Summary of CHEROKEE INC - Yahoo! Finance

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

Cautionary note regarding forward looking statements

This quarterly report on Form 10-Q and other filings which we make with the Securities and Exchange Commission, as well as press releases and other written or oral statements we may make may contain "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. When used, the words "anticipates", "believes", "estimates", "objectives", "goals", "aims", "hopes", "may", "likely", "should" and similar expressions are intended to identify such forward-looking statements. In particular, the forward-looking statements in this Form 10-Q include, among others, statements regarding our goals or expectations regarding our future revenues and earnings, the likelihood of increased retail sales by our current and future licensees, such as Target and Tesco, the likelihood that our licensees will achieve royalty rate reductions, our prospects for obtaining new licensees and our prospects for obtaining new brands to acquire or represent. Forward-looking statements involve known and unknown risks and uncertainties that may cause our actual results, performance, achievements or share price to be materially different from any future results, performance, achievements or share price expressed or implied by any forward-looking statements. Such risks and uncertainties include, but are not limited to, the financial condition of the apparel industry and the retail industry, the overall level of consumer spending, the effect of intense competition from other apparel lines both within and outside of Target and Tesco, adverse changes in licensee or consumer acceptance of products bearing the Cherokee or our other brands as a result of fashion trends or otherwise, the ability and/or commitment of our licensees to design, manufacture and market Cherokee or our other branded products, our dependence on a single licensee for a substantial portion of our revenues, our dependence on our key management personnel, any adverse determination of claims, liabilities or litigation, and the effect of a breach or termination by us of the Management Agreement. Several of these risks and uncertainties are discussed in more detail under "Item 1A. Risk Factors" in this Report on Form 10-Q or in the discussion and analysis below. You should, however, understand that it is not possible to predict or identify all risks and uncertainties and you should not consider the risks and uncertainties identified by us to be a complete set of all potential risks or uncertainties that could materially affect us. You should not place undue reliance on the forward-looking statements we make herein because some or all of them may turn out to be wrong. We undertake no obligation to update any of the forward-looking statements contained herein to reflect future events and developments.

Introduction

The following discussion should be read in conjunction with our consolidated financial statements and related notes included elsewhere in this Report on Form 10-Q. See "Item 1. Consolidated Financial Statements" and our Form 10-K for Fiscal 2008.

Cherokee Inc. (which may be referred to as we, us, our or the Company) is in the business of marketing and licensing the Cherokee, Sideout and Carole Little brands and related trademarks and other brands we own or represent. We are one of the leading licensors of brand names and trademarks for apparel, footwear and accessories in the world.

We own several trademarks, including Cherokee®, Sideout®, Sideout Sport®, Carole Little®, CLII®, Saint Tropez-West®, Chorus Line®, All That Jazz®, Molly Malloy® and others. As of November 1, 2008, we had nineteen continuing license agreements covering both domestic and international markets. During Fiscal 2007, we terminated one material licensing agreement (our Finder's Agreement with Mossimo Inc.) in exchange for a one-time payment of $33.0 million during our fourth quarter of that fiscal year. As part of our business strategy, we frequently evaluate other brands and trademarks for acquisition into our portfolio.

In addition to licensing our own brands, we also assist other brand-owners, companies, wholesalers and retailers in identifying licensees or licensors for their brands or stores. For example, during Fiscal 2008 we assisted Norma Kamali in her arrangement with Wal-Mart as a global licensee of the Norma Kamali brand.

We operate on a 52 or 53 week fiscal year ending on the Saturday nearest to January 31 in order to better align us with our licensees who generally also operate and plan using such a fiscal year. This results in a 53 week fiscal year approximately every four or five years. We do not believe that the extra week in the occasionally reported 53 week fiscal year results in any material impact on our financial results.

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Our Board of Directors has authorized and approved the extension of the expiration date of our stock repurchase program to January 31, 2010, and increased to 800,000 the number of shares which could currently be repurchased. During the Second Quarter we repurchased and retired 10,155 shares of our common stock at an average price of $21.59. During the Third Quarter we repurchased and retired 99,561 shares of our common stock at an average price of $17.62. From July 1999 through February 1, 2003, we repurchased and retired 607,800 shares of our common stock, and did not repurchase any other shares until our Second Quarter purchases noted above. Continued repurchases of our stock, if any, will be made from time to time in the open market at prevailing market prices or in privately negotiated transactions.

