Edgar Filing: TAG IT PACIFIC INC

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-Q

[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934.

For the quarterly period ended March 31, 2006.

[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934.

Commission file number 1-13669

TAG-IT PACIFIC, INC.
(Exact Name of Issuer as Specified in its Charter)

DELAWARE 95-4654481
(State or Other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification No.)

21900 BURBANK BOULEVARD, SUITE 270
WOODLAND HILLS, CALIFORNIA 91367
(Address of Principal Executive Offices)

(818) 444-4100
(Registrant's Telephone Number, Including Area Code)

Securities registered pursuant to Section 12(g) of the Act:

None

Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for past 90 days.

Yes |X| No |_|

Indicate by check mark whether the registrant is a large accelerated filer, an
accelerated filer or a non-accelerated filer . See definition of "accelerated
filer and large accelerated filer" in Rule 12b-2 of the Exchange Act. (Check
one):

Large accelerated filer [_] Accelerated filer [_] Non-accelerated filer [X]

Indicate by check mark whether the registrant is a shell company (as defined in
Rule 12b-2 of the Act). Yes [ ] No [X]

AT MAY 19, 2006 THE ISSUER HAD 18,376,180 SHARES OF COMMON STOCK, $.001 PAR
VALUE, ISSUED AND OUTSTANDING.

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TAG-IT PACIFIC, INC.
INDEX TO FORM 10-Q

PART I FINANCIAL INFORMATION PAGE
----

Item 1. Financial Statements...............................................3

Consolidated Balance Sheets as of March 31, 2006
and December 31, 2005 (unaudited)..................................3

Consolidated Statements of Operations for the Three Months
Ended March 31, 2006 and 2005 (unaudited)..........................4

Consolidated Statements of Cash Flows for the
Three Months Ended March 31, 2006 and 2005 (unaudited).............5

Notes to the Consolidated Financial Statements.....................6

Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations.........................................15

Item 3. Quantitative and Qualitative Disclosures About Market Risk........30

Item 4. Controls and Procedures...........................................30

PART II OTHER INFORMATION

Item 1. Legal Proceedings.................................................32

Item 1A. Risk Factors .....................................................33

Item 6. Exhibits..........................................................33

PART I
FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS.
TAG-IT PACIFIC, INC.
CONSOLIDATED BALANCE SHEETS

(unaudited)

March 31, December 31,
2006 2005
------------ ------------
Assets
Current Assets:
Cash and cash equivalents ................... $ 3,026,623 $ 2,277,397
Trade accounts receivable, net .............. 6,278,327 5,652,990
Note receivable ............................. 942,309 662,369
Inventories ................................. 4,688,671 5,573,099
Prepaid expenses and other current assets ... 275,381 618,577
------------ ------------
Total current assets ...................... 15,211,311 14,784,432

Property and equipment, net of accumulated
depreciation and amortization ............... 6,179,314 6,438,096
Fixed assets held for sale ..................... 826,904 826,904
Note receivable, less current portion .......... 2,477,359 2,777,631
Due from related parties ....................... 679,795 730,489
Other intangible assets, net ................... 4,233,250 4,255,125
Other assets ................................... 538,546 508,117
------------ ------------
Total assets ................................... $ 30,146,479 $ 30,320,794
============ ============
Liabilities and Stockholders' Equity
Current Liabilities:
Accounts payable ............................ $ 6,096,011 $ 6,719,226
Accrued legal costs ......................... 2,640,783 2,520,111
Other accrued expenses ...................... 5,323,166 4,168,552
Demand notes payable to related parties ..... 664,971 664,971
Current portion of capital lease obligations 441,086 590,884
Current portion of notes payable ............ 189,927 186,837
------------ ------------
Total current liabilities ................. 15,355,944 14,850,581

Capital lease obligations, less current portion 757,752 856,495
Notes payable, less current portion ............ 1,212,361 1,261,018
Secured convertible promissory notes ........... 12,448,624 12,440,623
------------ ------------
Total liabilities ......................... 29,744,681 29,408,717
------------ ------------
Contingencies and guarantees - (Note 4) ........ -- --

Stockholders' equity:
Preferred stock, Series A $0.001 par value;
250,000 shares authorized,
no shares issued or outstanding ........... -- --
Common stock, $0.001 par value, 30,000,000
shares authorized; 18,241,045 shares
issued and outstanding at March 31, 2006;
18,241,045 at December 31, 2005 ........... 18,241 18,241
Common stock, issuable under grants, 227,635
shares at March 31, 2006 .................. 102,725 --
Additional paid-in capital .................. 51,414,277 51,327,878
Accumulated deficit ......................... (51,163,445) (50,434,042)
------------ ------------
Total stockholders' equity ..................... 371,798 912,077
------------ ------------
Total liabilities and stockholders' equity ..... $ 30,146,479 $ 30,320,794
============ ============

See accompanying notes to consolidated financial statements.

TAG-IT PACIFIC, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited)

Three Months Ended March 31,
------------------------------
2006 2005
------------ ------------

Net sales .................................. $ 10,638,216 $ 13,055,277
Cost of goods sold ......................... 7,795,491 9,803,454
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Gross profit .......................... 2,842,725 3,251,823

Selling expenses ........................... 545,625 742,334
General and administrative expenses ........ 2,817,131 3,727,260
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Total operating expenses .............. 3,362,756 4,469,594

Loss from operations ....................... (520,031) (1,217,771)
Interest expense, net ...................... 209,372 268,655
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Loss before income taxes ................... (729,403) (1,486,426)
Provision for income taxes ................. -- 162,017
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Net loss .............................. $ (729,403) $ (1,648,443)
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Basic loss per share ....................... $ (0.04) $ (0.09)
============ ============
Diluted loss per share ..................... $ (0.04) $ (0.09)
============ ============

Weighted average number of common
shares outstanding:
Basic ................................. 18,241,045 18,179,426
============ ============
Diluted ............................... 18,241,045 18,179,426
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See accompanying notes to consolidated financial statements.

TAG-IT PACIFIC, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)

Three Months Ended March 31,
--------------------------
2006 2005
----------- -----------

Increase (decrease) in cash and cash equivalents
Cash flows from operating activities:
Net loss ............................................ $ (729,403) $(1,648,443)
Adjustments to reconcile net loss to net cash used
by operating activities:
Depreciation and amortization ........................ 305,304 555,148
Increase (decrease) in allowance for doubtful accounts (334,474) 74,941
Increase (decrease) in inventory valuation reserves . (2,850,093) --
Disposal of asset .................................... 8,502 --
Stock based compensation ............................. 189,124 --
Changes in operating assets and liabilities:
Receivables, including related party .............. (242,669) 1,351,809
Inventories ....................................... 3,734,521 (1,812,085)
Prepaid expenses and other current assets ......... 343,196 (504,565)
Note Receivable and other assets a&oothero ...... (10,097) 1,581
Accounts payable and accrued expenses ............. 531,399 841,612
Accrued legal expenses .......................... 120,672 (233,086)
----------- -----------
Net cash used by operating activities ................... 1,065,982 (1,373,088)
----------- -----------

Cash flows from investing activities:
Acquisition of property and equipment ............... (25,148) (587,923)
Proceeds from sale of equipment .................... 2,500 --
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Net cash used by investing activities ................... (22,648) (587,923)
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Cash flows from financing activities:
Repayment of bank line of credit, net ............... -- (15,824)
Proceeds from exercise of stock options and warrants -- 254,541
Repayment of capital leases ......................... (248,541) (232,441)
Repayment of notes payable .......................... (45,567) (642,673)
----------- -----------
Net cash used by financing activities ................... (294,108) (636,397)
----------- -----------

Net increase (decrease) in cash ......................... 749,226 (2,597,408)
Cash at beginning of period ............................. 2,277,397 5,460,662
----------- -----------
Cash at end of period ................................... $ 3,026,623 $ 2,863,254
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Supplemental disclosures of cash flow information:
Cash received (paid) during the period for:
Interest paid ..................................... $ (257,737) $ (358,887)
Income taxes paid ................................. $ -- $ (32,071)
Interest received ................................. $ 36,696 $ 14,009
Non-cash financing activities:
Capital lease obligation ............................ $ -- $ 270,597

See accompanying notes to consolidated financial statements.

TAG-IT PACIFIC, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

NOTE 1. PRESENTATION OF INTERIM INFORMATION

The accompanying unaudited consolidated financial statements have been
prepared in accordance with accounting principles generally accepted in the
United States for interim financial information and in accordance with the
instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do
not include all of the information and footnotes required by accounting
principles generally accepted in the United States for complete financial
statements. The accompanying unaudited consolidated financial statements reflect
all adjustments that, in the opinion of the management of Tag-It Pacific, Inc.
and Subsidiaries (collectively, the "Company"), are considered necessary for a
fair presentation of the financial position, results of operations, and cash
flows for the periods presented. The results of operations for such periods are
not necessarily indicative of the results expected for the full fiscal year or
for any future period. The accompanying financial statements should be read in
conjunction with the audited consolidated financial statements of the Company
included in the Company's Form 10-K for the year ended December 31, 2005. The
balance sheet as of December 31, 2005 has been derived from the audited
financial statements as of that date but omits certain information and footnotes
required for complete financial statements.

The accompanying consolidated financial statements have been prepared
assuming that the Company will continue as a going concern, which contemplates
the realization of assets and the satisfaction of liabilities in the normal
course of business. The Company has experienced substantial recurring losses
from operations on declining revenues and has an accumulated deficit of $51.1
million as of March 31, 2006. These matters, among others, raise substantial
doubt about the Company's ability to continue as a going concern. The Company's
continuation as a going concern is dependent on its ability to generate
sufficient cash flow to meet its obligations on a timely basis, to obtain
additional financing as may be required, and ultimately to attain profitable
operations. In response to these matters, during 2005 the Company adopted a
restructuring plan designed to better align the Company's organizational and
cost structures with its future growth opportunities. In connection with this
restructuring, management's operating plan for 2006 includes increased sales,
higher margins on certain products, reduced expenses as a percentage of revenues
and improved cash flows sufficient to cover the Company's operating needs. There
can be no assurance that the Company will be successful in these matters. The
financial statements do not include any adjustments that might result from the
outcome of this uncertainty.

