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 28, 2017.

 

☐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, a smaller reporting company, or an emerging growth company.  See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

 

 

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) 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. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

CHEROKEE INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

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

 

 

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

 

CHEROKEE INC.

 

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

Unaudited

(amounts in thousands, except per share amounts)

 

 

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

CHEROKEE INC.

 

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE (LOSS) INCOME

Unaudited

(amounts in thousands)

 

 

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

CHEROKEE INC.

 

CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY

Unaudited

(amounts in thousands)

 

 

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

CHEROKEE INC.

 

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

Unaudited

(amounts in thousands)

 

 

 

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

CHEROKEE INC.

 

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Unaudited

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

 

(1)   Basis of Presentation

 

The accompanying unaudited condensed consolidated financial statements as of October 28, 2017 and for the three and nine month periods ended October 28, 2017 and October 29, 2016 have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) and Article 10 of Regulation S-X. The accompanying condensed consolidated financial statements include the accounts of Cherokee Inc. and its consolidated subsidiaries (referred to collectively as “Cherokee Global Brands” or the “Company” unless the context indicates or requires otherwise) and include all adjustments, consisting of normal recurring accruals, which in the opinion of management of Cherokee Global Brands are necessary for a fair statement of the Company’s financial condition and the results of operations for the periods presented. All intercompany accounts and transactions have been eliminated during the consolidation process. The accompanying consolidated balance sheet as of January 28, 2017 has been derived from audited consolidated financial statements, but does not include all disclosures required by GAAP for an audited balance sheet. The Company’s financial condition and results of operations as of or for the three and nine month periods ended October 28, 2017 are not necessarily indicative of the financial condition or results to be expected as of or for the fiscal year ending February 3, 2018 or any other date or 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 28, 2017 (“Annual Report”).

 

As used herein, “Third Quarter” refers to the three month period ended October 28, 2017; “Nine Months” refers to the nine month period ended October 28, 2017; “Fiscal 2019” refers to the fiscal year ending February 2, 2019; “Fiscal 2018” refers to the fiscal year ending February 3, 2018; “Fiscal 2017” refers to the fiscal year ended January 28, 2017; and “Fiscal 2016” refers to the fiscal year ended January 30, 2016.

 

Liquidity and Going Concern

 

The accompanying condensed consolidated financial statements have been prepared on the going concern basis of accounting, which assumes that the Company will continue to operate as a going concern and which contemplates the realization of assets and the satisfaction of liabilities and commitments in the normal course of business. As described in Note 8, the Company has entered into the Cerberus Credit Facility with Cerberus (each as defined below), pursuant to which the Company has borrowed $45,000 under a term loan facility, which the Company drew down in December 2016, and $5,000 under a revolving credit facility, which the Company drew down in the first quarter of Fiscal 2018. As of October 28, 2017, the Company had $48,400 in principal amount of outstanding indebtedness owed under the Cerberus Credit Facility.

 

As of October 28, 2017, the Company was not in compliance with certain of its financial covenants set forth in the Cerberus Credit Facility (see Notes 8 and 11) and there is substantial doubt about the Company’s ability to continue as a going concern.  Such compliance failure subjected the Company to significant risks as of October 28, 2017 and through the effective date of the November Cerberus Amendment (as defined below). These risks included Cerberus’s right to terminate its obligations under the Cerberus Credit Facility, declare all or any portion of the borrowed amounts then outstanding to be accelerated and due and payable, and/or exercise any other rights or remedies it may have under applicable law, including foreclosing on the Company’s and/or its subsidiaries assets that serve as collateral for the borrowed amounts. If any of these rights had been exercised, the Company’s financial condition and ability to continue operations would have been materially jeopardized.

 

However, subsequent to October 28, 2017, the Company and Cerberus agreed to the terms of an amendment to the Cerberus Credit Facility (the “November Cerberus Amendment”), which, as of its effectiveness, waived the compliance failures described above and amended certain terms of the Cerberus Credit Facility. As a result, as of the date of this report, the Company believes it is in compliance with the Cerberus Credit Facility.  During the fourth quarter

of Fiscal 2018 we will further evaluate our ability to meet our obligations as they come due over the next 12 months from year end and the successful amendment of the Cerberus Credit Facility is a critical part of management’s plans to meet its obligations as they come due. 

