**SECURITIESAND EXCHANGE COMMISSION**

**Washington, D.C.20549**

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**FORM 10-Q**

**(Mark One)**
| **x**                                                                                                                                                                                                                                                                           | **Quarterly Report Pursuant to Section 13 or  15(d) of the Securities Exchange Act of 1934**       |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------------------------------------------------------------------------------------------------------------|
| ** **                                                                                                                                                                                                                                                                      | ** **                                                                                                   |
| **For the  quarterly period ended October 1, 2006**                                                                                                                                                                                                                        |
| ** **                                                                                                                                                                                                                                                                      | ** **                                                                                                   |
| **o**                                                                                                                                                                                                                                                                           | **Transition Report Pursuant to Section 13 or  15(d) of the Securities Exchange Act of 1934** |
| ** **                                                                                                                                                                                                                                                                      | ** **                                                                                                   |
| **For the  transition period from                       to                     ** |

 

**Commission FileNo. 000-50593**

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**CherokeeInternational Corporation**

(Exact name of Registrant as specified in its charter)

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

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

Securities registered pursuant to Section 12(b) of the Act:

**None**

Securities registered pursuant to Section 12(g) of the Act:

**Common Stock,$0.001 par value**

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.   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   AcceleratedFiler o   Non-Accelerated Filer x

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

As of October 31, 2006, 19,292,419 shares of theregistrant’s common stock, $0.001 par value, were outstanding.

 

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

 

2

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**PART I.FINANCIAL INFORMATION**

**Item 1. FinancialStatements.**

**CHEROKEEINTERNATIONAL CORPORATION AND SUBSIDIARIESCONDENSED CONSOLIDATED BALANCE SHEETS(In Thousands, Except Share Data)(Unaudited)**
| ** **                                                                                                                                                                         | ** ** | **October 1, 2006** | ** ** | **January 1, 2006** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------|------------|-------------------------------|------------|
| ASSETS                                                                                                                                                                             |       |                          |       |                          |       |
| CURRENT ASSETS:                                                                                                                                                                    |       |                          |       |                          |       |
| Cash and cash  equivalents                                                                                                                                                         |       | $                             | 9,667      |                          | $          | 10,543 |   |
| Accounts receivable,  net                                                                                                                                                          |       | 25,762                        |       | 24,999                        |       |
| Inventories, net                                                                                                                                                                   |       | 30,228                        |       | 26,851                        |       |
| Prepaid expenses and  other current assets                                                                                                                                         |       | 1,868                         |       | 1,698                         |       |
| Total current  assets                                                                                                                                                              |       | 67,525                        |       | 64,091                        |       |
| Property and equipment,  net                                                                                                                                                       |       | 19,309                        |       | 19,268                        |       |
| Deposits and other  assets                                                                                                                                                         |       | 1,320                         |       | 1,296                         |       |
| Deferred financing  costs, net                                                                                                                                                     |       | 249                           |       | 346                           |       |
| Goodwill                                                                                                                                                                           |       | 6,317                         |       | 6,317                         |       |
|                                                                                                                                                                               |       | $                             | 94,720     |                          | $          | 91,318 |   |
| LIABILITIES AND  STOCKHOLDERS’ EQUITY                                                                                                                                         |       |                          |       |                          |       |
| CURRENT LIABILITIES:                                                                                                                                                               |       |                          |       |                          |       |
| Accounts payable                                                                                                                                                                   |       | $                             | 11,114     |                          | $          | 11,658 |   |
| Accrued liabilities                                                                                                                                                                |       | 6,128                         |       | 6,028                         |       |
| Accrued compensation  and benefits                                                                                                                                                 |       | 7,584                         |       | 5,326                         |       |
| Accrued restructuring  costs                                                                                                                                                       |       | 662                           |       | 424                           |       |
| Total current  liabilities                                                                                                                                                         |       | 25,488                        |       | 23,436                        |       |
| 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  obligations                                                                                                                                                       |       | 5,532                         |       | 4,790                         |       |
|                                                                                                                                                                               |       |                          |       |                          |       |
| COMMITMENTS AND  CONTINGENCIES (Note 10)                                                                                                                                           |       |                          |       |                          |       |
|                                                                                                                                                                               |       |                          |       |                          |       |
| STOCKHOLDERS’ EQUITY:                                                                                                                                                         |       |                          |       |                          |       |
| Common stock: $0.001  par value; 60,000,000 shares authorized; 19,292,419 and 19,259,612 shares  issued and outstanding at October 1, 2006 and January 1, 2006,  respectively |       | 19                            |       | 19                            |       |
| Paid-in capital                                                                                                                                                                    |       | 184,457                       |       | 183,871                       |       |
| Accumulated deficit                                                                                                                                                                |       | (169,093                      | )          | (168,898                      | )          |
| Accumulated other  comprehensive income                                                                                                                                            |       | 1,687                         |       | 1,470                         |       |
| Net  stockholders’ equity                                                                                                                                                     |       | 17,070                        |       | 16,462                        |       |
|                                                                                                                                                                               |       | $                             | 94,720     |                          | $          | 91,318 |   |

 

See notes to condensed consolidatedfinancial statements.

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**CHEROKEEINTERNATIONAL CORPORATION AND SUBSIDIARIESCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS(In Thousands, Except Per Share Amounts)(Unaudited)**
| ** **                                   | ** ** | **Three Months Ended**               | ** ** | **Nine Months Ended**                | ** ** |
|----------------------------------------------|------------|------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                   | ** ** | **October 1, 2006  (13 weeks)** | ** ** | **October 2, 2005  (13 weeks)** | ** ** | **October 1, 2006  (39 weeks)** | ** ** | **October 2, 2005  (39 weeks)** | ** ** |
| ** **                                   | ** ** | ** **                                     | ** ** | ** **                                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net sales                                    |       | $                                              | 33,051     |                                           | $          | 26,418 |   | $ | 107,462 |   | $ | 89,420 |   |
| Cost of sales                                |       | 26,676                                         |       | 21,753                                         |       | 84,436 |   | 70,801 |   |
| Gross profit                                 |       | 6,375                                          |       | 4,665                                          |       | 23,026 |   | 18,619 |   |
| Operating  expenses:                         |       |                                           |       |                                           |       |   |   |   |   |
| Engineering and  development                 |       | 2,244                                          |       | 2,116                                          |       | 6,887 |   | 6,822 |   |
| Selling and  marketing                       |       | 1,721                                          |       | 1,631                                          |       | 4,742 |   | 5,633 |   |
| General and  administrative                  |       | 2,809                                          |       | 2,560                                          |       | 8,873 |   | 8,736 |   |
| Gain from  insurance proceeds                |       | —                                         |       | —                                         |       | — |   | (2,490 | ) |
| Restructuring  costs                         |       | 275                                            |       | —                                         |       | 275 |   | — |   |
| Asset impairment                             |       | 285                                            |       | —                                         |       | 285 |   | — |   |
| Total operating expenses                     |       | 7,334                                          |       | 6,307                                          |       | 21,062 |   | 18,701 |   |
|                                         |       |                                           |       |                                           |       |   |   |   |   |
| Operating income  (loss)                     |       | (959                                           | )          | (1,642                                         | )          | 1,964 |   | (82 | ) |
|                                         |       |                                           |       |                                           |       |   |   |   |   |
| Interest expense                             |       | (744                                           | )          | (643                                           | )          | (2,098 | ) | (2,035 | ) |
| Other income,  net                           |       | 129                                            |       | 50                                             |       | 321 |   | 75 |   |
| Income (loss)  before income taxes           |       | (1,574                                         | )          | (2,235                                         | )          | 187 |   | (2,042 | ) |
| Provision for  income taxes                  |       | (200                                           | )          | (73                                            | )          | 382 |   | 1,268 |   |
|                                         |       |                                           |       |                                           |       |   |   |   |   |
| Net loss                                     |       | $                                              | (1,374     | )                                              | $          | (2,162 | ) | $ | (195 | ) | $ | (3,310 | ) |
|                                         |       |                                           |       |                                           |       |   |   |   |   |
| Net loss per  share:                         |       |                                           |       |                                           |       |   |   |   |   |
| Basic                                        |       | $                                              | (0.07      | )                                              | $          | (0.11 | ) | $ | (0.01 | ) | $ | (0.17 | ) |
| Diluted                                      |       | $                                              | (0.07      | )                                              | $          | (0.11 | ) | $ | (0.01 | ) | $ | (0.17 | ) |
|                                         |       |                                           |       |                                           |       |   |   |   |   |
| Weighted average  common shares outstanding: |       |                                           |       |                                           |       |   |   |   |   |
| Basic                                        |       | 19,292                                         |       | 19,232                                         |       | 19,281 |   | 19,220 |   |
| Diluted                                      |       | 19,292                                         |       | 19,232                                         |       | 19,281 |   | 19,220 |   |

