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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-K
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[X] Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act
of 1934 for the fiscal year ended January 30, 1999
or
[_] Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934 for the Transition Period from _______ to _______
Commission file No. 0-18640
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CHEROKEE INC.
(Exact name of registrant as specified in charter)
Delaware 95-4182437
(State or other jurisdiction of (IRS Employer
incorporation or organization) Identification No.)
6835 Valjean Avenue
Van Nuys, CA 91406
(Address of principal executive office) (Zip Code)
(818) 908-9868
(Registrant's telephone number, including area code)
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Securities registered pursuant to Section 12(b) of the Act:
None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, $.02 par value per share
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 X No
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Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to
the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [_]
Applicable Only to Registrants Involved in Bankruptcy Proceedings During the
Preceding Five Years
Indicate by check mark whether the registrant has filed all documents and
reports required to be filed by Section 12, 13 or 15(d) of the Securities
Exchange Act of 1934 subsequent to the distribution of securities under a plan
confirmed by a court.
Yes X No
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As of April 14, 1999, the registrant had 8,705,428 shares of its Common
Stock, par value $.02 per share, issued and outstanding.
As of April 14, 1999, the aggregate market value of the voting stock held by
non-affiliates of the registrant was approximately $56,420,000 (computed on the
basis of the last trade of the Common Stock on the NASDAQ National Market
System on April 14, 1999).
Certain portions of the registrant's proxy statement for the Annual Meeting
of Stockholders to be held on June 14, 1999 are incorporated by this reference
into Part III as set forth herein.
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CHEROKEE INC.
INDEX
Page
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PART I
Item 1. Business...................................................... 2
Item 2. Properties.................................................... 14
Item 3. Legal Proceedings............................................. 14
Item 4. Submission of Matters to a Vote of Security Holders........... 14
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder
Matters....................................................... 15
Item 6. Selected Financial Data....................................... 16
Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operation...................................... 17
Item 7A. Qualitative and Quantitative Disclosures of Market Risk....... 22
Item 8. Consolidated Financial Statements and Supplementary Data...... 23
Item 9. Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure...................................... 24
PART III
Item 10. Directors and Executive Officers of the Registrant............ 24
Item 11. Executive Compensation........................................ 25
Item 12. Security Ownership of Certain Beneficial Owners and
Management.................................................... 25
Item 13. Certain Relationships and Related Transactions................ 25
PART IV
Item 14. Exhibits, Financial Statement Schedules and Reports on Form
8-K.......................................................... 26
1
PART I
Item 1. BUSINESS
Introduction
Cherokee Inc. (the "Company") is in the business of marketing and licensing
the Cherokee and Sideout brands and related trademarks and other brands it
owns. The Company is one of the leading licensors of brand names and trademarks
for apparel, footwear and accessories in the United States. The Company's
operating strategy emphasizes retail direct, wholesale and international
licensing whereby the Company grants retailers and wholesalers the license to
use the trademarks held by the Company on certain categories of merchandise,
and the licensees are responsible for manufacturing the merchandise subject to
approved quality, design and graphics. The Company and its wholly-owned
subsidiary, SPELL C. LLC ("Spell C"), hold several trademarks including
Cherokee(R), Sideout(R), Sideout Sport(R), King of the Beach(R) and others. The
Cherokee brand, which began as a footwear brand in 1973, has been positioned to
connote quality, comfort, fit, and a "Casual American" lifestyle with
traditional wholesome values. The Sideout brand and related trademarks, which
represent a beach-oriented, active, "California" lifestyle, were acquired by
the Company in November 1997. As of January 30, 1999, the Company had twenty-
nine continuing license agreements, covering both domestic and international
markets.
The Company's retail direct licensing strategy is premised on the proposition
that in North America nearly all aspects of the moderately priced apparel,
footwear and accessories business can be sourced most effectively by large
retailers, who not only command significant economies of scale, but also
interact daily with the end consumer. In addition, the Company believes that
these retailers in general may be able to obtain higher gross margins on sales
and increase store traffic by directly sourcing, stocking and selling licensed
products bearing widely recognized brand names, such as the Company's brands,
than through carrying strictly private label goods or branded product from
third-party vendors. The Company's strategy in North America is to capitalize
on these ideas by licensing its portfolio of brands primarily directly to
strong and growing retailers, who, working in conjunction with Company
management, develop merchandise for their stores.
Beginning in 1995, the Company began to take a number of important steps
designed to implement its retail direct licensing strategy. On August 15, 1995,
the Company entered into a major strategic alliance with one of the largest
retailers in the United States, Target Stores, a division of Dayton Hudson
Corporation. In November 1997, the Company reaffirmed its relationship with
Target, by entering into an amended licensing agreement (the "Amended Target
Agreement") which grants Target the exclusive right in the United States to use
the Cherokee trademarks on certain specified categories of merchandise. Under
the Amended Target Agreement, Target is obligated to pay a royalty based upon a
percentage of its net sales of Cherokee brand products, with a minimum
guaranteed royalty of $60.0 million over the six-year initial term of the
agreement. During the fiscal year ended January 30, 1999 ("Fiscal 1999"), a
wide range of Cherokee branded products were sold at the 866 Target stores.
Such Cherokee branded products included:
. men's, women's and children's apparel and fashion accessories;
. luggage, sports bags and backpacks;
. domestics and home decor items;
. home furnishings;
. sporting goods;
. bed and bath products and accessories; and
. cosmetics.
Due to the strong presence and sales of Cherokee branded products in Target
Stores during Fiscal 1999, royalties paid by Target exceeded $14.6 million,
which is 62% over the guaranteed minimum royalty for Fiscal 1999 under the
Amended Target Agreement.
2
In August 1997, the Company entered into a licensing agreement with one of
Canada's largest retailers, Zellers Inc., a division of the Hudson's Bay
Company, under which Zellers was granted the exclusive right in Canada to use
the Cherokee brand in connection with a broad range of categories of
merchandise. Under the Zellers licensing agreement Zellers is obligated to pay
the Company a minimum guaranteed royalty of $10.0 million over the five-year
initial term of the agreement. The agreement is subject to annual minimum
guarantees. Zellers commenced the initial sales of Cherokee branded merchandise
in over 350 stores in July 1998 and in the first six months, Cherokee goods
have struck a major chord with Zellers' core customers, with over $40.0 million
in sales. In the first six months, Zellers paid royalties in excess of
$1,147,000, which is 53% over the guaranteed minimum royalty for the first year
of the Zellers licensing agreement.
On November 7, 1997, the Company entered into an Agreement of Purchase and
Sale of Trademarks and Licenses (the "Sideout Agreement") with Sideout Sport
Inc., pursuant to which the Company agreed to purchase all of Sideout Sport
Inc.'s trademarks, copyrights, trade secrets and associated license agreements.
The trademarks acquired from Sideout Sport Inc. include, among others, Sideout,
Sideout Sport and King of the Beach. During Fiscal 1999, the Company entered
into four retail direct, two wholesale and two international licensing
agreements for the Sideout brand. The total number of retail stores these new
licensing agreements encompass currently approximates 750. These new retail
direct licensees are launching Sideout product in their stores in Spring 1999
and categories of merchandise will include (a) men's, women's and children's
apparel, (b) accessories, (c) luggage, sports bags and backpacks, (d) skin care
products and (e) hats. The Sideout brand generated licensing revenues from
existing agreements of approximately $585,000 for Fiscal 1999 and will begin
generating revenues from its eight newly-entered licensing agreements in the
fiscal year ended January 29, 2000.
Cherokee was incorporated in Delaware in 1988. Its principal executive
offices are located at 6835 Valjean Avenue, Van Nuys, California 91406,
telephone (818) 908-9868.
History and Restructurings
On November 7, 1994, the Company filed a petition with the United States
Bankruptcy Court in the District of Delaware for relief under Chapter 11 of the
United States Bankruptcy Code. Concurrent with such filing, the Company filed a
"prepackaged" Plan of Reorganization, which was the result of negotiations
among the Company and unofficial representatives of its debt-holders and
stockholders. On December 14, 1994, the Bankruptcy Court confirmed the 1994
Plan of Reorganization, and on December 23, 1994, the 1994 Plan of
Reorganization became effective. For financial statement purposes the effective
date of the 1994 Plan of Reorganization was deemed to be February 25, 1995.
On April 24, 1995, a group including Robert Margolis, who founded the
Company's Apparel Division in 1981, and who had been the Company's Chairman and
Chief Executive Officer from May 1989 to October 1993, purchased 1,358,000
shares, or approximately 22.3% of the Company's then outstanding Common Stock,
par value $.02 per share (the "Common Stock"). On May 5, 1995, Mr. Margolis was
appointed Chairman and Chief Executive Officer of the Company. After a period
of assessment, Mr. Margolis set in motion a strategy that redirected the
Company's principal business to being a marketer and licensor of the Cherokee
brand and other brands it owned or might acquire in the future. The Company
stopped manufacturing and importing apparel and footwear, sold its inventories
of apparel and footwear, and on July 28, 1995 sold the assets of its Uniform
Division. The proceeds from these sales were used to pay off all of the
Company's indebtedness. As a result of discontinuing the apparel and footwear
business and selling the Uniform Division, the number of employees was reduced
from approximately 345 on May 28, 1994 to 15 by November 1, 1995.
Prior to this major strategic change in direction, the Company was a
designer, manufacturer, and marketer of casual apparel and footwear primarily
under the Cherokee name. The Company operated four divisions during the fiscal
year ended June 3, 1995: the Apparel Division, the Footwear Division, the
Uniform Division, and the Licensing Division. The Apparel Division designed,
manufactured, imported and marketed moderately priced, natural fiber women's
and young girls' clothing. The Footwear Division designed, arranged for the
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manufacture, imported and marketed Cherokee brand and a broad line of private
label footwear for women, men and children. The Uniform Division designed,
manufactured and marketed Cherokee brand uniforms primarily for the medical
industry. The Company continues to license the use of its proprietary brand
names to domestic and international licensees for a variety of apparel,
footwear, accessories, home products and other lifestyle related products.
Recapitalization; Sale of Cherokee Trademarks to Spell C; Issuance of Secured
Notes
In September 1997, the Company's Board authorized Libra Investments, Inc., to
explore ways to maximize shareholder value, including a recapitalization or
sale of the Company. On December 23, 1997, the Company completed the
recapitalization described below and publicly announced that it would declare a
special dividend of $5.50 per share, which was subsequently paid on January 15,
1998.
To facilitate the recapitalization, the Company formed Spell C. LLC, a
special purpose, bankruptcy remote, single member Delaware limited liability
company, wholly owned by the Company. Pursuant to a Trademark Purchase and
License Assignment Agreement, dated December 23, 1997, between the Company and
Spell C (the "Assignment Agreement") the Company assigned to Spell C all of its
right, title and interest in the Amended Target Agreement and sold to Spell C
all of its right, title and interest in the Cherokee brand name and related
trademarks in the United States. The sale of the rights to the Cherokee
trademarks in the United States was subject to certain exceptions which (a)
allow the Company to continue to use the trademarks in the United States in
conjunction with the Company's then-existing license agreements, and (b) allow
the Company to use the trademarks in the United States in conjunction with
retail license agreements in the category of cosmetics, bath and body products.
The Company may extend existing Cherokee brand license agreements beyond
January 31, 2002 with the consent of Target; however, the Company must assign
50% of the royalties payable during the extended term to Target. Pursuant to
the Assignment Agreement, except for these exceptions, the Company no longer
has the right to license the Cherokee brand and related trademarks in the
United States, but retains all rights to do so outside of the United States.
Concurrently with the Assignment Agreement, the Company and Spell C entered
into an administrative services agreement under which the Company will perform
certain administrative duties on behalf of Spell C in connection with, among
other things, the Cherokee trademarks and the Assignment Agreement for a
nominal administrative fee.
On December 23, 1997 Spell C issued for gross proceeds of $47.9 million,
privately placed Zero Coupon Secured Notes (the "Secured Notes"), yielding 7.0%
interest per annum and maturing on February 20, 2004. The Secured Notes
amortize quarterly from May 20, 1998 through February 20, 2004, in the amount
of $9.0 million per year the first two years and $10.5 million per year the
third through sixth years. The Secured Notes are secured by the Amended Target
Agreement and the United States Cherokee trademarks and brand names. The
Secured Notes indenture requires that any proceeds due to Spell C under the
Amended Target Agreement and several other license agreements must be deposited
directly into a collection account controlled by the trustee under the
indenture. The trustee distributes from the collection account the amount of
principal due and payable to the holders of the Secured Notes on quarterly note
payment dates. Excess amounts on deposit in the collection account may only be
distributed to Spell C if the amount on deposit in the collection account
exceeds the amount of principal due and payable on the next quarterly note
payment date. Such excess amounts, if any, may then be distributed by Spell C
to the Company. During Fiscal 1999, of the 14,604,000 in royalty revenues
received from Target pursuant to the Amended Target Agreement, $6,750,000 was
paid to the holders of the Secured Notes, $4,911,000 remains in a collection
account for the benefit of the holders of Secured Notes and excess amounts
totaling $2,943,000 were distributed to Spell C. Spell C distributed $2,176,000
of such excess amounts to the Company on February 1, 1999. The minimum
guaranteed royalty under the Amended Target Agreement is $9.0 million for each
of the two fiscal years ending January 31, 1999 and 2000 and $10.5 million for
each of the four fiscal years ending January 31, 2001 through 2004. The
aggregate scheduled amortization under the Secured Notes is $60.0 million and
equals the aggregate minimum guaranteed royalty payable under the Amended
Target Agreement which is also $60.0 million. While the Company believes that
royalties payable under the Amended Target Agreement may continue to exceed the
minimum guaranteed royalties payable in upcoming fiscal years, the Company
cannot predict with accuracy
4
whether such royalties will exceed the minimum guaranteed royalties payable
during such years, and if they do not, the Company will not receive further
distributions from Spell C during the term of the Amended Target Agreement. See
"Risk Factors."
Pursuant to the Assignment Agreement, the gross proceeds of the Secured
Notes, which totaled approximately $47.9 million, were paid to the Company. On
December 23, 1997 the Company's Board declared a special dividend of $5.50 per
share, which was paid on January 15, 1998. The aggregate amount of the dividend
paid was approximately $47.4 million.
Sideout Agreement
On November 7, 1997, the Company entered into an Agreement of Purchase and
Sale of Trademarks and Licenses (the "Sideout Agreement") with Sideout Sport
Inc., pursuant to which the Company agreed to purchase all of Sideout Sport
Inc.'s trademarks, copyrights, trade secrets and associated license agreements.
The trademarks acquired from Sideout Sport Inc. include, among others, Sideout,
Sideout Sport and King of the Beach. Pursuant to the Sideout Agreement,
Cherokee paid $1.5 million at the closing of the acquisition and agreed to pay
an additional $500,000 upon release of liens on the assets which were
purchased. Most of the liens have since been released and $495,000 of the
$500,000 holdback has been paid. Under the terms of the Sideout Agreement, the
Company will also pay Sideout Sport Inc., on a quarterly basis, 40% of the
first $10.0 million, 10% of the next $5.0 million and 5% of the next $20.0
million, of royalties and license fees received by the Company through
licensing of the Sideout trademarks. Upon the earlier of such time as Cherokee
has paid Sideout a total of $7.5 million or October 22, 2004, Cherokee will
have no further obligation to pay Sideout Sport Inc. During Fiscal 1999, the
Company made payments of $205,000 under the Sideout Agreement.
During Fiscal 1999, the Company entered into four retail direct, two
wholesale and two international licensing agreements for the Sideout brand.
These new licensing agreements encompass approximately 750 retail stores. These
new retail direct licensees are launching the following categories of Sideout
merchandise in their stores in Spring 1999: (a) men's, women's and children's
apparel, (b) accessories and (c) luggage, sports bags and backpacks. The
Sideout brand generated licensing revenues from existing agreements of
approximately $585,000 for Fiscal 1999 and will begin generating revenues from
its eight newly-entered licensing agreements in the fiscal year ended January
29, 2000. The Company intends to further develop the Sideout brand through
retail direct, wholesale and international licensing; however, there can be no
assurance that the Company's efforts will result in significant increases in
royalty payments. See "Risk Factors." The Company is currently in discussions
with prospective licensees concerning significant new licensing agreements for
the Sideout brand. There can be no assurance, however, that these discussions
will result in definitive agreements.
Licensing Business
The Company is one of the leading licensors of brand names and trademarks for
apparel, footwear and accessories in the United States. The Cherokee name,
which began as a footwear brand in 1973, has been positioned to connote
quality, comfort, fit, and a "Casual American" lifestyle with traditional,
wholesome values. The Company's primary emphasis for the past three years has
been directed toward retail direct, wholesale and international licensing. As
of January 30, 1999, the Company had twenty-nine continuing license agreements,
covering both domestic and international markets, sixteen of which pertained to
the Cherokee name. The Sideout brand and related trademarks, which represent a
beach-oriented, active, "California" lifestyle, were acquired by the Company in
November 1997.
