As of November 13, 2007, 26,232,200 shares of the registrant’s common stock were outstanding.

---

 

TABLE OF CONTENTS

 

				Page
PART I	Financial Information
Item 1.	Condensed Consolidated Financial Statements			4
		Condensed Consolidated Balance Sheets as of September 30, 2007 (As restated, unaudited) and December 31, 2006		4
		Unaudited Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2007 (as restated) and 2006		5
		Unaudited Condensed Consolidated Statement of Stockholders’ Equity (Deficiency) for the three and nine months ended September 30, 2007 (as restated) and 2006		6
		Unaudited Condensed Consolidated Statements of Cash Flows for the three and nine months ended September 30, 2007 (as restated) and 2006		7
		Notes to the Unaudited Condensed Consolidated Financial Statements for the three and nine months ended September 30, 2007 (as restated) and 2006		8
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations			29
Item 4.	Controls and Procedures			44
PART II	Other Information
Item 6.	Exhibits			46

2

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EXPLANATORY NOTE

 

Blue Holdings, Inc. is filing this Amendment No. 2 to its Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2007 filed with the Securities and Exchange Commission on November 14, 2007 and amended on November 29, 2007 (the “Form 10-Q”). This filing amends and restates our unaudited condensed consolidated balance sheet as of September 30, 2007, and the condensed consolidated statements of operations, stockholders equity (deficiency), and cash flows for the three and nine month periods ending September 30, 2007 to reflect the Company’s failure to record $1,302,842 of inventory purchased from a vendor that was directly paid for by Mr. Guez, and rental expense for an office facility used by the Company that is owned by the living trust of Paul and Elizabeth Guez in the amount of $24,000. The Company has now agreed to a settlement with Mr. Guez relating to these disputed amounts. The effects of the settlement agreement on the previously filed Form 10-Q for the three and nine months ending September 30, 2007 are detailed at Note 1(d) of the accompanying restated condensed consolidated financial statements.

 

This Amendment No. 2 amends and restates the following items of the Form 10-Q as described above: (i) Part I, Item 1 - Financial Statements; (ii) Part I, Item 2 - Management’s Discussion and Analysis of Result of Operations and Financial Condition; (iii) Part I, Item 4 - Controls and Procedures and (iv) Part II, Item 6 - Exhibits.

 

All information in the Form 10-Q, as amended by this Amendment No. 2, speaks as to the date of the original filing of our Form 10-Q for such period and does not reflect any subsequent information or events except as noted in this Amendment No. 2. All information contained in this Amendment No. 2 is subject to updating and supplementing as provided in our reports, as amended, filed with the Securities and Exchange Commission subsequent to the date of the initial filing of the Form 10-Q.

3

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PART I

ITEM 1. CONDENSED FINANCIAL STATEMENTS

 

BLUE HOLDINGS INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
ASSETS		September 30			December 31,
		2007			2006
		( As Restated)
		(Unaudited)
Current assets:
Cash		$	221,202		$	109,031
Due from factor, net of reserves of $106,237 and $178,801, respectively			2,662,425			1,366,588
Accounts receivable, net of reserves of $1,193,000 and $901,941, respectively:
- Purchased by factor with recourse			3,380,109			7,662,198
- Others			146,672			19,312
Inventories, net of reserves of $590,701 and $1,742,893 respectively			8,943,060			5,394,006
Due from related parties			-			-
Income taxes receivable			61,190			2,030,919
Deferred income taxes			884,101			2,488,082
Prepaid expenses and other current assets			1,120,502			396,810
Total current assets			17,419,261			19,466,946
Deferred income taxes			1,875,925			-
Property and equipment, net of accumulated depreciation			1,881,012			1,611,171
Total assets		$	21,176,198		$	21,078,117
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIENCY)
Current liabilities:
Bank overdraft			903,804		$	266,788
Accounts payable			864,559			2,820,024
Short-term borrowings			14,463,317			10,026,814
Due to related parties			85,778			710,153
Advances from majority shareholder			1,326,842			1,876,991
Current portion of liability for unrecognized tax benefits			96,850			-
Current portion of convertible debt			-
Accrued expenses and other current liabilities			2,042,379			2,133,932
Total current liabilities			19,783,529			17,834,702
Loan from majority shareholder			2,556,682			-
Non-current portion of liability for unrecognized tax benefits			231,592			-
Non-current portion of convertible debt			-
Total liabilities			22,571,803			17,834,702
Stockholders' equity (deficiency):
Preferred stock $0.001 stated value, 5,000,000 shares authorized, 1,000,000
Series A convertible shares issued with 6% cumulative dividend of the
designated purchase price and initial conversion price of $0.7347 (note 12)
Common stock $0.001 par value, 75,000,000 shares authorized, 26,232,200 and
26,057,200 shares issued and outstanding, respectively			26,232			26,057
Additional paid-in capital			5,445,904			4,964,091
Accumulated deficit			(6,867,741	)		(1,746,733	)
Total stockholders' equity (deficiency)			(1,395,605	)		3,243,415
Total liabilities and stockholders' equity (deficiency)		$	21,176,198		$	21,078,117
SEE NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

4

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BLUE HOLDINGS INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2007 (AS RESTATED) AND 2006
		Three Months Ending						Nine Months Ending
		Sept. 30,			Sept. 30,			Sept. 30,			Sept. 30,
		2007			2006			2007			2006
		(As Restated)						(As Restated)
Net sales		$	9,458,399		$	14,551,581		$	26,300,592		$	41,610,112
Cost of goods sold			8,511,248			10,116,732			17,092,681			23,797,647
Gross profit			947,151			4,434,849			9,207,911			17,812,465
Selling, distribution & administrative expenses			4,492,960			4,281,467			13,070,619			13,204,554
Income (loss) before other expenses and provision for income taxes			(3,545,809	)		153,382			(3,862,708	)		4,607,911
Other expenses:
Interest expense			453,302			257,997			1,205,835			643,759
Expenses relating to the acquisition of Long Rap, Inc.			-			500,887			-			500,887
Income (loss) before provision for income taxes			(3,999,111	)		(605,502	)		(5,068,543	)		3,463,265
Provision (benefit) for income taxes			-			(184,642	)		-			1,489,453
Net income (loss)		$	(3,999,111	)	$	(420,860	)	$	(5,068,543	)	$	1,973,812
Income (loss) per common share, basic and diluted		$	(0.15	)	$	(0.02	)	$	(0.19	)	$	0.08
Weighted average shares outstanding, basic and diluted			26,232,200			26,057,200			26,154,422			26,057,200
SEE NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

5

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BLUE HOLDINGS INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY (DEFICIENCY)
FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2007 (UNAUDITED) (RESTATED)
		Common Shares Issued						Additional
					Par Value			Paid In			Accumulated
		Number			0.001			Capital			Deficit			Total
Balance, January 1, 2007			26,057,200		$	26,057		$	4,964,091		$	(1,746,733	)	$	3,243,415
Fair value of vested stock options			-			-			254,488						254,488
Cumulative effect of adoption of FIN 48			-			-						(52,465	)		(52,465	)
Fair value of shares issued under co-branding agreement			175,000			175			227,325						227,500
Net loss for the period (as restated)			-			-			-			(5,068,543	)		(5,068,543	)
Balance, Setptember 30, 2007 (as restated)			26,232,200		$	26,232		$	5,445,904		$	(6,867,741	)	$	(1,395,605	)
SEE NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

6

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BLUE HOLDINGS INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2007 AND 2006 (UNAUDITED)
		2007			2006
		(As Restated)
Cash flows from operating activities:
Net income (loss)		$	(5,068,543	)	$	1,973,812
Adjustments to reconcile net income to cash used in operating activities:
Depreciation and amortization			312,442			136,644
Fair value of vested stock options			254,488			356,528
Changes in assets and liabilities:
Accounts receivable			4,154,729			(3,598,620	)
Due from factor			(1,295,837	)		(789,990	)
Income taxes receivable			1,969,729			-
Inventories			(3,549,054	)		(3,629,291	)
Due to related parties			(624,375	)		399,950
Due from related parties			-			15,974
Deferred income taxes			4,033			(235,423	)
Prepaid expenses and other current assets			(496,192	)		(740,641	)
Income tax payable			-			(650,468	)
Bank overdraft			637,016			(594,303	)
Accounts payable			(1,955,466	)		553,751
Other current liabilities			(91,553	)		588,046
Net cash used in operating activities			(5,748,583	)		(6,214,031	)
Cash flows from investing activities:
Purchase of equipment			(582,282	)		(1,216,063	)
Net cash used in investing activities			(582,282	)		(1,216,063	)
Cash flows from financing activities:
Short-term borrowings			4,436,503			4,912,007
Advances from majority shareholder			2,006,533			2,412,025
Net cash provided by financing activities			6,443,036			7,324,032
Net (decrease) increase in cash			112,171			(106,062	)
Cash at beginning of period			109,031			228,127
Cash at end of period		$	221,202		$	122,065
SUPPLEMENTAL CASH FLOW INFORMATION:
Cash paid for interest		$	1,205,835		$	643,759
Cash paid for income tax		$	-		$	2,551,605
SUPPLEMENTAL DISCLOSURE OF NON-CASH FINANCING AND INVESTING ACTIVITIES:
Cumulative effect of adoption of FIN 48		$	52,465		$	-
Increase in prepaids for fair value of stock issued under co-branding agreement		$	227,500		$	-
SEE NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

7

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BLUE HOLDINGS, INC. AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2007 (AS RESTATED) AND 2006

 

NOTE 1 – BASIS OF PRESENTATION, ORGANIZATION AND NATURE OF OPERATIONS

 

(a) Basis of Presentation

 

The interim condensed consolidated financial statements are unaudited, but in the opinion of management of the Company, contain all adjustments, which include normal recurring adjustments, necessary to present fairly the financial position at September 30, 2007 and the results of operations for the three and nine months ended September 30, 2007 and 2006 and cash flow for the nine months ended September 30, 2007 and 2006. The condensed consolidated balance sheet as of December 31, 2006 is derived from the Company’s audited financial statements.

