Summary of CHEROKEE INC - Yahoo! Finance

Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION

Cautionary Note Regarding Forward-Looking Statements

This Annual Report on Form 10-K, our quarterly reports on Form 10-Q, other filings we may 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-K 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 with our Chief Executive Officer. Several of these risks and uncertainties are discussed in more detail under "Item 1A. Business-Risk Factors" as well as 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 effect 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. Certain of the information set forth herein are considered non-GAAP financial measures. Cherokee believes this information is useful to investors because it provides a basis for measuring the operating performance of the Company's business and the Company's cash flow, excluding non-cash items that would normally be included in the most directly comparable measures calculated and presented in accordance with generally accepted accounting principles. Non-GAAP financial measures should not be considered in isolation from, or as a substitute for, financial information presented in compliance with GAAP, and non-financial measures as reported by the Company may not be comparable to similarly titled amounts reported by other companies.

Overview

The following discussion should be read in conjunction with our consolidated financial statements and related notes included elsewhere in this Form 10-K.

Since May 1995, we have principally been in the business of marketing and licensing the Cherokee brand and related trademarks and other brands we own or represent. Our operating strategy emphasizes domestic and international retail direct and wholesale licensing, whereby we grant wholesalers and retailers the license to use our trademarks on certain categories of merchandise.

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On January 10, 2008, we reaffirmed our strategic relationship with Target by entering into the Restated Target Agreement, which grants Target the exclusive right in the United States to use the Cherokee trademarks in various categories of merchandise. See "Item 1. Business-Owned Brands-Cherokee Brand." Under the Restated Target Agreement, Target will pay a royalty each fiscal year during the term of the agreement based on a percentage of Target's net sales of Cherokee branded merchandise during each fiscal year, which percentage declines, on a prospective basis, as Target achieves certain thresholds on the volume of sales of merchandise. The current term of the Restated Target Agreement continues through January 31, 2012. However, the Restated Target Agreement provides that if Target remains current in its payments of the minimum guaranteed royalty of $9.0 million for the preceding fiscal year, then the term of the Restated Target Agreement will continue to automatically renew for successive fiscal year terms provided that Target does not give notice of its intention to terminate the Restated Target Agreement during February of the calendar year prior to termination.

Under the Restated Target Agreement, in most cases, we must receive Target's consent to enter into additional licensing agreements in the United States with respect to the Cherokee brand during the term of the Restated Target Agreement. Therefore, our current focus with respect to the Cherokee brand is to continue to develop that brand in several international markets through retail direct or wholesale licenses with manufacturers or other companies that have market power and economies of scale in those respective markets.

Target currently has approximately 1,650 stores in the United States. Retail sales of Cherokee branded products at Target decreased in Fiscal 2009 by 23.2% to $1.08 billion from the $1.4 billion reported in Fiscal 2008, which we attribute to changes in the mix (greater emphasis on kid's products, and current discontinuance of most Cherokee branded products in women's and men's categories) and placement of Cherokee branded products within Target, the seasonal displacement of the Cherokee brand on certain product categories during Fiscal 2009 and decreased levels of consumer spending in Fiscal 2009. Target pays royalty revenues to us based on a percentage of its sales of Cherokee branded products. The Restated Target Agreement is structured to provide royalty rate reductions for Target after it has achieved certain levels of retail sales of Cherokee branded products during each fiscal year. In Fiscal 2009 Target reached the guaranteed minimum royalty amount in the Second Quarter, and surpassed $1.0 billion in retail sales in the Fourth Quarter. Based upon the current economic conditions in the U.S., we believe that our future revenues from Target may be similar to or below those reported in Fiscal 2009, but we do not have direct oversight or involvement in the manufacturing, marketing or sales of the ultimate branded product, and hence do not have the information necessary to determine or predict the specific reasons why revenue may increase or decrease in any given future period. However, given our contractual royalty rate reductions as certain sales volume thresholds are achieved, in terms of future royalty revenues that we expect to receive from Target, we expect that our first quarter will continue to be our highest revenue and profitability quarter; our second quarter to be our next highest quarter, and our third and fourth quarters to be our lowest quarters.

Royalty revenues from our Cherokee brand at Target were $18.4 million in Fiscal 2007, $17.3 million in Fiscal 2008, and $15.2 million in Fiscal 2009, which accounted for 24% (42% if excluding the $33.0 million from the termination of our Mossimo Finder's Agreement), 42%, and 42%, respectively, of our consolidated revenues during such periods. The revenues generated from all other licensing agreements during Fiscal 2007 were $58.2 million, during Fiscal 2008 were $24.3 million, and during Fiscal 2009 were $21.0 million, which accounted for 76%, 58% and 58%, respectively, of our revenues during such periods.