Critical Accounting Policies and Estimates

Management's discussion and analysis of financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, management evaluates its estimates, including those related to revenue recognition, deferred taxes, impairment of long-lived assets, contingencies and litigation. Management bases its 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. Actual results may differ from these estimates.

We consider accounting policies relating to the following areas to be both those most important to the portrayal of our financial condition and those that require the most subjective judgment:

† Revenue recognition;

† Provision for income taxes and deferred taxes;

† Impairment of long-lived assets;

† Contingencies and litigation; and

† Accounting for stock-based compensation.

You should refer to our Annual Report on Form 10-K for the year ended February 2, 2008, for a discussion of our policies on revenue recognition, deferred taxes, impairment of long-lived assets, contingencies and litigation and accounting for stock-based compensation.

Effective February 4, 2007, we adopted the provision of FASB interpretation (FIN) No. 48, "Accounting for Uncertainty in Income Taxes" ("FIN 48") which clarifies the accounting for uncertainty in income taxes recognized in an enterprise's financial statements in accordance with FASB Statement No. 109, "Accounting for Income Taxes." FIN 48 prescribes a comprehensive model for how companies should recognize, measure, present, and disclose in their financial statements uncertain tax positions taken or expected to be taken on a tax return. Under FIN 48, tax positions shall initially be recognized in the financial statements when it is more likely than not the position will be sustained upon examination by the tax authorities. Such tax positions shall initially and subsequently be measured as the largest amount of tax benefit that is greater than 50% likely of being realized upon ultimate settlement with the tax authority assuming full knowledge of the position and all relevant facts. The cumulative effect of applying FIN 48 has resulted in a decrease to our retained earnings of approximately $0.4 million as of February 4, 2007.

We recognize interest and penalties, if any, related to unrecognized tax benefits within the provision for income taxes in our consolidated statement of income. As of February 2, 2008 and November 1, 2008, respectively, accrued interest on a gross basis was $1,270,000 and $92,000. The total amount of gross unrecognized tax benefits as of both February 2, 2008 and November 1, 2008, respectively, was approximately $1.8 million and $0.7 million, of which approximately $0.9 million and $0.7 million represents the amount of unrecognized tax benefits that, if

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recognized, would affect the effective tax rate. Currently, Cherokee expects the liability for unrecognized tax benefits will change by a significant amount during the next 12 months.

Cherokee files U.S. federal and state tax returns. For the federal tax returns, Cherokee is generally no longer subject to tax examinations for fiscal years prior to 2003. With limited exception, our significant state tax jurisdictions are no longer subject to examinations by the various tax authorities for fiscal years prior to 2003.

On January 29, 2006, Cherokee 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 for employee stock options based on estimated fair values. SFAS 123(R) supersedes Cherokee's previous accounting under Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB 25") for periods beginning on or after January 1, 2006.

Cherokee accounts for stock based compensation in accordance with Statement of Financial Accounting Standards No. 123 (revised 2004), "Share-Based Payment," ("SFAS 123(R)") which requires companies to estimate the fair value of share-based payment awards on the date of grant using an option-pricing model. The fair value of stock options are estimated using a Black-Scholes option valuation model. This model requires the input of subjective assumptions, including expected stock price volatility, estimated life and estimated forfeitures of each award. The fair value of equity-based awards is amortized over the vesting period of the award, and we have elected to use the straight-line method. We make quarterly assessments of the adequacy of the tax credit pool to determine if there are any deficiencies which require recognition in the consolidated statement of operations. Stock-based compensation expense recognized under SFAS 123(R) for the nine months ended November 1, 2008 and November 3, 2007 was $410,000 and $537,000, respectively.

Recent Accounting Pronouncements

We describe recent accounting pronouncements in Item 1 - "Consolidated Financial Statements - Notes to Consolidated Financial Statements."

Results of Operations

Retail Sales

During the Third Quarter, total sales of merchandise bearing the Cherokee brand were 24% below the total retail sales for the third quarter of Fiscal 2008, with retail sales totaling approximately $498.8 million in the Third Quarter versus approximately $657.6 million in total retail sales for the third quarter of Fiscal 2008.

During the Nine Months, total sales of merchandise bearing the Cherokee brand were 16.8% below the total retail sales for the comparable period for Fiscal 2008, with retail sales totaling approximately $1.54 billion in our Nine Months versus approximately $1.85 billion in retail sales for the comparable period for Fiscal 2008.