 

See notes to condensed consolidatedfinancial statements.

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**CHEROKEEINTERNATIONAL CORPORATION AND SUBSIDIARIESCONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE OPERATIONS(In Thousands)(Unaudited)**
| ** **                                                    | ** ** | **Three Months Ended**               | ** ** | **Nine Months Ended**                | ** ** |
|---------------------------------------------------------------|------------|------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                                    | ** ** | **October 1, 2006  (13 weeks)** | ** ** | **October 2, 2005  (13 weeks)** | ** ** | **October 1, 2006  (39 weeks)** | ** ** | **October 2, 2005  (39 weeks)** | ** ** |
| ** **                                                    | ** ** | ** **                                     | ** ** | ** **                                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net loss                                                      |       | $                                              | (1,374     | )                                              | $          | (2,162 | ) | $ | (195 | ) | $ | (3,310 | ) |
| Other comprehensive  income (loss):                           |       |                                           |       |                                           |       |   |   |   |   |
| Foreign currency translation adjustments                      |       | (76                                            | )          | 229                                            |       | 1,077 |   | (2,233 | ) |
| Income tax effect of foreign currency transaction adjustments |       | (861                                           | )          | —                                         |       | (861 | ) | — |   |
| Comprehensive income  (loss)                                  |       | $                                              | (2,311     | )                                              | $          | (1,933 | ) | $ | 21 |   | $ | (5,543 | ) |

 

See notes to condensedconsolidated financial statements.

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**CHEROKEE INTERNATIONALCORPORATION AND SUBSIDIARIESCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS(In Thousands)(Unaudited)**
| ** **                                                                       | ** ** | **Nine Months Ended**                | ** ** |
|----------------------------------------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                                                       | ** ** | **October 1, 2006  (39 weeks)** | ** ** | **October 2, 2005  (39 weeks)** | ** ** |
| CASH FLOWS FROM  OPERATING ACTIVITIES:                                           |       |                                           |       |   |   |
| Net loss                                                                         |       | $                                              | (195       | ) | $ | (3,310 | ) |
| Adjustments to reconcile net loss to net cash  provided by operating activities: |       |                                           |       |   |   |
| Depreciation and amortization                                                    |       | 2,474                                          |       | 2,335 |   |
| Asset impairment charge (a)                                                      |       | 285                                            |       | — |   |
| Gain on sale of property and equipment                                           |       | —                                         |       | (30 | ) |
| Amortization of deferred financing costs                                         |       | 97                                             |       | 97 |   |
| Stock-based compensation                                                         |       | 505                                            |       | — |   |
| Net change in operating assets and liabilities:                                  |       |                                           |       |   |   |
| Accounts receivable, net                                                         |       | (115                                           | )          | 2,030 |   |
| Inventories, net                                                                 |       | (2,863                                         | )          | (1,128 | ) |
| Prepaid expenses and other current assets                                        |       | (93                                            | )          | 269 |   |
| Deposits and other assets                                                        |       | (24                                            | )          | (332 | ) |
| Accounts payable                                                                 |       | (804                                           | )          | (3,541 | ) |
| Accrued liabilities and restructuring costs                                      |       | (1,347                                         | )          | 571 |   |
| Accrued compensation and benefits                                                |       | 1,993                                          |       | (343 | ) |
| Accrued interest payable                                                         |       | 607                                            |       | 585 |   |
| Other long-term obligations                                                      |       | 466                                            |       | 122 |   |
| Net cash provided by (used in) operating activities                              |       | 986                                            |       | (2,675 | ) |
| CASH FLOWS FROM  INVESTING ACTIVITIES:                                           |       |                                           |       |   |   |
| Additions to property and equipment                                              |       | (2,353                                         | )          | (4,799 | ) |
| Net change in short-term investments                                             |       | —                                         |       | 3,853 |   |
| Proceeds from sale of property and equipment                                     |       | —                                         |       | 34 |   |
| Net cash used in investing activities                                            |       | (2,353                                         | )          | (912 | ) |
| CASH FLOWS FROM  FINANCING ACTIVITIES:                                           |       |                                           |       |   |   |
| Proceeds from employee stock purchases and the  exercise of stock options        |       | 82                                             |       | 90 |   |
| Short-term advances for construction costs                                       |       |                                           |       | 1,217 |   |
| Net cash provided by financing activities                                        |       | 82                                             |       | 1,307 |   |
| EFFECT OF  EXCHANGE RATE CHANGES ON CASH AND CASH EQUIVALENTS                    |       | 409                                            |       | (894 | ) |
| NET DECREASE IN  CASH AND CASH EQUIVALENTS                                       |       | (876                                           | )          | (3,174 | ) |
|                                                                             |       |                                           |       |   |   |
| CASH AND CASH  EQUIVALENTS, BEGINNING OF PERIOD                                  |       | 10,543                                         |       | 14,585 |   |
|                                                                             |       |                                           |       |   |   |
| CASH AND CASH  EQUIVALENTS, END OF PERIOD                                        |       | $                                              | 9,667      |   | $ | 11,411 |   |
|                                                                             |       |                                           |       |   |   |
| SUPPLEMENTAL  INFORMATION                                                        |       |                                           |       |   |   |
| Cash paid for  interest                                                          |       | $                                              | 1,248      |   | $ | 1,300 |   |
| Cash paid for income  taxes                                                      |       | $                                              | 641        |   | $ | 364 |   |

 

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(a) The assetimpairment charge of $0.3 million for the nine months ended October 1, 2006 isrelated to the impairment of property and equipment calculated in accordancewith SFAS 144 due to the restructuring and closure of the Guadalajara, MexicoFacility (Note 11).

See notes to condensed consolidated financialstatements.

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**CHEROKEE INTERNATIONALCORPORATION AND SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Unaudited)**

**1.**                                      Nature ofOperations

Cherokee InternationalCorporation (the “Company”) is a designer and manufacturer of power suppliesfor original equipment manufacturers (OEMs). Its advanced power supply productsare typically custom designed into mid- to high-end commercial applications inthe computing and storage, wireless infrastructure, enterprise networking,telecom, medical and industrial markets.