Target's retail sales of Cherokee branded products during the Fourth Quarter of Fiscal 2009 totaled $291 million compared to $393 million for the fourth quarter of Fiscal 2008. As a consequence, our royalty revenues from Target for the Fourth Quarter were lower than the royalty revenues reported in the fourth quarter of Fiscal 2008.

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On August 1, 2001, we entered into a retail direct license agreement for the Cherokee brand with Tesco. See "Item 1. Business-Owned Brands-Cherokee Brand." Tesco was granted the exclusive right to manufacture, promote, sell and distribute a wide range of products bearing our Cherokee brand in the United Kingdom and Ireland and is obligated to pay us a royalty based upon a percentage of its net sales of Cherokee branded products in those countries. In January 2004, we granted Tesco the rights to certain other countries including South Korea, Malaysia, Thailand, Slovakia, and Hungary, and in 2005, we added the rights to Poland and the Czech Republic. In March 2006, Tesco began to sell Cherokee branded products in the Czech Republic, Poland, and Slovakia, and, in July 2006, Tesco began to sell Cherokee branded products in Hungary. In addition, in February 2007 we added the territory of China to the Tesco agreement. The term of the Tesco agreement expires on January 31, 2011, and Tesco has several options to extend this term.

Tesco's sales of merchandise bearing the Cherokee brand, which for Fiscal 2009 included the United Kingdom, Ireland, the Czech Republic, Slovakia, Poland, Hungary and Turkey, totaled $167.8 million in the Fourth Quarter of Fiscal 2009, as compared to $230 million for the fourth quarter of Fiscal 2008. For Fiscal 2009, Tesco's sales of Cherokee branded merchandise totaled $810 million as compared to $933 million in Fiscal 2008. Based upon the recent decline of our revenues received from Tesco for sales in the U.K., and the deteriorating economic climate in Europe, it is possible that our future revenues from Tesco will decline from those of Fiscal 2009. Tesco began to sell Cherokee branded products in the Czech Republic, Poland, and Slovakia in March 2006, and in Hungary in July 2006. Given the current weak retail environment, it is unclear when or if Tesco will start selling Cherokee branded products in certain Asian territories, including Malaysia, South Korea, Thailand and China.

Zellers' sales in Canada of merchandise bearing the Cherokee brand were approximately $19.7 million during the Fourth Quarter of Fiscal 2009 compared to $37.5 million for the fourth quarter of Fiscal 2008. For Fiscal 2009, Zellers' sales of Cherokee branded merchandise totaled $75.6 million as compared to $146 million in Fiscal 2008, primarily as a result of Zellers' significantly reducing the number of men's and women's categories for the Cherokee brand. We are unsure how our future revenues from Zellers' will trend, as there could be changes in strategy or future store closings which could negatively effect the sales of Cherokee branded products.

During the Fourth Quarter, total worldwide retail sales of merchandise bearing the Cherokee brand totaled $500 million versus $677 million in total retail sales for the fourth quarter of Fiscal 2008. For Fiscal 2009, total worldwide retail sales of merchandise bearing the Cherokee brand totaled over $2.0 billion, which was below the $2.53 billion in total retail sales reported for Fiscal 2008.

During Fiscal 2009, Mervyns, our former U.S. based licensee of the Sideout brand, filed for bankruptcy and subsequently began to liquidate their retailing operations. As a consequence our licensing revenues from Mervyns during Fiscal 2009 account for only 6 months of the year, and total retail sales of Mervyn's apparel and accessories bearing the Sideout brand were approximately $19.6 million in comparison to $32.7 million in Fiscal 2008.

TJX's sales of merchandise bearing the Carole Little and St. Tropez-West brands were approximately $9.3 million during the Fourth Quarter of Fiscal 2009 compared to $13.0 million for the fourth quarter of Fiscal 2008. For Fiscal 2009, TJX's sales of Carole Little and St. Tropez-West branded merchandise totaled $56.6 million as compared to $101.8 million in Fiscal 2008.

