SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

 

FORM 10-Q

 

 

☒Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

 

For the quarterly period ended October 29, 2016.

 

☐Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

 

For the Transition Period From            to            .

 

Commission file number 0-18640

 

 

CHEROKEE INC.

(Exact name of registrant as specified in its charter)

 

 

 

Registrant’s telephone number, including area code  (818) 908-9868

 

 

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 the past 90 days.  Yes ☒  No ☐

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes ☒  No ☐

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

 

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

 

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

 

 

 

 

 

 

CHEROKEE INC.

 

TABLE OF CONTENTS

 

 

 

PART 1. FINANCIAL INFORMATION

 

ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS

 

CHEROKEE INC.

CONSOLIDATED BALANCE SHEETS

Unaudited

(amounts in thousands, except share and per share amounts)

 

 

See the accompanying notes which are an integral part of these consolidated financial statements.

CHEROKEE INC.

 

CONSOLIDATED STATEMENTS OF OPERATIONS

Unaudited

(amounts in thousands, except per share amounts)

 

 

See the accompanying notes which are an integral part of these consolidated financial statements.

CHEROKEE INC.

 

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

Unaudited

(amounts in thousands)

 

 

See the accompanying notes which are an integral part of these consolidated financial statements.

CHEROKEE INC.

 

CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY

Unaudited

(amounts in thousands)

 

 

See the accompanying notes which are an integral part of these consolidated financial statements.

CHEROKEE INC.

 

CONSOLIDATED STATEMENTS OF CASH FLOWS

Unaudited

(amounts in thousands)

 

 

 

See the accompanying notes which are an integral part of these consolidated financial statements.

CHEROKEE INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Amounts in thousands, except percentages, share and per share amounts)

 

(1)   Basis of Presentation

 

The accompanying unaudited condensed consolidated financial statements as of October 29, 2016 and for the three and nine month periods ended October 29, 2016 and October 31, 2015 have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) and Article 10 of Regulation S-X. These consolidated financial statements include the accounts of Cherokee Inc. (“Cherokee” or the “Company”) and its consolidated subsidiaries and have not been audited by independent registered public accountants, but include all adjustments, consisting of normal recurring accruals, which in the opinion of management of Cherokee are necessary for a fair statement of the Company’s financial position and the results of operations for the periods presented. All material intercompany accounts and transactions have been eliminated during the consolidation process. The accompanying consolidated balance sheet as of January 30, 2016 has been derived from audited consolidated financial statements, but does not include all disclosures required by GAAP for an audited balance sheet. The results of operations for the three and nine month periods ended October 29, 2016 are not necessarily indicative of the results to be expected for the fiscal year ending January 28, 2017 or for any other period. For further information, refer to the consolidated financial statements and footnotes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year ended January 30, 2016.

 

As used herein, the term “First Quarter” refers to the three months ended April 30, 2016; the term “Second Quarter” refers to the three months ended July 30, 2016; the term “Third Quarter” refers to the three months ended October 29, 2016; the term “Nine Months” refers to the nine months ended October 29, 2016; the term “Fiscal 2019” refers to the fiscal year ending February 2, 2019; the term “Fiscal 2018” refers to the fiscal year ending February 3, 2018; the term “Fiscal 2017” refers to the fiscal year ending January 28, 2017; the term “Fiscal 2016” refers to the fiscal year ended January 30, 2016; and the term “Fiscal 2015” refers to fiscal year ended January 31, 2015.

 

(2)   Summary of Significant Accounting Policies

 

Receivables

 

Receivables are reported at amounts the Company expects to be collected, net of allowance for doubtful accounts.

 

Allowance for Doubtful Accounts

 

The Company records an allowance for doubtful accounts based upon its assessment of various factors, such as: historical experience, age of accounts receivable balances, credit quality of the Company’s licensees or franchisees, current economic conditions, bankruptcy, and other factors that may affect the Company’s licensees’ or franchisees’ ability to pay. There was no allowance for doubtful accounts as of October 29, 2016 or January 30, 2016.

 

Recent Accounting Pronouncements

 

In May 2014, the Financial Accounting Standards Board issued new guidance relating to revenue from contracts with customers that requires an entity to recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. In August 2015, the Financial Accounting Standards Board deferred the effective date of this guidance for all entities by one year. As a result, this guidance is effective for fiscal periods beginning after December 15, 2017. The anticipated impact of the adoption of this guidance on the Company’s consolidated financial statements is still being evaluated.

In November 2015, the Financial Accounting Standards Board issued authoritative guidance that modifies the balance sheet classification for deferred tax liabilities and assets to be classified as noncurrent in a statement of financial position. This guidance is effective for fiscal periods beginning after December 15, 2016, and allows for full retrospective adoption, with early adoption permitted. The Company has early adopted this guidance, as of January 30, 2016, which is reflected in the Company’s consolidated financial statements and related disclosures.

In March 2016, the Financial Accounting Standards Board issued authoritative guidance that modifies existing guidance for off-balance sheet treatment of a lessees’ operating leases. This guidance is effective for fiscal periods beginning after January 1, 2019 and allows for early adoption. The anticipated impact of the adoption of this guidance on the Company’s financial statements is still being evaluated.

In March 2016, the Financial Accounting Standards Board issued authoritative guidance that simplifies accounting for employee share-based payments. This guidance is effective for fiscal periods beginning after December 15, 2016 and allows for early adoption. The anticipated impact of the adoption of this guidance on the Company’s financial statements is still being evaluated.

In August 2016, the Financial Accounting Standards Board issued authoritative guidance that reduces the diversity in practice of the classification of certain cash receipts and cash payments within the statement of cash flows. This guidance is effective for fiscal periods beginning after December 15, 2017 and allows for early adoption. The anticipated impact of the adoption of this guidance on the Company’s financial statements is still being evaluated.

Use of Estimates

 

The preparation of these consolidated financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. The Company evaluates its estimates and assumptions on an ongoing basis, including those related to revenue recognition, allowance for doubtful accounts, impairment of long-lived assets, contingencies and litigation, stock-based compensation and income taxes. The Company bases its estimates on historical and anticipated results, trends and various other assumptions that it believes are reasonable under the circumstances, including expectations about future events. These estimates form the basis for making assumptions about the carrying values of assets and liabilities that are not readily apparent from other sources. By their nature, estimates are subject to an inherent degree of uncertainty. Actual results could differ materially from these estimates.

Cash and Cash Equivalents

 

The Company considers all highly liquid debt instruments purchased and money market funds purchased with an original maturity date of three months or less to be cash equivalents. At October 29, 2016 and January 30, 2016, the Company’s cash and cash equivalents exceeded Federal Deposit Insurance Corporation limits.

 

Revenue Recognition and Deferred Revenue

 

The Company recognizes revenue when persuasive evidence of a sale arrangement exists, delivery has occurred or services have been rendered, the buyer’s price is fixed or determinable and collection is reasonably assured. Revenues from royalty and brand representation agreements are recognized when earned by applying contractual royalty rates to quarterly point of sale data received from the Company’s licensees. The Company's royalty recognition policy provides for recognition of royalties in the quarter earned.