*Initial Public Offering*

The Company completed itsinitial public offering of 6,600,000 shares of its Common Stock, par value$0.001 per share (“Common Stock”), on February 25, 2004, at a price of$14.50 per share. The net proceeds to the Company from this offering afteroffering costs of $9.2 million were $86.5 million. The Company usedapproximately $73.2 million of the net proceeds to repay certain outstandingindebtedness and accrued interest. Immediately prior to the consummation of theoffering, the Company completed a 1 for 3.9 reverse stock split of itsoutstanding Common Stock. All share and per share amounts for all periodspresented in this report reflect this reverse stock split. Also in connectionwith the offering, the Company issued 6,283,796 shares of Common Stock uponconversion of the $53.4 million original principal amount of its outstandingsenior convertible notes, and issued 4,071,114 shares of Common Stock upon theexercise of outstanding warrants.

**2.**                                      Basis ofPresentation and Summary of Significant Accounting Policies

*Basis of Presentation*

The accompanyingcondensed consolidated financial statements of Cherokee InternationalCorporation have been prepared in accordance with accounting principlesgenerally accepted in the United States of America for interim financialinformation and in accordance with the instructions to Form 10-Q and Article 10of Regulation S-X.  Accordingly, they donot include certain footnotes and financial presentations normally requiredunder accounting principles generally accepted in the United States of Americafor complete financial reporting.  Theinterim financial information is unaudited, but reflects all normal adjustmentsand accruals, which are, in the opinion of management, considered necessary toprovide a fair presentation for the interim periods presented.  The condensed consolidated financialstatements include the financial statements of the Company and its wholly ownedsubsidiaries.  All intercompany balancesand transactions have been eliminated in the accompanying condensedconsolidated financial statements.

Results of operations forthe quarter ended and nine months ended October 1, 2006 and October 2,2005 are not necessarily indicative of the results to be expected for theentire fiscal year ending December 31, 2006 (“fiscal 2006.”) The accompanyingcondensed consolidated financial statements should be read in conjunction withthe audited consolidated financial statements for the fiscal year endedJanuary 1, 2006, included in the Company’s Annual Report on Form 10-K(FileNo. 000-50593) filed on April 18, 2006.

In our filings with theSecurities and Exchange Commission prior to our Quarterly Report on Form 10-Qfor the quarterly period ended July 2, 2006, we referred to fiscal periods asending on the last day of the nearest calendar month on our financialstatements and in our Management’s Discussion and Analysis of FinancialCondition and Results of Operations in order to provide the reader with a moreconvenient presentation of our disclosure. The dates shown on the cover of our prior reports on Forms 10-K and 10-Qhave always represented the actual period end dates, and will continue to doso.  In order to comply with a recentrequest from the Securities and Exchange Commission, we have reflected theactual period end dates throughout this filing.

*Use of 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

7

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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-Based Compensation*

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 atthe beginning of fiscal 2006. SFAS 123R permits companies to adopt itsrequirements using either a “*modifiedprospective*” method, or a “*modifiedretrospective*” method. Under the “*modifiedprospective*” method, compensation cost is recognized in thefinancial statements beginning with the effective date, based on therequirements of SFAS 123R for all share-based payments granted after that date,and based on the requirements of SFAS 123 for all unvested awards granted priorto the effective date of SFAS 123R. Under the “*modifiedretrospective*” method, the requirements are the same as under the “*modified prospective*’’ method, but also permits entitiesto restate financial statements of previous periods based on proformadisclosures made 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 nonemployees. While SFAS 123R permitsthe Company to continue to use such a model, the standard also permits the useof a “*lattice*” model. The Companyis continuing to use the Black-Scholes model to measure the fair value ofemployee stock options upon the adoption of SFAS 123R.

SFAS 123R also requiresthat the benefits associated with the tax deductions in excess of recognizedcompensation cost be reported as a financing cash flow, rather than as anoperating cash flow as required under prior literature. This requirement willreduce net operating cash flows and increase net financing cash flows inperiods after the effective date. These future amounts cannot be estimated,because they depend on, among other things, when employees exercise stockoptions.

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 the fiscal 2006 includes:  (a) compensation cost for allshare-based payments granted subsequent to February 25, 2004 and prior toJanuary 1, 2006 but not yet vested as of January 1, 2006, based on thegrant-date fair value estimated in accordance with the provisions of SFAS 123R,and (b) compensation cost for all share-based payments granted subsequentto January 1, 2006, based on the grant-date fair value estimated inaccordance with the provisions of SFAS 123R. In accordance with the modifiedprospective method of adoption, the Company’s results of operations andfinancial position for prior periods have not been restated.  At the date of the adoption, the unamortizedexpense for options issued prior to January 2, 2006 was $2.3 million, whichwill be amortized as stock compensation costs through December 2010.   Stock based compensation costs expensedduring the nine months ended October 1, 2006 were $0.5 million.

All grants are made atprices based on the fair market value of the stock on the date of grant.Outstanding options generally vest over periods ranging from two to four yearsfrom the grant date and generally expire up to ten years after the grant date.During the three months and nine months ended October 1, 2006 the Companyrecorded $0.2 million and $0.5 million, respectively, of stock compensationexpense.  No stock compensation expensewas recorded during the three months and nine months ended October 2, 2005.

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.  For options granted following the Company’sadoption of SFAS 123R, the expected life was increased to 6.25 years using the “simplifiedmethod” under SAB 107 (an expected term based on the mid point between thevesting date and the end of the contractual term).  The use of the simplified method is permittedthrough December 31, 2007.  We willconvert to company-specific experience on or before January 1, 2008. Theoptions have a maximum contractual term of 10 years and vest pro-rata over fouryears.   The risk-free rate is based onthe U.S. Treasury yield curve in effect at the time of grant for the estimatedlife of the option.

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The followingweighted-average assumptions were used to estimate the fair value of optionsgranted during the three and nine month periods ended October 1, 2006 andOctober 2, 2005 using the Black-Scholes option pricing formula.
|                          | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|--------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **               | ** ** | **October 1, 2006**    | ** ** | **October 2, 2005**   | ** ** | **October 1, 2006** | ** ** | **October 2, 2005** | ** ** |
| Dividend yield           |       | 0.0                              | %          | 0.0                             | %          | 0.0 | % | 0.0 | % |
| Expected  volatility     |       | 58.5                             | %          | 54.4                            | %          | 58.8 | % | 43.0 | % |
| Risk free  interest rate |       | 4.64                             | %          | 3.95                            | %          | 4.81 | % | 3.67 | % |
| Expected lives           |       | 5.0 - 6.25 years                 |       | 5.0 years                       |       | 5.0 - 6.25 years |   | 5.0 years |   |
| Forfeiture rates         |       | 8.51% - 20.41                    | %          | —                          |       | 8.51% - 20.41 | % | — |   |

 