 

(2)   Summary of Significant Accounting Policies

 

Recent Accounting Pronouncements

 

In May 2014, the Financial Accounting Standards Board (“FASB”) issued a comprehensive new revenue recognition standard which will supersede previous existing revenue recognition guidance. The standard creates a five-step model for revenue recognition that requires companies to exercise judgment when considering contract terms and relevant facts and circumstances. The five-step model includes (1) identifying the contract, (2) identifying the separate performance obligations in the contract, (3) determining the transaction price, (4) allocating the transaction price to the separate performance obligations and (5) recognizing revenue when each performance obligation has been satisfied. The standard also requires expanded disclosures surrounding revenue recognition. During Fiscal 2017, the FASB issued additional clarification guidance on the new revenue recognition standard which also included certain scope improvements and practical expedients. The standard (including clarification guidance issued) is effective for fiscal periods beginning after December 15, 2017 and allows for either full retrospective or modified retrospective adoption. Early adoption is permitted for fiscal periods beginning after December 15, 2016. The Company is primarily engaged in the business of marketing and licensing the brands it owns or represents, as well as marketing and franchising the Flip Flop Shops brand.  These royalty revenues are recognized when earned. To date, the Company has performed a preliminary detailed review of key contracts and compared historical accounting policies and practices to the new standard. Based upon the preliminary results of our evaluation, the adoption of the new revenue recognition standard may impact the recognition of minimum guarantees earned under our royalty contracts. The Company plans to adopt this guidance using the modified retrospective method beginning in the first quarter of Fiscal 2019 and is continuing to evaluate the impact of the adoption of this standard on its consolidated financial statements and related disclosures.

In May 2017, the FASB issued authoritative guidance to provide clarity and reduce diversity in practice as well as cost and complexity when applying the guidance in Accounting Standards Codification (“ASC”) Topic 718, Compensation-Stock Compensation, in the event of a change to the terms or conditions of a share-based payment award. Under the new guidance, an entity should account for the effects of a modification unless all of the following are met:

The new guidance does not change the current disclosure requirements. The guidance is effective for annual periods beginning after December 15, 2017, and interim periods within those annual periods. Early adoption is permitted and should be applied prospectively to awards modified after the adoption date. The adoption of this guidance is not expected to have a material impact on the Company’s consolidated financial statements or related disclosures.    

Use of Estimates

 

The preparation of the accompanying condensed 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. On an ongoing basis, management evaluates its estimates and assumptions, including those related to allowance for doubtful accounts, revenue recognition, deferred revenue, income taxes,

valuation of intangible assets, impairment of long-lived assets, contingencies and litigation and stock-based compensation. Management 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.

Income Taxes

 

Income tax (benefit) expense of ($889) and $665 was recognized for the Third Quarter and the Nine Months, respectively, resulting in an effective tax rate of (26.1)%  and 6.8% in the Third Quarter and the Nine Months, respectively, compared to (35.9)% and 37.5% in the three and nine months ended October 29, 2016, respectively, and compared to (69.8)% for the full year of Fiscal 2017. The effective tax rate for the Third Quarter and the Nine Months differ from the statutory rate due to the effect of certain permanent nondeductible expenses, the change in valuation allowance recorded against certain foreign deferred tax assets, unrecognized tax benefits, amortization of tax deductible goodwill acquired in the Hi-Tec Acquisition (as defined in Note 3) that is not an available source of income to realize deferred tax assets, foreign tax rate differential, the apportionment of income among state jurisdictions, and the benefit of certain tax credits. The difference in the effective tax rate for the Third Quarter and the Nine Months in comparison to Fiscal 2017 was primarily due to nondeductible transaction costs related to the Hi-Tec Acquisition.  Since the transaction costs exceeded the Fiscal 2017 pretax book loss, the result was a significant fluctuation in the Fiscal 2017 effective tax rate.

In accordance with authoritative guidance, interest and penalties related to unrecognized tax benefits are included within the provision for taxes in the condensed consolidated statements of operations. The total amount of interest and penalties recognized in the consolidated statements of operations for the Third Quarter  and the Nine Months were $35 and $99, respectively, compared to $0 in each of the third quarter and the nine months of Fiscal 2017. As of October 28, 2017 and January 28, 2017, the total amount of accrued interest and penalties included in the liability for unrecognized tax benefits was $275 and $167, respectively.

 

The Company files income tax returns in the U.S. federal, California and certain other state jurisdictions, as well as in the Netherlands and other foreign jurisdictions. For U.S federal and Netherlands income tax purposes, the fiscal year ended February 1, 2014 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 February 2, 2013 and later tax years remain open for examination by the tax authorities under a four-year statute of limitations.