As an incentive for our licensees to achieve higher retail sales of Cherokee or Sideout branded products, some of our existing license agreements, including the Restated Target Agreement and our license agreement with Tesco, are structured to provide royalty rate reductions for the licensees after they achieve certain levels of retail sales of Cherokee or our other branded products during each fiscal year. The royalty rate reductions do not apply retroactively to retail sales since the beginning of the year. As a result, our royalty revenues from our licensees' retail sales of branded products are highest

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at the beginning of each fiscal year and decrease in each fiscal quarter as licensees reach certain retail sales thresholds contained in their respective license agreements. Therefore, the amount of royalty revenue we recognize in any quarter is dependent on the cumulative level of retail sales. Historically, this has caused our first quarter to be our highest revenue and profitability quarter; our second quarter to be our next highest quarter; and our third and fourth quarters to be our lowest quarters. The amount of the royalty rate reductions and the level of retail sales at which they are achieved vary in each licensing agreement.

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 1A, "Risk Factors").

In addition to licensing our own brands, we assist other companies in identifying licensees for their brands. During fiscal 2001, we assisted Mossimo Inc. in locating Target as a licensee of the Mossimo brand and entered into a finder's agreement with Mossimo, which provided that we would receive a fixed percentage of all monies paid to Mossimo by Target. Under Mossimo's agreement with Target, Target was obligated to pay Mossimo a royalty based on a percentage of net sales of Mossimo branded products, with a minimum guaranteed royalty. In Fiscal 2007, we terminated our Mossimo Finder's Agreement in return for a $33.0 million payment in the fourth quarter of that year, and after Fiscal 2007 we will no longer receive any royalties from Mossimo. We also have provided our brand representation services for other brands, including HouseBeautiful, Latina and Norma Kamali. During Fiscal 2008 we assisted Norma Kamali in locating Wal-Mart as a global licensee of the Norma Kamali brand. During Fiscal 2009 we worked on several brand representation opportunities, but such work has not yet resulted in the signing of any new brand representation licensing agreements. We currently expect that our revenues from brand representation licensing agreements, which totaled $673,000 in Fiscal 2009, will grow over the next two years as a result of the Norma Kamali brand global license agreement with Wal-Mart, though we are unable to quantify our expectations in this regard.

The services of Mr. Robert Margolis, as our Chief Executive Officer are provided to us pursuant to a Management Agreement. The Management Agreement, as amended, provides for certain base compensation and bonuses, as defined, payable to Mr. Margolis. The initial term of the Management Agreement was until February 2, 2002, however, it will automatically be extended for each consecutive one year period in the event that pre-tax earnings, as defined, exceed specified levels as documented in the Management Agreement and as reviewed and agreed upon by the Company's Compensation Committee. The Management Agreement provides that, for each fiscal year after fiscal 2000, if our EBITDA for such fiscal year is no less than $5.0 million, then Mr. Margolis will receive a performance bonus equal to 10% of our EBITDA for such fiscal year in excess of $2.5 million up to $10.0 million, plus 15% of our EBITDA for such fiscal year in excess of $10.0 million. For Fiscal 2009, Fiscal 2008 and Fiscal 2007 Mr. Margolis' base compensation and bonuses were $3.7 million, $4.1 million and $8.7 million, respectively. As of January 31, 2009 and February 2, 2008, our accrued liabilities include a bonus payable of $2.9 million and $3.4 million, respectively, for Mr. Margolis. If our future EBITDA increases, the bonus payable to Mr. Margolis under the Management Agreement will also increase.

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If the Company fails to meet the criteria for extending the term of the Management Agreement in any particular fiscal year, the Management Agreement will not be extended in that year and will thereafter be scheduled to expire two-years from the date of such failure, but the Management Agreement will remain eligible to be extended by an additional year in any subsequent fiscal year during the term of the Management Agreement in which the criteria to extend the term of the Management Agreement are satisfied. Pre-tax earnings for Fiscal 2008, Fiscal 2007 and Fiscal 2006 exceeded specified levels documented in the Management Agreement, and as reviewed and agreed upon by the Company's Compensation Committee, thereby automatically extending the Management Agreement to February 1, 2011. Pre-tax earnings for Fiscal 2009 did not exceed such specified levels, and as a result for Fiscal 2009 the Management Agreement has not been extended beyond the February 1, 2011 date, but remains eligible to be extended, depending upon future financial results exceeding the specified levels. The Management Agreement also provides that Mr. Margolis may nominate one director to the Board of Directors and certain other investors may nominate one director to the Board of Directors.

