UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

For the transition period from                       to                      

Commission File Number:  0-18926

INNOVO GROUP INC.

(Exact name of registrant as specified in its charter)

 

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 o

Non-accelerated filer x

 

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 April 9, 2007 was 41,177,801.

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
Item 4T.		Controls and Procedures
PART II.		OTHER INFORMATION
Item 1.		Legal Proceedings
Item 1A.		Risk Factors
Item 2.		Unregistered Sales of Equity 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)

		02/24/07			11/25/06
		(unaudited)
ASSETS
Current assets
Cash and cash equivalents		$	1,328		$	385
Accounts receivable, net of allowance for customer credits and returns of $753 (2007) and $469 (2006)		2,447			498
Inventories, net		7,545			6,267
Due from related parties		1,061			2,163
Prepaid expenses and other current assets		1,141			671
Total current assets		13,522			9,984
Property and equipment, net		762			837
Goodwill		20			20
Intangible assets, net		188			200
Other assets		56			56
Total assets		$	14,548		$	11,097
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities
Accounts payable and accrued expenses		$	6,013		$	6,819
Due to factor		1,652			888
Due to related parties		149			82
Total current liabilities		7,814			7,789
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, 41,290 shares issued and 41,178 outstanding (2007) and 34,455 shares issued and 34,343 outstanding (2006)		4,131			3,447
Additional paid-in capital		82,678			79,763
Accumulated deficit		(77,299		)	(77,126		)
Treasury stock, 112 shares		(2,776		)	(2,776		)
Total stockholders’ equity		6,734			3,308
Total liabilities and stockholders’ equity		$	14,548		$	11,097

 

The accompanying notes are an integral part of these financial statements.

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INNOVO GROUP INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

		Three months ended
		02/24/07			02/25/06
		(unaudited)
Net sales		$	13,814		$	10,427
Cost of goods sold		8,719			8,607
Gross profit		5,095			1,820
Operating expenses
Selling, general and administrative		4,982			5,733
Depreciation and amortization		88			60
		5,070			5,793
Income (loss) from continuing operations		25			(3,973		)
Interest expense		(193		)	(129		)
Other income		3			—
Loss from continuing operations, before taxes		(165		)	(4,102		)
Income taxes		8			8
Loss from continuing operations		(173		)	(4,110		)
Income from discontinued operations, net of tax		—			418
Net loss		$	(173	)	$	(3,692	)
Earnings (loss) per common share - Basic
Loss from continuing operations		$	(0.00	)	$	(0.12	)
Income from discontinued operations		—			0.01
Loss per common share - Basic		$	(0.00	)	$	(0.11	)
Earnings (loss) per common share - Diluted
Loss from continuing operations		$	(0.00	)	$	(0.12	)
Income from discontinued operations		—			0.01
Loss per common share - Diluted		$	(0.00	)	$	(0.11	)
Weighted average shares outstanding
Basic		39,450			33,302
Diluted		39,450			33,302

 

The accompanying notes are an integral part of these financial statements.

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INNOVO GROUP, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

		Three months ended
		02/24/07			02/25/06
		(unaudited)
Cash provided by (used in) continuing activities		$	(3,442	)	$	2,524
Cash provided by (used in) discontinued operations		—			1,113
Net cash provided by (used in) operating activities		(3,442		)	3,637
CASH FLOWS FROM INVESTING ACTIVITIES
Proceeds from sales of property and equipment		2			—
Purchases of property and equipment		(4		)	(65		)
Net cash (used in) investing activities		(2		)	(65		)
CASH FLOWS FROM FINANCING ACTIVITIES
Proceeds from factor borrowing		764			—
Payments on factor borrowing		—			(2,607		)
Proceeds from issuance of common stock		3,623			—
Net cash provided by (used in) continuing activities		4,387			(2,607		)
Cash used by discontinued operations		—			(826		)
Net cash provided by (used in) financing activities		4,387			(3,433		)
NET CHANGE IN CASH AND CASH EQUIVALENTS		943			139
CASH AND CASH EQUIVALENTS, at beginning of period		385			560
CASH AND CASH EQUIVALENTS, at end of period		$	1,328		$	699
The accompanying notes are an integral part of these financial statements.