The Company’s agreement with Target Corporation (“Target”) covering sales of Cherokee branded products in the U.S. accounts for a large portion of the Company’s historical revenues and, for most such products, is structured to provide royalty rate reductions once certain cumulative levels of retail sales are achieved by Target. With respect to Target’s sales in the U.S. of Cherokee branded products other than in the school uniforms category and adult products sold on Target’s website, revenue is recognized by applying the reduced contractual royalty rates prospectively to point of sale data after defined sales thresholds are exceeded. The royalty rate reductions do not apply retroactively to sales since the beginning of the fiscal year. As a result, the Company’s historical royalty revenues as a percentage of Target’s retail sales in the U.S. are highest at the beginning of each fiscal year and decrease during the fiscal year as Target exceeds sales thresholds as set forth in the Company’s agreement with Target. The amount of Cherokee brand royalty revenue earned by the Company from Target in any quarter is dependent not only on Target’s retail sales of Cherokee branded products in the U.S. in each quarter, but also on the royalty rate then in effect after considering Target’s cumulative level of retail sales for most Cherokee branded products in the U.S. for the fiscal year. Historically, with Target, this has caused the Company to record its highest revenues and profits in its first quarter and its lowest revenues and profits in its fourth quarter. Any continuation of the Company’s historical revenue and profit patterns or development of any new revenue or profit patterns will depend upon, among other things, the terms of the Company’s license and franchise agreements, including the Target license agreement through the remainder of Fiscal 2017, the terms of any new license or franchise agreements, and retail sales volumes achieved from Target in the remaining quarter of its agreement and the Company’s other licensees and franchisees that are not subject to reduced royalty rates based upon cumulative sales.

Revenues from arrangements involving license fees, up-front payments and milestone payments, which are received or billable by the Company in connection with other rights and services that represent continuing obligations of the Company, are deferred and recognized in accordance with the license agreement. Deferred revenues also represent minimum licensee revenue royalties paid in advance of the culmination of the earnings process, the majority of which are non‑refundable to the licensee. Deferred revenues will be recognized as revenue in future periods in accordance with the license agreement.

Franchise revenues includes royalties and franchise fees. Royalties from franchisees are based on a percentage of net sales of the franchisee and are recognized as earned. Initial franchise fees are recorded as deferred revenue when received and are recognized as revenue when a franchised location commences operations, as all material services and conditions related to the franchise fee have been substantially performed upon the location opening. Renewal franchise fees are recognized as revenue when the franchise agreements are signed and the fee is paid, since there are no material services and conditions related to these franchise fees.

In order to ensure that Cherokee’s licensees and franchisees are appropriately reporting and calculating royalties owed to Cherokee, all of Cherokee’s license and franchise agreements include audit rights to allow Cherokee to validate the amount of the royalties paid. Any revenue resulting from these audits, or other audits, is recognized in the financial statements of the current reporting period.

Foreign Withholding Taxes

 

Licensing and franchising revenue is recognized gross of withholding taxes that are remitted by the Company’s licensees and franchisees directly to their local tax authorities.

 

Deferred Financing Costs and Debt Discount

 

Deferred financing costs and debt discounts are capitalized and amortized into interest expense over the life of the debt.

 

Property and Equipment

 

Property and equipment consist of the following:

 

 

Property and equipment are stated at cost, less accumulated depreciation. Maintenance and repairs are expensed as incurred. The cost and related accumulated depreciation of property and equipment sold or retired are written off, and the resulting gains or losses are included in current operations. Depreciation is provided on a straight line basis over the estimated useful life of the related asset.

 

Computers and related equipment and software are depreciated over three years. Furniture and store fixtures are depreciated over the shorter of seven years, or the remaining term of the corresponding license agreement. Leasehold improvements are depreciated over the shorter of five years, or the remaining life of the applicable lease term. Depreciation expense was $137 and $393 for the three and nine month periods ended October 29, 2016, respectively, and $115 and $322 for the three and nine month period ended October 31, 2015, respectively.

 

Earnings (Loss) Per Share Computation (amounts in thousands, including share amounts)

 

The following table provides a reconciliation of the numerator and denominator of the basic and diluted earnings (loss) per share (“EPS”) computations for the three and nine month periods ended October 29, 2016 and October 31, 2015:

 

 

The computation for the diluted number of shares excludes unexercised stock options that are anti-dilutive. There were 1,020 and 720 shares underlying anti-dilutive stock options for the three and nine month periods ended October 29, 2016, respectively, and 335 and 198 shares underlying anti-dilutive stock options for the three and nine month period ended October 31, 2015, respectively.

 

Basic EPS is computed by dividing the net income (loss) attributable to common stockholders by the weighted average number of common shares outstanding during the period. Diluted EPS is similar to the computation for basic EPS except that the denominator is increased to include the number of additional common shares that would have been outstanding if dilutive potential common shares had been issued.

 

Significant Contracts

 

The terms of the Company’s relationship with Target are set forth in a restated license agreement with Target, which was entered into effective as of February 1, 2008 and amended (i) on January 31, 2013 to add the category of school uniforms, (ii) on April 3, 2013 to provide for a fixed royalty rate of 2% for sales of Cherokee branded products in the category of adult merchandise sold on Target’s website (target.com) beginning in Fiscal 2015 and (iii) on January 6, 2014 to reflect Target’s election to renew the agreement through January 31, 2017 and to provide that Target can renew the agreement for successive two (2) year periods, provided that it satisfies the minimum annual royalty payment of $10,500 for the preceding fiscal year (the “Restated Target Agreement”). The Restated Target Agreement grants Target the exclusive right in the United States to use the Cherokee trademarks in various specified categories of merchandise. In September 2015, Target informed the Company that the Restated Target Agreement would not be renewed and will terminate at the end of its current term, which expires January 31, 2017 (except with respect to Cherokee branded products in the school uniforms category, which will expire at the end of its current term on January 31, 2018). The Restated Target Agreement, including the existing royalty obligations, will remain in effect and continue to generate revenues to Cherokee until its expiration.

 

Under the terms of the Restated Target Agreement, Target’s minimum annual royalty payment is $10,500 and applies to all sales made by Target in the United States, other than sales of Cherokee branded products in the school uniforms category (which products are subject to a separate minimum annual royalty payment of $800). Under the Restated Target Agreement, Target has agreed to pay royalties based on a percentage of Target’s net sales of Cherokee branded merchandise during each fiscal year, which percentage varies according to the volume of sales of merchandise other than sales of Cherokee branded products in the school uniforms category and, beginning in Fiscal 2015, other than sales of Cherokee branded products in the adult merchandise category that are made on Target’s website. The Company assumed a separate license agreement with Target for the Liz Lange brand in connection with the Company’s acquisition of the applicable assets in September 2012. The Company’s relationship with Target for the Liz Lange brand has been renewed through January 31, 2018.

 

In connection with the acquisition of the “Hawk” and “Tony Hawk” signature apparel brands and related trademarks in January 2014, Cherokee and Kohl’s Illinois, Inc. (“Kohl’s”) entered into an amended license agreement. Pursuant to the license agreement, Kohl’s is granted the exclusive right to sell Tony Hawk and Hawk branded apparel and related products in the United States for a four-year term and has agreed to pay Cherokee an annual royalty rate for its sales of Hawk branded signature apparel and related products in the United States, subject to a minimum annual royalty payment of $4,800.