The Management Agreement may be terminated at any time without cause or in the event of certain circumstances, as defined. If we terminate the agreement without cause or Mr. Margolis terminates the agreement if we materially breach the terms and conditions of the agreement or fail to perform any material obligation there under, Mr. Margolis is entitled to receive within 60 days of termination, a lump sum cash payment equal to three times the sum of his annual base compensation and the previous year's performance bonus (the "Termination Payment"). On August 28, 2007, we entered into an amendment (the "Amendment") to the Management Agreement which amends, among other things, the provisions regarding the Termination Payment to reduce the payment by disregarding all revenues received from Mossimo, Inc. during Fiscal 2007 and also the related expenses associated with the termination of the Finder's Agreement. The Amendment was approved by the Company's stockholders at the Annual Meeting of the Stockholders on August 28, 2007. In the event the Management Agreement, as amended, was terminated as described above, on February 1, 2009 the Termination Payment for Mr. Margolis would be approximately $11.1 million.

We have a 52 or 53 week fiscal year ending on the Saturday nearest to January 31, which aligns us with our retailer 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. In addition, certain of our international licensees report royalties to us for quarterly and annual periods which may differ from ours. We do not believe that the varying quarterly or annual period ending dates from our international licensees have a material impact upon our reported financial results, as these international licensees maintain comparable annual periods in which they report retail sales and royalties to us on a year-to-year basis.

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.

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Management applies the following critical accounting policies in the preparation of our consolidated financial statements:

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� Revenue Recognition Policy. Revenues from royalty and finders agreements are recognized when earned by applying contractual royalty rates to quarterly point of sale data received from our licensees. Our royalty recognition policy provides for recognition of royalties in the quarter earned, although a large portion of such royalty payments are actually received during the month following the end of a quarter. Revenues are not recognized unless collectability is reasonably assured. Royalty agreements that account for the majority of our historical revenues are structured to provide royalty rate reductions once certain cumulative levels of sales are achieved by our licensees. Revenue is recognized by applying the reduced contractual royalty rates prospectively to point of sale data as required sales thresholds are exceeded. The royalty rate reductions do not apply retroactively to sales since the beginning of the fiscal year, and as a consequence such royalty rate reductions do not impact previously recognized royalty revenue.

As a result, our royalty revenues from our licensees' retail sales of branded products are highest at the beginning of each fiscal year and decrease in each fiscal quarter as licensees reach certain retail sales thresholds contained in their respective license agreements. Therefore, the amount of royalty revenue we recognize in any quarter is dependent on the retail sales of branded products in such quarter and the royalty rate in effect after considering the cumulative level of retail sales. Historically, this has caused our first quarter to be our highest revenue and profitability quarter; our second quarter to be our next highest quarter, and our third and fourth quarters to be our lowest quarters. The amount of the royalty rate reductions and the level of retail sales at which they are achieved vary in each licensing agreement. At January 31, 2009, there was no allowance for doubtful accounts.

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� Deferred Taxes. Deferred taxes are determined based on the differences between the financial statement and tax bases of assets and liabilities, using enacted tax rates in effect for the year in which the differences are expected to reverse. Valuation allowances are established when necessary to reduce deferred tax assets to the amounts expected to be realized. In assessing the need for a valuation allowance management considers estimates of future taxable income and ongoing prudent and feasible tax planning strategies.

Effective February 4, 2007, we adopted the provision of FASB interpretation (FIN) No. 48, "Accounting for Uncertainty in Income Taxes" 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.

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� Impairment of Long-Lived Assets. We evaluate the recoverability of our identifiable intangible assets and other long-lived assets in accordance with SFAS No. 144, which generally requires management to assess these assets for recoverability when events or circumstances indicate a potential impairment by estimating the undiscounted cash flows to be generated from the use and ultimate disposition of these assets.

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� Contingencies and Litigation. We evaluate contingent liabilities including threatened or pending litigation in accordance with SFAS No. 5, "Accounting for Contingencies" and record accruals when the outcome of these matters is deemed probable and the liability is reasonably estimable. Management makes these assessments based on the facts and circumstances and in some instances based in part on the advice of outside legal counsel.

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� Stock Options. On January 29, 2006, we adopted Statement of Financial Accounting Standards No. 123 (revised 2004), "Share-Based Payment," ("SFAS 123(R)"), using the modified prospective method, 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. Prior to January 28, 2006, the Company accounted for its fixed stock options using the intrinsic value method, as prescribed by Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to . . .