the three months ended February 28, 2005.  This increase was due to higher interest rates charged on increased advances under the Company’s factoring agreement, as well as the inclusion of the interest expense of Designer Intimates.

          The Company’s income tax provision for the three months ended February 28, 2006 reflects $131,000 of tax expense accrued at an average 40% tax rate on pretax income before it was reduced by 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 Designer Intimates, Inc.

          On October 24, 2005, the Company acquired the remaining seventy-two percent (72%) of the issued and outstanding stock of Designer Intimates, Inc., a Delaware corporation (Designer Intimates) which Nitches did not own, resulting in the Company owning one hundred percent (100%) of Designer Intimates.  The aggregate purchase price for the acquisition was $1,800,000.  Nitches issued to the Sellers 540,000 restricted shares of its common stock at a value of $1.70 per share totaling $918,000 and 8,820 shares of Series A preferred stock at a value of $882,000.

          The primary reason for the acquisition was to acquire the trademarks and brand licenses to complement the Company’s broad production base.  The assets of Designer Intimates, which owns 100% of NAP, Inc., a New York-based intimate apparel company, include cash, finished goods inventory, customer lists, customer orders, trademarks, brand licenses, brand distribution agreements, office leases in New York City and Atlanta, and office equipment, furniture and fixtures, all of which Nitches intends to continue to use.

          The transaction is being accounted for using the purchase method of accounting.  The purchase price is in excess of the fair value of assets and liabilities acquired by $4,842,000 and is expected to be allocated to (i) trademarks that are not anticipated to be subject to amortization because of their indefinite life, (ii) goodwill that will not be subject to amortization but will be subject to yearly evaluation for write-down, (iii) licenses, among others, that will be subject to amortization based on the estimated useful life of the licenses, and (iv) to increase the value of purchased inventories to reflect estimated selling prices less cost of disposal and a reasonable profit allowance.  A final determination of the fair values of assets and liabilities acquired will be made after all available evidence has been obtained to reliably estimate those values. 

          The Company acquired its initial 28% interest in Designer Intimates in October 2002.  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 guaranteed $3.0 million of this credit line and this guaranty formed the consideration from Nitches for its 28% ownership interest in Designer Intimates.

Liquidity and Capital Resources

          For the period ended February 28, 2006 cash used by operating activities was approximately $2.7 million, whereas for the prior period ended February 28, 2005 cash used by operating activities was approximately $1.9 million.  The increase in cash used by operating activities during the period ended February 28, 2006, was due to an increase in accounts receivable and decrease in accounts payable and accrued expenses, offset partially by net income provided from operations.  For the period ended February 28, 2005, cash used by the net loss and an increase in inventories was offset partially by a reduction in accounts receivable due to decreased sales during the quarter.

11

          For the period ended February 28, 2006, net cash provided by investing activities of $7,000 derived from the acquisition of cash balances of Designer Intimates, offset by the cost of the acquisition as well as capital expenditures on equipment and leasehold improvements.  Minimal cash was used in the prior period for the purchase of furniture and equipment used in the ordinary course of business operations.

          For the period ended February 28, 2006, net cash provided by financing activities was approximately $2.9 million as compared to $1.8 million for the prior period ended February 28, 2005. For each of these periods cash provided by financing activities was attributable to advances from the Company’s factor in accordance with the terms of the factoring agreement.

          Working capital decreased to $1.6 million at February 28, 2006 from $4.3 million at August 31, 2005.  The current ratio decreased to 1.1:1 at February 28, 2006 from 1.7:1 at August 31, 2005.  These decreases resulted from the consolidation of higher liabilities and correspondingly lower current assets due to the Designer Intimates acquisition.

          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, 2006 was approximately $322,000, of which approximately $ 239,000 had been collected through March 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 7.25%) 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 $12 million.  At February 28, 2006, the Company had outstanding letters of credit of approximately $2.4 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									Over 5 years
								1-3 years			4-5 years
Operating leases		$	929,000		$	802,000		$	127,000			—			—
License royalty minimums			161,000			71,000			90,000			—			—
Letters of credit			2,413,000			2,413,000			—			—			—
Guarantees			3,000,000			—			—			3,000,000	*		—
Total obligations & commitments		$	6,503,000		$	3,286,000		$	217,000		$	3,000,000		$	—

* Due on demand

Inventory

          The Company’s inventory increased 69.8% to $7.8 million at February 28, 2006, from $4.6 million at August 31, 2005.  Compared to inventories of $5.7 million at February 28, 2005, inventories ending the current period increased 37.4%, primarily because the Company is holding additional inventory due to the acquisition of Designer Intimates.  The Company believes that its current inventory mix and unit levels are appropriate to respond to anticipated market demand.

12

          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, 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 February 28, 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 February 28, 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.

Backlog

          As of February 28, 2006, the Company had on-hand unfilled customer orders of $22.4 million as compared to $13.0 million at February 28, 2005, with such orders generally scheduled for delivery by August 2006 and 2005, respectively.  The increase in backlog is due primarily to the addition of $7.6 million in orders as a result of the acquisition of Designer Intimates, as well as $3.7 million in orders received from a new private label customer, offset partially by a decrease in orders for sleepwear and western wear.

          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, 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 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.

13

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, 2007.  In view of the market uncertainties and economic pressures facing the Company, management remains conservative in its approach to the reminder of the fiscal year.

ITEM 4.  Controls and Procedures

          As of the end of the period covered by 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 6.  Exhibits

31.1     Certification required under Section 302

32.1     Certification required under Section 906

14

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 19, 2006	By:	/s/ Steven P. Wyandt
		Steven P. Wyandt
		As Principal Financial Officer and on behalf of the Registrant

15

EXHIBIT INDEX

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

16