 

Stock-Based Compensation

 

Effective July 16, 2013, the Company’s stockholders approved the 2013 Stock Incentive Plan, and effective June 6, 2016, the Company’s stockholders approved the amendment and restatement of such plan (as amended and restated, the “2013 Plan”). The 2013 Plan serves as the successor to the 2006 Incentive Award Plan (which includes the 2003 Incentive Award Plan as amended by the adoption of the 2006 Incentive Award Plan) (the “2006 Plan”). The 2013 Plan authorizes to be issued (i) 1,200,000 additional shares of common stock, and (ii) 121,484 shares of common stock previously reserved but unissued under the 2006 Plan. No future grants will be awarded under the 2006 Plan, but outstanding awards previously granted under the 2006 Plan continue to be governed by its terms. Any shares of common stock that are subject to outstanding awards under the 2006 Plan which are forfeited, terminate or expire unexercised and would otherwise have been returned to the share reserve under the 2006 Plan will be available for issuance as common stock under the 2013 Plan. The 2013 Plan provides for the issuance of equity-based awards to officers, other employees, and directors.

 

Stock Options

 

Stock options issued to employees are granted at the market price on the date of grant, generally vest over a three-year period, and generally expire seven to ten years from the date of grant. The Company issues new shares of common stock upon exercise of stock options. The Company has also granted non-plan stock options to certain executives as a material inducement for employment. The Company accounts for stock options under authoritative guidance, which requires the measurement and recognition of compensation expense for all stock-based payment awards made to employees and directors based on estimated fair values.

 

The Company estimates the fair value of stock-based payment awards 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 an expense over the requisite service period in the consolidated statements of operations. The compensation expense recognized for all stock-based awards is net of estimated forfeitures over the award’s service period.

 

Stock-based compensation expense recognized in selling, general and administrative expenses for stock options for the Third Quarter and Nine Months was $245 and $792, as compared to $319 and $774 for the third quarter and nine months ended October 31, 2015.

 

A summary of activity for the Company’s stock options for the Nine Months is as follows:

 

 

As of October 29, 2016, total unrecognized stock-based compensation expense related to unvested stock options was approximately $1,315, which is expected to be recognized over a weighted average period of approximately 1.57 years. The total fair value of all options that vested during the Nine Months was $1,300.  

 

Performance Stock Units and Restricted Stock Units

 

In April 2016, the Compensation Committee of the Company’s board of directors granted certain performance-based equity awards, which are sometimes referred to as performance stock units, to executives under the 2013 Plan.

 

The performance metric applicable to such awards is compound stock price growth, using the closing price of the Company’s common stock on April 5, 2016, or $16.89, as the benchmark. The target growth rate is 10% annually, which results in an average share price target of (i) $18.58 for Fiscal 2017, (ii) $20.44 for Fiscal 2018 and (iii) $22.48 for Fiscal 2019. The average share price will be calculated as the average of all market closing prices during the January preceding the applicable fiscal year end. If a target is met at the end of a fiscal year, one third of the shares subject to the award will vest. If the stock price target is not met at the end of a fiscal year, the relevant portion of the shares subject to the award will not vest but will roll over to the following fiscal year. The executive must continue to be employed by the Company through the relevant vesting dates to be eligible for vesting.

Since the vesting of these performance-based equity awards is subject to market based performance conditions, the fair value of these awards was measured on the date of grant using the Monte Carlo simulation model for each vesting tranche. The Monte Carlo simulation model utilizes multiple input variables that determine the probability of satisfying the performance conditions stipulated in the award and calculates the fair market value for the performance stock units granted. The Monte Carlo simulation model also uses stock price volatility and other variables to estimate the probability of satisfying the performance conditions and the resulting fair value of the award.

 

Stock-based compensation expense for restricted stock units and performance stock units for the Third Quarter and Nine Months was $296 and $1,000 compared to $345 and $833 for the third quarter and nine months ended October 31, 2015.

 

A summary of activity for the Company’s restricted stock units and performance stock units for the Nine Months is as follows:

 

 

As of October 29, 2016, total unrecognized stock-based compensation expense related to restricted stock units and performance stock units was approximately $2,144, which is expected to be recognized over a weighted average period of approximately 1.61 years.

 

Intangible Assets

 

The Company holds various trademarks including Cherokee®, Liz Lange®, Completely Me by Liz Lange®, Hawk®, Tony Hawk®, Everyday California®, Flip Flop Shops®, Sideout®, Sideout Sport®, Carole Little®, Saint Tropez-West®, Chorus Line®, All That Jazz®, and others, in connection with numerous categories of apparel and other goods. These trademarks are registered with the United States Patent and Trademark Office and corresponding government agencies in a number of other countries. The Company also holds trademark applications for Cherokee, Liz Lange, Completely Me by Liz Lange, Hawk, Tony Hawk, Everyday California, Flip Flop Shops, Sideout, Sideout Sport, Carole Little, Saint Tropez-West, Chorus Line, All That Jazz, and others, in numerous countries. The Company intends to renew these registrations, as appropriate, prior to expiration. The Company monitors on an ongoing basis unauthorized uses of the Company’s trademarks, and relies primarily upon a combination of trademark, copyright, know-how, trade secrets, and contractual restrictions to protect the Company’s intellectual property rights both domestically and internationally. Refer to Note 7 “Subsequent Events” as it relates to intangible assets.

Trademark registration and renewal fees are capitalized and are amortized on a straight-line basis over the estimated useful lives of the assets. Trademark acquisitions are capitalized and are either amortized on a straight-line basis over the estimated useful lives of the assets, or are capitalized as indefinite-lived assets, if no legal, regulatory, contractual, competitive, economic, or other factors limit their useful lives to Cherokee. Trademarks are evaluated for the possibility of impairment at least annually or when events or circumstances indicate a potential impairment.

Franchise agreements have been treated as finite-lived and are amortized on a straight-line basis over the estimated useful lives of the agreements. Franchise agreements are evaluated for the possibility of impairment at least annually or when events or circumstances indicate a potential impairment.

Goodwill is evaluated for the possibility of impairment at least annually or when events or circumstances indicate a potential impairment.

Intangible assets consist of the following:

 

 

Fair Value of Financial Instruments

 

Authoritative guidance defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The guidance establishes a fair value hierarchy, which prioritizes the inputs used in measuring fair value into three broad levels as follows:

 

Level 1:  Observable inputs, such as quoted prices for identical assets or liabilities in active markets

 

Level 2:  Other inputs that are observable directly or indirectly, such as quoted prices for similar assets or liabilities or market-corroborated inputs

 

Level 3:  Unobservable inputs for which there is little or no market data, which require the owner of the assets or liabilities to develop its own assumptions about how market participants would price these assets or liabilities

 

The carrying amount of receivables, accounts payable and accrued liabilities approximates fair value due to the short-term nature of these instruments. Long-term debt approximates fair value due to the variable rate nature of the debt.

 

The realizability of long-lived assets is evaluated periodically as events or circumstances indicate a possible inability to recover the carrying amount. Long-lived assets that will no longer be used in the business are written off in the period identified since they will no longer generate any positive cash flows for the Company. Periodically, long-lived assets that will continue to be used by the Company need to be evaluated for recoverability when events or circumstances indicate a potential impairment. Such evaluation is based on various analyses, including cash flow and profitability projections. The analyses involve management judgment. In the event the projected undiscounted cash flows are less than the net book value of the assets, the carrying value of the assets will be written down to their estimated fair value, in accordance with authoritative guidance. The estimated undiscounted cash flows used for this nonrecurring fair value measurement are considered a Level 3 input, which consist of unobservable inputs that reflect assumptions about how market participants would price the asset or liability. These inputs would be based on the best information available, including the Company’s own data.

