Cygne Designs (CYDS) 10-Q 2007 Q1 Quarterly report

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 October 31, 2006

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

For the transition period from            to            

Commission File No. 0-22102

CYGNE DESIGNS, INC.

(Exact name of Registrant as specified in its charter)

Delaware	04-2843286
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)

11 West 42nd Street, New York, New York	10036
(Address of principal executive offices)	(Zip Code)

(212) 997-7767

(Registrant’s telephone number, including area code)

No Change

(Former name, address, and former fiscal year, if changed since last report)

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes  ¨    No  x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15 (d) of the Act.    Yes  ¨    No  x

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 Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    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 Act.

Large accelerated filer  ¨    Accelerated filer  ¨    Non-accelerated filer  x

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12 b-2 of the Act).    Yes  ¨    No  x

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practical date.

Common Stock, $0.01 par value, 26,462,109 shares as of December 15, 2006.

Cygne Designs, Inc. and Subsidiaries

Index to Form 10-Q

Part I. Financial Information
Item 1. Unaudited Financial Statements
Consolidated Balance Sheets at October 31, 2006 and January 31, 2006	1
Consolidated Statements of Operations for the three and nine months ended October 31, 2006 and October 31, 2005	2
Consolidated Statements of Stockholders’ Equity for the nine months ended October 31, 2006	3
Consolidated Statements of Cash Flows for the nine months ended October 31, 2006 and October 31, 2005	4
Notes to Consolidated Financial Statements	6
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations	27
Item 3. Quantitative and Qualitative Disclosures About Market Risk	46
Item 4. Controls and Procedures	46
Part II. Other Information
Item 1. Legal Proceedings	47
Item 1A. Risk Factors	47
Item 5. Other Information	47
Item 6. Exhibits and Reports on Form 8-K	48
Signatures	49

Cygne Designs, Inc. and Subsidiaries

Consolidated Balance Sheets

(In thousands, except share and per share amounts)

	October 31, 2006			January 31, 2006
	(unaudited)			(Restated)
Assets
Current assets:
Cash and cash equivalents	$	1,086		$	977
Non-factored trade accounts receivable		2,770			70
Due from factor		14,350			15,443
Due from related parties, net		123			—
Inventories		1,531			4,489
Marketable securities		58			23
Other receivables and prepaid expenses		68			306
Total current assets		19,986			21,308
Fixed assets, net		673			724
Intangible assets, net		6,259			2,475
Goodwill		71,881			66,576
Deposits		68			68
Total assets	$	98,867		$	91,151
Liabilities and Stockholders’ Equity
Current liabilities:
Advances from factor	$	14,388		$	15,887
Current portion of long term note payable to a related party		3,157			729
Due to related parties, net		—			550
Accounts payable		223			1,524
Accrued expenses		1,137			967
Income taxes payable		594			585
Total current liabilities		19,499			20,242
Secured subordinated promissory note payable to a related party, net		26,031			28,420
Deferred taxes		2,025			785
Total liabilities		47,555			49,447
Commitments and contingencies ( note 11)
Stockholders’ equity:
Preferred Stock, $0.01 par value; 1,000,000 shares authorized: none issued and outstanding		—			—
Common Stock, $0.01 par value; 100,000,000 shares authorized: 26,462,109 and 24,454,459 shares issued and outstanding, at October 31, 2006 and January 31, 2006, respectively		265			245
Paid-in capital		168,565			161,046
Deferred compensation		—			(255	)
Accumulated other comprehensive income (loss)		18			(17	)
Accumulated deficit		(117,536	)		(119,315	)
Total stockholders’ equity		51,312			41,704
Total liabilities and stockholders’ equity	$	98,867		$	91,151

See accompanying notes.

1

Cygne Designs, Inc. and Subsidiaries

Consolidated Statements of Operations

(In thousands except per share amounts)

	Three Months Ended					Nine Months Ended
	October 31, 2006		October 31, 2005			October 31, 2006		October 31, 2005
	(unaudited)
			(Restated)					(Restated)
Net sales	$	32,980	$	22,935		$	98,991	$	32,552
Cost of goods sold (1)		26,601		17,645			77,672		26,338
Gross profit		6,379		5,290			21,319		6,214
Selling, general and administrative expenses (1)		3,248		3,883			12,913		5,202
Depreciation and amortization		486		801			1,314		933
Provision for restructuring		—		—			—		102
Income (loss) from operations before interest and income taxes		2,645		606			7,092		(23	)
Interest income		—		—			—		(22	)
Interest expense including amortization of debt discount (1)		1,436		716			4,019		716
Income (loss) from operations before income taxes		1,209		(110	)		3,073		(717	)
Provision for income taxes		444		410			1,294		420
Net income (loss)	$	765	$	(520	)	$	1,779	$	(1,137	)
Net income (loss) per share-basic and diluted	$	0.03	$	(0.02	)	$	0.07	$	(0.07	)
Weighted average common shares outstanding:
Basic		26,462		22,958			25,727		16,002
Diluted		26,463		22,958			25,730		16,002

(1). Related Parties amounts included in the following line items:

	Three Months Ended				Nine Months Ended
	October 31, 2006		October, 31, 2005		October 31, 2006		October 31, 2005
Cost of goods sold	$	21,502	$	15,450	$	68,953	$	15,450
Selling, general and administrative expenses	$	260	$	1,871	$	3,790	$	1,871
Interest expense	$	470	$	561	$	1,540	$	561

See accompanying notes.

2

Cygne Designs, Inc. and Subsidiaries

Consolidated Statement of Stockholders’ Equity

For The Nine Months Ended October 31, 2006

(In thousands)

	Number of Common Shares	Amount		Paid-In Capital			Deferred Compensation			Accumulated Other Comprehensive Income (Loss)			Accumulated Deficit			Total
Balance at January 31, 2006 (As restated)	24,455	$	245	$	161,046		$	(255	)	$	(17	)	$	(119,315	)	$	41,704
Net income for the nine months ended October 31, 2006	—		—		—			—			—			1,779			1,779
Unrealized gain on marketable securities	—		—		—			—			35			—			35
Comprehensive income for the nine months ended October 31, 2006	—		—		—			—			—			—			1,814
Issuance of common stock as part of acquisition purchase price	2,000		20		7,660			—			—			—			7,680
Exercise of stock options	7		—		1			—			—			—			1
Stock-based compensation	—		—		4			—			—			—			4
Amortization of restricted stock	—		—		73			36			—			—			109
Adoption of FAS 123R	—		—		(219	)		219			—			—			—
Balance at October 31, 2006 (unaudited) (As restated)	26,462	$	265	$	168,565		$	—		$	18		$	(117,536	)	$	51,312

See accompanying notes.

3

Cygne Designs, Inc. and Subsidiaries

Consolidated Statements of Cash Flows

(In thousands)

	For the Nine Months Ended
	October 31, 2006			October 31, 2005
	(Unaudited)
				(Restated)
Operating activities
Net income (loss)	$	1,779		$	(1,137	)
Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:
Depreciation and amortization of fixed assets		98			208
Amortization of intangible assets		1,216			726
Amortization of debt discount		1,540			—
Deferred income tax provision		1,240			392
Allowance for customer chargebacks and trade discounts		(555	)		—
Non-cash stock compensation		113			—
Changes in operating assets and liabilities:
Non-factored trade accounts receivable		(2,700	)		837
Due from factor		1,648			(14,289	)
Inventories		2,958			(2,190	)
Other receivables and prepaid expenses		237			144
Other assets		—			(24	)
Due to related parties		(4,423	)		896
Accounts payable		(1,301	)		872
Accrued expenses		115			224
Income taxes payable		9			20
Net cash provided by (used in) operating activities		1,974			(13,321	)
Investing activities
Purchase of denim business from Diversified Apparel Resources LLC		(250	)		(3,419	)
Purchase of private label division from Innovo Group Inc.		(70	)		—
Purchase of fixed assets		(47	)		(39	)
Net cash used in investing activities		(367	)		(3,458	)
Financing activities
Exercise of stock options		1			6
Advances from factor		72,290			23,918
Repayment of advances to factor		(73,789	)		(10,408	)
Net cash ( used in) provided by financing activities		(1,498	)		13,516
Net change in cash and cash equivalents		109			(3,263	)
Cash and cash equivalents at beginning of period		977			3,575
Cash and cash equivalents at end of period	$	1,086		$	312

See accompanying notes.

4

Cygne Designs, Inc. and Subsidiaries

Consolidated Statements of Cash Flows (continued)

(In thousands)

		For the Nine Months Ended
		October 31, 2006		October 31, 2005
	��	(Unaudited)
Supplemental Disclosures of Cash Flow Information
Income taxes paid		$	45	$	8
Interest paid		$	1,069	$	155
Non-cash transactions recognized in connection with the acquisition of the private label division of Innovo Group, Inc.
Issuance of two million shares of common stock		$	7,680	$	—
Assumption of debt		$	2,500	$	—
Accrued transaction costs		$	11	$	—
Non-cash transactions recognized in connection with the payments required by the Secured Subordinated Promissory Note to Diversified Apparel Resources LLC (“Diversified Apparel”)
Principal payment offset against amount due from Diversified Apparel		$	1,500	$	—
Interest payment offset against amount due from Diversified Apparel		$	2,530	$	—

See accompanying notes.

5

Cygne Designs, Inc. and Subsidiaries

Notes to Consolidated Financial Statements

1. Summary of Significant Accounting Policies

Basis of Presentation

The accompanying unaudited consolidated financial statements of Cygne Designs, Inc. (“Cygne”) and its subsidiaries (collectively the “Company”) 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 consolidated financial statements should be read in conjunction with the amended audited consolidated financial statements and the related notes thereto contained in Cygne Designs, Inc.’s Annual Report on Form 10-K/A. In the opinion of management, the accompanying unaudited financial statements contain all adjustments (consisting of normal recurring accruals) which management considers necessary to present fairly the Company’s financial position, results of operations and cash flows for the interim period presented. Operating results for the three and nine months ended October 31, 2006 are not necessarily indicative of the results that may be expected for the fiscal year ended January 31, 2007. The balance sheet at January 31, 2006 has been derived from the amended audited financial statements at that date. See Note 13 for information with respect to the restatements of our Financial Statements as of January 31, 2006 and the three and six months ended July 31, 2006.

Organization and Principles of Consolidation

The consolidated financial statements include the accounts of Cygne and its subsidiaries. All inter-company balances and transactions were eliminated in consolidation.

Income Taxes

The Company follows SFAS No. 109, “Accounting for Income Taxes.” Under the asset and liability method of SFAS No. 109, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. The Company has recorded a valuation allowance against the net deferred tax asset due to the Company’s history of losses and near break-even results. However, should the Company conclude that utilization of deferred tax assets is more likely than not, the value of the deferred tax asset would be increased by eliminating some or all of the valuation allowance. The deferred tax assets are net of deferred tax liabilities except for deferred tax liabilities originating from the Company’s taxable business combinations that resulted in tax-deductible goodwill. In these instances, deferred tax liabilities accumulate over time as goodwill is deducted on tax returns but not amortized for financial reporting purposes. These deferred tax liabilities will reverse if impairment charges are recognized or when the business is disposed of through sale or otherwise. Because of the uncertainty of the timing of the reversal of the deferred tax liability related to the goodwill temporary difference, these deferred tax liabilities are not netted against the Company’s deferred tax assets in determining the valuation allowance.

Contingencies

The Company accounts for contingencies in accordance with Statement of Financial Accounting Standards No. 5, “Accounting for Contingencies” (“SFAS No. 5”). SFAS No. 5 requires that the Company record an estimated loss from a loss contingency when information available prior to issuance of the consolidated financial statements indicates that it is probable that an asset has been impaired or a liability has been incurred at the date of the financial statements and the amount of the loss can be reasonably estimated.

Rent Expense

Expenses related to the Company’s facility leases are recorded on a straight-line basis over the lease terms. Differences between the rent expenses incurred and the amounts paid are recorded as deferred rent and are amortized over the lease terms.

6

Cygne Designs, Inc. and Subsidiaries

Notes to Consolidated Financial Statements (continued)

1. Significant Accounting Policies (continued)

Segment Information

Based on the criteria in SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information,” the Company operates in one segment of the apparel market: women’s denim, casual, and career apparel.

Use of Estimates

The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Cash and Cash Equivalents

The Company considers all highly liquid financial instruments with maturity of three months or less when purchased to be cash equivalents.

Marketable Securities

The Company’s marketable securities are comprised of a public corporate security at October 31, 2006 and January 31, 2006. All investments are classified as available for sale and are recorded at market using the specific identification method. Realized gains and losses are reflected in other income and expense while unrealized gains and losses are included as a separate component of stockholders’ equity, except when a decline in the value of a security is believed to be other than temporary, in which case the loss will be recognized and reflected in other income and expense.

Fair Value of Financial Instruments

Carrying amounts of certain financial instruments of the Company, including cash, cash equivalents, marketable securities, accounts receivable, accounts payable, and other accrued liabilities, approximate fair value due to their short maturities. The fair values of investments are determined using quoted market prices for those securities. The fair value of amounts due to/from related parties is not known based on the related party nature of these amounts. The fair value of the secured subordinated promissory note payable to a related party is believed to approximate its carrying value, as the note’s face amount was reduced to reflect a market rate of interest based upon a third-party valuation at inception.

Inventories

Inventories are stated at the lower of cost (determined on a first-in, first-out basis) or market.

Depreciation and Amortization

Depreciation of property and equipment is provided for by the straight-line method over the estimated useful lives of the assets. Leasehold improvements are amortized using the straight-line method over the lesser of the useful life or the term of the related lease.

Intangible assets are amortized over the estimated lives, ranging from three months to seven years, using the straight-line method.

7

Cygne Designs, Inc. and Subsidiaries

Notes to Consolidated Financial Statements (continued)

1. Significant Accounting Policies (continued)

Impairment of Long-Lived and Intangible Assets

Long-lived assets consist of property and equipment, and intangible assets and goodwill. Intangible assets are comprised of trademarks, costs to create product lines, and the value of customer relationships from the acquisition of the denim apparel business of Diversified Apparel (“Acquired Business”) and customer relationships from the acquisition of the private label division of Innovo Group Inc. (“Innovo Acquisition”). In accordance with SFAS 142, “Goodwill and Other Intangible Assets,” the Company assesses the impairment of identifiable intangibles and goodwill at least annually in the case of goodwill, and whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors the Company considers to be important which could trigger an impairment review include the following:

• Significant underperformance relative to expected historical or projected future operating results;

• Significant changes in the manner of use of the acquired assets or the strategy for the overall business; and

• Significant negative industry or economic trends.

When the Company determines that the carrying value of long-lived assets and goodwill may not be recoverable based upon the existence of one or more of the above indicators of impairment and the carrying value of the asset cannot be recovered from projected undiscounted cash flows, the Company records an impairment charge. The Company measures goodwill impairment based on a projected discounted cash flow method using a discount rate determined by management to be commensurate with the risk inherent in the current business model. Significant management judgment is required in determining whether an indicator of impairment exists and in projecting cash flows. The Company measures impairment on long-lived assets on the cash flow method.

Revenue Recognition

Revenues are recorded at the time of shipment of merchandise, provided that the price is fixed, title has been transferred, collection of the resulting receivable is reasonably assured and the Company has no significant obligations remaining to be performed. The Company establishes allowances for customer chargebacks and trade discounts. Such reserves amounted to $1,407,000 and $1,962,000 at October 31, 2006 and January 31, 2006, respectively.

Cost of Goods Sold

Cost of goods sold includes costs of finished products purchased from Diversified Apparel and costs of products manufactured in the Company’s Guatemalan facility. Manufacturing costs of products manufactured in the Company’s Guatemala facility is comprised of raw materials, raw material special treatments, custom duties, freight, direct labor and manufacturing overhead.

Selling, General and Administrative Expenses

Selling general and administrative expenses (“SG&A”) include expenses related to compensation, selling commissions, travel and entertainment, samples, rent, office expenses, professional fees, insurance, restrictive covenant fees, earn-out fees, factor fees, director fees and other public company expenses. All of the Company’s restrictive covenant fees and distribution expenses during the three and nine months ended October 31, 2006 were incurred under either the Restrictive Covenant Agreement or the Distribution Agreement with Diversified Apparel and the earn-out fees were incurred under the provision of Innovo Acquisition agreement. See Note 2.

