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 August 26, 2006

OR

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934

For the transition period from                  to                 

Commission File Number:  0-18926

INNOVO GROUP INC.
(Exact name of registrant as specified in its charter)

Delaware

 

11-2928178

(State or other jurisdiction of

 

(I.R.S. Employer Identification No.)

incorporation or organization)

 

 

 

5901 South Eastern Avenue, Commerce, California

 

90040

(Address of principal executive offices)

 

(Zip Code)

 

(323) 837-3700
(Registrant’s telephone number, including area code)

5804 East Slauson Avenue, Commerce, California 90040
(Former name, former address and former fiscal year, if changed since last report)

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 the past 90 days.

x Yes                    o 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 o                                    Accelerated filer x                                             Non-accelerated filer  o

Indicate by check mark whether the registrant is a shell company (as defined by Rule 12b-2 of the Exchange Act).

Yes o No x

The number of shares of the registrant’s common stock outstanding as of October 4, 2006 was 34,343,454.

 




INNOVO GROUP INC.

QUARTERLY REPORT ON FORM 10-Q

 

 

 

 

PART I.

 

FINANCIAL INFORMATION

 

 

 

 

 

 

 

Item 1.

 

Financial Statements

 

 

 

 

 

 

 

Item 2.

 

Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

 

 

 

 

 

 

Item 3.

 

Quantitative and Qualitative Disclosures about Market Risk

 

 

 

 

 

 

 

Item 4.

 

Controls and Procedures

 

 

 

 

 

 

 

PART II.

 

OTHER INFORMATION

 

 

 

 

 

 

 

Item 1.

 

Legal Proceedings

 

 

 

 

 

 

 

Item 1A.

 

Risk Factors

 

 

 

 

 

 

 

Item 2.

 

Changes in Securities and Use of Proceeds

 

 

 

 

 

 

 

Item 3.

 

Defaults Upon Senior Securities

 

 

 

 

 

 

 

Item 4.

 

Submission of Matters to a Vote of Security Holders

 

 

 

 

 

 

 

Item 5.

 

Other Information

 

 

 

 

 

 

 

Item 6.

 

Exhibits

 

 

 

 

 

 

 

 

 

Signatures

 

 

 




PART I – FINANCIAL INFORMATION

Item 1.                    Financial Statements.

INNOVO GROUP INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands)

 

 

08/26/06

 

11/26/05

 

 

 

(unaudited)

 

 

 

ASSETS

 

 

 

 

 

Current assets

 

 

 

 

 

Cash and cash equivalents

 

$

226

 

$

560

 

Accounts receivable, net of allowance for customer credits and returns of $1,515 (2006) and $412 (2005)

 

793

 

60

 

Inventories, net

 

8,152

 

12,083

 

Due from related parties, net

 

 

2,781

 

Prepaid expenses and other current assets

 

382

 

96

 

Assets of discontinued operations

 

112

 

11,233

 

Total current assets

 

9,665

 

26,813

 

 

 

 

 

 

 

Property and equipment, net

 

855

 

428

 

Goodwill

 

20

 

20

 

Intangible assets, net

 

212

 

248

 

Other assets

 

134

 

87

 

 

 

 

 

 

 

Total assets

 

$

10,886

 

$

27,596

 

 

 

 

 

 

 

LIABILITIES AND STOCKHOLDERS’ EQUITY

 

 

 

 

 

Current liabilities

 

 

 

 

 

Accounts payable and accrued expenses

 

$

5,607

 

$

3,859

 

Due to factor

 

 

2,855

 

Due to related parties, net

 

1,777

 

54

 

Liabilities of discontinued operations

 

98

 

9,271

 

Total current liabilities

 

7,482

 

16,039

 

 

 

 

 

 

 

Commitments and contingencies

 

 

 

 

 

 

 

 

 

 

 

Stockholders’ equity

 

 

 

 

 

Preferred stock, $0.10 par value: 5,000 shares authorized, no shares issued or outstanding

 

 

 

Common stock, $0.10 par value: 80,000 shares authorized 34,455 shares issued and 34,343 outstanding (2006) and 33,414 shares issued and 33,302 outstanding (2005)

 

3,447

 

3,343

 

Additional paid-in capital

 

79,760

 

78,823

 

Accumulated deficit

 

(77,027

)

(67,833

)

Treasury stock, 112 shares

 

(2,776

)

(2,776

)

Total stockholders’ equity

 

3,404

 

11,557

 

 

 

 

 

 

 

Total liabilities and stockholders’ equity

 

$

10,886

 

$

27,596

 

 

The accompanying notes are an integral part of these financial statements

1




INNOVO GROUP INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except  per share data)

 

 

 

Three months ended

 

Nine months ended

 

 

 

08/26/06

 

08/27/05

 

08/26/06

 

08/27/05

 

 

 

(unaudited)

 

(unaudited)

 

Net sales

 

$

12,448

 

$

12,600

 

$

32,662

 

$

28,424

 

Cost of goods sold

 

7,485

 

7,830

 

22,648

 

16,901

 

Gross profit

 

4,963

 

4,770

 

10,014

 

11,523

 

 

 

 

 

 

 

 

 

 

 

Operating expenses

 

 

 

 

 

 

 

 

 

Selling, general and administrative

 

5,168

 

5,166

 

16,396

 

13,657

 

Depreciation and amortization

 

78

 

53

 

200

 

125

 

 

 

5,246

 

5,219

 

16,596

 

13,782

 

Loss from continuing operations

 

(283

)

(449

)

(6,582

)

(2,259

)

Interest expense

 

(133

)

(140

)

(378

)

(634

)

Other income (expense)

 

 

 

(68

)

7

 

Loss from continuing operations, before taxes

 

(416

)

(589

)

(7,028

)

(2,886

)

Income taxes

 

13

 

3

 

28

 

21

 

 

 

 

 

 

 

 

 

 

 

Loss from continuing operations

 

(429

)

(592

)

(7,056

)

(2,907

)

 

 

 

 

 

 

 

 

 

 

Income (loss) from discontinued operations, net of tax

 

(95

)

2,007

 

(2,138

)

4,209

 

Net income (loss)

 

$

(524

)

$

1,415

 

$

(9,194

)

$

1,302

 

 

 

 

 

 

 

 

 

 

 

Earnings (loss) per common share - Basic

 

 

 

 

 

 

 

 

 

Earnings (loss) from continuing operations

 

$

(0.01

)

$

(0.02

)

$

(0.21

)

$

(0.09

)

Earnings (loss) from discontinued operations

 

0.00

 

0.06

 

(0.06

)

0.13

 

Earnings (loss) per common share - Basic

 

$

(0.01

)

$

0.04

 

$

(0.27

)

$

0.04

 

 

 

 

 

 

 

 

 

 

 

Earnings (loss) per common share - Diluted

 

 

 

 

 

 

 

 

 

Earnings (loss) from continuing operations

 

$

(0.01

)

$

(0.02

)

$

(0.21

)

$

(0.09

)

Earnings (loss) from discontinued operations

 

0.00

 

0.06

 

(0.06

)

0.13

 

Earnings (loss) per common share - Diluted

 

$

(0.01

)

$

0.04

 

$

(0.27

)

$

0.04

 

 

 

 

 

 

 

 

 

 

 

Weighted average shares outstanding

 

 

 

 

 

 

 

 

 

Basic

 

34,343

 

33,286

 

33,691

 

31,489

 

Diluted

 

34,343

 

33,286

 

33,691

 

31,489

 

 

The accompanying notes are an integral part of these financial statements

2




INNOVO GROUP, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)

 

 

Nine months ended

 

 

 

08/26/06

 

08/27/05

 

 

 

(unaudited)

 

CASH FLOWS FROM OPERATING ACTIVITIES

 

 

 

 

 

Cash provided by (used in) continuing activities

 

$

3,187

 

$

(2,976

)

Cash provided by (used in) discontinued operations

 

574

 

(5

)

Net cash provided by (used in) operating activities

 

3,761

 

(2,981

)

 

 

 

 

 

 

CASH FLOWS FROM INVESTING ACTIVITIES

 

 

 

 

 

Purchases of property and equipment

 

(612

)

(331

)