Pursuant to our typical arrangements with our licensees, we receive quarterly royalty statements and periodic retail sales information for Cherokee branded products and other product brands that we own or represent. However, our licensees are generally not required to provide, and typically do not provide, information that would enable us to determine the specific reasons for period-to-period fluctuations in retail sales of our branded products by our licensees in the specific territories in which they operate. Fluctuations in retail sales of Cherokee branded products or other product brands that we own or represent may be the result of a variety of factors, including, without limitation: (i) changes in the number of product categories for which a licensee chooses to use our brands from period-to-period, which generally results in changes in the amount of inventory (utilizing our brands) available for sale from period-to-period; (ii) the number of geographical markets/territories or number of stores in which our licensees are currently selling Cherokee or our other branded products from period-to-period; or
(iii) our licensees experiencing changes in retail sales levels as a result of a variety of factors, including fashion-related and general retail sales trends (See Item IA "Risk Factors").

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During the Third Quarter, retail sales of Cherokee branded products by Target Stores totaled approximately $286.0 million compared to approximately $366.2 million for the three months ended November 3, 2007, or a decline of 21.9%. This decline can be attributed to the fewer men's and women's product categories allocated to the Cherokee brand in Fiscal 2009 as compared to Fiscal 2008. However, our royalty revenue for the Third Quarter from Target Stores increased by 11.7% as compared to the third quarter of Fiscal 2008, which is solely due to the higher contractual royalty rates applied during the Third Quarter as compared to the comparable period for Fiscal 2008. Target's retail sales of Cherokee branded products for the Nine Months totaled $788.5 million, as compared to $1.0 billion for the comparable period for Fiscal 2008, which represents a decline of 22%.

Tesco's sales of merchandise bearing the Cherokee brand, which for the Third Quarter and the third quarter of Fiscal 2008 included the U.K., Ireland, Poland, Czech Republic, Hungary and Slovakia, were $174.2 million in our Third Quarter, compared to $241.0 million in the third quarter of Fiscal 2008. Tesco's sales of Cherokee merchandise for the Nine Months totaled $642.4 million, which is less than the $703.5 million for the comparable period for Fiscal 2008. This decline is primarily attributable to lower retail sales in the U.K.

Zeller's sales of merchandise bearing the Cherokee brand were approximately $18.8 million during the Third Quarter compared to $39.5 million for the third quarter of Fiscal 2008. Zeller's sales of Cherokee merchandise for the Nine Months totaled $55.9 million, as compared to $108.7 million for the comparable period for Fiscal 2008. This decline is due to the elimination of many men's and women's product categories during Fiscal 2009, as Zellers has expanded their private label offerings in these categories. The retail sales of kid's Cherokee apparel at Zellers has grown in most product categories during the Nine Months as compared to the same period for Fiscal 2008.

During the Third Quarter, sales of Mervyn's apparel and accessories bearing the Sideout brand were approximately $7.7 million in comparison to $9.8 million for the third quarter of last year. For the Nine Months, sales of Sideout branded products at Mervyn's totaled $19.7 million as compared to $24.4 million for the comparable period last year. For Fiscal 2009, Cherokee had a greater amount of earned royalties in the Third Quarter than what is being recorded as revenues, because Mervyn's filed for bankruptcy in July and later announced that it would liquidate rather than be able to re-organize, the likelihood of realizing such earned royalties has been reduced.

Sales of Carole Little and St. Tropez-West branded products by TJX were approximately $10.8 million in the Third Quarter, as compared to $23.2 million for the comparable quarter of Fiscal 2008. For the Nine Months, sales of Carole Little and St. Tropez-West branded products at TJX totaled $47.3 million as compared to $88.8 million for the comparable period for Fiscal 2008.