The Company's license agreements are with wholesalers and retailers and are
either international master agreements or category-specific exclusive or non-
exclusive agreements. Of the twenty-nine licensing agreements, seven are with
retailers, six are with domestic wholesalers and sixteen are with international
wholesalers and/or retailers. In order to maximize the benefits of the
Company's retail direct licensing strategy,
5
during Fiscal 1999 the Company completed the planned termination of five of the
wholesale licensing agreements for the Sideout brand, which the Company
acquired in the Sideout trademarks purchase in November 1997. Wholesale
licensees manufacture and import various categories of footwear and accessories
under the Company's trademarks and sell the licensed products to retailers. In
retail direct licensing, the Company grants retailers a license to use the
trademarks on certain categories of merchandise, generally on a non-exclusive
basis, and the retailer is responsible for designing and manufacturing the
merchandise (the "retail direct" licensing strategy). The Company's wholesale,
retail and international license agreements provide the Company with final
approval of pre-agreed upon quality standards, packaging and marketing of
licensed products. The Company has the right to conduct periodic quality
control inspections to ensure that the image and quality of licensed products
remain consistent. The Company will continue to solicit new licensees through a
small number of executive employees and may retain the services of outside
consultants to assist the Company in this effort.
The Company's current business strategy is to maximize the value of its
existing and future brands by exploiting them in a manner that recognizes the
relative market power, in different areas of the world, of the various
participants--manufacturer, wholesaler and retailer--in the chain of supply to
the ultimate consumer. In North America, that market power, and accompanying
economies of scale, is generally and increasingly held by a few dominant
retailers of moderately priced merchandise, and, accordingly, in North America
the Company has pursued its retail direct licensing strategy. In contrast to
the retail market in North America, in selected international markets the
Company has sought to develop its brands through wholesale licenses with
manufacturers or other companies who have market power and economies of scale
in their respective markets. Finally, in some countries, the Company believes
that an owner or licensee of one or more well-known U.S. brands has the
opportunity to become a dominant, vertically integrated manufacturer or
retailer or both of branded apparel, footwear and accessories. Accordingly, in
those countries the Company has begun to pursue licensing or strategic
alignments whereby its brands can become the basis for such a vertically
integrated manufacturer/retailer. This strategy permits the Company to operate
with minimal working capital, virtually no capital expenditures (other than
those associated with acquiring new brands and related trademarks), no
production costs, significantly reduced design, marketing, distribution and
other operating expenses, and a small group of core employees. In addition, the
Company has a global network of finders, suppliers and manufacturers.
North American Retail Direct Licensing
The Company's retail direct licensing strategy is premised on the proposition
that in North America nearly all aspects of the moderately priced apparel,
footwear and accessories business, from product development and design, to
merchandising, to sourcing and distribution, can be executed most effectively
by large retailers, who not only command significant economies of scale, but
also interact daily with the end consumer. In addition, the Company believes
that these retailers in general may be able to obtain higher gross margins on
sales and increase store traffic by directly sourcing, stocking and selling
licensed products bearing widely recognized brand names (such as the Company's
brands) than through carrying strictly private label goods or branded product
from third-party vendors. The Company also expects that the enhanced
profitability to retailers of private label products and in-store brands,
coupled with the substantial and increasing marketing costs to establish and
maintain a widely recognized apparel brand, will result in further erosion of
revenues and profitability for mid-sized and small apparel manufacturers and
corresponding increased desirability to retailers of well-established brands
with broad appeal. The Company's strategy in North America is to capitalize on
these trends by licensing its portfolio of brand names primarily directly to
strong and growing retailers, who, working in conjunction with the Company's
management, develop merchandise for their stores, and to augment that portfolio
by acquiring additional brands which have high consumer awareness, broad appeal
and applicability to a range of merchandise categories.
6
On November 12, 1997, the Company reaffirmed its relationship with Target by
entering into the Amended Target Agreement. This agreement was subsequently
assigned to Spell C and pledged as collateral for the Secured Notes. The
Amended Target Agreement grants Target the exclusive right in the United
States to use the Cherokee trademarks in certain specified categories of
merchandise (collectively, the "Merchandise"), including:
. men's, women's and children's apparel, including intimate apparel,
foundations and sleepwear;
. men's, women's and children's fashion accessories;
. bed and bath products and accessories;
. luggage, sports bags and backpacks;
. home textiles;
. domestics and home decor products;
. home furnishings;
. sporting goods; and
. cosmetics, bath and body products.
Some of the above-listed categories are subject to current license
agreements between the Company and third parties. The Amended Target Agreement
provides that upon the expiration or termination of such agreements, the
categories of Merchandise subject to such agreements will become exclusive to
Target in the United States. However, with the consent of Target, the Company
and Spell C could renew and/or extend existing license agreements and Target
would receive 50% of the royalties earned under these renewed and extended
agreements. Due to the broad nature of the rights granted to Target in the
United States, and the restrictions contained in the Amended Target Agreement,
additional licensing agreements in the United States with respect to the
Cherokee brand during the terms of the Amended Target Agreement will be
limited to retail license agreements for cosmetics with several drug chain
stores.
Under the terms of the Amended Target Agreement, Target will pay a royalty
each fiscal year for the fiscal years ending January 31, 1999 through 2004
equal to the greater of:
. the Minimum Guaranteed Royalty (as defined below) for such year; or
. a percentage of Target's net sales of Merchandise during such fiscal year
which percentage varies according to the volume of sales of Merchandise
during such fiscal year.
The "Minimum Guaranteed Royalty" is $9.0 million for each of the two fiscal
years ending January 31, 1999 and 2000 and $10.5 million for each of the four
fiscal years ending January 31, 2001 through 2004. The initial term of the
Amended Target Agreement commenced on February 1, 1998 and ends January 31,
2004. If Target is current in its payments of the Minimum Guaranteed Royalty,
the Amended Target Agreement will automatically renew for the fiscal year
ending in 2005, and will continue to automatically renew for successive fiscal
year terms provided that Target has paid a Minimum Guaranteed Royalty equal to
or greater than $9.0 million for the preceding fiscal year. Target commenced
the initial sales of Cherokee brand merchandise in July 1996 and paid the
Company $5,935,000 during the fiscal year ended May 31, 1997, $6,428,000
during the eight month fiscal period ended January 31, 1998 (the "Eight Month
Fiscal Period") and paid to Spell C $14,604,000 during Fiscal 1999, which
accounted for 68%, 75% and 76%, respectively, of the Company's consolidated
revenues during such periods. See "Risk Factors."
On August 22, 1997, the Company entered into an international retail direct
licensing agreement with Zellers Inc., a Canadian corporation and a division
of Hudson's Bay Company. Zellers was granted the exclusive right in Canada to
use the Cherokee brand and related trademarks in connection with a broad range
of categories of merchandise, including (a) women's, men's and children's
apparel and footwear, (b) women's
7
intimate apparel, (c) fashion accessories, (d) home textiles, (e) cosmetics and
(f) recreational products. The term of the agreement is for five years, with
automatic renewal options, provided that specified minimums are met each
contract year. Under the agreement, Zellers will pay the Company a minimum
guaranteed royalty of $10.0 million over the five-year initial term of the
agreement. Zellers commenced the initial sales of Cherokee brand merchandise in
July 1998 and paid the Company $1,147,000 during Fiscal 1999.
Including the Amended Target Agreement, the Company had five retail direct
non-exclusive Cherokee brand licensing agreements covering North America. North
American retail licensees, during Fiscal 1999 included, among others, Caldor,
Brylane, Pamida and Zellers. Generally, royalties on non-exclusive domestic
retail licenses begin at 3% of the retailer's net sales of licensed products
and may decrease depending on the retailer's annual sales of licensed products
and/or the retailer's guaranteed annual sales of licensed products. Caldor
filed a Chapter 7 bankruptcy and it is unlikely that the Company will receive
the remaining minimum royalty, which is $1,293,000, for the final year of
contract. The Company has filed a claim in bankruptcy court for the outstanding
minimums owed under its licensing agreement with Caldor. It is unlikely that
the Company will receive the remaining minimums due for the final year of
contract from the Bankruptcy court.
All of the current United States Cherokee brand retail license agreements
will expire during the term of the Amended Target Agreement and due to the
exclusivity provision contained in the Amended Target Agreement, after 2002,
without Target's consent, the Company will not be permitted to renew or extend
such agreements under the terms of the Amended Target Agreement. Further, under
the Assignment Agreement, the Company may extend any existing United States
license agreement after January 31, 2002, with the consent of Target, but the
Company must assign 50% of the royalties payable during the extended term to
Target. The above restrictions under the Amended Target Agreement and
Assignment Agreement do not apply to Canada; however, under the Zellers
Agreement, Zellers has the exclusive right to use the Cherokee brand on a broad
range of products in Canada.
During Fiscal 1999 the Company entered into five non-exclusive retail direct
licensing agreements for the Sideout brand covering North America, which
include Mervyn's California, Uptons, Gart Sport/Sportmart, Bob's Stores and
Forzani Group Ltd. The total number of retail stores these licensing agreements
encompass in North America is 625. All of the retail direct licensing
agreements cover categories of merchandise including (a) men's, women's and
children's sportswear; (b) accessories; (c) luggage, sports bags and backpacks;
(d) skin care products and (e) hats and their terms vary in length. The Company
expects the launch of the Sideout brand by its retail direct licensees to occur
in the first half of 1999. The Company intends to continue to actively pursue
its retail direct licensing strategy to further develop the Sideout brand in
the United States.
During Fiscal 1999, the Company and Spell C received $17,550,000 in aggregate
royalties from North American retail license agreements, which accounted for
91% of the Company's consolidated revenues during such period.
North American Wholesale Licensing
The Company currently has six wholesale license agreements that grant
unaffiliated manufacturers the license to manufacture and market sunglasses,
watches, luggage, handbags and purses under the Company's trademarks in the
United States. The Company's wholesale license agreements typically require the
wholesale licensee to pay royalties on revenues against a guaranteed minimum
royalty that generally increases over the term of the agreement. All of the
current United States wholesale license agreements will expire during the term
of the Amended Target Agreement, and due to the exclusivity provisions
contained in the Amended Target Agreement, after 2002 in many circumstances the
Company will not be permitted to renew or extend such agreements under the
terms of the Amended Target Agreement without the consent of Target.
Pursuant to the Sideout Agreement, the Company acquired several existing
wholesale licensing agreements in North America. Since entering the Sideout
Agreement, in order to maximize the benefits of the Company's retail direct
licensing strategy, the Company completed the planned termination of all but
one of such
8
wholesale licensing agreements. During Fiscal 1999, the Company entered into
two new wholesale licensing agreements for the Sideout brand: (a) an exclusive
agreement for sunglasses with Outlook Eyewear, a division of Bausch & Lomb
Incorporated and (b) an exclusive agreement for watches and related time
products with Genender International Inc. The total number of wholesale
licensing agreements for the Sideout brand was three as of January 30, 1999.
The Company's wholesale license agreements for the Sideout brand are for
product categories including footwear, volleyballs, sunglasses, watches and
related time products. The agreements have various expiration dates and contain
three-to five-year renewal options. The footwear licensee sells men's, women's
and children's footwear to many of the better department and specialty stores,
including Nordstrom, Sportmart, Champs, Lady Footlocker, Bob's Stores and
Miller's Outpost. The royalties derived from footwear licensee have grown
substantially during the last two years. Minimum royalty guarantees total
$784,000 for the remaining term of the wholesale license agreements. Renewal
options held both by the licensees and the Company provide for minimum
guaranteed royalties of $3,030,000 to the Company if such contracts are
renewed.
During Fiscal 1999, the Company received $1,316,000 in aggregate royalties
from its wholesale licensing agreements, which accounted for 7% of the
Company's consolidated revenues during such period.
International Licensing
The Amended Target Agreement grants Target the rights to the Cherokee
trademarks only in the United States. Additionally, the Company sold Spell C
the United States, but not the international, rights to the Cherokee
trademarks. Therefore, the Company will continue to seek to develop in several
international markets both its Cherokee and Sideout brands through wholesale
licenses with manufacturers or other companies that have market power and
economies of scale in their respective markets.
Suzuya Co. Ltd., the Company's Far East licensee for the past ten years,
operated twenty-one Cherokee retail stores in Japan, and had eight sub-
licensees that manufactured and sold Cherokee brand apparel and accessories to
the Cherokee stores and to other unaffiliated retailers. In April 1997, the
Suzuya licensing agreement was terminated and the Company signed a new master
licensing agreement with Vantex, Inc. Vantex subsequently entered into four
sub-licensing agreements for the further development of the Cherokee brand in
Japan. During Fiscal 1999, however, Vantex filed for protection under Japan's
bankruptcy laws and the master licensing agreement was terminated with no
financial costs to the Company. The Company entered into interim licensing
agreements, on terms substantially similar to the master license agreement,
with the existing sub-licensees, Takaya, Sanmoto, Okudo and Takaishi, until
such time as the Company entered into a new master licensing agreement. In
January 1999, the Company entered into a new master licensing agreement with
Japan-based Itochu Corporation. Under the terms of the agreement, Itochu will
manufacture, promote, sell, distribute and sublicense products bearing the
Cherokee brand in Japan. The term of the agreement is five years and the
aggregate minimum guaranteed royalties for the first three years are
$1,100,000.
During Fiscal 1999, the Company entered into a master licensing agreement
with Shanghai Eesli Trading Company, to manufacture, promote, sell and
distribute products bearing the Company's Cherokee brand within the territories
of the People's Republic of China, including Shanghai, Jiangsu, Beijing,
Tianjin, Sichuan, Hubei, Gansu, Shanxi, Liaoning, Chongqing and Guangdong. The
agreement covers a broad range of product categories including (a) women's
sportswear and intimate apparel; (b) children's apparel; (c) women and
children's footwear; (d) women's fashion accessories; and (e) cosmetics. The
term of the agreement is for ten years and the aggregate minimum guaranteed
royalties for the first three years is $1,275,000.
The Company also entered into a license agreement with Mexico-based Bravo
Enterprises, a manufacturer, distributor and marketer of prestige brands in
Mexico. Under the terms of the agreement, Bravo Enterprises will manufacture,
promote, sell and distribute several products bearing the Cherokee brand in
Mexico.
9
The Company currently has eight international wholesale and/or retail license
agreements for the Cherokee brand, including a master licensing agreement with
Mondragon, a Philippines company. Due to the poor economy in Korea, the Company
terminated the licensing agreements with Kum Kyung Co. Ltd. and Joosung
Enterprises Co., Ltd. with no financial costs to the Company.
Pursuant to the Sideout Agreement, the Company acquired five international
licensing agreements with respect to the Sideout brand and related trademarks.
The Company's international licensing agreements for the Sideout and King of
the Beach brands are all exclusive and cover countries including Argentina,
Uruguay, Japan and Mexico, and product categories including volleyballs, men's,
boy's and women's apparel and footwear. Sideout Mexico, the Company's Mexican
licensee, currently distributes to department and specialty stores and has six
Sideout stores throughout Mexico. During Fiscal 1999, the Company entered into
a three-year licensing agreement with South Africa-based A M Moolla Group
Limited, the second largest clothing manufacturer in South Africa. Under the
terms of the AM Moola agreement, AM Moola will manufacture, promote, sell and
distribute products bearing the Company's Sideout brand in South Africa ,
Botswana, Zimbabwe, Namibia, Mozambique, Angola, Swaziland, Lesotho, Tanzania
and the Democratic Republic of Congo.
During Fiscal 1999, the Company received $441,000 in aggregate royalties from
its international license agreements, which accounted for 2% of the Company's
consolidated revenues during such period.
Trademarks
The Company holds various trademarks including Cherokee, Sideout, Sideout
Sport, King of the Beach 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 in a number of other countries. The Company
also holds trademark applications for Cherokee, Sideout, Sideout Sport and King
of the Beach 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 its trademarks, and the Company relies
primarily upon a combination of trademark, copyright, know-how, trade secrets,
and contractual restrictions to protect its intellectual property rights both
domestically and internationally. See " Risk Factors."
Marketing
The Company has positioned the Cherokee name to connote quality, comfort, fit
and a "Casual American" lifestyle with traditional, wholesome values. The
Sideout brand and related trademarks represent a beach-oriented, active,
"California" lifestyle. The Company integrates its advertising, product,
labeling and presentation to reinforce these brand images. The Company intends
to continue to promote a positive image in marketing the Cherokee and Sideout
brands through licensee-sponsored advertising. The Company's wholesale, retail
and international license agreements provide the Company with final approval of
pre-agreed upon quality standards, packaging and marketing of licensed
products. The Company principally relies on its licensees to advertise the
Cherokee brand, and as a result the Company's advertising costs have been
minimal.
The Company developed a Web site, which utilizes a business-to-business E-
commerce strategy. The Company's goal in developing the Web site is to enhance
communication, information flow and networking with existing and prospective
licensees. The Web site currently includes the profiles of the Company and its
brands, certain of the Company's financial statements and press releases, as
well as a secured area to support the Company's licensees with graphics,
packaging and trim items, design concepts, new developments and other
administrative needs.
Internationally, the Company intends to continue to seek to develop both of
its principal brands through license agreements and strategic alliances with
manufacturers or other companies who have market power and economies of scale
in their respective markets. The Company is also seeking to represent other
companies in licensing their brands around the world, on a shared revenue
basis. The Company will continue to market its
10
brands and solicit new licensees through a small number of executive employees
and may retain the services of outside consultants to assist the Company in
this effort. The Company recently hired additional marketing staff to intensify
the Company's international efforts to negotiate new license agreements and
provide support and advice regarding advertising and merchandising concepts to
existing licensees.
Competition
Royalties paid to the Company under its licensing agreements are generally
based on a percentage of the licensee's net sales of licensed products.