 

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INNOVO GROUP INC AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

(in thousands)

												Additional									Total
		Preferred Stock					Common Stock					Paid-In			Accumulated			Treasury			Stockholders’
		Shares		Par Value			Shares		Par Value			Capital			Deficit			Stock			Equity
Balance, November 26, 2005		—		$	—		33,414		$	3,343		$	78,823		$	(67,833	)	$	(2,776	)	$	11,557
Net loss (unaudited)		—		—			—		—			—			(3,692		)	—			(3,692		)
Stock-based compensation (unaudited)		—		—			—		—			291			—			—			291
Balance, February 25, 2006 (unaudited)		—		$	—		33,414		$	3,343		$	79,114		$	(71,525	)	$	(2,776	)	$	8,156
Balance, November 25, 2006		—		$	—		34,455		$	3,447		$	79,763		$	(77,126	)	$	(2,776	)	$	3,308
Net loss (unaudited)		—		—			—		—			—			(173		)	—			(173		)
Stock-based compensation (unaudited)		—		—			—		—			5			—			—			5
Issuance of common stock and warrants (unaudited)		—		—			6,835		684			2,910			—			—			3,594
Balance, February 24, 2007 (unaudited)		—		$	—		41,290		$	4,131		$	82,678		$	(77,299	)	$	(2,776	)	$	6,734

 

The accompanying notes are an integral part of these financial statements.

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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 months ended February 24, 2007 and February 25, 2006 and the related footnote information have been prepared on a basis consistent with Innovo Group’s audited consolidated financial statements as of November 25, 2006 contained in Innovo Group’s Annual Report on Form 10-K and Amendment No. 1 to its Annual Report on Form 10-K/A for the year ended November 25, 2006, or collectively, 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.

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 months ended February 24, 2007 are not necessarily indicative of the results anticipated for the entire year ending November 24, 2007.

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.  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) the craft and accessories division operated under its Innovo Inc. subsidiary, or Innovo, sold in May 2005; (2) the former headquarters in Springfield, Tennessee that were used as a commercial rental property operated under its Leaseall Management Inc. subsidiary, or Leaseall, sold in February 2006; and (3) the private label apparel division operated under 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.”  Certain reclassifications have been made to prior period consolidated financial statements to conform to the current year presentation.

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NOTE 2 – SEASONALITY

The market for apparel products is seasonal.  The majority of Innovo Group’s marketing and sales activities take place from late fall to early spring and the greatest volume of shipments and sales are generally made from late spring through the summer.  This time period coincides with Innovo Group’s second and third fiscal quarters and its cash flow is generally strongest in its third and fourth fiscal quarters when a significant amount of its net sales are realized as a result of shipping orders taken during earlier months.  In the second quarter in order to prepare for peak sales that occur during the second half of the year, Innovo Group builds its inventory levels, which results in higher liquidity needs compared to other quarters.  During this period, Innovo Group typically relies on its relationship with CIT Commercial Services, a unit of CIT Group, Inc., or CIT, for the sale of its account receivables and inventory advances to meet its cash flow requirements during the build up period immediately preceding the peak season.  Innovo Group’s working capital requirements during and in anticipation of its peak selling season require management to make and evaluate its estimates and judgments that affect its assets, liabilities, sales and expenses and any related contingencies.

Due to the seasonality of its business, as well as the evolution and changes in its business and product mix, Innovo Group’s quarterly or yearly results are not necessarily indicative of the results for the next quarter or year.

NOTE 3 – INVENTORIES

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

 

Innovo Group recorded charges to its inventory reserve allowance of $0 and $996,000 for the three months ended February 24, 2007 and February 25, 2006, respectively.

NOTE 4 —RELATED PARTY TRANSACTIONS

As of February 24, 2007 and November 25, 2006, 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)
		2/24/07			11/25/06
Commerce Investment Group and affliates		$	1,061		$	2,163
JD Design		(149		)	(82		)
Due (to) from related parties, net		$	912		$	2,081

 

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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 Production International, Inc., or Azteca, AZT International SA de CV, or AZT, 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, AZT and/or Commerce, entities in which Hubert Guez and Paul Guez have controlling interests.