Royalty Revenues and Expenses

Royalty revenues were $8.0 million and $30.1 million during the Third Quarter and Nine Months, respectively, compared to $8.9 million and $32.9 million during the third quarter and nine months ended November 3, 2007, respectively, a decrease of 10.1% for the Third Quarter, and a decrease of 8.5% for the Nine Months. Royalty revenues from the Cherokee brand were $7.6 million and $28.5 million during the Third Quarter and Nine Months, respectively, compared to $8.1 million and $30.7 million for the comparable periods last year. During the Third Quarter and Nine Months, revenues of $3.7 million and $13.0 million, respectively, were recognized from Target, compared to $3.3 million and $14.5 million for the comparable periods last year, which accounted for 46% and 43% of total revenues, respectively, versus 37% and 44% last year. The decrease in royalty revenues from Target for the Nine Months compared to the prior year periods was attributable to lower retail sales of Cherokee branded products due to a lower number of product categories allocated to the Cherokee brand in men's and women's apparel, women's accessories, and intimate apparel. Revenues from Tesco for sales of Cherokee branded products were $2.95 million and $12.7 million during the Third Quarter and Nine Months, respectively, compared to $3.7 million and $13.0 million for the comparable periods last year. The decline in royalties from Tesco during the Third Quarter and Nine Months is primarily due to reduced sales of Cherokee branded products in Tesco UK, which has been somewhat offset by increased sales in Tesco Central Europe. These lower royalties from Tesco UK were also a result of the strengthening U.S. dollar, as the dollar strengthened by 12% against the British Pound Sterling when comparing the Third Quarter to the comparable period last year. Revenues from Zellers were $376,000 and

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$1.1 million during the Third Quarter and Nine Months, respectively, compared to $773,000 and $2.2 million for the comparable periods last year, due primarily to fewer product categories allocated to the Cherokee brand. Royalty revenues from our retail direct licensee in Mexico, Comercial Mexicana, totaled $269,000 and $786,000 during the Third Quarter and Nine Months, respectively, compared to $226,000 and $591,000 in royalty revenues for the comparable periods last year. During the Third Quarter the parent company of Comercial Mexicana filed for bankruptcy protection in Mexico, due to losses incurred in their foreign currency hedging strategies. However, their filing was denied by the Mexican bankruptcy court. We received our payment of royalties due in the Third Quarter in the normal course of business, and it is unclear at this time whether this situation will have a future affect on our licensing agreement with Comercial Mexicana or not.

Royalty revenues from the retail sales of products bearing our Sideout brand were $65,000 and $497,000, respectively, during the Third Quarter and Nine Months compared to $275,000 and $828,000 for the comparable periods last year. Revenues from Mervyn's for sales of Sideout branded products during the Third Quarter and Nine Months were $26,000 and $355,000, respectively, compared to$252,000 and $749,000 for the comparable periods last year. The Company had a greater amount of earned royalties in the Third Quarter from Mervyns than what is being reported as revenues, but because Mervyn's filed for bankruptcy in July and later announced that it would liquidate rather than be able to re-organize, the likelihood of realizing such earned royalties has been reduced.

Third Quarter and Nine Months revenues also included $187,000 and $630,000, respectively, from the Carole Little brands, as compared to the $302,000 and $1.16 million reported last year from these brands. In addition, in the Third Quarter we recognized royalty revenues of $177,000 from our brand representation licensing agreements, which included one quarterly minimum royalty payment, as compared to $239,000 in the comparable period last year (which included two quarterly minimum royalty payments). The Norma Kamali branded clothing began being sold at Wal-Mart in September, and initial reports are positive.

During the Nine Months we also began earning royalty revenues from certain new licensees, including Shufersal in Israel and Pao de Acucar in Brazil during the Second Quarter, and Arvind in India during our Third Quarter.

Revenues from international licensees of both Cherokee and Sideout brands, such as Tesco, Zellers, Comercial Mexicana and others were collectively $4.0 million and $15.6 million during the Third Quarter and Nine Months, respectively, compared to $4.85 million and $16.1 million for the comparable periods last year. This decline reflects a decrease in royalties from Tesco UK and Zellers (Canada) due to lower retail sales; an increase in royalties and retail sales from Tesco Central Europe and Comercial Mexicana in Mexico; and also the inclusion of certain new licensees that began selling Cherokee branded products and reporting sales and royalties to us during our Second Quarter.

We believe that our future revenues from Target, based on the downward trend during the Nine Months, will be materially lower for Fiscal 2009 when compared to the revenues from Fiscal 2008. We believe that our future royalty revenues from Zellers will continue to be lower due to fewer product categories as compared to last year. We estimate that our future revenues from Mervyn's will likely cease, as Mervyn's filed for Chapter 11 bankruptcy protection at the end of July 2008, and has now indicated that the bankruptcy will be converted to a Chapter 7 liquidation. As a consequence, we have begun to actively re-market the Sideout brand to other potential U.S. licensees. Based on the current retail environment in the UK and Tesco UK's sales of Cherokee branded products in the Nine Months, we expect that royalties from Tesco UK will be lower than that in Fiscal 2008. However, based on Tesco's expansion of Cherokee branded products into Central Europe and their expressed interest in continuing to grow the Cherokee brand in new territories, we believe that Tesco Central Europe's royalties for Fiscal 2009 will be greater than those of Fiscal 2008. Based upon the royalties received for the Nine Months from TJX, we estimate that our future royalty revenues from TJX will be lower than the revenues received from TJX in Fiscal 2008.