Cash used in continuing activities

 

(612

)

(331

)

Cash provided by (used in) discontinued operations

 

614

 

(26

)

Net cash provided by (used in) investing activities

 

2

 

(357

)

 

 

 

 

 

 

CASH FLOWS FROM FINANCING ACTIVITIES

 

 

 

 

 

Proceeds from (payments on) factor borrowing, net

 

(2,855

)

885

 

Payments on note payable officer

 

 

(439

)

Proceeds from promissory note - former officer

 

 

703

 

Exercise of stock options

 

 

567

 

Exercise of warrants

 

 

2,284

 

Payment of stock issuance expense

 

 

(6

)

Net cash (used in) provided by continuing activities

 

(2,855

)

3,994

 

Cash used in discontinued operations

 

(1,242

)

(201

)

Net cash (used in) provided by financing activities

 

(4,097

)

3,793

 

 

 

 

 

 

 

NET CHANGE IN CASH AND CASH EQUIVALENTS

 

(334

)

455

 

 

 

 

 

 

 

CASH AND CASH EQUIVALENTS, at beginning of period

 

560

 

312

 

 

 

 

 

 

 

CASH AND CASH EQUIVALENTS, at end of period

 

$

226

 

$

767

 

 

The accompanying notes are an integral part of these financial statements

3




INNOVO GROUP INC AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
(in thousands)

 

 

 

 

 

 

 

 

 

 

Additional

 

 

 

Promissory

 

 

 

Total

 

 

 

Preferred Stock

 

Common Stock

 

Paid-In

 

Accumulated

 

Note - former

 

Treasury

 

Stockholders’

 

 

 

Shares

 

Par Value

 

Shares

 

Par Value

 

Capital

 

Deficit

 

Officer

 

Stock

 

Equity

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance, November 27, 2004

 

194

 

$

 

29,266

 

$

2,927

 

$

72,043

 

$

(51,400

)

$

(703

)

$

(2,588

)

$

20,279

 

Net loss

 

 

 

 

 

 

1,302

 

 

 

1,302

 

Payment of promissory note - former officer

 

 

 

 

 

 

 

703

 

 

703

 

Redemption of preferred stock

 

(194

)

 

 

 

 

 

 

 

 

Conversion of Convertible notes to common stock

 

 

 

2,560

 

256

 

4,129

 

 

 

 

4,385

 

Common stock registration related expense

 

 

 

 

 

(6

)

 

 

 

(6

)

Exercise of stock options

 

 

 

623

 

63

 

470

 

 

 

(188

)

345

 

Exercise of warrants

 

 

 

965

 

97

 

2,187

 

 

 

 

2,284

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance, August 27, 2005 (unaudited)

 

 

$

 

33,414

 

$

3,343

 

$

78,823

 

$

(50,098

)

$

 

$

(2,776

)

$

29,292

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance, November 26, 2005

 

 

$

 

33,414

 

$

3,343

 

$

78,823

 

$

(67,833

)

$

 

$

(2,776

)

$

11,557

 

Net loss

 

 

 

 

 

 

(9,194

)

 

 

(9,194

)

Common stock issued to related party

 

 

 

1,041

 

104

 

(104

)

 

 

 

 

Stock-based compensation

 

 

 

 

 

1,041

 

 

 

 

1,041

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance, August 26, 2006 (unaudited)

 

 

$

 

34,455

 

$

3,447

 

$

79,760

 

$

(77,027

)

$

 

$

(2,776

)

$

3,404

 

 

The accompanying notes are an integral part of these financial statements

4




INNOVO GROUP INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1 - BASIS OF PRESENTATION

The unaudited condensed consolidated financial statements of Innovo Group, Inc., or Innovo Group, which include the accounts of its wholly-owned subsidiaries, for the three and nine months ended August 26, 2006 and August 27, 2005 and the related footnote information have been prepared on a basis consistent with Innovo Group’s audited consolidated financial statements as of November 26, 2005 contained in Innovo Group’s Annual Report on Form 10-K for the year ended November 26, 2005, or the Annual Report.  Innovo Group’s operating subsidiaries include the following entities: Joe’s Jeans Inc., or Joe’s, and Innovo Azteca Apparel, Inc., or IAA.  All significant inter-company transactions have been eliminated.  Currently, Innovo Group has only one segment of operations - apparel.  Historically, Innovo Group operated in two segments - apparel and accessories.

As a result of the sale of assets related to certain areas of its operations, Innovo Group has reclassified and reported the following operating divisions of its various subsidiaries as “Discontinued Operations”:  (1) its craft and accessories division operated under its Innovo Inc. subsidiary, or Innovo, sold in May 2005; (2) its former headquarters in Springfield, Tennessee that was used as a commercial rental property operated under its Leaseall Management Inc. subsidiary, or Leaseall, sold in February 2006; and (3) its private label apparel division operated by its IAA subsidiary and sold in May 2006.  Continuing operations include the results of Innovo Group’s branded apparel business, including certain terminated branded apparel lines, which were not separate operating divisions and thus, not considered to be part of Innovo Group’s “Discontinued Operations.”

These unaudited condensed consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles for interim financial information and 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 U.S. generally accepted accounting principles for complete financial statements.  These unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and the related notes thereto contained in Innovo Group’s Annual Report.  In the opinion of management, the accompanying unaudited financial statements contain all adjustments (consisting of normal recurring adjustments), which management considers necessary to present fairly Innovo Group’s financial position, results of operations and cash flows for the interim periods presented.  The results for the three and nine months ended August 26, 2006 are not necessarily indicative of the results anticipated for the entire year ending November 25, 2006.

The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements.  Actual results may differ from those estimates.

5




NOTE 2 – INVENTORIES

Inventories are stated at the lower of cost, as determined by the first-in, first-out method, or market.  Inventories consisted of the following (in thousands):

 

08/26/06

 

11/26/05

 

 

 

 

 

 

 

Finished goods

 

$

4,904

 

$

10,396

 

Work in progress

 

2,077

 

1,381

 

Raw materials

 

2,328

 

4,015

 

 

 

9,309

 

15,792

 

Less allowance for obsolescence and slow moving items

 

(1,157

)

(3,709

)

 

 

$

8,152

 

$

12,083

 

 

NOTE 3 – SALE OF CERTAIN ASSETS OF PRIVATE LABEL APPAREL DIVISION

On March 31, 2006, Innovo Group and its IAA subsidiary entered into an Asset Purchase Agreement, or Cygne APA, with Cygne Designs, Inc., or Cygne.  Pursuant to the Cygne APA, Innovo Group agreed to sell to Cygne certain assets related to its private label apparel division.  These assets include the private label division’s customer list, the assumption of certain existing purchase orders and inventory related to the private label division, and the assumption of the benefit of a non-compete clause in favor of Azteca Production International, Inc., or Azteca, entered into under the original asset purchase agreement between IAA and Azteca.  In exchange for the purchased assets, Cygne agreed to assume certain liabilities associated with the private label division, including, the remaining obligation under the original promissory note executed in favor of Azteca under the original asset purchase agreement (and as more fully described in “Note 4 – Related Party Transactions”), certain other liabilities owed in connection with the private label division to Azteca in excess of $1,500,000, certain liabilities associated with outstanding purchase orders and inventory schedules listed in the Cygne APA, the obligation to continue to pay the earn-out under the original asset purchase agreement and the assumption of the liabilities related to the workforce of the private label division.  The aggregate value of the assumed liabilities which represented the purchase price for the transaction at the time of execution of the Cygne APA was estimated to be $10,437,000, subject to certain permitted adjustments on the closing date.  On May 12, 2006, Innovo Group conducted its annual meeting of stockholders and its stockholders approved the sale of its private label apparel division pursuant to the Cygne APA.  Immediately thereafter, Innovo Group and Cygne closed the transaction.  No cash was transferred at closing and each party was responsible for its respective transaction costs.  Innovo Group recorded an approximate charge of $36,000 for certain property and equipment disposed of or abandoned as part of discontinuing these operations.