NOTE 2. EARNINGS PER SHARE

The following is a reconciliation of the numerators and denominators of
the basic and diluted earnings per share computations:

THREE MONTHS ENDED MARCH 31, 2006: LOSS SHARES PER SHARE
----------- ----------- -----------

Basic loss per share:
Loss available to common stockholders .... $ (729,403) 18,241,045 $ (0.04)

Effect of Dilutive Securities:
Options .................................. -- -- --
Warrants ................................. -- -- --
----------- ----------- -----------
Loss available to common stockholders .... $ (729,403) 18,241,045 $ (0.04)
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THREE MONTHS ENDED MARCH 31, 2005:
Basic loss per share:
Loss available to common stockholders .... $(1,648,443) 18,179,426 $ (0.09)

Effect of Dilutive Securities:
Options .................................. -- -- --
Warrants ................................. -- -- --
----------- ----------- -----------
Loss available to common stockholders .... $(1,648,443) 18,179,426 $ (0.09)
=========== =========== ===========

Warrants to purchase 1,243,813 shares of common stock at between $3.50
and $5.06, options to purchase 4,474,635 shares of common stock at between $0.37
and $5.23, convertible debt of $12,500,000 convertible at $3.65 per share, and
other convertible debt of $500,000 convertible at $4.50 per share were
outstanding for the three months ended March 31, 2006, but were not included in
the computation of diluted loss per share because the effect of exercise or
conversion would have an antidilutive effect on loss per share.

Warrants to purchase 1,510,479 shares of common stock at between $3.50
and $5.06, options to purchase 1,872,000 shares of common stock at between $1.30
and $5.23 and convertible debt of $500,000 convertible at $4.50 per share were
outstanding for the three months ended March 31, 2005, but were not included in
the computation of diluted earnings per share because the effect of exercise or
conversion would have an antidilutive effect on loss per share.

NOTE 3. STOCK BASED COMPENSATION

On January 1, 2006, the Company adopted Statement of Financial
Accounting Standards No. 123 (revised 2004), "Share-Based Payment," ("SFAS
123(R)") which requires the measurement and recognition of compensation expense
for all share-based payment awards made to employees and directors based on
estimated fair values. SFAS 123(R) supersedes the Company's previous accounting
under Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued
to Employees" ("APB 25") for periods beginning in fiscal 2006. In March 2005,
the Securities and Exchange Commission issued Staff Accounting Bulletin No. 107
("SAB 107") relating to SFAS 123(R). The Company has applied the provisions of
SAB 107 in its adoption of SFAS 123(R).

The Company adopted SFAS 123(R) using the modified prospective
transition method, which requires the application of the accounting standard as
of January 1, 2006, the first day of the Company's fiscal year 2006. The
Company's financial statements as of and for the three months ended March 31,
2006 reflect the impact of SFAS 123(R). In accordance with the modified
prospective transition method, the Company's financial statements for prior
periods have not been restated to reflect, and do not include, the

impact of SFAS 123(R). There was no stock-based compensation expense related to
employee or director stock options recognized during the three months ended
March 31, 2005. Stock-based compensation expense recognized under SFAS 123(R)
for employee and directors for the three months ended March 31, 2006 was
$119,124. Basic and diluted loss per share for the quarter ended March 31, 2006
would have been $(.03) per share, if the Company had not adopted SFAS 123(R),
compared to reported basic and diluted loss of $(.04) per share.

During the quarter ended March 31, 2006, the Company granted awards of
stock for 227,635 shares at an average market price of $0.45 per share and
options to acquire 2,685,135 shares at an average exercise price of $0.42 per
share. Awards to acquire 1,625,000 shares were granted to employees outside of
the 1997 Plan (see Note 6), and awards of stock and options to acquire 167,500
shares were granted to a consultant. The estimated fair value of all awards
granted during the quarter was $1,200,000, of which $70,000 was accrued for in
accrued liabilities as of December 31, 2005. Assumptions used to value options
granted to employees were expected volatility of 140%, expected term of 5.3
years to 6.1 years, risk-free interest rate of approximately 4.4%, and an
expected dividend yield of zero. Assumptions used to value options granted to
consultants were expected volatility of 160%, expected term of 10 years
(contractual life), risk-free interest rate of 4.5%, and expected divided yield
of zero.

Options issued to consultants are being accounted for in accordance with
the provisions of Emerging Issues Task Force (EITF) No. 96-18, "Accounting for
Equity Instruments That Are Issued to Others Than Employees for Acquiring, or in
Conjunction with Selling, Goods or Services."

The following table illustrates the effect on net loss and loss per
share if the Company had applied the fair value recognition provisions of SFAS
123 to stock-based awards granted under the Company's stock option plans for the
three months ended March 31, 2005. For purposes of this pro-forma disclosure,
the fair value of the options is estimated using the Black-Scholes-Merton
option-pricing formula ("Black-Scholes model") and amortized to expense
generally over the options' requisite service periods (vesting periods).

Net loss as reported for the three months ended March 31, 2005 ................ $(1,648,443)
Plus: Stock-based expense recognized in the Statement of Operations, net of tax --
Less: Stock-based expense determined under fair-value based method, net of tax (11,730)
-----------
Pro forma net loss for the three months ended March 31, 2005 .................. $(1,660,173)
===========
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Net loss per share for the three months ended March 31, 2005:
As reported -- basic and diluted .............................................. $ (0.09)
Pro forma -- basic and diluted ................................................ $ (0.09)

SFAS 123(R) requires companies to estimate the fair value of share-based
payment awards to employees and directors on the date of grant using an
option-pricing model. The value of the portion of the award that is ultimately
expected to vest is recognized as expense over the requisite service periods in
the Company's Statements of Operations. Stock-based compensation expense
recognized in the Statements of Operations for the first quarter of fiscal 2006
included compensation expense for share-based payment awards granted prior to,
but not yet vested as of January 1, 2006 based on the grant date fair value
estimated in accordance with the pro-forma provisions of SFAS 123 and
compensation expense for the share-based payment awards granted subsequent to
January 1, 2006 based on the grant date fair value estimated in accordance with
the provisions of SFAS 123(R). For stock-based awards issued to employees and
directors, stock-based compensation is attributed to expense using the
straight-line single option method, which is consistent with how the
prior-period pro formas were provided. As stock-based compensation expense
recognized in the Statements of Operations for the first quarter of fiscal 2006
is

based on awards ultimately expected to vest, SFAS 123(R) requires forfeitures to
be estimated at the time of grant and revised, if necessary, in subsequent
periods if actual forfeitures differ from those estimates. For the quarter ended
March 31, 2006, expected forfeitures is immaterial and as such the Company is
recognizing forfeitures as they occur. In the pro-forma information provided
under SFAS 123 for the periods prior to fiscal 2006, the Company accounted for
forfeitures as they occurred.

Prior to the adoption of SFAS 123(R), the Company accounted for
stock-based awards to employees and directors using the intrinsic value method
in accordance with APB 25. Under the intrinsic value method, the Company
recognized share-based compensation equal to the award's intrinsic value at the
time of grant over the requisite service periods using the straight-line method.
Forfeitures were recognized as incurred. During the quarter ended March, 31,
2005, there was no stock-based compensation expense recognized in the Statements
of Operations for awards issued to employees and directors as the awards had no
intrinsic value at the time of grant because their exercise prices equaled the
fair values of the common stock at the time of grant.

The Company's determination of fair value of share-based payment awards
to employees and directors on the date of grant uses the Black-Scholes model,
which is affected by the Company's stock price as well as assumptions regarding
a number of complex and subjective variables. These variables include, but are
not limited to, our expected stock price volatility over the expected term of
the awards, and actual and projected employee stock option exercise behaviors.
The Company estimates expected volatility using historical data. The expected
term is estimated using the "safe harbor" provisions under SAB 107.

The Company has elected to adopt the detailed method provided in SFAS
123(R) for calculating the beginning balance of the additional paid-in capital
pool ("APIC pool") related to the tax effects of employee stock-based
compensation, and to determine the subsequent impact on the APIC pool and
Statements of Cash Flows of the tax effects of employee stock-based compensation
awards that are outstanding upon adoption of SFAS 123(R).

NOTE 4. INVENTORIES

Inventories are stated at the lower of cost or market value and are
categorized as raw materials, work-in -progress or finished goods. Inventory
reserves are recorded for damaged, obsolete, excess and slow-moving inventory.
We use estimates to record these reserves. Slow-moving inventory is reviewed by
category and may be partially or fully reserved for depending on the type of
product and the length of time the product has been included in inventory.
Reserve adjustments are made for the difference between the cost of the
inventory and the estimated market value, if lower, and charged to operations in
the period in which the facts that give rise to these adjustments become known.
Market value of inventory is estimated based on the impact of market trends, an
evaluation of economic conditions and the value of current orders relating to
the future sales of this type of inventory.

Inventories consist of the following:

March 31, December 31,
2006 2005
----------- -----------

Finished goods ....................... $ 9,144,600 $12,879,100
Less reserves ........................ 4,455,900 7,306,000
----------- -----------
Total inventories .................... $ 4,688,700 $ 5,573,100
=========== ===========

NOTE 5. CONTINGENCIES AND GUARANTEES

On October 12, 2005, a shareholder class action complaint-- Huberman vs
Tag-It Pacific, Inc., et al., Case No. CV05-7352 R(Ex)--was filed against the
Company and certain of the Company's current and former officers and directors
in the United States District Court for the Central District of California
alleging claims under Section 10(b) and Section 20 of the Securities Exchange
Act of 1934, as amended, and Rule 10b-5 promulgated thereunder. The action is
brought on behalf of all purchasers of the Company's publicly-traded securities
during the period from November 14, 2003 to August 12, 2005. On January 23, 2006
the court heard competing motions for appointment of lead plaintiff/counsel and
appointed Seth Huberman as lead plaintiff. The lead plaintiff thereafter filed
an amended complaint on March 13, 2006. The amended complaint alleges that the
defendants made false and misleading statements about the Company's financial
situation and its relationship with certain of its large customers during a
purported class period between November 13, 2003 and August 12, 2005. It
purports to state claims under Section 10(b)/Rule 10b-5 and Section 20(a) of the
Securities Exchange Act of 1934. The Company filed a motion to dismiss the
amended complaint which motion is scheduled to be heard on June 19, 2006.
Pursuant to the Private Securities Litigation Reform Act, discovery is stayed in
the case. Although the Company believes that it and the other defendants have
meritorious defenses to the class action complaint and intend to contest the
lawsuit vigorously, an adverse resolution the lawsuit could have a material
adverse effect on the Company's financial position and results of operations. At
this early stage of the litigation, the Company is not able to reasonably
predict the outcome of this action or estimate potential losses, if any, related
to the lawsuit.