 

Certain information and footnote disclosures normally included in financial statements that have been presented in accordance with generally accepted accounting principles have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission with respect to interim financial statements, although management of the Company believes that the disclosures contained in these financial statements are adequate to make the information presented therein not misleading. For further information, refer to the consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-KSB for the fiscal year ended December 31, 2006, as filed with the Securities and Exchange Commission.

 

The Company’s results of operations for the three and nine months ended September 30, 2007 are not necessarily indicative of the results of operations to be expected for the full fiscal year ending December 31, 2007.

 

The condensed consolidated financial statements include the operations of Blue Holdings, Inc. and its wholly-owned subsidiaries. Intercompany transactions and balances are eliminated in consolidation.

 

(b) Organization

 

Blue Holdings, Inc. (the “Company”) was incorporated in the State of Nevada on February 9, 2000 under the name Marine Jet Technology Corp. On April 14, 2005, Blue Holdings entered into an Exchange Agreement with Antik Denim, LLC (“Antik”). At the closing of the transactions contemplated by the Exchange Agreement, which occurred on April 29, 2005, Blue Holdings acquired all of the outstanding membership interests of Antik (the “Interests”) from the members of Antik, and the members contributed all of their Interests to Blue Holdings. In exchange, Blue Holdings issued to the members 843,027 shares of Series A Convertible Preferred Stock, par value $0.001 per share, of Blue Holdings (“Preferred Shares”), which, on June 7, 2005, as a result of a change to Marine Jet Technology Corp.’s name to Blue Holdings, Inc. and a 1 for 29 reverse stock split, were converted into 24,447,783 shares of Blue Holding’s common stock on a post-reverse stock split basis.

 

As such, immediately following the closing and upon the conversion of the Preferred Shares, the Antik members and Elizabeth Guez, our former Chief Operating Officer and wife of Paul Guez, owned approximately 95.8% of the total issued and outstanding common stock of Blue Holdings on a fully-diluted basis. Following completion of the exchange transaction, Antik became a wholly-owned subsidiary of Blue Holdings. The acquisition was accounted for as a reverse merger (recapitalization) in the accompanying financial statements with Antik deemed to be the accounting acquirer and Blue Holdings deemed to be the legal acquirer. As such, the financial statements herein include those of Antik since September 13, 2004 (the date of its inception). All assets and liabilities of Marine Jet Technology Corp. were assumed by the major shareholder of Blue Holdings, Inc. prior to the exchange transaction and were inconsequential to the merged companies.

 

8

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 BLUE HOLDINGS, INC. AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2007 (AS RESTATED) AND 2006

 

On June 7, 2005, Marine Jet Technology Corp. changed its name to Blue Holdings, Inc., and increased its authorized number of shares of common stock to 75,000,000.

 

On October 31, 2005, the Company entered into an exchange agreement with Taverniti So Jeans, LLC, a California limited liability company (“Taverniti”), and the members of Taverniti (the “Taverniti Members”). Under the exchange agreement, the Company acquired all of the outstanding membership interests of Taverniti (the “Taverniti Interests”) from the Taverniti Members, and the Taverniti Members contributed all of their Taverniti Interests to the Company. In exchange, the Company issued to the Taverniti Members, on a pro rata basis, an aggregate of 500,000 shares of the Common Stock, par value $0.001 per share, of the Company, and paid to the Taverniti Members, on a pro rata basis, an aggregate of Seven Hundred Fifty Thousand Dollars ($750,000). At the closing of the exchange transaction, Taverniti became a wholly-owned subsidiary of the Company. Paul Guez, the Company’s Chairman and majority shareholder, was and remains the sole manager and was a member of Taverniti. Elizabeth Guez, Paul Guez’s spouse and the Company’s former Chief Operating Officer, was also a member of Taverniti. Two other members of Mr. and Mrs. Guez’s family were the remaining members of Taverniti. The transaction was accounted for as a combination of entities under common control. As such, the financial statements herein have been presented to include the operations of Taverniti since September 13, 2004, the date of its inception, and the $750,000 payment was considered as a deemed distribution to the members of Taverniti upon the closing of the combination.

 

(c) Nature of Operations

 

The Company operates exclusively in the wholesale apparel industry. The Company designs, develops, markets and distributes high fashion jeans and accessories under the brand names Antik Denim, Yanuk, Faith Connexion and Taverniti So Jeans. The Company’s products currently include jeans, jackets, belts, purses and T-shirts. The Company currently sells its products in the United States, Canada, and Japan directly to department stores and boutiques and through distribution arrangements in certain foreign jurisdictions. The Company is headquartered in Commerce, California and maintains showrooms in New York and Los Angeles. The Company opened a retail store in Los Angeles during August 2005 and another store in San Francisco in September 2006. These retail operations are not yet significant to the consolidated operations.

 

(d) Restatement of Condensed Consolidated Financial Statements 

 

The Company has restated its unaudited condensed consolidated balance sheet as of September 30, 2007, and the condensed consolidated statements of operations, stockholders equity (deficiency), and cash flows for the three and nine month periods ending September 30, 2007.

 

From time to time Paul Guez, the Company’s Chairman of the Board and majority stockholder, and his spouse Elizabeth Guez made advances to the Company to support its working capital needs. These advances are part of a line of credit agreement with Mr. Guez which allows the Company to borrow from him up to a maximum of $3,000,000 at an interest rate of 6% per annum (the “Revolving Line”). The Company may repay the advances in full or in part at any time until the Revolving Line expires and repayment is required on December 31, 2007. The Company also maintains several due/to from related party accounts with Mr. Guez and his affiliated companies where funds are advanced to cover certain operating expenses. These advances are unsecured, non-interest bearing with no formal terms of repayment.

 

9

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 BLUE HOLDINGS, INC. AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2007 (AS RESTATED) AND 2006

 

In early May 2008, Mr. Guez informed the Company of claims for sums he believed were due and owing to him pursuant to advances made to and payments made on behalf of the Company during fiscal 2007 that were inaccurately recorded in the Company’s previously filed financial statements for the three and nine month periods ended September 30, 2007.

 

The Audit Committee commenced a review of these potential errors and instructed management to review the Registrant’s books and records to obtain a summary of transactions recorded and amounts owed per such records. These investigations revealed accounting errors in the Registrant’s related party accounts pertaining to payables due Mr. Guez as of September 30, 2007. These errors related to the Company not recording $1,302,842 of inventory purchased from a vendor that was directly paid for by Mr. Guez, and rental expense for an office facility used by the Company that is owned by the living trust of Paul and Elizabeth Guez in the amount of $24,000. The Company has now agreed to a settlement with Mr. Guez relating to these disputed amounts.

 

In light of this dispute and settlement, the Audit Committee and Management of the Company have determined that the Company’s unaudited condensed consolidated financial statements for the three and nine months ended September 30, 2007 need to be restated due to accounting errors in the Company’s related party accounts. The effects of the settlement agreement on the previously filed Form 10-Q for the three and nine months ending September 30, 2007 are summarized as follows:

 

10

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BLUE HOLDINGS, INC. AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2007 (AS RESTATED) AND 2006

 

ASSETS		September 30			September 30						September 30
		2007			2007						2007
		(As initially			(Adjustment)						(As restated)
		reported)
Current assets:
Cash		$	221,202								$	221,202
Due from factor, net of reserves			2,662,425									2,662,425
Accounts receivable, net of reserves:
- Purchased by factor with recourse			3,380,109									3,380,109
- Others			146,672									146,672
Inventories, net of reserves			8,943,060									8,943,060
Due from related parties			-									-
Income taxes receivable			61,190									61,190
Deferred income taxes			868,011			16,090			(3)			884,101
Prepaid expenses and other current assets			1,120,502									1,120,502
Total current assets			17,403,171			16,090						17,419,261
Deferred income taxes			1,875,925									1,875,925
Property and equipment, net of accumulated depreciation			1,881,012									1,881,012
Total assets		$	21,160,108		$	16,090					$	21,176,198
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIENCY)
Current liabilities:
Bank overdraft			903,804									903,804
Accounts payable			864,559									864,559
Short-term borrowings			14,463,317									14,463,317
Due to related parties			85,778									85,778
Advances from majority shareholder			-			1,326,842			(1,2)			1,326,842
Current portion of liability for unrecognized tax benefits			96,850									96,850
Current portion of convertible debt			-									-
Accrued expenses and other current liabilities			2,042,379									2,042,379
Total current liabilities			18,456,687			1,326,842						19,783,529
Loan from majority shareholder			2,556,682									2,556,682
Non-current portion of liability for unrecognized tax benefits			231,592									231,592
Non-current portion of convertible debt			-			-						-
Total liabilities			21,244,961			1,326,842						22,571,803
Stockholders' equity (deficiency):
Preferred stock $0.001 stated value, 5,000,000 shares authorized, 1,000,000
Series A convertible shares issued with 6% cumulative dividend of the
designated purchase price and initial conversion price of $0.7347 (note 12)
Common stock $0.001 par value, 75,000,000 shares authorized			26,232									26,232
Additional paid-in capital			5,445,904									5,445,904
Accumulated deficit			(5,556,989	)		(1,310,752	)					(6,867,741	)
Total stockholders' equity (deficiency)			(84,853	)		(1,310,752	)					(1,395,605	)
Total liabilities and stockholders' equity (deficiency)		$	21,160,108		$	16,090					$	21,176,198

 

11

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BLUE HOLDINGS, INC. AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2007 (AS RESTATED) AND 2006

 