The following table sets forth a summary of the assumption of the liabilities less the net book value of the assets and Innovo Group’s resulting loss on the sale of these assets (in thousands):

6




 

Note payable - related party

 

$

7,937

 

Other related party liabilities

 

2,500

 

Total purchase price (Liabilities assumed by buyer)

 

10,437

 

 

 

 

 

Net intangible asset - customer relationship

 

9,469

 

Raw material inventory

 

3,360

 

Loss on disposition of property and equipment

 

36

 

Net book value of assets sold

 

12,865

 

 

 

 

 

Loss, before transaction costs

 

2,428

 

Transaction costs

 

186

 

Loss on sale of Private Label Apparel Division

 

$

2,614

 

 

NOTE 4 –RELATED PARTY TRANSACTIONS

As of August 26, 2006 and November 26, 2005, Innovo Group’s related party balance consisted of amounts due (to) or due from certain related parties, as further described below, as follows:

 

(in thousands)

 

 

 

8/26/2006

 

11/26/05

 

 

 

 

 

 

 

Commerce Investment Group and affiliates

 

$

(1,594

)

$

2,781

 

JD Design

 

(183

)

(54

)

Due (to) from related parties, net

 

$

(1,777

)

$

2,727

 

 

Commerce Investment Group and affiliates

Innovo Group has a strategic relationship with certain of its stockholders, Hubert Guez, Paul Guez and their affiliated companies, including Azteca and Commerce Investment Group LLC, or Commerce.  By virtue of this relationship, Innovo Group has entered into the following agreements, at various times, with Hubert Guez, Paul Guez and their affiliated companies, Azteca and/or Commerce, entities in which Hubert Guez and Paul Guez have controlling interests.

The following table represents charges from the affiliated companies pursuant to Innovo Group’s relationship with them, including its discontinued operations, as follows:

 

 

Three months ended

 

Nine months ended

 

 

 

(in thousands)

 

(in thousands)

 

 

 

8/26/06

 

8/27/05

 

8/26/06

 

8/27/05

 

Continuing operations

 

 

 

 

 

 

 

 

 

Purchase order arrangements

 

$

6,661

 

$

795

 

$

8,611

 

$

1,919

 

Verbal facilities arrangement

 

28

 

109

 

255

 

242

 

Discontinued operations

 

 

 

 

 

 

 

 

 

Supply agreement / Purchase order arrangements

 

208

 

19,929

 

16,850

 

50,739

 

Earn-out due to Sweet Sportswear

 

4

 

436

 

248

 

1,120

 

Verbal facilities agreement

 

 

181

 

302

 

543

 

Principal and interest on note payable

 

 

273

 

1,087

 

518

 

Supply and Distribution agreement

 

 

 

 

639

 

 

7




Continuing Operations - Purchase order arrangement

Due to a preexisting relationship with AZT International SA de CV, a Mexican corporation and wholly owned subsidiary of Azteca, or AZT, as a supplier of finished goods for its discontinued private label operations, Innovo Group utilizes AZT as a supplier on a purchase order basis for certain of its Joe’s Jeans® denim products.  Under this arrangement, Innovo Group advances the funds to purchase raw materials, which primarily includes fabric, anticipated for production of its products.  Innovo Group pays AZT for the production cost less credit for the advances on raw materials.  Innovo Group purchases these products in various stages of production from partial to completed finished goods.

Continuing Operations - Verbal facilities arrangement

Until mid-July 2006, Innovo Group utilized space for its headquarters and principal executive offices under a verbal month-to-month arrangement with Azteca.  Under this arrangement, Innovo Group paid to Azteca a monthly fee for allocated expenses associated with its use of office and warehouse space, including a fee charged on a per unit basis for inventory, and expenses in connection with maintaining such office and warehouse space.  These allocated expenses included, but were not limited to, rent, security, office supplies, machine leases and utilities.  In mid-July 2006, Innovo Group moved its headquarters and principal executive offices to nearby office and warehouse space at 5901 Eastern Avenue, Commerce, California and accordingly, no longer has any obligation to pay Azteca under the verbal facilities arrangement.

Discontinued Operations – Supply Agreement

In July 2003, under an asset purchase agreement, or Blue Concept APA, with Azteca, Hubert Guez and Paul Guez, Innovo Group’s IAA subsidiary acquired the Blue Concept Division of Azteca, a division which sells denim apparel primarily to American Eagle Outfitters, Inc., or AEO.  Simultaneous with the Blue Concept APA, IAA entered into a non-exclusive Supply Agreement with AZT for the purchase of denim products to be sold to AEO, which expired on July 17, 2005.  Under the terms of the Supply Agreement, AZT agreed that the purchase price on the products supplied would provide for a margin per unit of 15%.  After the expiration of the supply agreement, Innovo Group continued to utilize AZT as a supplier on a purchase order basis for its AEO products under similar terms.  Upon completion of the sale of IAA’s private label division to Cygne, as discussed in Note 3 above, Cygne assumed $2,500,000 of the amount owed to AZT under this purchase order supply arrangement.

Discontinued Operations - Earn-out due to Sweet Sportswear LLC

The Blue Concept APA also provided for the calculation and payment, on a quarterly basis, to Sweet Sportswear LLC, an entity owned by Hubert and Paul Guez, of an amount equal to 2.5% of the gross sales solely attributable to AEO.  Under the terms of the Cygne APA, Cygne assumed the future liability associated with this payment.

Discontinued Operations - Principal and interest on note payable

Innovo Group had originally incurred long-term debt in connection with the purchase of the Blue Concept Division from Azteca.  In July 2003, IAA issued a seven-year unsecured, convertible promissory note in the principal amount of $21.8 million, or the Blue Concept Note.  The Blue Concept Note bore interest at a rate of 6% and required payment of interest only during the first 24 months and then was fully amortized over the remaining five-year period.  On March 5, 2004, after stockholder approval, a portion of the Blue Concept Note was converted into 3,125,000 shares of common stock at a value per share of $4.00.  Under the terms of the Cygne APA, Cygne assumed the remaining principal balance of the Blue

8




Concept Note.  On May 12, 2006, pursuant to the closing of the transaction, Azteca released Innovo Group from any and all remaining obligations under the Blue Concept Note and the Blue Concept Note has been reclassified as a discontinued operation liability.  Under the terms of the original asset purchase agreement, in addition to the shares previously issued, Innovo Group issued on May 17, 2006 an additional 1,041,667 shares of its common stock as a result of its average stock price trading at less than $3.00 per share for the period between February 10, 2006 and March 12, 2006.  This share issuance has been recognized in the Statement of Stockholders’ Equity.

Discontinued Operations - Craft and accessories business segment

In August 2000, Innovo Group entered into a supply agreement and a distribution agreement for its craft products with Commerce.  In connection with the sale of the craft inventory and certain other assets of its Innovo subsidiary in May 2005, both the supply agreement and the distribution agreement were terminated.

Aggregate balances by entities

As of August 26, 2006 and November 26, 2005, respectively, the balances due (to) or due from these related parties and certain of their affiliates are as follows:

 

(in thousands)

 

 

 

8/26/2006

 

11/26/05

 

 

 

 

 

 

 

AZT International SA de CV

 

$

(1,940

)

$

56

 

AZT International SA de CV - Raw Material Advances

 

3,922

 

 

Commerce Investment Group

 

(3,598

)

5,667

 

Sweet Sportswear, LLC

 

(4

)

(3,079

)

Owenslab Jean, LLC

 

 

61

 

Team Pro International

 

 

19

 

Blue Concepts, LLC/Yanuk

 

 

57

 

Cygne Design

 

26

 

 

 

 

$

(1,594

)

$

2,781

 

 

The AZT balances represent the balances due as a result of Innovo Group’s current production efforts in Mexico for our branded label apparel production.  Upon completion of the sale of IAA’s private label division to Cygne, as discussed in Note 3 above, Cygne assumed the aggregate liability in the amount of $2,500,000 owed to Commerce and its affiliates.  The balance due to Commerce represents the adjusted balance remaining that Innovo Group continues to be obligated for after the completion of the transaction with Cygne.  The balance of $26,000 due from Cygne represents the amount Innovo Group is owned by Cygne for various reimbursable expenses related to the transition of the private label division.