The Company has filed suit against Pro-Fit Holdings Limited in the U.S.
District Court for the Central District of California - Tag-It Pacific, Inc. v.
Pro-Fit Holdings Limited, CV 04-2694 LGB (RCx) - based on various contractual
and tort claims relating to the Company's exclusive license and intellectual
property agreement, seeking declaratory relief, injunctive relief and damages.
The agreement with Pro-Fit gives the Company the exclusive rights in certain
geographic areas to Pro-Fit's stretch and rigid waistband technology. Pro-Fit
filed an answer denying the material allegations of the complaint and filed a
counterclaim alleging various contractual and tort claims seeking injunctive
relief and damages. The Company filed a reply denying the material allegations
of Pro-Fit's pleading. Pro-Fit has since purported to terminate the exclusive
license and intellectual property agreement based on the same alleged breaches
of the agreement that are the subject of the parties' existing litigation, as
well as on an additional basis unsupported by fact. In February 2005, the
Company amended its pleadings in the litigation to assert additional breaches by
Pro-Fit of its obligations under the agreement and under certain additional
letter agreements, and for a declaratory judgment that Pro-Fit's patent No.
5,987,721 is invalid and not infringed by the Company. Thereafter, Pro-Fit filed
an amended answer and counterclaim denying the material allegations of the
amended complaint and alleging various contractual and tort claims seeking
injunctive relief and damages. Pro-Fit further asserted that the Company
infringed its United States Patent Nos. 5,987,721 and 6,566,285. The Company
filed a reply denying the substantive allegations of the reply. At the Company's
request, the Court bifurcated the contract issues for trial to commence on
January 10, 2006. The parties have filed summary judgment motions which may
dispose of some of the issues in this case prior to trial. The remaining issues
will be tried at a later date. As the Company derives a significant amount of
revenue from the sale of products incorporating the stretch waistband
technology, the Company's business, results of operations and financial
condition could be materially adversely affected if the dispute with Pro-Fit is
not resolved in a manner favorable to the Company. Additionally, the Company has
incurred significant legal fees in this litigation, and unless the case is
settled will continue to incur additional legal fees in increasing amounts as
the case accelerates to trial.

The Company currently has pending a number of other claims, suits and
complaints that arise in the ordinary course of its business. The Company
believes that it has meritorious defenses to these

claims and that the claims are either covered by insurance or, after taking into
account the insurance in place, would not have a material effect on the
Company's consolidated financial condition if adversely determined against the
Company.

In accordance with the bylaws of the Company, officers and directors
are indemnified for certain events or occurrences arising as a result of the
officer or director's serving in such capacity. The term of the indemnification
period is for the lifetime of the officer or director. The maximum potential
amount of future payments the Company could be required to make under the
indemnification provisions of its bylaws is unlimited. However, the Company has
a director and officer liability insurance policy that reduces its exposure and
enables it to recover a portion of any future amounts paid. As a result of its
insurance policy coverage, the Company believes the estimated fair value of the
indemnification provisions of its bylaws is minimal and therefore, the Company
has not recorded any related liabilities.

The Company enters into indemnification provisions under its agreements
with investors and its agreements with other parties in the normal course of
business, typically with suppliers, customers and landlords. Under these
provisions, the Company generally indemnifies and holds harmless the indemnified
party for losses suffered or incurred by the indemnified party as a result of
the Company's activities or, in some cases, as a result of the indemnified
party's activities under the agreement. These indemnification provisions often
include indemnifications relating to representations made by the Company with
regard to intellectual property rights. These indemnification provisions
generally survive termination of the underlying agreement. The maximum potential
amount of future payments the Company could be required to make under these
indemnification provisions is unlimited. The Company has not incurred material
costs to defend lawsuits or settle claims related to these indemnification
agreements. As a result, the Company believes the estimated fair value of these
agreements is minimal. Accordingly, the Company has not recorded any related
liabilities.

NOTE 6. STOCK OPTIONS AND WARRANTS

On October 1, 1997, the Company adopted the 1997 Stock Incentive Plan
("the 1997 Plan"), which authorized the granting of a variety of stock-based
incentive awards. The 1997 Plan is administered by the Board of Directors, or a
committee appointed by the Board of Directors, which determines the recipients
and terms of the awards granted. As of December 31, 2005, the Company may issue
awards to acquire up to a total of 3,077,500 shares of common stock under the
1997 Plan. As of December 31, 2005, there were awards issued and outstanding
under the 1997 Plan to acquire a total of 1,833,000 shares of common stock.

In addition to those awards issued under the 1997 Plan, the Company has
also issued certain warrants. As of December 31, 2005, there were warrants
issued to acquire a total of 1,377,147 shares of common stock. The weighted
average exercise prices, remaining contractual lives and aggregate intrinsic
values for employee and board member options granted, expected to vest, and
exercisable as of December 31, 2005 were as follows:

Weighted
Weighted Average
Number Average Remaining
Of Exercise Contractual Intrinsic
Shares Price Life (Years) Value

OPTIONS AS OF DECEMBER 31, 2005:
Outstanding 1,833,000 $ 3.46 6.02 $ -0-
Vested and Expected to Vest 1,809,000 $ 3.44 5.98 $ -0-
Exercisable 1,788,000 $ 3.44 5.97 $ -0-

The aggregate intrinsic value excludes those options that are
"not-in-the-money" as of December 31, 2005. Awards that are expected to vest
take into consideration estimate forfeitures for awards not yet vested. The
weighted average exercise prices, remaining contractual lives and aggregate
intrinsic values for warrants granted, exercisable, and expected to vest as of
December 31, 2005 were as follows:

Weighted
Weighted Average
Number Average Remaining
Of Exercise Contractual Intrinsic
Shares Price Life (Years) Value

WARRANTS AS OF DECEMBER 31, 2005:
Outstanding 1,377,147 $ 4.36 2.60 $ -0-
Vested and Expected to Vest 1,377,147 $ 4.36 2.60 $ -0-
Exercisable 1,377,147 $ 4.36 2.60 $ -0-

The aggregate intrinsic value excludes those warrants that are
"not-in-the-money" as of December 31, 2005. Awards that are expected to vest
take into consideration estimated forfeitures for awards not yet vested.

The intrinsic value of options exercised in 2005, 2004, and 2003 were
$1,500; $183,000; and $261,000. The total fair value of awards vested during the
years ended December 31, 2005, 2004 and 2003 approximates that which was
expensed for pro-forma purposes, or approximately $220,000, $55,000 and
$140,000, respectively.

As of December 31, 2005, there was $42,200 of total unrecognized
compensation costs related to non-vested share-based compensation arrangements
granted, including warrants. This cost is expected to be recognized over the
weighted-average period of 1.2 years.

When options are exercised, the Company's policy is to issue previously
registered, unissued shares of commons stock. As of December 31, 2005, the
Company had 1,244,500 registered but unissued shares of common stock available.

NOTE 7. NEW ACCOUNTING PRONOUNCEMENTS

Effective January 1, 2006 the Company implemented FASB Statement of
Financial Accounting Standards (SFAS) No. 154, "Accounting Changes and Error
Corrections", an amendment to accounting Principles Bulletin (APB) Opinion No.
20, "Accounting Changes", and SFAS No. 3, "Reporting Accounting Changes in
Interim Financial Statements". Though SFAS No. 154 carries forward the guidance
in APB No.20 and SFAS No.3 with respect to accounting for changes in estimates,
changes in reporting entity, and the correction of errors, SFAS No. 154
established new standards on accounting for changes in accounting principles,
whereby all such changes must be accounted for by retrospective application to
the financial statements of prior periods unless it is impracticable to do so.
SFAS No. 154 was effective for accounting changes and error corrections made in
fiscal years beginning after December 15, 2005. The adoption of this new
standard did not have a material impact upon the Company's financial position,
results of operations or cash flows.

In February 2006, the FASB issued Statement of Financial Accounting
Standards No. 155, "Accounting for Certain Hybrid Financial Instruments" ("SFAS
155"), which amends SFAS No. 133, "Accounting for Derivatives Instruments and
Hedging Activities" ("SFAS 133") and SFAS No. 140, "Accounting for Transfers and
Servicing of Financial Assets and Extinguishment of Liabilities" ("SFAS 140").
SFAS 155 amends SFAS 133 to narrow the scope exception for interest-only and
principal-only strips on debt instruments to include only such strips
representing rights to receive a specified portion of the contractual interest
or principle cash flows. SFAS 155 also amends SFAS 140 to allow qualifying
special-purpose entities to hold a passive derivative financial instrument
pertaining to beneficial interests that itself is a derivative instrument. We
are currently evaluating the impact of this new Standard, but believe that it
will not have a material impact on the Company's financial position, results of
operations or cash flows.

In March 2006, the FASB issued SFAS No. 156, "Accounting for Servicing
of Financial Assets" ("SFAS No. 156"), which provides an approach to simplify
efforts to obtain hedge-like (offset) accounting. This Statement amends FASB
Statement No. 140, "Accounting for Transfers and Servicing of Financial Assets
and Extinguishments of Liabilities", with respect to the accounting for
separately recognized servicing assets and servicing liabilities. The Statement
(1) requires an entity to recognize a servicing asset or servicing liability
each time it undertakes an obligation to service a financial asset by entering
into a servicing contract in certain situations; (2) requires that a separately
recognized servicing asset or servicing liability be initially measured at fair
value, if practicable; (3) permits an entity to choose either the amortization
method or the fair value method for subsequent measurement for each class of
separately recognized servicing assets or servicing liabilities; (4) permits at
initial adoption a one-time reclassification of available-for-sale securities to
trading securities by an entity with recognized servicing rights, provided the
securities reclassified offset the entity's exposure to changes in the fair
value of the servicing assets or liabilities; and (5) requires separate
presentation of servicing assets and servicing liabilities subsequently measured
at fair value in the balance sheet and additional disclosures for all separately
recognized servicing assets and servicing liabilities. SFAS No. 156 is effective
for all separately recognized servicing assets and liabilities as of the
beginning of an entity's fiscal year that begins after September 15, 2006, with
earlier adoption permitted in certain circumstances. The Statement also
describes the manner in which it should be initially applied. We are currently
evaluating the impact of this Statement.

NOTE 7. GEOGRAPHIC INFORMATION

The Company specializes in the distribution of a full range of trim
items to manufacturers of fashion apparel, specialty retailers and mass
merchandisers. There is not enough difference between the types of products
developed and distributed by the Company to account for these products
separately or to justify segmented reporting by product type.

The Company distributes its products internationally and has reporting
requirements based on geographic regions. Long-lived assets are attributed to
countries based on the location of the assets and revenues are attributed to
countries based on customer delivery locations, as follows:

THREE MONTHS ENDED
MARCH 31,
-------------------------------
2006 2005
----------- -----------
Sales:
United States ..................... $ 913,300 $ 587,500
Asia .............................. 6,320,400 4,295,200
Mexico ............................ 1,135,500 4,621,600
Dominican Republic ................ 1,640,800 2,219,400
Other ............................. 628,200 1,331,600
----------- -----------
$10,638,200 $13,055,300
=========== ===========

THREE MONTHS ENDED
MARCH 31,
-------------------------------
2006 2005
----------- -----------
Long-lived Assets:
United States ..................... $10,244,100 $10,493,900
Asia .............................. 212,900 226,200
Mexico ............................ 33,500 23,700
Dominican Republic ................ 749,000 776,300
----------- -----------
$11,239,500 $11,520,100
=========== ===========

NOTE 8. SUBSEQUENT EVENT

In May 2006, the Company received notice by letter from The American
Stock Exchange LLC ("AMEX") that the Company does not meet certain of the
continued listing standards as set forth in the AMEX Company Guide.
Specifically, the AMEX letter cited the Company's failure, as of December 31,
2005, to comply with: (i) Section 1003(a)(i) of the Company Guide because it had
shareholders' equity of less than $2,000,000 and losses from continuing
operations and/or net losses in two out of our last three most recent fiscal
years; and (ii) Section 1003(a)(ii) because it had shareholders' equity of less
than $4,000,000 and losses from continuing operations and/or net losses in three
out of our four most recent fiscal years.