Cherokee and Sideout brand footwear, apparel, and accessories, which are
manufactured and sold by both domestic and international wholesalers and retail
licensees, are subject to extensive competition by numerous domestic and
foreign companies. Such competitors with respect to the Cherokee brand include
Levi Strauss & Co., The Gap, Old Navy, Liz Claiborne and VF Corp. and private
labels developed for retailers. Competitors with respect to the Sideout brand
include Quicksilver, Mossimo, Nike and other activewear companies. Factors
which shape the competitive environment include quality of garment construction
and design, brand name, style and color selection, price and the manufacturer's
ability to respond quickly to the retailer on a national basis. In recognition
of the increasing trend towards consolidation of retailers and greater emphasis
by retailers on the manufacture of directly sourced merchandise, in the United
States the Company's business plan focuses on creating strategic alliances with
major retailers for their sale of products bearing the Company's brands through
the licensing of the Company's trademarks directly to retailers. Therefore, the
success of the Company is dependent on its licensees' ability to design,
manufacture and sell products bearing the Company's brands and to respond to
ever-changing consumer demands. Other companies owning established trademarks
could also enter into similar arrangements with retailers. See "Risk Factors."
Employees
As of January 30, 1999, the Company employed 13 persons. None of the
Company's employees are represented by labor unions and the Company believes
that its employee relations are satisfactory.
Risk Factors
This Risk Factors section has been written with the goal of being responsive
to the Security and Exchange Commission's recently enacted "Plain English"
guidelines. In this section the words "we", "our", "ours" and "us" refer only
to the Company and not any other person.
Payments to us from our subsidiary, Spell C, are subject to a number of
restrictions under the Amended Target Agreement.
We cannot assure you that our subsidiary, Spell C, will distribute any
significant amount of cash or property to us until after the maturity of the
Secured Notes, if then. The Secured Notes indenture provides that any royalties
payable under the Amended Target Agreement will be deposited directly into a
collection account controlled by the trustee under the Secured Notes indenture.
The trustee will distribute from the collection account the amount of principal
due and payable to the holders on the Secured Notes on quarterly note payment
dates. Excess amounts in the collection account may only be distributed to
Spell C if the amount in the collection account exceeds the aggregate amount of
principal due and payable on the next quarterly note payment date. Such excess
amounts, if any, may then be distributed by Spell C to us. The aggregate
scheduled amortization under the Secured Notes is $60.0 million and equals the
aggregate minimum guaranteed royalty payable under the Amended Target
Agreement, which is also $60.0 million. See "Recapitalization; Sale of Cherokee
Trademarks to Spell C; Issuance of Secured Notes" and "North American Retail
Direct Licensing." There is no assurance, therefore, that in the future there
will be any excess amounts available to be distributed to us. We do not expect
revenues deposited in the collateral account from sources other than the
Amended Target Agreement to be significant during fiscal year 2000. We cannot
predict with accuracy whether payments under the Amended Target Agreement will
exceed the minimum guaranteed royalty, and if they do not, no distribution will
be made to Spell C from the collateral account, and in turn, Spell C will have
no funds
11
available to distribute to us. If Spell C does not distribute any funds to us
during the balance of the initial term of the Amended Target Agreement it could
have a material adverse effect on our business, financial condition and results
of operations.
Our efforts to develop and market the recently acquired Sideout brand may not
be successful.
We acquired the Sideout brand and related trademarks in November 1997. See
"Sideout Agreement." We are attempting to develop the Sideout brand through
both domestic and international retail direct and wholesale licensing. Although
the Sideout brand is a well-recognized, beach volleyball brand, there can be no
assurance that our efforts to develop and market the Sideout brand will result
in significant increases in royalty payments. Our failure to increase royalty
payments from the Sideout brand could have a material adverse effect on the
growth of our business.
Our business is subject to intense competition.
Royalties paid to us under our licensing agreements are generally based on a
percentage of our licensee's net sales of licensed products. Cherokee and
Sideout brand footwear, apparel, and accessories, which are manufactured and
sold by both domestic and international wholesalers and retail licensees, are
subject to extensive competition by numerous domestic and foreign companies.
Such competitors with respect to the Cherokee brand include Levi Strauss & Co.,
The Gap, Old Navy, Liz Claiborne and VF Corp. and private labels developed for
retailers. Competitors with respect to the Sideout brand include Quicksilver,
Mossimo, Nike and other activewear companies. Factors which shape the
competitive environment include quality of garment construction and design,
brand name, style and color selection, price and the manufacturer's ability to
respond quickly to the retailer on a national basis. In recognition of the
increasing trend towards consolidation of retailers and greater emphasis by
retailers on the manufacture of private label merchandise, in the United States
our business plan focuses on creating strategic alliances with major retailers
for their sale of products bearing our brands through the licensing of our
trademarks directly to retailers. Therefore, our success is dependent on our
licensees' ability to design, manufacture and sell products bearing our brands
and to respond to ever-changing consumer demands, and any significant failure
by our licensees to do so could have a material adverse effect on our business,
financial condition and results of operations. Other companies owning
established trademarks could also enter into similar arrangements with
retailers. See "Competition."
Our business is dependent on Target Stores, which accounted for 76% of our
consolidated licensing revenues in Fiscal 1999.
During Fiscal 1999, 76% of our and Spell C's consolidated licensing revenues
were generated from a single source, Target Stores, a division of Dayton Hudson
Corporation. See "North American Retail Direct Licensing." We have assigned all
our rights in the Amended Target Agreement to Spell C, which has in turn
pledged the Amended Target Agreement as collateral for the Secured Notes. Spell
C will be dependent on revenues from the Amended Target Agreement for most, if
not all, of its revenues. Although the Amended Target Agreement provides for
minimum annual royalty payments, if for any reason Target does not pay the
minimum royalties, Spell C will likely be unable to meet, and will default on,
its payment obligations under the indenture for the Secured Notes. We are not a
guarantor of the Secured Notes; however, the United States Cherokee trademarks
have been pledged as security for the Secured Notes and the permanent loss of
such trademarks as a result of a default would have a material adverse effect
on our business, financial condition and results of operations. The Secured
Notes mature and the initial term of the Amended Target Agreement expires at
approximately the same time. At such time payments from the Amended Target
Agreement, if extended or renewed, may be distributed by Spell C to us. If
Target elects not to extend or renew the Amended Target License Agreement upon
the expiration of its initial term, it could have a material adverse effect on
our business, financial condition and results of operations. There can be no
guarantee that we would be able to replace the Target royalty payments from
other sources.
12
We are dependent on our intellectual property and we cannot assure you that we
will be able to successfully protect our rights.
We and Spell C hold various trademarks including Cherokee, Sideout, Sideout
Sport, King of the Beach and others in connection with apparel, footwear and
accessories. These trademarks are vital to the success and future growth of our
business. These trademarks are registered with the United States Patent and
Trademark Office and in several other countries. We and Spell C also hold
numerous trademark applications for Cherokee, Sideout, Sideout Sport and King
of the Beach in numerous countries. We monitor on an ongoing basis unauthorized
uses of our trademarks, and we rely primarily upon a combination of trademark,
copyright, know-how, trade secrets, and contractual restrictions to protect our
intellectual property rights. We believe that such measures afford only limited
protection and, accordingly, there can be no assurance that the actions taken
by us to establish and protect our trademarks and other proprietary rights will
prevent imitation of our products or infringement of our intellectual property
rights by others, or prevent the loss of licensing revenue or other damages
caused thereby. In addition, the laws of several countries in which we have
licensed our intellectual property may not protect our intellectual property
rights to the same extent as the laws of the United States. Despite our efforts
to protect our intellectual property rights, unauthorized parties may attempt
to copy aspects of our intellectual property which could have a material
adverse effect on our business, financial condition and results of operations.
We are currently involved in one infringement action with respect to the use by
a third party of the name Cherokee on two-way radios, which we believe will not
have a material adverse effect on our business, financial condition and results
of operations. However, in the future we may be required to assert infringement
claims against third parties, and there can be no assurance that one or more
parties will not assert infringement claims against us. While we currently have
the resources to pursue or defend most infringement claims, any resulting
litigation could result in significant expense and divert the efforts of our
management personnel whether or not such litigation is determined in our favor.
We are dependent on our key management personnel.
Our overall business and marketing strategy and current direction was
principally conceived and implemented by Robert Margolis, our Chairman and
Chief Executive Officer, with the assistance of Patricia Warren, our former
President and Carol Gratzke, our Chief Financial Officer. On March 3, 1998, we
announced the resignation of Patricia Warren as President of the Company. Ms.
Warren worked with us through 1998 in selected special projects. Howard Siegel
was appointed President of Operations in June 1998. Steven Ascher, the founder
and former President of Sideout Sport Inc., was also appointed as Executive
Vice President in June 1998. Despite the recent hires, the loss of the services
of Mr. Margolis could have a material adverse effect on our business, financial
condition and results of operations.
13
Item 2. PROPERTIES
Since October 15, 1995, the Company has utilized a 3,000 square foot office
facility in Van Nuys, California. This facility was leased until July 31, 1998
by The Wilstar Group ("Wilstar"), a business name used by The Newstar Group, to
which Mr. Margolis serves as Chief Executive Officer. The Company used
approximately one-half of such space and paid Wilstar for such usage at the
rate of $.75 per square foot or $1,125 per month. In addition, the Company
reimbursed Wilstar for one-half of certain costs relating to this office space.
Beginning November 1, 1997, the Company increased its rental space to 3,685
square feet and paid Wilstar $2,762 in rent per month, which included costs
relating to the office space. The Company also rented 4,000 square feet of
Wilstar's warehouse as a storage facility and paid rent at a rate of $.50 per
square foot. The Company believes that its rental of such space from Wilstar
was on terms no less favorable than could be obtained from an unaffiliated
third party. After the expiration of Wilstar's lease, the Company negotiated a
new lease with the facility's owner. The initial term of the lease is for three
years, the monthly rent is $8,500 and the Company has an option to extend the
term of the lease for two additional three-year periods. The Company leased a
1,158 square foot showroom facility in Dallas, Texas, which lease expired on
February 28, 1998.
Item 3. LEGAL PROCEEDINGS
In the ordinary course of business, the Company from time to time becomes
involved in legal claims and litigation. In the opinion of management, based on
consultations with legal counsel, the disposition of litigation currently
pending against the Company is unlikely to have, individually or in the
aggregate, a materially adverse effect on its business financial position or
results of operations.
Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
The Company did not submit any matters to a vote of holders of Common Stock
during the final quarter of Fiscal 1999.
14
PART II
Item 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The Common Stock traded on the NASDAQ Small Cap Issues Market under the
symbol CHKE until October 28, 1998. On October 29, 1998, the Company's Common
Stock began trading on the Nasdaq National Market System. The Company's Nasdaq
trading symbol has remained CHKE. The table below sets forth for each of the
fiscal quarters during the Company's last two fiscal years the range of the
high and low bid information for the Common Stock and the cash dividends paid.
Dividends
High Low Paid
------ ------ ---------
Eight Month Fiscal Period 1998
------------------------------
Quarter ended August 30, 1997....................... 12 6 3/4 $0.20
Quarter ended November 27, 1997..................... 15 1/8 10 3/4 --
Two months ended January 31, 1998................... 17 1/4 7 1/4* 5.50
Fiscal 1999
-----------
Quarter ended May 2, 1998........................... 8 3/4 7 3/8 0.50
Quarter ended August 1, 1998........................ 11 5/8 8 3/4 0.25
Quarter ended October 31, 1998...................... 10 7/8 7 5/8 0.25
Quarter ended January 30, 1999...................... 9 1/2 7 5/8 0.25
- --------
* The stock price reflects a higher stock price prior to the $5.50 price
adjustment due to the payment of the $5.50 special dividend on January 15,
1998.
On April 14, 1999, the latest bid price for the Common Stock, reported on the
NASDAQ National Market System, was $7 15/16 per share. As of April 14, 1999,
the number of stockholders of record of the Common Stock was 1,050. This figure
does not include beneficial holders whose shares may be held of record by
brokerage firms and clearing agencies.
Over the past two years, the Company has generally paid a quarterly dividend.
However, the payment of any future dividends will be at the discretion of the
Company's Board and will be dependent upon the Company's financial condition,
results of operations, capital requirements and other factors deemed relevant
by the Company's Board.
15
Item 6. SELECTED FINANCIAL DATA
The following selected consolidated financial information, except as noted,
has been taken or derived from the audited consolidated financial statements of
the Company and its predecessor and should be read in conjunction with the
consolidated financial statements included elsewhere in this Form 10-K. See "--
Item 8. Consolidated Financial Statements and Supplementary Data."
Given the developments involving the Company during the last two fiscal
years, such as the assignment of the Amended Target Agreement to Spell C, the
sale of the rights to the Cherokee trademarks in the United States to Spell C
and the issuance of the Secured Notes, the future results of the Company are
expected to differ significantly from the Company's historical results, and
therefore undue reliance should not be placed on the following selected
consolidated financial information as indicative of future results.
Predecessor
Successor Company Company
------------------------------------------------------ -----------
Eight Months Year Year 3 Months 9 Months
Year Ended Ended Ended Ended Ended Ended
January 30, January 31, May 31, June 1, June 3, Feb. 25,
1999 1998 1997 1996 1995 1995
----------- ------------ ------- ------- -------- -----------
($ In Thousands Except Per Share Data)
Statement of Operations
Data:
Royalty revenues / Net
sales.................. $ 19,307 $ 8,553 $ 8,718 $13,899 $20,264 $ 65,623
Cost of goods sold...... -- -- 184 10,445 16,310 54,994
-------- -------- ------- ------- ------- --------
Gross profit............ 19,307 8,553 8,534 3,454 3,954 10,629
Selling, general and
administrative
expenses............... 6,428 4,192 3,406 4,460 5,153 19,097
Performance option
expense................ -- -- -- 4,567 (1) -- --
Amortization of
trademarks and
goodwill............... 200 43 -- -- -- 819
Operational
restructuring.......... -- -- -- -- 3,165 --
-------- -------- ------- ------- ------- --------
Operating income
(loss)................. 12,679 4,318 5,128 (5,573) (4,364) (9,287)
Other (income) expense.. -- (422) (75) (96) (116) (167)
Interest expense........ 3,247 330 3 355 587 5,467 (2)
Investment and interest
income................. (638) (525) (460) (543) (24) (107)
Gain on sale of Uniform
Div and other assets... -- -- (220) (3,840) -- --
Reorganization items.... -- -- -- -- -- 54,093 (3)
-------- -------- ------- ------- ------- --------
Income(loss) before
income taxes........... 10,070 4,935 5,880 (1,449) (4,811) (68,573)
Income tax expense
(benefit).............. 3,982 (782) (771) -- (400) (5,230)
-------- -------- ------- ------- ------- --------
Income (loss) before
extraordinary item..... 6,088 5,717 6,651 (1,449) (4,411) (63,343)
Extraordinary item (net
of income taxes)....... -- -- -- -- -- 88,291 (3)
-------- -------- ------- ------- ------- --------
Net income (loss)....... 6,088 5,717 6,651 (1,449) (4,411) 24,948
Basic earnings (loss)
per share (4).......... $ 0.70 $ 0.73 $ 0.87 $ (0.22) $ (0.72) -- (4)
Diluted earnings (loss)
per share.............. $ 0.70 $ 0.68 $ 0.82 $ (0.22) $ (0.72) --
Cash distribution of
capital per share...... -- $ 5.50 -- $ 0.60 -- --
Cash dividends per
share.................. $ 1.25 $ 0.20 $ 0.35 -- -- --
January 30, January 31, May 31, June 1, June 3, Feb. 25,
1999 1998 1997 1996 1995 1995(3)
----------- ------------ ------- ------- -------- -----------
Balance Sheet Data:
Working capital......... $ (2,242) $ 4,445 $ 9,148 $ 227 $ 2,836 $ 27,321
Total assets............ 19,529 24,471 13,601 8,320 28,260 41,527
Long-term debt, net of
current maturities..... 35,697 41,675 -- -- -- 18,995
Stockholders' (deficit)
equity................. (29,879) (25,646) 12,224 6,070 7,222 11,825
- --------
(1) Represents a non-cash charge of $4,567,000 resulting from the exercise of
Wilstar performance options. Wilstar is a related party, and Robert
Margolis is the majority shareholder and Chief Executive Office of Wilstar.
(2) Interest expense includes non-cash charges of $4,361,000 for the nine
months ended February 25, 1995.
(3) On December 14, 1994, the 1994 Plan of Reorganization was confirmed by the
Bankruptcy Court and became effective on December 24, 1994. For financial
statement purposes the effective date of the 1994 Plan of Reorganization
was assumed to be February 25, 1995, the last day of the third quarter of
the Company's 1994 fiscal year. The Company has implemented "fresh start"
reporting; therefore all assets and liabilities have been restated to
reflect the reorganization value of the Company and as such the June 3,
1995 balance sheet is that of a successor company.
(4) Earnings per share for periods subsequent to the adoption of fresh-start
reporting as of February 25, 1995 is based on the weighted average number
of common shares, including those yet to be distributed by the disbursing
agent, appointed pursuant to the 1994 Plan, during the relevant periods.
Per share data is not presented for periods ending prior to June 3, 1995,
due to the general lack of comparability as a result of the revised capital
structure of the Company under the 1994 Plan of Reorganization.
16
Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATION
Overview
Since May 1995, the Company has principally been in the business of marketing
and licensing the Cherokee brand and related trademarks and other brands it
owns. In May 1995, the Company stopped manufacturing and importing apparel and
footwear, sold most of its inventories, and on July 28, 1995, sold the assets
of its uniform division.
The Company's operating strategy emphasizes domestic and international
wholesale and retail direct licensing, whereby the Company grants wholesalers
and retailers the license to use its trademarks on certain categories of
merchandise. Under this operating strategy, the Company has been able to
significantly reduce its overhead and ongoing operating costs as compared to
before May 1995.