 

Income Taxes

 

Income tax benefit of $489 was recognized for the Third Quarter, resulting in an effective tax rate of 35.9% in the Third Quarter, as compared to 34.2% in the third quarter of Fiscal 2016 and compared to 34.1% for the full year of Fiscal 2016. The effective tax rate for the Third Quarter differs from the statutory rate due to the effect of certain permanent nondeductible expenses, the apportionment of income among state jurisdictions, and the benefit of certain tax credits.

 

In accordance with authoritative guidance, interest and penalties related to unrecognized tax benefits are included within the provision for taxes in the consolidated statements of operations. The total amount of interest and penalties recognized in the consolidated statements of operations for the Third Quarter was $0 as compared with $(36) in the third quarter of Fiscal 2016. As of October 29, 2016 and January 30, 2016, the total amount of accrued interest and penalties included in the liability for unrecognized tax benefits was $0.

 

The Company files income tax returns in the U.S. federal and California and certain other state jurisdictions. For federal income tax purposes, the fiscal year ended February 2, 2013 and later tax years remain open for examination by the tax authorities under the normal three year statute of limitations. For state tax purposes, the fiscal year ended January 28, 2012 and later tax years remain open for examination by the tax authorities under a four year statute of limitations.

 

Marketing and Advertising

 

Generally, the Company’s licensees fund their own advertising programs. Cherokee’s marketing, advertising and promotional costs were approximately $1,059 and $858 for the nine month periods ended October 29, 2016 and October 31, 2015, respectively. These costs are expensed as incurred and were accounted for as selling, general and administrative expenses.

 

The Company provides marketing expense money to certain large licensees based upon sales criteria to help them build the Company’s licensed brands in their respective territories, thus providing an identifiable benefit to Cherokee. The amounts paid for such marketing expenses during the nine month periods ended October 29, 2016 and October 31, 2015 were approximately $521 and $396, respectively, and are included in the Company’s total marketing, advertising and promotional costs.

 

Deferred Rent and Lease Incentives

 

When a lease includes lease incentives (such as a rent abatement) or requires fixed escalations of the minimum lease payments, rental expense is recognized on a straight‑line basis over the term of the lease and the difference between the average rental amount charged to expense and amounts payable under the lease is included in deferred rent and lease incentives in the accompanying consolidated balance sheets. For leasehold allowances, the Company records a deferred lease credit on the consolidated balance sheets and amortizes the deferred lease credit as a reduction of rent expense in the consolidated statements of operations over the term of the lease.

Comprehensive Income (Loss)

 

Authoritative guidance establishes standards for reporting comprehensive income (loss) and its components in financial statements. Comprehensive income (loss), as defined, includes all changes in equity (net assets) during a period from non-owner sources. For the three and nine months ended October 29, 2016 and October 31, 2015, the Company had no comprehensive income (loss) components and accordingly, net income (loss) equals comprehensive income (loss).

 

Treasury Stock

 

Repurchased shares of the Company’s common stock are held as treasury shares until they are reissued or retired. When the Company reissues treasury stock, and the proceeds from the sale exceed the average price that was paid by the Company to acquire the shares, the Company records such excess as an increase in additional paid-in capital.

 

Conversely, if the proceeds from the sale are less than the average price the Company paid to acquire the shares, the Company records such difference as a decrease in additional paid-in capital to the extent of increases previously recorded, with the balance recorded as a decrease in retained earnings.

 

Additionally, if treasury stock is retired, the excess of repurchase price over par value is recorded as a decrease in retained earnings.

(3)   Debt

 

Credit Agreement with JPMorgan Chase

 

On September 4, 2012, Cherokee and JPMorgan Chase Bank, N.A. (“JPMorgan”) entered into a credit agreement (as amended, the “Credit Agreement”), which was amended on January 31, 2013 in connection with the Company’s acquisition of rights related to the Cherokee brand in the school uniforms category, was further amended on January 10, 2014 in connection with the Company’s acquisition of the Hawk and Tony Hawk brands, was further amended on October 13, 2015 in connection with the Company’s acquisition of the Flip Flop Shops trademark, brand name and franchisee relationships and was further amended on May 27, 2016 to extend the maturity dates of the amounts owed under the Credit Agreement and to permit the Company to make stock repurchases in an aggregate amount not to exceed $1,000 without obtaining JPMorgan’s prior consent.

 

As of October 29, 2016, Cherokee’s total borrowings under the Credit Agreement totaled approximately $17,211 and are evidenced by: (i) a term note that was originally issued as of September 4, 2012 (as amended, the “2013 Term Note”), which was issued in the principal amount of $16,600 and of which approximately $3,544 was outstanding as of October 29, 2016; (ii) a term note that was originally issued as of January 10, 2014 (as amended, the “2014 Term Note”), which was issued in the principal amount of $19,000 and of which approximately $8,867 was outstanding as of October 29, 2016; (iii) a term note that was originally issued October 13, 2015 (as amended, the “2015 Term Note” and, together with the 2013 Term Note and the 2014 Term Note, the “Term Notes”), which was issued in the principal amount of $6,000 and of which approximately $4,800 was outstanding as of October 29, 2016; and (iv) a line of credit note that was originally issued as of September 4, 2012 (as amended, the “Revolver”) which provides Cherokee with a revolving line of credit in the principal amount of $2,000,  none of which was outstanding as of October 29, 2016. Pursuant to amendments to the Credit Agreement, the Term Notes and the Revolver dated May 27, 2016, the maturity dates thereof were amended as follows: (i) the maturity date of the 2013 Term Note is August 31, 2017; (ii) the maturity date of the 2014 Term Note is December 31, 2018; (iii) the maturity date of the 2015 Term Note is October 13, 2020; and (iv) if any amounts are outstanding thereunder, the maturity date of the Revolver is June 30, 2017. The principal outstanding under each Term Note is to be repaid on a quarterly basis in equal principal installments, with any remaining principal balance due on the maturity date of the Term Note. The Term Notes bear interest equal to either: (i) an adjusted annual LIBOR rate reset monthly, bi-monthly or quarterly, plus 2.75% or 3.00% depending on the applicable senior funded debt ratio or (ii) JPMorgan’s annual prime rate or such annual prime rate plus 0.25% depending on the applicable senior funded debt ratio, with a floor equal to the 1 month LIBOR rate plus 2.5%. Pursuant to the Credit Agreement, the definition of “senior funded debt ratio” requires that Cherokee not exceed a ratio equal to (i) 2.25 to 1.00 until the fiscal quarter ended January 30, 2016, and (ii) 2.00 to 1.00 thereafter.