In order to maintain an AMEX listing, the Company is required to submit
a plan by June 15, 2006 advising AMEX of the actions it has taken or plans to
take to regain compliance with the AMEX continued listing requirements within 18
months. This plan is subject to the review and approval by AMEX. There is no
assurance that the Company's plan will be accepted by AMEX or of the period of
time, if any, that AMEX will allow the Company to continue its listing during
the plan period. If the Company fails to timely submit this plan, AMEX does not
accept the plan for any reason, or the Company fails to perform in accordance
with the plan, the Company will be subject to delisting procedures.

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

FORWARD LOOKING STATEMENTS

This report and other documents we file with the SEC contain forward
looking statements that are based on current expectations, estimates, forecasts
and projections about us, our future performance, our business or others on our
behalf, our beliefs and our management's assumptions. These statements are not
guarantees of future performance and involve certain risks, uncertainties, and
assumptions that are difficult to predict. We describe our respective risks,
uncertainties, and assumptions that could affect the outcome or results of
operations below. We have based our forward looking statements on our
management's beliefs and assumptions based on information available to our
management at the time the statements are made. We caution you that actual
outcomes and results may differ materially from what is expressed, implied, or
forecast by our forward looking statements. Reference is made in particular to
forward looking statements regarding projections or estimates concerning our
business, including demand for our products and services, mix of revenue
streams, ability to control and/or reduce operating expenses, anticipated gross
margins and operating results, cost savings, product development efforts,
general outlook of our business and industry, international businesses,
competitive position, adequate liquidity to fund our operations and meet our
other cash requirements.

OVERVIEW

The following management's discussion and analysis is intended to
assist the reader in understanding our consolidated financial statements. This
management's discussion and analysis is provided as a supplement to, and should
be read in conjunction with, our consolidated financial statements and
accompanying notes.

Tag-It Pacific, Inc. sells and distributes apparel zippers, specialty
waistbands and various apparel trim products to manufacturers of fashion
apparel, specialty retailers and mass merchandisers. We sell and market these
products under various branded names including Talon, Tekfit, and Trimfit. We
operate the business globally under three product groups.

We plan to increase our global expansion of Talon zippers through the
establishment of a network of Talon distribution relationships. These
distribution partners will be required to maintain excellent zipper
manufacturing capabilities and will adopt quality manufacturing procedures to
meet our high manufacturing standards. The network of these manufacturers under
the Talon brand is expected to improve the time-to-market by eliminating the
typical setup and build-out phase for new manufacturing capacity throughout the
world. In the last quarter of 2004 and early 2005 we entered into six franchise
agreements for the sale of Talon zippers. However, during 2005 several of these
initial distribution partners experienced delays in their acquisition of
necessary zipper equipment, and this in turn delayed the distribution of Talon
zippers within their respective territories. As a result of these delays, and
other performance deficiencies, the initial distribution agreements were
terminated. We are in the process of changing our distribution agreements to
better serve the local and regional markets and to provide more guidance and
flexibility in meeting our manufacturing standards.

During the third quarter of 2005 we restructured our trim business to
become an outsourced product development, sourcing and sampling department for
the most demanding brands and retailers. We believe that trim design
differentiation among brands and retailers has become a critical marketing tool
for our customers. By assisting our customers in the development, design and
sourcing of trim, we expect to achieve higher margins for our trim products,
create long-term relationships with our customers, grow our sales to a
particular customer by supplying trim for a larger proportion of their brands,
and better differentiate our trim sales and services from those of our
competitors. The restructuring (described more fully below) discontinued the
supply of trim products in preassembled kits. We will continue to

supply trim to customers who do not engage us to serve as an outsourced
development, sourcing and sampling department; however, we will not provide this
trim in a preassembled kit.

Our Tekfit services provide manufacturers with the patented technology,
manufacturing know-how and materials required to produce pants incorporating an
expandable waistband. These products are currently produced by several
manufacturers for one single brand. We intend to expand this product to other
brands; however our expansion has been limited to date due to a licensing
dispute. As described more fully in this report under Contingencies and
Guarantees (see Note 4 to our unaudited consolidated financial statements), we
are presently in litigation with Pro-Fit Holdings Limited related to our
exclusively licensed rights to sell or sublicense stretch waistbands
manufactured under Pro-Fit's patented technology. As we derive a significant
amount of revenue from the sale of products incorporating the stretch waistband
technology, our business, results of operations and financial condition could be
materially adversely affected if our dispute with Pro-Fit is not resolved in a
manner favorable to us.

In an effort to better align our organizational and cost structures
with its future growth opportunities, in August 2005 our Board of Directors
adopted a restructuring plan that was substantially completed by December 31,
2005. The plan included restructuring our global operations by eliminating
redundancies in our Hong Kong operation, closing our facilities in Mexico,
converting our Guatemala facility from a manufacturing site to a distribution
center, and closing our North Carolina manufacturing facility. We have also
refocused our sales efforts on higher margin products, which may result in lower
net sales over the next twelve months. As a result of this restructuring, we
will operate with fewer employees and will have lower associated operating and
distribution expenses.

RESULTS OF OPERATIONS

The following table sets forth selected statements of operations data
shown as a percentage of net sales for the periods indicated:

THREE MONTHS ENDED
MARCH 31,
------------------
2006 2005
------ ------
Net Sales .............................................. 100.0 % 100.0 %
Cost of goods sold ..................................... 73.3 75.1
------ ------
Gross margin ........................................... 26.7 24.9
Selling expenses ....................................... 5.1 5.7
General and administrative expenses .................... 26.5 28.5
------ ------
Operating loss ......................................... (4.9)% (9.3)%
====== ======

SALES

For the three months ended March 31, 2006 and 2005, sales by geographic
region based on the location of the customer as a percentage of sales:

THREE MONTHS ENDED
MARCH 31,
-----------------
2006 2005
------ ------
United States ............................................ 8.6% 4.5%
Asia ..................................................... 59.4 32.9
Mexico ................................................... 10.7 35.4
Dominican Republic ....................................... 15.4 17.0
Other .................................................... 5.9 10.2
------ ------
Total ................................................ 100.0% 100.0%
====== ======

Sales for the three months ended March 31, 2006 were $10.6 million or
$2.4 million (18.5%) less than sales for the same period in 2005. The net
decrease is primarily the result of the shift of apparel production from Latin
America to Asia and other worldwide markets that began in 2004, and the
resulting decrease in sales to our customers in Mexico of trim products. Sales
of our TEKFIT waistband also decreased in 2006 and 2005 because of lower demand
from the single customer for this product. We responded to these market changes
with a restructuring plan implemented in the third quarter of 2005 that included
reducing our operations in Mexico and focusing our efforts on the markets in
Asia.

COST OF SALES

Cost of sales, for the three months ended March 31, 2006 was $7.8
million or $2.0 million (20.5%) less than cost of sales for the same period in
2005, due to lower sales volume and a reduction in cost as a percentage of sales
from 75.1% in 2005 to 73.3% for the three months ended March 31, 2006. The
reduction in cost of sales as a percentage of sales is the result of our focus
on higher margin sales, and the reduction of assembly and manufacturing overhead
costs, partially offset (approximately 1.9 percentage points) by the impact of
$0.7 million of inventory liquidation sales in the quarter at cost. Cost of
sales, for the three months ended March 31, 2005 includes overhead costs
incurred in the startup of the manufacturing facility in North Carolina. This
manufacturing facility was closed in the third quarter of FY 2005 in conjunction
with our restructuring plan adopted at that time.

SELLING EXPENSES

Selling expenses for the three months ended March 31, 2006 were $0.5
million, or $0.2 million (26.5%) less than for the same period in 2005 due
principally to employee reductions in the U.S. and Mexico associated with the
restructuring plan adopted in 2005.

GENERAL AND ADMINISTRATIVE EXPENSES

General and administrative expenses for the three months ended March
31, 2006 were $2.8 million, or $0.9 million (24.4%) less than for the same
period in 2005. The decrease is principally the result of employee reductions
within the U.S., Mexico and Hong Kong and the elimination of associated costs,
completed with our restructuring plan implemented in the third quarter of fiscal
year 2005. These cost reductions were partially offset by substantially higher
legal, audit and professional costs incurred in the first quarter of 2006, as
well as non-cash compensation costs associated with the adoption of FAS 123R
effective January 1, 2006.

For the three months ended March 31, 2006 we incurred $1.2 million in
professional, audit and legal fees associated mainly with the completion of our
year-end audit of fiscal year 2005, our change in independent registered
auditors, and in litigation expenses associated with our Pro-Fit license dispute
and the shareholder class action complaint filed in October of 2005. These costs
represent an increase of $0.5 million over the comparable costs in the same
period of 2005, and we believe a substantial portion of the cost increase should
not occur in future periods.

In the first quarter of 2006 we adopted FAS 123R which requires the
company to recognize a non-cash expense associated with options and warrants
issued to employees, directors and consultants. For the three months ended March
31, 2006 we incurred $119,000 of costs associated with the implementation of
this accounting requirement. The majority of the recognized cost is associated
with the option grants issued to the executive management team in 2006.

INTEREST EXPENSE

Interest expense decreased by approximately $60,000 to $209,000 for the
three months ended March 31, 2006, as compared to the same period in 2005 due
primarily to lower borrowings under certain notes.

INCOME TAXES

There was no provision for income taxes for the three months ended March
31, 2006 due to the operating losses incurred and no benefit for income taxes
has been recorded since there is not sufficient evidence to determine that we
will be able to utilize our net operating loss carryforwards to offset future
taxable income. Income taxes for the three months ended March 31, 2005 included
a provision for earned income in our foreign subsidiary.

LIQUIDITY AND CAPITAL RESOURCES

The following table summarizes selected financial data at (amounts in
thousands):

March 31, December 31,
2006 2005
---------- ----------
Cash and cash equivalents .......................... $ 3,027 $ 2,277
Total assets ....................................... 30,146 30,321
Current debt ....................................... 15,356 14,850
Non-current debt ................................... 14,419 14,558
Stockholders' equity ............................... 372 912

CASH AND CASH EQUIVALENTS

Cash and cash equivalents increased by $749,000 for the three months
ended March 31, 2006 from December 31, 2005 principally due to cash generated by
operating activities, and lower cash used in investing and financing activities.