The following tablesummarizes the Company’s activities with respect to its stock option plans forthe nine months ended October 1, 2006 as follows:
| Options                                                            | ** ** | **Number  of  Shares** | ** ** | **Weighted-  Average  Exercise Price  Per Share** | ** ** | **Weighted-  Average  Remaining  Contractual  Term** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
|--------------------------------------------------------------------|------------|------------------------|------------|-------------------------------------------------------------|------------|------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                         | ** ** | ** **             | ** ** | ** **                                                  | ** ** | **(in years)**                                  | ** ** | ** **                      | ** ** |
| Outstanding at  January 1, 2006                               |       | 2,270,115              |       | $                                                           | 6.47       |                                                 | 8.73       |                            | —     |   |
| Granted                                                            |       | 102,500                |       | 3.83                                                        |       | 9.72                                                 |       | —                          |       |
| Exercised                                                          |       | —                 |       | —                                                      |       | —                                               |       | —                          |       |
| Forfeited                                                          |       | (89,782                | )          | $                                                           | 7.63       |                                                 | —     |                            | —     |   |
| Outstanding at  October 1, 2006                               |       | 2,282,833              |       | $                                                           | 6.30       |                                                 | 8.05       |                            | $          | 231,234 |   |
| Vested and  expected to vest in the future at October 1, 2006 |       | 2,011,623              |       | $                                                           | 6.49       |                                                 | 7.95       |                            | $          | 176,678 |   |
| Exercisable at  October 1, 2006                               |       | 872,351                |       | $                                                           | 7.86       |                                                 | 7.15       |                            | —     |   |

 

*Nooptions were exercised for the nine months ended October 1, 2006 and October 2,2005, respectively. Therefore there was no actual tax benefit realized relatingto stock option exercises in the nine months ended October 1, 2006 and October2, 2005.*

*Pro Forma Employee Share-Based Compensation Expense*

Prior to January 2, 2006,the Company accounted for its employee stock-based compensation plan using theintrinsic value method under APB Opinion No. 25, *Accountingfor Stock Issued to Employees,* and provided the expanded disclosuresspecified in SFAS 123, as amended by SFAS 148, *Accountingfor Stock-Based Compensation—Transition and Disclosure*.

As required by SFAS 123R,the required pro forma disclosure, for periods prior to adoption of SFAS 123R,is shown below (in thousands, except per share data):
|                                                                                                                                 | ** ** | **Three Months Ended  October 2, 2005** | ** ** | **Nine Months Ended  October 2, 2005** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------|------------|------------------------------------------------------------|------------|
| Net loss as  reported                                                                                                           |       | $                                                           | (2,162     | )                                                          | $          | (3,310 | ) |
| Add: Stock-based  employee compensation included in net loss, net of tax, as reported                                           |       | —                                                      |       | —                                                     |       |
| Less: Total  stock-based employee compensation expense determined under the fair value  based method for all awards, net of tax |       | (274                                                        | )          | (890                                                       | )          |
| Net loss—pro  forma                                                                                                        |       | $                                                           | (2,436     | )                                                          | $          | (4,200 | ) |
|                                                                                                                            |       |                                                        |       |                                                       |       |
| Net loss per  share, as reported:                                                                                               |       |                                                        |       |                                                       |       |
| Basic                                                                                                                           |       | $                                                           | (0.11      | )                                                          | $          | (0.17 | ) |
| Diluted                                                                                                                         |       | $                                                           | (0.11      | )                                                          | $          | (0.17 | ) |
| Pro forma net  loss per share:                                                                                                  |       |                                                        |       |                                                       |       |
| Basic                                                                                                                           |       | $                                                           | (0.13      | )                                                          | $          | (0.22 | ) |
| Diluted                                                                                                                         |       | $                                                           | (0.13      | )                                                          | $          | (0.22 | ) |

 

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*Translation of Foreign Currency*

Foreign subsidiary assetsand liabilities denominated in foreign currencies are translated at theexchange rate on the balance sheet date. Revenues, costs and expenses aretranslated at the average exchange rate during the period. Transaction gainsand losses are included in results of operations and have not been significantfor the periods presented. The functional currency of the Company’s operatingsubsidiary in Europe, Cherokee Europe SCA (“Cherokee Europe”), is theEuro. The functional currency of the Company’s operating subsidiaries inMexico (Cherokee Electronica, S.A. de C.V.), in India (Cherokee India Pvt. Ltd.and Powertel India Pvt. Ltd.), and in China (Cherokee International (China)Power Supply Co. Ltd) is the U.S. dollar, as the majority of transactions aredenominated in U.S. dollars. Translation adjustments, as well as the income taxeffect of currency gains or losses on certain intercompany loans, related toCherokee Europe are reflected as a component of comprehensive income (loss) andincluded in stockholders’ equity as accumulated other comprehensive income(loss).

***Segment Information***

The Company is a designerand manufacturer of power supplies for OEMs in the computing and storage,wireless infrastructure, enterprise networking, medical and industrial markets.Operating segments are defined as components of the Company’s business forwhich separate financial information is available that is evaluated by theCompany’s chief operating decision maker (its Chief Executive Officer) indeciding how to allocate resources and assessing performance. The Company’soperating segments consist of the United States, Mexico, and India operationsof Cherokee North America and Cherokee Europe and China. These operatingsegments have been aggregated into a single reporting segment based on theirsimilar economic characteristics and common operating characteristics,including comparable gross profit margins and common products, productionprocesses, customers, distribution channels and regulatory requirements.

*Recent Accounting Pronouncements*

In November 2004,the FASB issued SFAS 151,*Inventory Costs*,which amends the guidance in ARB 43, Chapter 4,*Inventory Pricing*. This amendmentclarifies the accounting for abnormal amounts of idle facility expense,freight, handling costs and wasted material (spoilage). SFAS 151 requires thatthose items be recognized as current-period charges, regardless of whether theymeet the criteria specified in ARB 43 of *soabnormal*. In addition, SFAS 151 requires that allocation of fixedproduction overheads to the costs of conversion be based on normal capacity ofthe production facilities. SFAS 151 is effective for financial statements forfiscal years beginning after June 15, 2005 with early applicationpermitted. The Company adopted SFAS 151 during the three-month periodended January 1, 2006; as the result of the adoption, $326,000 of freightrelated costs were reclassified from inventory to expense.

In December 2004,the FASB issued SFAS 153, *Exchanges ofNon-monetary Assets*—*an amendment of APBOpinion 29*. The amendment eliminates the exception to fair valueaccounting for non-monetary exchanges of similar productive assets and replacesit with a broader exception for exchanges of non-monetary assets that do nothave commercial substance. Under APB 29, accounting for an exchange of aproductive asset for a similar productive asset or an equivalent interest inthe same or similar productive asset is to be based upon the recorded amount ofthe asset relinquished (carry-over basis with no gain or loss recognition).Such transactions will now be accounted for based upon the fair value of theassets exchanged. SFAS 153 is effective for exchanges occurring in fiscal yearsbeginning after June 15, 2005 and is to be applied prospectively. Thisstatement did not have a material impact on the Company’s consolidated resultsof operations or financial position.

In May 2005, theFASB issued SFAS 154, *AccountingChanges and Error Corrections*, which replaced APB OpinionNo. 20, *Accounting Changes*,and SFAS No. 3, *Reporting Changes inInterim Financial Statements*. SFAS 154 requires retrospectiveapplication to prior periods’ financial statements of voluntary changes inaccounting principles and changes required by a new accounting standard whenthe standard does not include specific transition provisions. Previous guidancerequired most voluntary changes in accounting principle to be recognized byincluding in net income of the period in which the change was made, thecumulative effect of changing to the new accounting principle. SFAS 154 carriesforward existing guidance regarding the reporting of the correction of an errorand a change in accounting estimate. SFAS 154 is effective for accountingchanges and corrections of errors made in fiscal years beginning afterDecember 15, 2005. The Company adopted SFAS 154 as of January 2,2006; this statement did not have a material effect on the Company’sconsolidated financial position or results of operations.