Joe’s Jeans License

On February 7, 2001, Innovo Group acquired a license for the rights to the Joe’s Jeans label from JD Design, LLC, or JD Design, along with the right to market the previously designed product line and existing sales orders, in exchange for 500,000 shares of Innovo Group’s common stock and a warrant contingent on certain sales and gross margins which were not met and therefore, not eligible for exercise.

Additionally, Joe Dahan, the designer of the Joe’s Jeans line and managing member of JD Design, joined Innovo Group as President of its wholly owned subsidiary, Joe’s Jeans, Inc.  Under his

9




employment agreement, Mr. Dahan received an option, with a four-year term, to purchase 250,008 shares of Innovo Group’s common stock at $1.00 per share, vesting over 24 months.  This option was exercised in full as of January 26, 2005.  Under the terms of the license, Innovo Group is required to pay a royalty of 3% on net sales of its licensed products to JD Design.  In October 2005, Innovo Group granted JD Design the right to develop the children’s branded apparel line under an amendment to its master license agreement in exchange for a 5% royalty on net sales of those products.  In addition, Innovo Group had a verbal arrangement to pay JD Design a design fee of 3% of net sales for assistance related to designs for its indie™ products, the line of business that Innovo Group exited in early 2006.

For the three and nine months ended August 26, 2006 and August 27, 2005, the following table sets forth royalties, fees and income related to JD Design.

 

 

Three months ended

 

Nine months ended

 

 

 

(in thousands)

 

(in thousands)

 

 

 

8/26/06

 

8/27/05

 

8/26/06

 

8/27/05

 

Expense (income):

 

 

 

 

 

 

 

 

 

Joe’s Jeans royalty expense

 

$

372

 

$

367

 

$

935

 

$

791

 

indie Design Fee

 

2

 

7

 

40

 

25

 

Children’s license, royalty income

 

(14

)

 

(40

)

 

 

NOTE 5 – LOSS FROM DISCONTINUED OPERATIONS

During fiscal 2004, Innovo Group made the decision to market for sale its commercial rental property consisting of four separate buildings that served as its former headquarters located in Springfield, Tennessee and to offer for sale the assets of its craft and accessory segment of operations conducted through its Innovo subsidiary.  On May 17, 2005, Innovo Group completed the sale of the assets of its craft and accessory segment of operations.  In February 2006, Innovo Group completed the sale of each of the four separate buildings that served as its former headquarters for an aggregate sales price of $741,000 before net selling costs of approximately $126,000.  Innovo Group also paid off the remaining note payable balance of $287,000 collateralized by a first deed of trust on these buildings with the proceeds from the sale.  In connection with the sale of one of the buildings, Innovo Group received a promissory note issued by the purchaser in the original principal amount of $50,000, which represented a portion of the purchase price.  As of August 26, 2006, $2,000 of the promissory note has been included on Innovo Group’s balance sheet under “Other current assets” and $47,000 of the promissory note has been included under non-current “Other assets” of continuing operations.  The note bears interest at a rate of 8%, has a term of five years and is collateralized by a deed of trust on the building.

In accordance with the provisions of SFAS No. 144 “Accounting for the Impairment or Disposal of Long-Lived Assets,” the accompanying unaudited condensed consolidated financial statements reflect the results of operations and financial position of Innovo Group’s commercial rental property, its craft and accessory business segment and its private label apparel division separately as discontinued operations.

The assets and liabilities of the discontinued operations are presented in the unaudited condensed consolidated balance sheet under the captions “Assets of Discontinued Operations” and “Liabilities of Discontinued Operations.”  The underlying assets and liabilities of the discontinued operations are as follows:

10




 

 

 

(in thousands)

 

 

 

 

 

 

 

Private

 

 

 

 

 

Innovo,

 

Leaseall

 

Label

 

 

 

 

 

Inc.

 

Management

 

Business

 

Total

 

August 26, 2006

 

 

 

 

 

 

 

 

 

Cash and cash equivalents

 

 

 

$

19

 

$

19

 

Accounts receivable and due from factor, net of allowance for customer credits and allowances of $0 (2006)

 

 

 

70

 

70

 

Inventories

 

 

 

23

 

23

 

 

 

 

 

 

 

 

 

 

 

Assets of discontinued operations

 

 

 

$

112

 

$

112

 

 

 

 

 

 

 

 

 

 

 

Accounts payable and accrued expenses

 

 

 

$

98

 

$

98

 

 

 

 

 

 

 

 

 

 

 

Liabilities of discontinued operations

 

 

 

$

98

 

$

98

 

 

 

 

 

 

 

 

 

 

 

November 26, 2005

 

 

 

 

 

 

 

 

 

Cash and cash equivalents

 

$

5

 

 

$

68

 

$

73

 

Accounts receivable and due from factor, net of allowance for customer credits and allowances of $23 (2005)

 

 

16

 

8

 

24

 

Inventories

 

 

 

366

 

366

 

Prepaid expenses and other current assets

 

 

18

 

20

 

38

 

Property, Plant and Equipment, net

 

 

599

 

59

 

658

 

Intangible assets, net

 

 

 

10,074

 

10,074

 

 

 

 

 

 

 

 

 

 

 

Assets of discontinued operations

 

$

5

 

$

633

 

$

10,595

 

$

11,233

 

 

 

 

 

 

 

 

 

 

 

Accounts payable and accrued expenses

 

 

$

5

 

$

87

 

$

92

 

Due to factor

 

 

 

$

130

 

130

 

Note payable

 

 

$

287

 

 

287

 

Note payable - related party

 

 

 

8,762

 

8,762

 

Liabilities of discontinued operations

 

 

$

292

 

$

8,979

 

$

9,271

 

 

11




The following table sets forth the loss from the discontinued operations of each period.

 

 

(in thousands)

 

 

 

 

 

 

 

Private

 

 

 

 

 

 

 

Leaseall

 

Label

 

 

 

 

 

Innovo, Inc.

 

Management

 

Business

 

Total

 

 

 

 

 

 

 

 

 

 

 

Three months ended August 26, 2006

 

 

 

 

 

 

 

 

 

Net sales

 

$

 

$

 

$

482

 

$

482

 

Pre-tax loss from operations

 

 

 

(14

)

(14

)

Loss on sale of assets

 

 

 

(81

)

(81

)

Income tax

 

 

 

 

 

Discontinued operations, net of tax

 

$

 

$

 

$

(95

)

$

(95

)

 

 

 

 

 

 

 

 

 

 

Three months ended August 27, 2005

 

 

 

 

 

 

 

 

 

Net sales

 

$

 

$

 

$

23,752

 

$

23,752

 

Pre-tax income (loss) from operations

 

(45

)

(16

)

2,070

 

2,009

 

Gain on sale of assets

 

 

 

 

 

Income tax

 

1

 

1

 

 

2

 

Discontinued operations, net of tax

 

$

(46

)

$

(17

)

$

2,070

 

$

2,007

 

 

 

 

 

 

 

 

 

 

 

Nine months ended August 26, 2006

 

 

 

 

 

 

 

 

 

Net sales

 

$

 

$

 

$

20,483

 

$

20,483

 

Pre-tax income (loss) from operations

 

(4

)

(34

)

498

 

460

 

Gain (loss) on sale of assets

 

 

16

 

(2,614

)

(2,598

)

Income tax

 

 

 

 

 

Discontinued operations, net of tax

 

$

(4

)

$

(18

)

$

(2,116

)

$

(2,138

)

 

 

 

 

 

 

 

 

 

 

Nine months ended August 27, 2005

 

 

 

 

 

 

 

 

 

Net sales

 

$

2,490

 

$

 

$

60,424

 

$

62,914

 

Pre-tax income (loss) from operations

 

(263

)

(96

)

4,192

 

3,833

 

Gain on sale of assets

 

377

 

 

 

377

 

Income tax

 

1

 

 

 

1

 

Discontinued operations, net of tax

 

$

113

 

$

(96

)

$

4,192

 

$

4,209

 

 

Pre-tax income (loss) from discontinued operations does not include an allocation of corporate overhead costs.