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

		Three months ended
		(in thousands)
		2/24/07			2/25/06
Continuing operations
Purchase order arrangements		$	5,322		$	415
Verbal facilities arrangement		—			138
Discontinued operations
Supply agreement / Purchase order arrangements		—			9,480
Earn-out due to Sweet Sportswear		—			138
Verbal facilities agreement		—			181
Principal and interest on note payable		—			539

 

Continuing Operations - Purchase Order Arrangement

Innovo Group utilizes AZT as a supplier on a purchase order basis for certain of its Joe’s® denim products.  Under this arrangement, Innovo Group advances the funds to purchase raw materials, primarily 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 from AZT 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, thereby terminating its obligation to pay Azteca under the verbal facilities arrangement.

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Discontinued Operations — Supply Agreement/Purchase Order Arrangements

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 e Designs, Inc., or Cygne, as discussed in “Note 5 — Discontinued Operations,” 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 asset purchase agreement with Cygne, 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 asset purchase agreement with Cygne, Cygne assumed the remaining principal balance of the Blue 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 it 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 — Supply and Distribution Agreement

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.

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Aggregate balances by entities

As of February 24, 2007 and November 25, 2006, respectively, the balances due (to) or from these related parties and certain of their affiliates are as follows:

 

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 5 — Discontinued Operations,” 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 net balance of $5,000 due to Cygne represents the amount Innovo Group owes to Cygne as a result of certain chargebacks granted by Cygne on Innovo Group’s behalf to former customers.

Joe’s Jeans License

On February 7, 2001, Innovo Group acquired a license for the rights to the Joe’s 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.  In December 2006, JD Design transferred, through a merger, all of its assets to JD Holdings, Inc., or JD Holdings.  For purposes of this Quarterly Report on Form 10-Q, any previous transactions with JD Design will utilize the name JD Holdings as its successor.

Additionally, Joe Dahan, the designer of the Joe’s line and sole stockholder of JD Holdings, joined Innovo Group as President of its wholly owned subsidiary, Joe’s Jeans, Inc.  Under his 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 Holdings.  In October 2005, Innovo Group granted JD Holdings 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 Holdings 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.  See “Note 13 — JD Holdings Transaction” for a further discussion about a subsequent transaction between Innovo Group and JD Holdings.

For the three months ended February 24, 2007 and February 25, 2006, the following table sets forth royalties, fees and income related to JD Holdings.

		Three months ended
		(in thousands)
		2/24/07			2/25/06
Expense (income):
Joe’s Jeans royalty expense		$	395		$	302
indie Design fee		—			15
Children’s license, royalty income		—			(15		)

 

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NOTE 5 – DISCONTINUED OPERATIONS

Beginning in fiscal 2004, Innovo Group classified certain of its operations as discontinued as a result of such operations meeting certain accounting criteria of an asset held for sale.  As a result, in fiscal 2004, its commercial rental property consisting of four separate buildings that served as its former headquarters located in Springfield, Tennessee and the remaining assets of its craft and accessory business segment conducted through its Innovo Inc. subsidiary were both first classified as a discontinued operations.  On May 17, 2005, Innovo Group’s Innovo subsidiary completed the sale of the assets of its craft and accessory segment of operations.  In February 2006, Innovo Group’s Leaseall Management subsidiary 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 repaid 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 February 24, 2007, $4,000 of the promissory note has been included on its balance sheet under “Other current assets” and $46,000 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 January 2006, in connection with the Board of Directors decision to focus operations on its Joe’s® brand, Innovo Group began to look for a purchaser for its private label apparel division operated by its IAA subsidiary that was originally purchased in July 2003 from Azteca.  On May 12, 2006, Innovo Group completed the sale of its private label apparel division and accordingly, reported it as a discontinued operation.  As such, all prior periods have been reclassified to reflect this operating division as a discontinued operation.

Under the asset purchase agreement for the private label division entered into with Cygne the assets sold included 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.  In exchange for the purchased assets, Cygne assumed certain liabilities associated with the private label division, including, the remaining obligation under the original promissory note executed in favor of Azteca, all other liabilities, excluding the original promissory note, owed in connection with our operation of 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 asset purchase agreement, the obligation to continue to pay the earn-out under the original asset purchase agreement with Azteca and 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 was approximately $10,437,000 as of the closing date.  Innovo Group also 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 in the transaction less the net book value of the private label assets and Innovo Group’s resulting loss on the sale of these private label assets recorded during the second quarter of fiscal 2006 (in thousands):

 

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In accordance with the provisions of SFAS No. 144 “Accounting for the Impairment or Disposal of Long-Lived Assets,” the accompanying consolidated financial statements reflect the results of operations and financial position of the commercial rental property, the craft and accessory business segment and the private label apparel division separately as a discontinued operation and in the related discussions and comparisons between current and prior fiscal years.

As of February 24, 2007 and as of November 25, 2006, respectively, there were no assets and liabilities of the discontinued operations that were presented in the consolidated balance sheets.

The following is a summary of loss and other information of the discontinued operations for the three months ended February 25, 2006.  There was no loss and other information of the discontinued operations for the three months ended February 24, 2007.

		(in thousands)
		Private Label						Leaseall
		Business			Innovo, Inc.			Management			Total
Three months ended February 25, 2006
Net sales		$	11,502		$	—		$	—		$	11,502
Pre-tax income (loss) from operations		452			1			(35		)	418
Income taxes		—			—			—			—
Discontinued operations, net of tax		$	452		$	1		$	(35	)	$	418

 

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

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

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

		02/24/07			11/25/06
Non-recourse receivables assigned to factor		$	6,108		$	7,354
Recourse receivables assigned to factor		1,612			2,717
Total receivables assigned to factor		7,720			10,071
Allowance for customer credits and doubtful accounts		(806		)	(821		)
Net advances from factor		(8,566		)	(10,138		)
Due to factor		$	(1,652	)	$	(888	)
Non-factored accounts receivable		3,200			967
Allowance for customer credits and doubtful accounts		(753		)	(469		)
Accounts receivable and due from factor, net of allowance		$	2,447		$	498

 

As of February 24, 2007 and November 25, 2006, there were $1,612,000 and $2,717,000, respectively, of client recourse receivables, including advances under its inventory security agreement, sold to or advanced by factor.  Innovo Group bears the risk of payment in the event of non-payment by the customers for the client recourse receivables sold 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 the ability to obtain cash by selling to CIT certain of its accounts receivable for up to 85% of the face amount of the receivables, on either a recourse or non-recourse basis depending on the creditworthiness of the customer.  The Factoring Facilities also allow Innovo Group to obtain advances for up to 50% of the value of certain eligible inventory.  Innovo Group currently obtains funds under the Factoring Facilities at 85% of factored invoices and under the inventory security agreement up to approximately $2,700,000 of maximum availability.  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 loans or advances made to Innovo Group 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. This personal guarantee by Mr. Furrow has contributed to Innovo Group’s ability to obtain cash under its existing Factoring Facilities.  In addition, in October 2006, JD Holdings granted to CIT a security interest in the Joe’s® trademarks and executed a non-recourse guaranty in favor of CIT to allow Innovo Group to obtain additional advances under its inventory security agreement.  In connection with this security interest and guaranty, Innovo Group entered into an agreement with JD Holdings to provide protection to JD Holdings through the potential issuance of a maximum of 6,834,347 shares of its common stock as collateral for the non-recourse guaranty and security interest granted to CIT.

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As of February 24, 2007, Innovo Group’s availability with CIT was approximately $185,000 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 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 February 24, 2007, 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.

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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:

		Three months ended
		(in thousands, except per share data)
		02/24/07			02/25/06
Basic Earnings per share Computation:
Numerator:
Loss from continuing operations		$	(173	)	$	(4,110	)
Income from discontinued operations		—			418
Net loss		$	(173	)	$	(3,692	)
Denominator:
Weighted average common shares outstanding		39,450			33,302
Loss per Common Share - Basic
Loss from continuing operations		$	(0.00	)	$	(0.12	)
Income from discontinued operations		—			0.01
Net loss		$	(0.00	)	$	(0.11	)
Diluted Earnings per share Computation:
Numerator:
Loss from continuing operations		$	(173	)	$	(4,110	)
Income from discontinued operations		—			418
Net loss		$	(173	)	$	(3,692	)
Denominator:
Weighted average common shares outstanding		39,450			33,302
Effect of dilutive securities:
Options and warrants		—			—
Convertible notes		—			—
Dilutive potential common shares		39,450			33,302
Loss per Common Share - Dilutive
Loss from continuing operations		$	(0.00	)	$	(0.12	)
Income from discontinued operations		—			0.01
Net loss		$	(0.00	)	$	(0.11	)

 

Potentially dilutive convertible notes, options and warrants in the aggregate of 7,045,933 and 4,902,296 on February 24, 2007 and February 25, 2006, respectively, have been excluded from the calculation of the diluted loss per share as their effect would have been anti-dilutive.

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NOTE 8 –INCOME TAXES

Innovo Group’s income tax expense represents estimated state income and franchise tax expense.  For the three months ended February 24, 2007, Innovo Group recorded $8,000 of income tax expense.  For fiscal 2007 and 2006, the effective tax rate differed 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 9 – STOCKHOLDERS’ EQUITY

Recent Issuances of Common Stock

In July 2003, Innovo Group entered into an asset purchase agreement with Azteca for the purchase of Azteca’s private label division.  In connection with the agreement, Innovo Group was obligated to issue additional shares of its common stock in the event that it traded at an average stock price of less than $3.00 per share for the period between February 10, 2006 and March 12, 2006.  On May 17, 2006, Innovo Group issued an additional 1,041,667 shares as a result of this provision in this agreement.  The share issuance has been recognized in the Statement of Stockholders’ Equity.

In December 2006, Innovo Group issued 6,834,347 shares of its common stock at a purchase price of $0.53 per share, two warrants to purchase up to 2,050,304 shares of common stock each with an exercise price of $0.58 per share and one warrant to purchase up to 125,000 shares of common stock with an exercise price of $0.66 per share in a private placement transaction.  See “Note 11- Private Placement Transaction” for a further discussion of this equity financing transaction.

Warrants

Innovo Group has issued warrants in conjunction with various private placements of its common stock, debt to equity conversions, acquisitions and in exchange for services. All warrants are currently exercisable.  In December 2006, in connection with the equity financing private placement transaction, Innovo Group issued two warrants to purchase up to 2,050,304 common stock each with an exercise price of $0.58 per share and one warrant to purchase up to 125,000 shares of common stock with an exercise price of $0.66 per share.  See “Note 11- Private Placement Transaction” for a further discussion of this equity financing transaction.  As of February 24, 2007, outstanding common stock warrants are as follows:

 

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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.  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.  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.  On May 12, 2006, 1,050,000 options were forfeited by employees under the 2000 Employee Plan.  As of February 24, 2007, options to purchase up to 200,000 remained outstanding under the 2000 Employee Plan.  These options will expire, if unexercised, on December 11, 2007.

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 expire 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.  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.  As of February 24, 2007, options to purchase up to 203,546 remained outstanding under the 2000 Director Plan.  These options expire, if unexercised, on dates ranging from 2010 to 2013.

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.  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.  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 Stock 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 Stock 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 Stock Incentive Plan in exchange for a grant of new options pursuant to the 2004 Stock Incentive Plan.  As of February 24, 2007, 377,256 shares remain available for issuance under the 2004 Incentive Plan.

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.

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The following summarizes option grants to members of the Board of Directors for the fiscal years 2002 through first quarter of 2007 (in actual amounts):

		Number of		Exercise
		options		price
2002		40,000		$	1.00
2002		31,496		$	1.27
2003		30,768		$	1.30
2004		320,000		$	1.58
2005		300,000		$	5.91
2006		450,000		$	1.02
2007		—		—

 

Stock option activity, including grants to members of the Board of Directors, during the periods indicated is as follows (in actual amounts):

							Weighted
				Weighted			average
				average			remaining		Aggregate
				exercise			contractual		Intrinsic
		Options		price			Life (Years)		Value
Outstanding at November 25, 2006		4,092,296		$	1.68
Granted		—		—
Exercised		—		—
Expired		—		—
Forfeited		—		—
Outstanding at February 24, 2007		4,092,296		$	1.68		7.8		$	174,841
Exercisable and vested at February 24, 2007		3,973,546		$	1.72		7.7		$	101,216
Weighted average per option fair value of options granted during the year				N/A

 

							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		—		—
Exercised		—		—
Expired		—		—
Forfeited		—		—
Outstanding at February 25, 2006		4,123,963		$	2.91		8.0		$	59,487
Exercisable and vested at February 25, 2006		4,040,630		$	2.94		8.0		$	59,487
Weighted average per option fair value of options granted during the year				N/A

 

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Exercise prices for options outstanding as of February 24, 2007 are as follows:

		Options Outstanding				Options Exercisable
				Weighted-				Weighted-
				Average				Average
				Remaining		Number of		Remaining
		Number of		Contractual		options		Contractual
Exercise Price		shares		Life		vested		Life
$0.39 - $0.40		252,564		7.2		133,814		5.2
$1.00 - $1.02		2,515,000		8.4		2,515,000		8.4
$1.27 - $1.30		60,982		6.0		60,982		6.0
$1.58 - $1.63		613,750		7.5		613,750		7.5
$2.40		200,000		0.8		200,000		0.8
$5.91		450,000		8.3		450,000		8.3
		4,092,296		7.8		3,973,546		7.7

 

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 25, 2006		4,092,296		3,688,750		200,000		203,546
Granted		—		—		—		—
Exercised		—		—		—		—
Forfeited / Cancelled		—		—		—		—
Outstanding at February 24, 2007		4,092,296		3,688,750		200,000		203,546
Exercisable at February 24, 2007		3,973,546		3,570,000		200,000		203,546

 

The total fair values of options vested at February 24, 2007 and February 25, 2006 were $4,845 and $77,017, respectively.  The aggregate intrinsic value of options vested at February 24, 2007 was $101,216.

NOTE 10 – COMMITMENTS AND CONTINGENCIES

Engagement of Piper Jaffray & Co.

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, 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

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$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.  The agreement automatically terminated on February 24, 2007.  Innovo Group amortized the $200,000 termination fee over the twelve month period of the expected life of the contract during which services were performed.

JD Holdings Collateral Protection Agreement

On October 13, 2006, JD Holdings granted a security interest in and to the Joe’s brand to CIT.  This grant by JD Holdings was for the purpose of providing CIT additional collateral under Innovo Group’s current factoring and inventory security agreements to allow Innovo Group to obtain additional working capital.  Because JD Holdings entered into the agreements with CIT, CIT agreed to increase the maximum availability advanced on inventory to Innovo Group at CIT’s discretion.

In exchange for JD Holdings agreeing to provide this grant of a security interest to CIT, Innovo Group entered into a Collateral Protection Agreement, or CPA, with JD Holdings to provide additional consideration to JD Holdings in the event that the guaranty is called upon or CIT enforces its security interest in the collateral.  The CPA, as amended, states that in the event (i) there is a default by Innovo Group under its Factoring Facilities which remains uncured for a period of thirty (30) days from written notice by CIT, (ii) demand is made to JD Holdings by CIT under the guaranty and demand is not withdrawn within 10 days of the date of receipt of such demand by JD Holdings, (iii) CIT commences an action to enforce its security interest in the collateral, (iv) there is a materially false, misleading, erroneous or incorrect representation or warranty made by Innovo Group under or in connection with the CPA; or (v) Innovo Group fails to perform or observe any term, covenant or undertaking in the CPA, or collectively, an Event of Default, then Innovo Group will be obligated to issue shares of its common stock to JD Holdings as consideration for JD Holdings satisfying its obligations to CIT.  Innovo Group reserved 6,834,347 shares as the maximum number of shares that could potentially be issued under the CPA, or the Default Reserve, which represents 19.9% of its total shares outstanding, even though, after the amendment, the maximum number of shares that may be issued would be less.  If an Event of Default occurs, then the amount of shares to be issued would be calculated by dividing the amount owed by Innovo Group to CIT (not to exceed $2,000,000) by the greater of (i) $0.52 or (ii) the closing price of the Company’s shares of common stock as reported by Nasdaq on the date that JD Holdings fulfills its obligations to CIT.

The CPA further provides for additional consideration to be paid to JD Holdings in certain instances, such as failure by Innovo Group to obtain CIT’s consent to terminate the agreements with JD Holdings by April 13, 2007.  In the event that the agreements are not terminated by this date, Innovo Group will be obligated to issue to JD Holdings 200,000 shares of its common stock.  Additionally, if on April 13, 2008, the agreements with JD Holdings are still in effect, then Innovo Group will be required to pay to JD Holdings $25,000 for each quarterly period that the documents remain in effect.  If one or both of these additional distributions are made, JD Holdings will still be entitled to the default shares in the amount and instances described above.  However, if the 200,000 shares are issued, the Default Reserve will be reduced by 200,000.

Innovo Group believes that the possibility of event of default is remote and therefore, an estimate for the contingent liability associated with this CPA cannot be determined at this time.  Further, if an event of default were to occur, the exact amount of the liability would be determined at that time and based upon the amount of the default, not to exceed $2,000,000.

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NOTE 11 – PRIVATE PLACEMENT TRANSACTION

In December 2006, Innovo Group consummated a private placement of its common stock and warrants to purchase common stock to two “accredited investors” pursuant to Rule 506 of Regulation D under the Securities Act.  The proceeds from the transaction were used for general working capital purposes.  The transaction raised gross proceeds of approximately $3,623,000 initially and approximately $4,811,000 assuming the full exercise of all of the warrants issued in connection with the private placement.

Innovo Group issued 6,834,347 shares at a purchase price of $0.53 per share and warrants to purchase an additional 2,050,304 shares of common stock to these investors at an exercise price of $0.58 per share.  In addition, on December 26, 2006, Innovo Group issued an additional 125,000 warrants with an exercise price of $0.66 per share to an individual, also an accredited investor, in exchange for introducing one of the investors to the company.

Each of the warrants issued includes a cashless exercise option, pursuant to which the holder can exercise the warrant without paying the exercise price in cash.  If the holder elects to use this cashless exercise option, it will receive a fewer number of our shares than it would have received if the exercise price were paid in cash.  The number of shares of common stock a holder of the warrant would receive in connection with a cashless exercise is determined in accordance with a formula set forth in the warrant.  The warrants issued in connection with the private placement have a term of five years and are first exercisable on June 18, 2007 and June 25, 2007, respectively.

Innovo Group used the Black-Sholes pricing model to determine the fair value of each of the warrants granted in connection with this transaction.  Innovo Group determined the fair value of the warrants at the date of grant using the Black-Sholes option pricing model based on the market value of the underlying common stock, a volatility rate of 82.80% and 82.84%, respectively, based upon the implied volatility in market traded stock over the same period as the vesting period, zero dividends, a risk free interest rate of 4.56% and an expected life of 5 years.  The aggregate fair value of $56,000 of the 125,000 warrants issued was treated as a deal cost. In addition, Innovo Group incurred $29,000 in other transaction costs through February 24, 2007.  All transaction costs to date have been charged against the gross proceeds and the net proceeds of $3,594,000 were allocated to the common stock and warrants based upon fair values.

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NOTE 12 - DISSOLUTION OF MASTER DISTRIBUTION AGREEMENT

On February 1, 2007, Innovo Group and its international distributor, Beyond Blue Inc., or BBI, mutually agreed to dissolve the master distribution agreement pursuant to which BBI distributed Innovo Group’s Joe’s® products internationally.  Under the terms of the dissolution, Innovo Group has been assigned the rights associated with the sub-distributors in various countries.  The parties have each reserved certain rights under the master agreement in an effort to resolve outstanding issues related to each party’s obligations.

NOTE 13 - JD HOLDINGS TRANSACTION

On February 6, 2007, Innovo Group entered into a merger agreement with JD Holdings, the successor in interest to JD Design.  In exchange for the right to the Joe’s® brand and subject to approval by its stockholders, Innovo Group expects to issue to JD Holdings 14,000,000 shares of its common stock, $300,000 in cash and enter into an employment agreement with Joe Dahan, the sole stockholder of JD Holdings.  In the event that the merger is approved, the license agreement will terminate and Innovo Group will own all rights, title to and interest in the brand and the marks.

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