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In June 2006, the FASBissued FASB Interpretation No. 48 (FIN 48), *Accountingfor Uncertainty in**Income Taxes*,*an Interpretation of SFAS No. 109*.FIN 48 clarifies the accounting for uncertainty in income taxes recognized inan enterprise’s financial statements in accordance with SFAS No. 109, *Accounting for Income Taxe*s, 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. The cumulative effect, if any, ofapplying the provisions of FIN 48 will be reported as an adjustment to theopening balance of retained earnings in the period adopted. We are currentlyevaluating the impact that the adoption of FIN 48 will have on the Company’sconsolidated financial position, results of operations, and liquidity.

In September 2006, theU.S. Securities and Exchange Commission (SEC) issued Staff Accounting BulletinNo. 108, “Considering the Effects of Prior Year Misstatements when QuantifyingMisstatements in Current Year Financial Statements” (“SAB 108”). SAB 108addresses the diversity in practice of quantifying financial statementmisstatements resulting in the potential build up of improper amounts on thebalance sheet. SAB 108 provides interpretive guidance on how the effects of thecarryover or reversal of prior year misstatements should be considered inquantifying a current year misstatement. The SEC staff believes thatregistrants should quantify errors using both a balance sheet and an incomestatement approach and evaluate whether either approach results in quantifyinga misstatement that, when all relevant quantitive and qualitative factors areconsidered, is material. SAB 108 is effective for companies with fiscal yearsending after November 15, 2006. SAB 108 allows a one-time transitionalcumulative effect adjustment to beginning retained earnings, in the first yearof adoption, for errors that were not previously deemed material, but arematerial under the guidance in SAB 108. We are currently assessing the impactof SAB 108 on our consolidated financial statements and results of operations.

In September 2006, the FASB issued SFAS No. 157 (“SFAS157”), “Fair Value Measurements”, which defines fair value, establishes aframework for measuring fair value in generally accepted accounting principles(GAAP), and expands disclosures about fair value measurements. This Statementapplies in conjunction with other accounting pronouncements that require orpermit fair value measurements. This Statement shall be effective for financialstatements issued 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 results of operations.

InSeptember 2006, the FASB issued SFAS No. 158 (“SFAS 158”), “Employers’Accounting for Defined Benefit Pension and Other Postretirement Plans – anamendment of FASB Statements No. 87, 88, 106, and 132(R).” SFAS 158requires an employer to recognize a plan’s funded status in its statement offinancial position, measure a plan’s assets and obligations as of the end ofthe employer’s fiscal year and recognize the changes in a defined benefitpostretirement plan’s funded status in comprehensive income in the year inwhich the changes occur.  SFAS 158’srequirement to recognize the funded status of a benefit plan and new disclosurerequirements will be effective for the company’s 2006 fiscal year end.Presently, the plan is under funded when comparing plan assets to thediscounted projected benefit obligations.  A portion of this under fundedliability is currently recorded on the company’s balance sheet, but the companywill be required to record the previously unrecognized portion for its year-endfinancials.  While the requirement to measure plan assets and benefitobligations as of the date of the employer’s fiscal year-end statement offinancial position is required for the company’s 2008 fiscal year end, thecompany anticipates complying with this provision for the 2006 fiscal year end.  We are currently assessing the impact SFAS 158 will have on the Company’sconsolidated financial statements and results of operations.

*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 obsolescence (in thousands):
|                  | ** ** | **October 1, 2006** | ** ** | **January 1, 2006** | ** ** |
|------------------|------------|-------------------------------|------------|-------------------------------|------------|
| Raw material     |       | $                             | 20,771     |                          | $          | 18,855 |   |
| Work-in-process  |       | 4,333                         |       | 3,599                         |       |
| Finished goods   |       | 5,124                         |       | 4,397                         |       |
| Inventories, net |       | $                             | 30,228     |                          | $          | 26,851 |   |

 

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During the quarter endedOctober 1, 2006, the Company recorded $0.5 million of additional provision tothe reserve for excess and obsolete inventory, $0.3 million of which was due toour assessment of potential decrease in future customer demand of product as aresult of the restructuring and closure of the Company’s Guadalajara, Mexicofacility and its effect on the net realizable value of inventory on hand.

As of October 1, 2006 andJanuary 1, 2006, the reserve for inventory obsolescence was $4.3 millionand $3.8 million, respectively, and includes management’s assessment ofreserves for surplus and obsolescence for non-compliant material related to theRestriction of Hazardous Substances in Electrical and Electronic Equipmentdirective (more commonly known as “RoHS”).

The following are tworecent European Economic Community (“EEC”) directives that are having an effecton the entire electronics industry, including the Company:

(1)          Restrictionof Hazardous Substances in Electrical and Electronic Equipment. 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. The Company is focused onconsuming all non-compliant material on-hand within a reasonable period.However, the Company may have to dispose of non-compliant materials in thefuture, which could adversely affect the financial performance of the Company.There is also a risk of fines associated with non-compliance with the RoHSdirective; however, the Company is not aware of any specific potential fines,and the Company anticipates complying with all provisions of this legislation.

(2)          WasteElectrical and Electronic Equipment, also known as WEEE. This directiverequires manufacturers and importers to properly recycle or dispose of suchequipment at the end of its useful life. This directive became effectiveAugust 13, 2005. The Company believes it has limited exposure to the WEEEdirective because its products are usually installed into another user’ssystem, but this directive may be interpreted and enforced differently in thefuture. If so, the Company may face significant risk of fines and costsassociated with non-compliance with the existing laws and regulations in theEuropean Union.

**3.**                                      Income Taxes

The Company accounts forincome taxes in accordance with SFAS 109, *Accountingfor Income Taxes*. In accordance with SFAS 109, deferred taxassets and liabilities are recorded for the estimated future tax effects oftemporary differences between the carrying value of assets and liabilities forfinancial reporting and their tax basis, and carry-forwards to the extent theyare realizable. A deferred tax provision or benefit results from the net changein deferred tax assets and liabilities during the period. A valuation allowanceis recorded if it is more likely than not that all or a portion of the recordeddeferred tax assets will not be realized. As of January 1, 2006, deferred taxassets include $36.9 million relating to a tax basis step up from the 1999recapitalization transaction and $19.9 million of net operating loss (“NOL”)carry-forwards. The Company has recorded a valuation allowance against asignificant portion of its deferred tax assets.

For the three monthsended October 1, 2006 the Company recorded a benefit of $0.2 million comparedto a benefit of $0.1 million for the three months ended October 2, 2005.  The Company recorded a provision for incometaxes for the nine months ended October 1, 2006 and the comparable period of2005 was $0.4 million, and $1.3 million, respectively. The provision for thenine months ended October 1, 2006 is lower due to a higher percentage of taxableincome for 2006 being generated in tax jurisdictions with operating losscarryforwards.

Provision for incometaxes for the three and nine months ended October 1, 2006 was calculated byestimating taxable income for certain tax jurisdictions using actual year todate operating results as management has determined that it can no longerreliably estimate the taxable income (loss) for the full year; therefore, theactual year to date effective tax rate was determined to represent the bestestimate of the effective tax rate for the full fiscal year 2006.

United States incometaxes are not provided on undistributed earnings from certain foreignsubsidiaries.  Those earnings areconsidered to be permanently re-invested in accordance with the AccountingPrinciples Board (APB) Opinion 23.

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The income tax effect ofcurrency gains or losses on certain intercompany loans is included as acomponent of comprehensive income (loss) and included in stockholders’ equityas accumulated other comprehensive income (loss).