 

Consistent with the existing terms of the Credit Agreement, the amounts owed thereunder are secured by continuing security agreements, trademark security agreements and continuing guarantees executed by Cherokee and its subsidiaries, as applicable. In addition, the Credit Agreement includes various restrictions and covenants regarding the operation of Cherokee’s business, including covenants that require Cherokee to obtain JPMorgan’s consent in certain circumstances before Cherokee can: (i) incur additional indebtedness, (ii) make acquisitions, mergers or consolidations in excess of $5,000 on an aggregate basis, (iii) issue any equity securities other than pursuant to Cherokee’s employee equity incentive plans or programs or (iv) repurchase or redeem any outstanding shares of common stock, other than stock repurchases in an aggregate amount not to exceed $1,000, or pay dividends or other distributions, other than stock dividends, to Cherokee’s stockholders. The Credit Agreement also imposes financial covenants, including: (i) a minimum “fixed charge coverage ratio” of at least 1.2 to 1.0 and (ii) a limitation of Cherokee’s “senior funded debt ratio” as described above. Further, Cherokee has granted a security interest in favor of JPMorgan in all of Cherokee’s assets (including trademarks) as collateral for the amounts borrowed under the Credit Agreement. As of October 29, 2016, the Company was in compliance with its financial and other covenants under the Credit Agreement. If an event of default occurs under the Credit Agreement that is not forborne, cured or waived in accordance with the terms of the Credit Agreement, JPMorgan has the right to terminate its obligations under the Credit Agreement, accelerate the payment on any unpaid balance of the Credit Agreement and exercise any other rights it may have, including foreclosing on our assets under the related security agreements.  

 

Refer to Note 7 “Subsequent Events” as it relates to credit agreements.

 

 

(4)   Commitments and Contingencies

 

Trademark Indemnities

 

Cherokee indemnifies certain customers against liability arising from third- party claims of intellectual property rights infringement related to the Company’s trademarks. These indemnities appear in the licensing agreements with the Company’s customers, are not limited in amount or duration and generally survive the expiration of the contracts. Given that the amount of any potential liabilities related to such indemnities cannot be determined until an infringement claim has been made, the Company is unable to determine the range of estimated losses that it could incur related to such indemnifications.

 

Litigation Reserves

 

Estimated amounts for claims that are probable and can be reasonably estimated are recorded as liabilities in the consolidated balance sheets. The likelihood of a material change in these estimated reserves would be dependent on new claims as they may arise and the expected probable favorable or unfavorable outcome of each claim. As additional information becomes available, the Company assesses the potential liability related to new claims and existing claims and revises estimates as appropriate. As new claims arise or existing claims evolve, such revisions in estimates of the potential liability could materially impact the Company’s results of operations and financial position. The Company may also be involved in various other claims and other matters incidental to the Company’s business, the resolution of which is not expected to have a material adverse effect on the Company’s financial position or results of operations. No material amounts were accrued as of October 29, 2016 or January 30, 2016 related to any of the Company’s legal proceedings.

 

(5)   Segment Reporting

 

Authoritative guidance requires public companies to report financial and descriptive information about their reportable operating segments. The Company identifies reportable segments based on how management internally evaluates financial information, business activities and management responsibility.

 

The Company operates in a single business segment, the marketing and licensing of brand names and trademarks for apparel, footwear and accessories. Cherokee’s marketing and licensing activities extend to brands that the Company owns and to brands owned by others. Cherokee’s operating activities relating to owned and represented brands are identical and are performed by a single group of marketing professionals. While Cherokee’s principal operations are in the United States, the Company also derives royalty revenues from the Company’s international licensees and franchisees. Revenues by geographic area based upon the licensees’ country of domicile consisted of the following:

 

 

Long-lived tangible assets were located in the U.S., United Kingdom, Mexico and Asia with net values of approximately $787,  $99,  $215 and $23, respectively, as of October 29, 2016 and with net values of approximately $818,  $54,  $234 and $44, respectively, as of January 30, 2016.

 

(6) Stock Repurchases

 

Pursuant to the approval of our board of directors (“Board of Directors”), during the Second Quarter we repurchased and retired 60,082 shares of our common stock in open market transactions at a weighted average purchase price of $12.24 and for an aggregate purchase price of approximately $735.

 

 

(7)   Subsequent Events

 

Hi-Tec Acquisition

 

On November 29, 2016, the Company entered into a share purchase agreement (the “SPA”) with Sunningdale Corporation Limited (the “Seller”) and Irene Acquisition Company B.V., pursuant to which the Company agreed to acquire all of the issued and outstanding share capital of Hi-Tec Sports International B.V. (“Hi-Tec”) for a cash purchase price of 90,000 EURO on a cash-free debt-free basis, based on normalized working capital (the “Hi-Tec Acquisition”). The Hi-Tec Acquisition closed on December 7, 2016.

 

Hi-Tec and its subsidiaries are a Dutch footwear business that design, market and sell footwear globally, primarily under the Hi-Tec and Magnum brands. Hi-Tec sells its products through major retailers, independent distributors, licensees, government contracts and direct to consumer. Through the sale of certain of the operating assets of Hi-Tec and its subsidiaries to certain of Hi-Tec's operating partners and/or distributors (the “Sale Transactions”), the Company intends to convert the Hi-Tec business to a branded licensing model consistent with its business model of identifying and securing wholesale and retail licensing partners for the commercial exploitation of the intellectual property acquired, including the Hi-Tec and Magnum trademarks acquired and retained by the Company in the Hi-Tec Acquisition.

 

In connection with the closing of the Hi-Tec Acquisition, substantially all of the then-existing indebtedness of Hi-Tec has been repaid. The SPA contains customary warranties and indemnities for a Dutch transaction. Subject to certain carve-outs and qualifications as set forth in the SPA and subject to certain limited exceptions, the Company’s recourse for breaches of warranties under the SPA will be to a warranty and indemnity insurance policy.

 

The Company funded the purchase price of the Hi-Tec Acquisition through cash on hand, proceeds from the Sale Transactions, the prepayment of the first year of guaranteed minimum royalties under license agreements with certain operating partners and/or distributors of Hi-Tec, net proceeds of a public offering of the Company’s common stock, proceeds from a new credit facility with Cerberus, and proceeds from a receivables funding loan extended by one of the Company’s directors, each of which is described below.

 

Sale Transactions and License Agreements

 

On November 29, 2016, the Company and/or its affiliated entities entered into sales agreements with operating partners and/or distributors of Hi-Tec, including Carolina Footwear Group, LLC and Batra Limited. These sales agreements provide for the sale of certain of the operating assets of Hi-Tec and its subsidiaries to these operating partners and/or distributors. The aggregate cash purchase price of the Sale Transactions is approximately $25,000, based on expected working capital and subject to certain post-closing adjustments. The Sales Transactions closed approximately concurrently with the closing of the Hi-Tec Acquisition on December 7, 2016.

 

Consistent with the Company’s planned conversion of the Hi-Tec business, the Company continues to own the intellectual property assets of Hi-Tec following the Sale Transactions, and certain of the operating partners and/or distributors have entered into license agreements with the Company to license certain trademarks of Hi-Tec from, and pay royalties to, the Company. Under the associated license agreements, certain of the operating partners and/or distributors of Hi-Tec have licensed certain trademarks of Hi-Tec in the United States, Canada, the United Kingdom, continental Europe, South Africa and other jurisdictions in Africa. The Company used the prepayment of the first year of guaranteed minimum royalties under these license agreements to pay approximately $7,000 of the purchase price for the Hi-Tec Acquisition.