 

 

(3)   Business Combinations

 

On December 7, 2016, the Company closed under a Share Purchase Agreement (“SPA”) with Hi-Tec International Holdings BV (“Hi-Tec Holdings”) and simultaneous Asset Purchase Agreements (“APAs”) with various third parties, pursuant to which Cherokee Global Brands acquired all of the issued and outstanding equity interests of Hi-Tec Holdings for $87,252 in cash, excluding non-interest bearing liabilities assumed and capitalized transaction costs (the “Hi-tec Acquisition”). The Company has accounted for this transaction under ASC 805 as amended by Accounting Standards Update 2017-01.

For the year ended January 28, 2017, the Company also incurred restructuring charges of $3,782 related to the Hi-Tec Acquisition. Restructuring charges consisted of severance, contract termination and other restructuring-related costs. A liability for severance costs is typically recognized when the plan of termination has been communicated to the affected employees and is measured at its fair value at the communication date. Contract termination costs consist primarily of costs that will continue to be incurred under the contract for their remaining terms without economic benefit to the Company. A liability for lease obligations is recognized at the date the Company ceases using the rights conveyed by the lease contract and is measured at its fair value, which is determined based on the remaining contractual lease

rentals reduced by estimated sublease rentals. A liability for other restructuring-related costs is measured at its fair value in the period in which the liability is incurred.

 

 

The assets and liabilities recorded in the preliminary purchase price allocation for the Hi-Tec Acquisition are provisional, as the Company has not yet obtained all available information necessary to finalize the measurement of such assets and liabilities.  During the nine month period ended October 28, 2017, the Company recorded a working capital adjustment to goodwill of $149.  The measurement of acquired deferred income taxes has not been finalized as the Company is currently in the process of obtaining the necessary information to complete the analysis related to acquired net operating loss carryforwards, including the finalization of the assessment of available tax planning strategies.  In addition, the Company is also waiting on information related to certain pre-acquisition income tax filing positions of Hi-Tec in various taxing jurisdictions that will assist the Company in finalizing the amounts to record for the acquired deferred income taxes. The Company is also waiting on information to assist the Company in finalizing the recording of any assumed uncertain income tax positions. The Company is also finalizing the required working capital true-up in accordance with the SPA, and finalizing the settlement statements in relation to the APA’s. The final allocation of the purchase price is expected to be completed as soon as practicable, but no later than one year from the date of acquisition.  

(4)   Property and Equipment

 

Property and equipment consisted of the following:

 

 

Computers and related equipment and software are depreciated over three years. Furniture and store fixtures are depreciated over the shorter of five to 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 $156 and $560 for the three and nine month periods ended October 28, 2017, respectively,  and $137 and $393 for the three and nine month period ended October 29, 2016, respectively.

 

(5)   Intangible Assets

 

Intangible assets consisted of the following:

 

 

 

(6)   (Loss) Earnings Per Share

 

The following table provides a reconciliation of the numerator and denominator of the basic and diluted (loss) earnings per share (“EPS”) computations for the three and nine month periods ended October 28, 2017 and October 29, 2016:

 

 

The computation for the diluted number of shares excludes unvested restricted stock units, unexercised stock options and unexercised warrants that are anti-dilutive. There were 3,231 and 2,080 anti-dilutive shares for the three and nine month periods ended October 28, 2017, respectively, and 1,020 and 720 anti-dilutive shares for the three and nine month periods ended October 29, 2016, respectively.

 

(7)   Capitalization

 

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) 205,486 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 estimates the fair value of stock-based payment awards on the date of grant using an option-pricing model.

 

Stock-based compensation expense recognized in selling, general and administrative expenses for stock options for the Third Quarter and Nine Months was $220 and  $685, respectively, compared to $245 and $792 for the third quarter and nine months ended October 29, 2016, respectively.

 

The following table summarizes activity for the Company’s stock options in the Nine Months:

 

 

As of October 28, 2017, total unrecognized stock-based compensation expense related to unvested stock options was approximately $852, which is expected to be recognized over a weighted average period of approximately 1.41 years. The total fair value of all stock options that vested during the Nine Months was $870.

 

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 (“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 is to 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. The target average share price was not achieved for Fiscal 2017.

 

Since the vesting of these performance stock units 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 recognized in selling, general and administrative expenses for restricted stock units and performance stock units for the Third Quarter and Nine Months was $327 and $955, respectively, compared to $296 and $1,000 for the third quarter and nine months ended October 29, 2016.