The Company currently hasan income tax contingency related to its India operations.  In 2003, the Company paid and expensed anincome tax assessment of $0.4 million for three tax years for which anunfavorable ruling was rendered by the Indian tax authority.  In addition, the Company accrued a taxcontingency reserve of $0.9 million in 2003 for potential additional exposureon the same issue related to subsequent years for which an assessment had notbeen received.  In 2005, the Companyreceived a favorable ruling on one of the three tax years upon our appeal ofthis decision to the Indian Tribunal. Since the timing and the certainty of the $0.4 million favorable rulingare not probable, the Company has determined to recognize any gain contingencyas and when monies are received.  Inaddition, the $0.9 million tax contingency reserve is evaluated quarterly andmay be adjusted based on current facts and circumstances.

The Company is currentlyundergoing an audit in the Netherlands. We will continue to evaluate the need for additional tax contingencieson a quarterly basis. The Company does not believe that the outcome will have amaterial adverse effect on the Company’s consolidated financial position orresults of operations.

**4.**                                      Earnings PerShare

In accordance withSFAS 128, *Earnings Per Share*,basic income per share is based upon the weighted average number of commonshares outstanding. Diluted income per share is based upon the weighted averagenumber of common and potential shares of common stock for each periodpresented. Potential common shares include the dilutive effect of stock optionsand employee stock purchase plan shares. For the three and nine months endedOctober 1, 2006, all 2,282,833 of our outstanding stock options were excludedfrom the calculation of diluted earnings per share as their effect would havebeen anti-dilutive due to the net loss for such periods. For both the three andnine months ended October 2, 2005, all 1,796,342 of our outstanding stockoptions were excluded from the calculation of diluted earnings per share astheir effect would have been anti-dilutive due to the net loss for suchperiods.

The following table setsforth the computation of basic and diluted net income per share (in thousands,except share and per share amounts):
|                                                        | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|--------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                             | ** ** | **October 1, 2006**    | ** ** | **October 2, 2005**   | ** ** | **October 1, 2006** | ** ** | **October 2, 2005** | ** ** |
| Net loss                                               |       | $                                | (1,374     | )                               | $          | (2,162 | ) | $ | (195 | ) | $ | (3,310 | ) |
| Shares:                                                |       |                             |       |                            |       |   |   |   |   |
| Weighted-average common shares outstanding—basic  |       | 19,292                           |       | 19,232                          |       | 19,281 |   | 19,220 |   |
| Effect of  dilutive securities:                        |       |                             |       |                            |       |   |   |   |   |
| Stock options and employee stock purchase plan  shares |       | —                           |       | —                          |       | — |   | — |   |
| Weighted-average common sharesoutstanding—diluted |       | 19,292                           |       | 19,232                          |       | 19,281 |   | 19,220 |   |
| Net loss per  share:                                   |       |                             |       |                            |       |   |   |   |   |
| Basic                                                  |       | $                                | (0.07      | )                               | $          | (0.11 | ) | $ | (0.01 | ) | $ | (0.17 | ) |
| Diluted                                                |       | $                                | (0.07      | )                               | $          | (0.11 | ) | $ | (0.01 | ) | $ | (0.17 | ) |

 

**5.**                                      DeferredFinancing Costs

Net deferred financingcosts are comprised of the following as of October 1, 2006 and January 1, 2006(in thousands):
|                                | ** ** | **October 1, 2006** | ** ** | **January 1, 2006** | ** ** |
|--------------------------------|------------|-------------------------------|------------|-------------------------------|------------|
| Deferred  financing costs      |       | $                             | 580        |                          | $          | 580 |   |
| Accumulated  amortization      |       | (331                          | )          | (234                          | )          |
| Deferred financing  costs, net |       | $                             | 249        |                          | $          | 346 |   |

 

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The Company amortizesdeferred financing costs over the life of the related debt; these costs will befully amortized by August 2008.

**6.**                                      Long-Term Debt

Long-term debt consistsof the following at October 1, 2006 and January 1, 2006 (in thousands):
|                                              | ** ** | **October 1, 2006** | ** ** | **January 1, 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 October 1, 2006,all of the Company’s long-term debt 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 October 1, 2006, theCompany was in compliance with all of the covenants set forth in the principalagreements governing the 5.25% senior secured notes due in 2008.

In connection with theCompany’s initial public offering, the Company amended and restated itsexisting senior revolving credit facility with General Electric CapitalCorporation. The amended facility (the “Credit Facility”) provides forborrowings of up to $20.0 million that are subject to a borrowing basecomprised of eligible accounts receivable and inventory, which was $15.3million at October 1, 2006. The Credit Facility matures in August 2008 andborrowings bear interest, at the Company’s option, at a rate per annum equal toLIBOR plus 2.5% or the agent bank’s base rate plus 1.0%. In addition to payinginterest on outstanding principal, the Company is required to pay a commitmentfee to the lenders under the credit facility in respect of the average dailybalance of unused loan commitments at a rate of 0.5% per annum. The CreditFacility is secured by a first-priority lien, subject to permittedencumbrances, on substantially all of the Company’s domestic assets and by apledge of 65% of the equity of certain of the Company’s foreign subsidiaries.The Credit Facility contains restrictive covenants requiring the Company to,among other things, maintain certain senior leverage ratios. As of October 1,2006, there were no borrowings outstanding under the Credit Facility, and theCompany was in compliance with all of the covenants under the Credit Facility.

The agreements governingthe Credit Facility and senior notes contain covenants that restrict theCompany’s business operations, including covenants limiting the Company’sability to make investments, enter into mergers or acquisitions, dispose ofassets, incur additional debt, grant liens, enter into transactions withaffiliates, redeem or repurchase capital stock, repay other debt and paydividends, and contains a financial ratio test based on senior leverage. Theyalso contain customary events of default, including defaults in the payment ofprincipal or interest, defaults in the compliance with the covenants containedin the agreements governing the Company’s debt, cross defaults to othermaterial debt and bankruptcy or other insolvency events.

Cherokee Europe maintainsa working capital line of credit of approximately $3.8 million with BankBrussels Lambert, a subsidiary of ING Belgie NV, a bank in Brussels, which isdenominated in Euros, is collateralized by a pledge in first and second rankover a specific amount of business assets, requires Cherokee Europe to maintaina certain specific minimum solvency ratio and is cancelable at any time. As ofOctober 1, 2006, Cherokee Europe had no outstanding borrowings under the lineof credit and was in compliance with all covenants.

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**7.**                                      Other Long-TermObligations

Other long-termobligations consist of the following at October 1, 2006 and January 1, 2006 (inthousands):
|                                               | ** ** | **October 1, 2006** | ** ** | **January 1, 2006** | ** ** |
|-----------------------------------------------|------------|-------------------------------|------------|-------------------------------|------------|
| 1999 Europe  restructuring liabilities        |       | $                             | 497        |                          | $          | 585 |   |
| 2003 Europe  restructuring liabilities        |       | 1,120                         |       | 1,213                         |       |
| Long service  award liabilities               |       | 2,340                         |       | 2,075                         |       |
| Deferred compensation                         |       | 1,002                         |       | 917                           |       |
| Advances for  research & development |       | 573                           |       | —                        |       |
| Total other long-term  obligations            |       | $                             | 5,532      |                          | $          | 4,790 |   |

 

The Company hasagreements with a local government agency in Belgium whereby the agencyadvances funds to Cherokee Europe for research and development expenses. Theseadvances are expected to be repaid to the agency, either as a percentage of therevenues generated by the products developed or through a minimum fixed amounton an annual basis. These advances are interest free.

**8.**                                      Cherokee EuropeRestructuring

Prior to the Company’sacquisition of Cherokee Europe, the facility implemented a restructuring plan(the “1999 Europe Restructuring”). The 1999 Europe Restructuring liability of$2.2 million assumed by the Company was comprised entirely of terminationbenefits to be paid through 2010. The Company paid $0.2 million during thenine months ended October 1, 2006.

In June 2003, theCompany received approval for a restructuring plan (the “2003 EuropeRestructuring*”*) of its operationsin Europe from the Workers Union and the appropriate governmental authoritiesin Belgium. The 2003 Europe Restructuring involved the elimination of 61operational and administrative positions at the Cherokee Europe facility inBelgium due to unfavorable economic conditions in that market. All of theterminations were completed in 2003. Pursuant to the 2003 Europe Restructuring,the Company recorded a termination benefits charge of $4.5 million for the yearended December 28, 2003, to be paid through 2016. The Company paid $0.2million during the nine months ended October 1, 2006.

A reconciliation of the1999 Europe Restructuring and 2003 Europe Restructuring liabilities as ofOctober 1, 2006 (in thousands):
|                                     | ** ** | **1999 Europe  Restructuring** | ** ** | **2003 Europe  Restructuring** | ** ** |
|-------------------------------------|------------|-------------------------------------|------------|-------------------------------------|------------|
| Balance as of  January 1, 2006      |       | $                                   | 770        |                                | $          | 1,452 |   |
| Provision                           |       | —                              |       | —                              |       |
| Payments                            |       | (164                                | )          | (208                                | )          |
| Foreign exchange rate effect        |       | 53                                  |       | 101                                 |       |
| Balance as of  October 1, 2006 |       | 659                                 |       | 1,345                               |       |
| Less current  portion               |       | (162                                | )          | (225                                | )          |
| Due after one year                  |       | $                                   | 497        |                                | $          | 1,120 |   |

 

**9.**                                      CustomerConcentration

For the quarters endedOctober 1, 2006 and October 2, 2005, respectively, no customer accounted formore than 10% of net sales. For the nine months ended October 1, 2006, onecustomer accounted for 11% of net sales, and another customer accounted for 11%of net sales for the nine months ended October 2, 2005. For the fiscal yearended January 1, 2006, one customer accounted for 10.4% of our net sales. Adecision by a major customer to decrease the amount purchased from the Companyor to cease purchasing the Company’s products could have a material adverseeffect on the Company’s financial position and results of operations.

As of October 1, 2006 nocustomer accounted for more than 10% of our net accounts receivable.  As of January 1, 2006, one customer accountedfor 10.3% and no other customer accounted for more than 10% of net accountsreceivable.

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The Company sells itspower supply products to original equipment manufactures (OEMs) in thecomputing and storage, wireless infrastructure, enterprise networking, medicaland industrial markets. These activities are managed as a single business andhave been aggregated into a single reportable operating segment. Net sales byregions shipped to for the three and nine months ended October 1, 2006, andOctober 2, 2005, respectively, were as follows (in thousands):
|                                          | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                               | ** ** | **October 1, 2006**    | ** ** | **October 2, 2005**   | ** ** | **October 1, 2006** | ** ** | **October 2, 2005** | ** ** |
| North America  (primarily United States) |       | $                                | 17,522     |                            | $          | 14,262 |   | $ | 52,678 |   | $ | 41,163 |   |
| Europe                                   |       | 10,658                           |       | 9,413                           |       | 43,304 |   | 38,932 |   |
| Asia                                     |       | 4,755                            |       | 2,602                           |       | 11,251 |   | 8,878 |   |
| Other                                    |       | 116                              |       | 141                             |       | 229 |   | 447 |   |
|                                     |       | $                                | 33,051     |                            | $          | 26,418 |   | $ | 107,462 |   | $ | 89,420 |   |

 

The Company’s long-livedassets located outside of the United States were $17.5 million and $16.5million as of October 1, 2006 and January 1, 2006, respectively.

**10.**                               Commitments andContingencies

*Guarantees and 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 ofDelaware, and various lessors in connection with facility leases for certainclaims arising from such facility or lease. No claims are currently pendingagainst the Company for such indemnifications. The maximum amount of potentialfuture payments under such indemnification is not determinable.

The Company has notincurred significant amounts related to these guarantees and indemnificationobligations, and no liability has been recorded in the financial statements forguarantees and indemnification as of January 1, 2006 and October 1, 2006.

*Employment and Severance Agreements*

The Company has enteredinto employment agreements with certain executives, which provide for annualbase salaries and cash incentive payments of up to 120% of base salary subjectto attainment of corporate goals and objectives pursuant to incentivecompensation programs 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.

*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.

*India Matter*

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.

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The subject payments, inthe aggregate, amount to approximately $40,000 in each year during 2004 and2005, and less than $10,000 in 2006. The Company retained outside counsel whoconducted an internal investigation into these payments. In April 2006, the Companynotified the Department of Justice and the Securities and Exchange Commissionof this matter, and that we would cooperate fully with any investigations thatmay be conducted by such regulatory agencies. The Securities and Exchange Commission recently contacted our legalcounsel to schedule a meeting to discuss this matter. The Company believes thatthis matter will not have a material impact on its consolidated financialstatements.

During the quarter endedOctober 1, 2006, we were not a party to any material legal proceedings. We areoccasionally a party to lawsuits relating to routine matters incidental to ourbusiness. As with all litigation, we can provide no assurance as to the outcomeof any particular lawsuit, and we note that litigation inherently involvessignificant costs.

**11.**                               Restructuring Costs and Asset ImpairmentCharges for closure of Guadalajara, Mexico Facility

During the third quarterof 2006, the Company announced the planned closure of its Mexican facilitiesand a related restructuring plan, which was accounted for in accordance withSFAS 146, “Accounting for Costs Associated with Exit or Disposal Activities.”  The Company recorded pre-tax charges of $0.3million of restructuring costs to its accrued restructuring costs liability, and$0.3 million of impairment costs to the carrying value of those assetsdetermined to be impaired under the guidance of SFAS 144, “Accounting for theImpairment or Disposal of Long-Lived Assets.” The Company also recorded $0.3 million charge to the reserve for excessand obsolete inventory due to the potential decrease in future customer demandof product as a result of the restructuring and closure of the Company’sGuadalajara, Mexico facility.  The impactof the planned closure for the quarter ended October 1, 2006 was $0.8 millioncumulative.

The Company plans toclose its manufacturing operation in Guadalajara, Mexico (the “GuadalajaraFacility”) by the end of the first quarter of 2007, and move its operations toits newly developed facility in Shanghai, China (the “China Facility”). TheGuadalajara Facility encompasses 35,000 square feet in one building and hasbeen in operation since 1988, employing approximately 250 full-time andtemporary employees in the production of power supplies. The Company owns thebuilding and is seeking a buyer for the property.  Based on current market conditions theCompany does not anticipate an impairment charge to the net book value of thebuilding.  However, actual results couldvary depending on future real estate market demands and conditions.

In February 2006, theCompany opened a new, 120,000 square foot, state-of-the-art manufacturingfacility in Shanghai, China and has begun consolidating high volume, low mixmanufacturing from plants that are more costly to operate to this new facility.The design and location of the new China Facility improves the Company’s andits customers’ supply chains as an increasing number of Cherokee’s customersand suppliers have their own manufacturing operations in China.  It also positions the Company to takeadvantage of the overall business growth in Asia.