 

Public Offering

 

On November 29, 2016, the Company entered into an underwriting agreement with Roth Capital Partners, LLC (the “Underwriter”) relating to the firm commitment public offering (the “Offering”) of 4,237,750 shares of the Company’s common stock, including an additional 552,750 shares of its common stock to cover over-allotments, at a public offering price of $9.50 per share for net proceeds to the Company of approximately $38,000, after deducting the underwriting discount and estimated offering expenses payable by the Company. The Offering closed on December 2, 2016 and the net proceeds of the Offering have been used to fund a portion of the purchase price for the Hi-Tec Acquisition.

 

Cerberus Credit Facility

 

On December 7, 2016, in connection with the closing of the Hi-Tec Acquisition, the Company entered into a senior secured credit facility with Cerberus, as administrative agent and collateral agent for the lenders from time to time party thereto, pursuant to which the Company is permitted to borrow (i) up to $5,000 under a revolving credit facility, and (ii) up to $45,000 under a term loan facility. Also on December 7, 2016, the Company utilized $45,000 under the Cerberus term loan facility and has used a portion of such borrowings to fund the Hi-Tec Acquisition, including the repayment of the outstanding indebtedness of Hi-Tec, and, as described in Note 3 above, to repay all amounts owed under the Credit Agreement with JPMorgan. The Company expects to use the remaining amount of borrowings under the Cerberus credit facility for general working capital.

 

The Cerberus credit facility is secured by a first priority lien on, and security in, substantially all of the Company’s assets and those of the Company’s subsidiaries, is guaranteed by our subsidiaries and has a five-year term. The Cerberus credit facility bears interest at a rate per annum equal to either the rate of interest publicly announced from time to time by JPMorgan in New York, New York as its reference rate, base rate or prime rate or LIBOR plus, in each

case, the applicable margin and subject to the applicable rate floor. Borrowings under the Cerberus credit facility are subject to certain maintenance and other fees. The terms of the Cerberus credit facility include financial covenants that set financial standards the Company will be required to maintain and operating covenants that impose various restrictions and obligations regarding the operation of the Company’s business, including covenants that require the Company to obtain Cerberus’s consent before the Company can take certain specified actions.

 

Receivables Funding Loan

 

On December 7, 2016, in connection with the closing of the Hi-Tec Acquisition, the Company entered into an unsecured receivables funding loan agreement for $5,000 with Jess Ravich, the Chairman of the Board of Directors. The receivables funding loan bears interest at a rate of 9.5% per annum and is subject to a fee equal to 2.5% of the principal amount of the loan, of approximately $125, which was paid at closing. The outstanding principal and accrued interest under the receivables funding loan will be due and payable 180 days after the closing of the Hi-Tec Acquisition. The proceeds of the receivables funding loan have been used to fund a portion of the purchase price for the Hi-Tec Acquisition. The Company expects that certain accounts receivable assets that are expected to be collected in the ordinary course of business will be used to repay the receivables funding loan.  

 

 

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

 

The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (this “MD&A”) should be read together with the unaudited condensed consolidated financial statements and the related notes included in this report. For additional context with which to understand our financial condition and results of operations, refer to the MD&A for the fiscal year ended January 30, 2016 contained in our 2016 Annual Report on Form 10-K, which was filed with the Securities and Exchange Commission (“SEC”) on April 14, 2016, as well as the consolidated financial statements and notes contained therein (collectively, our “Annual Report”).  In addition to historical information, this MD&A contains forward-looking statements based upon our current views, expectations and assumptions that are subject to risks and uncertainties. Actual results may differ substantially from those expressed or implied by any forward-looking statements due to a number of factors, including, among others, the risks described in Part II, Item 1A, “Risk Factors” and elsewhere in this report. In preparing this MD&A, we presume that readers have access to and have read the MD&A in our Annual Report pursuant to Instruction 2 to paragraph (b) of Item 303 of Regulation S-K. We undertake no duty to update any of these forward-looking statements after the date we file this report to conform such forward-looking statements to actual results or revised expectations, except as otherwise required by law.

 

As used in this MD&A and elsewhere in this report, “Cherokee”, the “Company”, “we”, “us” and “our” refer to Cherokee Inc. and its consolidated subsidiaries, unless the context indicates or requires otherwise. Additionally, as used herein, the term “First Quarter” refers to the three months ended April 30, 2016; the term “Second Quarter” refers to the three months ended July 30, 2016; the term “Third Quarter” refers to the three months ended October 29, 2016; the term “Nine Months” refers to the nine months ended October 29, 2016; the term “Fiscal 2018” refers to the fiscal year ending February 3, 2018; the term “Fiscal 2017” refers to the fiscal year ending January 28, 2017; the term “Fiscal 2016” refers to the fiscal year ending January 30, 2016; and the term “Fiscal 2015” refers to fiscal year ended January 31, 2015.

 

We have a 52- or 53-week fiscal year ending on the Saturday nearest to January 31, which aligns us with our retail 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. Each of Fiscal 2016 and Fiscal 2017 is a 52-week fiscal year.  Certain of our international licensees report royalties to us for quarterly and annual periods that may differ from ours. We do not believe that the varying quarterly or annual period ending dates of 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.

 

We own the registered trademarks or trademark applications for Cherokee®, Liz Lange®, Completely Me by Liz Lange®, Hawk®, Tony Hawk®, Everyday California®, Flip Flop Shops®, Hi-Tec®, Magnum®, Sideout®, Sideout Sport®, Carole Little®, Saint Tropez-West®, Chorus Line®, All That Jazz®, and others. All other trademarks, trade names and service marks included in this MD&A or elsewhere in this report are the property of their respective owners.

 

Overview

Cherokee is a global marketer and manager of a portfolio of fashion and lifestyle brands it owns or represents, licensing the Cherokee, Liz Lange, Completely Me by Liz Lange, Hawk, Tony Hawk, Sideout, Carole Little, Everyday California, Flip Flop Shops, Hi-Tec and Magnum and related trademarks and other brands in multiple consumer product categories and sectors. We are one of the leading global licensors of style focused lifestyle brands for apparel, footwear, home products and accessories. As part of our business strategy, we frequently evaluate other brands and trademarks for acquisition into our portfolio. We enter into license agreements with recognizable retail partners in their respective global locations to provide them the rights to design, manufacture and sell products bearing our brands and to provide them our proprietary 360-degree platform. We refer to this strategy as our “Direct to Retail” or “DTR” licensing model. We have also entered into wholesale arrangements for the manufacture and sale of products bearing certain of our brands, including eight new wholesale arrangements with distributors and anticipate they will begin selling product at retail bearing our Cherokee brand at retail in the United States in early Fiscal 2018. In addition, we have franchise relationships for the Flip Flop Shops brand with franchisees that operate Flip Flop Shops retail stores located worldwide.

 

We believe our retail responsiveness process and 360-degree unique value proposition have allowed us to address the growing power of the consumer and the present and future needs of the retailers that are selling our portfolio of lifestyle brands. Based on consumer research, retail insights and brand insights that we continually measure, evaluate and incorporate into our 360-degree platform, we believe we have become a key strategic partner to our licensees. As of October 29, 2016,  we had forty-five effective license agreements covering domestic and international markets, twenty-six of which pertained to the Cherokee brand. 