In November 1997, the Company reaffirmed its strategic relationship with
Target Stores, a division of Dayton Hudson Corporation, by entering into the
Amended Target Agreement, which grants Target the exclusive right in the United
States to use the Cherokee trademarks in certain categories of merchandise. See
"--Item 1. Business. North American Retail Direct Licensing." Target will pay a
royalty each fiscal year for the fiscal years ending January 31, 1999 through
2004, equal to the greater of (a) the Minimum Guaranteed Royalty for such year,
or (b) a percentage of Target's net sales of Merchandise during such fiscal
year which percentage varies according to the volume of sales of Merchandise
during such fiscal year. The Minimum Guaranteed Royalty is $9.0 million for
each of the two fiscal years ending January 31, 1999 and 2000, and $10.5
million for each of the four fiscal years ending January 31, 2001 through 2004.
As part of a recapitalization that occurred in September 1997, the Company
sold to Spell C, its wholly-owned subsidiary, all of its rights to the Cherokee
brand and related trademarks in the United States and assigned to Spell C all
of its rights in the Amended Target Agreement in exchange for the proceeds from
the sale of the Secured Notes. See "Item 1. Business. Recapitalization; Sale of
Cherokee Trademarks to Spell C; Issuance of Secured Notes." Spell C issued for
an aggregate of $47.9 million, privately placed Zero Coupon Secured Notes,
yielding 7.0% interest per annum and maturing on February 20, 2004. The Secured
Notes amortize quarterly from May 20, 1998 through February 20, 2004, in the
amount of $9.0 million per year the first two years and $10.5 million per year
the third through sixth years. The Secured Notes are secured by the Amended
Target Agreement and the United States Cherokee brand name and trademarks. The
Secured Notes indenture provides that any royalties generated by the Amended
Target Agreement must be deposited directly into a collection account
controlled by the trustee under the indenture for distribution to holders of
the Secured Notes. Excess amounts in the collection account may be distributed
to Spell C only if the excess amounts exceed the aggregate amount of principal
due and payable on the next quarterly note payment date. Such excess amounts,
if any, will then be distributed by Spell C to the Company. Since the aggregate
payments due under the Amended Target Agreement are $60 million and equal the
aggregate Minimum Guaranteed Royalty payable under the Amended Target
Agreement, which are also $60 million, there is no assurance that there will be
any excess amounts to be distributed.
Target commenced the initial sales of Cherokee brand merchandise in July
1996, and paid the Company $5,935,000 million during the fiscal year ended May
31, 1997, $6,428,000 million during the Eight Month Fiscal Period and paid to
Spell C $14,604,000 million during Fiscal 1999, which accounted for 68%, 75%
and 76%, respectively, of the Company's consolidated revenues during such
periods. Royalties payable under the Amended Target Agreement appear in the
Company's consolidated financial statements for the Eight Month Fiscal Period
and Fiscal 1999. However, on a going-forward basis, most, if not all of such
royalties will be distributed to the holders of the Secured Notes. See "Item 1.
Risk Factors." Prior to the maturity of the Secured Notes, royalties from the
Amended Target Agreement will be offset by principal payments to the holders of
the Secured Notes in the amount of $9.0 million per year during the first two
years and $10.5 million per year during the third through sixth years of Spell
C's obligations under the indenture. During
17
Fiscal 1999, of the $14,604,000 in royalties received pursuant to the Amended
Target Agreement, $6,750,000 was paid to the holders of the Secured Notes,
$4,911,000 remains in a collection account for the benefit of the holders of
Secured Notes and excess amounts totaling $2,943,000 were distributed to Spell
C. Spell C distributed $2,176,000 of such excess amounts to the Company on
February 1, 1999. While the Company believes that royalties payable under the
Amended Target Agreement may continue to exceed the Minimum Guaranteed Royalty,
the Company cannot predict this with any accuracy. The revenues generated from
all other licensing agreements during the fiscal year ended May 31, 1997 were
$2,783,000, during the Eight Month Fiscal Period were $2,125,000 and during
Fiscal 1999 were $4,703,000, which accounted for 32%, 25% and 24%,
respectively, of the Company's revenues during such periods.
In November 1997, the Company purchased the Sideout brand and related
trademarks from Sideout Sport, Inc. for approximately $2.0 million and a
portion of the future royalties generated by the Sideout brand. Pursuant to the
Sideout Agreement, Cherokee paid $1.5 million at the closing of the acquisition
and agreed to pay an additional $500,000 upon release of liens on the assets
which were purchased. Most of the liens have since been released and $495,000
of the $500,000 holdback has been paid. Under the terms of the Sideout
Agreement, the Company will also pay Sideout Sport Inc., on a quarterly basis,
40% of the first $10.0 million, 10% of the next $5.0 million and 5% of the next
$20.0 million, of royalties and license fees received by the Company through
licensing of the Sideout trademarks. Upon the earlier of such time as Cherokee
has paid Sideout a total of $7.5 million or October 22, 2004, Cherokee will
have no further obligation to pay Sideout Sport Inc. During Fiscal 1999, the
Company made additional contingent payments of $205,000 under the Sideout
Agreement. The Sideout brand generated licensing revenues from existing
contracts of approximately $585,000 for Fiscal 1999. See "Item 1. Business.
Sideout Agreement."
During Fiscal 1999 the Company entered into five non-exclusive retail direct
licensing agreements for the Sideout brand covering North America, which
include Mervyn's California, Uptons, Gart Sport/Sportmart, Bob's Stores and
Forzani Group Ltd. All of the retail direct licensing agreements cover
categories of merchandise including (a) men's, women's and children's
sportswear; (b) accessories; (c) luggage; sports bags and backpacks; (d) skin
care products and (e) hats and their terms vary in length. The launch of the
Sideout brand by the Company's retail direct licensees will occur in the first
half of 1999. During Fiscal 1999, the Company also entered into an
international wholesale licensing agreement with South Africa-based A M Moolla
Group Limited and two North American wholesale licensing agreements for the
Sideout brand: (a) an exclusive agreement for sunglasses with Outlook Eyewear,
a division of Bausch & Lomb Incorporated and (b) an exclusive agreement for
watches and related time products with Genender International Inc. The total
number of retail stores these licensing agreements encompass is approximately
750. The Company intends to continue to actively pursue its retail direct
licensing strategy to further develop the Sideout brand in the United States
and internationally through retail direct and wholesale licensing.
Under the Amended Target Agreement, in most cases, the Company or Spell C
must receive Target's consent to enter into additional licensing agreements in
the United States with respect to the Cherokee brand during the term of the
agreement.
The Company's current focus with respect to the Cherokee brand is to continue
to develop that brand in several international markets through retail direct or
wholesale licenses with manufacturers or other companies who have market power
and economies of scale in the respective markets. In January 1999, the Company
entered into a new master licensing agreement for Japan with Itochu
Corporation. In August 1997, the Company entered into an international retail
direct licensing agreement with granting Zellers the exclusive right in Canada
to use the Cherokee brand in connection with a broad range of categories of
merchandise. Zellers will pay the Company a minimum guaranteed royalty of $10.0
million over the five year initial term of the agreement. The Agreement is
subject to annual minimum guarantees. Zellers launched its Cherokee program in
early August 1998 and during the last six months of Fiscal 1999, Zellers paid
to the Company $1,147,000 in royalty revenues for merchandise sold bearing the
Cherokee brand.
18
The Company is frequently approached by parties seeking to sell their brands
and related trademarks. Should an established and marketable brand become
available on favorable terms, the Company currently has significant assets with
which to pursue such an acquisition. In addition to acquiring brands, the
Company is seeking to represent and manage, as an exclusive agent, other brands
with respect to international marketing, licensing and distribution. As an
exclusive agent, Cherokee would perform services, which include solicitation,
contract completion, maintenance, development and administration of license or
distribution agreements. The Company would receive a certain percentage of net
royalties for the services it rendered as an exclusive agent. Cherokee intends
to use its newly developed Web-site (www.cherokeegroup.com) to enhance its
licensing activities.
In 1997, the Company's Board changed the fiscal year end of the Company to a
52 or 53 week fiscal year ending on the Saturday nearest to January 31 in order
to better align the Company with its licensees who generally also operate and
plan using such a fiscal year. Prior to this change the Company's fiscal year
was a 52 or 53 week fiscal year ending on the Saturday nearest May 31. As a
result, the 1997 fiscal year ended on May 31, 1997 and included 52 weeks, while
the Eight Month Fiscal Period ended January 31, 1998 and included 35 weeks.
Fiscal 1999 ended January 30, 1999 and included 52 weeks.
Results of Operations
The following table sets forth for the periods indicated certain consolidated
financial data of the Company. In December 1997, the Company entered into the
Assignment Agreement and Spell C entered into the Indenture. In addition, the
Company's historical financial statements (presented below) relating to the
Year Ended May 31, 1997 and the Year Ended June 1, 1996, include operating
results relating to the Apparel Division, Footwear Division and Uniform
Division, all of which have been terminated or sold. Therefore, the historical
financial statements are not indicative of the results of operations
attributable to the ongoing Company or after giving effect to the Assignment
Agreement or the indenture for the Secured Notes. Further, during the fiscal
year ended January 30, 1999, $6,750,000 in royalty revenues from the Company
were distributed to the holders of the Secured Notes.
Eight
Eight Months
Months Ended
Year Ended Ended January 31, Year Ended Year Ended
January 30, January 1997 May 31, June 1,
1999 31, 1998 (unaudited) 1997 1996
----------- ---------- ----------- ---------- -----------
Royalty Revenues / Net
Sales
Apparel Division...... $ -- $ -- $ -- $ -- $ 7,846,000
Footwear Division..... -- -- -- -- 2,331,000
Licensing Division.... 19,307,000 8,553,000 4,723,000 8,333,000 1,421,000
Other(1)/Uniforms..... -- -- 366,000 385,000 2,301,000
Total Company....... $19,307,000 $8,553,000 $5,089,000 $8,718,000 $13,899,000
=========== ========== ========== ========== ===========
Gross Profit
Apparel Division...... $ -- $ -- $ -- $ -- $ 1,217,000
Footwear Division..... -- -- -- -- 56,000
Licensing Division.... 19,307,000 8,553,000 4,723,000 8,333,000 1,421,000
Other(1)/Uniforms..... -- -- 183,000 201,000 760,000
Total Company....... $19,307,000 $8,553,000 $4,906,000 $8,534,000 $ 3,454,000
=========== ========== ========== ========== ===========
Selling, general ,
administrative and
Amortization expenses.. $ 6,628,000 $4,235,000 $1,778,000 $3,406,000 $ 4,460,000
Performance option
expense................ -- -- -- -- $ 4,567,000(2)
Operating income
(loss)................. $12,679,000 $4,318,000 $3,128,000 $5,128,000 $(5,573,000)
- --------
(1) Other sales include the liquidation of the remaining sweatshirt inventory
during fiscal year ended May 31, 1997.
(2) A non-cash charge of $4,567,000 resulting from the exercise of performance
options for the year ended June 1, 1996.
19
Fiscal 1999 compared to Comparative 1998
In Fiscal 1999, revenues increased 58% to $19,307,000 from $12,182,000 for
the unaudited 12 month period ended January 30, 1998, used for comparative
purposes ("Comparative 1998"). Revenues for both Fiscal 1999 and Comparative
1998 were generated solely from licensing the Company's trademarks. Revenues
from Target for Fiscal 1999 and Comparative 1998 were $14,604,000 or 76% and
$8,884,000 or 73%, respectively, of revenues. Revenues from all other sources
for Fiscal 1999 and Comparative 1998 were $4,703,000 or 24% and $3,298,000 or
27%, respectively, of revenues.
Selling, general and administrative expenses (excluding trademark
amortization expense of $200,000) for Fiscal 1999 were $6,428,000 or 33% of
revenues compared to $5,950,000 or 49% of revenues for Comparative 1998. During
Fiscal 1999, selling, general and administrative expenses increased due to
expenses of approximately $200,000 in amortization of the Company's trademarks,
$260,000 in salaries for additional marketing staff to intensify the Company's
domestic and international efforts to negotiate contracts, $206,000 in
amortization of the securitization fees, which were incurred by Spell C in
completing the recapitalization and $1,770,000 in accrued management bonus.
The Company's interest expense for Fiscal 1999 and Comparative 1998 was
$3,247,000 and $330,000, respectively. The interest expense is attributable to
the Secured Notes. The Company's investment and interest income for Fiscal 1999
and Comparative 1998 was $638,000 and $690,000, respectively.
The Company's net income for Fiscal 1999 was $6,088,000 or $0.70 per diluted
share compared to a net income of $8,862,000 or $1.05 per diluted share for
Comparative 1998, a period in which an income tax benefit of $1,553,000 or
$0.18 per diluted share was booked due to net operating loss carryforwards
("NOL's"). For Fiscal 1999, the Company booked for GAAP purposes a tax
provision of $3,982,000 or $0.46 per diluted share, which amounts were offset
against the Company's deferred tax asset account.
For Fiscal 1999, the income tax provision was calculated using an effective
tax rate of 39.5%. At January 30, 1999, the Company has federal NOL's,
generated subsequent to the Company's 1994 reorganization, of approximately
$5,175,000, which will begin to expire in 2011. The Company believes
utilization of these losses is not subject to Internal Revenue Code Section 382
limitations. The Company has fully utilized the California NOL's generated
after the 1994 reorganization.
Eight Months Ended January 31, 1998 Compared to Eight Months Ending February 1,
1997
Revenues for the Eight Month Fiscal Period ended January 31, 1998 were
$8,553,000, 100% of which represented licensing revenues. In comparison, net
sales for the unaudited eight months ended February 1, 1997 (the "1997 Eight
Months") were $5,089,000, which included $4,723,000 in licensing revenues with
the remaining sales from the liquidations of apparel and footwear inventories.
As a percentage of total revenues for the 1997 Eight Months, licensing revenues
represented 93%. Revenues from Target for the Eight Month Fiscal Period were
$6,428,000, which represented 75% of net revenues. Revenues from all other
sources for the Eight Month Fiscal Period were $2,125,000, which represented
25% of net revenues.
The Company's gross profit margin for the Eight Month Fiscal Period was
$8,553,000 or 100% of net revenues compared to $4,906,000 or 96% of net sales
for the 1997 Eight Months. The gross profit percentage is not comparable to
historical levels as a result of the Company ceasing to manufacture and import
apparel and footwear and selling its inventories.
Selling, general and administrative expenses (excluding amortization expense
of $43,000) for the Eight Month Fiscal Period were $4,192,000 or 49% of net
revenues compared to $1,778,000 (net of certain other liabilities totaling
$700,000 which were deemed no longer necessary), or 35% of net sales for the
1997 Eight Months. During the Eight Month Fiscal Period, selling, general and
administrative expenses increased due to the payment of $474,000 in financial
advisory services, $240,000 in staff bonuses, the addition of marketing staff
to intensify the Company's international efforts to negotiate contracts, and
the development of advertising
20
materials to expand the Company's global marketing and to maintain the synergy
of the Cherokee brand image on a worldwide basis. Selling, general and
administrative expenses for the Eight Month Fiscal Period included certain non-
recurring expenses totaling $474,000.
Liquidity and Capital Resources
On January 30, 1999, the Company had $7,347,000 in cash and cash equivalents,
including restricted cash of $4,500,000. Cash flow needs over the next twelve
months are expected to be met through the operating cash flows generated from
licensing revenues and the Company's cash and cash equivalents.
During Fiscal 1999, cash provided by operations was $12,818,000. During
Fiscal 1999, cash used in investing activities was $957,000 due mainly to
$216,000 in office equipment and leasehold improvements to the office facility
and $741,000 in trademark purchases and registration fees. During Fiscal 1999,
cash used in financing activities was $14,789,000, excluding restricted cash,
which represented the net from the proceeds received from the exercise of stock
options, the Secured Notes payments and the cash dividend distributions made
during Fiscal 1999.
Inflation and Changing Prices
Inflation, traditionally, has not had a significant effect on the Company's
operations. Since most of the Company's future revenues are based upon a
percentage of sales of the licensed products by the Company's licensees, the
Company does not anticipate that inflation will have a material impact on
future operations.
Year 2000 Compliance
The Year 2000 issue is a result of computer programs being written using two
digits, e.g. "98", to define a year. Date-sensitive software may recognize the
year "00" as the year 1900 rather than the year 2000. This would result in
errors and miscalculations or even system failure causing disruptions in
everyday business activities and transactions. Software is termed "Year 2000
compliant" when it is capable of performing transactions correctly in the year
2000.
Because the Company's primary business is marketing and licensing its
trademarks, the Company has only modest information technology requirements and
resources, none of which is critical to the Company's day-to-day operations.
Based on a recent assessment of the Company's computer hardware and software,
it has been determined that more than 95% of the Company's hardware and
software systems are either currently Year 2000 compliant or have an existing
upgrade available from the software vendor that is Year 2000 compliant. All
systems that are not currently Year 2000 compliant will either be upgraded to
be Year 2000 compliant or replaced with alternative systems that are Year 2000
compliant over the next eight months. The Company expects the costs to upgrade
or replace such systems will not exceed approximately $12,000.
The Company does not expect that the achievement of Year 2000 compliance by
the Company will have a material impact on its financial condition or results
of operations. However, the Company's financial condition or results of
operations could be materially adversely effected if its significant licensees
fail to adequately address and correct Year 2000 problems and such failures
result in the interruption of royalty payments or lower royalty payments. The
Company has no control over its licensees' Year 2000 compliance and as a result
the Company cannot develop a contingency plan to respond to any material
failures by its licensees to achieve Year 2000 compliance. The Company has
contacted its most significant licensees in an effort to determine the status
of their Year 2000 compliance efforts. The Company has received information
that these licensees have evaluated the impact, assessed the potential problems
of Year 2000 and they are currently taking steps to be in compliance in a
timely manner. Notwithstanding, there can be no assurance that the Company's
significant licensees will be Year 2000 compliant in a timely manner, and as
discussed above, their failure to do so could materially adversely effect the
Company
21
New Accounting Standards
In June 1998, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 133, "Accounting for Derivative Instruments
and Hedging Activities." This statement requires that all derivative
instruments be recorded on the balance sheet at their fair value. Changes in
the fair value of derivatives will be recorded each period in current earnings
or other comprehensive income, depending on whether a derivative is designated
as part of a hedge transaction and, if it is the type of hedge transaction. The
new rules will be effective the first quarter of 2000. The Company does not
believe that the new standard will have a material impact on the Company's
financial statements because the Company is not involved in derivative
instruments and hedging activities.
Subsequent Events
On March 1, 1999, the Company announced the hiring of Oliver E. Wood, Jr. as
Executive Vice-President of International Licensing. Mr. Wood has had extensive
international management, marketing and licensing experience in the apparel,
footwear and sports products industries. In his role as Executive Vice
President of International Licensing, Mr. Wood will help lead the Company to
further develop internationally its Cherokee and Sideout brands as well as
other brands it may acquire or represent in the future.
On April 14, 1998, the Company announced that its Board of Directors had
declared a cash dividend of $0.25 per share to be distributed on May 21, 1999
to the Company's shareholders of record on the close of business on April 30,
1999.
Item 7A. QUALITATIVE AND QUANTITATIVE DISCLOSURES OF MARKET RISK
Market risk generally represents the risk that losses may occur in the values
of financial instruments as a result of movements in interest rates, foreign
currency exchange rates and commodity prices. The Company does not enter into
derivatives or other financial instruments for trading or speculative purposes.
Interest: From time to time the Company invests its excess cash in interest-
bearing temporary investments of high-quality issuers. Due to the short time
the investments are outstanding and their general liquidity, these instruments
are classified as cash equivalents in the consolidated balance sheet of the
Company and do not represent a material interest rate risk to the Company. The
Company's only long-term debt obligations are the Secured Notes, which are
zero-coupon secured notes yielding interest of 7.0% interest per annum. This
long-term debt obligation does not represent a material interest rate risk to
the Company.
Foreign Currency: The Company conducts business in various parts of the
world. The Company is exposed to fluctuations in exchange rates to the extent
that the foreign currency exchange rate fluctuates in countries where the
Company's licensees do business. For Fiscal 1999, a hypothetical 10%
strengthening of the US dollar relative to the foreign currencies of countries
where the Company operates was not material.
Special Note Regarding Forward-Looking Statements
This Annual Report on Form 10-K contains certain forward-looking statements,
including without limitation, statements containing the words, "believes,"
"anticipates," "estimates," "expects," and words of similar import. Such
forward-looking statements involve known and unknown risks, uncertainties and
other factors which may cause the actual results, performance or achievements
of the Company to be materially different from any future results, performance
or achievements expressed or implied by such forward-looking statements. The
Company is subject to certain risk factors, which include, but are not limited
to, restrictions on distributions by Spell C, uncertainty regarding the Sideout
brand, competition, dependence on a single licensee, dependence on intellectual
property rights, and dependence on key management and other factors referenced
in this Form 10-K. Certain of these factors are discussed in more detail
elsewhere in this Form 10-K, including without limitation under the captions,
"Item 1. Business-Risk Factors" and "Item 7. Management's Discussion and
Analysis of Financial Condition and Results of Operations." The forward-looking
information provided by the Company pursuant to the safe harbor established
under the Private Securities Litigation Reform Act of 1995 should be evaluated
in conjunction with the risk factors listed under "Item 1. Business-Risk
Factors." Given the known and unknown risks and uncertainties, undue reliance
should not be placed on the forward-looking statements contained herein. In
addition, the Company disclaims any intent or obligation to update any of the
forward-looking statements contained herein to reflect future events and
developments.
22
Item 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
INDEX TO FINANCIAL STATEMENTS
Page
----
CHEROKEE INC.
Report of Independent Accountants......................................... F-1
Consolidated Balance Sheets At January 30, 1999, January 31, 1998 and May
31, 1997................................................................. F-2
Consolidated Statements of Operations For the Years Ended January 30, 1999
and for the Eight Months Ended January 31, 1998 and for the Years Ended
May 31, 1997 and June 1, 1996............................................ F-3
Consolidated Statements of Stockholders' Equity (Deficit) For the Years
Ended January 30, 1999 and for the Eight Months Ended January 31, 1998
and for the Years Ended May 31, 1997 and June 1, 1996.................... F-4
Consolidated Statements of Cash Flows For the Years Ended January 30, 1999
and for the Eight Months Ended January 31, 1998 and for the Years Ended
May 31, 1997 and June 1, 1996............................................ F-5
Notes to Financial Statements............................................. F-6
SCHEDULES
11 Valuations and Qualifying Accounts and Reserves...................... F-19
All other schedules for which provision is made in the applicable accounting
regulation of the SEC have been omitted since the required information is not
applicable or is not present in amounts sufficient to require submission of the
schedule, or because the information required is included in the Consolidated
Financial Statements and related notes.
23
Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
Not applicable.
PART III
Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required by this Item with respect to directors and
compliance with Section 16(a) of the Exchange Act is incorporated herein by
reference to the information contained in the Proxy Statement relating to the
Company's 1999 Annual Meeting of Stockholders scheduled to be held on June 14,
1999, which will be filed with the SEC no later than 120 days after the close
of the fiscal year ended January 30, 1999. The following table sets forth
information with respect to each of the Company's current executive officers.
Name, Age and Principal Occupation for Past Five Years;
Present Position with the Company Business Experience
--------------------------------- -----------------------------------------
Robert Margolis, 51 Mr. Margolis was appointed Chairman of the Board
Director, Chairman of the Board of and Chief Executive Officer of the Company on
Directors May 5, 1995. Mr. Margolis was the co-founder of
and Chief Executive Officer the Company's Apparel Division in 1981. He had
been the Co-Chairman of the Board of Directors,
President and Chief Executive Officer of the
Company since June 1990 and became Chairman of
the Board on June 1, 1993. Mr. Margolis resigned
all of his positions with the Company on
October 31, 1993 and entered into a one-year
consulting agreement with the Company. Since
1994 Mr. Margolis has been Chief Executive
Officer and a Director of a privately owned
company operates various textiles and apparel
related enterprises, including a private label
manufacturing operation. Wilstar's private label
manufacturing operations were sold to an
unrelated party in April 1997. Wilstar provides
Mr. Margolis' services as Chief Executive
Officer of the Company pursuant to the terms of
a management agreement between the Company and
Wilstar.
Howard Siegel, 43 Mr. Siegel has been employed by Cherokee since
President-Operations January 1996 as Vice President of Operations and
administration and became President of
Operations on June 1, 1998. Prior to January
1996, Mr. Siegel had a long tenure in the
apparel business industry working as a Senior
Executive for both Federated Department stores
and Carter Hawley Hale Broadway stores. He was
instrumental in the reorganization of Carter
Hawley Hale prior to joining Cherokee.
Carol Gratzke, 50 Ms. Gratzke returned to Cherokee in November
Chief Financial Officer 1995 as its Chief Financial Officer. From August
1986 to July 1994, she was the Controller and,
for a portion of such period, the Chief
Financial Officer of the Apparel & Uniform
Divisions. From July 1994 to September 1995, she
was Executive Vice President of Finance for a
Los Angeles based apparel manufacturing company.
24
Name, Age and Principal Occupation for Past Five Years;
Present Position with the Company Business Experience
--------------------------------- -----------------------------------------
Stephen Ascher, 36 Mr. Ascher joined Cherokee in November 1997 when
Executive Vice President, North America the worldwide rights of the Sideout brand were
purchased in November 1997. In November 1983,
Mr. Ascher founded Sideout Sport, Inc. and the
original concept of Sideout Sport as a line of
clothing that would be functional and classic,
both on and off the volleyball court. He was the
President and CEO of Sideout Sport through
October 1997. and the former President of
Sideout Sport Inc.
Oliver E. Wood, Jr., 56 Mr. Wood joined Cherokee in March 1999 as
Executive Vice President, Executive Vice President of International
International Marketing Marketing. He has extensive international
management, marketing and licensing experience
in the apparel, footwear and sports products
industries. From 1987 to March 1996, Mr. Wood
was Corporate Vice President, International
division of Oshkosh B'Gosh, Inc. Other career
experience included management of international
divisions for Levi Strauss, Healthtex and
Genesco. From March 1996 to March 1999, he was
president of his own international consulting
firm.
Item 11. EXECUTIVE COMPENSATION
The information required by this Item is incorporated herein by reference to
the information contained in the Proxy Statement relating to the Company's 1999
Annual Meeting of Stockholders scheduled to be held on June 14, 1999, which
will be filed with the SEC no later than 120 days after the close of the fiscal
year ended January 30, 1999.
Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by this Item is incorporated herein by reference to
the information contained in the Proxy Statement relating to the Company's 1999
Annual Meeting of Stockholders scheduled to be held on June 14, 1999, which
will be filed with the SEC no later than 120 days after the close of the fiscal
year ended January 30, 1999.
Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by this Item is incorporated herein by reference to
the information contained in the Proxy Statement relating to the Company's 1999
Annual Meeting of Stockholders scheduled to be held on June 14, 1999, which
will be filed with the SEC no later than 120 days after the close of the fiscal
year ended January 30, 1999.
25
PART IV
Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a)(1) The List of Financial Statements are filed as Item 8 of Part II of this
Form 10-K.
(2) List of Financial Statement Schedules.
II. Valuations and Qualifying Accounts and Reserves [included in the
Financial Statements filed as Item 8 of Part II of this Form 10-K].
(3) List of Exhibits.
The exhibits listed in the accompanying Index to Exhibits are filed as
part of this Form 10-K.
Exhibit
Number Description of Exhibit
------- ----------------------
2.1 Plan of Reorganization of Cherokee Inc. as confirmed on December 14,
1994 (incorporated by reference from Exhibit 2.1 to Cherokee Inc.'s
Current Report on Form 8-K dated January 5, 1995).
3.1 Amended and Restated Certificate of Incorporation of Cherokee Inc.
(incorporated by reference from Exhibit 3.1 of Cherokee Inc.'s Form 10
dated April 24, 1995).
3.2 Bylaws of Cherokee Inc. (incorporated by reference from Exhibit 3.2 of
Cherokee Inc.'s Form 10 dated April 24, 1995).
4.1 Indenture, dated December 23, 1997, among SPELL C. LLC, as issuer, and
Wilmington Trust Company, as trustee, with respect to the Zero Coupon
Secured Notes (incorporated by reference from Exhibit 4.3 of Cherokee
Inc.'s Form 10-K dated January 31, 1998).
4.2 Security Agreement dated December 23, 1997, between SPELL C. LLC and
Wilmington Trust Company (incorporated by reference from Exhibit 4.4
of Cherokee Inc.'s Form 10-K dated January 31, 1998).
10.1 Form of Director Warrant (incorporated by reference from Exhibit 10.3
of Cherokee Inc.'s Form 10 dated April 24, 1995).
10.2 Management Agreement dated as of May 4, 1995 between Cherokee Inc. and
The Newstar Group Inc., d/b/a The Wilstar Group ("Wilstar")
(incorporated by reference from Exhibit 10.5 of Cherokee Inc.'s Form
10-K dated June 3, 1995).
10.3 Option Agreement dated as of May 4, 1995 between Cherokee Inc. and
Wilstar (incorporated by reference from Exhibit 10.5 of Cherokee
Inc.'s Form 10-K dated June 3, 1995).
10.4 Registration Rights Agreement dated as of May 4, 1995 between Cherokee
Inc. and Wilstar (incorporated by reference from Exhibit 10.6 of
Cherokee Inc.'s Form 10-K dated June 3, 1995).
10.5 Amendment No. 1 to the Non-Qualified Stock Option Agreement dated
October 30, 1995. (incorporated herein by reference from Exhibit 10.7
of Cherokee Inc.'s Form 10-K dated June 1, 1996).
10.6 Amendment No. 2 to the Non-Qualified Stock Option Agreement dated
March 23, 1996. (incorporated herein by reference from Exhibit 10.7 of
Cherokee Inc.'s Form 10-K dated June 1, 1996).
10.7 Amendment No. 1 to the Revised and Restated Wilstar Management
Agreement dated April 26, 1996. (incorporated herein by reference from
Exhibit 10.7 of Cherokee Inc.'s Form 10-K dated June 1, 1996).
10.8 Asset Purchase Agreement dated July 17, 1995 between Cherokee Inc. and
Strategic Partners, Inc. (incorporated herein by reference from
Exhibit 2.1 to Cherokee Inc.'s Current Report on Form 8-K dated August
10, 1995).
26
Exhibit
Number Description of Exhibit
------- ----------------------
10.9 License Agreement between Cherokee Inc. and Target Stores, a division
of Dayton-Hudson Corporation, dated August 15, 1995 (incorporated by
reference from Exhibit 10.9 of Cherokee Inc.'s Form 10-K dated June 3,
1995).
10.10 Amendment No. 2 to the Revised and Restated Wilstar Management
Agreement dated July 21, 1997 (incorporated by reference from Exhibit
10.11 of Cherokee Inc.'s Form 10-K dated May 31, 1997).
10.11 Amendment No. 3 to the Revised and Restated Wilstar Management
Agreement dated July 21, 1997 (incorporated by reference from Exhibit
10.12 of Cherokee Inc.'s Form 10-K dated May 31, 1997).
10.12 Plan for Compensation in Lieu of Cash Dividends, dated January 15,
1997 (incorporated by reference from Exhibit 10.13 of Cherokee Inc.'s
Form 10-K dated May 31, 1997).
10.13 Agreement of Purchase and Sale of Trademarks and Licenses between
Cherokee Inc. and Sideout Sport, Inc. dated November 7, 1997
(incorporated by reference from Exhibit 2.1 of Cherokee Inc.'s Current
Report on Form 8-K dated November 7, 1997).
10.14 License Agreement between Cherokee Inc. and Dayton Hudson Stores dated
November 12, 1997 (incorporated by reference from Exhibit 10.1 of
Cherokee Inc.'s Current Report on Form 8-K dated November 7, 1997).
10.15 Note Purchase Agreement dated December 23, 1997, between SPELL C. LLC
and the purchasers listed on the signature pages thereto (incorporated
by reference from Exhibit 10.16 of Cherokee Inc.'s Form 10-K dated
January 31, 1998).
10.16 Trademark Purchase and License Assignment Agreement dated December 23,
1997 between SPELL C. LLC and Cherokee Inc. (incorporated by reference
from Exhibit 10.17 of Cherokee Inc.'s Form 10-K dated January 31,
1998).
10.17 Administrative Services Agreement dated December 23, 1997, between
SPELL C. LLC and Cherokee Inc. (incorporated by reference from Exhibit
10.18 of Cherokee Inc.'s Form 10-K dated January 31, 1998).
10.18 Limited Liability Company Agreement of SPELL C. LLC dated as of
December 23, 1997, between SPELL C. LLC and Cherokee Inc.
(incorporated by reference from Exhibit 10.19 of Cherokee Inc.'s Form
10-K dated January 31, 1998).
21.1 Subsidiaries of Cherokee Inc. (incorporated by reference from Exhibit
21.1 of Cherokee Inc.'s Form 10-K dated January 31, 1998).
23.1 Consent of Independent Auditors dated April 19, 1999.
27.1 Article 5 of Regulation S-X-- Financial Data Schedule
(b) Reports on Form 8-K.
none
27
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed
on its behalf by the undersigned, thereunto duly authorized.
CHEROKEE INC.
By /s/ Robert Margolis
-----------------------------------
Robert Margolis
Chairman and Chief Executive Officer
Date: April 19, 1999
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.
Signature Title Date
--------- ----- ----
/s/ Robert Margolis Chairman and Chief Executive April 19, 1999
____________________________________ Officer and Director
Robert Margolis
/s/ Carol Gratzke Chief Financial Officer / April 19, 1999
____________________________________ Chief Accounting Office
Carol Gratzke
/s/ Timothy Ewing Director April 19, 1999
____________________________________
Timothy Ewing
/s/ Keith Hull Director April 19, 1999
____________________________________
Keith Hull
/s/ Douglas Weitman Director April 19, 1999
____________________________________
Douglas Weitman
/s/ Jess Ravich Director April 19, 1999
____________________________________
Jess Ravich
28
REPORT OF INDEPENDENT ACCOUNTANTS
The Board of Directors and Stockholders of
Cherokee Inc.
In our opinion, the consolidated financial statements listed in the
accompanying index present fairly, in all material respects, the financial
position of Cherokee Inc. and its subsidiaries at January 30, 1999, January 31,
1998 and May 31, 1997, and the results of their operations and their cash flows
for the year ended January 30, 1999, the eight month period ended January 31,
1998, and the two years ended May 31, 1997 and June 1, 1996, in conformity with
generally accepted accounting principles. In addition, in our opinion, the
financial statement schedule listed in the accompanying index, presents fairly,
in all material respects, the information set forth therein when read in
conjunction with the related consolidated financial statements. These financial
statements and financial statement schedule are the responsibility of the
Company's management; our responsibility is to express an opinion on these
financial statements and financial statement schedule based on our audits. We
conducted our audits of these statements in accordance with generally accepted
auditing standards which require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements, assessing
the accounting principles used and significant estimates made by management,
and evaluating the overall financial statement presentation. We believe that
our audits provide a reasonable basis for the opinion expressed above.
/s/ PricewaterhouseCoopers LLP
Los Angeles, California
March 30, 1999
F-1
CHEROKEE INC.
CONSOLIDATED BALANCE SHEETS
January 30, January 31, May 31,
1999 1998 1997
------------ ------------ -----------
ASSETS
Current assets:
Cash and cash equivalents............ $ 2,847,000 $ 10,275,000 $ 9,391,000
Restricted cash...................... 4,500,000 -- --
Receivables, net..................... 3,232,000 2,347,000 1,024,000
Inventories.......................... -- 45,000 80,000
Prepaid expenses and other current
assets.............................. 29,000 220,000 30,000
Deferred tax asset................... 861,000 -- --
------------ ------------ -----------
Total current assets............... 11,469,000 12,887,000 10,525,000
Securitization fees, net of accumulated
amortization of $206,000, $17,000 and
$0, respectively...................... 1,018,000 1,218,000 --
Deferred tax asset..................... 3,527,000 7,576,000 2,408,000
Property and equipment, net of
accumulated depreciation of
$95,000,$63,000 and $40,000,
respectively.......................... 233,000 49,000 48,000
Trademarks, net........................ 3,176,000 2,703,000 577,000
Other assets........................... 106,000 38,000 43,000
------------ ------------ -----------
Total assets....................... $ 19,529,000 $ 24,471,000 $13,601,000
============ ============ ===========
LIABILITIES AND STOCKHOLDERS' (DEFICIT) EQUITY
Current liabilities:
Accounts payable..................... $ 280,000 $ 645,000 $ 210,000
Dividends payable.................... 2,176,000 -- --
Other accrued liabilities............ 1,755,000 522,000 417,000
Current portion of long term notes
payable............................. 9,000,000 6,525,000 --
------------ ------------ -----------
Total current liabilities.......... 13,211,000 7,692,000 627,000
Other liabilities...................... 500,000 750,000 750,000
Notes payable less current portion..... 35,697,000 41,675,000 --
------------ ------------ -----------
Total liabilities.................. 49,408,000 50,117,000 1,377,000
------------ ------------ -----------
COMMITMENTS AND CONTINGENCIES (NOTE 8)
STOCKHOLDERS' (DEFICIT) EQUITY
Common stock, $.02 par value,
20,000,000 shares authorized,
8,705,428, 8,612,657 and 7,726,986
shares issued and outstanding at
January 30, 1999, January 31, 1998,
and May 31, 1997, respectively........ 174,000 173,000 155,000
Additional paid-in capital............. -- -- 11,334,000
Accumulated deficit.................... (27,919,000) (23,806,000) 735,000
Note receivable from stockholder....... (2,134,000) (2,013,000) --
------------ ------------ -----------
Total stockholders' (deficit)
equity............................ (29,879,000) (25,646,000) 12,224,000
------------ ------------ -----------
Total liabilities and stockholders'
(deficit) equity.................. $ 19,529,000 $ 24,471,000 $13,601,000
============ ============ ===========
The accompanying notes are an integral part of these financial statements.
F-2
CHEROKEE INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
Eight Months
Year Ended Ended Year Ended Year Ended
January 30, January 31, May 31, June 1,
1999 1998 1997 1996
----------- ------------ ---------- -----------
Revenues:
Product sales, net......... $ -- $ -- $ 385,000 $12,478,000
Licensing revenues......... 19,307,000 8,553,000 8,333,000 1,421,000
----------- ---------- ---------- -----------
Total net revenues....... 19,307,000 8,553,000 8,718,000 13,899,000
Cost of goods sold......... -- -- 184,000 10,445,000
----------- ---------- ---------- -----------
Gross profit............... 19,307,000 8,553,000 8,534,000 3,454,000
Selling, general and
administrative expenses... 6,428,000 4,192,000 3,406,000 4,460,000
Performance option
expense................... -- -- -- 4,567,000
Amortization of
trademarks................ 200,000 43,000 -- --
----------- ---------- ---------- -----------
Operating income (loss).... 12,679,000 4,318,000 5,128,000 (5,573,000)
Other income (expenses):
Interest expense........... (3,247,000) (330,000) (3,000) (355,000)
Investment and interest
income.................... 638,000 525,000 460,000 543,000
Gain on sale of Uniform
Division and other
assets.................... -- -- 220,000 3,840,000
Other income............... -- 422,000 75,000 96,000
----------- ---------- ---------- -----------
Total other income
(expenses), net......... (2,609,000) 617,000 752,000 4,124,000
Income (loss) before income
taxes..................... 10,070,000 4,935,000 5,880,000 (1,449,000)
Income tax provision
(benefit)................. 3,982,000 (782,000) (771,000) --
----------- ---------- ---------- -----------
Net income (loss).......... $ 6,088,000 $5,717,000 $6,651,000 $(1,449,000)
=========== ========== ========== ===========
Basic earnings (loss) per
share..................... $ 0.70 $ 0.73 $ 0.87 $ (0.22)
=========== ========== ========== ===========
Diluted earnings (loss) per
share..................... $ 0.70 $ 0.68 $ 0.82 $ (0.22)
=========== ========== ========== ===========
Weighted average shares
outstanding:
Basic...................... 8,683,601 7,866,862 7,688,521 6,480,443
Diluted.................... 8,706,011 8,412,768 8,154,311 6,480,443
The accompanying notes are an integral part of these financial statements.
F-3
CHEROKEE INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' (DEFICIT) EQUITY
Accumulated Notes
Common Stock Additional (Deficit)/ Receivable
-------------------- Paid-in Retained from
Shares Par Value Capital Earnings Stockholder Total
--------- --------- ----------- ----------- ----------- -----------
Balance at June 3,
1995................... 6,096,000 122,000 11,703,000 (4,411,000) (192,000) 7,222,000
Issuance of new common
stock.................. 366,667 7,000 (7,000) -- -- --
Exercise of director
warrants, employee
stock options and
performance options.... 1,694,739 35,000 4,620,000 -- -- 4,655,000
Purchase and retirement
of treasury shares..... (31,593) (1,000) (60,000) (56,000) -- (117,000)
Cancellation of shares
held and returned by
disbursing agent....... (475,000) (10,000) 10,000 -- -- --
Distribution of
capital................ -- -- (4,289,000) -- -- (4,289,000)
Repayment on note
receivable............. -- -- -- -- 48,000 48,000
Net loss for the year
ended June 1, 1996..... -- -- -- (1,449,000) -- (1,449,000)
--------- ------- ----------- ----------- ---------- -----------
Balance at June 1,
1996................... 7,650,813 153,000 11,977,000 (5,916,000) (144,000) 6,070,000
Exercise of director
warrants and employee
stock options.......... 95,000 2,000 404,000 -- -- 406,000
Cancellation of shares
held and returned by
disbursing agent....... (18,827) -- -- -- -- --
Cash dividend
distributions.......... -- -- (2,529,000) -- -- (2,529,000)
Utilization of pre-
bankruptcy NOL
carryforwards.......... -- -- 1,482,000 -- -- 1,482,000
Repayment on note
receivable............. -- -- -- -- 144,000 144,000
Net income for the year
ended May 31, 1997..... -- -- -- 6,651,000 -- 6,651,000
--------- ------- ----------- ----------- ---------- -----------
Balance at May 31,
1997................... 7,726,986 155,000 11,334,000 735,000 -- 12,224,000
Exercise of director
warrants and employee
stock options.......... 885,671 18,000 2,850,000 -- -- 2,868,000
Cash dividend
distributions.......... -- -- (18,661,000) (30,258,000) -- (48,919,000)
Utilization of pre-
bankruptcy NOL
carryforwards.......... -- -- 1,727,000 -- -- 1,727,000
Stock option tax
benefit................ -- -- 2,750,000 -- -- 2,750,000
Note receivable from
stockholder............ -- -- -- -- (2,013,000) (2,013,000)
Net income for the eight
months ended January
31, 1998............... -- -- -- 5,717,000 -- 5,717,000
--------- ------- ----------- ----------- ---------- -----------
Balance at January 31,
1998................... 8,612,657 173,000 -- (23,806,000) (2,013,000) (25,646,000)
Exercise of director
warrants and employee
stock options.......... 92,771 1,000 667,000 -- -- 668,000
Cash dividend
distributions.......... -- -- (667,000) (10,210,000) -- (10,877,000)
Utilization of pre-
bankruptcy NOL
carryforwards.......... -- -- -- 9,000 -- 9,000
Stock option tax
benefit................ -- -- -- -- -- --
Note receivable from
stockholder............ -- -- -- -- (121,000) (121,000)
Net income for the year
ended January 30,
1999................... -- -- -- 6,088,000 -- 6,088,000
--------- ------- ----------- ----------- ---------- -----------
Balance at January 30,
1999................... 8,705,428 174,000 -- (27,919,000) (2,134,000) (29,879,000)
The accompanying notes are an integral part of these financial statements.
F-4
CHEROKEE INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
Eight Months
Year Ended Ended Year Ended
January 30, January 31, May 31, Year Ended
1999 1998 1997 June 1, 1996
------------ ------------ ----------- ------------
OPERATING ACTIVITIES
Net (loss) income....... $ 6,088,000 $ 5,717,000 $ 6,651,000 $ (1,449,000)
Adjustments to reconcile
net (loss) income to
net cash provided by
operating activities:
Depreciation and
amortization.......... 32,000 23,000 19,000 18,000
Amortization of
trademarks............ 200,000 43,000 -- --
Amortization of
securitization fees... 206,000 17,000 -- --
Amortization of debt
discount.............. 3,247,000 330,000 -- --
Provision for bad
debts................. -- -- (112,000) 112,000
Gain on Sale of
Uniform Division...... -- -- -- (1,588,000)
Interest income on
note receivable from
stockholder........... (121,000) (13,000) -- --
Deferred taxes......... 3,197,000 (3,058,000) (926,000) --
Stock option tax
benefit............... -- 2,367,000 -- --
Amortization of
discount on note
receivable............ -- -- -- 108,000
Performance option
exercise expense...... -- -- -- 4,567,000
Changes in current
assets and liabilities:
Receivables.......... (885,000) (1,573,000) (218,000) 10,747,000
Inventories.......... 45,000 35,000 176,000 11,274,000
Prepaids and other
current assets...... 191,000 (190,000) (20,000) 496,000
Accounts payable..... (365,000) 435,000 (122,000) (1,348,000)
Accrued payroll and
related expenses.... 1,233,000 105,000 -- (1,559,000)
Other liabilities.... (250,000) -- (750,000) (1,668,000)
------------ ------------ ----------- ------------
Net cash provided by
operating
activities.......... 12,818,000 4,238,000 4,698,000 19,710,000
INVESTING ACTIVITIES
Purchases of trademark.. $ (673,000) $ (2,169,000) $ (458,000) $ (119,000)
Purchase of property and
equipment.............. (216,000) (24,000) (23,000) (25,000)
Proceeds from sales of
assets held for sale... -- -- 3,576,000 89,000
Purchase of treasury
shares................. -- -- -- (117,000)
Restricted cash......... -- -- 310,000 (310,000)
Repayment on note
receivable from
stockholder............ -- -- 144,000 48,000
Change in other assets.. (68,000) 5,000 99,000 60,000
Collection of notes
receivable............. -- 250,000 1,961,000 --
------------ ------------ ----------- ------------
Net cash (used in)
provided by
investing
activities.......... (957,000) (1,938,000) 5,609,000 (374,000)
FINANCING ACTIVITIES
Increase in restricted
cash................... (4,500,000) -- -- --
Payment of long-term
debt................... (6,750,000) -- -- --
Net proceeds from the
issuance of long-term
debt................... -- 47,870,000 -- --
Debt issuance costs..... (6,000) (1,235,000) -- --
Net payments on
revolving credit and
other.................. -- -- -- (14,213,000)
Note receivable from
stockholder............ -- (2,000,000) -- --
Proceeds from exercise
of stock options....... 668,000 2,786,000 336,000 64,000
Proceeds from exercise
of warrants............ -- 82,000 70,000 24,000
Cash distributions and
dividends.............. (8,701,000) (48,919,000) (2,529,000) (4,289,000)
------------ ------------ ----------- ------------
Net cash used in
financing
activities.......... (19,289,000) (1,416,000) (2,123,000) (18,414,000)
------------ ------------ ----------- ------------
(Decrease) increase in
cash and cash
equivalents............ (7,428,000) 884,000 8,184,000 922,000
Cash and cash
equivalents at
beginning of period.... 10,275,000 9,391,000 1,207,000 285,000
------------ ------------ ----------- ------------
Cash and cash
equivalents at end of
period................. $ 2,847,000 $ 10,275,000 $ 9,391,000 $ 1,207,000
============ ============ =========== ============
TOTAL PAID DURING
PERIOD:
Income taxes........... $ 221,000 $ 64,000 $ 4,600 $ --
Interest............... $ 298,000 $ -- $ 3,000 $ 355,000
NON-CASH TRANSACTIONS:
Declaration of cash
dividend.............. $ 2,176,000 $ -- $ -- $ --
Utilization of pre-
bankruptcy NOL
carryforwards......... $ 9,000 $ 1,727,000 $ 1,482,000 $ --
The accompanying notes are an integral part of these financial statements.
F-5
CHEROKEE INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. Business
Cherokee Inc. (the "Company") is in the business of marketing and licensing
the Cherokee and Sideout brands and related trademarks and other brands it
owns. The Company is one of the leading licensors of brand names and trademarks
for apparel, footwear and accessories in the United States. The Company's
operating strategy emphasizes retail direct, wholesale and international
licensing whereby the Company grants retailers and wholesalers the license to
use the trademarks held by the Company on certain categories of merchandise and
the licensees are responsible for designing and manufacturing the merchandise.
The Company and its wholly-owned subsidiary, Spell C. LLC ("Spell C"), hold
several trademarks including Cherokee(R), Sideout(R), Sideout Sport(R), King of
the Beach(R), and others. The Cherokee brand, which began as a footwear brand
in 1973, has been positioned to connote quality, comfort, fit, and a "Casual
American lifestyle with traditional wholesome values." The Sideout brand and
related trademarks, which represent a beach-oriented active, "California"
lifestyle, were acquired by the Company in November 1997. As of January 30,
1999 the Company had twenty-nine continuing license agreements, covering both
domestic and international markets. The Company currently enters into three
main types of licensing agreements; North American retail direct, North
American wholesale and International licensing agreements. In North American
retail direct licensing, the Company grants retailers the license to use the
trademarks on certain categories of merchandise, including those products that
the Company previously manufactured, generally on a non-exclusive basis, and
the retailer is responsible for designing and manufacturing the merchandise. In
North American wholesale licensing, the Company grants unaffiliated
manufacturers the license to manufacture and market certain categories of
merchandise, such as sunglasses, watches and luggage. In International
licensing, the Company seeks to develop in certain international markets its
brands through wholesale licenses with manufacturers or other companies who
have market power and economies of scale in their respective markets.
In 1995, the Company stopped manufacturing and importing apparel and
footwear, sold its existing inventories of apparel and footwear, and on July
28, 1995 sold the assets of its Uniform Division.
2. Summary of Significant Accounting Policies
Principles of Consolidation
The consolidated financial statements include the accounts of the Company and
its wholly-owned subsidiary, SPELL C. LLC, a Delaware limited liability
corporation. All significant intercompany accounts and transactions have been
eliminated in consolidation.
Company Year End
On December 19, 1997, the Company changed its fiscal year to a 52 or 53 week
fiscal year ending on the Saturday nearest to January 31 in order to better
align the Company with its licensees who also generally operate and plan using
a fiscal year ending nearest to January 31. Prior to this change, the Company's
fiscal year was a 52 or 53 week fiscal year ending on the Saturday nearest to
May 31.
Use of Estimates
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions
that affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the dates of the financial statements and
revenues and expenses during the reporting periods. Actual results could differ
from those estimates.
F-6
CHEROKEE INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Cash and Cash Equivalents
The Company considers all highly liquid debt instruments purchased and money
market funds with an original maturity date of three months or less to be cash
equivalents.
The Secured Notes indenture requires the trustee to retain in the collection
account an amount equal to two quarterly note payments, which totals $4,500,000
for Fiscal 1999.
Revenue Recognition
Product sales are recognized on the date of shipment. Royalty revenues are
recognized when earned based upon contractual agreement.
Property and Equipment
Property and equipment are stated at cost, less accumulated depreciation and
amortization. Maintenance and repairs are expensed as incurred. The cost and
related accumulated depreciation of property and equipment sold or retired are
removed from the accounts 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 ranging from three to eight years.
Trademarks
Trademark registrations, renewal fees and acquired trademarks are stated at
cost and are amortized over the useful life of the registrations ranging from
ten to fifteen years.
Securitization Fees
Securitization fees are the costs associated with the leveraged
recapitalization which have been capitalized and are being amortized over the
term of the Secured Notes indenture.
Long-Lived Assets
The carrying value of long-lived assets is periodically reviewed by
management, and impairment losses, if any, are recognized when the expected
nondiscounted future operating cash flows derived from such assets are less
than their carrying value. Based on current information management believes no
impairment exists.
Income Taxes
Income tax expense is the tax payable for the period and the change during
the period in deferred tax assets and liabilities. Deferred income taxes are
determined based on the difference between the financial reporting and tax
bases of assets and liabilities using enacted rates in effect during the year
in which the differences are expected to reverse. Valuation allowances are
established when necessary to reduce deferred tax assets to the amount expected
to be realized.
Following bankruptcy by the Company in 1994, the Company adopted fresh-start
reporting. Under fresh-start reporting and Statement of Financial Accounting
Standards No. 109 "Accounting for Income Taxes", the tax benefits realized from
net operating loss carryforwards that survive the reorganization will be a
direct credit to additional paid-in-capital.
F-7
CHEROKEE INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Concentrations of Credit Risk
Financial instruments which potentially subject the Company to concentration
of credit risk consist principally of cash and cash equivalents and trade
receivables. The Company limits its credit risk with respect to cash by
maintaining cash balances with quality financial institutions. At January 30,
1999, January 31, 1998 and May 31, 1997, the Company's cash and cash
equivalents exceeded FDIC limits. Concentrations of credit risk with respect to
trade receivables are minimal due to the limited amount of open receivables and
due to the nature of the Company's licensing royalty revenue program.
Generally, the Company does not require collateral or other security to support
customer receivables. As of January 30, 1999, the Company had twenty-nine
continuing license agreements; seven of which were with retailers, six of which
were with domestic licensees and sixteen of which were with international
licensees.
One customer accounted for approximately 76%, 96% and 83%, respectively, of
the Company's trade receivables at January 30, 1999, January 31, 1998 and May
31, 1997 and approximately 76%, 75% and 68%, respectively, of the Company's
revenues during the fiscal periods ended January 30, 1999, January 31, 1998 and
May 31, 1997.
Stock-Based Compensation
SFAS No. 123 "Accounting for the Awards of Stock-Based Compensation to
Employees" encourages, but does not require companies to record compensation
cost for stock-based compensation plans at fair value. The Company has adopted
the disclosure requirements of SFAS No. 123, which involves proforma disclosure
of net income under SFAS No. 123, detailed description of plan terms and
assumptions used in valuing stock option grants. The Company has chosen to
continue to account for stock-based compensation awards in accordance with
Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to
Employees".
Advertisement
The Company's retail direct licensees fund their own advertisement programs.
The Company's advertising and promotional costs are immaterial and are expensed
as incurred.
Earnings Per Share
Basic earnings per share is computed by dividing the net income attributable
to common shareholders by the weighted average number of common shares
outstanding during the period. Diluted earnings per share is computed by
dividing the net income attributable to common shareholders by the weighted
average number of common and common equivalent shares outstanding during the
period. Common share equivalents included in the diluted computation represent
shares issuable upon assumed exercise of stock options using the treasury stock
method.
Comprehensive Income
In June 1997, the FASB issued SFAS No. 130 "Reporting Comprehensive Income,"
which establishes standards for reporting and displaying comprehensive income
and its components (revenues, expenses, gains and losses) in a full set of
general-purpose financial statements. Comprehensive income includes net income
and other comprehensive income components which under generally accepted
accounting principles ("GAAP") bypass the income statement and are reported in
the balance sheet as a separate component of equity. For the year ended January
30, 1999, the eight months ended January 31, 1998 and the two years ended May
31, 1997 and June 1, 1996, the Company had no other comprehensive income
components as defined in SFAS No. 130, and accordingly, net income equals
comprehensive income.
F-8
CHEROKEE INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Segment Reporting
The Company adopted SFAS No. 131. "Disclosures about Segments of an
Enterprise and Related Information" for the year ended January 30, 1999. SFAS
No. 131 supercedes SFAS No. 14, "Financial Reporting for Segments of a Business
Enterprise", replacing the "industry segment" approach with the "management"
approach. The management approach designates the internal organization that is
used by management for making operating decisions and assessing performance as
the source of the Company's reportable segments. SFAS No. 131 also requires
disclosures about products or services, geographic areas and major customers.
The adoption of SFAS No. 131 did not affect the results of operations or
financial position nor the the disclosure of segment information, as the
Company's reporting structure provides for only one segmentthe marketing and
licensing of its trademarks.
Reclassifications
Certain prior year amounts have been reclassified to conform with current
period presentation.
3. Receivables
Receivables consist of the following:
January January May 31,
30, 1999 31, 1998 1997
---------- ---------- ----------
Trade...................................... $3,223,000 $2,289,000 $ 657,000
Note Receivable, Current................... -- -- 250,000
Other...................................... 9,000 58,000 117,000
---------- ---------- ----------
$3,232,000 $2,347,000 $1,024,000
========== ========== ==========
4. Trademarks
Intangible and other assets consist of the following:
January January May 31,
30, 1999 31, 1998 1997
---------- ---------- --------
Trademarks................................... $3,419,000 $2,746,000 $577,000
Accumulated amortization..................... 243,000 43,000 --
---------- ---------- --------
Total...................................... $3,176,000 $2,703,000 $577,000
========== ========== ========
In November 1997, the Company entered into an agreement with Sideout Sport
Inc. (the "Sideout Agreement") to purchase trademarks and licenses related to
Sideout(R), Sideout Sport(R) and King of the Beach(R). Pursuant to the Sideout
Agreement the Company paid $1,500,000 at the closing date of the acquisition
and agreed to pay $500,000 upon the release of liens, of which $495,000 was
paid during Fiscal 1999. The Company will also pay Sideout Sport Inc., on a
quarterly basis, additional consideration contingent upon a formula of
licensing revenues, as defined in the Sideout Agreement. Such contingent
consideration is limited to a maximum of $5,500,000, or the lesser amount which
may be earned through October 22, 2004.
5. Long-Term Debt
In September 1997, the Company's Board authorized Libra Investments, Inc.
("Libra") to explore ways to maximize shareholder value, including a
recapitalization or sale of the Company. On December 23, 1997,
F-9
CHEROKEE INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
the Company completed the recapitalization described below and publicly
announced that it would declare a special dividend of $5.50 per share, which
was subsequently paid on January 15, 1998. The dividend was initially recorded
as a debit to additional paid in capital. For the year ended January 30, 1999
this dividend has been reclassified as a deduction from accumulated deficit.
As part of the recapitalization, the Company, in exchange for the proceeds
from the Secured Notes (as defined below), sold to its wholly-owned subsidiary,
Spell C, all its rights to the Cherokee brand and related trademarks in the
United States and assigned to Spell C all of its rights in an amended licensing
agreement (the "Amended Target Agreement") with Target Stores, a division of
Dayton Hudson Corporation ("Target"). Spell C issued for gross proceeds of
$47.9 million, privately placed Zero Coupon Secured Notes (the "Secured
Notes"), yielding 7.0% interest per annum and maturing on February 20, 2004.
The Secured Notes amortize quarterly from May 20, 1998 through February 20,
2004. The Secured Notes are collateralized by the Amended Target Agreement and
the domestic Cherokee brand name and trademarks. The Secured Notes indenture
requires that any proceeds due to Spell C under the Amended Target Agreement
must be deposited directly into a collection account controlled by the trustee
under the indenture. The trustee will distribute from the collection account
the amount of principal due and payable on the Secured Notes to the holders
thereof on quarterly note payment dates. Excess amounts on deposit in the
collection account may only be distributed to Spell C if the amount on deposit
in the collection account exceeds the aggregate amount of principal due and
payable on the next quarterly note payment date. Such excess amounts, if any,
may then be distributed by Spell C to the Company. During Fiscal 1999, of the
$14,604,000 in royalty revenues received from Target pursuant to the Amended
Target Agreement, $6,750,000 was paid to the holders of the Secured Notes,
$4,911,000 remains in a collection account for the benefit of the holders of
Secured Notes and excess amounts totaling $2,943,000 were distributed to Spell
C. No amounts were distributed from Spell C to the Company during Fiscal 1999.
The minimum guaranteed royalty under the Amended Target Agreement is $9.0
million for each of the two fiscal years ending January 29, 1999 and 2000 and
$10.5 million for each of the four fiscal years ending January 31, 2001 through
2004. The aggregate scheduled amortization under the Secured Notes is $60.0
million and equals the aggregate minimum guaranteed royalty payable under the
Amended Target Agreement which is also $60.0 million. During Fiscal 1999, the
trustee distributed from the collection account $6,750,000 to the holders of
the Secured Notes.
The Maturity Schedule of Secured Notes is as follows:
Face Value
-----------
2000............................................................ $ 9,000,000
2001............................................................ 10,125,000
2002............................................................ 10,500,000
2003............................................................ 10,500,000
2004............................................................ 10,500,000
Thereafter...................................................... 2,625,000
-----------
Total......................................................... $53,250,000
Less unamortized note discount.................................. 8,553,000
-----------
44,697,000
Less current portion of long term debt.......................... 9,000,000
-----------
Long term obligation............................................ $35,697,000
===========
F-10
CHEROKEE INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
6. Income Taxes
The income tax benefit as shown in the statements of operations includes the
following:
Eight Months Year Year
Year Ended Ended Ended Ended
January 30, January 31, May 31, June 1,
1999 1998 1997 1996
----------- ------------ --------- -------
Current:
Federal.......................... $ 229,000 $1,892,000 $ 96,000 $--
State............................ 410,000 353,000 32,000 --
Foreign.......................... 155,000 31,000 27,000 --
---------- ---------- --------- ----
794,000 2,276,000 155,000 --
Deferred:
Federal.......................... 2,923,000 (3,058,000) (785,000) --
State............................ 265,000 -- (141,000) --
---------- ---------- --------- ----
3,188,000 (3,058,000) (926,000) --
---------- ---------- --------- ----
$3,982,000 $ (782,000) $(771,000) $--
========== ========== ========= ====
Deferred income taxes are comprised of the following:
January 30, 1999 January 31, 1998
-------------------- -------------------
Current Non-Current Current Non-Current
-------- ----------- ------- -----------
Deferred tax assets:
Fixed assets..................... $ -- $ 11,000 $-- $ --
Accrued liabilities.............. 776,000 -- -- --
Tax effect of NOL carryovers..... -- 5,070,000 -- 9,110,000
AMT credit carryforward.......... -- 352,000 -- --
Other............................ 85,000 (48,000) -- 324,000
Valuation allowance.............. -- (1,858,000) -- (1,858,000)
-------- ----------- ---- -----------
Total deferred tax assets...... $861,000 $ 3,527,000 $-- $ 7,576,000
======== =========== ==== ===========
May 31, 1997
--------------------
Current Non-Current
-------- -----------
Deferred tax assets:
Tax effect of NOL carryovers..... $ -- $ 8,648,000
Other............................ -- 218,000
Valuation allowance.............. -- (6,458,000)
-------- -----------
Total deferred tax assets...... $ -- $ 2,408,000
======== ===========
The Company's deferred tax asset is primarily related to accrued liabilities,
AMT credit carryforwards and net operating loss carryforwards. For the fiscal
period ended January 31, 1998, the valuation allowance was reduced since the
the Company believes that it is more likely than not that the majority of the
deferred tax asset will be realized based upon the expected future income. The
remaining valuation allowance relates to amounts attributable to IRC Section
382 net operating losses (as described below), which the Company believes may
expire unused. The reduction in the valuation allowance relating to pre-
reorganization carryovers was credited to additional paid-in-capital. No
further adjustment was made to the valuation allowance in the year ended
January 30. 1999.
F-11
CHEROKEE INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
A reconciliation of the actual income tax rates to the federal statutory rate
follows:
Eight
Months Year Year
Year Ended Ended Ended Ended
January 30, January 31, May 31, June 1,
1999 1998 1997 1996
----------- ----------- ------- -------
Tax (benefit) expense at U.S.
statutory rate.................. 34.0 % 34.0 % 34.0 % (34.0)%
Additional paid-in-capital....... 35.2 25.2 --
Net operating loss for which no
tax benefit was recognized...... -- -- -- 34.0
Utilization of Net operating Loss
carryforward.................... -- -- (33.6) --
Valuation Allowance.............. -- (93.8) (41.0) --
Foreign taxes.................... 1.6 .6 .5 --
State income tax benefit net of
federal income tax.............. 4.5 4.8 .4 --
Others........................... (.6) 3.4 1.4 --
---- ----- ----- -----
Tax provision (benefit).......... 39.5 % (15.8)% (13.1)% --
==== ===== ===== =====
At January 30, 1999 the Company has federal net operating loss carryovers
("NOL's"), generated subsequent to the Company's 1994 reorganization, of
approximately $5,175,000, which will begin to expire in 2011. The Company
believes utilization of these losses is not subject to Internal Revenue Code
("IRC") Section 382 limitations. The Company has fully utilized the California
NOL's generated after the 1994 reoganization.
In 1994, the Company filed a prepackaged plan of reorganization pursuant to
Chapter 11 of the United States Bankruptcy Code. As a result of the Plan, an
ownership change occurred and the annual utilization of pre-reorganization
NOL's and built-in losses (i.e. the tax bases of assets exceeded their fair
market value at the date of the ownership change) has been substantially
limited under IRC Section 382. The annual limitation amount, computed pursuant
to IRC Section 382(1)(6), is approximately $780,000. Any unused IRC Section 382
annual loss limitation amount may be carried forward to the following year.
Those unused limitation losses are then added to the current IRC Section 382
annual limitation amount. Given the IRC Section 382 limitations, a substantial
portion of the pre-reorganization losses will expire unused. Such deferred tax
assets have been written off against the valuation allowance.
F-12
CHEROKEE INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
7. Earnings Per Share
The following table provides a reconciliation of the numerators and
denominators of the basic and diluted per-share computations for the year ended
January 30, 1999, the eight month period ended January 31, 1998, the year ended
May 31, 1997 and the year ended June 1, 1996:
Income Shares Per Share
(Numerator) (Denominator) Amount
----------- ------------ ---------
For the year ended January 31, 1999:
Basic earnings per share............. $ 6,088,000 8,683,601 $ 0.70
Effect of dilutive securities--stock
options and warrants................ 22,410
----------- --------- ------
Dilutive earnings per share.......... $ 6,088,000 8,706,011 $ 0.70
=========== ========= ======
For the eight month period ended
January 31, 1998:
Basic earnings per share............. $ 5,717,000 7,866,862 $ 0.73
Effect of dilutive securities--stock
options and warrants................ 545,906
----------- --------- ------
Dilutive earnings per share.......... $ 5,717,000 8,412,768 $ 0.68
=========== ========= ======
For the year ended May 31, 1997:
Basic earnings per share............. $ 6,651,000 7,688,521 $ 0.87
Effect of dilutive securities--stock
options and warrants................ 465,790
----------- --------- ------
Dilutive earnings per share.......... $ 6,651,000 8,154,311 $ 0.82
=========== ========= ======
For the year ended June 1, 1996:
Basic earnings per share............. $(1,449,000) 6,480,443 $(0.22)
Effect of dilutive securities--stock
options and warrants................ --
----------- --------- ------
Dilutive earnings per share.......... $(1,449,000) 6,480,443 $(0.22)
=========== ========= ======
The computation for diluted number of shares excludes unexercised stock
options and warrants which are anti-dilutive. The number of such shares for the
year ended January 30, 1999, the eight month period ended January 31, 1998, the
year ended May 31, 1997 and the year ended June 1, 1996 were 173,655, 290,000,
zero, and 896,000, respectively.
For the eight months ended January 31, 1998, the Company, in consolidation,
recorded as a charge against income, $474,000 in financial advisory services,
resulting in a reduction in basic and diluted earnings per share of $0.06 and
$0.05, respectively. For the year ended June 1, 1996, the Company recorded a
non-cash charge to recognize performance option expense of $4,567,000,
resulting in a reduction in baasic and diluted earnings per share of $0.70 and
$0.66, respectively.
8. Commitments and Contingencies
Leases
In 1998, the Company negotiated a new lease for its current facility directly
with the facility's owner. The initial term of the lease is for three years,
beginning August 1, 1998 and ending July 31, 2001, the monthly rent is $8,500
and the Company has an option to extend the term of the lease for two
additional three-year periods. The future minimum non-cancellable lease
payments are as follows:
Operating
Leases
---------
2000............................................................... $102,000
2001............................................................... 102,000
2002............................................................... 51,000
--------
Total future minimum lease payments.............................. $255,000
========
F-13
CHEROKEE INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Total rent expense was $91,000, $48,000, $60,000 and $198,000 for the year
ended January 30, 1999, the eight months ended January 31, 1998 and the years
ended May 31, 1997 and June 1, 1996, respectively.
9. Employment and Management Agreements
On April 24, 1995, a group which included Mr. Margolis (a former Chairman and
Chief Executive Officer of the Company) acquired approximately 22.3% of the
Company's then outstanding Common Stock (the "Group"). The Group sought to have
Mr. Margolis installed as Chief Executive Officer of the Company and to have
Mr. Margolis appointed a director of the Company. On May 4, 1995, the Company
and The Newstar Group d/b/a The Wilstar Group ("Wilstar") entered into a
Management Agreement (the "Agreement") pursuant to which Wilstar agreed to
provide executive management services to the Company by providing the services
of Robert Margolis as Chief Executive Officer. The Agreement originally
provided it would terminate on May 31, 1998; however, the Agreement provided an
automatic extension for additional one-year terms as long as the Company's pre-
tax earnings are equal to at least 80% of the pre-tax earnings contained in the
budget submitted to and approved by the Board of Directors for such fiscal
year. During the year ended June 1, 1996, Wilstar met the 80% pre-tax earning
requirement; hence, the contract was extended for an additional one year term.
In addition, Wilstar received an option to purchase 7 1/2% of the Common Stock
on a fully diluted basis (675,700 shares) at a purchase price of $3.00 per
share (the "Wilstar Options"). The Wilstar Options were exercised on December
29, 1997. Subsequent to the exercise date and pursuant to a redemption
agreement entered into by all its principals, Wilstar transferred to each
principal individually his pro-rata share of the Common Stock as consideration
for redeeming his Wilstar shares.
On April 24, 1996, the Board of Directors revised the Agreement to accelerate
the vesting of Wilstar's performance options (the "Performance Options") so
that Wilstar was immediately vested in its right to purchase up to 20% of the
Company's fully diluted Common Stock. Wilstar agreed to relinquish its rights
to purchase up to an additional 2.5% of the Company's fully diluted stock
pursuant to the Performance Options grant. Wilstar exercised the Performance
Options in full on April 25, 1996 and purchased 1,674,739 shares. The Company
accounted for this transaction as a non-cash charge to earnings of $4,567,000.
During Fiscal 1997, Wilstar transferred to its principals an aggregate of
874,739 shares of the Common Stock in satisfaction of principal and interest
due on indebtedness, bonuses and Subchapter S distributions owed to its
principals and shareholders. During Fiscal 1998, Wilstar transferred 17,500
shares of the Common Stock to certain employees and 384,386 shares of the
Common Stock to its principals, whereby, pursuant to a redemption agreement,
each principal received his pro-rata share individually as consideration for
redeeming his Wilstar shares.
The Agreement further provides that Wilstar and the Group each have the right
to elect two members of the Company's Board of Directors.
Effective for services rendered on or after June 1, 1997, the Compensation
Committee and the Board of Directors amended the Agreement by the adoption of
two amendments, designated, respectively, the Second Amendment and the Third
Amendment. The changes to the Agreement made by the Second Amendment include
(i) extension of the specified term of the Agreement to May 31, 2000; (ii)
modification of the existing provision of the Agreement for automatic extension
of its term for an additional year for each year after fiscal year 1997 in
which the Company achieves specified levels of pre-tax earnings; (iii) increase
in the annual base compensation of Wilstar from $400,000 to $550,000; (iv)
provision for an annual cost-of-living increase in base compensation after
fiscal year 1998; and (v) increase in the annual performance bonus percentage
payable to Wilstar based on the Company's earnings before interest, taxes,
depreciation and amortization above specified levels from 10% to 15% of such
earnings in excess of $10,000,000. At January 30, 1999, January 31, 1998 and
May 31, 1997, the Company had accrued the bonus payable under Other Accrued
Liabilities.
F-14
CHEROKEE INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
The Third Amendment, approved by a majority of shareholders on September 15,
1997 at the 1997 Annual Meeting, further provided changes to the Agreement
including, (i) provision for payment of an "acquisition bonus" to Wilstar in
the event of an acquisition of the Company for a price per share of not less
than $12 pursuant to an acquisition agreement entered into by the end of fiscal
year 2000 (the amount of such acquisition bonus ranges from $1,000,000 to
$2,500,000 in the event of an acquisition of the Company for a price per share
ranging from $12 to $15 or more and automatically decreases by one-third per
year if the acqusition agreement is not entered into by the end of May 31,
1998, 1999, or 2000); and (ii) provision for payment of $3,000,000 to Wilstar
in consideration for an agreement not to compete with the Company for a
specified period of time by Wilstar and Mr. Margolis in the event of an
acquisition of the Company pursuant to an acquisition agreement entered into by
the end of May 31, 2000 (the amount of such payment automatically decreases by
one-third per year if the acquisition agreement is not entered into by the end
of May 31, 1998, 1999, or 2000); and (iii) provision for reduction of payments
under the Agreement that are contingent on a change in control if it is
determined that such payments would result in the nondeductibility of some or
all of such payments under the provisions of Section 280G of the Internal
Revenue Code.
During the eight months ended January 31, 1998 and the year ended May 31,
1997, the Company made compensation payments in lieu of cash dividends to
Wilstar totalling $135,134 and $375,100, respectively. No such payments were
made during the year ended January 30, 1999.
Mr. Seyhun, the former Chief Operating Officer and the former Chief Financial
Officer of the Company, was employed pursuant to a 28 month agreement expiring
May 31, 1997. In connection with the agreement on February 1, 1995, Mr. Seyhun
purchased 96,000 shares of Common Stock from the Company at a price of $2.00
per share. Mr. Seyhun paid for these shares with a $192,000, 7% Promissory Note
for which $48,000 was paid in May 1996. Proceeds from the sale of such stock
must be applied first to accrued and unpaid interest and then to unpaid
principal. The note was recorded as a reduction to stockholders equity. Mr.
Seyhun repaid the note in full on February 19, 1997. Mr. Seyhun also received
an option to purchase 96,000 shares for a price of $2.00 per share which was
cancelled upon termination of his employment agreement. Mr. Seyhun terminated
his employment on January 5, 1996. Mr. Seyhun paid the remaining principal and
interest on the Promissory Note on February 19, 1997.
Ms. Warren, the former President of the Company, who resigned March 3, 1998,
was employed pursuant to a three-year agreement expiring on May 30, 1998 which
provided for a salary at an annual rate of $100,000 from June 21, 1995 to May
31, 1996 and $325,000 from June 1, 1996 to May 31, 1998. Ms. Warren worked with
the Company on selected special projects through November 1998 and was paid
through December 4, 1998.
10. Related Party Transactions
On December 23, 1997 the Company loaned $2.0 million to Robert Margolis, who
is a Director, the Chairman of the Board of Directors and the Chief Executive
Officer of the Company. The loan was approved by a majority of the
disinterested members of the Company's Board of Directors on December 19, 1997.
Mr. Margolis executed a note, dated December 23, 1997, in favor of the Company
for $2.0 million which yields 6.0% interest per annum, which has been recorded
as a reduction to stockholders' equity on the January 30, 1999 Balance Sheet.
The principal amount of the note and all accrued interest thereon is due and
payable on December 23, 2002. The note may be repaid in whole or in part at any
time without penalty.
In connection with the recapitalization of the Company and issuance of the
Secured Notes in December 1997, the Company paid to Libra fees totaling
$1,432,000. Mr. Jess Ravich, the Chairman of Libra, is a member of the Board of
Directors of the Company.
In fiscal years ended May 31, 1997 and June 1, 1996, Wilstar purchased
apparel and trim from the Company totalling $87,000 and $154,000, respectively.
F-15
CHEROKEE INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
11. Warrants
On February 1, 1995, the Company granted warrants to purchase 5,000 shares of
Common Stock at an exercise price of $2.43 to each of the Company's five
outside directors of the Board. All but one of the Board members have exercised
their warrants in full and each purchased 5,000 shares. The warrants expire on
January 31, 2000.
12. Stock Option Plan
The Company's 1995 Incentive Stock Option Plan (the "Plan") was approved at
the October 30, 1995 Annual Meeting of Stockholders. The purpose of the Plan is
to further the growth and development of the Company by providing an incentive
to officers and other key employees who are in a position to contribute
materially to the prosperity of the Company. Two types of stock options (the
"Option") may be granted under the plan--Incentive and Non-Qualified stock
options. The Options are vested in equal installments over a three year period
starting at the grant date and have a term of ten years. The maximum number of
shares authorized for grants of options under the 1995 Plan is 900,000.
SFAS No. 123 "Accounting for the Awards of Stock-Based Compensation to
Employees" encourages, but does not require companies to record compensation
cost for stock based compensation plans at fair value. The Company has chosen
to continue to account for stock based compensation using the intrinsic value
method prescribed in Accounting Principles Board Opinion No. 25, " Accounting
for Stock Issued to Employees," and related interpretations. Had compensation
costs for the Company's stock option plan (for options granted in the year
ended January 30, 1999, the eight-month period ended January 31, 1998, the year
ended May 31, 1997 and the year ended June 1, 1996) been determined based upon
the methodology prescribed under SFAS No. 123, the Company's net income (loss)
would approximate the pro forma amounts below:
1999 1998 1997 1996
---------- ---------- ---------- -----------
Pro Forma net income (loss).. $5,480,000 $5,179,000 $6,546,000 $(1,502,000)
Pro Forma basic earnings
(loss) per share............ $ 0.63 $ 0.66 $ 0.85 $ (0.23)
Pro Forma diluted earnings
(loss) per share............ $ 0.63 $ 0.62 $ 0.80 $ (0.23)
The fair value for these options was estimated at the date of grant using a
Black-Scholes option pricing model with the following weighted-average
assumptions for 1996 and 1997: weighted-average risk-free interest rate range
between 5.27% and 6.57%; dividend yields of 12.80%; weighted-average volatility
factors of the expected market price of the Company's common stock of 99.24%;
and a weighted-average expected life of the option of three years. For 1998,
the weighted-average assumptions were as follows: weighted-average risk-free
interest rate range between 5.80% and 6.35%; dividend yields of 7.50%;
weighted-average volatility factors of the expected market price of the
Company's common stock of 68.97%; and a weighted-average expected life of the
option of three years. For 1999, the weighted-average assumptions were as
follows: weighted-average risk-free interest rate range between 4.57% and
5.56%; dividend yields of 12.50%; weighted-average volatility factors of the
expected market price of the Company's common stock of 56.67%; and a weighted-
average expected life of the option of three years.
The Black-Scholes option valuation model was developed for use in estimating
the fair value of traded options which have no vesting restrictions and are
fully transferable. In addition, option valuation models require the input of
highly subjective assumptions including the expected stock price volatility.
Because the Company's stock options have characteristics significantly
different from those of traded options, and because changes in the subjective
input assumptions can materially affect the fair value estimates, in
management's opinion, the existing models do not necessarily provide a reliable
single measure of the fair value of its employee stock options.
F-16
CHEROKEE INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
A summary of the Company's stock option activity, and related information for
the year ended January 30, 1999, the eight months ended January 31, 1998 and
the years ended May 31, 1997 and June 1, 1996 follows:
1999 1998
------------------ --------------------
Weighted Weighted
Average Average
Exercise Exercise
Options Price Options Price
-------- -------- -------- --------
Outstanding at beginning of
year............................ 480,083 $ 9.46 180,000 $ 3.91
Granted........................ 230,000 8.88 480,083(1) 9.46
Exercised...................... (10,000) 10.50 (180,000) 3.91
Forfeited...................... (139,024) 10.03 -- --
-------- ------ -------- ------
Outstanding at end of year....... 561,059 9.06 480,083 9.46
======== ====== ======== ======
Exerciseable at end of year...... 276,292 $ 8.61 78,635 $ 9.46
Weighted average grant date fair
value of options granted during
the year........................ $ 1.75 $ 4.23
1997 1996
------------------ --------------------
Weighted Weighted
Average Average
Exercise Exercise
Options Price Options Price
-------- -------- -------- --------
Outstanding at beginning of
year............................ 180,000 $ 3.29 -- $ --
Granted........................ 35,000 6.25 210,000 3.27
Exercised...................... (20,000) 3.03 (10,000) 3.00
Forfeited...................... (15,000) 3.13 (20,000) 3.00
-------- ------ -------- ------
Outstanding at end of year....... 180,000 3.91 180,000 3.29
======== ====== ======== ======
Exerciseable at end of year...... 45,003 $ 3.35 -- $ --
Weighted average grant date fair
value of options granted during
the year........................ $ 2.43 $ 1.46
- --------
(1) The options have exercise prices and become exercisable in four
installments upon the following dates, subject to the optionee's continued
employment by the Company on each vesting date installments: (i) 25% of the
number of shares vest immediately with an adjusted exercise price of $8.15,
(ii) 25% of the number of shares vest November 10, 1998 with an adjusted
exercise price of $8.97, (iii) 25% of the number of shares vest November
10, 1999 with an adjusted exercise price of $9.86 and (iv) 25% of the
number of shares vest November 10, 2000 with an adjusted exercise price of
$10.85. As a result of the Company's payment of an extraordinary cash
dividend to the Company's shareholders, the exercise price of each of the
options has been adjusted in accordance with Section 7.13 of the Plan.
Options Outstanding Options Exercisable
----------------------------------------- --------------------------
Number of Weighted Weighted Number of Weighted
shares average average shares average
Range outstanding remaining life exercise price outstanding exercise price
----- ----------- -------------- -------------- ----------- --------------
$7.00-$8.00 41,250 9.48 years $ 7.94 21,250 $ 7.88
$8.00-$9.00 342,542 8.55 years $ 8.52 240,042 $ 8.56
$9.00-$10.00 81,134 8.32 years $ 9.85 -- --
$10.00-$11.00 96,133 8.49 years $10.79 15,000 $10.50
------- -------
561,059 276,292
======= =======
F-17
CHEROKEE INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
During the fiscal year ended May 31, 1997, the Board of Directors adopted a
plan for compensation of officers of the Company, employees of the Company, and
Wilstar in lieu of cash dividends. If and when cash dividends are paid on
outstanding shares of common stock of the Company, compensation will be paid to
each plan participant in an amount equal to the cash dividends which would have
been paid on the vested option shares covered by stock options of the Company
held by such participant as if such shares had been purchased by such
participant prior to, and were outstanding and owned by such participant on,
the record date and the payment date for such cash dividend. The plan began on
January 15, 1997 and terminated on December 31, 1998. During the year ended
January 30, 1999, the eight months ended January 31, 1998 and the year ended
May 31, 1997, an aggregate of $81,134, $150,801 and $391,850, respectively, was
paid to participants in the plan.
13. Sale of Uniform Division
On July 28, 1995, the Company sold the Uniform Division to Strategic
Partners, Inc. ("Strategic Partners"), a corporation which was formed by
Michael Singer and investors unaffiliated with Cherokee. Mr. Singer was the
President of Cherokee's Uniform Division until the sale of the Uniform Division
and is the President and Chief Executive Officer of Strategic Partners. The
assets sold included accounts receivable, inventory, furniture and fixtures,
equipment, and the exclusive right to use the Cherokee trademark with respect
to the manufacture and sale of uniforms. The sales price was approximately
$11,700,000, which was $4,000,000 greater than the book value of the assets
that were sold. Of the purchase price, approximately $9,575,000 was paid in
cash and $2,125,000 was paid by a 10% subordinated promissory note ("Note").
The Company recorded the Note at its estimated fair value of $1,588,000,
which represents a discount of $537,000, resulting in an effective interest
rate of 16%. The Note required quarterly payments of interest and principal
payments of $300,000 on July 27, 1997, 1998, 1999 and 2000 with the remaining
principal amount due on July 27, 2001. On April 3, 1997, Strategic Partners and
the Company negotiated a 10% discount to pay off the $2,125,000 note due 2001.
Strategic Partners delivered a payment of $1,912,500 on May 14, 1997 in full
satisfaction of the Note.
14. Selected Quarterly Financial Data (Unaudited):
The following table summarizes certain financial information by quarter for
1998 and 1999:
Comparative Fiscal year ended January 31,
1998
-------------------------------------------
May 3, August 2, November January
1997 1997 1, 1997 31, 1998
---------- ---------- ---------- ----------
Net Sales....................... $2,175,000 $2,331,000 $2,368,000 $5,308,000
Earnings before taxes........... 1,510,000 1,510,000 1,569,000 2,720,000
Net Income...................... 1,510,000 2,281,000 1,569,000 3,502,000
Net income per share--basic..... 0.20 0.29 0.20 0.44
Net income per share--diluted... 0.18 0.27 0.19 0.41
Fiscal year ended January 30, 1999
-------------------------------------------
May 2, August 1, October January
1998 1998 31, 1998 30, 1999
---------- ---------- ---------- ----------
Net Sales....................... $5,296,000 $4,879,000 $5,133,000 $3,999,000
Earnings before taxes........... 3,379,000 2,153,000 2,641,000 1,897,000
Net Income...................... 2,027,000 1,292,000 1,582,000 1,187,000
Net income per share--basic..... 0.23 0.15 0.18 0.14
Net income per share--diluted... 0.23 0.15 0.18 0.14
F-18
CHEROKEE INC.
Schedule II--Valuations and Qualifying Accounts and Reserves
Charged/
(Credited)
Balance at to Costs Charged to Balance at
Beginning and Other End of
Description of Period Expenses Accounts Deductions Period
----------- ----------- ---------- ---------- ---------- -----------
Deducted from assets to
which they apply:
Allowance for doubtful
accounts
Year ended Jan 30,
1999............... $ -- $ -- $ -- $ -- $ --
Year ended Jan 31,
1998............... $ -- $ -- $ -- $ -- $ --
Year ended May 31,
1997............... $ 591,000 $ (112,000) $ -- $ 479,000(1) $ --
Year ended June 1,
1996............... $ 1,006,000 $ 112,000 $ -- $ 527,000(1) $ 591,000
Inventory Reserve
Year ended Jan 30,
1999............... $ -- $ -- $ -- $ -- $ --
Year ended Jan 31,
1998............... $ -- $ -- $ -- $ -- $ --
Year ended May 31,
1997............... $ -- $ -- $ -- $ -- $ --
Year ended June 1,
1996............... $ 6,011,000 $ -- $ -- $6,011,000 $ --
Tax Valuation
Allowance
Year ended Jan 30,
1999............... $ 1,858,000 $ -- $ -- $ -- $ 1,858,000
Year ended Jan 31,
1998............... $ 6,458,000 $2,559,000 $2,041,000 $ -- $ 1,858,000
Year ended May 31,
1997............... $10,714,000 $2,408,000 $1,848,000 $ -- $ 6,458,000
Year ended June 1,
1996............... $19,901,000 $ -- $5,702,000 $3,485,000 $10,714,000
- --------
(1) Uncollectible accounts receivable written off against the allowance.
F-19