 

The following table summarizes activity for the Company’s restricted stock units and performance stock units in the Nine Months:

 

 

As of October 28, 2017, total unrecognized stock-based compensation expense related to restricted stock units and performance stock units was approximately $862, which is expected to be recognized over a weighted average period of approximately 0.80 years.

August 2017 Financing

On August 11, 2017, the Company and several investors, including certain of the Company’s directors, officers and large stockholders, entered into common stock purchase agreements (the “Purchase Agreements”) to effect certain equity financings required by the August Cerberus Amendment, as described in Note 8. Pursuant to the terms of the Purchase Agreements, the investors agreed to purchase, and the Company agreed to issue and sell, an aggregate of 947,870 shares of the Company’s common stock in a private placement financing at a per share purchase price of $4.22 for net cash proceeds to the Company of approximately $4,000 (the “August 2017 Financing”). The August 2017 Financing closed on August 17, 2017.

 

In addition, pursuant to the terms of the Purchase Agreements, certain investors agreed to participate in certain subsequent equity financings (the “Committed Financings”), such that, if the Company notified any such investor on or before March 5, 2018 of a failure to meet a certain liquidity covenant set forth in the August Cerberus Amendment (see Note 8), then such investor would be obligated to purchase in a private placement financing additional shares of the Company’s common stock as requested at a per share purchase price equal to the lower of $4.22, 90% of the average closing price of the Company’s common stock for the 20 days prior to the date of the Company’s notification, or the closing price of the Company’s common stock on the day prior to the Company’s notification, subject to certain other conditions and caps, including that the aggregate number of shares issuable in the August 2017 Financing and the Committed Financings could not exceed 19.9% of the total number of shares of the Company’s common stock outstanding as of August 11, 2017. The maximum aggregate value of the commitments from all investors for the Committed Financings was approximately $5,500. As described in Note 11, the requirement to effect the Committed Financings has been eliminated from the Cerberus Credit Facility as of the effectiveness of the November Cerberus Amendment, and as a result, we do not expect to effect any Committed Financings.

 

Pursuant to the terms of the Purchase Agreements, and in consideration for the agreement of certain investors to participate in the Committed Financings, the Company issued to such investors certain warrants to purchase shares of the Company’s common stock, as further described under “Warrants” below.

 

Certain terms of the August 2017 Financing and the Committed Financing with respect to each of the Company’s directors, officers, large stockholders and other investors participating therein are as follows:

 

(1)Assumes the purchase by each investor of its maximum commitment in the Committed Financings. However, as described above and in Note 11, the requirement to effect the Committed Financings has been eliminated as of the  effectiveness of the November Cerberus Amendment, and as a result, the Company does not expect to effect any Committed Financings.

 

Warrants

Warrants Issued in Connection with Hi-Tec Acquisition

As of October 28, 2017, the Company had outstanding a warrant to purchase up to 120,000 shares of the Company’s common stock, which was issued on November 28, 2016 in connection with a customer license agreement for the Hi-Tec brand. The shares subject to the warrant vest in five tranches of 20,000 shares each corresponding to the five-year initial term of the related license agreement, plus a sixth tranche that vests only if the license agreement is renewed for a subsequent five-year period. The sixth tranche is assigned no value until such time as the related contingency is resolved. For the year ended January 28, 2017, the Company determined the fair value of this warrant to be $567. During the three and nine month periods ended October 28, 2017, the Company recognized contra-revenue and APIC of $13 and $39, respectively, related to the amortization of deferred expense related to this warrant.

 

Warrants Issued in August 2017 Financing

 

On August 17, 2017 and in connection with the August 2017 Financing, the Company issued to certain of the investors in such financing warrants to purchase up to an aggregate of 326,695 shares of the Company’s common stock at an exercise price of $4.22 per share. The warrants are exercisable at any time from March 5, 2018 until the seven-year anniversary of the initial issuance date, may be exercised in cash or on a “cashless” basis, and are subject to customary adjustments in the event of stock dividends or other distributions, stock splits, or mergers, reclassifications or similar transactions. As of October 28, 2017, the Company determined the fair value of these warrants to be $665, using a Black Scholes option pricing model. During the three and nine month periods ended October 28, 2017, the Company recognized warrant expense and additional paid in capital of $665. Warrant expense was recorded in our Selling, General and Administrative expenses.