We derive revenues primarily from licensing our trademarks to retailers all over the world. Our current retail licensee relationships cover over fifty countries and include relationships with Target Corporation (“Target”), Kohl’s Illinois, Inc. (“Kohl’s”), RT Mart, Comercial Mexicana, TJ Maxx, Tottus, Pick N Pay, Argos, Nishimatsuya, Walmart Canada and Sears Canada. Our two most significant licensees are Target and Kohl’s.

Recent Developments

 

Hi-Tec Acquisition and Related Transactions

 

Hi-Tec Acquisition

 

On November 29, 2016, we entered into a share purchase agreement (the “SPA”) with Sunningdale Corporation Limited (the “Seller”) and Irene Acquisition Company B.V., pursuant to which we agreed to acquire all of the issued and outstanding share capital of Hi-Tec Sports International B.V. (“Hi-Tec”) for a cash purchase price of 90 million EURO on a cash-free debt-free basis, based on normalized working capital (the “Hi-Tec Acquisition”). Subject to post-closing adjustments, and after giving effect to the sale of certain of the operating assets of Hi-Tec and its subsidiaries to certain of Hi-Tec's operating partners and/or distributors (the “Sale Transactions,”), the purchase price for the Hi-Tec intellectual property assets to be retained by us is approximately $62.0 million. The Hi-Tec Acquisition closed on December 7, 2016.

 

Hi-Tec and its subsidiaries are a Dutch footwear business that design, market and sell footwear globally, primarily under the Hi-Tec and Magnum brands. Hi-Tec sells its products through major retailers, independent distributors, licensees, government contracts and direct to consumer. Through the Sale Transactions, we intend to convert the Hi-Tec business to a branded licensing model consistent with its business model of identifying and securing wholesale and retail licensing partners for the commercial exploitation of the intellectual property acquired, including the Hi-Tec and Magnum trademarks acquired and retained by us in the Hi-Tec Acquisition.

 

In connection with the closing of the Hi-Tec Acquisition, substantially all of the then-existing indebtedness of Hi-Tec has been repaid. The SPA contains customary warranties and indemnities for a Dutch transaction. Subject to certain carve-outs and qualifications as set forth in the SPA and subject to certain limited exceptions, our recourse for breaches of warranties under the SPA will be to a warranty and indemnity insurance policy.

 

We funded the purchase price of the Hi-Tec Acquisition through cash on hand, proceeds from the Sale Transactions, the prepayment of the first year of guaranteed minimum royalties under license agreements with certain operating partners and/or distributors of Hi-Tec, net proceeds of a public offering of our common stock, proceeds from a new credit facility with Cerberus, and proceeds from a receivables funding loan extended by one of our directors, each of which is described below.

 

Sale Transactions and License Agreements

 

On November 29, 2016, we entered into sales agreements with operating partners and/or distributors of Hi-Tec, including Carolina Footwear Group, LLC and Batra Limited. These sales agreements provide for the sale of certain of the operating assets of Hi-Tec and its subsidiaries to these operating partners and/or distributors. The aggregate cash purchase price of the Sale Transactions is approximately $25.0 million, based on expected working capital and subject to certain post-closing adjustments. The Sales Transactions closed approximately concurrently with the closing of the Hi-Tec Acquisition on December 7, 2016.

 

Consistent with our planned conversion of the Hi-Tec business, we continues to own the intellectual property assets of Hi-Tec following the Sale Transactions, and certain of the operating partners and/or distributors have entered into license agreements with us to license certain trademarks of Hi-Tec from, and pay royalties to, us. Under the associated license agreements, certain of the operating partners and/or distributors of Hi-Tec have licensed certain trademarks of Hi-Tec in the United States, Canada, the United Kingdom, continental Europe, South Africa and other jurisdictions in Africa. We used the prepayment of the first year of guaranteed minimum royalties under these license agreements to pay approximately $7.0 million of the purchase price for the Hi-Tec Acquisition.

 

Public Offering

 

On November 29, 2016, we entered into an underwriting agreement with Roth Capital Partners, LLC (the “Underwriter”) relating to the firm commitment public offering (the “Offering”) of 4,237,750 shares of our common stock, including an additional 552,750 shares of its common stock to cover over-allotments, at a public offering price of $9.50 per share for net proceeds to us of approximately $38.0 million, after deducting the underwriting discount and estimated offering expenses payable by us. The Offering closed on December 2, 2016 and the net proceeds of the Offering have been used to fund a portion of the purchase price for the Hi-Tec Acquisition.

 

Cerberus Credit Facility

 

On December 7, 2016, in connection with the closing of the Hi-Tec Acquisition, we entered into a senior secured credit facility with Cerberus, as administrative agent and collateral agent for the lenders from time to time party thereto, pursuant to which we are permitted to borrow (i) up to $5.0 million under a revolving credit facility, and (ii) up to $45.0 million under a term loan facility. Also on December 7, 2016, we utilized $45.0 million under the Cerberus term loan facility and has used a portion of such borrowings to fund the Hi-Tec Acquisition, including the repayment of the outstanding indebtedness of Hi-Tec, and, as described in Note 3 above, to repay all amounts owed under the Credit Agreement with JPMorgan. We expect to use the remaining amount of borrowings under the Cerberus credit facility for general working capital.

 

The Cerberus credit facility is secured by a first priority lien on, and security in, substantially all of our assets and those of our subsidiaries, is guaranteed by our subsidiaries and has a five-year term. The Cerberus credit facility bears interest at a rate per annum equal to either the rate of interest publicly announced from time to time by JPMorgan in New York, New York as its reference rate, base rate or prime rate or LIBOR plus, in each case, the applicable margin and subject to the applicable rate floor. Borrowings under the Cerberus credit facility are subject to certain maintenance and other fees. The terms of the Cerberus credit facility include financial covenants that set financial standards we will be required to maintain and operating covenants that impose various restrictions and obligations regarding the operation of the Company’s business, including covenants that require us to obtain Cerberus’s consent before we can take certain specified actions.

 

Receivables Funding Loan

 

On December 7, 2016, in connection with the closing of the Hi-Tec Acquisition, we entered into an unsecured receivables funding loan agreement for $5.0 million with Jess Ravich, the Chairman of the Board of Directors. The receivables funding loan bears interest at a rate of 9.5% per annum and is subject to a fee equal to 2.5% of the principal amount of the loan, of $0.1 million, which was paid at closing. The outstanding principal and accrued interest under the receivables funding loan will be due and payable 180 days after the closing of the Hi-Tec Acquisition. The proceeds of the receivables funding loan have been used to fund a portion of the purchase price for the Hi-Tec Acquisition. We expect that certain accounts receivable assets that are expected to be collected in the ordinary course of business will be used to repay the receivables funding loan.

 

Stock Repurchases

 

Pursuant to the approval of our board of directors (“Board of Directors”) in June 2016, we repurchased and retired 60,082 shares of our common stock in open market transactions at a weighted average purchase price of $12.24 and for an aggregate purchase price of approximately $735,000.

 

New Licensee Partners

 

During the Nine Months, we have acquired new licensees for our brands in the United States in an effort to expand our portfolio of licensee partners. Below is a discussion of certain license agreements that we entered into in the Nine Months:

 

Cherokee

 

In the Nine Months, we entered into license agreements with nine wholesale distributors to distribute a variety of categories of products bearing the Cherokee brand within the U.S. to various retailers beginning in Fiscal 2018. The categories cover a wide range of Cherokee products including men’s and boy’s casual sportswear, sweaters and outerwear; newborn, infant and toddler boys and girls clothing and layette; girl’s active wear, sportswear, dresses, denim, and sweaters; and swimwear and sleepwear.