		Three Months Ended												Nine Months Ended
		Sept. 30,			Sept. 30,						Sept. 30,			Sept. 30,			Sept. 30,						Sept. 30,
		2007			2007						2007			2007			2007						2007
		(As initially			(Adjustment)						(As restated)			(As initially			(Adjustment)						(As restated)
		reported)												reported)
Net sales		$	9,458,399			-					$	9,458,399		$	26,300,592			-					$	26,300,592
Cost of goods sold			8,511,248			-						8,511,248			15,789,839			1,302,842			(1)			17,092,681
Gross profit			947,151			-						947,151			10,510,753			(1,302,842	)					9,207,911
Selling, distribution & administrative expenses			4,468,960			24,000			(2)			4,492,960			13,046,619			24,000			(2)			13,070,619
Income (loss) before other expenses and provision for income taxes			(3,521,809	)		(24,000	)					(3,545,809	)		(2,535,866	)		(1,326,842	)					(3,862,708	)
Other expenses:
Interest expense			453,302			-						453,302			1,205,835			-						1,205,835
Expenses relating to the acquisition of Long Rap, Inc.												-												-
Income (loss) before provision for income taxes			(3,975,111	)		(24,000	)					(3,999,111	)		(3,741,701	)		(1,326,842	)					(5,068,543	)
Provision (benefit) for income taxes			(92,826	)		92,826			(3)			-			16,090			(16,090	)		(3)			-
Net income (loss)		$	(3,882,285	)	$	(116,826	)				$	(3,999,111	)	$	(3,757,791	)	$	(1,310,752	)				$	(5,068,543	)
Income (loss) per common share, basic and diluted		$	(0.15	)	$	(0.00	)		(4)		$	(0.15	)	$	(0.14	)	$	(0.05	)		(4)		$	(0.19	)
Weighted average shares outstanding, basic and diluted			26,232,200			-						26,232,200			26,154,422			-						26,154,422

 

12

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BLUE HOLDINGS, INC. AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2007 (AS RESTATED) AND 2006

 

		2007			2007						2007
		(As initially			(Adjustment)						(As restated)
		reported)
Cash flows from operating activities:
Net income (loss)		$	(3,757,791	)	$	(1,310,752	)				$	(5,068,543	)
Adjustments to reconcile net income to cash used in operating activities:
Depreciation and amortization			312,442									312,442
Fair value of vested stock options			254,488									254,488
Changes in assets and liabilities:
Accounts receivable			4,154,729									4,154,729
Due from factor			(1,295,837	)								(1,295,837	)
Income taxes receivable			1,969,729									1,969,729
Inventories			(3,549,054	)								(3,549,054	)
Due to related parties			(624,375	)								(624,375	)
Deferred income taxes			20,123			(16,090	)		(3)			4,033
Prepaid expenses and other current assets			(496,192	)								(496,192	)
Bank overdraft			637,016									637,016
Accounts payable			(1,955,466	)								(1,955,466	)
Other current liabilities			(91,553	)								(91,553	)
Net cash used in operating activities			(4,421,741	)		(1,326,842	)					(5,748,583	)
Cash flows from investing activities:
Purchase of equipment			(582,282	)		-						(582,282	)
Net cash used in investing activities			(582,282	)		-						(582,282	)
Cash flows from financing activities:
Short-term borrowings			4,436,503			-						4,436,503
Advances from majority shareholder			679,691			1,326,842			(1,2)			2,006,533
Net cash provided by financing activities			5,116,194			1,326,842						6,443,036
Net (decrease) increase in cash			112,171			-						112,171
Cash at beginning of period			109,031			-						109,031
Cash at end of period		$	221,202		$	-					$	221,202
SUPPLEMENTAL CASH FLOW INFORMATION:
Cash paid for interest		$	1,205,835		$	-					$	1,205,835
Cash paid for income tax		$	-		$	-					$	-
SUPPLEMENTAL DISCLOSURE OF NON-CASH FINANCING AND INVESTING ACTIVITIES:
Cumulative effect of adoption of FIN 48		$	52,465		$	-					$	52,465
Increase in prepaids for fair value of stock issued under co-branding agreement		$	227,500		$	-					$	227,500

 

13

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 BLUE HOLDINGS, INC. AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2007 (AS RESTATED) AND 2006

 

Description of adjustments:

1.

To reflect a $1,302,842 adjustment to cost of sales and to increase payable to Paul Guez at September 30, 2007 for inventory purchases paid directly to a vendor by Mr. Guez that were not previously recorded.

2.

To reflect a $24,000 adjustment to selling distribution and administrative expenses for lease of an office facility to the Company by the living trust of Paul and Elizabeth Guez that was previously unrecorded.

3.

To remove the previously recorded tax provision for the period.

4.

To reflect change in loss per share based on adjustments.

 

NOTE 2 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

(a) Use of Estimates

 

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America 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. On an ongoing basis, we evaluate estimates, including those related to returns, discounts, bad debts, inventories, intangible assets, income taxes, contingencies and litigation. We base our estimates on historical experience and on various assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

 

(b) Revenue Recognition

 

Revenue is recognized when merchandise has been shipped against a customer’s written purchase order, the risk of ownership has passed, selling price has been fixed and determined and collectibility is reasonably assured either through payment received, or fulfillment of all the terms and conditions of the particular purchase order. Revenue is recorded net of estimated returns, charge backs and markdowns based on management’s estimates and historical experience.

 

(c) Advertising

 

Advertising costs are expensed as of the first date the advertisements take place. Advertising expenses included in selling expenses approximated $165,442 and $285,016 for the three and nine months ended September 30, 2007, respectively, as compared with $51,420 and $627,482 for the same respective periods last year.

 

14

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 BLUE HOLDINGS, INC. AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2007 (AS RESTATED) AND 2006

 

(d) Shipping and Handling Costs

 

Freight charges are included in selling, distribution and administrative expenses in the statement of operations and approximated $187,731 and $484,966 for the three and nine months ended September 30, 2007, respectively, as compared to $263,881 and $588,672 for the same respective periods in the prior year.

 

(e) Major Suppliers

 

We purchase our fabric, thread and other raw materials from various industry suppliers within the United States and abroad. We do not currently have any long-term agreements in place for the supply of our fabric, thread or other raw materials. The fabric, thread and other raw materials used by us are available from a large number of suppliers worldwide. During the three months ended September 30, 2007, only three suppliers accounted for more than 10% of our purchases. Purchases from these suppliers were 12.9%, 11.2% and 10.7%, respectively. During the nine months ended September 30, 2007, two suppliers accounted for more than 10% of our purchases and purchases from these suppliers were 15.4% and 11.4% , respectively. During the three months ended September 30, 2006, three suppliers accounted for more than 10% of our purchases. Purchases from these suppliers were 31.5%, 13.0% and 11.8%, respectively. During the nine months ended September 30, 2006, two suppliers accounted for more than 10% of our purchases and purchases from these suppliers were 13.6% and 12.9%, respectively.

 

(f) Major Customers

 

During three months ended September 30, 2007, one customer accounted for more than 10% of the Company’s sales and sales to that customer was 11.1%. For the nine months ended September 30, 2007, two customers accounted for more than 10% of the Company’s sales and sales to those customers were 10.7% and 10.5%, respectively. During fiscal 2006, two customers accounted for more than 10% of the Company’s sales. Sales to those customers were 30.3% and 11.6%, for the three months ended September 30, 2006 and 15.6% and 14.3% for the nine months ended September 30, 2006, respectively.

 

International sales accounted for approximately 17.9% and 20.9% of the Company’s sales during the three and nine months ended September 30, 2007, respectively, including Japan which accounted for 9.7% and 12%, respectively, of our total sales. International sales accounted for approximately 25% and 30% of sales in the three and nine months ended September 30, 2006, respectively, including Japan which accounted for 16% and 17%, respectively, of our total sales.

 

As of September 30, 2007 and December 31, 2006, one customer accounted for 18% and 42% of total accounts receivable, respectively.

 

(g) Stock-Based Compensation

 

In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards 123R, “Share-Based Payment” (“SFAS 123R”). This statement requires that the cost resulting from all share-based payment transactions be recognized in the financial statements. This statement establishes fair value as the measurement objective in accounting for share-based payment arrangements and requires all entities to apply a fair-value based measurement method in accounting for share-based payment transactions with employees except for equity instruments held by employee share ownership plans. Effective January 1, 2006, the Company adopted the fair value recognition provisions of SFAS 123R, using the modified prospective method. Under this method, the provisions of SFAS 123R apply to all awards granted or modified after the date of adoption and all previously granted awards not yet vested as of the date of adoption.

 

15

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 BLUE HOLDINGS, INC. AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2007 (AS RESTATED) AND 2006

 

The fair value of options was estimated on the date of grant using the Black-Scholes option pricing model with the following weighted-average assumptions for the three months ended September 30, 2007 and 2006:

 

		September 30,			September 30,
		2007			2006
Dividend yield			—			—
Risk-free interest rate			4.50	%		4.50	%
Expected volatility			48.20	%		46.01	%
Expected life of options			6 years			5 years

 

(h) Earnings per Share

 

Statement of Financial Accounting Standards No. 128, “Earnings per Share,” requires presentation of basic earnings per share (“Basic EPS”) and diluted earnings per share (“Diluted EPS”). Basic earnings (loss) per share are computed by dividing net income by the weighted average number of common shares outstanding during the period. Diluted earnings per share reflects the potential dilution, using the treasury stock method, that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the Company. In computing diluted earnings per share, the treasury stock method assumes that outstanding options and warrants are exercised and the proceeds are used to purchase common stock at the average market price during the period. Options and warrants will have a dilutive effect under the treasury stock method only when the average market price of the common stock during the period exceeds the exercise price of the options and warrants.

 

At September 30, 2007 and 2006, potentially dilutive securities consisted of outstanding common stock options to acquire 1,096,500 and 685,000 shares, respectively. These potentially dilutive securities were not included in the calculation of loss per share for the three and nine months ended September 30, 2007 as they were anti-dilutive for the periods in 2007 and insignificant to the calculation in 2006. Accordingly, basic and diluted earnings per share for each of the three and nine months ended September 30, 2007 and 2006 are the same.

 

Issued but unvested shares of common stock under forfeitable service agreements are excluded from the calculations of basic and diluted earnings per share until such shares are earned.

 

(i) Reclassifications

 

Certain prior year balance sheet items have been reclassified to conform to the current period presentation.

 

16

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 BLUE HOLDINGS, INC. AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2007 (AS RESTATED) AND 2006

 

(j) Adoption of new accounting policy

 

Effective January 1, 2007, the Company adopted Financial Accounting Standards Board Interpretation No. 48, “Accounting for Uncertainty in Income Taxes (“FIN 48”)—an interpretation of FASB Statement No. 109, Accounting for Income Taxes.” The Interpretation addresses the determination of whether tax benefits claimed or expected to be claimed on a tax return should be recorded in the financial statements. Under FIN 48, we may recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position should be measured based on the largest benefit that has a greater than fifty percent likelihood of being realized upon ultimate settlement. FIN 48 also provides guidance on derecognition, classification, interest and penalties on income taxes, accounting in interim periods and requires increased disclosures. At the date of adoption, and as of September 30, 2007, the Company made a cumulative effect adjustment. See note 8.

 

The Company files income tax returns in the U.S. federal jurisdiction and various states. The Company is subject to U.S. federal or state income tax examinations by tax authorities for years after 2002. The Company’s tax returns are currently under examination by the government. As of September 30, 2007, the taxing authorities have not proposed any significant adjustments to taxable income. The Company does not expect to receive any adjustments that would result in a material change to its final position.

 

The Company’s policy is to record interest and penalties on uncertain tax provisions as income tax expense. See note 8.

 

(k) Recent accounting pronouncements

 

In February 2007, the Financial Accounting Standards Board (FASB) issued FASB Statement No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities — including an amendment of FASB Statement No. 115” (FAS 159).  FAS 159, which becomes effective for the company on January 1, 2008, permits companies to choose to measure many financial instruments and certain other items at fair value and report unrealized gains and losses in earnings. Such accounting is optional and is generally to be applied instrument by instrument. The company does not anticipate that election, if any, of this fair-value option will have a material effect on its consolidated financial condition, results of operations, cash flows or disclosures.

 

In September 2006, the FASB issued FAS No. 157 (“FAS 157”), “Fair Value Measurements,” which establishes a framework for measuring fair value in accordance with GAAP and expands disclosures about fair value measurements. FAS 157 does not require any new fair value measurements but rather eliminates inconsistencies in guidance found in various prior accounting pronouncements. FAS 157 is effective for fiscal years beginning after November 15, 2007. The Company is currently evaluating the impact this standard will have on its consolidated financial condition, results of operations, cash flows or disclosures.

 

17

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 BLUE HOLDINGS, INC. AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2007 (AS RESTATED) AND 2006

NOTE 3 – DUE FROM FACTOR

 

We use a factor for working capital and credit administration purposes. Under the various factoring agreements entered into separately by Blue Holdings, Antik and Taverniti, the factor purchases all the trade accounts receivable assigned by the Company and its subsidiaries and assumes all credit risk with respect to those accounts approved by it.

 

The factor agreements provide that we can borrow an amount up to 90% of the value of our purchased customer invoices, less a reserve of 10% of unpaid accounts purchased and 100% of all such accounts which are disputed. The factor agreements provide for automatic renewal subject to 120 days’ termination notice from any party. The factor also makes available to all three companies a combined line of credit up to the lesser of $2.4 million or 50% of the value of eligible raw materials and finished goods. As of September 30, 2007, borrowings under this line of credit were $14.5 million of which, the Company drew down $2.4 million of this credit line against inventory, $4.9 million against accounts receivable and $7.2 million against personal guarantees of Paul Guez, our Chairman and majority shareholder, and the living trust of Paul and Elizabeth Guez.

 

As of September 30, 2007, the factor holds $2,831,979 of accounts receivable purchased from us on a without recourse basis and has made advances to us of $63,315 against those receivables, resulting in a net balance amount Due from Factor of $2,662,425, net of reserves of $106,237, as of September 30, 2007. The Company has accounted for the sale of receivables to the factor in accordance with SFAS No. 140, “Accounting for the Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.”

 

As of September 30, 2007, the factor also held as collateral $3,380,109 of accounts receivable that were subject to recourse, against which the Company has provided reserves of $1,193,000 and as of September 30, 2007, the Company received advances totaling $14,463,000 against such receivables, eligible inventory, intangibles, and on the personal guarantee of Mr. Paul Guez. The Company has included the $3,114,334 in accounts receivable, and has reflected the $14,463,000 as short term borrowings on the accompanying balance sheet. The factor commission against such receivables is 0.4% and interest is charged at the rate of 1% over the factor’s prime lending rate per annum.

 

The factor commission on receivables purchased on a without recourse basis is 0.75% if the aggregate amount of approved invoices is below $10 million per annum, 0.70% if between $10 million and $20 million and 0.65% if between $20 million and $30 million. The Company is contingently liable to the factor for merchandise disputes, customer claims and the like on receivables sold to the factor. To the extent that the Company draws funds prior to the deemed collection date of the accounts receivable sold to the factor, interest is charged at the rate of 1% over the factor’s prime lending rate per annum. Factor advances are collateralized by the non-factored accounts receivable, inventories and the personal guarantees of Paul Guez, our Chairman and majority shareholder, and the living trust of Paul and Elizabeth Guez (see note 6).

 

18

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 BLUE HOLDINGS, INC. AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2007 (AS RESTATED) AND 2006

 

NOTE 4 – RELATED PARTY TRANSACTIONS

 

Inventories at September 30, 2007 and December 31, 2006 are summarized as follows:

 

		September 30,			December 31,
		2007			2006
		(Unaudited)
Raw Materials		$	3,027,735		$	3,583,019
Work-in-Process			1,037,913			991,775
Finished Goods			5,468,113			2,562,105
			9,533,761			7,136,899
Less: Inventory valuation allowance			($590,701	)		(1,742,893	)
TOTAL		$	8,943,060		$	5,394,006

 

NOTE 5 – PROPERTY AND EQUIPMENT

 

Property and equipment at September 30, 2007 and December 31, 2006 are summarized as follows:

 

		September 30,			December 31,
		2007			2006
		(Unaudited)
Furniture		$	33,316		$	14,294
Leasehold Improvements			1,308,423			1,219,094
Computer Equipment			1,090,826			616,551
			2,432,565			1,849,939
Less: Accumulated depreciation and amortization			(551,553	)		(238,768	)
		$	1,881,012		$	1,611,171

 

19

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 BLUE HOLDINGS, INC. AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2007 (AS RESTATED) AND 2006

 

Depreciation expense for the three months ended September 30, 2007 and 2006 was $124,763 and $59,174, respectively and for the nine months ended September 30, 2007 and 2006 was $312,442 and $136,644, respectively.

 

NOTE 6 – RELATED PARTY TRANSACTIONS

 

The Company purchased fabric at cost from Blue Concept, LLC an entity that is owned by Paul Guez, the Company’s Chairman, for $1,502 and $184,830 during the three and nine months ended September 30, 2007, respectively, and $10,555 and $262,213 respectively, during the same periods in the prior year.

 

On January 1, 2006, the Company leased its facility at Commerce, California from Azteca Production International Inc., as a sub-tenant and is paying it $19,030 per month. Azteca is a company that is co-owned by Paul Guez. Rent expense includes $57,090 and $171,270, respectively, for the three and nine months ended September 30, 2007, paid under this lease.

 

On September 1, 2007, the Company began occupying a design and merchandising facility owned by the living trust of Paul and Elizabeth Guez. While there is no formal lease agreement between the Company and the living trust of Paul and Elizabeth Guez, the parties have agreed that the Company will pay the living trust of Paul and Elizabeth Guez $24,000 per month in rent on a month-to-month basis.

 

On July 5, 2005 the Company entered into a ten-year license agreement with Yanuk Jeans, LLC., an entity that is solely owned by Paul Guez. Under the terms of the agreement, the Company became the exclusive licensor for the design, development, manufacture, sale, marketing and distribution of the Yanuk brand products to the wholesale and retail trade. The Company pays to Yanuk Jeans, LLC a royalty of six percent of all net sales of the licensed products and a guaranteed minimum royalty on an annual basis. Yanuk has agreed to waive such royalties due for the three and nine months ended September 30, 2007, and has agreed to waive such royalties through December 31, 2008. Yanuk Jeans, LLC is solely owned by Paul Guez. In addition, during the term of the license agreement, the Company has the option to purchase from Yanuk Jeans, LLC the property licensed under the agreement. The royalties paid and payable for the three and nine months ended September 30, 2006, were $60,902 and $243,833, respectively.

 

On October 6, 2005, the Company entered into a five-year license agreement with Yanuk Jeans, LLC. Under the terms of the agreement, the Company became the exclusive licensor for the design, development, manufacture, sale, marketing and distribution of Yanuk Jeans, LLC’s U brand products to the wholesale and retail trade. The Company pays to Yanuk Jeans, LLC a royalty of five percent of all net sales of the licensed products and shall pay a guaranteed minimum royalty on an annual basis. In addition, during the term of the license agreement, the Company has the option to purchase from Yanuk Jeans, LLC the property licensed under the agreement. The royalties for the three and nine months ended September 30, 2007 paid or payable to Yanuk Jeans, LLC for the U brand products was $0 and $0, respectively and $0 and $0, respectively, for the same period last year.

 

Paul Guez and the living trust of Paul and Elizabeth Guez have guaranteed all advances and ledger debt due to the Company’s factor (see note 3).

 

20

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 BLUE HOLDINGS, INC. AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2007 (AS RESTATED) AND 2006

 

On August 27, 2005, the Company opened a retail store on Melrose Avenue, Los Angeles, California and took over all the obligations of a 10-year property lease which was entered into by Blue Concept, LLC in April 2005. The lease will expire on March 15, 2015.

 

Taverniti is the exclusive licensee for the design, development, manufacture, sale, marketing and distribution of the Taverniti So Jeans trademark in the denim and knit sports wear categories for men and women. It is paying royalties to Taverniti Holdings, LLC in the ranges of 5-8 percent depending on the net sales of the licensed products pursuant to a license agreement with Taverniti Holdings, LLC. Taverniti Holdings, LLC is jointly owned by Paul Guez (60%) and Jimmy Taverniti (40%), the designer of the products for the brand, and Mr. Guez is the sole manager. The license agreement was signed in May 2004 and expires on December 31, 2015. Royalties paid or payable for the three months ended September 30, 2007 and 2006 were $77,878 and $217,728, respectively, and $289,634 and $874,254 for the nine months ended September 30, 2007 and 2006, respectively.

 

NOTE 7 – DUE FROM/TO RELATED PARTIES

 

The related parties are the Company’s majority shareholder (who is also the Chairman, Chief Executive Officer and President of the Company) and limited liability companies that are either owned or co-owned by the majority shareholder. These amounts are all unsecured and non-interest bearing. All non-trade related advances from related parties have been repaid. Trade-related outstanding items follow regular payment terms as invoiced. As of September 30, 2007 and December 31, 2006, total trade-related items due to related parties amounted to $85,778 and $710,153, respectively.

 

From time to time, the Company’s majority shareholder, Mr. Paul Guez, made advances to the Company to support its working capital needs. These advances were non-interest bearing and unsecured, with no formal terms of repayment. On July 1, 2006, Mr. Guez converted the advances to a line of credit in an agreement with the Company. The line of credit allows the Company to borrow from him up to a maximum of $3 million at an interest rate of 6% per annum. The Company may repay the advances in full or in part at any time until the credit line expires and repayment is required, on December 31, 2007. As of September 30, 2007 and December 31, 2006, the balance of these advances was $2,556,682 and $1,876,991 respectively and accrued interest thereon was $104,857 and $0, respectively. Interest expense includes $37,356 and $0, for three months ended September 30, 2007 and 2006, respectively, and $104,857 and $0, for nine months ended September 30, 2007 and 2006, respectively.

 

Subsequent to September 30, 2007 the Company agreed to issue convertible preferred shares valued at $2,556,682 to Mr. Guez in satisfaction of $2,556,682 of advances to the Company by the majority stockholder (see Note 12).

 

Subsequent to September 30, 2007, in early May, 2008, as detailed above at Note 1(d), the Company and Mr. Guez agreed that, as of September 30, 2007, Mr. Guez was in fact owed additional monies totaling $1,326,842, which had not previously been reflected in the Company’s financial statements. Such monies were advanced under the same terms as the line of credit agreement described above and are reflected as a current liability in these restated financial statements.

 

21

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 BLUE HOLDINGS, INC. AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2007 (AS RESTATED) AND 2006

NOTE 8 – INCOME TAX

 

The Company accounts for income taxes and the related accounts under the liability method. Deferred tax liabilities and assets are determined based on the difference between the financial statement and tax bases of assets and liabilities using enacted rates expected to be in effect during the year in which the basis differences reverse.

 

The Company’s provision for income taxes, as restated, was $0 for the nine months ended September 30, 2007 compared to $1,489,453 for the same period of the prior year.

 

The provision for income taxes consists of the following for the periods ended September 30:
		2007			2006
		(As Restated)
Current
Federal		$	0		$	1,305,011
State			0			419,865
Deferred
Federal			0			(189,462	)
State			0			(45,961	)
Provision for income tax expense		$	0		$	1,489,453

 

A reconciliation of the statutory federal income tax rate to the effective tax rate is as follows for the periods ended September 30:
		2007			2006
Statutory federal rate			34.0	%		34.0	%
State taxes, net of federal benefit			6.6	%		7.1	%
Income not taxed at Company level			0.0	%		2.0	%
Permanent differences			0.0	%		-0.1	%
Change in valuation reserve			-40.4	%		0.0	%
Unrecognized tax benefits			-0.3	%		0.0	%
Other			0.1	%		0.0	%
Effective tax rate			0.0	%		43.0	%

 

The Company and its subsidiaries files income tax returns in the U.S. federal jurisdiction and various state jurisdictions. With few exceptions, the Company is no longer subject to U.S. federal or state and local income tax examinations by tax authorities for years before 2003. The Internal Revenue Service (IRS) commenced an examination of the Company’s U.S. income tax return for 2005 in the first quarter of 2007 that is anticipated to be completed by the end of 2007. As of September 30, 2007, the IRS has not proposed any adjustments.

 

22

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 BLUE HOLDINGS, INC. AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2007 (AS RESTATED) AND 2006

 

The Company adopted the provisions of FASB Interpretation No.48, Accounting for Uncertainty in Income Taxes, on January 1, 2007. As a result of the implementation of Interpretation 48, the Company recognized a $52,465 increase in the liability for unrecognized tax benefits, which was accounted for as a reduction to the January 1, 2007 balance of retained earnings. A reconciliation of the beginning and ending amount of unrecognized tax benefits is as follows:

 

Balance at January 1, 2007		$	(310,458	)
Additions based on tax positions related to the current year			-
Additions for tax positions of prior years			(17,984	)
Reductions for tax positions of prior years			-
Settlements			-
Balance		$	(328,442	)

 

Included in the balance at September 30, 2007 are $263,731 of tax positions for which the ultimate deductibility is highly certain but for which there is uncertainty about the timing of such deductibility. Because of the impact of deferred tax accounting, other than interest and penalties, the disallowance of the shorter deductibility period would not affect the annual effective tax rate but would accelerate the payment of cash to the taxing authority to an earlier period.

 

The Company recognizes accrued interest and penalties related to unrecognized tax benefits in income tax expense. During the period ended September 30, 2007, the Company recognized in income tax expense $ 0 for interest and penalties, as reflected in these restated financial statements. The Company included in its balance for unrecognized tax benefits at September 30, 2007 $61,489 for the payment of interest and penalties.

 

NOTE 9 – STOCK OPTIONS

 

Under the Company’s 2005 Stock Incentive Plan (the “Company Plan”), the Company may grant qualified and nonqualified stock options and stock purchase rights to selected employees. The Company reserved 2,500,000 shares of common stock for issuance under the Company Plan.

 

23

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BLUE HOLDINGS, INC. AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2007 (AS RESTATED) AND 2006

 

At September 30, 2007, options outstanding are as follows:
		Number of options			Weighted average exercise price			Intrinsic Value
Balance at January 1, 2007			335,500			$5.75			-
Granted			925,000			$1.98			-
Exercised			-			-			-
Cancelled			(164,000	)		$5.20			-
Balance at September 30, 2007			1,096,500			$2.27			-

 

		Additional information regarding options outstanding as of June 30, 2007 is as follows:
		Options outstanding												Options exercisable
		Exercise price			Number outstanding			Weighted average remaining contractual life (years)			Weighted average exercise price			Number exercisable			Weighted average exercise price
			$8.10			42,000			7.43			$8.10			22,000			$8.10
			$5.30			33,500			7.87			$5.30			33,500			$5.30
			$5.20			96,000			8.25			$5.20			35,500			$5.20
			$1.98			300,000			9.50			$1.98			100,000			$1.98
			$1.40			625,000			9.75			$1.40			125,000			$1.40
Total			$1.40 - $8.10			1,096,500			9.40			$2.27			316,000			$2.89

 

Stock based compensation expense of $254,488 and $356,528 were recognized during the nine months ended September 30, 2007 and 2006, respectively, relating to the vesting of such options. As of September 30, 2007, the unamortized value of these option awards were $587,119 which will be amortized as a stock based compensation cost over the average of approximately three years as the options vest.

 

NOTE 10 – CO-BRANDING AGREEMENT

 

On May 11, 2007, the Company entered into a Letter of Intent with William Adams, aka will.i.am, of the Black Eyed Peas, pursuant to which the parties agreed to, within 30 days of the date of execution, enter into (i) a co-branding agreement for the creation of a collection of premium denim and denim-related apparel under the name “i.am Antik” or such other similar name upon which the parties shall agree, and (ii) a joint venture agreement pursuant to which the parties will design, develop, market, manufacture and distribute apparel products bearing the “I.Am” trademark subject to a license agreement. The term of each of the co-branding agreement and the joint venture agreement shall be for five years, with the first year commencing on the execution of the Letter of Intent and ending on the last day of February 2008, and each year thereafter commencing on March 1 and ending on the last day of February. Prior to their entry into the Letter of Intent, the parties had no material relationship with each other. The Letter of Intent was effective May 11, 2007 and was approved and certified by the shareholders of the Company on June 21, 2007.

 

24

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BLUE HOLDINGS, INC. AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2007 (AS RESTATED) AND 2006

 

Mr. Adams is required to perform specific design, marketing and promotional services under the term of Letter of Intent. In consideration of such services rendered by Mr. Adams, the Company issued to Mr. Adams as base compensation 175,000 shares of its common stock on May 21, 2007 and will issue to Mr. Adams 81,250 shares on each anniversary of the effective date of the Letter of Intent for a period of 4 years, subject to the prior effectiveness of a registration statement on Form S-8 registering the issuance of the shares to Mr. Adams. Mr. Adams will also be entitled to receive up to an aggregate of 500,000 additional shares of common stock from the Company upon achieving certain milestones based on net sales.

Mr. Adams is permitted to terminate the co-branding agreement and/or joint venture agreement in the event that the Company is delisted from the NASDAQ Capital Market, a final and binding legal determination is made by a body with appropriate jurisdiction that the Company has failed to comply with the rules and regulations promulgated by the Securities and Exchange Commission, or the joint venture’s failure to launch an “I.Am” collection within 12 months from the date of execution of the definitive joint venture agreement.

The Company determined that since the shares contain performance requirements and specific services to be performed, and the shares would be returned if such services were not preformed, it is appropriate to recognize as expense the value of the issued shares that are earned each month. As such, the Company determined that the 175,000 shares that valued at $227,500 were issued in May 2007 will be amortized as earned over a one year period. The shares earned will be valued at the end of each month based on the fair value of those shares in accordance with EITF 96-18. Compensation expense for the nine months ended September 30, 2007 amounted to $63,000.

NOTE 11 – COMMITMENTS AND CONTINGENCIES

 

License agreements:

 

On January 12, 2007, the Company entered into a License Agreement with Faith Connexion S.A.R.L., a company formed under the laws of France (“Faith”). Pursuant to the License Agreement, Faith granted an exclusive right and license to use the Faith Connexion trademark for the manufacture, marketing, promotion, sale, distribution and other exploitation of men’s and women’s hoodies, t-shirts, sweatshirts, sweatpants and hats in North America (including Canada), South America, Japan and Korea. Compensation for use of the Faith Connexion trademark will consist of a royalty calculated as 9% of the Company’s net sales arising from products bearing the Faith Connexion trademark in the first two years, and 9.5% of net sales in year three. The License Agreement has a term of three years as follows: the first year is comprised of 18 months, year two is comprised of the next nine months, and year three is comprised of the following 12 months. Per the agreement, the Company has agreed to a guarantee payment of royalties on identified minimum net sales amounts ranging from $3.5 to $10 million over each of the three years (equal to minimum royalties of $450,000, $315,000, and $950,000, in each of years one (first eighteen months), two (next 6 months) and three (next twelve months), respectively, and to spend at least 3% of actual net sales amounts on marketing and advertising the Faith Connexion trademarked products in the territory. During three months ended September 30, 2007, the Company recorded royalty expense of $75,000.

 

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BLUE HOLDINGS, INC. AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2007 (AS RESTATED) AND 2006

 

On April 27, 2007, Antik Denim, LLC (“Antik”), a California limited liability company and our wholly-owned subsidiary, executed a License Agreement (the “Mercier License Agreement”) dated to be effective as of April 18, 2007, by and between Antik and Mercier SARL, a company formed under the laws of France (“Mercier”).

 

Pursuant to the Mercier License Agreement, Antik granted an exclusive right and license to use the Antik Denim trademark for the manufacture, marketing, promotion, sale, distribution and other exploitation of denim and sportswear apparel in Europe. Compensation for use of the Antik Denim trademark will consist of a royalty calculated as 10% of Mercier’s net sales arising from products bearing the Antik Denim trademark. The Mercier License Agreement has an initial term of twenty (20) months, and includes four (4) one (1)-year extension options available to Mercier to the extent it achieves specified minimum net sales. Mercier has agreed to guarantee payment of royalties on an identified minimum net sales amount of $2.5 million during the initial twenty (20) month term, and on identified minimum net sales amounts ranging from $2.5 million to $10 million over the eligible extension terms. In connection with these minimum net sales, the Mercier License Agreement provides for an upfront minimum guarantee advance of $250,000 which has been received by the Company and recorded as a deferred revenue as of September 30, 2007, and an aggregate of minimum royalty payments of $2.5 million for the years 2009 though 2012 assuming the Mercier License Agreement is renewed at the end of 2008.

 

On April 27, 2007, in anticipation of Antik’s entry into the Mercier License Agreement, Antik executed Amendment No. 1 to License Agreement (the “Amendment”), dated to be effective as of April 25, 2007, by and between Antik and North Star, LLC (“North Star”). The sole purpose of the Amendment was to remove the European territory from the rights previously granted to North Star.

 

On May 1, 2007, Antik executed a License Agreement (the “Max Ray License Agreement”) dated to be effective as of May 1, 2007, by and between Antik and Max Ray, Inc., a California corporation (“Max Ray”). Pursuant to the Max Ray License Agreement, Antik granted an exclusive right and license to use the Antik Denim trademark for the manufacture, marketing, promotion, sale, distribution and other exploitation of small leather goods consisting of belts, handbags, small leather accessories and scarves in the United States and its territories. Compensation for use of the Antik Denim trademark will consist of a royalty calculated as 8% of Max Ray’s net sales arising from products bearing the Antik Denim trademark. The Max Ray License Agreement has an initial term of eighteen (18) months, and includes four (4) one (1)-year extension options available to Max Ray unless earlier terminated by Max Ray. Max Ray has agreed to guarantee payment of royalties on an identified minimum net sales amount of $1.1 million during the initial eighteen (18) month term, and on identified minimum net sales amounts ranging from $3 million to $10 million over the eligible extension terms. In connection with these minimum net sales, the Max Ray License Agreement provides for an upfront minimum guarantee advance of $20,000 to be applied against the minimum guaranty for the aggregate initial term, and an aggregate of minimum royalty payments of $2.1 million for the years 2009 though 2012 assuming the Max Ray License Agreement is renewed at the end of 2008.

 

Employment agreements:

 

On September 21, 2007, the Company elected Glenn S. Palmer as a new member of its board of directors. Prior to his appointment as a member of the Company’s board of directors, Mr. Palmer was appointed as the Company’s Chief Executive Officer and President on July 24, 2007. Mr. Palmer has no family relationships with any of the Company’s other directors or executive officers.

 

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BLUE HOLDINGS, INC. AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2007 (AS RESTATED) AND 2006

 

On September 21, 2007, the compensation committee of the Company’s Board of Directors approved the Company’s entry into a revised Employment Agreement with Mr. Palmer and revisions to the termination provisions of the option previously granted to Mr. Palmer on July 24, 2007.

The revised Employment Agreement is effective as of July 1, 2007, has an initial term through December 31, 2010, and is subject to automatic renewal thereafter for one-year terms unless either party gives the other party written notice of its intention to terminate the Employment Agreement at least 90 days prior to the expiration of the initial term or any renewal term. Under the terms of the Employment Agreement, Mr. Palmer will receive base compensation for each of the third and fourth quarters of fiscal 2007 of $87,500 and minimum annual compensation for each of fiscal 2008 through 2010 of $400,000. Mr. Palmer is also entitled to receive an annual bonus equivalent to 2.5% of the Registrant’s earnings before interest, taxes, depreciation and amortization for each of the years ended December 31, 2008 through 2010, and is eligible to receive a bonus for the period ended December 31, 2007, if any, as determined by the Compensation Committee of the Company’s Board of Directors. Mr. Palmer is also entitled to four weeks paid vacation and reimbursement of expenses, including up to $2,000 per month for all expenses incurred by Mr. Palmer with respect to his personal automobile. The Company has also agreed to provide Mr. Palmer with a furnished apartment or comparable living space in Los Angeles, California suitable to his position for the initial twelve months of the term of the Employment Agreement. Additionally, the Company has agreed to pay for no more than two coach or economy class round trip tickets per month from Los Angeles to New Jersey for Mr. Palmer to visit with his family. Mr. Palmer has agreed to establish a permanent residence within twenty miles of Los Angeles, California no later than July 1, 2008. Upon the termination of Mr. Palmer’s employment under the Employment Agreement before the expiration of its stated term by Mr. Palmer for good reason or by the Company for any reason other than death, disability or cause, the Company has agreed to pay Mr. Palmer 12 months base salary plus a pro-rated bonus for the year during which such termination occurs as severance.

As an inducement material to Mr. Palmer’s decision to enter into employment with the Company, the Company previously granted to Mr. Palmer an option to purchase 625,000 shares of the Company’s common stock. The option has a term of 10 years, a per share exercise price of $1.40 and will vest over a period of two years, with 125,000 shares vesting on the date of grant and 125,000 shares vesting on each subsequent six-month anniversary of the date of grant. The revised option provides that upon the termination of Mr. Palmer’s employment with the Company, the option remains exercisable for various periods based on the circumstances under which Mr. Palmer’s employment was terminated.

Legal proceedings:

 

On July 17, 2006, Taverniti Holdings, LLC (THL), an independent entity not owned or controlled by us, and Jimmy Taverniti, an individual, filed an action in the United States District Court for the Central District of California (Case No. CV06-4522 DDP) against Henri Levy alleging that defendant has infringed THL’s mark J. TAVERNITI and further infringed Mr. Taverniti’s commercial publicity rights, by defendant’s adoption and use of the mark TAVERNITY. We have been informed that in a counter-claim against THL, defendant has also named our company and Taverniti as purported counter defendants. As it relates to Taverniti and our company, the counter claim seeks only a declaration of rights, to the effect that Taverniti and our company have conspired with THL to defeat defendant’s alleged rights in his TAVERNITY mark, and a further declaration that as a result of such alleged misconduct, neither Taverniti nor our company have any enforceable rights in the TAVERNITI SO JEANS mark. It does not seek any monetary relief against either Taverniti or our company.

 

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BLUE HOLDINGS, INC. AND SUBSIDIARIES

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2007 (AS RESTATED) AND 2006

 

We have taken the position that neither Taverniti nor our company can properly be added as new parties to this lawsuit by naming us as counter defendants, and that we can only be named as third party defendants. The defendant has not, as yet, served either Taverniti or us with the counter claim, and so we are not yet formally parties to the case. At such time, if ever, that the defendant takes the necessary action to formally serve us with the counter claim, we intend to deny all the material charging allegations of the defendant’s claim for declaratory relief and to vigorously defend against his claims. At this time, we are unable to express an opinion whether it is likely that the defendant will take such actions, or whether, if he does, it is likely or unlikely that he will be able to prevail against us on his claim for declaratory relief.

 

NOTE 12 – SUBSEQUENT EVENTS

 

Issue of Series A Convertible Preferred Stock

 

Subsequent to September 30, 2007 the Company agreed to issue 1,000,000 Series A convertible preferred shares valued at $2,556,682 to Mr. Guez in satisfaction of $2,556,682 of advances to the Company by Mr. Guez. The Series A preferred shares are convertible into 3,479,899 shares of our common stock based on a conversion formula equal to the price per share ($2.556682) divided by the conversion price ($0.7347) multiplied by the total number of Series A preferred shares issued, subject to adjustment in accordance with the provisions of the certificate of designation for the Series A preferred shares. The conversion price equals the average closing price of a share of the Company’s common stock, as quoted on the NASDAQ Capital Market, over the 20 trading days immediately preceding November 13, 2007, the closing date of the transaction. The Series A preferred shares accrue cumulative dividends at the annual rate of 6% of the purchase price in preference to the common stock. The purchase price for the Series A preferred shares is $2.556682 per share. Upon the liquidation or dissolution of the Company the Series A preferred shares are entitled to receive, prior to any distribution to the holders of common stock, 100% of the purchase price plus all accrued but unpaid dividends.

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

 

Forward-Looking Statements

 

Statements made in this Form 10-Q (the “Quarterly Report”) that are not historical or current facts are “forward-looking statements” made pursuant to the safe harbor provisions of Section 27A of the Securities Act of 1933, as amended (the “Act”), and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). We intend that such forward-looking statements be subject to the safe harbors for such statements. We wish to caution readers not to place undue reliance on any such forward-looking statements, which speak only as of the date made. Any forward-looking statements represent management’s best judgment as to what may occur in the future. The forward-looking statements included herein are based on current expectations that involve numerous risks and uncertainties. Assumptions relating to the foregoing involve judgments with respect to, among other things, future economic, competitive and market conditions and future business decisions, all of which are difficult or impossible to predict accurately and many of which are beyond our control. Although we believe that the assumptions underlying the forward-looking statements are reasonable, any of the assumptions could be inaccurate and, therefore, there can be no assurance that the forward-looking statements included in this Quarterly Report will prove to be accurate. In light of the significant uncertainties inherent in the forward-looking statements included herein, the inclusion of such information should not be regarded as a representation by us or any other person that our objectives and plans will be achieved. We disclaim any obligation subsequently to revise any forward-looking statements to reflect events or circumstances after the date of such statement or to reflect the occurrence of anticipated or unanticipated events.

 

The words “we,” “us,” “our,” and the “Company,” refer to Blue Holdings, Inc. The words or phrases “may,” “will,” “expect,” “believe,” “anticipate,” “estimate,” “approximate,” or “continue,” “would be,” “will allow,” “intends to,” “will likely result,” “are expected to,” “will continue,” “is anticipated,” “estimate,” “project,” or similar expressions, or the negative thereof, are intended to identify “forward-looking statements.” Actual results could differ materially from those projected in the forward looking statements as a result of a number of risks and uncertainties, including but not limited to: (a) our failure to implement our business plan within the time period we originally planned to accomplish; and (b) other risks that are discussed in this Quarterly Report or included in our previous filings with the Securities and Exchange Commission (“SEC”).

 

Description of Business

 

Overview

 

Blue Holdings, Inc. designs, develops, markets and distributes high end fashion jeans, apparel and accessories under the brand name names Antik Denim, Yanuk, U, Faith Connexion and Taverniti So Jeans. We plan to also design, develop, market and distribute jeans and accessories under other brands that we may license or acquire from time to time. Our products currently include jeans, jackets, belts, purses and T-shirts. We currently sell our products in the United States, Canada, and Japan directly to department stores and boutiques and through distribution arrangements in certain foreign jurisdictions. We are headquartered in Commerce, California and maintain two showrooms in New York and Los Angeles. We opened a retail store in Los Angeles during August 2005 and another in San Francisco in September 2006. The Company has announced that it is reviewing its strategic alternatives regarding its retail stores. These retail strategic alternatives include no action, sale, licensing, and/or possibly closing the stores. As of November 13, 2007, no determination has been made by the Company’s Board of Directors.

 

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Corporate Background

 

We were incorporated in the State of Nevada on February 9, 2000 under the name Marine Jet Technology Corp. From our inception through January 2005, we focused on developing and marketing boat propulsion technology. Between January and February 2005, we entered into separate transactions whereby, among other matters, Keating Reverse Merger Fund, LLC (“KRM Fund”), an existing shareholder of the Company, agreed to purchase a substantial majority of our outstanding common stock, and Intellijet Marine, Inc., a company formed by our former majority shareholder and principal executive officer and director, Jeff P. Jordan, acquired all of our boat propulsion technology assets and assumed all of our then existing liabilities.

 

Between February 4, 2005 and April 29, 2005, we existed as a public “shell” company with nominal assets.

 

Significant Developments in Third Quarter

 

On July 24, 2007, we appointed Glenn S. Palmer as our new Chief Executive Officer and President. Mr. Palmer’s Employment Agreement is effective as of July 1, 2007, has an initial term that expires on December 31, 2010, and is subject to automatic renewal thereafter for one-year terms unless either party gives the other party written notice of its intention to terminate the Employment Agreement at least 90 days prior to the expiration of the initial term or any renewal term. Under the terms of the Employment Agreement, Mr. Palmer will receive base compensation for each of the third and fourth quarters of fiscal 2007 of $87,500 and minimum annual compensation for each of fiscal 2008 through 2010 of $400,000. Mr. Palmer is also entitled to receive an annual bonus equivalent to 2.5% of our earnings before interest, taxes, depreciation and amortization for each of the years ended December 31, 2008 through 2010, and is eligible to receive a bonus for the period ended December 31, 2007, if any, as determined by the Compensation Committee of our Board of Directors. Mr. Palmer is also entitled to four weeks paid vacation and reimbursement of expenses, including up to $2,000 per month for all expenses incurred by Mr. Palmer with respect to his personal automobile. We have also agreed to provide Mr. Palmer with a furnished apartment or comparable living space in Los Angeles, California suitable to his position for the initial twelve months of the term of the Employment Agreement. Additionally, we have agreed to pay for no more than two coach or economy class round trip tickets per month from Los Angeles to New Jersey for Mr. Palmer. As an inducement material to Mr. Palmer’s decision to enter into employment with us, we agreed to grant Mr. Palmer an option to purchase 625,000 shares of our common stock. The option has a term of 10 years, a per share exercise price of $1.40 and will vest over a period of two years, with 125,000 shares vesting on the date of grant and 125,000 shares vesting on each subsequent six-month anniversary of the date of grant. Upon the termination of Mr. Palmer’s employment with us the option remains exercisable for various periods based on the circumstances under which Mr. Palmer’s employment was terminated.

 

Mr. Palmer commenced the implementation of a comprehensive action plan with key strategic initiatives focused on cutting costs to reduce our SG&A by approximately 10% by the end of the year, selling off our excess inventory, and aggressively reviewing and evaluating the long-term viability of our brands, licensees and retail strategy. On September 24, 2007, we announced the discontinuation of our joint venture with Life & Death LLC, a reduction in approximately 25% of our workforce and our plans to exit our two retail stores. We continue to evaluate our retail strategy which includes a variety of options including the possibility of exiting the retail business. At this time no determination has been made.

 

On September 28, 2007, Scott J. Drake resigned as our President of Sales and Chief Operating Officer. We appointed Mr. Drake to those positions in March 2007.

 

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Results of Operations

 

		Three Months Ended September 30,						Nine Months Ended September 30,
		2007			2006			2007			2006
		(As restated)						(As restated)
Net Sales		$	9,458,399		$	14,551,581		$	26,300,592		$	41,610,112
Gross Profit			947,151			4,434,849			9,207,911			17,812,465
Percentage of net sales			10	%		30	%		35	%		43	%
Selling, distribution & administrative expenses		$	4,492,960		$	4,281,467		$	13,070,619		$	13,204,554
Percentage of net sales			48	%		29	%		50	%		32	%
Income (loss) before provision for income taxes		$	(3,999,111	)	$	(605,502	)	$	(5,068,543	)	$	3,463,265
Percentage of net sales			-42	%		-4	%		-19	%		8	%
Net income (loss)		$	(3,999,111	)	$	(420,860	)	$	(5,068,543	)	$	1,973,812
Percentage of net sales			-42	%		-3	%		-19	%		5	%

 

Three Months Ended September 30, 2007 vs. 2006

 

During the third quarter, net sales, and in particular gross margin, were impacted by our strategic decision to reduce excess inventory through increased sales volume of discounted merchandise and substantially increased markdown levels. In addition, poor product assortment, late deliveries and the softening of the denim market had a significant impact on both net sales and gross margin.

 

Net sales decreased from $14.55 million for the three months ended September 30, 2006 to $9.46 million for the three months ended September 30, 2007. The sales decreased due to the recessionary economic climate, weak premium denim market and lack of any material European distribution.

 

Gross profit for the three months ended September 30, 2007 decreased to $0.95 million from $4.43 million during the three months ended September 30, 2006. The decrease in gross profit was largely due to reduced sales during the quarter ended September 30, 2007 and also due to the mark down of inventory and sales of off-price inventory, approximately 27%, during the period. During the third quarter, the Company experienced a dramatic reduction in the price at which it could sell its off-price product. There is a rather restricted avenue of distribution for off-price denim product and that market at this time is deluged with off price product, resulting in substantially lower selling prices.

 

However, we expect our gross margin to be maintained at approximately 50% or greater in the future.

 

Selling, distribution and administrative expenses for the three months ended September 30, 2007 totaled $4.49 million compared with $4.28 million for the three months ended September 30, 2006. The principal components in the second quarter of 2007 were payroll of $1.89 million (compared to $2.28 million in the third quarter last year), trade show expense of $0.21 million ($0.27 million in the same period of 2006), professional fee expenses of $0.19 million ($0.23 million in the same period of 2006), royalties of $0.15 million ($0.51 million in 2006) and stock-based compensation of $0.12 million ($0.13 million in the same period last year). At the conclusion of the quarter ended September 30, 2007, the Company made significant reductions in its selling, distribution, and administrative expenses. Payroll was reduced by $2,400,000 dollars on an annual basis, or $600,000 quarterly.

 

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Net Income (loss) after provision/benefit for taxes in the third quarter of 2007 was $(4.0 ) million or 42% of net sales compared to $(0.42) million or 3% of net sales in the third quarter of 2006. Basic and diluted earnings per share decreased to $(0.15) from $(0.02) in the same period of last year. For the three months ended September 30, 2007, the Company recognized income tax benefit of $0.0 compared to income tax benefit of $0.18 million for the three months ended September 30, 2006.

 

Nine Months Ended September 30, 2007 vs. 2006

 

Net sales decreased from $41.6 million for the nine months ended September 30, 2006 to $26.3 million for the nine months ended September 30, 2007. The sales were less than during the same period last year for a variety of reasons. First, the recessionary economic climate coupled with weak premium denim market sales resulted in reduced sales during the nine months ended September 30, 2007. Secondly, our international sales decreased from 30% in 2006 to 20.9% during the nine months ended September 30, 2007.

 

Gross profit for the nine months ended September 30, 2007 decreased to $9.2 million from $17.81 million during the same period last year. The decrease in gross profit was largely due to reduced sales during the nine months ended September 30, 2007 and also due to mark down of the inventory and sales of off-price inventory, approximately 27%, during the period. During the third quarter, the Company experienced a dramatic reduction in the price at which it could sell its off-price product. There is a rather restricted avenue of distribution for off-price denim product and that market at this time is deluged with off price product, resulting in substantially lower selling prices.

 

However, we expect our gross margin to be maintained at approximately 50% or greater in the future.

 

Selling, distribution and administrative expenses for the nine months ended September 30, 2007 totaled $13.07 million compared with $13.20 million for the same period last year. The principal components during the nine months ended September 30, 2007 were payroll of $5.24 million (compared to $3.5 million in the same period last year), professional fee expenses of $0.65 million ($0.58 million in the same period of 2006), advertising and trade show expenses of $0.55 million ($0.71 million in the same period of 2006), rent expense of $0.49 million ($0.37 million in the same period of 2006), royalties of $0.36 million ($0.83 million in 2006) and stock-based compensation of $0.14 million ($0.23 million in the same period last year). At the conclusion of the quarter ended September 30, 2007, the Company made significant reductions in its selling, distribution, and administrative expenses. Payroll was reduced by $2,400,000 dollars on an annual basis.

 

Net Income (loss) after provision for taxes during the nine months ended September 30, 2007 was $(5.1 ) million or 19.3% of net sales compared to $1.97 million or 4.7% of net sales during the same period of 2006. Basic and diluted earnings per share decreased to $(0.19 ) from $0.08 in the same period of last year. For the nine months ended September 30, 2007, the Company recognized income tax provision of $0.0 million compared to the provision for income tax of $1.49 million for the nine months ended September 30, 2006.

 

Liquidity and Capital Resources

 

We believe we currently have adequate resources to fund our anticipated cash needs through December 31, 2007 and beyond. However, an adverse business development could require us to raise additional financing sooner than anticipated.

 

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Our primary source of liquidity is expected to be cash flow generated from operations, cash and cash equivalents currently on hand, and working capital attainable through our factor. We received a $2.0 million tax refund during the third quarter of 2007. We may seek to finance future capital needs through various means and channels, such as issuance of long-term debt or sale of equity securities.

 

For the nine months ended September 30, 2007, net cash used in operating activities was $(5.7 million). The deficit was primarily due to an increase of $3.5 million in inventory and $1.3 million in due from factor and a decrease in accounts payable of $1.9 million and was offset by a decrease in accounts receivables of $4.2 million, and an increase in bank overdraft of $0.6 million. Net cash provided by financing activities was $6.4 million due to an increase in short-term borrowings by $4.4 million and an increase in advances from our majority shareholder by $2.0 million.

 

Under a new initiative instituted by the Company’s CEO, the Company plans to significantly reduce its level of both fabric and finished goods inventory. This reduction will provide the company with a substantial amount of liquidity. The plan is to reduce the fabric inventory by approximately 200,000 yards, and the finished good inventory by approximately 75,000 to 110,000 units. The Company anticipates this will result in the generation of approximately $2,500,000 of cash.

 

The Company currently is in negotiations with its factor to term out a portion of its short term debt. If completed, this negotiation will result in the generation of additional working capital.

 

The Company currently is in negotiations with its majority stockholder to sell to the Company his interest in the trademarks Yanuk and Taverniti So Jeans.

 

We use a factor for working capital and credit administration purposes. Under the various factoring agreements entered into separately by Blue Holdings, Antik and Taverniti, the factor purchases all the trade accounts receivable assigned by the Company and its subsidiaries and assumes all credit risk with respect to those accounts approved by it.

 

The factor agreements provide that we can borrow an amount up to 90% of the value of our purchased customer invoices, less a reserve of 10% of unpaid accounts purchased and 100% of all such accounts which are disputed. The factor agreements provide for automatic renewal subject to 120 days’ termination notice from any party. The factor also makes available to all three companies a combined line of credit up to the lesser of $2.4 million or 50% of the value of eligible raw materials and finished goods. As of September 30, 2007, borrowings under this line of credit were $14.5 million, of which, the Company drew down $2.4 million of this credit line against inventory, $4.9 million against accounts receivable and $7.2 million against personal guarantees of Paul Guez, our Chairman and majority shareholder, and the living trust of Paul and Elizabeth Guez.

 

As of September 30, 2007, the factor holds $2,831,979 of accounts receivable purchased from us on a without recourse basis and has made advances to us of $63,315 against those receivables, resulting in a net balance amount Due from Factor of $2,662,425, net of reserves of $106,236, as of September 30, 2007. The Company has accounted for the sale of receivables to the factor in accordance with SFAS No. 140, “Accounting for the Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.”

 

As of September 30, 2007, the factor also held as collateral $3,380,109 of accounts receivable that were subject to recourse, against which the Company has provided reserves of $1,193,000 and as of September 30, 2007, the Company received advances totaling $14,463,000 against such receivables, eligible inventory, intangibles, and on the personal guarantee of Mr. Paul Guez. The Company has included the $3,114,334 in accounts receivable, and has reflected the $14,463,000 as short term borrowings on the accompanying balance sheet. The factor commission against such receivables is 0.4% and interest is charged at the rate of 1% over the factor’s prime lending rate per annum.

 

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The factor commission on receivables purchased on a without recourse basis is 0.75% if the aggregate amount of approved invoices is below $10 million per annum, 0.70% if between $10 million and $20 million and 0.65% if between $20 million and $30 million. The Company is contingently liable to the factor for merchandise disputes, customer claims and the like on receivables sold to the factor. To the extent that the Company draws funds prior to the deemed collection date of the accounts receivable sold to the factor, interest is charged at the rate of 1% over the factor’s prime lending rate per annum. Factor advances are collateralized by the non-factored accounts receivable, inventories and the personal guarantees of Paul Guez, our Chairman and majority shareholder, and the living trust of Paul and Elizabeth Guez (see note 6).

 

From time to time, our majority shareholder, Mr. Paul Guez, made advances to us to support our working capital needs. These advances were non-interest bearing. On July 1, 2006, Mr. Guez converted the advances to a line of credit in an agreement with us. The line of credit allows us to borrow from him up to a maximum of $3 million at an annual interest rate of 6%. We may repay the advances in full or in part at any time until the credit line expires on December 31, 2007. As of September 30, 2007, the balance of these advances was $2.6 million.

 

Subsequent to September 30, 2007 the Company agreed to issue 1,000,000 Series A convertible preferred shares valued at $2,556,682 to Mr. Guez in satisfaction of $2,556,682 of advances to the Company by Mr. Guez. The Series A preferred shares are convertible into 3,479,899 shares of our common stock based on a conversion formula equal to the price per share ($2.556682) divided by the conversion price ($0.7347) multiplied by the total number of Series A preferred shares issued, subject to adjustment in accordance with the provisions of the certificate of designation for the Series A preferred shares. The conversion price equals the average closing price of a share of the Company’s common stock, as quoted on the NASDAQ Capital Market, over the 20 trading days immediately preceding November 13, 2007, the closing date of the transaction. The Series A preferred shares accrue cumulative dividends at the annual rate of 6% of the purchase price in preference to the common stock. The purchase price for the Series A preferred shares is $2.556682 per share. Upon the liquidation or dissolution of the Company the Series A preferred shares are entitled to receive, prior to any distribution to the holders of common stock, 100% of the purchase price plus all accrued but unpaid dividends. The Company has reflected the effect of this transaction as if it would have occurred on September 30, 2007 in the proforma liabilities and stockholders’ equity section on the balance sheet.

 

Subsequent to September 30, 2007, in early May, 2008, the Company and Mr. Guez agreed that, as of September 30, 2007, Mr. Guez was in fact owed additional monies totaling $1,326,842, which had not previously been reflected in the Company’s financial statements. Such monies are reflected as a current liability in the Company’s restated financial statements, and reflect additional advances made by Mr. Guez to support the Company’s working capital needs.

 

Critical Accounting Policies

 

Estimates

 

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America 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. On an ongoing basis, we evaluate estimates, including those related to returns, discounts, bad debts, inventories, intangible assets, income taxes, contingencies and litigations. We base our estimates on historical experience and on various assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

 

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