We recognize royalty revenues in the quarter earned. A large portion of such royalty revenues recognized as earned are collected from licensees during the month following the end of a quarter. Our trade receivables balance of $7.4 million as of the end of the Third Quarter included accrual for revenues earned from Target Stores, Zeller's, Mervyn's, Tesco, and other licensees that are expected to be received in the month or 45 days following the end of the Third Quarter.

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Selling, general and administrative expenses for the Third Quarter and Nine Months were $3.4 million and $11.0 million, respectively, or 41.9% and 36.5%, of revenues, in comparison to selling, general and administrative expenses of $3.9 million and $12.0 million, respectively, or 43.2% and 36.4% of revenues during the comparable periods last year. Our selling, general and administrative expenses of $3.4 million in our Third Quarter represents a decrease of approximately $500,000 from the comparable quarter in the prior year. The overall decrease in our selling, general and administrative expenses of $500,000 during the Third Quarter was primarily attributable to the following positive and negative variances: (i) lower payroll and accrued bonus expense as compared to the third quarter of last year; (ii) lower marketing expenses; (iii) lower stock compensation expenses of $130,000, as compared to $203,000 in the third quarter of last year; and (iv) lower audit and tax fees. The decrease in our selling, general and administrative expenses of $1.0 million during the Nine Months was primarily attributable to the following positive and negative variances: (i) lower salaries, payroll taxes and accrued bonus expense as compared to the comparable period last year; (ii) lower marketing expenses;
(iii) lower stock compensation expenses of $410,000, as compared to $537,000 in the nine months quarter of last year; (iv) a one-time payment of $254,000 pertaining to the 45% royalty share of the Carole Little royalties in the first quarter of last year, as compared to $0 in the Nine Months (although our trademark amortization expenses increased by $310,000); (v) lower audit and legal expenses, and (v) higher bank fees in relation to expenses paid to an investment banking firm whose engagement was terminated at the end of July.

We reported zero interest expense during the Third Quarter and Nine Months and the comparable periods last year. During the Third Quarter and Nine Months our interest and other income was $46,000 and $144,000, respectively, compared to $269,000 and $944,000 for the comparable periods last year. The decrease in interest income is primarily due to lower cash balances during the Third Quarter and Nine Months, as compared to the comparable periods in the prior year.

During the Third Quarter and Nine Months we recorded a tax provision of $1.46 million and $7.3 million, respectively, which equates to an effective tax rate of 31.0% and 37.8% for such periods compared to $1.6 million and $8.2 million and an effective tax rate of 30.8% and 37.6% recorded for the same periods last year. We are making quarterly estimated tax payments for our federal and state income tax liabilities. During the Third Quarter and Nine Months our net income was $3.25 million and $11.96 million or $0.37 and $1.34 per diluted share, respectively, compared to $3.7 million and $13.6 million or $0.41 and $1.52 per diluted share for the comparable periods last year. The decrease in the Third Quarter of our effective tax rates, as compared to the tax rates utilized in prior quarters of Fiscal 2009, was primarily due to the settlement of certain FIN 48 related items.

Liquidity and Capital Resources

Cash Flows. On November 1, 2008, we had cash and cash equivalents of $14.0 million. On February 2, 2008, we had cash and cash equivalents of $22.0 million. The $8.0 million decrease in cash and cash equivalents during the Nine Months is primarily attributable to the payment of $17.8 million in dividends during this period, the use of $2.0 million to repurchase and retire 109,716 shares of its common stock, and the payment of our previously accrued management and employee bonuses of $3.9 million during the First Quarter. These were offset by various other items detailed below.

During the Nine Months, cash provided by our operations was $11.8 million, compared to cash used in our operations of $0.1 million for the nine months ended November 3, 2007. The cash provided by our operations of $11.8 million during the Nine Months was primarily due to the following changes: (i) an . . .