8

Cygne Designs, Inc. and Subsidiaries

Notes to Consolidated Financial Statements (continued)

1. Significant Accounting Policies (continued)

Product Design, Advertising and Sales Promotion Costs

Product design, advertising and sales promotion costs are expensed as incurred and included in the category of SG&A. Product design, advertising and sales promotion costs included in operating expenses in the accompanying statements of operations amounted to approximately $238,000 and $721,000 for the three and nine months ended October 31, 2006 respectively, and $420,000 for the three and nine months ended October 31, 2005. The Acquired Business and the Innovo Acquisition, which are described in Note 2, incurred the product design costs.

Interest Expense

For the three and nine months ended October 31, 2006, interest expense is comprised of interest payable on the secured subordinated promissory note, interest on advances from factor, and amortization of the discount on the secured subordinated promissory note. For the three and nine months ended October 31, 2005, interest expense is comprised of interest payable on the secured subordinated promissory note and interest on advances from factor.

Foreign Currency Translation

The functional currency for the Company’s foreign operations is the U.S. Dollar. The translation from the applicable foreign currencies to U.S. dollars is performed for balance sheet accounts using current exchange rates in effect at the balance sheet date and for revenue and expense accounts using a weighted average exchange rate during the period.

Net Income (Loss) Per Share

The following is an analysis of the differences between basic and diluted outstanding shares in accordance with Statement of Financial Standards No. 128, “Earnings Per Share”.

	Three Months Ended		Nine Months Ended
	October 31, 2006	October 31, 2005 (Restated)	October 31, 2006	October 31, 2005 (Restated)
	(in thousands)
Weighted average common shares outstanding	26,462	22,958	25,727	16,022
Effect of dilutive securities: Stock Options	1	0	3	0
Weighted average common shares outstanding and common shares equivalents	26,463	22,958	25,730	16,022

Basic and diluted net loss per share information for all periods is presented under the requirements of SFAS No. 128 “Earnings Per Share”. Basic loss per share is calculated by dividing the net loss attributable to common shareholders by the weighted-average common shares outstanding during the period. Diluted loss per share is calculated by dividing net loss attributable to common stockholders by the weighted-average common shares outstanding. The dilutive effect of options convertible into an aggregate of approximately 15,000 and 13,000 common shares for the three and nine months ended October 31, 2005, respectively, are not included, as the inclusion of such would be anti-dilutive for the periods presented.

9

Cygne Designs, Inc. and Subsidiaries

Notes to Consolidated Financial Statements (continued)

1. Significant Accounting Policies (continued)

Accumulated Other Comprehensive Income (Loss)

Accumulated other comprehensive income (loss) is comprised of unrealized gain (loss) on marketable securities for the nine months ended October 31, 2006 and January 31, 2006.

Stock Based Compensation

The Company adopted SFAS No. 123 (revised 2004), “Share-Based Payment” (SFAS No. 123R), which supersedes Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees.” The revised statement addresses the accounting for share-based payment transactions with employees and other third parties, eliminates the ability to account for share-based transactions using APB No. 25 and requires that the compensation costs relating to such transactions be recognized in the consolidated financial statements. SFAS No. 123R requires additional disclosures relating to the income tax and cash flow effects resulting from share-based payments. The Company’s adoption of the modified prospective application method of SFAS No.123(R), effective February 1, 2006, had an immaterial impact on its consolidated results of operations and earnings per share. As a result of the adoption, the Company reclassified $219,000 from Deferred Compensation included in stockholders’ equity to paid-in capital at January 31, 2006.

Recent Accounting Pronouncements

In November 2004, the Financial Accounting Standards Board (“FASB’) issued Statement of Financial Accounting Standards (“SFAS”) No. 151, “Inventory Costs, an amendment of ARB No. 43, Chapter 4.” SFAS No. 151 retains the general principle of ARB 43, Chapter 4, “Inventory Pricing (AC Section I78),” that inventories are presumed to be stated at cost; however, it amends ARB 43 to clarify that abnormal amounts of idle facility expense, freight, handling costs, and wasted materials (spoilage) should be recognized as current-period charges and require the allocation of fixed production overheads to inventories based on the normal capacity of the production facilities. The guidance is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. Earlier application is permitted for inventory costs incurred during fiscal years beginning after November 23, 2004. The adoption of SFAS No. 151 did not have a material impact on the Company’s financial condition, results of operations or cash flows.

In May 2005, the FASB issued SFAS 154, “Accounting Changes and Error Corrections,” that applies to all voluntary changes in accounting principle. This Statement requires retrospective application to prior periods’ financial statements of changes in accounting principle, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. When it is impracticable to determine the period-specific effects of an accounting change on one or more individual prior periods presented, this Statement requires that the new accounting principle be applied to the balances of assets and liabilities as of the beginning of the earliest period for which retrospective application is practicable and that a corresponding adjustment be made to the opening balance of retained earnings (or other appropriate components of equity or net assets in the statement of financial position) for that period rather than being reported in an income statement. When it is impracticable to determine the cumulative effect of applying a change in accounting principle to all prior periods, this Statement requires that the new accounting principle be applied as if it were adopted prospectively from the earliest date practicable. The Company adopted SFAS 154 for the fiscal year ended January 31, 2007. The adoption of SFAS No. 154 did not have a material impact on the Company’s financial condition, results of operations or cash flows.

10

Cygne Designs, Inc. and Subsidiaries

Notes to Consolidated Financial Statements (continued)

1. Significant Accounting Policies (continued)

In June 2006, the FASB issued FASB Interpretation No. 48 (“FIN 48”), “Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109,” which establishes that the financial statement effects of a tax position taken or expected to be taken in a tax return are to be recognized in the financial statements when it is more likely than not, based on the technical merits, that the position will be sustained upon examination. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company does not anticipate that adoption of FIN 48 will have a material impact on the Company’s financial condition, results of operations or cash flows.

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements,” which establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. SFAS No. 157 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. SFAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The adoption of SFAS No. 157 is not expected to have a material impact on the Company’s financial condition, results of operations or cash flows.

2. Acquisition of Companies

Acquisition of the Private Label Division from Innovo Group, Inc. (“Innovo Acquisition”)

On May 12, 2006, the Company, Innovo Group Inc, (“Innovo”), and Innovo Azteca Apparel, Inc., a wholly owned subsidiary of Innovo, closed the transaction contemplated by an Asset Purchase Agreement entered into on March 31, 2006. Azteca Productions International, Inc. “Azteca Productions” is a party to certain ancillary agreements related to the Asset Purchase Agreement because they are an interested party in the transaction. Innovo is a designer, developer and worldwide marketer of apparel products. Pursuant to the Asset Purchase Agreement, Innovo sold the Company certain assets related to its private label apparel division. Innovo purchased these assets from Azteca Productions in July 2003 pursuant to an asset purchase agreement referred to as the Blue Concept Asset Purchase Agreement.

Cygne’s primary purpose for the purchase was to diversify its business. Cygne accounted for this transaction as a purchase.

The assets acquired by the Company include the private label division’s customer list, the assumption of current workforce related to the private label division, the assumption of all existing purchase orders and inventory related to the private label division, and the assumption of the benefit of a non-compete clause with Azteca Productions. In exchange for the purchased assets, we assumed certain liabilities associated with Innovo’s private label division, including the remaining obligation under the original promissory note executed by Innovo in favor of Azteca Productions under the Blue Concept Asset Purchase Agreement, all other liabilities, other than the original promissory note, owed in connection with the private label division to Azteca Productions in excess of $1,500,000, all liabilities associated with Innovo’s outstanding purchase orders and inventory schedules listed in the Asset Purchase Agreement, and the obligations to continue to pay the earn-out under the Blue Concept Asset Purchase Agreement. The aggregate value of the assumed liabilities was $2,500,000, which excluded the remaining unpaid principal amount of the original promissory note of $7.9 million, which was paid through the issuance of shares of Cygne’s common stock, as described below, and any amounts which might be owed under the earn-out.

11

Cygne Designs, Inc. and Subsidiaries

Notes to Consolidated Financial Statements (continued)

2. Acquisition of Companies (continued)

The Asset Purchase Agreement contained customary terms and conditions, including, among other things, indemnification provisions, representations and warranties and post-closing covenants.

In connection with the Asset Purchase Agreement, the Company entered into a Letter Agreement dated April 24, 2006 among Azteca Productions, Hubert Guez, Paul Guez and Sweet Sportswear, LLC. Pursuant to the Letter Agreement and in connection with the closing of the Innovo transaction, on May 12, 2006 the Company issued 1,000,000 shares of its common stock to each of Hubert Guez and Paul Guez, for an aggregate issuance of 2,000,000 shares, in lieu of assuming the remaining outstanding balance of the promissory note issued by Innovo to Azteca Productions. Under the Letter Agreement, the 2,000,000 shares have piggy-back registration rights on any future registration statements on Form S-3 filed by Cygne. Messrs. Hubert and Paul Guez also agreed not to offer to sell, contract to sell, or otherwise sell, dispose of, loan, pledge or grant any rights with respect to any such shares until the close of trading on April 23, 2007. In addition, 250,000 of the shares issued to Paul Guez and 250,000 of the shares issued to Hubert Guez were placed in an escrow account until the expiration of the lock-up period, with the escrowed shares being returned to the Company in the event that the Company’s common stock is traded on NASDAQ (or any other stock exchange, market or trading facility on which the shares are traded) at an average price above $5.00 per share during the one month period immediately preceding the expiration of the lock-up period.

As of May 12, 2006, pursuant to information set forth in a Form 4 filed with the SEC, Mr. Guez beneficially owns, has the power to dispose or direct the disposition of, and to vote or direct the voting of, shares, personally, through various trusts and Diversified Apparel, representing approximately 49.03% of the shares of our common stock. In addition, Mr. Guez (i) owns approximately 47% of Azteca Production International, Inc., (ii) has a 50% membership interest in Sweet Sportswear, LLC and (iii) has approximately a 32% membership interest in Diversified Apparel Resources, LLC. AZT International, S.A. de C.V is a 100% subsidiary of Azteca Production International, Inc.

As of May 21, 2006, Azteca Production International, Inc. may be deemed the beneficial owner of approximately 12.7% of Innovo Group Inc. common stock. Mr. Guez may be deemed to have the sole power to direct the voting and disposition of approximately 5.9% of Innovo Group Inc. common stock.

The purchase price consideration is comprised of the following:

	(In thousands)
Issuance of 2,000,000 shares of Cygne Common Stock at $3.84 per share	$	7,680
Assumption of liability to Diversified Apparel Resources LLC		2,500
Transaction costs of which $114,000 was paid prior to October 31, 2006 ($11,000 remains in accrued liabilities)		125
Total Purchase Price	$	10,305

The purchase price was allocated as follows.

	(In thousands)
Intangible assets—customer relationships, mostly amortized over 10 years	$	5,000
Excess purchase price allocated to goodwill		5,305
	$	10,305

The final allocation of the purchase price may involve revaluation of certain assets as well as a change in amortization period. Cygne has engaged an independent third party to determine the value of the intangible

12

Cygne Designs, Inc. and Subsidiaries

Notes to Consolidated Financial Statements (continued)

2. Acquisition of Companies (continued)

assets. As a result, the final allocation of the purchase price will be based on the results of the final valuation which will consider the fair value of intangible assets acquired, which could materially differ from the preliminary amounts shown herein. Accordingly, a change in the fair value of intangible assets and the amortization periods could impact the amount of annual amortization expense.

Acquisition of the denim apparel business from Diversified Apparel Resources LLC. (“Acquired Business”)

On July 31, 2005, Cygne, Commerce Clothing Company LLC (whose name was subsequently changed to Diversified Apparel Resources, LLC [“Diversified Apparel”]), and the members of Diversified Apparel including Mr. Guez (“Guez”), Diversified Apparel’s managing member and Chief Executive Officer, entered into an asset purchase agreement (the “Agreement”), and simultaneously closed the transactions contemplated thereby, providing for the purchase by Cygne from Diversified Apparel of the assets (the “Assets”) used in Diversified Apparel’s business of the designing, merchandising and wholesaling of branded and private label denim apparel (the “Acquired Business”), which includes, among other things, all of Diversified Apparel’s (i) tangible personal property, (ii) open purchase orders, (iii) New York showroom leases (for the property located on the fourth floor of 215 West 40^th Street) and (iv) trademarks and intellectual property associated with the Acquired Business. Cygne accounted for this transaction as a purchase.

In consideration for the Assets, Cygne (i) issued to Diversified Apparel 10.5 million shares of its Common Stock, $0.01 par value per share, (ii) issued to Diversified Apparel a secured subordinated promissory note (the “Note”) in the principal amount of $47.5 million, (iii) paid $2 million in cash at the Closing and (iv) agreed to pay to Diversified Apparel $1,750,000 in seven monthly installments of $250,000 each, without interest, on the last day of each month commencing August 2005. On January 3, 2006, the Company and Diversified Apparel entered into a Note Conversion Agreement providing for the conversion of $7,500,000 of the principal amount of the Note to Diversified Apparel into 1,428,571 shares of the Company’s common stock at the rate of $5.25 per share.

Pro-forma Statements

The following unaudited pro forma condensed combined statement of operations (unaudited) for the three and nine months ended October 31, 2006 and October 31, 2005 sets forth the combined results of operations for Cygne giving effect to the Acquired Business and Innovo Acquisition using the purchase method of accounting as if the combination was consummated as of the beginning of the earliest period presented.

Pro forma adjustments to the statement of operations for the three and nine months ended October 31, 2005 combine the pro forma Acquired Business adjustments with the pro forma Innovo Acquisition adjustments.

The Acquired Business pro forma adjustments include the adjustment of the historical gross profit to the contractual gross profit which is defined in the Cygne supply agreement with Diversified Apparel, adjustment of Acquired Business historical distribution and occupancy costs to the contractual cost as defined in the Cygne distribution agreement with Diversified Apparel, the recording of the expense under the restrictive covenant agreement with Hubert Guez, the recording of the amortization of the intangible assets in connection with the Acquired Business, the recording of the deferred tax liability and the adjustment to reflect the interest expense on the secured subordinated promissory note and amortization of debt discount expense recorded under the Acquired Business.

13

Cygne Designs, Inc. and Subsidiaries

Notes to Consolidated Financial Statements (continued)

2. Acquisition of Companies (continued)

The Innovo Acquisition pro forma adjustments include the adjustment of Innovo Acquisition historical amortization of its intangibles to the amortization of Cygne’s intangibles in connection with the Innovo Acquisition, the recording of the deferred tax liability and the elimination of the Innovo Acquisition impairment of goodwill.

Under the purchase method of accounting, the excess purchase price, including transaction costs in the Innovo Acquisition, over the fair value of net assets acquired was approximately $10,305,000. $5,000,000 of the purchase price has been recorded as intangible assets assigned to customer relationships. These intangible assets are being amortized over periods ranging from three months and seven years. At this time, the work needed to provide the basis for determining these fair values and their amortization periods has not been completed. Cygne has engaged an independent third party to determine the value of the intangible assets. As a result, the final allocation of the purchase price will be based on the results of the final valuation which will consider the fair value of intangible assets acquired, which could materially differ from the pro forma amounts shown herein. Accordingly, a change in the fair value of intangible assets and the amortization periods could impact the amount of annual amortization expense.

The pro forma information is presented for illustration purposes only and is not necessarily indicative of the financial position or results of operations which would actually have been reported had the combination been in effect during these periods or which might be reported in the future. The pro forma financial information includes expenses allocated by Innovo Group Inc. to the Innovo Acquisition which may not be indicative of future results which will include actual expenses.

	(In thousands, except per share amounts)
	Three Months Ended				Nine Months Ended
	10/31/06 Actual		10/31/05 Pro forma (Restated)		10/31/06 Pro forma		10/31/05 Pro forma (Restated)
Net revenue	$	32,980	$	46,687	$	118,992	$	133,376
Net income	$	765	$	1,300	$	1,208	$	4,638
Net income per share—basic and diluted	$	0.03	$	0.05	$	0.05	$	0.26

3. Marketable Securities

Marketable securities are stated at fair value as determined by quoted market price. The related unrealized holding gains and losses are excluded from operations and recorded in Accumulated Other Comprehensive Income (loss) on the Consolidated Balance Sheets. At October 31, 2006 and January 31, 2006, the gross unrealized gain (loss) was approximately $18,000 and ($17,000), respectively. Realized gains and losses and declines in value judged to be other-than-temporary on marketable securities are included in other expense.

The following table summarizes the marketable securities as of October 31, 2006 and January 31, 2006:

	Cost or Amortized Cost		Gross Unrealized Gain(Loss)			Gross Recorded Gain/(Loss)			Estimated Fair Value
Marketable securities, January 31, 2006	$	215,000	$	(17,000	)	$	(175,000	)	$	23,000
Marketable securities, October 31, 2006		40,000		18,000			—			58,000

14

Cygne Designs, Inc. and Subsidiaries

Notes to Consolidated Financial Statements (continued)

4. Credit Facilities

Effective July 31, 2005, the Company began to use Milberg Factors, Inc. (“Milberg”) for credit administration and cash flow purposes.

The Company and Milberg entered into a one-year factoring agreement effective July 31, 2005 which was amended on January 31, 2006 and July 31, 2006 and renewed through July 31, 2007 (the “Factoring Agreement”). Under the Factoring Agreement, the Company sells to Milberg without recourse all of Cygne’s receivables which are acceptable to Milberg. Milberg is responsible for collection, assumes all credit risk, and obtains all of the rights and remedies of the Company against the Company’s customers for those receivables purchased by Milberg without recourse. Further, payment is due from Milberg upon the payment of the receivable to Milberg by Cygne’s customer less a Milberg reserve for known future chargebacks from all customers.

Cygne estimates the allowances for customer chargebacks and trade discounts to be applied against its factored trade accounts receivable considering both historical and anticipated deductions taken by customers. As of October 31, 2006, Cygne had reserved approximately $1,407,000 for allowances for customer chargebacks and trade discounts.

Milberg’s basic factoring charge is fifty-five one hundredths of one percent (0.55%) of the gross amount of the first $25,000,000 of receivables factored by Milberg in any contract year, forty-five one hundredths of one percent (0.45%) of the next $25,000,000 of receivables factored by Milberg in any contract year, and forty one hundredths of one percent (0.40%) of receivables factored by Milberg in any contract year in excess of $50,000,000, in each case, less any trade discounts to customers. For accounts with a low, but acceptable credit rating, Milberg adds approximately 1.00% of factored receivables to the factoring charge. The Factoring Agreement contains covenants with respect to working capital and net worth. The working capital (as defined) had to be at least $1 million for the period July 31, 2005 through January 31, 2006 and at least $3 million thereafter. Cygne was in default with regard to this covenant at January 30, 2006 for which Cygne obtained a waiver from Milberg. The tangible net worth (as defined) had to be at least $1 million through January 31, 2006 and at least $3 million thereafter. These covenants were amended with an effective date of January 31, 2006. The revised working capital (as defined) has to be at least $2 million for the period from January 31, 2006 through April 30, 2006, and at least $3 million thereafter. The revised tangible net worth (as defined) has to be at least $2 million for the period from January 31, 2006 through April 30, 2006, at least $3 million thereafter. An amendment with an effective date of September 30, 2006 provided that working capital at October 2006 had to be at least $2,000,000. Cygne was in compliance with the working capital covenant at October 31, 2006. Cygne was in default with the tangible net worth covenant at October 31, 2006 for which Cygne obtained a waiver from Milberg at October 31, 2006.

As discussed in Note 13, management determined to change the Company’s previous accounting for amounts due from Milberg (its Factor) net of advances received from Milberg, recorded as a current asset in the balance sheet. Management of the Company has determined that it is more appropriate to report amounts due from Milberg as a current asset and advances from Milberg as a current liability because advances from Milberg are due on demand and amounts due from Milberg are payable upon receipt of payment by Milberg from the Company’s customers. As a result, management of the Company determined that it was more appropriate to report amounts due from Milberg as a current asset and advances from Milberg as a current liability because advances from Milberg are due on demand and amounts due from Milberg are payable upon receipt of payment by Milberg from the Company’s customers. The statement of cash flows for the nine months ended October 31, 2005 have been revised to present advances from Milberg and repayment of those advances as financing activities and the change in amounts due from Milberg as an operating activity.

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Cygne Designs, Inc. and Subsidiaries

Notes to Consolidated Financial Statements (continued)

4. Credit Facilities (continued)

The minimum aggregate factoring charges payable under the Factoring Agreement for the contract year are $95,000. The factor fees for the three and nine months ended October 31, 2006 were approximately $87,000 and $394,000, respectively. The maximum revolving amount set forth in the agreement was $20,000,000. In an amendment with an effective date of July 31, 2006, the maximum revolving amount was increased to $25,000,000. At the time of purchase of receivables and periodically thereafter, Milberg may in its sole discretion make advances to Cygne. In addition, upon Cygne’s request, Milberg must remit (and at any time in Milberg’s sole discretion Milberg may remit) any money standing to Cygne’s credit on Milberg’s books in excess of a reserve for known future chargebacks from all customers.

Advances from Milberg are repayable on demand. The maximum advances are the lower of 90% of the net amount due from Milberg after a Milberg reserve for known chargebacks and trade discounts from all customers or $25,000,000. Advances from Milberg at October 31, 2006 were approximately $14,388,000. Interest paid to Milberg for the three and nine months ended October 31, 2006 was approximately $452,000 and $1,069,000 respectively.

Milberg may charge interest on any monies remitted or otherwise advanced or charged to Cygne’s account before the collection of receivables. The interest rate is prime plus 0.5% (prime rate at October 31, 2006 was 8.25%). As security for all of Cygne’s obligations to Milberg, including advances made by Milberg to Cygne, Cygne granted to Milberg a continuing security interest in substantially all of its property. Such security interest is senior to the security interest granted to Diversified Apparel with respect to its Secured Subordinated Promissory Note.

In connection with the Factoring Agreement, Mr. Guez guaranteed Cygne’s obligations to Milberg up to $1,000,000, plus accrued and unpaid interest, plus any costs and expenses of enforcing the guaranty, except that such guaranty is unlimited in the case of fraud. In an amendment with an effective date of July 31, 2006, Mr. Guez increased his guarantee of Cygne’s obligations to Milberg to $1,500,000.

Also in connection with the Factoring Agreement, Diversified Apparel agreed to subordinate to Milberg the present and future indebtedness owed to Diversified Apparel by Cygne until all of Cygne’s obligations to Milberg made in connection with the Factoring Agreement have been fully paid and discharged.

Due from factor, net of factor advances and allowances for chargebacks and trade discounts, are summarized below. Factored receivables of $15,757,000 and $17,405,000 at October 31, 2006 and January 31, 2006, respectively, are without recourse.

	(In thousands)
	October 31, 2006			(Restated) January 31, 2006
Outstanding factored receivables	$	15,757		$	17,405
Less, allowances for chargebacks and trade discounts		1,407			1,962
Due from factor, net of allowances for chargebacks and trade discounts		14,350			15,443
Less, advances from factor		14,388			15,887
Due from (to) factor net of factor advances and reserves for chargebacks and trade discounts	$	(38	)	$	(444	)

The average factor advances for the nine months ended October 31, 2006 were approximately $15,406,000 and the highest advance during this period was approximately $25,274,000, which was $274,000 over the maximum advance stated in the Factoring Agreement.

16

Cygne Designs, Inc. and Subsidiaries

Notes to Consolidated Financial Statements (continued)

5. Inventories

Inventories consist of the following:

	(In thousands)
	October 31, 2006		January 31, 2006
Raw materials and Work-in-Process	$	420	$	1,140
Finished goods		1,111		3,349
Total	$	1,531	$	4,489

6. Fixed Assets

Fixed assets are stated at cost, less accumulated depreciation and amortization and are summarized below together with estimated useful lives used in computing depreciation and amortization:

	(In thousands)
	October 31, 2006		January 31, 2006		Estimated Useful Lives
Land	$	258	$	258
Building and building improvements		117		117
Leasehold improvements		281		278	Life of lease
Equipment, furniture, and fixtures		288		244	2-7 years
		944		897
Less accumulated depreciation and amortization		271		173
	$	673	$	724

Depreciation and amortization expense for fixed assets was approximately $33,000 and $98,000 for the three and nine months ended October 31, 2006, respectively, and $76,000 and $208,000 for the three and nine months ended October 31, 2005, respectively. Depreciation of property and equipment is provided for by the straight-line method over the estimated useful lives of the assets. Leasehold improvements are amortized using the straight-line method over the term of the related lease. At January 31, 2006 based on an appraisal by an independent third party, the Company recorded a 100% impairment charge against its equipment, furniture and fixtures at its Guatemalan facility and established a salvage value, not subject to depreciation, for its building and building improvements in its Guatemala facility.

7. Note Payable to Related Party

Secured Subordinated Promissory Note to Diversified Apparel (the “Note”)

In connection with the acquisition of Diversified Apparel, the Company issued a secured subordinated promissory note to Diversified Apparel, a related party. The Note bears interest at 4.7% per annum, compounded annually. Interest and principal on the Note are payable quarterly commencing on October 31, 2006. The principal amount of the Note is payable as follows: (i) ten quarterly payments of $1,500,000 commencing on October 31, 2006; and (ii) ten quarterly payments of $2,500,000 commencing on October 31, 2009, with the final payment to be made on July 31, 2011. Subject to the subordination agreement between Diversified Apparel and Milberg Factors, Inc., Cygne is required to use fifty percent of the net proceeds of any sale of its debt securities in a public offering or a private placement (but not including any bank debt, debt to any senior lender as set forth in the Note or any other ordinary course short term obligations) or any sale of its equity securities (other than pursuant to the exercise of

17

Cygne Designs, Inc. and Subsidiaries

Notes to Consolidated Financial Statements (continued)

7. Note Payable to Related Party (continued)

options to purchase securities) to prepay the Note, with the principal amount of the Note being reduced by the amount of the prepayment at a discount of one percent (1%) of the prepayment. During the year ended January 31, 2006, Cygne issued common stock to repay $7,500,000 of the face amount of the Note, effectively reducing future payments to be made. On October 31, 2006, Cygne made a principal payment of $1,500,000 and an interest payment of approximately $2,530,000, both of which were paid through the offset of amounts owed to Diversified Apparel.

Notwithstanding anything to the contrary in the Note, no payment in respect of the indebtedness evidenced by the Note, including any scheduled payment of principal and/or interest or any prepayment, may be made by Cygne or accepted by Diversified Apparel, except as expressly permitted pursuant to the Factoring Agreement.

Cygne’s obligations under the Note are secured by a pledge of the trademarks purchased by Cygne under the Agreement, pursuant to a Security Agreement entered into with Diversified Apparel.

The Company obtained a third-party valuation to determine the fair value of the note for the purposes of determining the purchase price of the Acquisition. As a result, the Company recorded a debt discount of $14,200,000 to reduce the carrying value of the note to fair value. The discount is being amortized to interest expense over the term of the loan. During the three and nine months ended October 31, 2006, $514,000 and $1,540,000 of debt discount amortization was recorded.

Note Conversion Agreement

On January 3, 2006, the Company and Diversified Apparel entered into a Note Conversion Agreement providing for the conversion of $7,500,000 of the principal amount of the Promissory Note to Diversified Apparel into 1,428,571 shares of the Company’s common stock at the rate of $5.25 per share. Accordingly, the Company canceled the principal payments due October 31, 2011, January 31, 2012 and July 31, 2012. The following schedule sets forth required minimum future principal payments required on the Note, as adjusted for the above conversion. Payments will be made on a quarterly basis, commencing October 31, 2006, in ten equal payments of $1,500,000 each, followed by ten equal payments of $2,500,000 each. In connection with the conversion of the $7,500,000 of the note, a loss on extinguishment (recorded as a component of interest expense) of approximately $2,063,000 was recorded representing the pro-rata unamortized discount.

As January 31, 2006, future minimum principal repayments required under the secured subordinated promissory note are as follows:

Year Ended January 31:	Principal		Note Discount Amortization		Total Principal Payments
2007	$	729,000	$	2,271,000	$	3,000,000
2008		3,214,000		2,786,000		6,000,000
2009		3,476,000		2,524,000		6,000,000
2010		7,953,000		2,047,000		10,000,000
2011		8,832,000		1,168,000		10,000,000
Thereafter		4,945,000		55,000		5,000,000
	$	29,149,000	$	10,851,000	$	40,000,000

18

Cygne Designs, Inc. and Subsidiaries

Notes to Consolidated Financial Statements (continued)

7. Note Payable to Related Party (continued)

The Note bears interest at 4.7%, and the Company expects to record approximately $7,613,000 of interest over the remaining term of the Note, with payments commencing in the year ended January 31, 2007, as shown in the following table:

Year Ended January 31:
2007	$	3,016,000
2008		1,633,000
2009		1,354,000
2010		997,000
2011		526,000
Thereafter		87,000
	$	7,613,000

8.Stock Options

At October 31, 2006, 500 options were outstanding under the Company’s 1993 Stock Option Plan for Non-Employee Directors. The 1993 stock option plan was established for a ten-year period and expired on April 15, 2003. The outstanding options have an expiration date of 2013.

On January 20, 2006, the stockholders of Cygne approved the Company’s 2006 Incentive Plan (the “Plan”) to enable the Company to attract, motivate, reward, and retain key personnel through the use of equity-based and cash incentive compensation awards. Subject to adjustment for recapitalization events, a total of 3,000,000 shares of the Company’s Common Stock may be issued under the Plan, exclusive of shares repurchased, forfeited, or otherwise canceled. No employee may be granted options to purchase more than 600,000 shares under the Plan in a single calendar year. With respect to performance-based awards not valued by reference to the Company’s Common stock at date of grant, the maximum amount that may be earned by any employee during any calendar year is $1,000,000. Any unused portion of the annual limitations on awards that may be earned by an employee shall be carried forward on a cumulative basis. No options have been granted under the Plan to date.

On January 20, 2006, the Company issued 60,000 shares of restricted Common Stock to directors, subject to vesting over a period of eight quarters of continued service, beginning with the quarter ended January 31, 2006. The shares were valued at $4.85 a share. The shares will also vest in full upon a Change in Control, as defined in the Plan, or upon the termination of the director’s service due to death or disability. In connection therewith, the Company recorded deferred compensation of $291,000, representing the fair value of the shares, which is being amortized over the vesting period. During the three and nine months ended October 31, 2006, approximately $36,000 and $109,000, respectively, was amortized.

During the nine months ended October 31, 2006, a director exercised options to purchase 7,650 shares at strike prices ranging from $0.08 to $0.23.

Prior to February 1, 2006, the Company accounted for the above plans under the recognition and measurement provisions of APB Opinion (“APB”) No. 25, “Accounting for Stock Issued to Employees,” and related Interpretations, as permitted by FASB Statement No. 123 (revised 2004) (“SFAS 123”), “Accounting for Stock-Based Compensation.” No stock-based employee compensation cost was recognized in the Statement of Operations for the nine months ended October 31, 2005, as all options granted under those plans had an exercise price equal to the market value of the underlying common stock on the date of grant. Effective February 1, 2006, the Company adopted the fair value recognition provisions of FASB Statement No. 123(R) (“SFAS

19

Cygne Designs, Inc. and Subsidiaries

Notes to Consolidated Financial Statements (continued)

8. Stock Options (continued)

123R”), “Share-Based Payment”, using the modified-prospective-transition method. Under that transition method, compensation cost recognized in the nine months ended October 31, 2006 includes: (a) compensation cost for all share-based payments granted prior to, but not yet vested as of January 31, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS 123, and (b) compensation cost for all share-based payments granted subsequent to January 31, 2006, based on the grant-date fair value estimated in accordance with the provisions of SFAS 123R. Results for prior periods have not been restated. The overall effect of the transition was immaterial.

The Company recognized stock-based compensation related to vesting for stock options previously awarded and previously recorded using the intrinsic-value method. For the nine months ended October 31, 2006, the amount of stock based compensation was $3,792. During the nine months ended October 31, 2006 and 2005, no stock options were granted.

As a result of adopting SFAS 123R on February 1, 2006, the Company’s income before income taxes and net income for the three and nine months ended October 31, 2006, are $3,792 lower than if it had continued to account for share-based compensation under APB No. 25. Basic and diluted earnings per share for the three and nine months ended October 31, 2006 resulted in no change due to the Company adopting SFAS 123R during the quarter.

The following table summarizes information about stock options outstanding at October 31, 2006:

		Outstanding				Exercisable (Vested)
Exercise price		Number of options	Weighted average remaining years of contractual life	Weighted average Exercise price		Number of options	Weighted average exercise price
$	0.13	500	6.75	$	0.13	—	—

Had compensation costs for the Company’s stock option grants been determined based on the fair-value-based method at the grant dates for awards under these plans in accordance with SFAS 123R, the effect on the Company’s net income (loss) and net income (loss) per share for the three and nine months ended October 31, 2006 and 2005 would have been immaterial. The fair value for the options was estimated at the date of grant using the Black-Scholes option-pricing model.

9. Concentrations of Risk

For the nine months ended October 31, 2006 sales to JC Penney, Kohl’s, Target and American Eagle Outfitters accounted for approximately 16.2%, 13.6%, 12.2% and 26.9%, respectively, of Cygne’s net sales. For the nine months ended October 31, 2005, sales to New York & Company, J C Penney and Kohl’s accounted for 45%, 12% and 14%, respectively, of Cygne’s net sales.

Foreign manufacturing is subject to a number of risks, including work stoppages, transportation delays and interruptions, political instability, foreign currency fluctuations, economic disruptions, expropriation, nationalization, the imposition of tariffs and import and export controls, changes in governmental policies (including U.S. policy toward these countries). The occurrence of certain of these factors in Guatemala where Cygne owns a manufacturing facility could result in a loss of the Company’s investment located in this country.

The Company has entered into a Supply Agreement and a Distribution Agreement with Diversified Apparel. Diversified Apparel, under the terms of these Agreements, supplies the Company with all of its product and all of its distribution services.

20

Cygne Designs, Inc. and Subsidiaries

Notes to Consolidated Financial Statements (continued)

10. Related Party Transactions

Cygne entered into several agreements and a secured subordinated promissory note at July 31, 2005 with companies controlled by its largest shareholder, Mr. Guez. See Notes 2 and 7 for further information.

The Supply Agreement. Under the terms of the Supply Agreement, as amended, AZT International S. de R.L. de C.V. (“AZT’), an affiliate of Mr. Guez, manufactures for Cygne branded and private label denim apparel for Cygne in Mexico at various guaranteed gross margins.

The second amendment to the Supply Agreement with an effective date of July 31, 2005 between Cygne and Diversified Apparel specifies that AZT will ship its manufactured apparel to the United States and invoice Diversified Apparel, an affiliate of Mr. Guez. Diversified Apparel retains the physical risk of loss while the inventory is in its possession and invoices Cygne for the apparel that has been shipped to Cygne’s customers after deducting payment for inventory previously purchased. Before the end of each month, Diversified Apparel invoices Cygne for the apparel it has on hand that Cygne estimates that it will ship to its customers in the subsequent month. This third amendment to the Supply Agreement dated April 27, 2006, extends the expiration date of the Supply Agreement to April 30, 2007, and if not renewed, AZT will invoice Cygne directly for all inventory on hand as specified in the Supply Agreement. The fourth amendment to the Supply Agreement with an effective date of July 31, 2006, extends the expiration date of the second amendment extends the expiration date of the Supply Agreement to July 31, 2007 and specifies the guaranteed gross margins for the new customers. The apparel purchased from Diversified Apparel under the Supply Agreement for the three and nine months ended October 31, 2006 was $19,608,000 and $53,300,000, respectively. At all times, Cygne is subject to obsolescence risk. Approximately $828,000 of the purchases for the three months ended October 31, 2006 is included in inventory at October 31, 2006.

The Supply Agreement states that if the purchase orders outstanding from Cygne under the Supply Agreement equal or exceed $7.5 million, Cygne will advance to Diversified Apparel up to 50% of any such amounts exceeding $7.5 million in order to finance production if Diversified Apparel requests such advance in writing, The planned repayment terms for the outstanding advances are to deduct the advances from the payments made in connection with future inventory purchases. Since Diversified Apparel is a related party, Cygne does not deem it probable that the total 50% advance of the outstanding purchase orders under the Supply Agreement would be requested if Cygne did not have the available funds to make the entire advance. If the total 50% advance were to be requested, it would have a material adverse effect on the Company’s financial condition and the Company would have to renegotiate the agreement with Diversified Apparel, curtail purchases or seek additional working capital funding.

The third amendment to the Supply Agreement dated April 27, 2006 states that Cygne will advance to Diversified Apparel, at Diversified’s request, up to 50% of the amount of purchase orders outstanding, thus removing the $7.5 million base, if Diversified requests such advance in writing. At January 31, 2006 and October 31, 2006, advances from Cygne to Diversified Apparel were approximately $1,272,000 and $3,930,000, respectively.

The Distribution Agreement. Under the terns of the Distribution Agreement, as amended, Diversified Apparel provides distribution and operations services for Cygne. The distribution cost for the three and nine months ended October 31, 2006 was approximately $600,000 and $3,342,000 respectively, and is included in Selling, General and Administrative expenses in the statement of operations. The $600,000 of distribution cost for the three months ended October 31, 2006 has been offset by a credit from Diversified Apparel of $855,000 (thus a net credit for the three months of $255,000 and a net cost for nine months of $2,487,000) to adjust for a retroactive billing adjustment, as agreed among the parties, for the three months ended July 31, 2006.

21

Cygne Designs, Inc. and Subsidiaries

Notes to Consolidated Financial Statements (continued)

10. Related Party Transactions (continued)

In addition, the cost of the packing materials purchased from Diversified Apparel during the three and nine months ended October 31, 2006 was approximately $58,000 and $257,000, respectively, and is included in Selling, General and Administrative expenses in the statement of operations.

An amendment to the Distribution Agreement with an effective date of July 31, 2005 specifies that Cygne will purchase all of its denim apparel manufactured outside of Mexico from Diversified Apparel. Diversified Apparel will receive this apparel in its United States warehouse and retain the physical risk of loss while the inventory is in its possession. Diversified Apparel will invoice Cygne for the apparel that has been shipped to Cygne’s customers after deducting payment for inventory previously purchased. Before the end of each month, Diversified Apparel will invoice to Cygne the apparel that Cygne estimates that it will ship to its customers in the subsequent month. The second amendment to the Distribution Agreement dated April 27, 2006, extends the expiration date of the Distribution Agreement to April 30, 2007. The third amendment to the Distribution Agreement with an effective date of July 31, 2006 extends the expiration o the Distribution Agreement to July 31, 2007 and states that Cygne will advance to Diversified Apparel, at Diversified Apparel’s written request, up to 50% of any outstanding product purchase orders. At all times, Cygne is subject to obsolescence risk. The planned repayment terms for the outstanding advances are to deduct the advances from the payments made in connection with future inventory purchases. Since Diversified Apparel is a related party, Cygne does not deem it probable that the total 50% advance of the outstanding purchase orders under the Distribution Agreement would be requested if Cygne did not have the available funds to make the entire advance. If the total 50% advance were to be requested, it would have a material adverse effect on the Company’s financial condition and the Company would have to renegotiate the agreement with Diversified Apparel, curtail purchases or seek additional working capital funding.

The apparel purchased from Diversified Apparel under this arrangement for the three and nine months ended October 31, 2006 was $2,074,550 and $15,653,000, respectively. Approximately $283,000 of the purchases for the three months ended October 31, 2006 is included in inventory at October 31, 2006. There were no advances for inventory at January 31, 2006 and October 31, 2006.

Restrictive Covenant Agreement: Cygne and Mr. Guez entered into a restrictive covenant agreement whereby Cygne pays Mr. Guez one percent (1%) of net sales, not including non-denim sales to New York & Company, and not including sales of denim apparel resulting from subsequent business acquisitions. The Company recorded an expense under the agreement of $140,000 and $538,000, respectively, for the three and nine months ended October 31, 2006. The amounts due to Mr. Guez were $1,155,000 and $386,000, at October 31, 2006 and January 31, 2006, respectively, and were included in Due to Related Parties.

Secured Subordinated Promissory Note: In connection with the acquisition of the denim business from Diversified Apparel, Cygne issued to Diversified Apparel a $47.5 million note bearing interest at 4.7% per annum. On January 3, 2006, the Company and Diversified Apparel entered into a Note Conversion Agreement providing for the conversion of $7,500,000 of principal due under the Promissory Note to Diversified Apparel, into 1,428,571 shares of the Company’s common stock. Accordingly, Cygne canceled the principal payments due October 31, 2011, January 31, 2012 and July 31, 2012.

First Finish Inc., an affiliate of Mr. Guez, operates a fabric finishing testing and development facility in California. The cost for services rendered to Cygne by First Finish Inc. for the three and nine months ended October 31, 2006 was approximately $29,000 and $126,000, respectively. Payments to reduce prior amounts due to First Finish, Inc. during the three and nine months ended October 31, 2006 was $28,000 and $183,000, respectively.

22

Cygne Designs, Inc. and Subsidiaries

Notes to Consolidated Financial Statements (continued)

10. Related Party Transactions (continued)

In connection with the Innovo Acquisition, Cygne assumed the earn-out fees of 2.5% of the net sales to American Eagle Outfitters (“AEO”). The Company recorded an expense under the agreement of $288,000 and $662,000, respectively, for the three and nine months ended October 31, 2006.

Due to Related Parties is comprised of the following amounts.

	October 31, 2006			January 31, 2006
	(In thousands)
Due (from) Diversified Apparel—amount due under Supply Agreement	$	(3,930	)	$	(1,272	)
Due to Diversified Apparel—interest on secured subordinated promissory note payable		—			1,120
Due to Diversified Apparel—deferred purchase price		—			250
Due to Diversified Apparel—assumption of liability under Innovo Acquisition Agreement		2,500			—
Due to First Finish Inc.		8			66
Due to Mr. Guez - restricted covenant and earn-out agreements		1,155			386
Due to Mr. Paul Guez—earn-out fees		144			—
Due (from) Related Parties		(123	)		550
Secured subordinated promissory notes payable, at face amount		38,500			40,000
Due to Related Parties	$	38,377		$	40,550

The categories of the related party charges are:

Statement Placement See below		Three Months Ended October 31, 2006			Nine Months Ended October 31, 2006
		(In thousands)
1	Supply Agreement	$	19,608		$	53,300
1	Distribution Agreement relating to purchase of imported goods		1,894			15,653
2	Distribution Agreement relating to distribution expenses		(255	)		2,487
2	Distribution Agreement relating the purchase of packing materials		58			257
2	Restrictive Covenant Agreement		140			258
2	Earn-out under Innovo Acquisition Agreement		288			662
2	Services performed by First Finish, Inc.		29			126
3	Interest on Secured Subordinated Promissory Note		470			1,540
	Total	$	22,232		$	74,283

Statement Placement See below		Three Months Ended October 31, 2005		Nine Months Ended October 31, 2005
		(In thousands)
1	Supply Agreement	$	12,708	$	12,708
1	Distribution Agreement relating to purchase of imported goods		2,742		2,742
2	Distribution Agreement relating to distribution expenses		758		758
2	Distribution Agreement relating the purchase of packing materials
2	Restrictive Covenant Agreement		166		166
2	Charges by Diversified Apparel for employees performing services for Cygne		885		885
2	Services performed by First Finish, Inc.		62		62
3	Interest on Secured Subordinated Promissory Note		561		561
	Total	$	17,882	$	17,882

23

Cygne Designs, Inc. and Subsidiaries

Notes to Consolidated Financial Statements (continued)

10. Related Party Transactions (continued)

The categories identified above are shown in the financial statement under the following captions.

Statement Placement
1	Cost of goods sold
2	Selling, general and administrative expenses
3	Interest expense

In addition, as of October 31, 2006 and January 31, 2006, the Company has outstanding short-term purchase order commitments to Diversified Apparel for approximately $18,843,000 and $27,257,000, respectively.

11. Litigation

Litigation

The Company is involved in various legal proceedings that are incidental to the conduct of its business, none of which the Company believes could reasonably be expected to have a material adverse effect on the Company’s financial condition, results of operations or cash flows.

12. Income Taxes

The provision for income taxes for the third quarter and nine months ended October 31, 2006 was $444,000 and $1,294,000, respectively, as compared to an income tax provision of $410,000 and $420,000, respectively for the three and nine months ended October 31, 2005. The provision for the three months ended October 31, 2006 was comprised of $18,000 of minimum state and local income taxes, and a deferred tax provision of $426,000 related to the difference between book and tax basis from indefinite lived goodwill. A valuation allowance has been provided against net deferred tax assets except for deferred tax liabilities originating from the Company’s taxable business combination that resulted in deductible goodwill. The provision for three months ended October 31, 2005 was $410,000 which was comprised of $18,000 of minimum state and local income taxes and a deferred tax provision of $392,000 related to the difference between book and tax basis from indefinite lived goodwill.

The provision for the nine months ended October 31, 2006 was comprised of $54,000 of minimum state and local income taxes, and a deferred tax provision of $1,240,000 related to the difference between book and tax basis from indefinite lived goodwill. A valuation allowance has been provided against net deferred tax assets except for deferred tax liabilities originating from the Company’s taxable business combination that resulted in deductible goodwill. The provision for the nine months ended October 31, 2005 of $420,000 was comprised of $28,000 of minimum state and local income taxes and a deferred tax provision of $392,000 related to the difference between book and tax basis from indefinite lived goodwill.

The Company’s effective tax rate differs from the federal statutory rate of 34% and the Company’s normal effective minimum state and local tax rate of 6% (for a total tax rate of 40%) due to United States operating losses, foreign tax-free operations and deferred tax on goodwill amortization for the three and nine months ended October 31, 2006 and United States operating losses and foreign tax-free operations for the three and nine months ended October 31 2005.

24

Cygne Designs, Inc. and Subsidiaries

Notes to Consolidated Financial Statements (continued)

Note 13 Restatement

On December 1, 2006, management determined to change the Company’s previous accounting for amounts due from Milberg (its factor) net of advances received from Milberg as a current asset in the balance sheet. Management of the Company determined that it was more appropriate to report amounts due from Milberg as a current asset and advances from Milberg as a current liability because advances from Milberg are due on demand and amounts due from Milberg are payable upon receipt of payment by Milberg from the Company’s customers. As a result, management of the Company determined that it was more appropriate to report amounts due from Milberg as a current asset and advances from Milberg as a current liability because advances from Milberg are due on demand and amounts due from Milberg are payable upon receipt of payment by Milberg from the Company’s customers. The statements of cash flows have been revised to present advances from Milberg and repayment of those advances as financing activities and the change in amounts due from Milberg as an operating activity.

The Company is also correcting errors identified related to the income tax expense and related deferred taxes payable for the three and nine months ended October 31, 2006 in order to increase the amount of the valuation allowance previously provided. In accordance with SFAS No. 109, “Accounting for Income Taxes”, and SFAS No.142, “Goodwill and Other Intangible Assets”, for taxable business combinations that yield tax-deductible goodwill, there is an accumulation of deferred tax liabilities over time as goodwill is deducted on tax returns but not amortized for financial reporting purposes. The deferred tax liabilities will reverse if impairment charges are recognized or when the business is disposed of through sale or otherwise. The Company had netted the deferred tax liability resulting from the indefinite life goodwill with gross deferred tax assets and provided a valuation allowance on the net asset balance. Because of the uncertainty of the timing of the reversal of the deferred tax liability related to the goodwill temporary difference, the Company has determined that the valuation allowance should have been provided against the net deferred tax assets without taking into account the indefinite lived goodwill.

The following is a summary of the effects on the consolidated statements of income for the three and nine months ended October 31, 2005 and on the cash flows for the nine months ended October 31, 2005.

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Cygne Designs, Inc. and Subsidiaries

Notes to Consolidated Financial Statements (continued)

Note 13 Restatement (continued)

For Three Months Ended October 31, 2005:

	Consolidated Statements of Operations
	As Previously Reported			Adjustments			As Restated
(Loss) before income taxes	$	(110	)	$	—		$	(110	)
Provision for income taxes		18			392			410
Net (loss)		(128	)		(392	)		(520	)
Net (loss) per share-basic and diluted	$	(0.01	)	$	(0.01	)	$	(0.02	)

For Nine Months Ended October 31, 2005:

	Consolidated Statements of Operations
	As Previously Reported			Adjustments			As Restated
(Loss) before income taxes	$	(717	)	$	—		$	(717	)
Provision for income taxes		28			392			420
Net (loss)		(745	)		(392	)	$	(1,137	)
Net (loss) per share-basic and diluted	$	(0.05	)	$	(0.02	)	$	(0.07	)

For Nine Months Ended October 31, 2005:

			Consolidated Statements of Cash Flow
	As Previously Reported		Adjustments			As Restated
Net cash provided by (used in) operating activities	$	189	$	(13,510	)	$	(13,321	)
Net cash (used in) provided by financing activities		6		13,510			13,516

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Unless otherwise noted, all references to the periods ended prior to October 31, 2005 are to our fiscal year that commenced in that calendar year and ending on the Saturday closest to January 31 of the following year. Effective July 31, 2005, we changed from a thirteen-week quarterly reporting period to a last day of month quarterly reporting period, with our fiscal year now ending on January 31 of each year. The change was made to conform to the quarterly accounting periods of other major apparel companies. The change did not have a material impact on our financial condition, results of operations, or cash flows.

Overview

Acquisition of the Private Label Division from Innovo Group, Inc. (“Innovo Acquisition”)

On May 12, 2006, we, Innovo Group Inc. (“Innovo”), and Innovo Azteca Apparel, Inc., a wholly owned subsidiary of Innovo, closed the transaction contemplated by an Asset Purchase Agreement entered into on March 31, 2006. Azteca Productions International, Inc. (“Azteca Productions”) is a party to certain ancillary agreements related to the Asset Purchase Agreement because they are an interested party in the transaction. Innovo is a designer, developer and worldwide marketer of apparel products. Pursuant to the Asset Purchase Agreement, Innovo sold us certain assets related to its private label apparel division. Innovo purchased these assets from Azteca Productions in July 2003 pursuant to an asset purchase agreement referred to as the Blue Concept Asset Purchase Agreement.

Cygne’s primary purpose for the purchase was to diversify its business. We accounted for this transaction as a purchase.

The assets acquired by us include the private label division’s customer list, the assumption of current workforce related to the private label division, the assumption of all existing purchase orders and inventory related to the private label division, and the assumption of the benefit of a non-compete clause with Azteca Productions.

In exchange for the purchased assets, we assumed certain liabilities associated with Innovo’s private label division, including the remaining obligation under the original promissory note executed by Innovo in favor of Azteca Productions under the Blue Concept Asset Purchase Agreement, all other liabilities, other than the original promissory note, owed in connection with the private label division to Azteca Productions in excess of $1,500,000, all liabilities associated with Innovo’s outstanding purchase orders and inventory schedules listed in the Asset Purchase Agreement, and the obligations to continue to pay the earn-out under the Blue Concept Asset Purchase Agreement. The aggregate value of the assumed liabilities was $2,500,000, which excluded the remaining unpaid principal amount of the original promissory note of $7.9 million, which was paid through the issuance of shares of our common stock, as described below, and any amounts which might be owed under the earn-out.

The Asset Purchase Agreement contained customary terms and conditions, including, among other things, indemnification provisions, representations and warranties and post-closing covenants.

In connection with the Asset Purchase Agreement, we entered into a Letter Agreement dated April 24, 2006 among Azteca Productions, Hubert Guez, Paul Guez and Sweet Sportswear, LLC. Pursuant to the Letter Agreement and in connection with the closing of the Innovo transaction, on May 12, 2006 we issued 1,000,000 shares, of our common stock to each of Hubert Guez and Paul Guez, for an aggregate issuance of 2,000,000 shares in lieu of assuming the remaining outstanding balance of the promissory note issued by Innovo to Azteca Productions. Under the Letter Agreement, the 2,000,000 shares have piggy-back registration rights on any future registration statements on Form S-3 filed by Cygne. Messrs. Hubert and Paul Guez also agreed not to offer to sell, contract to sell, or otherwise sell, dispose of, loan, pledge or grant any rights with respect to any such shares until the close of trading on April 23, 2007. In addition, 250,000 of the shares issued to Paul Guez

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and 250,000 of the shares issued to Hubert Guez were placed in an escrow account until the expiration of the lock-up period, with the escrowed shares being returned to us in the event that our common stock is traded on NASDAQ (or any other stock exchange, market or trading facility on which the shares are traded) at an average price above $5.00 per share during the one-month period immediately preceding the expiration of the lock-up period.

As of May 12, 2006, pursuant to information set forth in a Form 4 filed with the SEC, Mr. Guez beneficially owns, has the power to dispose or direct the disposition of, and to vote or direct the voting of shares, personally, through various trusts and Diversified Apparel, representing approximately 49.03% of the shares of our common stock. In addition, Mr. Guez (i) owns approximately 47% of Azteca Production International, Inc., (ii) has a 50% membership interest in Sweet Sportswear, LLC and (iii) has approximately a 32% membership interest in Diversified Apparel Resources. LLC. AZT International, S.A. de C.V is a 100% subsidiary of. Azteca Production International, Inc.

As of May 21, 2006, Azteca Production International, Inc. may be deemed the beneficial owner of approximately 12.7% of Innovo Group Inc. common stock. Mr. Guez may be deemed to have the sole power to direct the voting and disposition of approximately 5.9% of Innovo Group Inc. common stock.

Acquisition of the denim apparel business from Diversified Apparel Resources LLC. (“Acquired Business”)

On July 31, 2005, we acquired from Diversified Apparel, a privately owned company principally owned by Mr. Guez, its business of designing, merchandising, and distributing of branded and private label denim apparel pursuant to an asset purchase agreement (“Acquired Business”).

The assets we acquired from Diversified Apparel included:

Diversified Apparel’s:

• tangible personal property;

• open purchase orders;

• New York showroom leases for the property located on the fourth floor of 215 West 40^th Street; and

• trademarks and intellectual property associated with the Acquired Business.

In consideration for the assets we acquired from Diversified Apparel, we:

• issued to Diversified Apparel 10,500,000 shares of our common stock;

• issued to Diversified Apparel a secured subordinated promissory note in the principal amount of $47.5 million;

• paid $2 million in cash to Diversified Apparel on the closing date; and

• agreed to pay to Diversified Apparel deferred purchase price payments totaling $1,750,000 in seven monthly installments of $250,000 each, without interest, on the last day of each month commencing with August 2005. We were permitted to defer payment of the first through fifth installments of such monthly payments for up to 180 days each, to the extent that our Board of Directors determined in its good faith sole discretion that any or all of such first through fifth installments of such monthly payments would adversely affect our business or financial condition, and we initially deferred the August payment. Our board of directors subsequently determined that payments of the August 2005 through the December 2005 installments would not adversely affect

28

• our business and financial condition and accordingly has made these payments to Diversified Apparel. We made the last of the seven required payments of $250,000 in February 2006.

• On January 3, 2006, we issued 1,428,571 shares of our common stock in payment of $7.5 million principal amount of the secured subordinated promissory note.

We accounted for this transaction as a purchase.

We also entered into several related agreements, including a registration rights agreement, a supply agreement, a distribution agreement, a stock transfer restriction agreement and a restrictive covenant agreement. Also in connection with this acquisition, we entered into a factoring agreement with Milberg Factors, Inc. The supply and distribution arrangements govern purchases of Diversified Apparel products by us, as well as related advances for inventory purchases. The restrictive covenant agreement sets forth agreed-upon non-competition covenants between Mr. Guez and us. The Registration Rights Agreement required us to use reasonable commercial efforts to register securities issued as a part of the acquisition price for the Acquired Business within a specified time frame. Notes 2 and 10 to the Consolidated Financial Statements provide detailed explanations of each these agreements.

As the result of our acquisitions, we are now a designer, merchandiser, manufacturer and distributor of branded and private label women’s denim, causal and career apparel with sales to retailers located in the United States. Our major customers include New York & Company, Inc. (“NY&C”), JC Penney, Kohl’s, Target Stores (“Target”) and American Eagle Outfitters (“AEO”). As a private label manufacturer, we produce apparel upon orders from our customers for sale under the customers’ own labels, rather than producing our own inventory of apparel for sale under a brand name. Our branded products are sold under the names “Hippie, “Hint Jeans” and “Voyou”.

Historically, our largest shipments are in our second quarter and third quarter, with lower sales in the fourth and first quarter.

A manufacturer of private label apparel is characterized by high volume sales to a small number of customers at competitive prices. Although private label gross margins are lower than the gross margins in the brand name apparel industry, collection and markdown costs are typically commensurably lower, and inventory turns are generally higher. Inventory risks are also generally reduced because the purchasing of fabric and other supplies begins only after purchase commitments have been obtained from customers. We believe that retailers, including our customers, are increasingly sourcing private label products themselves rather than utilizing outside vendors like us.

We manufacture our non-denim private label garments at our facilities in Guatemala or through third party manufacturers. Our branded and private label denim products are manufactured by AZT International S. de R.L. de C.V., an affiliate of Diversified Apparel, or through third party manufacturers.

We historically have been dependent on one or more key customers. A significant portion of our sales has been to NY&C. Sales to NY&C accounted for approximately 32% in year 2005.

For the three and nine months ended October 31, 2006 sales to JC Penney, Kohl’s, Target and AEO accounted for approximately 12.0%, 14.5%, 15.8% and 35.4% and 16.2%, 13.6%, 12.2% and 26.9%, respectively, of our net sales. For the three and nine months ended October 31, 2005, sales to New York & Company, JC Penney and Kohl’s accounted for approximately 25.5%, 16.9%, 20.4% and 45.4%, 11.9% and 14.4%, respectively, of our net sales.

We do not have long-term contracts with our customers JC Penney, Kohl’s, Target and AEO. Our future success will be dependent upon our ability to attract new customers and to continue to service our present customers. We continue to strive to maintain our positive working relationships with our customers by providing on-time deliveries of quality products.

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We cannot assure you that our major customers will continue to purchase merchandise from us at the same rate as they have historically purchased merchandise from us or the Acquired Business and the Innovo Acquisition, or at all in the future, or that we will be able to attract new customers. In addition, our major customers have the ability to exert significant control over our business decisions, including prices.

Effective January 1, 2005, the United States (“U.S.”) discontinued textile import quotas affecting the products sourced by us. As a result, the U.S. total imports in 2005 from China and other countries in the Far East, including the product categories manufactured by us in Guatemala and Mexico, have increased substantially. The U.S. has established a safeguard program which will limit the increase in apparel imports from China for years 2005 through 2008. Notwithstanding the safeguard program, our results of operations for products manufactured in Guatemala have been adversely affected for the year 2005 and the three and nine months ended October 31, 2006. We anticipate that our results of operations for products manufactured in Guatemala will continue to be adversely affected for the remainder of year 2006. The provision for restructuring of $102,000 recorded in the first quarter of 2005 represents the severance cost associated with the reduction of the production capacity at our Guatemalan facility. At January 31, 2006 based on an appraisal by an independent third party, the Company recorded an impairment charge against its building, building improvements, equipment, furniture and fixtures at its Guatemalan facility.

The Central American countries, which include Guatemala, and the U.S., have negotiated a Central America Free Trade Agreement (“CAFTA”). CAFTA, which was signed by U.S. on August 2, 2005, will allow in most cases the U.S. duty free imports from Guatemala if the woven fabric is manufactured in a CAFTA country using yarn produced in a CAFTA country. The Republic of Guatemala ratified CAFTA on July 1, 2006. We anticipate that, over time, CAFTA may make Guatemala more competitive with imports from China in the categories manufactured by us in Guatemala.

We have in the past incurred costs in restructuring our operations due to the loss of customers. We are continuing to review our existing business operations and could incur additional costs in the future associated with the further restructuring of our operations.

The apparel industry is highly competitive and historically has been subject to substantial cyclical variation, with purchases of apparel and related goods tending to decline during recessionary periods when disposable income is low. This could have a material adverse effect on our business. Retailers, including our customers are increasingly sourcing private label products themselves rather than utilizing outside vendors like us.

In March 2006, we were informed that the Securities and Exchange Commission (the “Commission”) had commenced a nonpublic formal investigation in December 2005 with respect to certain trading in our Common Stock during the period preceding the April 19, 2005 announcement that we had entered into preliminary discussions to acquire the branded and private label denim clothing supply business of Commerce Clothing Company, LLC (which, after the closing of the acquisition, changed its name to, and conducts its non-acquired businesses under the name, Diversified Apparel Resources, LLC). We have cooperated with the Commission’s investigation, which began as an informal investigation, and have responded to the Commission’s requests. One of our executive officers and the two persons who were our directors at the time of the acquisition have voluntarily testified to the Commission staff when the investigation was in the informal stage. Although we believe that the resolution of this matter will not have a material adverse effect on us, there can be no assurance as to the outcome of the Commission’s informal investigation. We intend to continue to cooperate with the Commission.

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Restatement

On December 1, 2006, management determined to change our previous accounting for amounts due from Milberg net of advances received from Milberg as a current asset in the balance sheet. Our management determined that it was more appropriate to report amounts due from Milberg as a current asset and advances from Milberg as a current liability because advances from Milberg are due on demand and amounts due from Milberg are payable upon receipt of payment by Milberg from our customers. As a result, our management determined that it was more appropriate to report amounts due from Milberg as a current asset and advances from Milberg as a current liability because advances from Milberg are due on demand and amounts due from Milberg are payable upon receipt of payment by Milberg from the Company’s customers. The statements of cash flows have been revised to present advances from Milberg and repayment of those advances as financing activities and the change in amounts due from Milberg as an operating activity.

We are also correcting errors identified related to the income tax expense and related deferred taxes payable for the three and nine months ended October 31, 2006 in order to increase the amount of the valuation allowance previously provided. In accordance with SFAS No. 109, “Accounting for Income Taxes”, and SFAS No.142, “Goodwill and Other Intangible Assets”, for taxable business combinations that yield tax-deductible goodwill, there is an accumulation of deferred tax liabilities over time as goodwill is deducted on tax returns but not amortized for financial reporting purposes. The deferred tax liabilities will reverse if impairment charges are recognized or when the business is disposed of through sale or otherwise. We had netted the deferred tax liability resulting from the indefinite life goodwill with gross deferred tax assets and provided a valuation allowance on the net asset balance. Because of the uncertainty of the timing of the reversal of the deferred tax liability related to the goodwill temporary difference, we have determined that the valuation allowance should have been provided against the net deferred tax assets without taking into account the indefinite lived goodwill.

Based on our present bookings, we believe that the net sales for the three months ended January 31, 2007 will be less than the actual sales for the three months ended January 31, 2006.

Critical Accounting Estimates

The preparation of our financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in our financial statements and accompanying notes. Actual results could differ materially from those estimates. We believe that the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements.

Accounts Receivable, Due from Factor and Allowance for Customer Chargebacks and Trade Discounts

Substantially all of our accounts receivable are factored without recourse. We estimate the allowances for customer chargebacks and trade discounts to be applied against our factored trade accounts receivable considering both historical and anticipated deductions taken by customers. As of October 31, 2006 and January 31, 2006, we had reserved approximately $1,407,000 and $1,962,000, respectively, for allowances for customer chargebacks and trade discounts. A change in this estimate could result in the need to record additional reserves.

Marketable Securities

Our marketable securities are comprised of a public company security at October 31, 2006 and January 31, 2006. All investments are classified as available for sale and are recorded at market, using the specific identification method. Realized gains and losses are reflected in other income and expense while unrealized gains and losses are included as a separate component of stockholders’ equity. A change in our determination of the permanent portion of losses on marketable securities could result in additional expense charged to operations.

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Inventories

We estimate the amount of goods that we will not be able to sell in the normal course of business and write down the value of these goods to the recovery value expected to be realized through off-price channels. In addition, we review the amount of goods for which we have purchase commitments to determine what we will not be able to sell in the normal course of business and record the anticipated loss on these goods based on the recovery value of the goods expected to be realized through off-price channels. A change in this estimate could result in the need to record additional reserves.

Income Taxes

We estimate the amounts of additional income taxes that may be assessed by the various taxing authorities upon audit of our filed tax returns based upon our knowledge of the cases and upon the advice of our tax counsel. A change in the estimated additional liability for income taxes could result in a higher provision for income taxes.

We estimate the valuation allowance against our deferred tax asset. We have recorded a valuation allowance against the net deferred tax asset due to our history of losses and near break-even results. However, should we conclude that utilization of deferred tax assets is more likely than not, the value of the deferred tax asset would be increased by eliminating some or all of the valuation allowance. The deferred tax assets are net of deferred tax liabilities except for deferred tax liabilities originating from our taxable business combinations that resulted in tax-deductible goodwill. In these instances, deferred tax liabilities accumulate over time as goodwill is deducted on tax returns but not amortized for financial reporting purposes. These deferred tax liabilities will reverse if impairment charges are recognized or when the business is disposed of through sale or otherwise. Because of the uncertainty of the timing of the reversal of the deferred tax liability related to the goodwill temporary difference, these deferred tax liabilities are not netted against our deferred tax assets in determining the valuation allowance.

Contingencies

We account for contingencies in accordance with Statement of Financial Accounting Standards No. 5, “Accounting for Contingencies” (“SFAS No. 5”). SFAS No. 5 requires that we record an estimated loss from a loss contingency when information available prior to issuance of our financial statements indicates that it is probable that an asset has been impaired or a liability has been incurred at the date of the financial statements and the amount of the loss can be reasonably estimated. Accounting for contingencies such as legal and income tax matters requires management to use judgment. Many of these legal and tax contingencies can take years to be resolved. We believe that the accruals made for these matters are adequate. Should events or circumstances change, we could have to record additional accruals.

Depreciation and Amortization

Depreciation of property and equipment is provided for by the straight-line method over the estimated useful lives of the assets. Leasehold improvements are amortized using the straight-line method over the term of the related lease. As of January 31, 2006, based on an appraisal by an independent third party, we recorded a 100% impairment charge against the equipment, furniture and fixtures at our Guatemalan facility and established a salvage value, not subject to depreciation, for our building and building improvements in our Guatemala facility.

Impairment of Long-Lived Assets and Goodwill

Long-lived assets consist of property and equipment, and intangible assets and goodwill. Intangible assets are comprised of trademarks, costs to create product lines, and the value of customer relationships from the acquisition of the denim apparel business of Diversified Apparel (“Acquired Business”) and the value of the customer relationships from the acquisition of the private label division of Innovo Group Inc. (“Innovo Acquisition”). In accordance with SFAS 142, “Goodwill and Other Intangible Assets,” we assess the impairment of identifiable intangibles and goodwill at least annually in the case of goodwill, and whenever

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events or changes in circumstances indicate that the carrying value may not be recoverable. Factors we consider to be important which could trigger an impairment review include the following:

• Significant underperformance relative to expected historical or projected future operating results;

• Significant changes in the manner of use of the acquired assets or the strategy for the overall business; and

• Significant negative industry or economic trends.

When we determine that the carrying value of long-lived assets may not be recoverable based upon the existence of one or more of the above indicators of impairment and the carrying value of the asset cannot be recovered from projected undiscounted cash flows, we record an impairment charge. We measure any goodwill impairment based on a projected discounted cash flow method using a discount rate determined by management to be commensurate with the risk inherent in the current business model. Significant management judgment is required in determining whether an indicator of impairment exists and in projecting cash flows.

Amortization of Discounts on Secured Subordinated Promissory Note

We recorded the fair value of the secured subordinated promissory note (“Note”) issued in connection with the acquisition of the Acquired Business at $33,300,000, which was originally a $14,200,000 discount from the face value of the $47,500,000 note. The discount to the note is being amortized to interest expense over the term of the Note. The note discount of $14,200,000 reduced the purchase price paid for the Acquired Business. In connection with the conversion of the $7,500,000 of the Note, a loss on extinguishment (recorded as a component of interest expense) of approximately $2,063,000 was recorded representing the pro-rata unamortized discount. Should events or circumstances change, we could have to record additional amortization of the note discount or the deferred purchase price.

Revenue Recognition

Revenues are recorded at the time of shipment of merchandise, provided that the price is fixed, title has been transferred, collection of the resulting receivable is reasonably assured and we have no significant obligations remaining to be performed. We establish allowances for customer chargebacks and trade discounts. Such reserves amounted to $1,407,000 and $1,962,000 at October 31, 2006 and January 31, 2006, respectively. Should events or circumstances change, we could have to record additional accruals for increased reserves.

Foreign Currency Exchange

The Company negotiates substantially all its purchase orders with its foreign manufacturers in U.S. dollars. Thus, notwithstanding any fluctuation in foreign currencies, the Company’s cost for any purchase order is not subject to change after the time the order is placed. However, the weakening of the U.S. dollar against local currencies could lead certain manufacturers to increase their U.S. dollar prices for products. The Company believes it would be able to compensate for any such price increase.

The above listing is not intended to be a comprehensive list of all of our accounting policies. In many cases, the accounting treatment of a particular transaction is specifically dictated by U.S. generally accepted accounting principles with no need for management’s judgment in their application. There are also areas in which management’s judgment in selecting any available alternative would not produce a materially different result. See our audited consolidated financial statements and notes thereto, which contain accounting policies and other disclosures required by U.S. generally accepted accounting principles.

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If we incorrectly anticipate these trends or unexpected events occur, our results of operations could be materially affected.

Results of Operations

The following table is derived from the Company’s consolidated statements of operations and expresses for the periods indicated certain data as a percentage of net sales.

	Three Months Ended:				Nine Months Ended
	October 31, 2006		October 31, 2005 (Restated)		October 31, 2006		October 31, 2005 (Restated)
Net Sales	100.0	%	100.0	%	100.0	%	100.0	%
Gross profit	19.3		23.1		21.5		19.1
Selling, general and administrative expenses	9.8		16.9		13.0		16.0
Depreciation and amortization	1.5		3.6		1.3		2.9
Provision for restructuring	—		—		—		0.3
Income (loss) before interest and income taxes	8.0		2.6		7.2		(0.1	)
Interest expense (income)	4.4		3.1		4.1		2.1
Provision for income taxes	1.3		1.8		1.3		1.3
Net loss	2.3	%	(2.3	)%	1.8	%	(3.5	)%

Three months ended (third quarter of 2006) and the nine months ended October 31, 2006 compared to three months ended (third quarter of 2005) the nine months ended October 31, 2005

Acquisition of Companies

On May 12, 2006, we acquired the private label division of Innovo Group Inc. (“Innovo Acquisition”). We accounted for this transaction as a purchase.

On July 31, 2005, we acquired the assets used in the branded and private label denim apparel business, which we refer to as the Acquired Business, of Commerce Clothing (which was later renamed Diversified Apparel Resources, LLC), a privately-held company principally owned by Mr. Guez, Diversified Apparel’s managing member and Chief Executive Officer, pursuant to an asset purchase agreement. We accounted for this transaction as a purchase. In connection with this transaction, Mr. Guez became our principal stockholder. Because of the two acquisitions, the results for the three and nine months ended October 31, 2005 and October 31, 2006 are not necessarily comparable.

Net Sales

Net sales for the third quarter of 2006 were $32,980,000, an increase of $10,045,000, or 43.8%, from net sales of $22,935,000 for the third quarter of 2005. Net sales for the nine months ended October 31, 2006 were $98,991,000 an increase of $66,439,000 from net sales of $32,552,000 for the nine months ended October 31, 2005.

The increase in sales for the third quarter of 2006 compared to the third quarter of 2005 of $10,045,000 was attributable to sales from the Acquired Business and from the Innovo Acquisition of $13,973,000, decreased sales to New York & Company (“NY&C”) of $4,269,000, and increased sales to other customers of $341,000.

The increase in sales for the nine months ended October 31, 2006 compared to the nine months ended October 31, 2005 of $66,439,000 was attributable to sales from the Acquired Business and from the Innovo Acquisition of $75,911,000, decreased sales to NY&C of $10,043,000, and increased sales to other customers of $571,000.

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The decrease in the programs offered by NY&C to us for the third quarter and nine months ended October 31, 2006 compared to the third quarter and nine months ended October 31, 2005 was a direct result of NY&C placing orders in China and other countries in the Far East. We believe that NY&C will substantially reduce the number of programs offered to us for the balance of the year 2006, as NY&C opts to place orders in China and other countries in the Far East.

For the three and nine months ended October 31, 2006 sales to JC Penney, Kohl’s, Target and AEO accounted for approximately 12.0%, 14.5%, 15.8% and 35.4% and 16.2%, 13.6%, 12.2% and 26.9%, respectively, of our net sales. For the three and nine months ended October 31, 2005, sales to NY&C, JC Penney and Kohl’s accounted for approximately 25.5%, 16.9%, 20.4% and 45.4%, 11.9% and 14.4%, respectively, of our net sales.

Gross Profit

The gross profit for the third quarter of 2006 was $6,379,000, or 19.3% of net sales, an increase of $1,089,000 from the gross profit of $5,290,000, or 23.1% of net sales, for the third quarter of 2005. The gross profit for the nine months ended October 31, 2006 was $21,319,000 or 21.5% of net sales, an increase of $15,105,000 from the gross profit of $6,214,000, or 19.1% of net sales for the nine months ended October 31, 2005.

The increase in gross profit for the third quarter of 2006 compared to the third quarter of 2005 of $1,081,000 was attributable to the gross profit of $2,120,000 from the Acquired Business and from the Innovo Acquisition, which had a 22.0% gross margin on sales of its products in 2006 compared to a 27.8% in 2005, decreased gross profit of $472,000 from NY&C, which had 12.1% and 11.5% gross margin on NY&C sales for the third quarter of 2006 and 2005, respectively, and a decrease in gross profit of approximately $559,000 on account of unused capacity at our Guatemalan manufacturing facility.

The increase in gross profit for the nine months ended October 31, 2006 compared to the nine months ended October 31, 2005 of $15,105,000 was attributable to the gross profit of $17,177,000 from the Acquired Business and from the Innovo Acquisition, which had a 21.5% gross margin on sales of its products in 2006 compared to 27.8% in 2005, decreased gross profit of $1,359,000 from NY&C which had 12.7% and 10.8% gross margin on NY&C sales for the nine months ended October 31, 2006 and 2005, respectively, decreased gross profit of $182,000 from all other customers, and a decrease in gross profit of approximately $531,000 on account of unused capacity at our Guatemalan manufacturing facility.

The decrease in the NY&C gross profit of $472,000 and $1,359,000, respectively, for the third quarter and nine months ended October 31, 2006 compared to the third quarter and nine months ended October 31, 2005 was primarily caused by lower sales in 2006 compared to 2005. The increase in the unused capacity at our Guatemalan manufacturing facilities of $531,000 was a direct result of lower sales volume from NY&C.

The gross margins were guaranteed for the product produced in Mexico at the Diversified Apparel’s facilities, a related party.

Selling, General and Administrative Expenses

Selling, general, and administrative (“SG&A”) expenses for the third quarter of 2006 were $3,248,000, a decrease of $635,000 from $3,883,000 in the comparable period in 2005. Selling, general, and administrative expenses for the nine months ended October 31, 2006 were $12,913,000, an increase of $7,711,000 from $5,202,000 for the nine months ended October 31, 2005.

The decrease in SG&A expenses for the third quarter of 2006 compared to the third quarter of 2005 of $635,000 was mainly attributable to (i) an increase in non- compete and earn-out fees of $264,000 due to higher sales in 2006 than 2005, (ii) an increase in professional fees of $76,000 mainly due to accounting and legal services performed in connection with the restatement of SEC filings, (iii) an increase in direct administrative expenses of $59,000, (iv) an increase in NASD fees of $25,000, (v) an increase of $36,000 for directors’ restricted stock which became vested during the third quarter of 2006, and (vi) an increase in the production staff of $86,000 on

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account of increases of current and projected sales volume. These increases of $546,000 were offset by (a) a decrease in distribution and operating service expenses of $947,000 of which $855,000 was from a credit issued by Diversified Apparel, a related party, to adjust for a retroactive billing adjustment, as agreed among the parties for the three months ended July 31, 2006 with the balance of the reduction of $92,000 linked to the sales volume subject to the Diversified Apparel distribution fee, (b) the elimination of a one-time 2005 factor fee of approximately $87,000, and (c) a decrease in advertising expense of $260,000. In addition the SG&A expenses in the third quarter of 2005 benefited from the reversal of certain accruals no longer required amounting to $112,000. There was no similar benefit in the third quarter of 2006.

The increase in SG&A expenses for the nine months of 2006 compared to the nine months of 2005 of $7,711,000 was mainly attributable to (i) an increase in non- compete and earn-out fees of $1,036,000 due to higher sales in 2006 than 2005, (ii) an increase in professional fees of $76,000 mostly due to accounting and legal services performed in connection with the restatement of SEC filings, an increase in audit fees of $128,000, an increase in legal fees of $115,000 such fees are primarily related to an increase in regulatory filings, (iii) an increase in NASD fess of $79,000, (iv) an increase in the cost of the board of directors and related activities of $96,000, (v) an increase of $108,000 for directors’ restricted stock which became vested during the nine months of 2006, and (vi) an increase in the production staff of $86,000 on account of increases of current and projected sales volume, (vii) an increase in the expenses to develop, sell and purchase our denim products in the amount of $3,319,000, (viii) an increase in distribution and operating service expenses of $2,096,000, (ix) an increase in direct administrative expenses in the amount of $1,114,000 and (x) severance costs of $292,000 caused by the combination of the functions with Acquired Business These increases of $8,545,000 were offset by (a) the elimination of a one-time 2005 factor fee of approximately $87,000, (b) a decrease in advertising expense of $260,000, and (c) a reduction of $599,000 which resulted from our reduction of payroll associated with operations to support orders placed by NY&C. .In addition the SG&A expenses in the third quarter of 2005 benefited from the reversal of certain accruals no longer required amounting to $112,000. There was no similar benefit in the third quarter of 2006.

Depreciation and Amortization

Depreciation on furniture, fixtures and leasehold improvements was $33,000 and $75,000, respectively, for the third quarter of 2006 and the third quarter of 2005. Amortization of intangible assets, which resulted from the acquisition of the Acquired Business and the Innovo Acquisition, was $453,000 and $726,000, respectively, for third quarter of 2006 and the third quarter of 2005.

Depreciation on furniture, fixtures and leasehold improvements was $98,000 and $208,000, respectively, for the nine months ended October 31, 2006 and the nine months ended October 31, 2005. Amortization of intangible assets, which resulted from the acquisition of the Acquired Company and the Innovo Acquisition, was $1,216,000 and $726,000 for the nine months ended October 31, 2006 and the nine months ended October 31, 2005, respectively.

As of January 31, 2006 based on an appraisal by an independent third party, we recorded a 100% impairment charge against the equipment, furniture and fixtures at our Guatemalan facility and established a salvage value, not subject to depreciation, for our building and building improvements in our Guatemala facility. Thus, there was no depreciation expense for the Guatemalan facility in the third quarter and the nine months ended October 31, 2006 as compared to $40,000 and $143,000 during the third quarter and nine months ended October 31, 2005, respectively.

Provision for Restructuring

The provision for restructuring of $102,000 recorded in the second quarter of 2005 represents the severance cost associated with the reduction of the production capacity at our Guatemalan manufacturing facility. On January 1, 2005, the United States discontinued its textile import quotas. As a result, our customers have been able to secure some of their products previously purchased from us from China and other countries in the Far East at a lower price.

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Interest Expense

Interest expense for the third quarter of 2006 was approximately $1,436,000 as compared to $716,000 for the third quarter of 2005. Interest expense for the nine months ended October 31, 2006 was $4,019,000 compared to $716,000 for the nine months ended October 31, 2005.

Interest expense for the third quarter of 2006 includes interest paid to factor of $452,000 on its advances to us, interest on the secured subordinated promissory note (“Note”) of $470,000 and the amortization of the discount on the Note of $514,000.

Interest expense for the nine months ended October 31, 2006 includes interest paid to factor of $1,069,000 on its advances to us, interest on the Note of $1,410,000 and the amortization of the discount on the Note of $1,540,000.

We recorded the fair value of the Note issued in connection with the acquisition at $33,300,000, which was originally a $14,200,000 discount from the face value of the $47,500,000 Note. As of October 31, 2005, we obtained a third part’s valuation of the Note. The discount to the Note is being amortized to interest expense over the term of the Note.

Provision for Income Taxes

The provision for income taxes for the third quarter and nine months of 2006 was $444,000 and $1,294,000 respectively, as compared to an income tax provision of $410,000 and $420,000, respectively, for the third quarter and nine months of 2005. The provision for the third quarter of 2006 was comprised of $18,000 of minimum state and local income taxes, and a deferred tax provision of $426,000 related to the difference between book and tax basis from indefinite lived goodwill. A valuation allowance has been provided against net deferred tax assets except for deferred tax liabilities originating from our taxable business combination that resulted in deductible goodwill. The provision for the third quarter of 2005 was $410,000, which was comprised of $18,000 of minimum state and local income taxes and a deferred tax provision of $426,000 related to the difference between book and tax basis from indefinite lived goodwill.

The provision for the nine months of 2006 was comprised of $36,000 of minimum state and local income taxes, and a deferred tax provision of $1,258,000 related to the difference between book and tax basis from indefinite lived goodwill. A valuation allowance has been provided against net deferred tax assets except for deferred tax liabilities originating from our taxable business combination that resulted in deductible goodwill. The provision for the nine months of 2005 of $420,000 was comprised of $28,000 of minimum state and local income taxes a deferred tax provision of $392,000 related to the difference between book and tax basis from indefinite lived goodwill.

Our effective tax rate differs from the federal statutory rate of 34% and our normal effective minimum state and local tax rate of 6% (for a total tax rate of 40%) due to United States operating losses, foreign tax-free operations and deferred tax on goodwill amortization for the third quarter and nine months of 2006 and United States operating losses and foreign tax-free operations for the third quarter and nine months of 2005.

Pro forma statement of operations

The following unaudited pro forma condensed combined statement of operations (unaudited) for the three and nine months ended October 31, 2006 and October 31, 2005 sets forth the combined results of operations for Cygne giving effect to the Innovo Acquisition using the purchase method of accounting as if the combination was consummated as of the beginning of the earliest period presented.

Pro forma adjustments to the statement of operations for the three and nine months ended October 31, 2005 combine the pro forma Acquired Business adjustments with the pro forma Innovo Acquisition adjustments.

The Acquired Business pro forma adjustments include the adjustment of the historical gross profit to the contractual gross profit which is defined in our supply agreement with Diversified Apparel, adjustment of

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Acquired Business historical distribution and occupancy costs to the contractual cost as defined in our distribution agreement with Diversified Apparel, the recording of the expense under the restrictive covenant agreement with Hubert Guezt, the recording of the amortization of the intangible assets in connection with the Acquired Business, the recording of the deferred tax liability and the adjustment to reflect the interest expense the amortization of debt discount expense on the secured subordinated promissory note issued in connection with the acquisition of the Acquired Business. The intangible assets included values for trademarks, costs to create product lines and value for customer relationships.

The Innovo Acquisition pro forma adjustments include the adjustment of Innovo Acquisition historical distribution and occupancy costs to the contractual cost as defined in our distribution agreement with Diversified Apparel, the adjustment of Innovo Acquisition historical amortization of its intangibles to the amortization of our intangibles in connection with the Innovo Acquisition, the recording of the deferred tax liability and the elimination of the Innovo Acquisition impairment of goodwill.

Under the purchase method of accounting, the excess purchase price, including transaction costs in the Innovo Acquisition, over the fair value of net assets acquired was approximately $9,804,000. $3,300,000 of the purchase price has been recorded as intangible assets assigned to customer relationships. These intangible assets are being amortized over periods ranging from three months to seven years. At this time, the work needed to provide the basis for determining these fair values and their amortization periods has not been completed. We have engaged an independent third party to determine the value of the intangible assets. As a result, the final allocation of the purchase price will be based on the results of the final valuation, which will consider the fair value of intangible assets acquired, which could materially differ from the pro forma amounts shown herein. Accordingly, a change in the fair value of intangible assets and the amortization periods could impact the amount of annual amortization expense.

The pro forma information is presented for illustration purposes only and is not necessarily indicative of the financial position or results of operations which would actually have been reported had the combination been in effect during these periods or which might be reported in the future. The pro forma financial information includes expenses allocated by Innovo Group Inc. to the Innovo Acquisition which may not be indicative of future results which will include actual expenses.

	(In thousands, except per share amounts)
	Three Months Ended				Nine Months Ended
	10/31/06 Actual		10/31/05 Pro forma (Restated)		10/31/06 Pro forma		10/31/05 Pro forma (Restated)
Net revenues	$	32,980	$	46,687	$	118,992	$	133,376
Net income	$	765	$	1,300	$	1,208	$	4,638
Net income per share—basic and diluted	$	0.03	$	0.05	$	0.05	$	0.26

Non-GAAP financial measures

Earnings before interest, taxes, depreciation and amortization (“EBITDA”) is used as a supplemental financial measure by management and by external users of our financial statements, such as investors and our factor, to assess:

• the financial performance of our assets without regard to financing methods, capital structures or historical cost basis;

• the ability of our assets to generate cash sufficient to pay interest on our indebtedness; and

• our operating performance and return on invested capital as compared to those of other companies in the apparel business, without regard to financing methods and capital structure,

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EBITDA should not be considered an alternative to net income, operating income, cash flow from operating activities or any other measure of financial performance or liquidity presented in accordance with general accepted accounting principles (“GAAP”).

EBITDA excludes some, but not all, items that affect net income and operating income, and these measures may vary among other companies. Therefore, EBITDA as presented below may not be comparable to similarly titled measures of other companies.

	(In thousands)
	Three Months Ended					Nine Months Ended
	10/31/06		10/31/05 (Restated)			10/31/06		10/31/05 (Restated)
Reconciliation of EDITDA tonet income
Net income (loss)	$	765	$	(520	)	$	1,779	$	(1,137	)
Depreciation and amortization		486		801			1,314		933
Interest expense		1,436		716			4,019		716
Provision for income taxes		444		410			1,294		420
EBITDA	$	3,131	$	1,407		$	8,406	$	932

	(In thousands)
	Three Months Ended				Nine Months Ended
	10/31/06		10/31/05 (Restated)		10/31/06		10/31/05 (Restated)
Reconciliation of EDITDA topro forma net income
Net income	$	765	$	1,300	$	1,208	$	4,638
Depreciation and amortization		496		932		1,546		1,674
Interest expense		1,436		964		4,401		4,358
Provision for income taxes		444		410		1,294		420
EBITDA	$	3,141	$	3,606	$	8,449	$	11,090

Liquidity and Capital Resources

The primary factors that affect our cash flow are (i) our net income (ii) our customer payment terms, (iii) our payments terms to our major supplier who is a related party and (iv) our inventory levels.

Net cash provided by our operating activities for the nine months ended October 31, 2006 was $1,974,000. The components of cash provided by operating activities totaling $10,398,000 are (i) an increase in inventories of $2,958,000 which reflects more denim inventory (ii) an decrease in other receivables and prepaid expenses of $237,000, which was substantially caused by a decrease in prepaid personnel costs, (iii) an increase in income taxes payable of $9,000, and (iii) our net profit of $5,431,000, after adding back depreciation of $98,000, amortization of intangible assets of $1,216,000, amortization of debt discount of $1,540,000, decrease in allowance for customer chargebacks and trade discounts of $555,000, deferred tax liability of $1,240,000 and non-cash stock compensation of $113,000, (iv) decrease in due from factor of $1,648,000 which was due to a decrease in sales and (v) an increase in accrued expenses of $115,000 which was primarily caused by an increase in professional fees. The cash provided by operations was partially offset by cash used in operations totaling $8,424,000 consisting of (a) an increase in non-factored trade receivables of $2,700,000 which is represented by an increase in American Eagle Outfitters trade receivables, (b) an increase in due from related parties of $4,423,000 which was primarily due to amounts advanced under the Supply Agreement offset by an

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increase in the fees due on the restrictive covenant and earn-out agreements and (c) a decrease in accounts payable of $1,301,000 which was principally caused by a decrease in professional fees payable and fabric vendors payables.

Net cash used in operating activities for the nine months ended October 31, 2005 was $13,321,000. The components of cash used by operating activities totaling $16,503,000 are (i) an increase in due to factor of $14,289,000 caused by our factoring our trade accounts receivable starting on July 31, 2005 and a change in accounting for amounts due from factor as described in Note 13 to Consolidated Financial Statements (ii) and increase in inventories of $2,190,000 caused by the acquisition of the Acquired Business, (iii) and increase in other assets of $24,000 caused by an additional lease deposit. The cash used in operations was partially offset by cash provided in operations totaling $3,182,000. The components of cash provided by operations are (a) our net profit of $189,000 which is net of depreciation of $208,000, amortization of debt discount of $726,000 and deferred income tax provision of $392,000 (b) a decrease of non factored trade accounts receivable of $837,000 caused by our decision to factor our receivables starting on July 31, 2005, thus substantially reducing our trade accounts receivable, (c) an increase in other receivables and prepaid expenses of $144,000 caused primarily by increase prepaid insurance, (d) an increase in due to related parties of $896,000 which is comprised of amounts due to Diversified Apparel under the Supply Agreement, amount due on Note amount, amount due to First Finish, Inc. and amount to due under the restrictive covenant agreement, (e) an increase in accounts payable of $872,000 primarily caused by increased amounts due on account of increased fabric purchases and amounts due to our advertising agency, (f) an increase in accrued expenses of $224,000 caused by an increase in amounts due as compensation to employees and (g) and increase in income taxes payable of $20,000.

Cash used in investing activities in the nine months ended October 31, 2006 of $367,000 consisted of expenditures incurred in connection with purchase of denim business from Diversified Apparel of $250,000, the purchase of the Innovo Acquisition of $70,000 and the purchase of computers of $47,000.

Cash used in investing activities in the nine months ended October 31, 2005 was $3,458,000 consisted of expenditures incurred in connection with the purchase of the Acquired Business of $3,419,000 and the purchase of computers of $39,000.

The financing activities in the nine months ended October 31, 2006 of $1,498,000 consisted of cash received of $1,000 from the exercise of stock options, advances from the factor of $72,290,000 and repayment of advances to the factor of $73,789,000.

The financing activities in the nine months ended October 31, 2005 of $13,516,000 consisted of cash received of $6,000 from the exercise of stock options, advances from the factor of $23,918,000 and repayment of advances to the factor of $10,408,000.

The secured subordinated promissory note (“Note”) in the principal amount of $47.5 million issued in connection with the acquisition from Diversified Apparel on July 31, 2005 has a maturity date of July 31, 2012. The note bears interest at 4.7% per annum, compounded annually. Interest and principal on the note are payable quarterly commencing on October 31, 2006. The principal amount of the note was payable as follows: (i) ten quarterly payments of $1,500,000 commencing on October 31, 2006; and (ii) ten quarterly payments of $2,500,000 commencing on July 31, 2009, with the final payment to be made on July 31, 2011. Subject to the subordination agreement between Diversified Apparel and Milberg Factors, Inc., we are required under the Note to use fifty percent of the net proceeds of any sale of our debt securities in a public offering or a private placement (but not including any bank debt, debt to any senior lender as set forth in the Note or any other ordinary course short term obligations) or any sale of our equity securities (other than pursuant to the exercise of options to purchase securities) to prepay the Note, with the principal amount of the Note being reduced by the amount of the prepayment at a discount of 1% of the prepayment. Our obligations under the Note are secured by a pledge of the trademarks purchased by us under the Agreement, pursuant to a security agreement entered into with Diversified Apparel.

We obtained a third-party valuation to determine the fair value of the Note for the purposes of determining the purchase price of the Acquisition. As a result, we recorded a debt discount of $14,200,000 to reduce the carrying value of the Note to fair value. The discount is being amortized to interest expense over the term of the

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Note as shown on the table below. During the three and nine months ended October 31, 2006, $514,000 and $1,514,000 of debt discount amortization was recorded.

On January 3, 2006, we and Diversified Apparel entered into a Note Conversion Agreement providing for the conversion of $7,500,000 of principal due under the Promissory Note to Diversified Apparel, into 1,428,571 shares of our common stock at the price of $5.25 per share. Accordingly, we canceled the principal payments due October 31, 2011, January 31, 2012 and July 31, 2012. The following schedule sets forth required minimum future principal payments required on the Note, as adjusted for the above conversion. Payments are to be made on a quarterly basis, commencing October 31, 2006.

Future minimum principal repayments required under the secured subordinated promissory note are as follows:

Year Ended January 31:	Principal		Note Discount Amortization		Total Principal Payments
2007	$	729,000	$	2,271,000	$	3,000,000
2008		3,214,000		2,786,000		6,000,000
2009		3,476,000		2,524,000		6,000,000
2010		7,953,000		2,047,000		10,000,000
2011		8,832,000		1,168,000		10,000,000
Thereafter		4,945,000		55,000		5,000,000
	$	29,149,000	$	10,851,000	$	40,000,000

The Note bears interest at 4.7%, and the Company expects to pay approximately $7,613,000 of interest over the life of the loan, commencing in the year ended January 31, 2007, as shown in the following table:

Year Ended January 31:
2007	$	3,016,000
2008		1,633,000
2009		1,354,000
2010		997,000
2011		526,000
Thereafter		87,000
	$	7,613,000

Effective July 31, 2005, we began to use Milberg Factors, Inc. (“Milberg”) for credit administration and cash flow purposes.

We entered into a one-year factoring agreement with Milberg effective July 31, 2005 which was amended on January 31, 2006 and July 31, 2006 and renewed through July 31, 2007 (the “Factoring Agreement”). Under the Factoring Agreement, we sell to Milberg without recourse all of our receivables which are acceptable to Milberg. Milberg is responsible for collection, assumes all credit risk, and obtains all of the rights and remedies of the Company against the Company’s customers for those receivables purchased by Milberg without recourse. Further, payment is due from Milberg upon the payment of the receivable to Milberg by our customer less a Milberg reserve for known future chargebacks from all customers. We estimate the allowances for customer chargebacks and trade discounts to be applied against our factored trade accounts receivable considering both historical and anticipated deductions taken by customers. As of October 31, 2006, we had reserved approximately $1,407,000 for allowances for customer chargebacks and trade discounts.

Milberg’s basic factoring charge is fifty-five one hundredths of one percent (0.55%) of the gross amount of the first $25,000,000 of receivables factored by Milberg in any contract year, forty-five one hundredths of one percent (0.45%) of the next $25,000,000 of receivables factored by Milberg in any contract year, and forty one hundredths of one percent (0.40%) of receivables factored by Milberg in any contract year in excess of

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$50,000,000, in each case, less any trade discounts to customers. For accounts with a low, but acceptable credit rating, Milberg adds approximately 1.00% of factored receivables to the factoring charge. The Factoring Agreement contains covenants with respect to working capital and net worth. The working capital (as defined) had to be at least $1 million for the period July 31, 2005 through January 31, 2006 and at least $3 million thereafter. We were in default with regard to this covenant at January 30, 2006 for which we obtained a waiver from Milberg. The tangible net worth (as defined) had to be at least $1 million through January 31, 2006 and at least $3 million. These covenants were amended with an effective date of January 31, 2006. The revised working capital (as defined) has to be at least $2 million for the period from January 31, 2006 through April 30, 2006, and at least $3 million thereafter. The revised tangible net worth (as defined) has to be at least $2 million for the period from January 31, 2006 through April 30, 2006, at least $3 million thereafter. An amendment with an effective date of September 30, 2006 provided that working capital at October 31, 2006 had to be at least $2,000,000. Cygne was in compliance with the working capital covenant at October 31, 2006. Cygne was in default with the tangible net worth covenant at October 31, 2006 for which Cygne obtained a waiver from Milberg.

The minimum aggregate factoring charges payable under the Factoring Agreement for the contract year are $95,000. The factor fees for the three and nine months ended October 31, 2006 were approximately $87,000 and $394,000, respectively. The maximum revolving amount set forth in the agreement was $20,000,000. In an amendment with an effective date of July 31, 2006, the maximum revolving amount was increased to $25,000,000. At the time of purchase of receivables and periodically thereafter, Milberg may in its sole discretion make advances to us. In addition, upon our request, Milberg must remit (and at any time in Milberg’s sole discretion Milberg may remit) any money standing to our credit on Milberg’s books in excess of a reserve for known future chargebacks from all customers.

Advances from Milberg are repayable on demand. The maximum advances are the lower of 90% of the net amount due from Milberg after a Milberg reserve for known chargebacks and trade discounts from all customers or $25,000,000. Advances from Milberg at October 31, 2006 were approximately $14,388,000. Interest paid to Milberg for the three and nine months ended October 31, 2006 was approximately $452,000 and $1,069,000, respectively.

Milberg may charge interest on any monies remitted or otherwise advanced or charged to our account before the collection of receivables. The interest rate is prime plus 0.5% (prime rate at October 31, 2006 was 8.25%). As security for all of our obligations to Milberg, including advances made by Milberg to us, we granted to Milberg, a continuing security interest in substantially all of its property. Such security interest is senior to the security interest granted to Diversified Apparel with respect to its Secured Subordinated Promissory Note.

In connection with the Factoring Agreement, Mr. Guez guaranteed our obligations to Milberg up to $1,000,000, plus accrued and unpaid interest, plus any costs and expenses of enforcing the guaranty, except that such guaranty is unlimited in the case of fraud. In an amendment with an effective date of July 31, 2006, Mr. Guez increased his guarantee of our obligations to Milberg to $1,500,000.

Also in connection with the Factoring Agreement, Diversified Apparel agreed to subordinate to Milberg the present and future indebtedness owed to Diversified Apparel by us until all of our obligations to Milberg made in connection with the Factoring Agreement have been fully paid and discharged.

Due from factor, net of factor advances and allowances for chargebacks and trade discounts, are summarized below. Factored receivables of $14,350,000 and $17,405,000 at October 31, 2006 and January 31, 2006, respectively, are without recourse.

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	(In thousands)
	October 31, 2006			January 31, 2006
Outstanding factored receivables	$	14,350		$	17,405
Less, allowances for chargebacks and trade discounts		1,407			1,962
Due from factor, net of allowances for chargebacks and trade discounts		12,943			15,443
Less, advances from factor		14,388			15,887
Due (to) factor net of factor advances and reserves for chargebacks and trade discounts	$	(1,445	)	$	(444	)

The average factor advances for the nine months ended October 31, 2006 were approximately $15,406,000 and the highest advance during this period was approximately $25,274,000, which was $274,000 over the maximum advance stated in Factoring Agreement.

We intend to finance our operations for the next twelve months through the use of operating profits, advances from our Factor, and our extended payment terms from Diversified Apparel, an affiliate of Mr. Guez, as provided in our Supply and Distribution Agreements with Diversified Apparel.

Our financial performance for the next twelve months will depend on a variety of factors, including the success of the Acquired Business and the Innovo Acquisition, the amount of sales to JC Penney, Kohl’s, Target and AEO, and the effect on our business on account of the discontinuance of textile import quotas by the United States on January 1, 2005. As a result of the discontinuance of textile import quotas, our customers may be able to secure the products currently being purchased from us in other places at a lower price. If we have significant operating losses, we could face severe liquidity pressures, which would adversely affect our financial condition and results of operations and cash flows. We have in the past incurred costs in restructuring our operations due to the loss of customers and could incur additional costs in the future associated with the restructuring of our operations. We believe that we will have sufficient working capital to support our business for the next twelve months if our assumptions regarding our anticipated operating profits are correct, our Factor continues making advances on the present terms of our Agreement, and our extended payment terms from Diversified Apparel remain in place.

Off-Balance Sheet Arrangements

We have not created, and we are not party to, any special-purpose or off-balance sheet entities for the purpose of raising capital, incurring debt or operating our business.

In connection with the Acquired Business, we entered into a supply agreement (the “Supply Agreement”) with AZT International S. de R.L. de C.V. (“AZT”), an affiliate of Mr. Guez. Under the Supply Agreement, AZT will manufacture and supply us with our entire requirements of branded and private label denim apparel (“Denim Products”) until July 31, 2007. Although AZT is obligated to deliver Denim Products ordered by us under the Supply Agreement, we have no obligation to source Denim Products from AZT. Pricing under the Supply Agreement, as modified under the first amendment, is based on providing us with guaranteed gross margins on our sales of Denim Products.

The second amendment to the Supply Agreement with an effective date of July 31, 2005 between Diversified Apparel and us specifies that AZT will ship its manufactured apparel to the United States and invoice Diversified Apparel, an affiliate of Mr. Guez. Diversified Apparel will retain the physical risk of loss while the inventory is in its possession and each month invoices to us for the apparel that we have shipped to our customers after deducting payment for inventory previously purchased. At the end of each month, Diversified Apparel invoices us for the apparel on hand that we estimate that we will ship to our customers in the subsequent month. This third amendment the Supply Agreement dated April 27, 2006 extends the expiration date of the Supply Agreement from January 31, 2007 to April 30, 2007, and if not renewed AZT will invoice us directly as specified in the Supply Agreement. The fourth amendment to the Supply Agreement with an

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effective date of July 31, 2006, extends the expiration date of the Supply Agreement to July 31, 2007 and specifies the guaranteed gross margins for our new customers. The apparel purchased from Diversified Apparel for the three and nine months ended October 31, 2006 was $19,608,000 and $53,300,000, respectively. At all times, Cygne is subject to obsolescence risk.

The Supply Agreement states that if the purchase orders outstanding from us under the Supply Agreement equal or exceed $7.5 million, we will advance to Diversified Apparel, at Diversified’s written request, up to 50% of any such amounts exceeding $7.5 million in order to finance production. The third amendment to the Supply Agreement dated April 27, 2006 states that we will advance to Diversified Apparel, at Diversified’s written request, up to 50% of the amount of all purchase orders outstanding, thus removing the $7.5 million base. At January 31, 2006 and October 31, 2006, advances from us to Diversified Apparel were approximately $1,272,000 and $3,930,000, respectively. The planned repayment terms for the outstanding advances are to deduct the advances from the payments made in connection with future inventory purchases. Since Diversified Apparel is a related party, Cygne does not deem it probable that the total 50% advance of the outstanding purchase orders under the Supply Agreement would be requested if Cygne did not have the available funds to make the entire advance. If the total 50% advance were to be requested, it would have a material adverse effect on the Company’s financial condition and the Company would have to renegotiate the agreement with Diversified Apparel, curtail purchases or seek additional working capital funding.

Under the terns of the Distribution Agreement, as amended, Diversified Apparel provides distribution and operations services for us. The distribution cost for the three and nine months ended October 31, 2006 was approximately $600,000 and $3,342,000 respectively, and is included in Selling, General and Administrative expenses in the statement of operations. The $600,000 cost for the three months ended October 31, 2006 has been offset by a credit from Diversified Apparel of $855,000 (thus a net credit for the three months of $255,000 and a net cost for nine months of $2,487,000) to adjust for a billing error for the three months ended July 31, 2006. In addition, the cost of the packing materials purchased from Diversified Apparel during the three and nine months ended October 31, 2006 was approximately $58,000 and $257,000, respectively, and is included in Selling, General and Administrative expenses in the statement of operations.

An amendment to the Distribution Agreement with an effective date of July 31, 2005 specifies that we will purchase all of our denim apparel manufactured outside of Mexico from Diversified Apparel. Diversified Apparel will receive this apparel in its United States warehouse and retain the physical risk of loss while the inventory is in its possession. Diversified Apparel will invoice us for the apparel that has been shipped to our customers after deducting payment for inventory previously purchased. Before the end of each month, Diversified Apparel will invoice to us the apparel that we estimate that we will ship to our customers in the subsequent month. The second amendment to the Distribution Agreement dated April 27, 2006, extends the expiration date of the Distribution Agreement to April 30, 2007. The third amendment to the Distribution Agreement with an effective date of July 31, 2006 extends the expiration date of the Distribution Agreement to July 31, 2007 and states that Cygne will advance to Diversified Apparel, at Diversified’s written request, up to 50% of any outstanding product purchase orders. At all times, Cygne is subject to obsolescence risk. The apparel purchased from Diversified Apparel under this arrangement for the three and nine months ended October 31, 2006 was $1,894,000 and $15,653,000, respectively. The planned repayment terms for the outstanding advances are to deduct the advances from the payments made in connection with future inventory purchases. Since Diversified Apparel is a related party, Cygne does not deem it probable that the total 50% advance of the outstanding purchase orders under the Distribution Agreement would be requested if Cygne did not have the available funds to make the entire advance. If the total 50% advance were to be requested, it would have a material adverse effect on the Company’s financial condition and the Company would have to renegotiate the agreement with Diversified Apparel, curtail purchases or seek additional working capital funding.

As of October 31, 2006, we have outstanding short-term purchase order commitments to Diversified Apparel, a related party, for approximately $22,491,000. In addition, we have short-term purchase order commitments to non-related parties of approximately $5,000.

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Effect of New Accounting Standards

In November 2004, the Financial Accounting Standards Board (“FASB’) issued Statement of Financial Accounting Standards (“SFAS”) No. 151, “Inventory Costs, an amendment of ARB No. 43, Chapter 4.” SFAS No. 151 retains the general principle of ARB 43, Chapter 4, “Inventory Pricing (AC Section I78),” that inventories are presumed to be stated at cost; however, it amends ARB 43 to clarify that abnormal amounts of idle facility expense, freight, handling costs, and wasted materials (spoilage) should be recognized as current-period charges and require the allocation of fixed production overheads to inventories based on the normal capacity of the production facilities. The guidance is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. Earlier application is permitted for inventory costs incurred during fiscal years beginning after November 23, 2004. The adoption of SFAS No. 151 did not have a material impact on our financial condition, results of operations or cash flows.

In May 2005, the FASB issued SFAS 154, “Accounting Changes and Error Corrections,” that applies to all voluntary changes in accounting principle. This Statement requires retrospective application to prior periods’ financial statements of changes in accounting principle, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. When it is impracticable to determine the period-specific effects of an accounting change on one or more individual prior periods presented, this Statement requires that the new accounting principle be applied to the balances of assets and liabilities as of the beginning of the earliest period for which retrospective application is practicable and that a corresponding adjustment be made to the opening balance of retained earnings (or other appropriate components of equity or net assets in the statement of financial position) for that period rather than being reported in an income statement. When it is impracticable to determine the cumulative effect of applying a change in accounting principle to all prior periods, this Statement requires that the new accounting principle be applied as if it were adopted prospectively from the earliest date practicable. SFAS 154 will be effective for us for fiscal year ended January 31, 2007. The adoption of SFAS No. 154 did not have a material impact on our financial condition, results of operations or cash flows.

In June 2006, the FASB issued FASB Interpretation No. 48 (“FIN 48”), “Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109,” which establishes that the financial statement effects of a tax position taken or expected to be taken in a tax return are to be recognized in the financial statements when it is more likely than not, based on the technical merits, that the position will be sustained upon examination. FIN 48 is effective for fiscal years beginning after December 15, 2006. We do not anticipate that adoption of FIN 48 will have a material impact on our financial condition, results of operations or cash flows.

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements,” which establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. SFAS No. 157 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. SFAS No. 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The adoption of SFAS No. 157 is not expected to have a material impact on the Company’s financial condition, results of operations or cash flows.

Inflation

The Company does not believe that the relatively moderate rates of inflation which have been experienced in the United States, where it competes, have had a significant effect on its net sales or profitability.

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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We are not a party to any derivative financial instruments. We are subject to changes in the prime rate based on the Federal Reserve actions and general market interest fluctuations. We believe that moderate interest rate increases will not have a material adverse impact on our results of operations, or financial position, in the foreseeable future. For the nine months ended October 31, 2006, factor advances peaked at $25,274,000 and the average amount of factor advances was $18,774,000. An increase of 1% in the interest rate would have increased our interest expense for factor advances by approximately $140,000 in the nine months ended October 31, 2006.

ITEM 4. CONTROLS AND PROCEDURES

As discussed in Note 13 to the Consolidated Financial Statements, management of the Company has restated the Company’s consolidated financial statements for the three and nine months ended October 31, 2005. The determination to restate these consolidated financial statements and other financial information was made in order to correct errors in the Company’s accounting for its factoring agreement and income tax expense and related deferred taxes payable.

Identification of Material Weaknesses

As a result of the errors related to the Company’s accounting for its factoring agreement and income taxes, the Company concluded that it did not maintain effective controls over the completeness and accuracy of its accounting for the factoring agreement and deferred tax liabilities including the related deferred income tax valuation allowance and the income tax (benefit) expense accounts. These control deficiencies resulted in the restatement discussed above, and could result in a misstatement of current assets and liabilities and cash flows from operating and financing activities, in the case of the treatment of the factoring agreement, and a misstatement of income tax (benefit) expense and deferred taxes payable in the case of the accounting for taxes on goodwill resulting from an acquisition, that in each case could result in a material misstatement to the annual or interim financial statements that would not be prevented or detected.

Accordingly, management has determined that the control deficiencies referred to above constitute material weaknesses. A material weakness is a control deficiency, or combination of control deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected.

Conclusion Regarding the Effectiveness of Disclosure Controls and Procedures

We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in the reports that we file or submit under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the SEC, and that such information is accumulated and communicated to our management timely.

An evaluation was performed under the supervision and with the participation of our management, including our Chief Executive Officer and our Chief Financial Officer, of the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934) as of the three and nine months ended October 31, 2006. Based upon that evaluation, and as a result of the material weaknesses discussed above, our management, including our Chief Executive Officer and our Chief Financial Officer, has concluded that our disclosure controls and procedures were not effective as of October 31, 2005.

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Remediation of Material Weaknesses

With respect to the material weakness related to the accounting for the factoring agreement and for deferred income taxes, management has researched and reviewed the detailed technical requirements related to the accounting for the factoring agreement and for deferred tax asset valuation allowances, and has revised its policy regarding the presumed reversal pattern of taxable temporary differences. Management has documented its conclusions so that it can continue to be applied consistently and appropriately in future periods. Management believes that implementation of this action will effectively remediate the material weakness described above.

Changes in Internal Control over Financial Reporting

The changes in the Company’s internal controls over financial reporting described above were implemented subsequent to the quarter ended October 31, 2005. There was no change in the Company’s internal control over financial reporting that occurred during the three and nine months ended October 31, 2006 that has materially affected, or is reasonably likely to materially affect, the internal control over financial reporting.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

The Company is involved in various legal proceedings that are incidental to the conduct of its business, none of which the Company believes could reasonably be expected to have a material adverse effect on the Company’s financial condition, results of operations and cash flows.

Item 1A. Risk Factors

There are no material changes from the risk factors previously disclosed on our Form 10-K for the fiscal year ended January 31, 2006.

Item 5. Other Information

We have been granted an extension by Diversified Apparel to have our Registration Statement to be declared effective by December 31, 2006 from the previous effective date of September 30, 2006.

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Item 6. Exhibits and Reports on Form 8-K

a. Exhibits

10.28 Amendment to Factoring Agreement, dated as of September 30, 2006, by and between Milberg Factors and Cygne Designs, Inc.*

10.29 Waiver to Factoring Agreement, dated as of October 31, 2006, by and between Milberg Factors and Cygne Designs, Inc. *

31.1 Certification of Principal Executive Officer *

31.2 Certification of Principal Financial Officer *

32.1 Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted to Section 906 of the Sarbanes-Oxley Act of 2002 *

32.2 Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted to Section 906 of the Sarbanes-Oxley Act of 2002 *

* Included herewith

b. Reports on Form 8-K

Date	Item	Event
September 14, 2006 (8-K)	2.02, 9.01	Announcement of financial results for the three and six months ended July 31, 2006

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

December 19, 2006	By:	/s/ Bernard M. Manuel
		Bernard M. Manuel, Chairman of the Board and Chief Executive Officer
December 19, 2006	By:	/s/ Roy E. Green
		Roy E. Green, Senior Vice President, Chief Financial Officer and Treasurer and Secretary

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