 

We believe these agreements signal a significant shift in our future strategy for sales of products bearing the Cherokee brand in the U.S., which currently and in the past has been governed by license arrangements using our Direct to Retail licensing model and which, commencing in early Fiscal 2018 will be governed by our new wholesale arrangements with distributors as they begin selling product at retail bearing our Cherokee brand. Our new wholesale arrangements for the Cherokee brand in the U.S. consist of multiple license agreements at higher royalty rates as compared to one license agreement with Target at a lower and declining, tiered royalty rate but a higher minimum annual royalty obligation. Our shift to a wholesale licensing model for sales in the U.S. of Cherokee-branded products exposes us to a number of risks. See Item 1A, “Risk Factors”, for additional information.

 

Multi-Brand

 

Star Brands

 

In August 2016, we entered into a license agreement with Star Brands. This agreements covers a broad range of apparel and other products for the Cherokee, Tony Hawk, Sideout and Liz Lange brands in Brazil.

 

Critical Accounting Policies and Estimates

 

There has been no material change to our critical accounting policies and estimates from the information provided in our Annual Report.

 

This MD&A is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). The preparation of these financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. Management evaluates its estimates and assumptions on an ongoing basis. Management bases its estimates on historical and anticipated results, trends and various other assumptions that are believed to be reasonable under the circumstances, including expectations about future events. These estimates form the basis for making assumptions about the carrying values of assets and liabilities that are not readily apparent from other sources. By their nature, estimates are subject to an inherent degree of uncertainty. Actual results could differ materially 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:

 

 

 

 

 

 

 

Refer to our Annual Report and Note 2 to the consolidated financial statements included in this report 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.

 

See Note 2 to our consolidated financial statements included in this report for a description of recent accounting pronouncements.

 

Results of Operations

 

The table below sets forth certain of our consolidated financial data for the periods indicated. Historical results are not necessarily indicative of results to be expected in the current period or in future periods.

 

 

 

Revenues

 

In the three and nine month periods ended October 29, 2016, our revenues totaled $6.5 and $25.6 million, respectively, compared to $8.1 and $26.8 million in the three and nine month periods ended October 31, 2015, respectively. The decrease in revenues between periods was principally due to a decrease in North American royalties as we transition from Target to our new wholesale licensing partners for sales of Cherokee branded products in the United States. The decrease is partially offset by an increase in royalties from our licensees in South America, India, the Middle East, South Africa and Asia as the demand for Cherokee-branded and other products continues to grow, as well as a full quarter of Flip Flop Shops franchise royalties as compared to a partial quarter in the prior year period (as we acquired the Flip Flop Shops brand in October 2015). Revenues for periods were primarily generated from licensing our trademarks to retailers and, to a lesser extent, to wholesalers, our share of licensing revenues from brand representation licensing agreements with other brand owners and franchise fees and royalty revenues received from franchisees of our Flip Flop Shops brand in periods after October 2015.

 

Because we do not have direct oversight over our licensees and franchisees, we may not have all the information necessary to assess the impact on our operations of changes in price, volume or amount of products sold or the introduction of new products, or to otherwise determine or predict the specific reasons why revenue may increase or decrease in any given period.

 

In the Nine Months, we entered into several new wholesale licensing arrangements covering sales of products bearing our Cherokee brand in the U.S. We anticipate that these wholesale licensing arrangements will help to diversify our sources of revenue and licensee or other partner relationships and provide additional avenues to obtain brand recognition and grow our Company. For further discussion on wholesale licensing arrangements, see Item 1A, “Risk Factors”.

Given our contractual royalty rate reductions as certain sales volume thresholds are achieved by Target for Cherokee branded products in various product categories in the U.S., historically, this has caused the Company to record its highest revenues and profits in its first quarter and its lowest revenues and profits in its fourth quarter. However, in Fiscal 2018, and in future fiscal years, we do not anticipate this trend to continue due to the expiration of the Target license agreement at the end of Fiscal 2017. As a result, beginning in Fiscal 2018, we will no longer be subject to royalty rate reductions over the course of the year for sales of our Cherokee branded products in the U.S., as our new wholesale license agreements covering these products include a fixed royalty rate that is consistent throughout the year. As U.S. wholesalers and retailers, including our new wholesale licensees, typically record their highest sales in the fourth quarter for the holiday season, we anticipate that our performance in future periods could be more strongly influenced by this seasonality of the retail business and potentially subject to more material fluctuations between periods. Any continuation of the Company’s historical revenue and profit patterns or development of any new revenue or profit patterns will depend upon, among other things, the terms of the Company’s license and franchise agreements, including the Target license agreement through the remainder of Fiscal 2017, the terms of any new license or franchise agreements, and retail sales volumes achieved from Target in the remaining quarter of its agreement and the Company’s other licensees and franchisees that are not subject to reduced royalty rates based upon cumulative sales.

 

During Fiscal 2015 and Fiscal 2016, Target reached its annual minimum guarantee of $10.5 million in the third quarter of each respective year. Due to the expiration of the Target license agreement at the end of Fiscal 2017, Target has transitioned away from sales of the Cherokee brand as we approach the expiration of this license agreement. Because retail sales did not exceed the contractual minimum guarantee in the Third Quarter, royalty revenues from our Cherokee brand at Target were $1.1 million, which is the recognition of the balance of the minimum guarantee over the final two quarters of the contract. Cherokee-brand royalties received from Target during the first nine months of Fiscal 2017 were $9.4 million with the balance of the minimum guarantee of $10.5 million expected to be recorded during the fourth quarter of Fiscal 2017. As a result, we expect declining and/or minimal revenues from Target in fourth quarter of Fiscal 2017. However, we anticipate that we will record revenue in the fourth quarter of Fiscal 2017 from our new wholesale arrangements with our domestic licensees for Cherokee branded products as we expect them to begin delivering products to retailers during the fourth quarter, with our new retailer partnerships selling these products commencing in early Fiscal 2018. See Item 1A, “Risk Factors”, for additional information such as the risk of replacing Target’s royalty payments for Cherokee branded products on a long-term basis will be a significant challenge. 

 

We anticipate that our Flip Flop Shops brand contribution as a percentage of total revenues will increase in future periods as additional shops open. We anticipate revenues will fluctuate depending upon the number of shops opened both domestically and internationally in any given period, as well as royalty fluctuations based on seasonal demand, brand offerings, promotions and the number of existing shops open.

In December 2016, we completed the Hi-Tec Acquisition, in which we acquired the intellectual property assets of Hi-Tec, including the Hi-Tec and Magnum trademarks. In connection with the Hi-Tec Acquisition, we also entered into license agreements with certain of Hi-Tec’s operating partners and/or distributors. Under the license agreements, the operating partners and/or distributors have licensed certain trademarks of Hi-Tec in the United States, Canada, the United Kingdom, continental Europe, South Africa and other jurisdictions in Africa.

Revenues By Brand

 

The following table sets forth our revenues by brand for the three and nine months ended October 29, 2016 and October 31, 2015:

 

 

Geographic Revenues

 

The following table sets forth our geographic licensing revenues for the three and nine months ended October 29, 2016 and October 31, 2015: