**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

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**FORM 10-Q**

** **
| **(Mark One)**                                                                                                                                              | ** ** | ** **                                                                                    |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------|
| ** **                                                                                                                                                  | ** ** | ** **                                                                                    |
| x                                                                                                                                                           | ** ** | **QUARTERLY REPORT PURSUANT TO SECTION 12 OR 15(d)  OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|                                                                                                                                                        | ** ** | ** **                                                                                    |
| **For the  quarterly period ended July 1, 2007**                                                                                                       |
|                                                                                                                                                        | ** ** | ** **                                                                                    |
| o                                                                                                                                                           | ** ** | **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. 000-50593**

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**Cherokee International Corporation**

(Exact name of Registrantas specified in its charter)

 

| **Delaware**                                                     |   | **95-4745032**                           |
|------------------------------------------------------------------|--------|------------------------------------------|
| (State or Other  Jurisdiction of  Incorporation of Organization) |   | (I.R.S. Employer  Identification Number) |
|                                                             |   |                                     |
| **2841  Dow Avenue Tustin, California**                          |   | **92780**                                |
| (address of the  principal executive offices)                    |   | (zip code)                               |

 

Registrant’s telephone number, including area code **(714) 544-6665**

Securitiesregistered pursuant to Section 12(b) of the Act:

| Title of Class                  | ** ** | **Name of Exchange on which Registered** |
|---------------------------------|------------|------------------------------------------|
| Common Stock,  $0.001 par value |       | The NASDAQ Stock  Market, LLC            |

 

Securities registeredpursuant to Section 12(g) of the Act:

**None**

Indicate by check markwhether the registrant; (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the Registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.  (1) Yes x  No o    (2) Yes x  No o

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer. See definition of “accelerated filer” and “largeaccelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

| Large Accelerated  Filer  o | Accelerated  Filer  o | Non-Accelerated Filer  x |
|---------------------------------------|---------------------------------|------------------------------------|

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act).  Yes o  No x

As ofJuly 31, 2007, 19,412,355 shares of the registrant’s common stock, $0.001par value, were outstanding.

 

 

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**TABLE OF CONTENTS**
| PART I FINANCIAL  INFORMATION                                                                  |   | 1  |   |
|-----------------------------------------------------------------------------------------------------|--------|----|--------|
| Item  1. Financial Statements:                                                                      |   | 1  |   |
| Condensed Consolidated Balance Sheets (unaudited)                                                   |   | 1  |   |
| Condensed Consolidated Statements of Operations  (unaudited)                                        |   | 2  |   |
| Condensed Consolidated Statements of Comprehensive  Operations (unaudited)                          |   | 3  |   |
| Condensed Consolidated Statements of Cash Flows  (unaudited)                                        |   | 4  |   |
| Notes to Condensed Consolidated Financial Statements  (unaudited)                                   |   | 5  |   |
| Item 2. Management’s Discussion and Analysis of  Financial Condition and Results of Operations |   | 16 |   |
| Item 3. Quantitative and Qualitative Disclosures About  Market Risk                                 |   | 26 |   |
| Item  4. Controls and Procedures                                                                    |   | 27 |   |
| PART II OTHER  INFORMATION                                                                     |   | 29 |   |
| Item  1. Legal Proceedings                                                                          |   | 29 |   |
| Item  1A. Risk Factors                                                                              |   | 29 |   |
| Item 6.  Exhibits                                                                                   |   | 29 |   |
| Signatures                                                                                          |   | 30 |   |

 

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**PART I.   FINANCIAL INFORMATION**

**Item1.   FINANCIAL STATEMENTS**

**CHEROKEEINTERNATIONAL CORPORATION AND SUBSIDIARIES**

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

**(InThousands, Except Share and Per Share Data)(Unaudited)**
| ** **                                                                                                                                                                                  | ** ** | **July 1, 2007** | ** ** | **December 31, 2006** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------|------------|---------------------------------|------------|
| **ASSETS**                                                                                                                                                                                  | ** ** | ** **                 | ** ** | ** **                      | ** ** |
| **CURRENT ASSETS:**                                                                                                                                                                         | ** ** | ** **                 | ** ** | ** **                      | ** ** |
| Cash and cash  equivalents                                                                                                                                                                  |       | $                          | 6,624      |                            | $          | 8,881 |   |
| Accounts receivable,  net of allowance for doubtful accounts of $275 and $292 at July 1, 2007  and December 31, 2006, respectively                                                     |       | 23,672                     |       | 27,403                          |       |
| Inventories, net                                                                                                                                                                            |       | 33,398                     |       | 29,991                          |       |
| Prepaid expenses and  other current assets                                                                                                                                                  |       | 1,872                      |       | 2,503                           |       |
| Total current assets                                                                                                                                                                        |       | 65,566                     |       | 68,778                          |       |
| Property and equipment,  net                                                                                                                                                                |       | 19,184                     |       | 19,888                          |       |
| Deposits and other  assets                                                                                                                                                                  |       | 1,406                      |       | 1,376                           |       |
| Deferred financing  costs, net of accumulated amortization of $429 and $364 at July 1, 2007  and December 31, 2006, respectively                                                       |       | 151                        |       | 216                             |       |
| Deferred income  taxes-long-term portion                                                                                                                                                    |       | 325                        |       | 318                             |       |
| Goodwill                                                                                                                                                                                    |       | 6,317                      |       | 6,317                           |       |
| Total Assets                                                                                                                                                                                |       | $                          | 92,949     |                            | $          | 96,893 |   |
| ** **                                                                                                                                                                                  | ** ** | ** **                 | ** ** | ** **                      | ** ** |
| **LIABILITIES AND STOCKHOLDERS’  EQUITY**                                                                                                                                              | ** ** | ** **                 | ** ** | ** **                      | ** ** |
| **CURRENT LIABILITIES:**                                                                                                                                                                    | ** ** | ** **                 | ** ** | ** **                      | ** ** |
| Accounts payable                                                                                                                                                                            |       | $                          | 14,414     |                            | $          | 13,944 |   |
| Accrued liabilities                                                                                                                                                                         |       | 2,975                      |       | 4,968                           |       |
| Accrued compensation  and benefits                                                                                                                                                          |       | 7,111                      |       | 7,882                           |       |
| Accrued restructuring  costs                                                                                                                                                                |       | 463                        |       | 879                             |       |
| Borrowings under  revolving line of credit                                                                                                                                                  |       | 1,307                      |       | —                          |       |
| Total current  liabilities                                                                                                                                                                  |       | 26,270                     |       | 27,673                          |       |
| Long-term debt                                                                                                                                                                              |       | 24,485                     |       | 24,485                          |       |
| Long-term debt payable  to affiliates                                                                                                                                                       |       | 22,145                     |       | 22,145                          |       |
| Total long-term debt                                                                                                                                                                        |       | 46,630                     |       | 46,630                          |       |
| Other long-term  liabilities                                                                                                                                                                |       | 6,987                      |       | 6,715                           |       |
| Total Liabilities                                                                                                                                                                           |       | 79,887                     |       | 81,018                          |       |
|                                                                                                                                                                                        |       |                       |       |                            |       |
| Commitments and  contingencies (Note 9)                                                                                                                                                     |       |                       |       |                            |       |
| ** **                                                                                                                                                                                  | ** ** | ** **                 | ** ** | ** **                      | ** ** |
| **STOCKHOLDERS’ EQUITY:**                                                                                                                                                              | ** ** | ** **                 | ** ** | ** **                      | ** ** |
| Common stock: $0.001  par value; 60,000,000 shares authorized; 19,411,105  and 19,337,709 shares issued and outstanding at July 1, 2007 and  December 31, 2006, respectively |       | 19                         |       | 19                              |       |
| Paid-in capital                                                                                                                                                                             |       | 185,373                    |       | 184,813                         |       |
| Accumulated deficit                                                                                                                                                                         |       | (173,025                   | )          | (169,373                        | )          |
| Accumulated other  comprehensive income                                                                                                                                                     |       | 695                        |       | 416                             |       |
| Total stockholders’  equity                                                                                                                                                            |       | 13,062                     |       | 15,875                          |       |
| Total Liabilities and Stockholders’ Equity                                                                                                                                             |       | $                          | 92,949     |                            | $          | 96,893 |   |

 

Seenotes to condensed consolidated financial statements.

 

1

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**CHEROKEEINTERNATIONAL CORPORATION AND SUBSIDIARIES**

**CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS**

**(In Thousands, Except Per ShareAmounts)(Unaudited)**
| ** **                                | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                | ** ** | **July 1, 2007**       | ** ** | **July 2, 2006**     | ** ** | **July 1, 2007** | ** ** | **July 2, 2006** | ** ** |
| Net sales                                 |       | $                                | 29,574     |                           | $          | 38,314 |   | $ | 59,594 |   | $ | 74,411 |   |
| Cost of sales                             |       | 24,023                           |       | 30,179                         |       | 48,326 |   | 57,760 |   |
| Gross profit                              |       | 5,551                            |       | 8,135                          |       | 11,268 |   | 16,651 |   |
| Operating expenses:                       |       |                             |       |                           |       |   |   |   |   |
| Engineering and  development              |       | 2,837                            |       | 2,323                          |       | 5,479 |   | 4,643 |   |
| Selling and marketing                     |       | 1,873                            |       | 1,708                          |       | 3,737 |   | 3,021 |   |
| General and  administrative               |       | 3,380                            |       | 3,060                          |       | 6,517 |   | 6,064 |   |
| Restructuring costs                       |       | (38                              | )          | —                         |       | 155 |   | — |   |
| Total operating  expenses                 |       | 8,052                            |       | 7,091                          |       | 15,888 |   | 13,728 |   |
| Operating income (loss)                   |       | (2,501                           | )          | 1,044                          |       | (4,620 | ) | 2,923 |   |
| Interest expense                          |       | (692                             | )          | (657                           | )          | (1,377 | ) | (1,354 | ) |
| Gain on sale of Mexico  Facility building |       | 430                              |       | —                         |       | 430 |   | — |   |
| Other income, net                         |       | 152                              |       | 101                            |       | 314 |   | 192 |   |
| Income (loss) before  income taxes        |       | (2,611                           | )          | 488                            |       | (5,253 | ) | 1,761 |   |
| Provision (benefit) for  income taxes     |       | (958                             | )          | 136                            |       | (1,578 | ) | 582 |   |
| Net income (loss)                         |       | $                                | (1,653     | )                              | $          | 352 |   | $ | (3,675 | ) | $ | 1,179 |   |
| Net income (loss) per  share:             |       |                             |       |                           |       |   |   |   |   |
| Basic                                     |       | $                                | (0.09      | )                              | $          | 0.02 |   | $ | (0.19 | ) | $ | 0.06 |   |
| Diluted                                   |       | $                                | (0.09      | )                              | $          | 0.02 |   | $ | (0.19 | ) | $ | 0.06 |   |
| Weighted average shares  outstanding:     |       |                             |       |                           |       |   |   |   |   |
| Basic                                     |       | 19,359                           |       | 19,292                         |       | 19,350 |   | 19,276 |   |
| Diluted                                   |       | 19,359                           |       | 19,372                         |       | 19,350 |   | 19,324 |   |

 

Seenotes to condensed consolidated financial statements.

** **

2

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**CHEROKEEINTERNATIONAL CORPORATION AND SUBSIDIARIES**

**CONDENSEDCONSOLIDATED STATEMENTS OF COMPREHENSIVE OPERATIONS**

** (In Thousands)**

** (Unaudited)**
| ** **                                | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                | ** ** | **July 1, 2007**       | ** ** | **July 2, 2006**     | ** ** | **July 1, 2007** | ** ** | **July 2, 2006** | ** ** |
| Net  income (loss)                        |       | $                                | (1,653)    |                           | $          | 352 |   | $ | (3,675 | ) | $ | 1,179 |   |
| Other  comprehensive income:              |       |                             |       |                           |       |   |   |   |   |
| Foreign  currency translation adjustments |       | 135                              |       | 791                            |       | 298 |   | 1,154 |   |
| Comprehensive income  (loss)              |       | $                                | (1,518)    |                           | $          | 1,143 |   | $ | (3,377 | ) | $ | 2,333 |   |

 

Seenotes to condensed consolidated financial statements.

 

3

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**CHEROKEEINTERNATIONAL CORPORATION AND SUBSIDIARIES**

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

**(InThousands)**

**(Unaudited)**
| ** **                                                                                           | ** ** | **Six Months Ended** | ** ** |
|------------------------------------------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                                                           | ** ** | **July 1, 2007**     | ** ** | **July 2, 2006** | ** ** |
| **CASH FLOWS FROM OPERATING ACTIVITIES:**                                                            | ** ** | ** **                     | ** ** | ** ** | ** ** |
| Net  income (loss)                                                                                   |       | $                              | (3,675     | ) | $ | 1,179 |   |
| Adjustments  to reconcile net income (loss) to net cash (used in) provided by operating  activities: |       |                           |       |   |   |
| Depreciation  and amortization                                                                       |       | 1,610                          |       | 1,584 |   |
| Gain  on sale of property and equipment                                                              |       | (430                           | )          | — |   |
| Amortization  of deferred financing costs                                                            |       | 65                             |       | 65 |   |
| Stock-based  compensation                                                                            |       | 341                            |       | 324 |   |
| Net  change in operating assets and liabilities:                                                     |       |                           |       |   |   |
| Accounts  receivable, net                                                                            |       | 3,968                          |       | 683 |   |
| Inventories,  net                                                                                    |       | (3,241                         | )          | (2,621 | ) |
| Prepaid  expenses and other current assets                                                           |       | 647                            |       | (1,011 | ) |
| Deposits  and other assets                                                                           |       | (7                             | )          | 8 |   |
| Accounts  payable                                                                                    |       | 338                            |       | 2,004 |   |
| Accrued  liabilities and restructuring costs                                                         |       | (2,492                         | )          | (652 | ) |
| Accrued  compensation and benefits                                                                   |       | (876                           | )          | 1,016 |   |
| Accrued  interest payable                                                                            |       | 12                             |       | (110 | ) |
| Other  long-term obligations                                                                         |       | 136                            |       | 515 |   |
| Net  cash (used in) provided by operating activities                                                 |       | (3,604                         | )          | 2,984 |   |
| **CASH FLOWS FROM INVESTING ACTIVITIES:**                                                            | ** ** | ** **                     | ** ** | ** ** | ** ** |
| Additions  to property and equipment                                                                 |       | (1,505                         | )          | (1,102 | ) |
| Proceeds  from sale of property and equipment                                                        |       | 1,229                          |       | — |   |
| Net  cash used in investing activities                                                               |       | (276                           | )          | (1,102 | ) |
| **CASH FLOWS FROM FINANCING ACTIVITIES:**                                                            | ** ** | ** **                     | ** ** | ** ** | ** ** |
| Borrowings  on revolving lines of credit                                                             |       | 1,307                          |       | — |   |
| Net  proceeds from employee stock purchases and the exercise of stock options                        |       | 219                            |       | 82 |   |
| Net  cash provided by financing activities                                                           |       | 1,526                          |       | 82 |   |
| Effect  of exchange rate changes on cash and cash equivalents                                        |       | 97                             |       | 416 |   |
| Net  increase (decrease) in cash and cash equivalents                                                |       | (2,257                         | )          | 2,380 |   |
| Cash  and cash equivalents, beginning of period                                                      |       | 8,881                          |       | 10,543 |   |
| Cash  and cash equivalents, end of period                                                            |       | $                              | 6,624      |   | $ | 12,923 |   |
| **SUPPLEMENTAL INFORMATION**                                                                         | ** ** | ** **                     | ** ** | ** ** | ** ** |
| Cash  paid during the period for interest                                                            |       | $                              | 1,278      |   | $ | 1,248 |   |
| Cash paid during the  period for income taxes                                                        |       | $                              | 198        |   | $ | 158 |   |

 

See notes tocondensed consolidated financial statements.

4

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**CHEROKEEINTERNATIONAL CORPORATION AND SUBSIDIARIES**

**NOTESTO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**(Unaudited)**

**1.      NATUREOF OPERATIONS**

Cherokee International Corporation (the “Company”) isa designer and manufacturer of power supplies for original equipmentmanufacturers (“OEMs”). Its advanced power supply products are typically customdesigned into mid- to high-end commercial applications in the computing andstorage, wireless infrastructure, enterprise networking, telecom, medical andindustrial markets.

**2.      BASISOF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**

*Basis of Presentation*

The accompanying condensed consolidated financialstatements of Cherokee International Corporation have been prepared inaccordance with accounting principles generally accepted in the United Statesof America for interim financial information and in accordance with theinstructions to Form 10-Q and Article 10 of Regulation S-X.  Accordingly,they do not include certain footnotes and financial presentations normallyrequired under accounting principles generally accepted in the United States ofAmerica for complete financial reporting.  The interim financialinformation is unaudited, but reflects all normal adjustments and accruals,which are, in the opinion of management, considered necessary to provide a fairpresentation for the interim periods presented.  The condensedconsolidated financial statements include the financial statements of theCompany and its wholly owned subsidiaries.  All intercompany balances andtransactions have been eliminated in the accompanying condensed consolidatedfinancial statements.

Results of operations for the three months and sixmonths ended July 1, 2007, are not necessarily indicative of the resultsto be expected for the entire fiscal year ending December 30, 2007 (“fiscal2007”). The accompanying condensed consolidated financial statements should beread in conjunction with the audited consolidated financial statements for thefiscal year ended December 31, 2006, included in the Company’s AnnualReport on Form 10-K (File No. 000-50593) filed on May 23, 2007.

*Useof Estimates*

The preparation offinancial statements in accordance with accounting principles generallyaccepted in the United States of America requires management to make estimatesand assumptions that affect the reported amounts of assets and liabilities anddisclosure of contingent liabilities at the date of the financial statementsand the amounts of revenues and expenses during the reporting period. Actualresults could differ from such estimates.

*Stock-BasedCompensation*

In December 2004,SFAS 123R, *Share-Based Payment*,was issued. SFAS 123R is a revision of SFAS 123, *Accounting for Stock Based Compensation*,and supersedes APB 25. Among other items, SFAS 123R eliminates the use ofAPB 25 and the intrinsic value method of accounting, and requires companies torecognize the cost of employee services received in exchange for awards ofequity instruments, based on the grant date fair value of those awards, in thefinancial statements. The Company was required to adopt SFAS 123R effective onJanuary 2, 2006. SFAS 123R permits companies to adopt its requirementsusing either a “*modified prospective*”method, or a “*modified retrospective*”method. Under the “*modified prospective*”method, compensation cost is recognized in the financial statements beginningwith the effective date, based on the requirements of SFAS 123R for allshare-based payments granted after that date, and based on the requirements ofSFAS 123 for all unvested awards granted prior to the effective date of SFAS123R. Under the “*modified retrospective*”method, the requirements are the same as under the “*modified prospective*’’ method, but also permits entities torestate financial statements of previous periods based on proforma disclosuresmade in accordance with SFAS 123.

The Company currentlyuses the Black-Scholes standard option-pricing model to measure the fair valueof stock options granted to employees and non-employees. While SFAS 123Rpermits the Company to continue to use such a model, the standard also permitsthe use of a “*lattice*” model. TheCompany is continuing to use the Black-Scholes model to measure the fair valueof employee stock options upon the adoption of SFAS 123R.

5

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SFAS 123R also requires that the benefits associatedwith the tax deductions in excess of recognized compensation cost be reportedas a financing cash flow, rather than as an operating cash flow as requiredunder prior literature. This requirement will reduce net operating cash flowsand increase net financing cash flows in periods after the effective date.These future amounts cannot be estimated, because they depend on, among otherthings, when employees exercise stock options.

The Company adopted SFAS123R on January 2, 2006 using the “*modified prospective*”method as permitted by SFAS 123R. Under this transition method, stockcompensation cost recognized beginning in the first quarter of fiscal year 2006includes:  (a) compensation cost for all share-based payments grantedsubsequent to February 25, 2004 and prior to January 1, 2006 but notyet vested as of January 1, 2006, based on the grant-date fair valueestimated in accordance with the provisions of SFAS 123R, and(b) compensation cost for all share-based payments granted subsequent toJanuary 1, 2006, based on the grant-date fair value estimated inaccordance with the provisions of SFAS 123R. In accordance with the “*modified prospective*” method of adoption, the Company’sresults of operations and financial position for prior periods have not beenrestated. At the date of the adoption, the unamortized expense for optionsissued prior to January 2, 2006 was $2.3 million, which will be amortizedas stock compensation costs through December 2010.  Stock based compensation costs expensedduring the quarters ended July 1, 2007 and July 2, 2006, were $0.1 millionand $0.2 million, respectively.  Duringthe six months ended July 1, 2007 and July 2, 2006 the costs recorded were $0.3million for each period.

All grants are made atprices based on the fair market value of the stock on the date of grant.Outstanding options generally vest over four years from the grant date withcertain limited exceptions and subject to accelerated vesting in the event of achange in control of the company, and expire up to ten years after the grantdate.

The Company recordscompensation expense for employee stock options based on the estimated fairvalue of the options on the date of grant using the Black-Scholes optionpricing formula with the assumptions included in the table below. The Companyuses historical data, among other factors, to estimate the expected pricevolatility and the expected forfeiture rate. For options granted prior toJanuary 2, 2006, the Company used the expected option life of 5 years. Foroptions granted following the Company’s adoption of SFAS 123R, the expectedlife was increased to 6.25 years using the “simplified method” under SAB 107(an expected term based on the mid-point between the vesting date and the endof the contractual term). The use of the simplified method is permitted throughDecember 31, 2007. We will convert to company-specific experience on orbefore January 1, 2008. The options have a maximum contractual term of 10years and generally vest as to 25% of the underlying stock on each anniversaryof the date of grant, subject to accelerated vesting in the event of a changein control of the Company.  The risk-freerate is based on the U.S. Treasury yield curve in effect at the time of grantfor the estimated life of the option.

Thefollowing weighted-average assumptions were used to estimate the fair value ofoptions granted during the three and six-month periods ended July 1, 2007and July 2, 2006, using the Black-Scholes option pricing formula:

|                          | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|--------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **               | ** ** | **July 1, 2007**       | ** ** | **July 2, 2006**     | ** ** | **July 1, 2007** | ** ** | **July 2, 2006** | ** ** |
| Dividend  yield          |       | 0.0%                             |       | 0.0%                           |       | 0.0% |   | 0.0% |   |
| Expected  volatility     |       | 54.8%                            |       | 58.8%                          |       | 54.8% |   | 58.8% |   |
| Risk  free interest rate |       | 5.03%                            |       | 4.83%                          |       | 5.02% |   | 4.83% |   |
| Expected  lives          |       | 6.25 years                       |       | 6.25 years                     |       | 6.25 years |   | 6.25 years |   |
| Forfeiture rates         |       | 12.58% - 21.71%                  |       | 4.1% - 21.91%                  |       | 12.58% - 21.71% |   | 4.1% - 21.91% |   |   |
|                          |            |                                  |            |                                |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

6

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The followingtable summarizes the Company’s activities with respect to its stock optionplans for the six months ended July 1, 2007 as follows:

| Options                                                    | ** ** | **Number  of  Shares** | ** ** | **Weighted-  Average  Exercise Price  Per Share** | ** ** | **Weighted-  Average  Remaining  Contractual  Term  (in years)** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
|------------------------------------------------------------|------------|------------------------|------------|-------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|---------------------------------|------------|
| Outstanding  at December 31, 2006                          |       | 2,297,054              |       | $                                                           | 6.23       |                                                                  | 7.84       |                            | $          | 671,221 |   |
| Granted                                                    |       | 655,500                |       | $                                                           | 4.95       |                                                                  | 9.97       |                            | $          | 9,800 |   |
| Exercised                                                  |       | (26,250                | )          | $                                                           | 3.17       |                                                                  | 8.31       |                            | $          | 19,700 |   |
| Forfeited                                                  |       | (149,247               | )          | $                                                           | 5.48       |                                                                  | 7.63       |                            | $          | — |   |
| Outstanding  at July 1, 2007                               |       | 2,777,057              |       | $                                                           | 6.00       |                                                                  | 7.92       |                            | $          | 1,310,737 |   |
| Vested  and expected to vest in the future at July 1, 2007 |       | 2,390,841              |       | $                                                           | 6.21       |                                                                  | 7.69       |                            | $          | 1,097,814 |   |
| Exercisable at July 1,  2007                               |       | 1,319,900              |       | $                                                           | 7.21       |                                                                  | 6.71       |                            | $          | 330,331 |   |

 

Since its inception onFebruary 16, 2004, a total of 400,000 shares of common stock have beenreserved for issuance under the 2004 Employee Stock Purchase Plan (“ESPP”),subject to annual increases as described under Note 11 below. Under the termsof the ESPP, the Company’s U.S. employees, nearly all of whom are eligible toparticipate, can choose to have up to a maximum of 15% of their eligible annualbase earnings withheld, subject to an annual maximum of $25,000 or 2,100 sharesper offering period, to purchase our common stock. The purchase price of thestock is 85% of the lower of the closing price at the beginning of eachsix-month offering period or at the end of each six-month offering period. TheCompany recognizes compensation cost for its ESPP under SFAS 123R.

In accordance with SFAS 148, and as required by SFAS123R, the required pro forma disclosure, for options granted in periods priorto adoption of SFAS 123R, is shown below (in thousands except per shareamounts):

|                                                                                                                                                                 | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                                                                                                                      | ** ** | **July 1, 2007**       | ** ** | **July 2, 2006**     | ** ** | **July 1, 2007** | ** ** | **July 2, 2006** | ** ** |
| Net income (loss), as  reported                                                                                                                                 |       | $                                | (1,653     | )                              | $          | 352 |   | $ | (3,675 | ) | $ | 1,179 |   |
| Stock-based employee  compensation related to stock options included in net income (loss), as  reported, net of tax                                        |       | —                           |       | —                         |       | — |   | — |   |
| Total stock-based  employee compensation expense determined under the fair value based  method for all awards (under provisions of APB 25), net of tax (a) |       | (87                              | )          | (152                           | )          | (182 | ) | (305 | ) |
| Net income (loss)—pro  forma                                                                                                                               |       | $                                | (1,740     | )                              | $          | 200 |   | $ | (3,857 | ) | $ | 874 |   |
| Net income (loss) per  share, as reported:                                                                                                                      |       |                             |       |                           |       |   |   |   |   |
| Basic                                                                                                                                                           |       | $                                | (0.09      | )                              | $          | 0.02 |   | $ | (0.19 | ) | $ | 0.06 |   |
| Diluted                                                                                                                                                         |       | $                                | (0.09      | )                              | $          | 0.02 |   | $ | (0.19 | ) | $ | 0.06 |   |
| Pro forma net income  (loss) per share:                                                                                                                         |       |                             |       |                           |       |   |   |   |   |
| Basic                                                                                                                                                           |       | $                                | (0.09      | )                              | $          | 0.01 |   | $ | (0.20 | ) | $ | 0.04 |   |
| Diluted                                                                                                                                                         |       | $                                | (0.09      | )                              | $          | 0.01 |   | $ | (0.20 | ) | $ | 0.04 |   |

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(a)    During 2007 and 2006, the Company accountedfor stock-based compensation for options granted prior to February 25,2004, the date of our initial public offering, to employees and directors usingthe intrinsic value method prescribed in APB 25 and adopted the disclosure-onlyalternative of SFAS 123, as amended by SFAS 148 for these options.

7

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*Translationof Foreign Currency*

Foreign subsidiary assets and liabilities denominatedin foreign currencies are translated at the exchange rate on the balance sheetdate. Revenues, costs and expenses are translated at the average exchange rateduring the period. Transaction gains and losses are included in results ofoperations and have not been significant for the periods presented. Thefunctional currency of the Company’s operating subsidiary in Europe, CherokeeEurope SCA (“Cherokee Europe”), is the Euro. The functional currency ofthe Company’s operating subsidiaries in Mexico (Cherokee Electronica, S.A. deC.V., or “Cherokee Mexico”), in India (Cherokee India Pvt. Ltd., or “CherokeeIndia” and Powertel India Pvt. Ltd., “Cherokee Powertel”), and in China (CherokeeInternational (China) Power Supply Co. Ltd, or “Cherokee China”) is the U.S.dollar, as the majority of transactions are denominated in U.S. dollars.  Translation adjustments, as well as theincome tax effect of currency gains or losses on certain intercompany loans,related to Cherokee Europe are reflected as a component of comprehensive income(loss) and included in stockholders’ equity as accumulated other comprehensiveincome (loss).

*RecentAccounting Pronouncements*

In June 2006, theFASB issued FIN 48, *Accounting for Uncertaintyin Income Taxes*. FIN 48 clarifies the accounting for uncertainty inincome taxes recognized in an enterprise’s financial statements in accordancewith SFAS 109, *Accounting for IncomeTaxes*, by prescribing a recognition threshold and measurementattribute for the financial statement recognition and measurement of a taxposition taken or expected to be taken in a tax return. Under FIN 48, thefinancial statement effects of a tax position should initially be recognizedwhen it is more likely than not, based on the technical merits, that theposition will be sustained upon examination. A tax position that meets themore-likely-than-not recognition threshold should initially, and subsequently,be measured as the largest amount of tax benefit that has a greater than fiftypercent likelihood of being realized upon ultimate settlement with a taxingauthority. FIN 48 is effective for fiscal years beginning afterDecember 15, 2006. In accordance with the adoption of FIN 48 on January 1,2007, we recognized a cumulative-effect adjustment of less than $0.1 million tothe opening balance of accumulated deficit. See Note 3, “Income Taxes,” foradditional information.

InSeptember 2006, the FASB issued SFAS 157, *Fair ValueMeasurements*, which defines fair value, establishes a framework formeasuring fair value in generally accepted accounting principles (GAAP), andexpands disclosures about fair value measurements. This Statement applies inconjunction with other accounting pronouncements that require or permit fairvalue measurements. This Statement shall be effective for financial statementsissued for fiscal years beginning after November 15, 2007. We arecurrently evaluating the impact that the adoption of SFAS 157 will have on theCompany’s consolidated financial position and result of operations.

InFebruary 2007, the FASB issued SFAS 159, *The FairValue Option for Financial Assets and Financial Liabilities – Including anAmendment of FASB Statement No. 115*. SFAS 159 permits entitiesto choose to measure certain financial instruments and other eligible items atfair value when the items are not otherwise currently required to be measuredat fair value. Entities that elect the fair value option will report unrealizedgains and losses in earnings at each subsequent reporting date. The fair valueoption may be elected on an instrument-by-instrument basis, with fewexceptions. SFAS 159 also establishes presentation and disclosurerequirements to facilitate comparisons between companies that choose differentmeasurement attributes for similar assets and liabilities. The provisions ofSFAS 159 are effective for fiscal years beginning after November 15,2007. The Company is currently evaluating the impact of adoption ofSFAS 159 on the consolidated financial statements.

*Inventories*

Inventories are valued atthe lower of weighted average cost or market. Inventory costs include the costof material, labor and manufacturing overhead and consist of the following, netof reserve for surplus and obsolescence (in thousands):

|                  | ** ** | **July 1, 2007** | ** ** | **December 31, 2006** | ** ** |
|------------------|------------|----------------------------|------------|---------------------------------|------------|
| Raw  material    |       | $                          | 20,435     |                            | $          | 20,991 |   |
| Work-in-process  |       | 3,864                      |       | 4,034                           |       |
| Finished  goods  |       | 9,099                      |       | 4,966                           |       |
| Inventories, net |       | $                          | 33,398     |                            | $          | 29,991 |   |

 

8

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As of July 1, 2007 and December 31, 2006, thereserve for inventory surplus and obsolescence was $3.4 million and $4.4million, respectively, including management’s assessment of reserves forsurplus and obsolescence for non-compliant material related to the Restrictionof Hazardous Substances in Electrical and Electronic Equipment directive.

Thefollowing are two European Economic Community (“EEC”) directives that arehaving an effect on the entire electronics industry, including the Company:

(1)    Restriction of Hazardous Substances inElectrical and Electronic Equipment, more commonly known as RoHS. This Europeandirective bans the use of certain elements that are commonly found incomponents used to manufacture electrical and electronic assemblies. Thisdirective became effective on July 1, 2006. The Company is activelyworking with its customers to ensure compliance, and began manufacturingcompliant products in 2006.  The Companyis focused on consuming all non-compliant material on-hand within a reasonableperiod.  However, the Company may have todispose of non-compliant materials in the future, which could adversely affectthe financial performance of the Company. There is also a risk of finesassociated with non-compliance with the RoHS directive; however, the Company isnot aware of any specific potential fines, and the Company anticipatescomplying with all provisions of this legislation.

(2)    Waste Electrical and Electronic Equipment,also known as WEEE. This directive requires manufacturers and importers toproperly recycle or dispose of such equipment at the end of its useful life.This directive became effective on August 13, 2005. The Company believesit has limited exposure to the WEEE directive because its products are usuallyinstalled into another user’s system, but this directive may be interpreted andenforced differently in the future. If so, the Company may face significantrisk of fines and costs associated with non-compliance with the existing lawsand regulations in the European Union. The Company is actively working with itscustomers to ensure compliance, and began manufacturing compliant products in2005.

**3.      INCOMETAXES**

The Company accounts for income taxes in accordancewith SFAS 109, *Accounting for IncomeTaxes*. In accordance with SFAS 109, deferred tax assets andliabilities are recorded for the estimated future tax effects of temporarydifferences between the carrying value of assets and liabilities for financialreporting and their tax basis, and carry-forwards to the extent they arerealizable.  A deferred tax provision or benefit results from the netchange in deferred tax assets and liabilities during the period.  Avaluation allowance is recorded if it is more likely than not that all or aportion of the recorded deferred tax assets will not be realized.  As ofDecember 31, 2006, deferred tax assets include $32.7 million relating to atax basis step up from a re-capitalization transaction in 1999 and $24.2million of net operating loss (“NOL”) carry-forwards.  The Company hasrecorded a valuation allowance against a significant portion of its deferredtax assets.

Provision (benefit) for income taxes for the threemonths ended July 1, 2007 and the comparable period of July 2, 2006, were a$1.0 million benefit and a $0.1 million expense, respectively.  Provision for income taxes for the six months ended July 1, 2007 and thecomparable period of July 2, 2006, were a $1.6 million benefit and a $0.6million expense, respectively.  Thebenefit for the six months ended July 1, 2007 is higher by $2.2 million thanthe comparable period of July 2, 2006 due to operating losses generated in taxjurisdictions which were taxable in prior year.  Based on availableevidence, management expects the benefit to be realized during 2007 orrecognized as a deferred tax asset at year-end.

Provision (benefit) for income taxes for the three andsix months ended July 1, 2007 was calculated by estimating taxable income(loss) for certain tax jurisdictions using actual year to date operatingresults which represents the best estimate of the effective tax rate for thefull fiscal year.

The Company adopted FIN 48, *Accounting for Uncertainty in Income Taxes* onJanuary 1, 2007.  As a result of adoption, the Company recognized acumulative effect adjustment of less than $0.1 million to the January 1,2007 accumulated deficit balance.  At January 1, 2007, we had $1.8million of gross unrecognized tax benefits, of which $0.6 million wouldreduce our effective tax rate if recognized.  Of the total unrecognizedtax benefits at the adoption date, $1.2 million was recorded as a reduction todeferred tax assets, which caused a corresponding reduction in our valuationallowance of $1.2 million.  To the extent such portion of unrecognized taxbenefits is recognized at a time such valuation allowance no longer exists, therecognition would impact our effective tax rate.  The Company’s continuingpractice is to recognize interest and/or penalties related to income taxmatters in income tax expense.  As of July 1, 2007, we have approximately$0.1 million of accrued interest and penalties related to uncertain taxpositions.

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The tax years 1997 to 2006 remain open to examinationby the major taxing jurisdictions to which we are subject. The Company iscurrently under examination in India for certain years between 2000 and 2005and during the current quarter effectively settled the Netherlands examinationof years 2002 through 2006. As a result of the Netherlands settlement, theCompany reduced the liability for unrecognized tax benefits by $0.3 millionduring the current quarter.  The Companydoes not believe the amount of unrecognized tax benefits as of July 1, 2007will significantly increase or decrease within the next twelve months.

United States income taxes are not provided onundistributed earnings from certain foreign subsidiaries. Those earnings areconsidered to be permanently re-invested in accordance with the AccountingPrinciples Board (APB) Opinion 23.

**4.****     ****NET INCOME (LOSS) PERSHARE**

In accordance withSFAS 128, *Earnings Per Share*,basic income (loss) per share is based upon the weighted average number ofcommon shares outstanding. For the three months ended July 1, 2007 and July 2,2006, options for shares of 2,777,057, and 2,241,000, respectively, ofoutstanding stock options were excluded from the calculation of diluted income(loss) per share as their exercise prices would render them anti-dilutive.  For the three months and six months endedJuly 1, 2007, all of our outstanding stock options were excluded from thecalculation of diluted loss per share as their effect would have beenanti-dilutive due to the net loss for the periods. For the six months endedJuly 1, 2007 and July 2, 2006, options for shares of 2,777,057, and 2,272,000,respectively, of outstanding stock options were excluded from the calculationof diluted income (loss) per share.

Thefollowing table sets forth the computation of basic and diluted net income(loss) per share (in thousands, except per share amounts):
|                                                          | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|----------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                               | ** ** | **July 1, 2007**       | ** ** | **July 2, 2006**     | ** ** | **July 1, 2007** | ** ** | **July 2, 2006** | ** ** |
| Net  income (loss)                                       |       | $                                | (1,653     | )                              | $          | 352 |   | $ | (3,675 | ) | $ | 1,179 |   |
| Shares:                                                  |       |                             |       |                           |       |   |   |   |   |
| Weighted-average  common shares outstanding—basic   |       | 19,359                           |       | 19,292                         |       | 19,350 |   | 19,276 |   |
| Effect  of dilutive securities:                          |       |                             |       |                           |       |   |   |   |   |
| Stock  options                                           |       | —                           |       | 80                             |       | — |   | 48 |   |
| Weighted-average  common shares outstanding—diluted |       | 19,359                           |       | 19,372                         |       | 19,350 |   | 19,324 |   |
| Net  income (loss) per share:                            |       |                             |       |                           |       |   |   |   |   |
| Basic                                                    |       | $                                | (0.09      | )                              | $          | 0.02 |   | $ | (0.19 | ) | $ | 0.06 |   |
| Diluted                                                  |       | $                                | (0.09      | )                              | $          | 0.02 |   | $ | (0.19 | ) | $ | 0.06 |   |

 

**5.      DEFERREDFINANCING COSTS**

The Company capitalizescosts directly related to financing agreements and certain qualified debtrestructuring costs, and amortizes these costs as additional interest expenseover the terms of the related debt. These costs will be fully amortized by August 2008.

Net deferred financingcosts are comprised of the following as of July 1, 2007 and December 31,2006 (in thousands):
|                                | ** ** | **July 1, 2007** | ** ** | **December 31, 2006** | ** ** |
|--------------------------------|------------|----------------------------|------------|---------------------------------|------------|
| Deferred  financing costs      |       | $                          | 580        |                            | $          | 580 |   |
| Accumulated  amortization      |       | (429                       | )          | (364                            | )          |
| Deferred financing  costs, net |       | $                          | 151        |                            | $          | 216 |   |

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**6.      DEBT**

Long-term debt consistsof the following at July 1, 2007 and December 31, 2006 (in thousands):

|                                              | ** ** | **July 1, 2007** | ** ** | **December 31, 2006** | ** ** |
|----------------------------------------------|------------|----------------------------|------------|---------------------------------|------------|
| 5.25%  senior notes payable to third parties |       | $                          | 24,485     |                            | $          | 24,485 |   |
| 5.25%  senior notes payable to affiliates    |       | 22,145                     |       | 22,145                          |       |
| Total long-term debt                         |       | $                          | 46,630     |                            | $          | 46,630 |   |

 

As of July 1, 2007, all of the Company’s long-termdebt is scheduled to be repaid in 2008.

Long-term debt includesthe Company’s senior notes, which mature on November 1, 2008. Interest onthe senior notes is payable in cash on May 1 and November 1 of eachyear. The senior notes are secured by a second-priority lien on substantiallyall of the Company’s domestic assets and by a pledge of 65% of the equity ofcertain of the Company’s foreign subsidiaries. As of July 1, 2007, the Companywas in compliance with all of the covenants set forth in the principalagreements governing the 5.25% senior secured notes due in 2008.

TheCompany’s primary line of credit is its senior revolving credit facility withGeneral Electric Capital Corporation (the “Credit Facility”).  The Credit Facility provides for borrowingsof up to $20.0 million that are subject to a borrowing base comprised ofeligible accounts receivable and inventory, which was $13.8 million at July 1,2007. There is a trailing twelve month Earnings Before Interest, Taxes,Depreciation and Amortization (“EBITDA”) covenant which limits our borrowing tothe lower of the borrowing base or two times our EBITDA as defined by thecredit agreement. As of July 1, 2007 this covenant limited our borrowingunder the agreement to $1.2 million. The Credit Facility matures inAugust 2008 and borrowings bear interest, at the Company’s option, at arate per annum equal to LIBOR plus 2.5% or the agent bank’s base rate plus1.0%. In addition to paying interest on outstanding principal, the Company isrequired to pay a commitment fee to the lenders under the credit facility inrespect of the average daily balance of unused loan commitments at a rate of0.5% per annum. The Credit Facility is secured by a first-priority lien,subject to permitted encumbrances, on substantially all of the Company’sdomestic assets and by a pledge of 65% of the equity of certain of theCompany’s foreign subsidiaries. The Credit Facility contains restrictivecovenants requiring the Company to, among other things, maintain certain seniorleverage ratios.  As of July 1, 2007,there were no borrowings outstanding under the Credit Facility, and the Companywas in compliance with all of the covenants under the Credit Facility.

Cherokee Europe maintainsa working capital line of credit of approximately $4.1 million with BankBrussels Lambert, a subsidiary of ING Belgie NV, a bank in Brussels, which isdenominated in Euros, collateralized by a pledge in first and second rank overa specific amount of business assets, requires Cherokee Europe to maintain acertain specific minimum solvency ratio and is cancelable at any time. Ouraccess to the line is currently limited to $3.6 million because $0.5 million iscommitted to minimum guarantees on specific collections and payments. Therewere no outstanding borrowings as of July 1, 2007. As of August 10,2007, Cherokee Europe had $0.7 million in outstanding borrowings under theline of credit and was in compliance with all covenants.

In January 2007,Cherokee China entered into a loan contract with Industrial and Commercial Bankof China Ltd. (“ICBC”) for a working capital line of credit. Pursuant to thecontract, ICBC agreed to make advances up to the equivalent of approximately$3.0 million, expressed as RMB 25.0 million. The line of credit iscollateralized by the Company’s building in Shanghai, China. The term endsJanuary 29, 2008 but is cancelable at any time. Interest is payablemonthly at a fixed rate based on the transaction date of our borrowings, therates vary according to the specific dates and are announced by the People’sBank of China, which was 6.55% at January 29, 2007 and 6.04% atMarch 20, 2007, based on dates amounts were borrowed. Beginning with itsinitial borrowing under the contract, Cherokee China has agreed to deposit inthe ICBC Shanghai Branch at least 90% of the operating revenue it collects. Thecash from these deposits made into our bank account are not restricted from ourusage of these funds.  As of July 1,2007, Cherokee China had $1.3 million of borrowings under the line of creditand was in compliance with all covenants.

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**7.      OTHERLONG-TERM OBLIGATIONS**

Other long-termobligations consist of the following at July 1, 2007 and December 31, 2006(in thousands):

|                                               | ** ** | **July 1, 2007** | ** ** | **December 31, 2006** | ** ** |
|-----------------------------------------------|------------|----------------------------|------------|---------------------------------|------------|
| 1999  Europe restructuring liabilities        |       | $                          | 433        |                            | $          | 486 |   |
| 2003  Europe restructuring liabilities        |       | 1,097                      |       | 1,161                           |       |
| Long  service award liabilities               |       | 821                        |       | 795                             |       |
| Pension  liability-SFAS 158                   |       | 2,736                      |       | 2,671                           |       |
| Deferred  compensation                        |       | 1,332                      |       | 1,105                           |       |
| Advances  for research & development |       | 568                        |       | 497                             |       |
| Total other long-term  obligations            |       | $                          | 6,987      |                            | $          | 6,715 |   |

The Company has agreements with a local governmentagency in Belgium for funding in advances to Cherokee Europe for research anddevelopment expenses. These advances are expected to be repaid to the agency;either as a percentage of the revenues generated by the products developed orthrough a minimum fixed amount on an annual basis. These advances are interestfree.

**8.      CUSTOMERCONCENTRATION**

For the quarter ended July 1, 2007, one customeraccounted for 12% of net sales, and no other customer accounted for more than10% of net sales. For the quarter ended July 2, 2006, one customer accountedfor 16% of net sales, and no other customer accounted for more than 10%. Forthe six months ended July 1, 2007, one customer accounted for 11% of net sales,and no other customer accounted for more than 10% of net sales. For the sixmonths ended July 2, 2006, one customer accounted for 16% of net sales, and noother customer accounted for more than 10%. For the fiscal year ended December 31, 2006, no customer accountedfor more than 10% of net sales. A decision by a major customer to decrease theamount purchased from the Company or to cease purchasing the Company’s productscould have a material adverse effect on the Company’s financial position and resultsof operations.

As of July 1, 2007 and December 31, 2006,  no customer accounted for more than 10% ofnet accounts receivable.

**9.      COMMITMENTSAND CONTINGENCIES**

*Guaranteesand Indemnities*

The Company has agreed toindemnify the former owners of Cherokee Europe for product liability,environmental hazard and employment practice claims relating solely topost-acquisition business. The Company also indemnifies its directors andofficers to the maximum extent permitted under the laws of the State of Delaware,and various lessors in connection with facility leases for certain claimsarising from such facility or lease. The maximum amount of potential futurepayments under such indemnifications is not determinable.

The Company has notincurred significant amounts related to these guarantees and indemnifications,and no liability has been recorded in the consolidated financial statements forguarantees and indemnifications as of July 1, 2007 and December 31, 2006.

***Cash Incentive Compensation Program and Severance Agreements***

The Company adopted acash incentive program for certain executives, which provides for cashincentive payments of up to 120% of base salary subject to attainment ofcorporate goals and objectives approved by the Company’s board of directors. Inaddition, the Company has entered into severance agreements with certainexecutives, which provide payments to the executive if the executive isterminated other than for cause, as defined in the applicable severanceagreement. Certain of the severance agreements provide additional benefits,including acceleration of stock options, in the event of termination inconnection with a change of control, as defined in the applicable severanceagreement.

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*Other Matters*

In the first quarter of2006, we executed a mutual release agreement with a former business partner.The agreement released both parties from obligations arising from pasttransactions. As a result of this agreement, we made a one-time adjustment toreduce our selling and marketing expense by $0.4 million during the threemonths ended April 2, 2006.

*IndiaMatter*

In late March 2006,the Company learned that employees of its Indian subsidiary manufacturingoperations had made certain unauthorized payments that may have been inviolation of the Foreign Corrupt Practices Act and local laws. The facility inIndia is used for the sole purpose of manufacturing products for other Companylocations and, as such, does not generate revenue or issue invoices to externalcustomers. It manufactures approximately 6% (by volume) of the products offeredby the Company.

The subject payments, inthe aggregate, amounted to approximately $40,000 in each of the years endedJanuary 2, 2005 and January 1, 2006, and less than $10,000 in theyear ended December 31, 2006. The Company retained outside counsel whoconducted an internal investigation into these payments. In January 2007,the Company’s outside counsel met with the SEC to discuss the results of theinternal investigation.  The Companyconsiders this matter closed.

**10.**   COMPLETIONOF RESTRUCTURING AND CLOSURE OF GUADALAJARA, MEXICO FACILITY

Duringthe three months ended October 1, 2006, the Company announced the plannedclosure of its Mexican facilities and a related restructuring plan, which wasaccounted for in accordance with SFAS 146, *Accounting for CostsAssociated with Exit or Disposal Activities*. The Mexico Facilityencompassed 35,000 square feet in one building and had been in operation since1988, employing approximately 250 full-time and temporary employees in theproduction of power supplies.

As of July 1, 2007, therestructuring and closure of our Mexico Facility was completed.  The cumulative costs for the closure of theMexico Facility were $1.5 million ($1.3 million of which were recorded in2006). This was made up of $0.9 million restructuring, $0.3 millionasset impairment and $0.3 million additional excess and obsolescencereserve. During the three months ended July 1, 2007, there was a reversal of$38,000 to severance costs due to the transfer and relocation of an employeefrom the Mexico Facility to our Tustin Facility.  The remaining accrued balance for severanceand stay bonuses was paid on July 1, 2007 to the remaining employees.

 *Assets held for sale-Mexico Facility building sold*

The Company began activelysearching for a buyer for the Mexico Facility building during the three monthsended October 1, 2006; however, in accordance with SFAS 144, *Accounting for the Impairment or Disposal of Long-Lived Assets*,the related assets were not classified as assets held for sale in the condensedconsolidated balance sheets prior to April 1, 2007, because the Companydid not meet the criterion that “the asset (disposal group) is available forimmediate sale in its present condition subject only to terms that are usualand customary for sales of such assets”, due to our continued utilization ofassets in our ongoing operations at our Mexico Facility.

The Company ceasedoperations in Mexico in March 2007, and reclassified the net book value of$0.7 million for the building and the related assets to *assets held for sale* on the condensed consolidated balancesheet as of April 1, 2007, in accordance with SFAS 144.  In addition depreciation of the assetsrelated to this sale was suspended as of April 1, 2007.   There was no impairment charge to therelated assets because the measurement value, the net book value, was lowerthan the fair value less cost to sell.

On February 22,2007, Cherokee Electronica, S.A. de C.V. (“Cherokee Mexico”), a subsidiary ofCherokee International Corporation, a Delaware corporation (the “Company”),entered into a Purchase and Sale Agreement (the “Agreement”) with InmobiliariaHondarribia, S.A. de C.V. (the “Buyer”) for the sale of Cherokee Mexico’s35,000-foot manufacturing facility in Guadalajara, Mexico. The Agreementprovided that the Buyer pay Cherokee Mexico an aggregate purchase price ofapproximately US $1.2 million of which a 15% deposit, approximately US$182,000, was paid on February 22, 2007. On May 24, 2007, the sale of the building was completed, and theremaining 85% of the sales price was transferred into the Company’s bankaccount. The Company also collected the value added tax on the building inaddition to the sales price and paid the taxes collected to the Mexicangovernment in June 2007.  The net gain ofthe sale recorded during the three months ended July 1, 2007 was$0.4 million, net of $0.1 million related to the cost to sell the assetswas deducted from the gain.

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***Asset Impairment Charges related to Other Assets***

**Duringthe three months ended October 1, 2006, the Company performed an impairmentreview in accordance with SFAS 144,  *Accounting for the Impairment and Disposal of Long-Lived Assets,*to determine whether any of its long-lived assets located at the MexicoFacility were impaired. The Company identified certain long-lived assetsassociated with the restructuring and closure of the Mexico Facility whosecarrying value would not be recoverable from future cash flows and recorded animpairment charge of $0.3 million for these assets. These assets consisted ofmachinery and equipment, computer technology and equipment, and officefurniture and equipment. The majority of these assets were written off becausethe Company considered them to have no market value. None of the impairmentcharges included cash components.**

***Restructuring Costs***

In accordance with SFAS146, employee severance, contract termination and other exit costs are recordedat their estimated fair value when they are incurred. During the three monthsended July 1, 2007, there was a reversal of $38,000 to severance costs due tothe transfer and relocation of an employee from the Mexico Facility to ourTustin Facility.  There were $0.2 millionof employee severance and stay bonus costs for the six months ended July 1,2007, which included a pro-rata portion from August 10, 2006, thecommunication date, through July 1, 2007, of an estimated amount ofstatutory required severance payments and management performance stay-onbonuses incurred for employees at the Mexico Facility.  The Company paid $0.6 million of severanceand related expenses to the remainder of employees terminated during the threemonths ended July 1, 2007.   Allseverance charges were settled with cash.

A summary of therestructuring costs and reserve activity during the six months ended July 1,2007 is as follows (in thousands):

|                            | ** ** | **Restructuring**               | ** ** | ** **        | ** ** | ** **         | ** ** | **Restructuring**          | ** ** |
|----------------------------|------------|---------------------------------|------------|-------------------|------------|--------------------|------------|----------------------------|------------|
| ** **                 | ** ** | **Liabilities at**         | ** ** | **Restructuring** | ** ** | ** **         | ** ** | **Liabilities at**    | ** ** |
| ** **                 | ** ** | **December 31, 2006** | ** ** | **Charges**       | ** ** | **Cash Paid** | ** ** | **July 1, 2007** | ** ** |
| Severance  and bonuses     |       | $                               | 429        |              | $          | 155                |       | $                          | (584       | ) | $ | — |   |
| Total Restructuring  Costs |       | $                               | 429        |              | $          | 155                |       | $                          | (584       | ) | $ | — |   |

**11.****   STOCK AND DEFERREDCOMPENSATION PLANS**

***2002 Stock Option Plan***

In July 2003, theCompany adopted the Cherokee International Corporation 2002 Stock Option Plan(the “2002 Stock Option Plan”) under which up to 1,410,256 shares of theCompany’s common stock may be issued pursuant to the grant of non-qualifiedstock options to the directors, officers, employees, consultants and advisorsof the Company and its subsidiaries. In connection with the adoption of the2002 Stock Option Plan, the Company granted 1,087,327 stock options. Theoptions typically vest over a four-year period, have a ten-year contractuallife, range in exercise price from $5.85 to $10.34 per share and were grantedwith exercise prices at or above fair value as determined by Cherokee’s Boardof Directors based on income and market valuation methodologies. InFebruary 2004, the Company granted options to purchase 328,320 shares of commonstock at an exercise price of $14.50 and terminated the 2002 Stock Option Plan.As of July 1, 2007, the Company had granted a total of 1,415,647 options topurchase shares of common stock under the 2002 Stock Option Plan, whichincludes options to purchase shares that were cancelled and subsequentlyre-granted.

***2004 Omnibus Stock Incentive Plan***

On February 16,2004, the Company adopted the 2004 Omnibus Stock Incentive Plan (the “2004Plan”), which provided for the issuance of 800,000 shares of common stock. The2004 Plan also provides for an annual increase to be**added on the first day of the Company’s fiscal year equalto the lesser of (i) 450,000 shares or (ii) 2% of the number ofoutstanding shares on the last day of the immediately preceding fiscal year.  As of July 1, 2007, a total of 1,929,820shares of the Company’s common stock were reserved for issuance under the 2004Plan. Any officer, director, employee, consultant or advisor of the Company iseligible to participate in the 2004 Plan. The 2004 Plan provides for theissuance of stock-based incentive awards, including stock options, stockappreciation rights, restricted stock, deferred stock, and performance shares.As of July 1, 2007, the Company had granted options to purchase 2,239,489shares of common stock under the 2004 Plan, which includes options to purchaseshares that were cancelled and subsequently re-granted.  Of the cumulative options granted as of July1, 2007, 248,153 options were issued as partial compensation to non-employeedirectors.

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During the three months ended July 1, 2007, 18,250shares were issued through the exercise of outstanding vested options.  The Company granted a total of 645,500 ofoptions to purchase shares of common stock under the 2004 Plan during the threemonths ended July 1, 2007. The aggregate fair value of these options grantedduring the three months ended July 1, 2007 was $1,860,000, which will beamortized as stock compensation costs over 4 years.

At the Annual Meeting ofStockholders (the “Annual Meeting”) the Company held on July 17, 2007, thestockholders of the Company approved an amendment to the 2004 plan to increasethe number of shares of the Company’s common stock reserved for issuance underthe 2004 plan by 1,000,000 shares, which increased the Company’s reserve to2,929,820 shares.

***2004 Employee Stock Purchase Plan***

On February 16,2004, the Company adopted the 2004 Employee Stock Purchase Plan (the “ESPP”).The ESPP provides for an annual increase to be added on the first day of theCompany’s fiscal year equal to the lesser of (i) 250,000 shares or(ii) 1% of the number of outstanding shares on the last day of theimmediately preceding fiscal year. As of July 1, 2007, a total of 978,035shares of common stock were reserved for issuance under the plan. The ESPP,which is intended to qualify as an “employee stock purchase plan” underSection 423 of the Internal Revenue Code of 1986, is implemented utilizingsix-month offerings with purchases occurring at six-month intervals, with a newoffering period commencing on the first trading day on or after May 15 andNovember 15 and ending on the last trading day on or beforeNovember 14 or May 14, respectively. The Compensation Committee ofthe Company’s Board of Directors oversees administration of the ESPP. Employeesare eligible to participate if they are employed for at least 20 hours per weekand more than 5 months in a calendar year by the Company, subject to certainrestrictions. The ESPP permits eligible employees to purchase common stockthrough payroll deductions, which may not exceed 15% of an employee’scompensation. The price of common stock purchased under the ESPP is 85% of thelower of the fair market value of the common stock at the beginning of eachsix-month offering period or on the applicable purchase date. Employees may endtheir participation in an offering at any time during the offering period, andparticipation ends automatically upon termination of employment. TheCompensation Committee may at any time amend or terminate the ESPP, except thatno such amendment or termination may adversely affect shares previously issuedunder the ESPP. As of July 1, 2007, a total of 197,314 shares of common stockhad been issued under the ESPP.

*Deferred Compensation Plans*

On February 16,2004, the Company adopted two executive deferred compensation plans for thebenefit of certain designated employees and non-employee directors of theCompany. The plans allow participating employees and non-employee directors tomake pre-tax deferrals of up to 100% of their annual base salary and bonuses,and retainer fees and meeting fees, respectively. The plans allow the Companyto make matching contributions and employer profit sharing credits at the solediscretion of the Company. A participant’s interest in each matchingcontribution and employer profit sharing credit, if any, vests in full no laterthan after 3 years.

As of July 1, 2007, theCompany has recorded a liability of $1.3 million, for employee and non-employeedirector contributions and investment activity to date, which is recorded inother long-term liabilities, and the Company has provided no matchingcontributions during the quarter ended July 1, 2007 and the prior years.

**12.  ****RETIREMENT PLANS**

Cherokee Europe maintainsa pension plan for certain levels of staff and management that include adefined benefit feature. The following represents the amounts related to thisdefined benefit plan for the three months and six months ended July 1, 2007 andJuly 2, 2006, respectively  (inthousands):
|                                                                      | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|----------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| **Components of Net Periodic Benefit Cost** | ** ** | **July 1, 2007**       | ** ** | **July 2, 2006**     | ** ** | **July 1, 2007** | ** ** | **July 2, 2006** | ** ** |
| Service  cost                                                        |       | $                                | 90         |                           | $          | 48 |   | $ | 177 |   | $ | 92 |   |
| Interest  cost                                                       |       | 105                              |       | 57                             |       | 207 |   | 115 |   |
| Expected  return on plan assets                                      |       | (59                              | )          | (30                            | )          | (116 | ) | (61 | ) |
| Net periodic benefit  cost                                           |       | $                                | 136        |                           | $          | 75 |   | $ | 268 |   | $ | 146 |   |

 

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**Item 2.   MANAGEMENT’S DISCUSSSIONAND ANALYSIS OF FINANACIAL CONDITION AND RESULTS OF OPERATIONS**

**FORWARD-LOOKING STATEMENTS**

Certain statements inthis Quarterly Report on Form 10-Q, other than purely historicalinformation, including estimates, projections, statements relating to ourbusiness plans, objectives and expected operating results, and the assumptionsupon which those statements are based, are “forward-looking statements” withinthe meaning of the Private Securities Litigation Reform Act of 1995,Section 27A of the Securities Act of 1933 and Section 21E of theSecurities Exchange Act of 1934. These forward-looking statements are basedupon our current expectations about future events. When used in this QuarterlyReport, the words “believes,” “projects,” “expects,” “anticipates,”“estimates,” “intends,” “strategy,” “plan,” “may,” “will,” “would,” “will be,”“will continue,” “will likely result,” and similar expressions, or the negativeof such words and expressions, are intended to identify forward-lookingstatements, although not all forward-looking statements contain such words orexpressions. These forward-looking statements generally relate to our plans,objectives and expectations for future operations. However, these statementsare subject to a number of risks and uncertainties affecting our business. Youshould read this Quarterly Report completely and with the understanding thatactual future results may be materially different from what we expect as aresult of these risks and uncertainties and other factors, which include, butare not limited to:  (1) changes ingeneral economic and business conditions, domestically and internationally,(2) reductions in sales to, or the loss of, any of the Company’ssignificant customers or in customer capacity generally, (3) the Company’sinability to realize expected cost savings by shifting production to itsShanghai facility, (4) changes in the Company’s sales mix to lower marginproducts, (5) increased competition in the Company’s industry,(6) disruptions of the Company’s established supply channels, (7) theCompany’s level of debt and restrictions imposed by its debt agreements, and(8) the additional risk factors in our filings with the Securities andExchange Commission, including our Annual Report on Form 10-K (CommissionFile No. 000-50593).  Except asrequired by law, the Company undertakes no obligation to update any forward-lookingstatements, even though the Company’s situation may change in the future.

**OVERVIEW**

**Business**

We are a designerand manufacturer of power supplies for OEMs. Our advanced power supplyproducts are typically custom designed into mid- to high-end commercialapplications in the computing and storage, wireless infrastructure, enterprisenetworking, telecom, medical and industrial markets.

We operateworldwide and have facilities in Orange County, California; Bombay, India;Wavre, Belgium (Europe) and Shanghai, China. In August 2006, we announcedour intention to close our facility in Guadalajara, Mexico, and we ceasedoperations there in March 2007. We were founded in 1978 in Orange County,California. As we expanded our business and customer base, we opened facilitiesin Bombay, India, Guadalajara, Mexico, and Shanghai, China. In June 2000,we acquired Cherokee Europe, which added a manufacturing facility in Wavre,Belgium to our manufacturing capacity and enabled us to better serve theEuropean market.

We generate all ofour sales in four market sectors, datacom, telecom, industrial, and medical.For the six months ended July 1, 2007, our revenues by market sector consistedof 46% datacom, 28% telecom, and 26% industrial, medical and other.

During the first six months of 2007, our NorthAmerican markets were flat compared to the prior period in 2006. Our Europeanoperation was down approximately 44% with one large customer making up 79% ofthe revenue shortfall from the first six months of 2006.

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**Basis of Reporting**

***Principles of Consolidation***

The consolidatedfinancial statements include the financial statements of the Company and itswholly owned subsidiaries, Cherokee Europe SCA and related entities (“CherokeeEurope”), Cherokee Electronica, S.A. DE C.V. (“Cherokee Mexico”), CherokeeIndia Pvt. Ltd. (“India”), Powertel India Pvt. Ltd. (“Powertel”), andCherokee International (China) Power Supply LLC (“Cherokee China”).Inter-company accounts and transactions have been eliminated.

*Net Sales*

We recognize revenue whenpersuasive evidence of an arrangement exists, title transfer has occurred, theprice is fixed or readily determinable, and collectibility is probable. Werecognize revenue in accordance with Staff Accounting Bulletin No. 104, *Revenue Recognition.*Salesare recorded net of discounts, which are estimated at the time of shipmentbased upon historical data. Changes in assumptions regarding the rate of salesdiscounts earned by our customers could impact our results.

We generally recognizerevenue at the time of shipment because this is the point at which revenue isearned and realizable and the earnings process is complete. For most shipments,title to shipped goods transfers at the shipping point, so the risks andrewards of ownership transfer once the product leaves our facility orthird-party hub. Revenue is only recognized when collectibility is reasonablyassured. Shipping and handling fees are included in revenue, with related costsrecorded to cost of sales.

*Cost of Sales*

The principal elementscomprising cost of sales are raw materials, labor and manufacturing overhead.Raw materials account for a large majority of our costs of sales. Raw materialsinclude magnetic sub-assemblies, sheet metal, electronic and other components,mechanical parts and electrical wires. Direct labor costs primarily includecosts of hourly employees. Manufacturing overhead includes salaries, and thedirect expense and allocation of costs attributable to manufacturing for leasecosts, depreciation on property, plant and equipment, utilities, property taxesand repairs and maintenance.

*Operating Expenses*

Operating expensesinclude engineering costs, selling and marketing costs and general andadministrative expenses. Engineering costs primarily include salaries andbenefits of engineering personnel, safety approval and quality certificationfees, and depreciation on equipment and consulting and professional services.Selling and marketing expenses primarily include salaries and benefits toaccount managers and commissions to independent sales representatives.Administrative expenses primarily include salaries and benefits for certainmanagement and administrative personnel, professional fees and informationsystem costs. Operating expenses also include the direct expense and allocationof costs attributable to these departments for lease costs, depreciation onproperty, plant and equipment, utilities, property taxes and repairs andmaintenance.

**Critical Accounting Policies**

We prepare our condensedconsolidated financial statements in conformity with accounting principlesgenerally accepted in the United States. As such, we are required to makecertain estimates, judgments and assumptions that we believe are reasonablebased upon the information currently available. These estimates and assumptionsaffect the reported amounts of assets and liabilities at the date of thecondensed consolidated financial statements and the reported amounts ofrevenues and expenses during the periods presented. Any future changes to theseestimates and assumptions could have a material effect on our reported amountsof revenue, expenses, assets and liabilities. The significant accountingpolicies that we believe are the most critical to aid in fully understandingand evaluating our reported financial results include the following:

*Revenue Recognition*

We recognize revenue whenpersuasive evidence of an arrangement exists, title transfer has occurred, theprice is fixed or readily determinable, and collectibility is probable. Werecognize revenue in accordance with Staff Accounting Bulletin No. 104, *Revenue Recognition.*Sales are recordednet of discounts, which are estimated at the time of shipment based upon historicaldata. Changes in assumptions regarding the rate of sales discounts earned byour customers could impact our results.

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We generally recognizerevenue at the time of shipment because this is the point at which revenue isearned and realizable and the earnings process is complete. For most shipments,title to shipped goods transfers at the shipping point, so the risks andrewards of ownership transfer once the product leaves our facility orthird-party hub. Revenue is only recognized when collectibility is reasonablyassured. Shipping and handling fees are included in revenue with related costsrecorded to cost of sales.

The Company has enteredinto arrangements with certain customers whereby products are delivered to athird-party warehouse location for interim storage until subsequently shippedand accepted by our customers. Revenues from these sales are recognized uponshipment from the third-party warehouse location to the customers, when titlehas passed. The Company generally offers a one-year warranty for defectiveproducts. Warranty charges have been insignificant during the periodspresented.

*Accounts Receivable*

In our North Americanoperations we perform ongoing credit evaluations of our customers and adjustcredit limits based upon payment history, the customer’s current creditworthiness and various other factors, as determined by our review of theircurrent credit information. We continuously monitor collections and paymentsfrom our customers and maintain a provision for estimated credit losses basedupon our historical experience and any specific customer collection issues thatwe have identified. While credit losses have historically been within ourexpectations and the provisions established, we might not continue toexperience the same credit loss rates that we have in the past. A significantportion of our accounts receivable are concentrated in a small number ofcustomers. A significant change in the liquidity or financial position of anyone of these customers could have a material adverse effect on thecollectibility of our accounts receivable, our liquidity and our futureoperating results. As of July 1, 2007 and December 31, 2006, our top tencustomers accounted for approximately 49% and 41% of our accounts receivables,respectively.

***Credit Risk***

The Company performsongoing credit evaluations of its customers and generally does not requirecollateral. The Company maintains reserves for estimated credit losses. TheCompany generally does not charge interest on customer balances.

***Translation of Foreign Currencies***

Foreign subsidiary assetsand liabilities denominated in foreign currencies are translated at theexchange rate in effect on the balance sheet date. Revenues, costs and expensesare translated at the average exchange rate during the period. Transactiongains and losses are included in results of operations and have not beensignificant for the periods presented. The functional currency of CherokeeEurope is the Euro. The functional currency of Cherokee Mexico, India, Powerteland Cherokee China is the U.S. dollar, as the majority of transactions aredenominated in U.S. dollars. Translation adjustments related to Cherokee Europeare reflected as a component of stockholders’ equity in other comprehensiveincome (loss).

*Inventories*

We value our inventory atthe lower of the actual cost to purchase and/or manufacture the inventory andthe current estimated market value of the inventory using the weighted averagecost method. We regularly review inventory quantities on hand and record aprovision for excess and obsolete inventory based primarily on our historicalusage data and estimates of future demand. Since substantially all of ourproducts are manufactured according to firm purchase orders and customerforecasts, we evaluate the potential of recovery from our customers whencustomized products approach end-of-life. Our customers are generally liablefor inventory costs we incur for order cancellations that occur after we havecommitted resources to procure or manufacture product. We also regularlyevaluate inventory that is non-compliant with the RoHS directive to determineif additional reserves are needed to cover for potential obsolescence. We havenot established a separate reserve for non-RoHS compliant inventory above whatour normal calculations would require.

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Our industry ischaracterized by rapid technological change, frequent new product development,and rapid product obsolescence that could result in an increase in the amountof obsolete inventory quantities on hand. As demonstrated during the past fiveyears, demand for our products can fluctuate significantly. A significantincrease in the demand for our products could result in a short-term increasein the cost of inventory purchases while a significant decrease in demand couldresult in an increase in the amount of excess inventory quantities on hand. Inaddition, our estimates of future product demand may prove to be inaccurate, inwhich case we may have understated or overstated the provision required forexcess and obsolete inventory. In the future, if our inventory were determinedto be overvalued, we would be required to recognize additional expense in ourcost of sales at the time of such determination. Likewise, if our inventory isdetermined to be undervalued, we may have over reported our costs of sales inprevious periods and would be required to recognize additional operating incomeat the time such inventory is sold. Therefore, although we make everyreasonable effort to ensure the accuracy of our estimates of future productdemand, any significant unanticipated changes in demand or technologicaldevelopments could have a material effect on the value of our inventory and ourreported operating results.

*Deferred Taxes*

We recognize deferred tax assets and liabilities basedon the differences between the financial statement carrying values and the taxbases of assets and liabilities. We regularly review our deferred tax assetsfor recoverability and establish a valuation allowance based on historicaltaxable income, projected future taxable income, and the expected timing of thereversals of existing temporary differences. If our future taxable income issignificantly higher than expected and/or we are able to utilize our taxcredits, we may be required to reverse all or a significant part of ourvaluation allowance against such deferred tax assets which could substantiallyreduce our effective tax rate for such period. Therefore, any significantchanges in statutory tax rates or the amount of our valuation allowance couldhave a material effect on the value of our deferred tax assets and liabilitiesand our reported financial results.

The preparation of condensed consolidated financialstatements in conformity with generally accepted accounting principles in theUnited States requires us to make estimates and assumptions that affect thereported amount of tax-related assets and liabilities and income taxprovisions. The Company’s effective tax rate may be subject to fluctuationsduring the fiscal year as new information is obtained which may affect theassumptions management uses to estimate the annual effective tax rate includingmix of pre-tax earnings in the various tax jurisdictions in which it operates.

 

The Company adopted the provisions of FASBInterpretation (FIN) 48, *Accounting forUncertainty in Income Taxes* (FIN 48) on January 1, 2007. FIN 48clarifies the accounting for uncertainty in income taxes recognized in anenterprise’s financial statements in accordance with SFAS 109, *Accounting for Income Taxes*, byprescribing a recognition threshold and measurement attribute for the financialstatement recognition and measurement of a tax position taken or expected to betaken in a tax return. Under FIN 48, the financial statement effects of a taxposition should initially be recognized when it is more likely than not, basedon the technical merits, that the position will be sustained upon examination.A tax position that meets the more-likely-than-not recognition threshold shouldinitially and subsequently be measured as the largest amount of tax benefitthat has a greater than fifty percent likelihood of being realized uponultimate settlement with a taxing authority. FIN 48 is effective for fiscalyears beginning after December 15, 2006. See Note 3, “Provision for IncomeTaxes” in Notes to Unaudited Condensed Consolidated Financial Statements foradditional information regarding the impact of adoption.

United States income taxes are not provided onundistributed earnings from certain foreign subsidiaries. Those earnings areconsidered to be permanently re-invested in accordance with the Accounting PrinciplesBoard (APB) Opinion 23.

***Other Comprehensive Income***

Belgium taxes forunrealized foreign exchange gains on an intercompany loan consideredpermanently re-invested are provided for as a component of other comprehensiveincome. Foreign exchange gains were recognized as Belgium taxable income in2005 and 2006 from repayments of the loan.

*Goodwilland Long Lived Assets*

We review therecoverability of the carrying value of goodwill on an annual basis or morefrequently when an event occurs or circumstances change to indicate that animpairment of goodwill has possibly occurred. The determination of whether anypotential impairment of goodwill exists is based upon a comparison of the fairvalue of the reporting unit to the accounting value of its net assets.

We also review therecoverability of the carrying value of long-lived assets whenever events orchanges in circumstances indicate that the carrying amount of an asset may notbe recoverable. Recoverability of these assets is determined based upon the forecastedundiscounted future net cash flows from the operations to which the assetsrelate, utilizing our best estimates, appropriate assumptions and projectionsat the time. 

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These projected futurecash flows may vary significantly over time as a result of increasedcompetition, changes in technology, fluctuations in demand, consolidation ofour customers and reductions in average selling prices. If the carrying valueis determined not to be recoverable from future operating cash flows, the assetwould be deemed impaired and an impairment loss would be recognized to theextent the carrying value exceeded the estimated fair market value of theasset.

***Stock-Based Compensation***

The Company adopted SFAS123R on January 2, 2006 using the “modified prospective” method aspermitted by SFAS 123R. Under this transition method, stock compensation costrecognized beginning in the first quarter of fiscal year 2006 includes: (a) compensation cost for all share-based payments granted subsequent toFebruary 25, 2004 and prior to January 1, 2006 but not yet vested asof January 1, 2006, based on the grant-date fair value estimated inaccordance with the provisions of SFAS 123R, and (b) compensation cost forall share-based payments granted subsequent to January 1, 2006, based onthe grant-date fair value estimated in accordance with the provisions of SFAS123R. In accordance with the modified prospective method of adoption, theCompany’s results of operations and financial position for prior periods havenot been restated. At the date of the adoption, the unamortized expense foroptions issued prior to January 2, 2006 was $2.3 million, which will beamortized as stock compensation costs through December 2010. All grantsare made at prices based on the fair market value of the stock on the date ofgrant. Outstanding options generally vest four years from the grant date, withcertain limited exceptions, and expire up to ten years after the grant date.

The Company records compensation expense for employeestock options based on the estimated fair value of the options on the date ofgrant using the Black-Scholes option pricing formula with the assumptionsincluded in the table under “Stock-Based Compensation” in Note 2 of the Notesto Unaudited Condensed Consolidated Financial Statements. The Company useshistorical data, among other factors, to estimate the expected price volatilityand the expected forfeiture rate. For options granted prior to January 2,2006, the Company used the expected option life of 5 years. For options grantedfollowing the Company’s adoption of SFAS 123R, the expected life was increasedto 6.25 years using the “simplified method” under SAB 107 (an expected termbased on the mid-point between the vesting date and the end of the contractualterm). The use of the simplified method is permitted through December 31,2007. We will convert to company-specific experience on or beforeJanuary 1, 2008. The options have a maximum contractual term of 10 yearsand generally vest as to 25% of the underlying stock on each anniversary of thedate of grant, subject to accelerated vesting in the event of a change incontrol of the Company.  The risk-freerate is based on the U.S. Treasury yield curve in effect at the time of grantfor the estimated life of the option.

 

**RESULTS OFOPERATIONS FOR THE THREE MONTHS ENDED JULY 1, 2007 COMPARED TO THE THREE MONTHSENDED JULY 2, 2006**

**NETSALES**

Net sales decreased byapproximately 22.8%, or $8.7 million, to $29.6 million for the three monthsended July 1, 2007 from $38.3 million for the three months ended July 2,2006. During the three months ended July 2, 2006, net sales included $6.1million of sales from one of our largest customers in the telecom sector,compared to no sales from that customer during the three months ended July 1,2007.  This customer has had no new salesin the past twelve months, however the customer remains active and weanticipate future sales. The overall sales in the telecom sector decreased52.7%, or $8.2 million, to $7.3 million for the three months ended July 1, 2007compared to $15.5 million for the three months ended July 2, 2006.

**GROSSPROFIT**

Gross profit decreased byapproximately 31.8%, or $2.6 million, to $5.5 million for the three monthsended July 1, 2007 from $8.1 million for the three months ended July 2,2006. Gross margin for the three months ended July 1, 2007 decreased to 18.8%from 21.2% in the prior year period.

For the three monthsended July 1, 2007, the decrease in gross profits was due to the overall lowersales volume and resulted in unfavorable absorption and labor rate efficienciescompared to the three months ended July 2, 2006.

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**OPERATINGEXPENSES**

Operating expenses for the three months ended July 1,2007 increased by approximately 13.6%, or $1.0 million, to $8.1 million from$7.1 million for the three months ended July 2, 2006. As a percentage ofnet sales, operating expenses increased to 27.2% from 18.5% in the prior yearperiod.

Engineering anddevelopment expense consists primarily of engineering salaries for ongoingdesign and development of active projects. For the three months ended July 1,2007, engineering and development costs increased by $0.5 million compared tothe three months ended July 2, 2006 related to the increase in headcount tosupport our increase in new product development. We currently have adevelopment team of 21 engineers in China compared to 2 in the prior yearperiod, related expenses were higher by $0.1 million compared to the prior yearperiod. This investment follows our strategic plan to capitalize on incrementalsales opportunities in the Asian market.

Selling and marketingexpense consists primarily of sales salaries and commissions, travel,advertising and marketing expenses. For the three months ended July 1, 2007,selling and marketing expense increased by $0.2 million compared to the threemonths ended July 2, 2006. During the three months ended July 1, 2007, $0.1million of the increase was related to customer promotional events.

General andadministrative expense consists primarily of salaries and other expense formanagement, finance, human resources, information systems, legal andprofessional fees. For the three months ended July 1, 2007, general andadministrative expense increased by $0.3 million compared to the three monthsended July 2, 2006, of which $0.2 million was related to professional fees andout of pocket expenses from additional work required to file our Form 10-Kduring the quarter, compared to none during the three months ended July 2,2006. We also incurred approximately $0.1 million in redundant general and administrativecosts related to the closure of the Mexico facility that will not repeat.

**OPERATINGINCOME (LOSS)**

As a result of the factors discussed above, operatingincome decreased $3.5 million to a loss of $2.5 million for the three monthsended July 1, 2007, from income of $1.0 million for the three months endedJuly 2, 2006. Operating margin decreased to a loss of 8.5% from income of2.7% in the prior year period.

**INTEREST EXPENSE**

Interest expense for thethree months ended July 1, 2007, and July 2, 2006 was $0.7 million for eachperiod.  The interest expense isprimarily related to payments for the $46.6 million of senior notes bearinginterest at 5.25% annually.

**OTHER INCOME**

For the three monthsended July 1, 2007, the Company recorded a net gain of $0.4 million to otherincome related to the sale of the Mexico Facility building.  See Note 10 to the Notes to UnauditedCondensed Financial Statements for additional information.

**INCOME TAXES**

Provision (benefit) for income taxes for the threemonths ended July 1, 2007 and the comparable period of July 2, 2006, was a $1.0million benefit and a $0.1 million expense, respectively. The benefit for thethree months ended July 1, 2007 is higher by $1.1 million than the comparableperiod of July 2, 2006 due to operating losses generated in tax jurisdictionswhich were taxable in the prior year. Based on available evidence, management expects the benefit to berealized during 2007 or recognized as a deferred tax asset at year-end.

Provision (benefit) for income taxes for the threemonths ended July 1, 2007 was calculated by estimating taxable income (loss)for certain tax jurisdictions using actual year to date operating results whichrepresents the best estimate of the effective tax rate for the full fiscalyear.

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**NET INCOME (LOSS)**

As a result of the factors discussed above, werecorded a net loss of $1.7 million for the three months ended July 1, 2007,compared to $0.4 million of net income for the three months ended July 2,2006.

**RESULTS OFOPERATIONS FOR THE SIX MONTHS ENDED JULY 1, 2007 COMPARED TO THE SIX MONTHSENDED JULY 2, 2006**

**NET SALES**

Net sales decreased by approximately 19.9%, or $14.8million, to $59.6 million for the six months ended July 1, 2007 from $74.4million for the six months ended July 2, 2006.

The overall sales in thetelecom sector decreased 44.1%, or $13.1 million, to $16.6 million for the sixmonths ended July 1, 2007, compared to $29.7 million for the six months endedJuly 2, 2006. During the six months ended July 2, 2006, net sales included$11.7 million in sales from one of our largest customers in the telecomsector.  This customer has had no newsales in the past twelve months, however the customer remains active and weanticipate future sales.

**GROSS PROFIT**

Gross profit decreased by approximately 32.3%, or $5.3million, to $11.3 million for the six months ended July 1, 2007 from $16.6million for the six months ended July 2, 2006. Gross margin for the six monthsended July 1, 2007 decreased to 18.9% from 22.4% in the prior year period.

For the six months endedJuly 1, 2007, the decrease in gross profit was primarily related to theunfavorable absorption and labor rate efficiencies compared to the six monthsended July 2, 2006, due to the overall lower sales volume. In addition, $0.3million was related to temporarily higher factory overhead costs caused byrunning dual operations in Mexico and China.

**OPERATING EXPENSES**

Operating expenses for the six months ended July 1,2007 increased by approximately 15.7%, or $2.2 million, to $15.9 million from$13.7 million for the six months ended July 2, 2006.  As a percentage ofsales, operating expenses increased to 26.7% from 18.4% in the prior yearperiod.

For the six months endedJuly 1, 2007, engineering and development costs increased by $0.8 millioncompared to the six months ended July 2, 2006, due to the increase in headcountto support our increase in new product development. Engineering and developmentexpense was higher by $0.7 million in 2007 compared to the prior period in 2006in our North America and Europe businesses due to ongoing design anddevelopment of active projects.   Chinawas higher by $0.1 million during the six months ended July 1, 2007 compared tothe prior period in 2006.   We currentlyhave a development team of twenty-one engineers in China compared to two inJuly a year ago. This investment follows our strategic plan, the next step ofwhich is to capitalize on incremental sales opportunities in the Asian market.

Selling and marketingexpense consists primarily of sales salaries and commissions, travel,advertising and marketing expenses. For the six months ended July 1, 2007, sellingand marketing expense increased by $0.7 million compared to the six monthsended July 2, 2006, of which $0.4 million is related to a decrease during theprior period due to a mutual release agreement made with a former businesspartner over sales commissions. The agreement released both parties fromobligations arising from past transactions. As a result of this agreement, wemade a one-time adjustment to reduce our selling and marketing expense by $0.4million during the three months ended April 2, 2006.  We incurred additional sales marketingexpenses related to customer promotional events during the six months endedJuly 1, 2007 compared to the prior year period in 2006.

General andadministrative expense consists primarily of salaries and other expense formanagement, finance, human resources and information systems. For the sixmonths ended July 1, 2007, general and administrative expense increased by $0.5million compared to the six months ended July 2, 2006, of which $0.4 millionwas related to professional fees and out of pocket expenses from additionalwork required to file our Form 10-K for the year ended December 31, 2006,compared to none during the six months ended July 2, 2006 for the prior year’sForm 10-K. We also incurred approximately $0.3 million redundant general andadministrative costs related to the closure of the Mexico facility that willnot repeat.  These higher expenses during2007 were offset by a $0.1 million decrease in administrative salaries and $0.1million decrease in legal fees compared to the prior period in 2006.

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During the three monthsended October 1, 2006, the Company announced the planned closure of its MexicoFacility. The Company incurred $0.2 million of operating costs related toseverance and facility closure costs for the six months ended July 1, 2007 thatdid not occur in the comparable period from 2006.

**OPERATING INCOME (LOSS)**

As a result of the factors discussed above, operatingincome decreased to a loss of $4.6 million for the six months ended July 1, 2007compared to income of $2.9 million for the six months ended July 2, 2006. Operating margin decreased to a loss of 7.8% from income of 3.9% in the prioryear period.

**INTEREST EXPENSE**

Interest expense for the six months ended July 1, 2007was $1.4 million compared to $1.4 million for the six months ended July 2,2006.  The interest expense is mainly related to our 5.25% senior notesand commitment fees on our senior revolving credit line.

**OTHER INCOME**

For the six months ended July 1, 2007, the Companyrecorded a net gain of $0.4 million to other income related to the sale of theMexico Facility building.  See Note 10 tothe Notes to Unaudited Condensed Consolidated Financial Statements foradditional information.

**INCOME TAXES**

Provision (benefit) for income taxes for the sixmonths ended July 1, 2007 and the comparable period of July 2, 2006 was a $1.6million benefit and a $0.6 million expense, respectively. The benefit for thesix months ended July 1, 2007 is higher by $2.2 million than the comparable periodof July 2, 2006 due to operating losses generated in tax jurisdictions whichwere taxable in the prior year.  Based on available evidence, managementexpects the benefit to be realized during 2007 or recognized as a deferred taxasset at year-end.

Provision (benefit) for income taxes for the sixmonths ended July 1, 2007 was calculated by estimating taxable income (loss)for certain tax jurisdictions using actual year to date operating results whichrepresents the best estimate of the effective tax rate for the full fiscalyear.

**NET INCOME (LOSS)**

 As a result of the factors discussed above, werecorded a net loss of $3.7 million for the six months ended July 1, 2007,compared to the net income of $1.2 million for the six months ended July 2,2006.

**LIQUIDITYAND CAPITAL RESOURCES**

**CASHFLOWS**

**FOR THE SIX MONTHSENDED JULY 1, 2007 COMPARED TO THE SIX MONTHS ENDED JULY 2, 2006**

Net cash used by operating activities for the sixmonths ended July 1, 2007 was $3.6 million, compared to net cash provided byoperating activities of $3.0 million for the six months ended July 2, 2006.

Net cash used in operating activities for the sixmonths ended July 1, 2007 reflected a net loss of $3.7 million which wasprimarily a result of $14.8 million lower revenues in 2007 compared to 2006,offset by a $0.4 million gain in the sale of assets held for sale related tothe sale of the Mexico Facility building, a $3.2 million increase in inventory,a $2.5 million decrease in accrued liabilities and restructuring costs, and a$0.9 million decrease in accrued compensation. This was offset by $1.6 million in depreciation and amortization, $0.3million of stock-based compensation related to SFAS 123R, a $4.0 milliondecrease in accounts receivable, a $0.6 million decrease in prepaid expensesand other current assets, a $0.4 million increase in accounts payable, and a$0.1 million increase in other long-term obligations.

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Net cash provided by operating activities for the sixmonths ended July 2, 2006 reflected the positive effect of $1.2 million in netincome due to higher revenues, $1.6 million of depreciation and amortization,$0.3 million of stock-based compensation related to SFAS 123R, $0.7 milliondecrease in accounts receivable due to higher collections, an $2.0 millionincrease in accounts payable due to higher costs during the period as a resultof higher revenues, $1.0 million increase in accrued compensation and benefitsmainly due to the increase in bonus accrual, and an increase of $0.5 million inlong-term obligations.  These amounts were partially offset by a$2.6 million increase in inventories during the six months endedJuly 2, 2006 due to a large past due and higher backlog, $1.0 millionincrease in prepaid expenses and other current assets due to the increase invalue added tax (“VAT”) receivables in China and Europe, resulting fromincreased purchases to support higher revenues, a $0.7 million decrease inaccrued liabilities and restructuring costs.

Net cash used in investing activities for the sixmonths ended July 1, 2007 was $0.3 million, in which $1.5 million was relatedto capital expenditures.  We invested$1.4 million in our China facility. We received $1.2 million of proceeds fromthe sale of the Mexico Facility building. Net cash used in investing activitiesfor the six months ended July 2, 2006 was $1.1 million related to capitalexpenditure purchases, of which $0.9 million was invested in our Chinafacility.

Net cash provided by financing activities for the sixmonths ended July 1, 2007 and the six months ended July 2, 2006 was $1.5million and $0.1 million, respectively. In January 2007, we opened a credit facility with the Industrial andCommercial Bank of China Ltd., or ICBC. Pursuant to the loan contract, ICBC will advance up to the equivalent ofapproximately $3.0 million, expressed as RMB 25.0 million. The line iscollateralized by the Company’s building in Shanghai, China. During the firstthree months of 2007, Cherokee China borrowed $1.3 million under this creditfacility to support working capital requirements as our China subsidiary buildsinventory and incur value-added tax on local purchases. As of July 1, 2007, theoutstanding balance of $1.3 million due to ICBC remained due.   During the six months ended July 1, 2007,and the six months ended July 2, 2006, $0.2 million, and $0.1 million,respectively, of employee stock purchase plan proceeds were received.

**LIQUIDITY**

We expect our liquidityrequirements will be primarily for working capital and capital expenditures. Asof July 1, 2007, we had cash and cash equivalents of $6.6 million, workingcapital of $39.3 million, no outstanding borrowings under our mainrevolving credit facility and borrowing base availability of $13.8 millionunder the same facility.  The Companyalso experienced an increase in inventory of $3.4 million since the year endedDecember 31, 2006, driven by an increase in finished goods. Part of theincrease is related to finished goods inventory shipped to third-party warehouses(hub locations). Revenues from these sales will be recognized upon shipmentfrom the hub locations to the customers, when title has passed.  The other part of the increase in inventory wasto maximize the utilization of our relatively fixed manufacturing labor pool inEurope in anticipation of forecasted customer demand. Historically, we havefinanced our operations with cash from operations supplemented by borrowingsfrom credit facilities and debt and equity issuances. Besides our credit linein the United States, Cherokee Europe also maintains a working capital line ofcredit of approximately $4.1 million with Bank Brussels Lambert, a subsidiaryof ING Belgie NV, a bank in Brussels, which is denominated in Euros, and iscollateralized by a pledge in first and second rank over a specific amount ofbusiness assets. However, our access to the line is limited to $3.6 millionbecause $0.5 million is committed to minimum guarantees on specific collectionsand payments. The facility requires Cherokee Europe to maintain a certainsolvency ratio and is cancelable at any time. There were no outstandingborrowings as of July 1, 2007. As of August 10, 2007, Cherokee Europehad $0.7 million in outstanding borrowings under the line of credit andwas in compliance with all covenants.

In January 2007, weopened a credit facility with the Industrial and Commercial Bank of China Ltd.,or ICBC. Pursuant to the contract, ICBC will advance up to the equivalent ofapproximately $3.0 million, expressed as RMB 25.0 million. The line iscollateralized by the Company’s building in Shanghai, China. Interest ispayable monthly at a fixed rate based on the transaction date of ourborrowings, the rates vary according to the specific dates and are announced bythe People’s Bank of China. This facility is intended for working capitalrequirements in China, especially as our China subsidiary builds inventory forexport to the United States and Europe and incur value-added tax on localpurchases that can only be recovered through in-country sales of ourproduct.  As of July 1, 2007, CherokeeChina had $1.3 million of borrowings under this line of credit.

We believe these amounts,together with cash flow from operations and our credit lines in the UnitedStates, Europe and China, are sufficient to meet our cash requirements for atleast the next twelve months.

 

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The prior two years, 2006and 2005, were unusual in that we financed the building, capital expendituresand start-up working capital requirements of our new Shanghai facility entirelyfrom internally generated cash. Our ongoing current and future liquidity needsprimarily arise from working capital requirements and capital expenditures thathave now returned to comparable historical levels as we have completed theconstruction of our plant in China. Our historical capital expenditures haveprimarily resulted from investments in equipment to increase or replacemanufacturing capacity and to improve manufacturing efficiencies.

For 2007, we originallyexpected global capital expenditures to be approximately $2.9 million, however,after our recent forecast of our capital expenditures requirements for theyear, we currently expect to spend $1.9 million.  Most of this spending will be in ourinvestments in our manufacturing equipment at our facilities, of which $1.7million will be for our China facility. Our required capital investment in China is decreasing rapidly. In 2006our China facility required $3.0 million, or almost twice what we expect tospend in China during 2007. In 2005, starting our China facility required $5.5million, or over three times the anticipated spending for 2007.

As of July 1, 2007, wehad approximately $46.6 million of senior notes bearing an annual interest rateof 5.25%, payable semi-annually.  Thesenotes become due on November 1, 2008. Our plan for 2007 through 2009 projects that we will have adequate cashflow to support refinancing these notes at current market rates.  Based on preliminary discussions with thirdparties, management is optimistic that several viable solutions will beavailable to the Company for satisfying this obligation on or before its statedmaturity date.

***Contractual Obligations***

As of July 1, 2007,our borrowings consisted of approximately $46.6 million of senior notes bearinginterest at 5.25% annually, and no outstanding borrowings under our revolvingcredit facility. We are required to make semi-annual interest payments toholders of the senior notes.

We have operating leaseobligations relating to our facilities in Tustin and Irvine, California andBombay, India.

We have purchasecommitments primarily with vendors and suppliers for the purchase of inventoryand for other goods, services, and equipment as part of the normal course ofbusiness. These commitments are generally evidenced by purchase orders that mayor may not include cancellation provisions. Based on current expectations, wedo not believe that any cancellation penalties we incur under these obligationswould have a material adverse effect on our consolidated financial condition orresults of operations.

Thematurities of our long-term debt, including capital leases, and future paymentsrelating to our operating leases and other obligations as of July 1, 2007 areas follows (in thousands):

| Contractual Obligations           | ** ** | **July 1, 2007  to  December 30,  2007** | ** ** | **2008** | ** ** | **2009** | ** ** | **2010** | ** ** | **2011** | ** ** | **Thereafter** | ** ** | **Total** | ** ** |
|----------------------------------------|------------|---------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------------|------------|-----------|------------|
| Long-term  debt                        |       | $                                                       | —     |     | $          | 46,630   |       | $        | —     |     | $          | —         |       | $         | —     |   | $ | — |   | $ | 46,630 |   |
| Operating  leases                      |       | 812                                                     |       | 1,634    |       | 592      |       | 30       |       | 20       |       | 112            |       | 3,200     |       |
| Purchase  order commitments            |       | 15,403                                                  |       | 8        |       | —   |       | —   |       | —   |       | —         |       | 15,411    |       |
| 1999  Europe restructuring             |       | 112                                                     |       | 154      |       | 303      |       | 53       |       | —   |       | —         |       | 622       |       |
| 2003  Europe restructuring             |       | 154                                                     |       | 241      |       | 234      |       | 216      |       | 177      |       | 350            |       | 1,372     |       |
| Long  service award                    |       | 13                                                      |       | 51       |       | 100      |       | 194      |       | 21       |       | 479            |       | 858       |       |
| Deferred  compensation                 |       | —                                                  |       | —   |       | —   |       | —   |       | —   |       | 1,333          |       | 1,333     |       |
| Advances  for research and development |       | 102                                                     |       | 59       |       | 56       |       | 56       |       | 56       |       | 341            |       | 670       |       |
| Total                                  |       | $                                                       | 16,596     |     | $          | 48,777   |       | $        | 1,285      |     | $          | 549            |       | $         | 274        |   | $ | 2,615 |   | $ | 70,096 |   |

 

The long-termliability for accrued pension costs included on the consolidated balance sheetis excluded from the table above. Cherokee is unable to estimate the timing ofpayments for these costs. During the six months ended July 1, 2007, the Companycontributed approximately $125,000. Cherokee anticipates making non-U.S. pension contributions ofapproximately $250,000 in 2007.

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Long-term debt includesour senior notes, which mature on November 1, 2008. Interest on the seniornotes is payable in cash on May 1 and November 1 of each year. Thesenior notes are secured by a second-priority lien on substantially all of ourdomestic assets and by a pledge of 65% of the equity of certain of our foreignsubsidiaries.

The Credit Facilityprovides for borrowings of up to $20.0 million, subject to a borrowing basecomprised of eligible accounts receivables and inventory, which was $13.8million at July 1, 2007. There is a trailing twelve month EBITDA covenant whichlimits our borrowing to the lower of the borrowing base or two times our EBITDAas defined by the credit agreement. As of July 1, 2007 this covenantlimited our borrowing under the agreement to $1.2 million. As ofJuly 1, 2007 this covenant limited our borrowing under the agreement to$1.2 million. We plan to use funds available under the Credit Facility tofinance working capital and other cash requirements as needed. The CreditFacility matures in August 2008 and bears interest, at our option, at a rateper annum equal to LIBOR plus 2.5% or the agent bank’s base rate plus 1.0%. Inaddition to paying interest on outstanding principal, we are required to pay acommitment fee to the lenders under the Credit Facility in respect of theaverage daily balance of the unused loan commitment at a rate of 0.5% perannum. The Credit Facility is our senior obligation and ranks equal in right ofpayment with our existing and future permitted senior debt (including oursenior notes), and senior in right of payment to our future permittedsubordinated debt. The Credit Facility is secured by a first-priority lien,subject to permitted encumbrances, on substantially all of our domestic assetsand by a pledge of 65% of the equity of certain of our foreign subsidiaries.

The agreements governingthe Credit Facility and our senior notes contain covenants that restrict ourbusiness operations, including covenants limiting our ability to makeinvestments, enter into mergers or acquisitions, dispose of assets, incuradditional debt, grant liens, enter into transactions with affiliates, redeemor repurchase our capital stock, repay other debt and pay dividends, andcontains a financial ratio test based on senior leverage. They also containcustomary events of default, including defaults in the payment of principal orinterest, defaults in the compliance with the covenants contained in theagreements governing our debt, cross defaults to other material debt andbankruptcy or other insolvency events.

Cherokee Europe maintainsa working capital line of credit of approximately $4.1 million with BankBrussels Lambert, a subsidiary of ING Belgie NV, a bank in Brussels, which isdenominated in Euros, collateralized by a pledge in first and second rank overa specific amount of business assets, requires Cherokee Europe to maintain acertain specific minimum solvency ratio and is cancelable at any time. Ouraccess to the line is also limited to $3.6 million because $0.5 million iscommitted to minimum guarantees on specific collections and payments. Therewere no outstanding borrowings as of July 1, 2007. As of August 10,2007, Cherokee Europe had $0.7 million in outstanding borrowings under theline of credit and was in compliance with all covenants.

Cherokee China enteredinto a loan contract with Industrial and Commercial Bank of China Ltd. (“ICBC”)for a working capital line of credit during January 2007. Pursuant to thecontract, ICBC agreed to make advances up to the equivalent of approximately$3.0 million, expressed as RMB 25.0 million. The line of credit iscollateralized by the Company’s building in Shanghai, China. The term endsJanuary 29, 2008 but is cancelable at any time. Interest is payablemonthly at a fixed rate based on the transaction date of our borrowings, therates vary according to the specific dates and are announced by the People’sBank of China. Beginning with its initial borrowing under the contract,Cherokee China has agreed to deposit in the ICBC Shanghai Branch at least 90%of the operating revenue it collects. The cash from these deposits made intoour bank account are not restricted from our usage of these funds.  As of July 1, 2007, Cherokee China had $1.3million of borrowings under this line of credit. As of July 1, 2007, we were incompliance with all of the covenants set forth in the principal agreementsgoverning our debt.

Based on our presentexpectations, we believe that our existing cash and cash equivalents, workingcapital and available borrowing capacity at July 1, 2007 will be sufficient tomeet our anticipated cash requirements for the next twelve months, includingoperating requirements, contractual obligations, planned capital expendituresand debt service.

**RECENTACCOUNTING PRONOUNCEMENTS**

For a discussion of the impact of recently issuedaccounting pronouncements, see the subsection entitled “Recent AccountingPronouncements” contained in Note 2 of the Notes to Unaudited CondensedConsolidated Financial Statements under “Item 1. Financial Statements.”

**Item3.   QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

Market risk relating toour operations results primarily from changes in foreign currency exchangerates and short-term interest rates. We did not have any derivative financialinstruments at July 1, 2007.

We had no variable ratedebt outstanding at July 1, 2007. However, any debt we incur under the CreditFacility and the Cherokee Europe line of credit will bear interest at avariable rate. We cannot predict market fluctuations in interest rates andtheir impact on any variable rate debt we may incur in the future, nor canthere be any assurance that fixed rate long-term debt will be available to usat favorable rates, if at all.

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Thefunctional currency for our European operations is the Euro. We are, therefore,subject to a certain degree of market risk associated with changes in foreigncurrency exchange rates. This risk is mitigated by the fact that our revenuesand expenses are generally both transacted in Euros, thereby reducing the riskof foreign currency fluctuation on our European operations. The effect offoreign currency exchange rate fluctuations on our operating results as of andfor the three months ended July 1, 2007, was not material. Historically, wehave not actively engaged in exchange rate-hedging activities.

**Item 4.   CONTROL AND PROCEDURES**

(a)    *Evaluationof Disclosure Controls and Procedures*

As of July 1, 2007, the end of the period covered bythis Quarterly Report on Form 10-Q, our management, including our ChiefExecutive Officer and our Chief Financial Officer, reviewed and evaluated theeffectiveness of our disclosure controls and procedures (as defined inSecurities Exchange Act of 1934, Rule 13a-15(e) and 15d-15(e)). Such disclosurecontrols and procedures are designed to ensure that material information wemust disclose in this report is recorded, processed, summarized, and filed orsubmitted on a timely basis. Based upon this evaluation and due to materialweaknesses existing in our internal controls as of December  31, 2006(described below), which have not been fully remediated as of July 1, 2007, wehave concluded that, as of July 1, 2007, our disclosure controls and procedureswere ineffective.

(b)    *Changesin Internal Control over Financial Reporting*

A material weakness is a significant deficiency, orcombination of significant deficiencies, that results in more than a remotelikelihood that a material misstatement of the annual or interim financialstatements will not be prevented or detected.

As reported in Item 9A of our Annual Report onForm 10-K (for the year ended December 31, 2006) filed with the Securities andExchange Commission on May 23, 2007, and updated in Item 4 on Form 10-Q (forthe quarter ended April 1, 2007) filed with the Securities and ExchangeCommission on June 8, 2007, we determined that the following materialweaknesses in internal control over financial reporting still exist as of July1, 2007:

*Architecture of Company’s IT systems does notpresently support the financial reporting requirements of the Company’sinternational operations.*

Our subsidiaries in Indiaand China maintain disparate financial accounting systems that do not interfacewith the Company’s primary ERP system, resulting in duplicate accountingentries on multiple systems. This causes a protracted reporting cycle whichlimits the oversight from corporate headquarters of transactional details atour international sites. Site level financial statements are delivered onspreadsheets to the corporate office for consolidation.

Our European operationhas its own separate ERP system that is integrated into the local accountingsystem; however this system does not automatically interface financially withour corporate headquarters. Therefore, financial results are also delivered toour corporate office by means of spreadsheets, and the corporate office alsohas insufficient visibility to transactional details.

The consolidation of allthese local results delivered on spreadsheets is in turn prepared onspreadsheets at our corporate office. Consolidations performed on spreadsheetsare prone to human error and are difficult to review. As such, the existingconsolidation process requires additional monitoring and oversight. Segregationof duties, oversight and monitoring are discussed in more detail below.

The Company has begunperforming comprehensive assessments of its current IT architecture and hasdeveloped IT interface solutions for key activities in China that are currentlyin testing phase.  After these solutionsare fully implemented, we will determine what IT solutions will be required forour other locations.   In the interim,the Company has supplemented these technical IT solutions with additionalstaffing and improved internal monitoring procedures.

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*The methodology and support for valuing andcapitalizing inventory costs, and determining inventory reserves*

The Company nowevaluates historical and projected labor and overhead costs to determine theirreasonableness.  This process is subjectto finance management oversight and review. The Company does not track labor byproduct model.

The methodology andsupport for maintaining our inventory reserves, specifically surplus andobsolescence, have been reviewed and a methodology implemented from the quarterended April 1, 2007.  Our corporateoffice has also taken the additional step of using the ERP system informationto verify monthly cost of sales in both India and China.

*Segregation of duties*

*The lack of an integrated financial reportingsystem creates the need for significant manual intervention and staffing toprepare spreadsheets, create eliminating entries, make tax adjustments, andU.S. GAAP adjustments. In order to mitigate segregation of duties created by asmall corporate staff, the Company has enhanced the segregation of duties byreallocating staff responsibilities and work load among other staff members inthe Corporate Finance Department.   TheCompany has also revised and improved the monthly financial reporting packagegiven to management.  The monthlyfinancial results and reporting package are reviewed by Corporate Managementwith the local general managers and controllers each month..*

*Oversight and monitoringcontrols*

Our remote locations,other than Europe, have one local controller with little more than clericalsupport to maintain the local accounting system, transport information from ourERP system to their local books, report financial statements to our headquartersin the U.S. and perform routine functions like account reconciliations. As partof our SOX compliance efforts, the Company is performing a detailed review ofprocedures and personnel at each site location. The Company is committed to resolving all deficiencies identified.

Wehave identified and have performed or are working on the following remediationto resolve the weakness in oversight and monitoring controls over internationalfinancial reporting:

·           All subsidiary controllers report toour corporate controller in the U.S.

·           The process of adding structure anduniformity of accounting standards and process among our site controllerscontinues through distribution of corporate policies and procedures, plannedcontinued development and distribution of policies, reinforcement of managementrepresentations and corporate code of conduct, and regular visits by thecorporate controller to various company sites. We continue critical self-review of how accounting is performedworldwide.

·           An internal audit department charterhas been developed and approved by the Audit Committee.  Internal audit is currently focused on sitevisits for Sarbanes-Oxley Act of 2002 compliance (“SOX”) and is also reviewingcompliance with selected key corporate policies.  Specific financial audit testing is beingperformed in conjunction with the SOX compliance efforts.

·           The corporate controller is visitingvarious company sites to reinforce company accounting policies and financialstatement closing procedures with local controllers.  There is additional oversight at thecorporate offices with a consolidated reporting package being provided tocorporate management and significant items being reviewed with localmanagement.

The continued remediationof the weaknesses identified above and their associated risks is dependent onthe Company’s ability to address these issues effectively. The issues of ITsystems, people and process are interrelated and difficult to separate. Striking the optimum balance betweenimproved process, better trained and supervised staff and mission critical ITimprovements is essential for success.

Except as noted above,there have not been any changes in our internal control over financialreporting (as such term is defined in Rules 13a-15(f) and15d-15(f) under the Exchange Act) during our July 1, 2007 quarter-end thathave materially affected, or are reasonably likely to materially affect, ourinternal control over financial reporting.

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**PART II  OTHER INFORMATION**

**Item1.   Legal Proceedings**

During the quarter ended July 1, 2007, we were not aparty to any material legal proceedings. We are occasionally a party tolawsuits relating to routine matters incidental to our business. As with alllitigation, we can provide no assurance as to the outcome of any particularlawsuit, and we note that litigation inherently involves significant costs.

**Item1A.   Risk Factors**

There have been no material changes to the Company’srisk factors from those disclosed in the Company’s 2006 Annual Report onForm 10-K.

**Item 6.   EXHIBITS**

**EXHIBIT INDEX**

Exhibits have heretoforebeen filed with the SEC and are incorporated herein by reference. Managementcontracts or compensatory plans or arrangements are marked with an asterisk.
| Exhibit No. | ** ** | **Description**                                                                                                                                                                          | ** ** |
|------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| 3.1              |       | Restated Certificate of  Incorporation of Cherokee International Corporation.(1)                                                                                                         |       |
| 3.2              |       | Amended and Restated By-Laws of Cherokee  International Corporation.(1)                                                                                                                  |       |
| 4.1              |       | Specimen certificate for shares of common stock, par  value $0.001 per share.(3)                                                                                                         |       |
| 4.2              |       | Indenture, dated as of November 27, 2002,  between Cherokee International Corporation, as issuer, and U.S. Bank, N.A.,  as trustee, relating to the 5.25% Senior Notes due 2008.(2) |       |
| 4.3              |       | Form of 5.25% Senior Notes due 2008.(2)                                                                                                                                             |       |
| 31.1             |       | Certification of President, Chief Executive Officer,  and Director pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                       |       |
| 31.2             |       | Certification of Executive Vice President of  Finance, Chief Financial Officer and Secretary pursuant to Section 302  of the Sarbanes-Oxley Act of 2002.                            |       |
| 32.1             |       | Certification of CEO and CFO Pursuant to 18 U.S.C.  Section 1350, as Adopted Pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.                                       |       |

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(1)   Incorporatedby reference from the Registration Statement on Form S-8, filed by theRegistrant on March 16, 2004.

(2)   Incorporatedby reference from the Registration Statement on Form S-1 (FileNo. 333-110723), filed by the Registrant on November 25, 2003.

(3)   Incorporated byreference from Amendment No. 4 to the Registration Statement onForm S-1 (File No. 333-110723), filed by the Registrant onFebruary 17, 2004.

 

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**SIGNATURES**

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned, thereunto duly authorized.
|                            |   | CHEROKEE INTERNATIONAL CORPORATION |
|----------------------------|--------|------------------------------------|
|                       |   |                               |   |   |
| Date: August 14, 2007 |   | By:                                |   | /s/ JEFFREY M. FRANK |
|                       |   |                               |   | Jeffrey M. Frank |
|                       |   |                               |   | President, Chief Executive Officer, and Director |
| Date: August 14, 2007 |   | By:                                |   | /s/ LINSTER W. FOX |
|                       |   |                               |   | Linster W. Fox |
|                       |   |                               |   | Executive Vice President, Chief Financial Officer,  and Secretary |

 

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