12




NOTE 6 – ACCOUNTS RECEIVABLE, FACTOR FINANCING AND DUE (TO) FACTOR

Accounts receivable and due to factor consist of the following (in thousands):

 

 

Continuing operations

 

Discontinued operations

 

 

 

08/26/06

 

11/26/05

 

08/26/06

 

11/26/05

 

 

 

 

 

 

 

 

 

 

 

Non-recourse receivables

 

$

6,747

 

$

3,435

 

$

147

 

$

3,654

 

Client recourse receivables

 

2,345

 

1,989

 

84

 

70

 

Total receivables assigned to factor

 

9,092

 

5,424

 

231

 

3,724

 

Allowance for customer credits and doubtful accounts

 

(907

)

(796

)

 

(67

)

Net loan balance from factor

 

(7,656

)

(7,483

)

(161

)

(3,787

)

 

 

 

 

 

 

 

 

 

 

Due from (to) factor

 

$

529

 

$

(2,855

)

$

70

 

$

(130

)

 

 

 

 

 

 

 

 

 

 

Non-factored accounts receivable

 

872

 

472

 

 

47

 

Allowance for customer credits and doubtful accounts

 

(608

)

(412

)

 

(23

)

Accounts receivable, net of allowance

 

$

793

 

$

60

 

$

70

 

$

24

 

 

Innovo Group bears the risk of payment in the event of non-payment by the customers for the client recourse receivables sold to factor for both continuing and discontinued operations.  Innovo Group records its accounts receivable on the balance sheet net of receivables factored with CIT.  Further, in the event its loan balance with CIT exceeds the face value of the receivables factored, net of allowances, with CIT, Innovo Group records the difference as a liability on its balance sheet as “Due to Factor.”

CIT Commercial Services

On June 1, 2001, Innovo Group’s Innovo and Joe’s subsidiaries, and on September 10, 2001, its IAA subsidiary, entered into accounts receivable factoring agreements with CIT.  Subsequent to these agreements, the subsidiaries also entered into inventory security agreements, collectively with the factoring agreements referred to as the Factoring Facilities.  These Factoring Facilities give Innovo Group, through its operating subsidiaries, the ability to obtain cash in advance from the sale of certain of its account receivables for up to 85% of the face amount of the factored receivables, on either a recourse or non-recourse basis depending on the creditworthiness of the customer, and also allow Innovo Group to obtain advances for up to 50% of the value of certain eligible inventory.  CIT has the ability, in its discretion at any time or from time to time, to adjust or revise any limits on the amount of cash available or advances made to us pursuant to the Factoring Facilities.  As further assurance to enter into the Factoring Facilities, cross guarantees were executed by and among Innovo Group, Innovo, Joe’s and IAA, to guarantee each subsidiaries’ obligations and in November 2004, upon request by CIT, Innovo Group’s Chairman, Sam Furrow, executed a personal guarantee for up to $1,000,000.  During fiscal 2006, this personal guarantee by Mr. Furrow allowed Innovo Group to obtain advances under the existing Factoring Facilities.

Presently, Innovo Group obtains funds under the Factoring Facilities at 85% of factored invoices and under the inventory security agreement of up to $1,000,000 of maximum availability.  As of August 26, 2006, Innovo Group’s availability with CIT was approximately $341,000 under the Factoring Facilities.  This amount fluctuates on a daily basis based upon invoicing and collection related activity by CIT for the receivables sold.  In connection with the agreements with CIT, certain assets are pledged to CIT, including all of the inventory, merchandise, and/or goods, including raw materials through finished

13




goods and receivables.  With the sale and cessation of operations for certain divisions and business lines, Innovo Group is primarily utilizing the Factoring Facilities of its Joe’s Jeans subsidiary; however, certain of its other subsidiary Factoring Facilities have limited activity.

These Factoring Facilities may be terminated by CIT upon 60 days prior written notice or immediately upon the occurrence of an event of default, as defined in the agreement.  The agreements may be terminated by Innovo Group or its subsidiaries, upon 60 days advanced written notice prior to June 30, 2007 or earlier provided that the minimum factoring fees have been paid for the respective period.

The factoring rate that Innovo Group pays to CIT to factor accounts is at 0.6% for accounts which CIT bears the credit risk and 0.4% for accounts which Innovo Group bears the credit risk and the interest rate associated with borrowings under the inventory lines and factoring facility is at 0.25% plus the Chase prime rate.  As of August 26, 2006, the Chase prime rate was 8.25%.

In addition, in the event Innovo Group needs additional funds, Innovo Group has also established a letter of credit facility with CIT to allow it to open letters of credit for a fee of 0.25% of the letter of credit face value with international and domestic suppliers, subject to availability under the Factoring Facilities.

As of August 26, 2006, Innovo Group had $8,416,000 of factored accounts receivable, net of allowances, with CIT and a loan balance of $7,817,000, including a discontinued operations balance.  Innovo Group had seven open letters of credit outstanding in the aggregate amount of $220,000 as of August 26, 2006.

NOTE 7 – EARNINGS PER SHARE

Earnings (loss) per share are computed using weighted average common shares and dilutive common equivalent shares outstanding. Potentially dilutive securities consist of outstanding convertible notes, options and warrants.  A reconciliation of the numerator and denominator of basic earnings per share and diluted earnings per share is as follows:

14




 

 

 

Three months ended

 

Nine months ended

 

 

 

(in thousands, except per share data)

 

(in thousands, except per share data)

 

 

 

08/26/06

 

08/27/05

 

08/26/06

 

08/27/05

 

Basic Earnings (Loss) per share Computation:

 

 

 

 

 

 

 

 

 

Numerator

 

 

 

 

 

 

 

 

 

Loss from continuing operations

 

$

(429

)

$

(592

)

$

(7,056

)

$

(2,907

)

Income (loss) from discontinued operations

 

(95

)

2,007

 

(2,138

)

4,209

 

Net income (loss)

 

$

(524

)

$

1,415

 

$

(9,194

)

$

1,302

 

 

 

 

 

 

 

 

 

 

 

Denominator:

 

 

 

 

 

 

 

 

 

Weighted average common shares outstanding

 

34,343

 

33,286

 

33,691

 

31,489

 

 

 

 

 

 

 

 

 

 

 

Earnings (Loss) per Common Share - Basic

 

 

 

 

 

 

 

 

 

Loss from continuing operations

 

$

(0.01

)

$

(0.02

)

$

(0.21

)

$

(0.09

)

Income (loss) from discontinued operations

 

(0.00

)

0.06

 

(0.06

)

0.13

 

Net income (loss)

 

$

(0.01

)

$

0.04

 

$

(0.27

)

$

0.04

 

 

 

 

 

 

 

 

 

 

 

Diluted Earnings (Loss) per share Computation:

 

 

 

 

 

 

 

 

 

Numerator

 

 

 

 

 

 

 

 

 

Loss from continuing operations

 

$

(429

)

$

(592

)

$

(7,056

)

$

(2,907

)

Income (loss) from discontinued operations

 

(95

)

2,007

 

(2,138

)

4,209

 

Net income (loss)

 

$

(524

)

$

1,415

 

$

(9,194

)

$

1,302

 

 

 

 

 

 

 

 

 

 

 

Denominator:

 

 

 

 

 

 

 

 

 

Weighted average common shares outstanding

 

34,343

 

33,286

 

33,691

 

31,489

 

Effect of dilutive securities:

 

 

 

 

 

 

 

 

 

Options and warrants

 

 

 

 

 

Convertible notes

 

 

 

 

 

Dilutive potential common shares

 

34,343

 

33,286

 

33,691

 

31,489

 

 

 

 

 

 

 

 

 

 

 

Earnings (Loss) per Common Share - Dilutive

 

 

 

 

 

 

 

 

 

Loss from continuing operations

 

$

(0.01

)

$

(0.02

)

$

(0.21

)

$

(0.09

)

Income (loss) from discontinued operations

 

(0.00

)

0.06

 

(0.06

)

0.13

 

Net income (loss)

 

$

(0.01

)

$

0.04

 

$

(0.27

)

$

0.04

 

 

Potentially dilutive options and warrants in the aggregate of 4,720,629 and 4,802,296 for the three and nine months ended August 26, 2006 and August 27, 2005, respectively, have been excluded from the calculation of the diluted loss per share as their effect would have been anti-dilutive.

15




NOTE 9 –INCOME TAXES

Innovo Group’s income tax expense for the nine months ended August 26, 2006 and August 27, 2005, respectively, represents estimated state income and franchise tax expense.  For the 2006 period, Innovo Group recorded $28,000 of income tax.  For the 2006 and 2005 periods, the effective tax rate differs from the statutory rate primarily as a result of the accrual for state taxes and the recording of a valuation allowance which fully offset the benefit of the losses for the period.

NOTE 10 – STOCKHOLDERS’ EQUITY

Preferred Stock

In April 2002, Innovo Group issued 195,295 shares of $100, 8% Series A Redeemable Cumulative Preferred Stock, or Series A Shares, to certain holders in connection with its Innovo Realty Inc., or IRI, subsidiary acquiring a 30% limited partnership interest in each of 22 separate partnerships that invested in real estate apartment complexes located throughout the United States.  The holders of the Series A Shares were the sellers of the apartment complexes. During the first quarter of fiscal 2004, there were approximately 194,000 shares outstanding.  In April 2005, Innovo Group executed a settlement agreement with the holders of its Series A Shares and redeemed all of the Series A Shares in exchange for the transfer of all of the stock of its Innovo Realty, Inc. subsidiary.  No shares were outstanding as of November 26, 2005 and August 26, 2006, respectively.

Recent Issuances of Common Stock

Under the terms of the original asset purchase agreement with Azteca entered into in July 2003, Innovo Group issued on May 17, 2006, an additional 1,041,667 shares as a result of the average stock price of Innovo Group’s common stock being less than $3.00 per share for the period between February 10, 2006 and March 12, 2006, which has been recognized in the Statement of Stockholders’ Equity.

Stock Option Plans

In March 2000, Innovo Group adopted the 2000 Employee Stock Option Plan, or the 2000 Employee Plan.  In May 2003, the 2000 Employee Plan was amended to provide for incentive and nonqualified options for up to 3,000,000 shares, subject to adjustment, of common stock that may be granted to employees, officers, directors and consultants.  The exercise price for incentive options may not be less than the fair market value of Innovo Group’s common stock on the date of grant and the exercise period may not exceed ten years.  Vesting periods and option terms are determined by the Board of Directors.  As of August 26, 2006, options to purchase up to 200,000 remained outstanding under our 2000 Employee Plan.  On June 3, 2004, in connection with stockholder approval of the 2004 Stock Incentive Plan, Innovo Group stated that it would no longer grant options pursuant to the 2000 Employee Plan, however, the 2000 Employee Plan remains in effect for awards outstanding as of June 3, 2004.  On May 12, 2006, 1,050,000 options were forfeited by employees under the 2000 Employee Plan.

In September 2000, Innovo Group adopted the 2000 Director Stock Incentive Plan, or the 2000 Director Plan, under which nonqualified options for up to 500,000 shares of common stock may be granted.  At the first annual meeting of stockholders following appointment to the board and annually thereafter during their term, each non-employee director received an option to purchase common stock with an aggregate fair value of $10,000.  These options vested on a monthly basis and were generally exercisable in full one year from the date of grant and expired ten years after the date of grant.  The exercise price was set at 50% of the fair market value of the common stock on the date of grant.  The discount was in lieu of cash director fees.  As of August 26, 2006, options to purchase up to 203,546

16




remained outstanding under the 2000 Director Plan.  On June 3, 2004, in connection with stockholder approval of the 2004 Stock Incentive Plan, Innovo Group stated that it would no longer grant options pursuant to the 2000 Director Plan; however, the 2000 Director Plan remains in effect for awards outstanding as of June 3, 2004.

On June 3, 2004, Innovo Group’s stockholders adopted the 2004 Stock Incentive Plan, or the 2004 Incentive Plan, and on June 9, 2005, Innovo Group’s stockholders amended it to increase the number of shares authorized for issuance to 4,265,172 shares of common stock.  Under the 2004 Incentive Plan, grants may be made to employees, officers, directors and consultants.  The 2004 Incentive Plan limits the number of shares that can be granted to any employee in one year to 1,250,000.  Exercise price for incentive options may not be less than the fair market value of Innovo Group’s common stock on the date of grant and the exercise period may not exceed ten years.  Vesting periods and option terms are determined by the Board of Directors and/or its Compensation and Stock Option Committee, or Compensation Committee.  As of August 26, 2006, 626,839 shares remain available for issuance under the 2004 Incentive Plan.  The 2004 Incentive Plan includes a provision for the acceleration of vesting of stock options upon a change of control of Innovo Group as well as a provision that allows forfeited or unexercised options that have expired to be available again for future issuance.

The shares of common stock issued upon exercise of a previously granted stock option are considered new issuances from shares reserved for issuance in connection with the adoption of the various plans.  Innovo Group requires that the option holder provide a written notice of exercise in accordance with the option agreement and plan to the stock plan administrator and full payment for the shares be made prior to issuance.  All issuances are made under the terms and conditions set forth in the applicable plan.

The following table summarizes the stock option activity for all plans for the periods indicated (in actual amounts):

17




 

 

 

 

 

 

 

Weighted

 

 

 

 

 

 

 

Weighted

 

average

 

 

 

 

 

 

 

average

 

remaining

 

Aggregate

 

 

 

 

 

exercise

 

contractual

 

Intrinsic

 

 

 

Options

 

price

 

Life (Years)

 

Value

 

 

 

 

 

 

 

 

 

 

 

Outstanding at November 26, 2005

 

4,123,963

 

$

2.91

 

 

 

 

 

Granted

 

1,500,000

 

1.02

 

 

 

 

 

Exercised

 

 

 

 

 

 

 

Expired

 

 

 

 

 

 

 

Forfeited/ cancelled

 

(1,681,667

)

(2.24

)

 

 

 

 

Outstanding at August 26, 2006

 

3,942,296

 

$

1.73

 

8.2

 

$

9,231

 

 

 

 

 

 

 

 

 

 

 

Exercisable and vested at August 26, 2006

 

3,942,296

 

$

1.73

 

8.2

 

$

9,231

 

 

 

 

 

 

 

 

 

 

 

Weighted average per option fair value of options granted during the year

 

 

 

$

0.35

 

 

 

 

 

 

 

 

 

 

 

 

Weighted

 

 

 

 

 

 

 

Weighted

 

average

 

 

 

 

 

 

 

average

 

remaining

 

Aggregate

 

 

 

 

 

exercise

 

contractual

 

Intrinsic

 

 

 

Options

 

price

 

Life (Years)

 

Value

 

 

 

 

 

 

 

 

 

 

 

Outstanding at November 27, 2004

 

3,198,554

 

$

1.93

 

 

 

 

 

Granted

 

1,525,000

 

4.27

 

 

 

 

 

Exercised

 

(699,591

)

(1.25

)

 

 

$

2,266,339

 

Expired

 

 

 

 

 

 

 

Forfeited

 

 

 

 

 

 

 

Outstanding at August 27, 2005

 

4,023,963

 

$

2.94

 

8.5

 

$

517,116

 

 

 

 

 

 

 

 

 

 

 

Exercisable and vested at August 27, 2005

 

3,784,380

 

$

2.99

 

8.4

 

$

460,825

 

 

 

 

 

 

 

 

 

 

 

Weighted average per option fair value of options granted during the year

 

 

 

$

2.70

 

 

 

 

 

 

18




 

Information regarding stock options outstanding as of August 26, 2006 is as follows:

 

Options Outstanding

 

Options Exercisable

 

 

 

 

 

Weighted-

 

 

 

Weighted-

 

 

 

 

 

Average

 

 

 

Average

 

 

 

 

 

Remaining

 

Number of

 

Remaining

 

Exercise

 

Number of

 

Contractual

 

options

 

Contractual

 

Price

 

shares

 

Life

 

vested

 

Life

 

 

 

 

 

 

 

 

 

 

 

$

0.39

 

102,564

 

4.3

 

102,564

 

4.3

 

$

1.00

 

40,000

 

5.7

 

40,000

 

5.7

 

$

1.02

 

2,475,000

 

9.0

 

2,475,000

 

9.0

 

$

1.27

 

31,496

 

6.3

 

31,496

 

6.3

 

$

1.30

 

29,486

 

6.7

 

29,486

 

6.7

 

$

1.58

 

163,750

 

7.8

 

163,750

 

7.8

 

$

1.63

 

450,000

 

8.0

 

450,000

 

8.0

 

$

2.40

 

200,000

 

1.3

 

200,000

 

1.3

 

$

5.91

 

450,000

 

8.8

 

450,000

 

8.8

 

 

 

 

 

 

 

 

 

 

 

 

3,942,296

 

 

 

3,942,296

 

 

 

 

The following table summarizes the stock option activity by plan.