Cash provided by operating activities is our only recurring source of
funds, and was approximately $1.1 million for the three months ended March 31,
2006. The increase in cash provided by operating activities during the three
months resulted principally from a $3.7 million decrease in inventory, net of
reserves of $3.2 million, for a $0.5 million net increase; a $0.3 million
reduction in prepaid purchases; and a $0.4 million reduction in operating
capital requirements offset in part by the loss from operations. Cash used in
operating activities for the three months ended March 31, 2005 was approximately
$1.3 million resulting from increased inventories and prepaid expenses offset
partially by a decrease in accounts receivable.

Net cash used in investing activities for the three months ended March
31, 2006 was $22,000 as compared to $588,000 for the three months ended March
31, 2005. The cash used in the first quarter of 2006 represents capital
expenditures for replacement computer equipment. In the first quarter of 2005
the cash used for investing activities consisted primarily of capital
expenditures for zipper equipment and leasehold improvements for the
manufacturing facility in North Carolina.

Net cash used in financing activities for the three months ended March
31, 2006 was approximately $300,000 and primarily reflects the repayment of
borrowings under capital leases and notes payable. For the three months ended
March 31, 2005 the cash used by financing activities was $636,000 and
represented the repayment of notes payable and capital leases, partially offset
by funds raised from the exercise of stock options and warrants.

We currently satisfy our working capital requirements primarily through
cash flows generated from operations, sales of equity securities and borrowings
from institutional investors and individual accredited investors.

As we continue to respond to the current industry trend of large retail
brands to outsource apparel manufacturing to offshore locations, our foreign
customers, though backed by U.S. brands and retailers, are increasing. This
makes receivables based financing with traditional U.S. banks more difficult.
Our current borrowings may not provide the level of financing we may need to
expand into additional foreign markets. As a result, we are continuing to
evaluate non-traditional financing of our foreign assets.

We have incurred significant legal fees in our litigation with Pro-Fit
Holdings Limited. Unless the case is settled, we will continue to incur
additional legal fees in increasing amounts as the case accelerates to trial.

We believe that our existing cash and cash equivalents and anticipated
cash flows from our operating activities and available financing will be
sufficient to fund our minimum working capital and capital expenditure needs for
at least the next twelve months. This conclusion is based on the assumption that
we will be successful in restructuring our operations in accordance with the
restructuring plan adopted in 2005, and that we will collect our note and
accounts receivable in accordance to existing terms. If we are unable to
successfully fully implement our restructuring initiative or collect the note
receivable, or experience greater than anticipated reductions in sales, we may
need to raise additional capital or further reduce the scope of our business in
order to fully satisfy our future short-term liquidity requirements. If we
cannot raise additional capital or reduce the scope of our business in response
to our failure to implement our restructuring initiative in accordance with our
plan, there may be substantial doubt about our ability to continue as a going
concern. Our auditors have included in their report on our financial statements
for the year ended December 31, 2005 an explanatory paragraph expressing
substantial doubt about our ability to continue as a going concern if we fail to
successfully implement our restructuring initiative.

The extent of our future long-term capital requirements will depend on
many factors, including our results of operations, future demand for our
products, the size and timing of future acquisitions, our borrowing base
availability limitations related to eligible accounts receivable and inventories
and our expansion into foreign markets. Our need for additional long-term
financing includes the integration and expansion of our operations to exploit
our rights under our Talon trade name, the expansion of our operations in the
Asian, Central and South American and Caribbean markets and the further
development of our waistband technology. If our cash from operations is less
than anticipated or our working capital requirements and capital expenditures
are greater than we expect, we may need to raise additional debt or equity
financing in order to provide for our operations. We are continually evaluating
various financing strategies to be used to expand our business and fund future
growth or acquisitions. There can be no assurance that additional debt or equity
financing will be available on acceptable terms or at all. If we are unable to
secure additional financing, we may not be able to execute our plans for
expansion, including expansion into foreign markets to promote our Talon brand
tradename, and we may need to implement additional cost savings initiatives.

CONTRACTUAL OBLIGATIONS AND OFF-BALANCE SHEET ARRANGEMENTS

The following summarizes our contractual obligations at March 31, 2006
and the effects such obligations are expected to have on liquidity and cash flow
in future periods:

Payments Due by Period
---------------------------------------------------------------------
Less than 1-3 4-5 After
Contractual Obligations Total 1 Year Years Years 5 Years
------------------------------- ------------- ------------ ------------- ---------- -----------

Demand notes payable to $ 875,200 $ 875,200 $ - $ - $ -
related parties (1)
Capital lease obligations $ 1,198,800 $ 342,300 $ 856,000 $ 500 $ -
Operating leases $ 1,892,000 $ 628,000 $ 1,126,000 $ 138,000 $ -
Notes payable $ 1,447,300 $ 235,000 $ 574,100 $ 638,200 $ -
Convertible notes payable $ 12,448,600 $ - $ 12,448,600 $ - $ -
-------------------------------------------------------------------------------------------------------

(1) The majority of notes payable to related parties are due on demand with
the remainder due and payable on the fifteenth day following the date
of delivery of written demand for payment, and include accrued interest
payable through March 31, 2006.

At March 31, 2006 and 2005, we did not have any relationships with
unconsolidated entities or financial partnerships, such as entities often
referred to as structured finance or special purpose entities, which would have
been established for the purpose of facilitating off-balance sheet arrangements
or other contractually narrow or limited purposes. As such, we are not exposed
to any financing, liquidity, market or credit risk that could arise if we had
engaged in such relationships.

RELATED PARTY TRANSACTIONS

Prior to 2005 we operated under an apparel trim supply agreement with
Tarrant Apparel Group. Two of Tarrant's executive officers and significant
shareholders are also significant shareholders of our company. The supply
agreement was terminated in December 2004; however we continue to conduct
business with Tarrant Apparel Group on a limited basis. For the three months
ended March 31, 2006 sales to Tarrant Apparel Group were $25,300. There were no
sales to Tarrant or its affiliates for the three months ended March 31, 2005.

As of March 31, 2006 accounts receivable included $206,400 due from
Tarrant. At March 31, 2005 accounts receivable, related party included $4.5
million due from Tarrant's affiliate, United Apparel Ventures. United Apparel
Ventures paid this balance over a nine-month period and it was fully paid as of
December 31, 2005.

As of March 31, 2006 and 2005, we had outstanding related-party notes
payable of $665,000, at interest rates ranging from 0% to 11%. The majority of
related-party debt is due on demand, with the remainder due and payable within
15 days of demand. Accrued interest associated with these notes is included in
other accrued liabilities.

As of March 31, 2006 and 2005, we had receivables due from related
parties of $680,000 and $567,000, respectively. The receivables consist of
unsecured notes, advances and accrued interest receivable from a former officer
and stockholder of the Company who is related to or affiliated with a director
of the Company. The notes and advances bear interest at 0%, 8.5% and prime and,
together with accrued interest, are due on demand.

APPLICATION OF CRITICAL ACCOUNTING POLICIES AND 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 for the reporting period and as of
the financial statement date. We base our estimates on historical experience and
on various other 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. These
estimates and assumptions affect the reported amounts of assets and liabilities,
the disclosure of contingent liabilities and the reported amounts of revenue and
expense. Actual results could differ from those estimates.

Critical accounting policies are those that are important to the
portrayal of our financial condition and results, and which require us to make
difficult, subjective and/or complex judgments. Critical accounting policies
cover accounting matters that are inherently uncertain because the future
resolution of such matters is unknown. We believe the following critical
accounting policies affect our more significant judgments and estimates used in
the preparation of our consolidated financial statements:

o Accounts receivable balances are evaluated on a continual
basis and allowances are provided for potentially
uncollectible accounts based on management's estimate of the
collectibility of customer accounts. If the financial
condition of a customer deteriorates, resulting in an
impairment of its ability to make payments, an additional
allowance may be required. Allowance adjustments are charged
to operations in the period in which the facts that give rise
to the adjustments become known.

o Inventories are stated at the lower of cost or market value.
Inventory is evaluated on a continual basis and reserve
adjustments are made based on management's estimate of future
sales value, if any, of specific inventory items. Inventory
reserves are recorded for damaged, obsolete, excess and
slow-moving inventory. We use estimates to record these
reserves. Slow-moving inventory is reviewed by category and
may be partially or fully reserved for depending on the type
of product and the length of time the product has been
included in inventory. Reserve adjustments are made for the
difference between the cost of the inventory and the estimated
market value, if lower, and charged to operations in the
period in which the facts that give rise to these adjustments
become known. Market value of inventory is estimated based on
the impact of market trends, an evaluation of economic
conditions and the value of current orders relating to the
future sales of this type of inventory.

o We record deferred tax assets arising from temporary timing
differences between recorded net income and taxable net income
when and if we believe that future earnings will be sufficient
to realize the tax benefit. For those jurisdictions where the
expiration date of tax benefit carry-forwards or the projected
taxable earnings indicate that realization is not likely, a
valuation allowance is provided. If we determine that we may
not realize all of our deferred tax assets in the future, we
will make an adjustment to the carrying value of the deferred
tax asset, which would be reflected as an income tax expense.
Conversely, if we determine that we will realize a deferred
tax asset, which currently has a valuation allowance, we would
be required to reverse the valuation allowance, which would be
reflected as an income tax benefit. We believe that our
estimate of deferred tax assets and determination to record a
valuation allowance against such assets are critical
accounting estimates because they are subject to, among other
things, an estimate of future taxable income, which is
susceptible to change and dependent upon events that may or
may not occur, and because the impact of recording a valuation
allowance may be material to the assets reported on the
balance sheet and results of operations.

o We record impairment charges when the carrying amounts of
long-lived assets are determined not to be recoverable.
Impairment is measured by assessing the usefulness of an asset
or by comparing the carrying value of an asset to its fair
value. Fair value is typically determined using quoted market
prices, if available, or an estimate of

undiscounted future cash flows expected to result from the use
of the asset and its eventual disposition. The amount of
impairment loss is calculated as the excess of the carrying
value over the fair value. Changes in market conditions and
management strategy have historically caused us to reassess
the carrying amount of our long-lived assets. Long-lived
assets are evaluated on a continual basis and impairment
adjustments are made based upon management's valuations. As
part of the 2005 Restructuring Plan, certain long-lived
assets, primarily machinery and equipment, were impaired and
their values adjusted accordingly.

o Sales are recognized when persuasive evidence of an
arrangement exists, product delivery has occurred, pricing is
fixed or determinable, and collection is reasonably assured.
Sales resulting from customer buy-back agreements, or
associated inventory storage arrangements are recognized upon
delivery of the products to the customer, the customer's
designated manufacturer, our upon notice from the customer to
destroy or dispose of the goods. Sales, provisions for
estimated sales returns, and the cost of products sold are
recorded at the time title transfers to customers. Actual
product returns are charged against estimated sales return
allowances.

o We are currently involved in various lawsuits, claims and
inquiries, most of which are routine to the nature of the
business, and in accordance with SFAS No. 5, "Accounting for
Contingencies," we accrue estimates of the probable and
estimable losses for the resolution of these claims. The
ultimate resolution of these claims could affect our future
results of operations for any particular quarterly or annual
period should our exposure be materially different from our
earlier estimates or should liabilities be incurred that were
not previously accrued.

NEW ACCOUNTING PRONOUNCEMENTS

In February 2006, the FASB issued Statement of Financial Accounting
Standards No. 155, "Accounting for Certain Hybrid Financial Instruments" ("SFAS
155"), which amends SFAS No. 133, "Accounting for Derivatives Instruments and
Hedging Activities" ("SFAS 133") and SFAS No. 140, "Accounting for Transfers and
Servicing of Financial Assets and Extinguishment of Liabilities" ("SFAS 140").
SFAS 155 amends SFAS 133 to narrow the scope exception for interest-only and
principal-only strips on debt instruments to include only such strips
representing rights to receive a specified portion of the contractual interest
or principle cash flows. SFAS 155 also amends SFAS 140 to allow qualifying
special-purpose entities to hold a passive derivative financial instrument
pertaining to beneficial interests that itself is a derivative instrument. We
are currently evaluating the impact this new Standard, but believe that it will
not have a material impact on the Company's financial position, results of
operations or cash flows.

CAUTIONARY STATEMENTS AND RISK FACTORS

Several of the matters discussed in this document contain
forward-looking statements that involve risks and uncertainties. Factors
associated with the forward-looking statements that could cause actual results
to differ from those projected or forecast are included in the statements below.
In addition to other information contained in this report, readers should
carefully consider the following cautionary statements and risk factors.

OUR GROWTH AND OPERATING RESULTS COULD BE MATERIALLY, ADVERSELY
EFFECTED IF WE ARE UNSUCCESSFUL IN RESOLVING A DISPUTE THAT NOW EXISTS REGARDING
OUR RIGHTS UNDER OUR EXCLUSIVE LICENSE AND INTELLECTUAL PROPERTY AGREEMENT
("AGREEMENT") WITH PRO-FIT. Pursuant to our agreement with Pro-Fit Holdings,
Limited, we have exclusive rights in certain geographic areas to Pro-Fit's
stretch and rigid waistband technology. We are in litigation with Pro-Fit
regarding our rights. See Part II, Item 1, "Legal Proceedings" for discussion of
this litigation. We derive a significant amount of revenues from the sale of
products incorporating the stretch waistband technology. Our business, results
of operations and financial condition could be materially adversely affected if
we are unable to conclude our present negotiations in a manner acceptable to us
and ensuing litigation is not resolved in a manner favorable to us.
Additionally, we have incurred significant legal fees in this litigation, and
unless the case is settled, we will continue to incur additional legal fees in
increasing amounts as the case accelerates to trial.

WHILE WE EXPECT THAT THE RESTRUCTURING WILL RESULT IN REDUCED OPERATING
COSTS AND IMPROVED OPERATING RESULTS AND CASH FLOWS, THERE CAN BE NO ASSURANCE
THAT THESE RESULTS WILL BE ACHIEVED. We recorded restructuring costs during 2005
of $6.4 million. We face many challenges related to our decision to implement
this restructuring plan, including that we may not execute the restructuring
effectively, and our expectation that we will benefit from greater efficiencies
may not be realized. Any failure on our part to successfully manage these
challenges or other unanticipated consequences may result in the loss of
customers and sales, which could cause our results to differ materially from our
current expectations. The challenges we face include:

o Our ability to execute successfully through business cycles
while we continue to implement the restructuring plan and cost
reductions;

o Our ability to meet and achieve the benefits of our
cost-reduction goals and otherwise successfully adapt our cost
structures to continuing changes in business conditions;

o The risk that our cost-cutting initiatives will impair our
ability to develop products and remain competitive and to
operate effectively;

o We may experience delays in implementing our restructuring
plan and incur additional costs;

o We may experience decreases in employee morale; and

o We may experience unanticipated expenses winding down
manufacturing operations, including labor costs, which may
adversely affect our results of operations in the short term.

WE MAY BE UNABLE TO CONTINUE AS A GOING CONCERN IF WE DO NOT
SUCCESSFULLY ACHIEVE CERTAIN OBJECTIVES. If we are unable to successfully fully
implement our restructuring initiative, or collect the note receivable, or
experience greater than anticipated reductions in sales, we may need to raise
additional capital or further reduce the scope of our business to fully satisfy
our future short-term liquidity requirements. If we cannot raise additional
capital, or reduce the scope of our business in response to our failure to
implement our restructuring initiative in accordance with our plan, or fail to
achieve other operating objectives, the Company may be otherwise unable to
achieve its goals or continue its operations. Our auditors have included in
their report on our financial statements for the year ending December 31, 2005
an explanatory paragraph expressing substantial doubt about our ability to
continue as a going concern.

IF WE LOSE OUR LARGER CUSTOMERS OR THEY FAIL TO PURCHASE AT ANTICIPATED
LEVELS, OUR SALES AND OPERATING RESULTS WILL BE ADVERSELY AFFECTED. Our results
of operations will depend to a significant extent upon the commercial success of
our larger customers. If these customers fail to purchase our products at
anticipated levels, or our relationship with these customers terminates, it may
have an adverse affect on our results because:

o We will lose a primary source of revenue if these customers
choose not to purchase our products or services;

o We may not be able to reduce fixed costs incurred in
developing the relationship with these customers in a timely
manner;

o We may not be able to recoup setup and inventory costs;

o We may be left holding inventory that cannot be sold to other
customers; and

o We may not be able to collect our receivables from them.

CONCENTRATION OF RECEIVABLES FROM OUR LARGER CUSTOMERS MAKES RECEIVABLE
BASED FINANCING DIFFICULT AND INCREASES THE RISK THAT IF OUR LARGER CUSTOMERS
FAIL TO PAY US, OUR CASH FLOW COULD BE SEVERELY AFFECTED. Our business relies
heavily on a relatively small number of customers. This concentration of our
business reduces the amount we can borrow from our lenders under receivables
based financing agreements. If we are unable to collect any large receivables
due us, our cash flow would be severely impacted.

IF CUSTOMERS DEFAULT ON INVENTORY PURCHASE COMMITMENTS WITH US, WE WILL
BE LEFT HOLDING NON-SALABLE INVENTORY. We hold significant inventories for
specific customer programs, which the customers have committed to purchase. If
any customer defaults on these commitments, or insists on markdowns, we may
incur a charge in connection with our holding significant amounts of non-salable
inventory and this would have a negative impact on our operations and cash flow.

OUR REVENUES MAY BE HARMED IF GENERAL ECONOMIC CONDITIONS WORSEN. OUR
REVENUES DEPEND ON THE HEALTH OF THE ECONOMY AND THE GROWTH OF OUR CUSTOMERS AND
POTENTIAL FUTURE CUSTOMERS. When economic conditions weaken, certain apparel
manufacturers and retailers, including some of our customers may experience
financial difficulties that increase the risk of extending credit to such
customers. Customers adversely affected by economic conditions have also
attempted to improve their own operating efficiencies by concentrating their
purchasing power among a narrowing group of vendors. There can be no assurance
that we will remain a preferred vendor to our existing customers. A decrease in
business from or loss of a major customer could have a material adverse effect
on our results of operations. Further, if the economic conditions in the United
States worsen or if a wider or global economic slowdown occurs, we may
experience a material adverse impact on our business, operating results, and
financial condition.

BECAUSE WE DEPEND ON A LIMITED NUMBER OF SUPPLIERS, WE MAY NOT BE ABLE
TO ALWAYS OBTAIN MATERIALS WHEN WE NEED THEM AND WE MAY LOSE SALES AND
CUSTOMERS. Lead times for materials we order can vary significantly and depend
on many factors, including the specific supplier, the contract terms and the
demand for particular materials at a given time. From time to time, we may
experience fluctuations in the prices, and disruptions in the supply, of
materials. Shortages or disruptions in the supply of materials, or our inability
to procure materials from alternate sources at acceptable prices in a timely
manner, could lead us to miss deadlines for orders and lose sales and customers.

WE OPERATE IN AN INDUSTRY THAT IS SUBJECT TO SIGNIFICANT FLUCTUATIONS
IN OPERATING RESULTS THAT MAY RESULT IN UNEXPECTED REDUCTIONS IN REVENUE AND
STOCK PRICE VOLATILITY. We operate in an industry that is subject to significant
fluctuations in operating results from quarter to quarter, which may lead to
unexpected reductions in revenues and stock price volatility. Factors that may
influence our quarterly operating results include:

o The volume and timing of customer orders received during the
quarter;

o The timing and magnitude of customers' marketing campaigns;

o The loss or addition of a major customer;

o The availability and pricing of materials for our products;

o The increased expenses incurred in connection with the
introduction of new products;

o Currency fluctuations;

o Delays caused by third parties; and

o Changes in our product mix or in the relative contribution to
sales of our subsidiaries.

DUE TO THESE FACTORS, IT IS POSSIBLE THAT IN SOME QUARTERS OUR
OPERATING RESULTS MAY BE BELOW OUR STOCKHOLDERS' EXPECTATIONS AND THOSE OF
PUBLIC MARKET ANALYSTS. If this occurs, the price of our common stock could be
adversely affected. In the past, following periods of volatility in the market
price of a company's securities, securities class action litigation has often
been instituted against such a company. In October 2005, a securities class
action lawsuit was filed against us. See footnote 4, Contingencies and
Guarantees for a detailed description of this lawsuit.

THE OUTCOME OF LITIGATION IN WHICH WE HAVE BEEN NAMED, AS A DEFENDANT
IS UNPREDICTABLE AND AN ADVERSE DECISION IN ANY SUCH MATTER COULD HAVE A
MATERIAL ADVERSE AFFECT ON OUR FINANCIAL POSITION AND RESULTS OF OPERATIONS. We
are defendants in a number of litigation matters. These claims may divert
financial and management resources that would otherwise be used to benefit our
operations. Although we believe that we have meritorious defenses to the claims
made in each and all of the litigation matters to which we have been named a
party, and intend to contest each lawsuit vigorously, no assurances can be given

that the results of these matters will be favorable to us. An adverse resolution
of any of these lawsuits could have a material adverse affect on our financial
position and results of operations.

WE MAINTAIN PRODUCT LIABILITY AND DIRECTOR AND OFFICER INSURANCE THAT
WE REGARD AS REASONABLY ADEQUATE TO PROTECT US FROM POTENTIAL CLAIMS; HOWEVER WE
CANNOT ASSURE YOU THAT IT WILL. Further, the costs of insurance have increased
dramatically in recent years, and the availability of coverage has decreased. As
a result, we cannot assure you that we will be able to maintain our current
levels of insurance at a reasonable cost, or at all.

OUR CUSTOMERS HAVE CYCLICAL BUYING PATTERNS WHICH MAY CAUSE US TO HAVE
PERIODS OF LOW SALES VOLUME. Most of our customers are in the apparel industry.
The apparel industry historically has been subject to substantial cyclical
variations. Our business has experienced, and we expect our business to continue
to experience, significant cyclical fluctuations due, in part, to customer
buying patterns, which may result in periods of low sales usually in the first
and fourth quarters of our financial year.

OUR BUSINESS MODEL IS DEPENDENT ON INTEGRATION OF INFORMATION SYSTEMS
ON A GLOBAL BASIS AND, TO THE EXTENT THAT WE FAIL TO MAINTAIN AND SUPPORT OUR
INFORMATION SYSTEMS, IT CAN RESULT IN LOST REVENUES. We must consolidate and
centralize the management of our subsidiaries and significantly expand and
improve our financial and operating controls. Additionally, we must effectively
integrate the information systems of our Hong Kong facility with the information
systems of our principal offices in California. Our failure to do so could
result in lost revenues, delay financial reporting or adversely affect
availability of funds under our credit facilities.

THE LOSS OF KEY MANAGEMENT AND SALES PERSONNEL COULD ADVERSELY AFFECT
OUR BUSINESS, INCLUDING OUR ABILITY TO OBTAIN AND SECURE ACCOUNTS AND GENERATE
SALES. Our success has and will continue to depend to a significant extent upon
key management and sales personnel, many of whom would be difficult to replace.
In connection with our restructuring, we significantly reduced the number of
employees within our company, which has increased our reliance on those
employees that have remained with the company. The loss of the services of key
employees could have a material adverse effect on our business, including our
ability to establish and maintain client relationships. Our future success will
depend in large part upon our ability to attract and retain personnel with a
variety of sales, operating and managerial skills.

IF WE EXPERIENCE DISRUPTIONS AT ANY OF OUR FOREIGN FACILITIES, WE WILL
NOT BE ABLE TO MEET OUR OBLIGATIONS AND MAY LOSE SALES AND CUSTOMERS. Currently,
we do not operate duplicate facilities in different geographic areas. Therefore,
in the event of a regional disruption where we maintain one or more of our
facilities, it is unlikely that we could shift our operations to a different
geographic region and we may have to cease or curtail our operations. This may
cause us to lose sales and customers. The types of disruptions that may occur
include:

o Foreign trade disruptions;

o Import restrictions;

o Labor disruptions;

o Embargoes;

o Government intervention;

o Natural disasters; or

o Regional pandemics.

INTERNET-BASED SYSTEMS THAT HOST OUR MANAGED TRIM SOLUTION MAY
EXPERIENCE DISRUPTIONS AND AS A RESULT WE MAY LOSE REVENUES AND CUSTOMERS. Our
Managed Trim Solution is an Internet-based business-

to-business e-commerce system. To the extent that we fail to adequately continue
to update and maintain the hardware and software implementing the system, our
customers may experience interruptions in service due to defects in our hardware
or our source code. In addition, since our software is Internet-based,
interruptions in Internet service generally can negatively impact our customers'
ability to use the Managed Trim Solution to monitor and manage various aspects
of their trim needs. Such defects or interruptions could result in lost revenues
and lost customers.

THERE ARE MANY COMPANIES THAT OFFER SOME OR ALL OF THE PRODUCTS AND
SERVICES WE SELL AND IF WE ARE UNABLE TO SUCCESSFULLY COMPETE OUR BUSINESS WILL
BE ADVERSELY AFFECTED. We compete in highly competitive and fragmented
industries with numerous local and regional companies that provide some or all
of the products and services we offer. We compete with national and
international design companies, distributors and manufacturers of tags,
packaging products, zippers and other trim items. Some of our competitors have
greater name recognition, longer operating histories and greater financial and
other resources than we do.

UNAUTHORIZED USE OF OUR PROPRIETARY TECHNOLOGY MAY INCREASE OUR
LITIGATION COSTS AND ADVERSELY AFFECT OUR SALES. We rely on trademark, trade
secret and copyright laws to protect our designs and other proprietary property
worldwide. We cannot be certain that these laws will be sufficient to protect
our property. In particular, the laws of some countries in which our products
are distributed or may be distributed in the future may not protect our products
and intellectual rights to the same extent as the laws of the United States. If
litigation is necessary in the future to enforce our intellectual property
rights, to protect our trade secrets or to determine the validity and scope of
the proprietary rights of others, such litigation could result in substantial
costs and diversion of resources. This could have a material adverse effect on
our operating results and financial condition. Ultimately, we may be unable, for
financial or other reasons, to enforce our rights under intellectual property
laws, which could result in lost sales.

IF OUR PRODUCTS INFRINGE ANY OTHER PERSON'S PROPRIETARY RIGHTS, WE MAY
BE SUED AND HAVE TO PAY LEGAL EXPENSES AND JUDGMENTS AND REDESIGN OR DISCONTINUE
SELLING OUR PRODUCTS. From time to time in our industry, third parties allege
infringement of their proprietary rights. Any infringement claims, whether or
not meritorious, could result in costly litigation or require us to enter into
royalty or licensing agreements as a means of settlement. If we are found to
have infringed the proprietary rights of others, we could be required to pay
damages, cease sales of the infringing products and redesign the products or
discontinue their sale. Any of these outcomes, individually or collectively,
could have a material adverse effect on our operating results and financial
condition.

OUR STOCK PRICE MAY DECREASE, WHICH COULD ADVERSELY AFFECT OUR BUSINESS
AND CAUSE OUR STOCKHOLDERS TO SUFFER SIGNIFICANT LOSSES. The following factors
could cause the market price of our common stock to decrease, perhaps
substantially:

o The failure of our quarterly operating results to meet
expectations of investors or securities analysts;

o Adverse developments in the financial markets, the apparel
industry and the worldwide or regional economies;

o Interest rates;

o Changes in accounting principles;

o Intellectual property and legal matters;

o Sales of common stock by existing shareholders or holders of
options;

o Announcements of key developments by our competitors; and

o The reaction of markets and securities analysts to
announcements and developments involving our company.

IF WE NEED TO SELL OR ISSUE ADDITIONAL SHARES OF COMMON STOCK OR ASSUME
ADDITIONAL DEBT TO FINANCE FUTURE GROWTH, OUR STOCKHOLDERS' OWNERSHIP COULD BE
DILUTED OR OUR EARNINGS COULD BE ADVERSELY IMPACTED. Our business strategy may
include expansion through internal growth, by acquiring complementary businesses
or by establishing strategic relationships with targeted customers and
suppliers. In order to do so or to fund our other activities, we may issue
additional equity securities that could dilute our stockholders' value. We may
also assume additional debt and incur impairment losses to our intangible assets
if we acquire another company.

IF WE ARE NOT ABLE TO REGAIN COMPLIANCE WITH LISTING REQUIREMENTS, OUR
SHARES MAY BE REMOVED FROM LISTING ON AMEX. We have been advised by AMEX that we
are non-compliant with certain listing requirements related to the number of
independent board members, and the number of members on our audit committee. The
AMEX has allowed the company until July 28, 2006 to regain compliance with these
matters. We have been advised by AMEX that we are also non-compliant with the
minimum net equity listing requirements and we must submit a plan acceptable to
AMEX by June 15, 2006 that provides for increases in our equity beyond the
minimum $4.0 million equity within a timeframe that is acceptable to AMEX. We
have suffered substantial recurring losses and may fail to comply with other
listing requirements of AMEX. We may not be able to regain compliance with these
matters within the time allowed by the exchange, and our shares of common stock
may be removed from the listing on AMEX.

WE MAY NOT BE ABLE TO REALIZE THE ANTICIPATED BENEFITS OF ACQUISITIONS.
WE MAY CONSIDER STRATEGIC ACQUISITIONS AS OPPORTUNITIES ARISE, SUBJECT TO THE
OBTAINING OF ANY NECESSARY FINANCING. Acquisitions involve numerous risks,
including diversion of our management's attention away from our operating
activities. We cannot assure you that we will not encounter unanticipated
problems or liabilities relating to the integration of an acquired company's
operations, nor can we assure you that we will realize the anticipated benefits
of any future acquisitions.

OUR ACTUAL TAX LIABILITIES MAY DIFFER FROM ESTIMATED TAX RESULTING IN
UNFAVORABLE ADJUSTMENTS TO OUR FUTURE RESULTS. The amount of income taxes we pay
is subject to ongoing audits by federal, state and foreign tax authorities. Our
estimate of the potential outcome of uncertain tax issues is subject to our
assessment of relevant risks, facts, and circumstances existing at that time.
Our future results may include favorable or unfavorable adjustments to our
estimated tax liabilities in the period the assessments are made or resolved,
which may impact our effective tax rate and our financial results. See Item 3
"Legal Proceedings" for discussion of certain tax claims.

WE HAVE ADOPTED A NUMBER OF ANTI-TAKEOVER MEASURES THAT MAY DEPRESS THE
PRICE OF OUR COMMON STOCK. Our stockholders' rights plan, our ability to issue
additional shares of preferred stock and some provisions of our certificate of
incorporation and bylaws and of Delaware law could make it more difficult for a
third party to make an unsolicited takeover attempt of us. These anti-takeover
measures may depress the price of our common stock by making it more difficult
for third parties to acquire us by offering to purchase shares of our stock at a
premium to its market price.

INSIDERS OWN A SIGNIFICANT PORTION OF OUR COMMON STOCK, WHICH COULD
LIMIT OUR STOCKHOLDERS' ABILITY TO INFLUENCE THE OUTCOME OF KEY TRANSACTIONS. As
of March 31, 2006, our officers and directors and their affiliates beneficially
owned approximately 10.5% of the outstanding shares of our common stock. The
Dyne family, which includes Mark Dyne, Colin Dyne, and Jonathan Burstein, who
are also our directors; Larry Dyne and the estate of Harold Dyne; beneficially
owned approximately 12.7% of the outstanding shares of our common stock at March
31, 2006. As a result, our officers and directors and the Dyne family are able
to exert considerable influence over the outcome of any matters submitted to a
vote of the holders of our common stock, including the election of our Board of
Directors. The voting power of these stockholders could also discourage others
from seeking to acquire control of us through the purchase of our common stock,
which might depress the price of our common stock.

WE MAY FACE INTERRUPTION OF PRODUCTION AND SERVICES DUE TO INCREASED
SECURITY MEASURES IN RESPONSE TO TERRORISM. Our business depends on the free
flow of products and services through the channels of commerce. In response to
terrorists' activities and threats aimed at the United States, transportation,
mail, financial and other services may be slowed or stopped altogether.
Extensive delays or stoppages in transportation, mail, financial or other
services could have a material adverse effect on our business, results of
operations and financial condition. Furthermore, we may experience an increase
in operating costs, such as costs for transportation, insurance and security as
a result of the activities and potential delays. We may also experience delays
in receiving payments from payers that have been affected by the terrorist
activities. The United States economy in general may be adversely affected by
the terrorist activities and any economic downturn could adversely impact our
results of operations, impair our ability to raise capital or otherwise
adversely affect our ability to grow our business.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

All of our sales are denominated in United States dollars or the
currency of the country in which our products originate. We are exposed to
market risk for fluctuations in the foreign currency exchange rates for certain
product purchases that are denominated in British Pounds. There were no hedging
contracts outstanding as of March 31, 2006. Currency fluctuations can increase
the price of our products to foreign customers which can adversely impact the
level of our export sales from time to time. The majority of our cash
equivalents are held in United States bank accounts and we do not believe we
have significant market risk exposure with regard to our investments.

ITEM 4. CONTROLS AND PROCEDURES

EVALUATION OF CONTROLS AND PROCEDURES

We conducted an evaluation, with the participation of our Chief
Executive Officer and Chief Financial Officer, of the effectiveness of the
design and operation of our disclosure controls and procedures, as defined in
Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as
amended, or the Exchange Act, as of March 31, 2006, to ensure that information
required to be disclosed by us in the reports filed or submitted by us under the
Exchange Act is recorded, processed, summarized and reported, within the time
periods specified in the Securities Exchange Commission's rules and forms,
including to ensure that information required to be disclosed by us in the
reports filed or submitted by us under the Exchange Act is accumulated and
communicated to our management, including our principal executive and principal
financial officers, or persons performing similar functions, as appropriate to
allow timely decisions regarding required disclosure. Based on that evaluation,
our Chief Executive Officer and Chief Financial Officer have concluded that as
of March 31, 2006, our disclosure controls and procedures were not effective at
the reasonable assurance level due to the significant deficiencies described
below.

In light of the significant deficiencies described below, we performed
additional analysis and other post-closing procedures to ensure our consolidated
financial statements were prepared in accordance with generally accepted
accounting principles. Accordingly, we believe that the consolidated financial
statements included in this report fairly present, in all material respects, our
financial condition, results of operations and cash flows for the periods
presented.

A material weakness is a control deficiency (within the meaning of the
Public Company Accounting Oversight Board (PCAOB) Auditing Standard No. 2) or
combination of control deficiencies that result in more than a remote likelihood
that a material misstatement of the annual or interim financial statements will
not be prevented or detected. Management previously identified the following
deficiencies

that represented material weaknesses in internal control over financial
reporting which have caused management to conclude that our disclosure controls
and procedures were not effective at the reasonable assurance level:

In conjunction with preparing our Form 10-K for the period ended
December 31, 2005, management reviewed our revenue recognition practices as they
relate to the recognition of revenues on certain sale and inventory storage
transactions. As a result of this review, management concluded that our controls
over the identification and monitoring of assumptions and factors affecting the
recording of revenue were not in accordance with generally accepted accounting
principles and that our revenue for the quarters ended June 30, 2005 and
September 30, 2005 had been misstated. Based upon this conclusion, management
with concurrence of our Audit Committee, decided to restate our financial
statements as of and for those quarters to reflect the corrections in the
application of our revenue recognition policies. We believe this control
weakness has been corrected as of March 31, 2006 and did not result in a
material misstatement of our consolidated financial statements for this interim
period.

In fiscal year 2005 we previously reported the failure to maintain
sufficient documentation supporting inventory costs necessary to effectively
analyze our inventory for lower-of-cost or market reserves. We believe this
control weakness has been corrected as of March 31, 2006 and did not result in a
material misstatement of our consolidated financial statements.

We previously reported the failure to maintain sufficient documentation
supporting our perpetual inventory counts and our year end physical inventories
were not effectively controlled, requiring a recount of our inventory balances
at year end. We believe we have implemented appropriate procedures to ensure
this weakness is remedied; however as of March 31, 2006 we have not tested these
procedures. This control deficiency did not result in a material misstatement of
our consolidated financial statements.

To address these material weaknesses, management performed additional
analyses and other procedures to ensure that the financial statements included
herein fairly present, in all material respects, our financial position, results
of operations and cash flows for the periods presented.

REMEDIATION OF MATERIAL WEAKNESSES

To remediate the material weaknesses in our disclosure controls and
procedures identified above, we have done the following which correspond to the
material weaknesses identified above:

We have revised our review procedures over the application of our
revenue recognition practices, particularly as they relate to inventory storage
transactions. We have instituted additional control and disclosure procedures to
effectively and timely identify such transactions including a review of all
major sale transactions by our disclosure committee.

We have implemented additional documentation control procedures over
the assumptions and factors affecting our inventory costs and reserves to ensure
that inventory balances are appropriately supported and reduced to their net
realizable values on a timely basis. These controls include the segregation and
review of selected inventory adjustment transactions and management analysis of
inventory cost and reserve changes during the reporting period.

We have modified our physical inventory process procedures and
instructions to ensure that the appropriate documentation regarding physical
inventories is maintained and controlled, and that the physical counting of
inventories is performed at regular intervals.

CHANGES IN INTERNAL CONTROLS OVER FINANCIAL REPORTING

There were no significant changes in our internal controls over
financial reporting that occurred during the first quarter that have materially
affected, or are reasonably likely to materially affect, our

internal control over financial reporting, other than the changes we implemented
as discussed above to address the material weaknesses.

PART II
OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

On October 12, 2005, a shareholder class action complaint-- Huberman vs
Tag-It Pacific, Inc., et al., Case No. CV05-7352 R(Ex)--was filed against us and
certain of our current and former officers and directors in the United States
District Court for the Central District of California alleging claims under
Section 10(b) and Section 20 of the Securities Exchange Act of 1934, as amended,
and Rule 10b-5 promulgated thereunder. The action is brought on behalf of all
purchasers of our publicly-traded securities during the period from November 14,
2003 to August 12, 2005. On January 23, 2006 the court heard competing motions
for appointment of lead plaintiff/counsel and appointed Seth Huberman as lead
plaintiff. The lead plaintiff thereafter filed an amended complaint on March 13,
2006. The amended complaint alleges that the defendants made false and
misleading statements about our financial situation and our relationship with
certain of our large customers during a purported class period between November
13, 2003 and August 12, 2005. It purports to state claims under Section
10(b)/Rule 10b-5 and Section 20(a) of the Securities Exchange Act of 1934. We
filed a motion to dismiss the amended complaint which motion is scheduled to be
heard on June 19, 2006. Pursuant to the Private Securities Litigation Reform
Act, discovery is stayed in the case. Although we believe that we and the other
defendants have meritorious defenses to the class action complaint and intend to
contest the lawsuit vigorously, an adverse resolution the lawsuit could have a
material adverse effect on our financial position and results of operations. At
this early stage of the litigation, we are not able to reasonably predict the
outcome of this action or estimate potential losses, if any, related to the
lawsuit.

We have filed suit against Pro-Fit Holdings Limited in the U.S.
District Court for the Central District of California - Tag-It Pacific, Inc. v
Pro-Fit Holdings Limited, CV 04-2694 LGB (RCx) - based on various contractual
and tort claims relating to our exclusive license and intellectual property
agreement, seeking declaratory relief, injunctive relief and damages. The
agreement with Pro-Fit gives us the exclusive rights in certain geographic areas
to Pro-Fit's stretch and rigid waistband technology. Pro-Fit filed an answer
denying the material allegations of the complaint and filed a counterclaim
alleging various contractual and tort claims seeking injunctive relief and
damages. We filed a reply denying the material allegations of Pro-Fit's
pleading. Pro-Fit has since purported to terminate the exclusive license and
intellectual property agreement based on the same alleged breaches of the
agreement that are the subject of the parties' existing litigation, as well as
on an additional basis unsupported by fact. In February 2005, we amended our
pleadings in the litigation to assert additional breaches by Pro-Fit of its
obligations under the agreement and under certain additional letter agreements,
and for a declaratory judgment that Pro-Fit's patent No. 5,987,721 is invalid
and not infringed by us. Thereafter, Pro-Fit filed an amended answer and
counterclaim denying the material allegations of the amended complaint and
alleging various contractual and tort claims seeking injunctive relief and
damages. Pro-Fit further asserted that we infringed its United States Patent
Nos. 5,987,721 and 6,566,285. We filed a reply denying the substantive
allegations of the reply. At our request, the Court bifurcated the contract
issues for trial to commence on January 10, 2006. The parties have filed summary
judgment motions which may dispose of some of the issues in this case prior to
trial. The remaining issues will be tried at a later date. As we derive a
significant amount of revenue from the sale of products incorporating the
stretch waistband technology, our business, results of operations and financial
condition could be materially adversely affected if the dispute with Pro-Fit is
not resolved in a manner favorable to us. Additionally, we have incurred
significant legal fees in this litigation, and unless the case is settled will
continue to incur additional legal fees in increasing amounts as the case
accelerates to trial.

We currently have pending a number of other claims, suits and
complaints that arise in the ordinary course of its business. We believe that we
has meritorious defenses to these claims and that the claims are either covered
by insurance or, after taking into account the insurance in place, would not
have a material effect on our consolidated financial condition if adversely
determined against us.

ITEM 1A. RISK FACTORS

A restated description of the risk factors associated with the Company
is included under "Cautionary Statements and Risk Factors" in Management's
Discussion and Analysis of Financial Condition and Results of Operations,"
contained in Item 2 of Part I of this report. This description includes any
material changes to and supersedes the description of the risk factors
associated with the Company previously disclosed in the Company's 2005 Annual
Report on Form 10-K and is incorporated herein by reference.

ITEM 6. EXHIBITS

10.1 Executive Employment Agreement dated March 16, 2006 between Tag-It
Pacific, Inc. and Stephen P. Forte.

10.2 Employment offer letter dated March 16, 2006 between Tag-It Pacific,
Inc. and Wouter van Biene.

10.3 Employment offer letter dated March 16, 2006 between Tag-It Pacific,
Inc. and Lonnie D. Schnell.

10.4 Employment offer letter dated March 16, 2006 between Tag-It Pacific,
Inc. and Jonathan Burstein.

31.1 Certificate of Chief Executive Officer pursuant to Rule 13a-14(a) under
the Securities and Exchange Act of 1934, as amended.

31.2 Certificate of Chief Financial Officer pursuant to Rule 13a-14(a) under
the Securities and Exchange Act of 1934, as amended.

32.1 Certificate of Chief Executive Officer and Chief Financial Officer
pursuant to Rule 13a-14(b) under the Securities and Exchange Act of
1934, as amended.

SIGNATURES

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

Dated: May 22, 2006 TAG-IT PACIFIC, INC.

` /S/ LONNIE D. SCHNELL
--------------------------------------
By: Lonnie D. Schnell
Its: Chief Financial Officer