 

Total

 

2004

 

2000

 

2000

 

 

 

Number of

 

Incentive

 

Employee

 

Director

 

 

 

Shares

 

Plan

 

Plan

 

Plan

 

 

 

 

 

 

 

 

 

 

 

Outstanding at November 26, 2005

 

4,123,963

 

2,670,417

 

1,250,000

 

203,546

 

Granted

 

1,500,000

 

1,500,000

 

 

 

Exercised

 

 

 

 

 

 

Forfeited/ cancelled

 

(1,681,667

)

(631,667

)

(1,050,000

)

 

Outstanding at August 26, 2006

 

3,942,296

 

3,538,750

 

200,000

 

203,546

 

 

 

 

 

 

 

 

 

 

 

Exercisable at August 26, 2006

 

3,942,296

 

3,538,750

 

200,000

 

203,546

 

 

Stock Based Compensation

In December 2004, the Financial Accounting Standards Board, or FASB, issued Statement of Financial Accounting Standards, or SFAS, No. 123(R) “Share Based Payment,” which requires all share-based payments to employees and directors, including grants to employees and directors of stock options, to be recognized in the statement of operations based upon their fair values.  Pro forma disclosure is no longer an alternative.  Innovo Group adopted SFAS No. 123(R) utilizing the “modified prospective” basis method on November 27, 2005, the beginning of its 2006 fiscal year.  A “modified prospective” method is where compensation cost is recognized beginning on November 27, 2005 for all share-based payments granted after that date and for all awards that remain unvested as of that date.  Under the modified prospective application transition method, no cumulative effect of change in accounting principle charge is required for Innovo Group and prior periods have not been restated.  If Innovo Group had elected to recognize compensation cost for stock options based on their fair value at the grant dates consistent with

19




the method prescribed by SFAS No. 123(R), the pro forma net loss and net loss per share for the three and nine months ended August 27, 2005, would have been as follows:

 

 

August 27 ,2005

 

 

 

Three months ended

 

Nine months ended

 

 

 

(in thousands, except per share data)

 

 

 

 

 

 

 

Net income as reported

 

$

1,415

 

$

1,302

 

Add:

 

 

 

 

 

Stock based employee compensation expense included in reported net income, net of related tax effects

 

 

 

Deduct:

 

 

 

 

 

Total stock based employee compensation expense determined under fair market value based method for all awards

 

4,123

 

4,826

 

Pro forma net loss

 

$

(2,708

)

$

(3,524

)

 

 

 

 

 

 

Net income (loss) per share

 

 

 

 

 

As reported - basic

 

$

0.04

 

$

0.04

 

As reported - diluted

 

$

0.04

 

$

0.04

 

 

 

 

 

 

 

Pro forma - basic

 

$

(0.08

)

$

(0.11

)

Pro forma - diluted

 

$

(0.08

)

$

(0.11

)

 

The total stock based compensation expense for the three months ended August 26, 2006 was $19,000 and the nine months ended August 26, 2006 was $1,041,000.  For existing grants that were not fully vested, for the three months and nine months ended August 26, 2006, there was a total of $19,000 and $128,000, respectively, of stock based compensation expense.  All granted options have vested in full as of August 26, 2006.  As a result, Innovo Group does not expect to record any additional stock-based compensation expenses associated with existing options.  During the first quarter of fiscal 2006, Innovo Group also recorded a stock based compensation charge of $213,000 related to the modification of certain stock options of its former CEO pursuant to his severance agreement.  Under the general terms and conditions of the option agreements granted pursuant to the 2004 Incentive Plan, if the optionee’s Continuous Service (as defined in the 2004 Incentive Plan) is terminated for any reason other than death or Disability or Cause (as defined in the 2004 Incentive Plan), all vested options only remain exercisable for a period of three months following the termination date.  As a result of this prohibition on exercise after three months following an optionee’s termination date, under the severance agreement with its former CEO, Innovo Group agreed to delete this provision in its entirety, thus giving him the benefit of the full term of the option, or ten years from the date of grant, in which to exercise such options.

During the second quarter of fiscal 2006, Innovo Group granted options to purchase up to 1,500,000 shares of its common stock to its directors and employees pursuant to the 2004 Incentive Plan.  In May 2006, Innovo Group’s Compensation Committee of its Board of Directors approved a direct amendment under the terms of the 2004 Incentive Plan to reduce the exercise price for certain previously granted options for certain participants to $1.02, which was the closing price on May 12, 2006.  In addition, two employees forfeited previous option grants to purchase 1,050,000 shares of common stock pursuant to the 2000 Employee Plan in exchange for a grant of new options pursuant to the 2004

20




Incentive Plan.  The aggregate charges recorded for this repricing activity was approximately $413,000.  In addition in the second quarter of fiscal 2006, Innovo Group granted fully vested options to purchase 450,000 shares of common stock, in the aggregate, to members of its Board of Directors which resulted in a stock-based compensation charge of $288,000.

As a result of adopting Statement 123(R) on November 27, 2005, Innovo Group’s loss from continuing operations, loss before income taxes, net income and cash flow from operations for the three and nine months ended August 26, 2006 are $19,000 and $1,041,000 higher, respectively, than if it had continued to account for share-based compensation under Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees.”  As there were no exercises of options in the nine months ended August 26, 2006, there was no effect on cash flow from financing activities or operations related to excess tax benefits as a result of adopting Statement 123(R).  Basic and diluted loss per share for the three and nine months ended August 26, 2006 would have been $0.01 and $0.24, respectively, if Innovo Group had not adopted Statement 123(R), compared to a reported basic and diluted loss per share of $0.01 and $0.27, respectively as reported.

The fair value of each option granted and/or modified is estimated on the date of grant or the date of modification using the Black-Scholes option pricing model with the following assumptions:

 

2005

 

2006

 

Estimated dividend yield

 

0.00

%

0.00

%

Expected stock price volatility

 

82-94

%

92-94

%

Risk-free interest rate

 

3.99

%

4.28-5.01

%

Expected life of options

 

4 yrs

 

3.3-4 years

 

 

The Black-Scholes model was developed for use in estimating the fair value of traded options, which have no vesting restrictions and are fully transferable.  In addition, the assumptions used in option valuation models are subjective and can materially impact fair value estimates.  Therefore, the actual value of stock options may differ materially to values computed under the Black-Scholes model.

NOTE 11 – COMMITMENTS

On February 24, 2006, Innovo Group entered into an engagement letter with Piper Jaffray & Co., or Piper, pursuant to which Piper agreed to provide certain consulting services to Innovo Group and its Board of Directors relating to, among other things, reviewing, analyzing, presenting and assisting with strategic and financial alternatives for Innovo Group.  Under the terms of the agreement that automatically terminates on February 24, 2007 unless terminated earlier, Innovo Group paid to Piper a non-refundable retainer fee of $50,000, which may be credited against a Transaction Fee (as defined in the Agreement), if any.  In the event that Innovo Group does not consummate a transaction or terminates the agreement early, Innovo Group is obligated to pay to Piper a termination fee of $200,000 in addition to the retainer fee previously paid.  This amount represents Innovo Group’s minimum commitment under the agreement.  Innovo Group is not required to pay any Transaction Fee for the sale of its indie™ product line or the private label business.  If a transaction is entered into during the term of the agreement or within a year after termination, then Innovo Group is obligated to pay Piper a transaction fee that is equal to 2.75% of the aggregate transaction value.  Either party may terminate the agreement with or without cause upon ten (10) days advanced written notice to the other party.  Innovo Group is amortizing the $200,000 termination fee over the twelve month period of the expected life of the contract during which services are to be performed.  Innovo Group has charged to expense $100,000 in the nine months ended August 26, 2006.

21




NOTE 12 – SUPPLEMENTAL CASH FLOW INFORMATION

Significant Non-cash transactions

During the nine months ended August 27, 2005, Innovo Group converted $4,385,000 of convertible promissory notes into 2,560,000 shares of common stock pursuant to the terms of the notes.

On May 12, 2006, Innovo Group sold certain assets of its private label apparel division for a purchase price $10,437,000, which included the assumption of a note payable for $7,937,000 and the assumption of certain liabilities of the division.  The liabilities assumed included an aggregate balance due to certain of Innovo Group’s related parties in the amount of $2,500,000.  As a result of the sale of these assets, Innovo Group recognized a non-cash loss on the sale of the assets of $2,428,000.  Including approximately $186,000 of Innovo Group’s transaction costs, Innovo Group recognized an aggregate loss on the sale of the assets of $2,614,000.  Included in the aggregate loss on sale of the assets is $36,000 for certain property and equipment that Innovo Group disposed of or abandoned as part of discontinuing these operations.

Under the terms of the original asset purchase agreement entered into with Azteca in July 2003, Innovo Group issued on May 17, 2006 an additional 1,041,667 shares of its common stock as a result of its average stock price trading at less than $3.00 per share for the period between February 10, 2006 and March 12, 2006, which has been recognized in the Statement of Stockholders’ Equity.  There was no cash or consideration involved in connection with this share issuance.

NOTE 13 – SUBSEQUENT EVENTS

In September 2006, Innovo Group executed an assignment and assumption of sublease to assign its lease obligations for space in New York originally leased in connection with the launch and support of its Fetish™ and Shago® branded apparel lines.  This assignment and assumption of sublease will be effective upon Innovo Group obtaining all necessary consents and satisfaction of all conditions under the terms of the master lease and sublease agreements and satisfaction of all conditions under the assignment and assumption agreement.  In connection with the assignment and assumption, Innovo Group agreed to pay DWI Holdings, Inc., the assignee, an assignment fee of $200,000, which represents a lump sum payment for the difference in the per month rent obligation Innovo Group would owe to its landlord and the amount the assignee will be paying for the remaining term of the sublease.  Innovo Group expects to incur approximately an additional $100,000 in miscellaneous expenses associated with entering into this assignment and assumption agreement, including real estate commissions.  The original guaranty of payment for the sublease entered into by Innovo Group remains in effect until the end of the original term of the sublease, which is July 2009.

22




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

Forward-Looking Statements

When used in this Quarterly Report on Form 10-Q, or Quarterly Report, the words “may,” “will,” “expect,” “anticipate,” “intend,” “estimate,” “continue,” “believe” and similar expressions are intended to identify forward-looking statements.  Similarly, statements that describe our future expectations, objectives and goals or contain projections of our future results of operations or financial condition are also forward-looking statements.  Statements looking forward in time are included in this Quarterly Report pursuant to the “safe harbor” provision of the Private Securities Litigation Reform Act of 1995.  Such statements are subject to certain risks and uncertainties, which could cause actual results to differ materially, including, without limitation, continued acceptance of our product, product demand, competition, capital adequacy and the potential inability to raise additional capital if required, and the risk factors contained in our reports filed with the Securities and Exchange Commission, or SEC,  pursuant to the Securities Exchange Act of 1934, as amended, including our Annual Report on Form 10-K and Amendment No. 1 to our Annual Report of Form 10-K for the year ended November 26, 2005, or collectively, the Annual Report.  Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof.  Our future results, performance or achievements could differ materially from those expressed or implied in these forward-looking statements.  We do not undertake and specifically decline any obligation to publicly revise these forward-looking statements to reflect events or circumstances occurring after the date hereof or to reflect the occurrence of unanticipated events.

The following discussion provides information and analysis of our results of operations for the three and nine month period ended August 26, 2006 and August 27, 2005, and our liquidity and capital resources.  The following discussion and analysis should be read in conjunction with our notes to our accompanying condensed consolidated financial statements included elsewhere herein.

Introduction

This discussion and analysis summarizes the significant factors affecting our results of operations and financial condition during the three and nine month periods ended August 26, 2006 and August 27, 2005.  This discussion should be read in conjunction with our accompanying condensed consolidated financial statements, our notes to condensed consolidated financial statements and information in Item 1 of this Quarterly Report.  The discussion and analysis contains statements that may be considered forward-looking.  These statements contain a number of risks and uncertainties as discussed here, under the heading “Forward-Looking Statements” of this Quarterly Report that could cause actual results to differ materially.

Executive Overview

Our principal business activity has evolved into the design, development and worldwide marketing of denim apparel products.  Our products historically have consisted of Joe’s Jeans®, other branded products, such as indie™, and private label denim and denim related products.  Joe’s is designed, developed and marketed by us internally pursuant to a license agreement and indie™ is a proprietary brand owned by us.  In May 2006, we sold the assets of our private label apparel division to Cygne Designs, Inc., or Cygne, including our private label customer list, which consisted of American Eagle Outfitters, Inc., or AEO, and Target Corporation, or Target.  As a result of this transaction, we exited our private label apparel division of operations.  In January 2006, we announced that we were exiting our

23




operation of our indie™ branded apparel line and by the end of June 2006, all remaining indie™ finished goods inventory had been sold.  As a result of these divestitures, going forward our continuing operation consists of Joe’s Jeans® branded apparel line.

We do not manufacture any of our apparel products and rely on third party manufacturers to manufacture our products for distribution.  We primarily manufacture our branded apparel products in Mexico and the United States and utilize an existing manufacturing relationship with certain related parties for the manufacture of our products in Mexico.  A majority of our branded apparel products originate in Mexico and we purchase our products in various stages of production from partial to completed finished goods.  We sell our products to numerous retailers, which include major department stores, specialty stores and mass market retailers, and distributors.

Our business is seasonal.  The majority of our marketing and sales activities take place from late fall to early spring.  The greatest volume of shipments and sales are generally made from late spring through the summer, which coincides with our second and third fiscal quarters and our cash flow is strongest in our third and fourth fiscal quarters.  Due to the seasonality of our business, as well as the evolution and changes in our business and product mix and classification of certain activities as Discontinued Operations, our quarterly or yearly results are not necessarily indicative of the results for the next quarter or year.  Accordingly, our operational performance during the first and second fiscal quarters of our calendar year are historically weak for us and have, in the recent past, resulted in operating losses.  For the third quarter of fiscal 2006, we had a loss from continuing operations of $429,000 compared to $592,000 for the third quarter of fiscal 2005.  The decrease in our loss from continuing operations can be attributed to an increase in our gross profit for our Joe’s Jeans® branded apparel and our other branded product lines as we completed liquidation of the other branded finished goods inventory.  However, these increases were partially offset by an increase in depreciation and amortization expenses.

During the course of fiscal 2006, we began to implement certain strategic initiatives to restructure, improve and focus our operations on our growing Joe’s Jeans® brand.  Consistent with this intent, we entered into several transactions that allowed us to focus our efforts on our Joe’s Jeans® line.  First, in April 2006, we announced that we entered into an agreement in the ordinary course of business with Pixior LLC, or Pixior, a Los Angeles-based apparel distribution company, to outsource our product fulfillment services, including our warehousing, distribution and customer services needs for our branded apparel products.  We began operating under this agreement in the third quarter of fiscal 2006.  Second, in May 2006, after stockholder approval, we sold our private label apparel division of operations.  Third, in mid-July 2006, we moved our principal executive offices to space located within Pixior’s current space under a verbal month to month arrangement for the use of general administrative offices.  We pay Pixior $10,000 a month plus a proportional share of our occupancy costs as a facility expense.  This month to month rental payment is in addition to the fee we pay for our product fulfillment services.  Through these strategic divestitures and arrangements, we have been able to eliminate long term debt from our balance sheet and realign our efforts behind our Joe’s Jeans® brand.  In addition, we also expect to see improvement in our general and administrative expenses associated with only one line of operations.  Finally, in February 2006, we engaged Piper Jaffray & Co. to advise us on other strategic alternatives to enhance stockholder value, including but not limited to strategic acquisitions, a combination, sale or merger of us with another entity, and the raising of capital through the s