*RestructuringCosts*

In accordance with SFAS146, employee severance, contract termination and other exit costs are recordedat their estimated fair value when they are incurred.  Employee severance costs for the three monthsended October 1, 2006, were $0.3 million, which included a pro-rata portionfrom August 10, 2006, the communication date, through October 1, 2006, of anestimated amount of statutory required severance payments and managementperformance stay-on bonuses incurred for approximately 128 employees at theGuadalajara Facility. The Company anticipates approximately $1.0 millionof employee severance and related costs to be incurred in connection with thisplan which will be amortized over the next six months as it is earned, andexpects to pay severance and related expenses to those employees terminating inDecember 2006, and the remainder of employees being terminated by the end ofthe first quarter of 2007.  All restructuringcharges will be settled with cash. Actual results could vary from these estimated dates and amounts due tovarious unforeseen causes, such as employees leaving sooner than expected, orwe may extend employees’ length of stay past March 2007 due to a delay in thetransfer of production to our Shanghai, China Facility.

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A summary of the restructuring costs and reserveactivity during the quarter ended October 1, 2006 is as follows (in thousands):
|                            | ** ** | **Restructuring  Liabilities at  July 2, 2006** | ** ** | **Restructuring  Charges** | ** ** | **Cash Paid** | ** ** | **Restructuring  Liabilities at  October 1, 2006** | ** ** |
|----------------------------|------------|----------------------------------------------------------------|------------|----------------------------|------------|--------------------|------------|-------------------------------------------------------------------|------------|
| Severances and  bonuses    |       | $                                                              | —     |                       | $          | 275                |       | $                                                                 | —     |   | $ | 275 |   |
| Total  Restructuring Costs |       | $                                                              | —     |                       | $          | 275                |       | $                                                                 | —     |   | $ | 275 |   |

 

A summary of the restructuring costs during the threeand nine months ended October 1, 2006 is as follows (in thousands):
|                            | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|----------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                 | ** ** | **October 1, 2006**    | ** ** | **October 1, 2006**   | ** ** |
| Severances and  bonuses    |       | $                                | 275        |                            | $          | 275 |   |
| Total  Restructuring Costs |       | $                                | 275        |                            | $          | 275 |   |

 

*AssetImpairment Charges*

During the three monthsended October 1, 2006, the Company performed impairment reviews in accordancewith SFAS 144, “Accounting for the Impairment and Disposal of Long-LivedAssets,” to determine whether any of its long-lived assets were impaired. The Company identified certain long-lived assets associated with therestructuring and closure of the Mexico Facility whose carrying value would notbe recoverable from future cash flows, and recorded an impairment charge of$0.3 million for these assets. These assets consisted of machinery andequipment, computer technology and equipment, and office furniture andequipment. The majority of these assets were written off because the Companyconsidered them to have no market value, and the remaining assets which will beheld for sale after operations cease in our Mexico Facility and assets becomeimmediately available for sale, were written down to a fair market value basedon our internal estimates. None of the impairment charges include cash components.

At October 1, 2006 noneof our assets were classified as held for sale in accordance with SFAS 144rules because the Company did not meet the criterion that “the asset (disposalgroup) is available for immediate sale in its present condition subject only toterms that are usual and customary for sales of such assets”, due to ourcontinued utilization of assets in our ongoing operations at our MexicoFacility during the quarter.  We plan onutilizing our assets located at our Mexico Facility until we cease operationsby March 2007, at that time we will classify those assets to be sold as heldfor sale.

**12.**                               Stock and DeferredCompensation Plans

*2002Stock 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 ofCommon Stock at an exercise price of $14.50 and terminated the 2002 StockOption Plan. As of October 1, 2006, the Company had granted a total of1,415,647 options to purchase shares of Common Stock under the 2002 StockOption Plan, which includes options to purchase shares that were cancelled andsubsequently re-granted.

*2004Employee 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 October 

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1,2006, a total of 784,658 shares of Common Stock were reserved for issuanceunder the plan. The ESPP, which is intended to qualify as an “employee stockpurchase plan” under Section 423 of the Internal Revenue Code of 1986, isimplemented utilizing six-month offerings with purchases occurring at six-monthintervals, with a new offering period commencing on the first trading day on orafter May 15 and November 15 and ending on the last trading day on orbefore November 14 or May 14, respectively. The CompensationCommittee of the Company’s Board of Directors oversees administration of theESPP. Employees are eligible to participate if they are employed for at least20 hours per week and more than 5 months in a calendar year by the Company,subject to certain restrictions. The ESPP permits eligible employees to purchaseCommon Stock through payroll deductions, which may not exceed 15% of anemployee’s compensation. The price of Common Stock purchased under the ESPP is85% of the lower of the fair market value of the Common Stock at the beginningof each six-month offering period or on the applicable purchase date. Employeesmay end their participation in an offering at any time during the offeringperiod, and participation ends automatically upon termination of employment.The Compensation Committee may at any time amend or terminate the ESPP, exceptthat no such amendment or termination may adversely affect shares previouslygranted under the ESPP. As of October 1, 2006, 104,878 shares of Common Stockhad been issued under the ESPP.

*2004Omnibus Stock Incentive Plan*

On February 16,2004, the Company adopted the 2004 Omnibus Stock Incentive Plan (the “2004 Plan”),which provided for the issuance of 800,000 shares of Common Stock. The 2004Plan also provides for an annual increase to be added on the first day of theCompany’s fiscal year equal to the lesser of (i) 450,000 shares or(ii) 2% of the number of outstanding shares on the last day of theimmediately preceding fiscal year. As of October 1, 2006, a total of 1,569,316shares 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, stock appreciationrights, restricted stock, deferred stock, and performance shares. As of October1, 2006, the Company had granted options to purchase 1,528,989 shares of CommonStock under the 2004 Plan, which included 218,153 options issued as partialcompensation to non-employee directors. During the three months and nine monthsended October 1, 2006, 10,000, and 102,500 shares, respectively, were issuedunder the 2004 Plan, the aggregate fair value for these shares was $21,000, and$237,000, respectively, which will be amortized as stock compensation costsover 6.25 years.

*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 bonusesand 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 credits, if any, vests in full nolater than after 3 years. As of October 1, 2006, the Company has recorded aliability of $1.0 million for employee and non-employee director contributionsand investment activity to date, which is recorded in other long-termliabilities, and the Company has provided no matching contributions for thethree months and nine months ended October 1, 2006 and October 2, 2005.

**13.**                               Retirement Plans

Cherokee Europe maintainsa pension plan for certain levels of staff and management that includes adefined benefit feature. The following represents the amounts related to thisdefined benefit plan for the three and nine months ended October 1, 2006 andOctober 2, 2005, respectively (in thousands):
|                                                                      | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|----------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| **Components of Net Periodic Benefit Cost** | ** ** | **October 1, 2006**    | ** ** | **October 2, 2005**   | ** ** | **October 1, 2006** | ** ** | **October 2, 2005** | ** ** |
| Service cost                                                         |       | $                                | 45         |                            | $          | 37 |   | $ | 137 |   | $ | 115 |   |
| Interest cost                                                        |       | 67                               |       | 60                              |       | 182 |   | 187 |   |
| Expected return  on plan assets                                      |       | (31                              | )          | (34                             | )          | (92 | ) | (105 | ) |
| Net periodic benefit  cost                                           |       | $                                | 81         |                            | $          | 63 |   | $ | 227 |   | $ | 197 |   |

 

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**14.**                               SubsequentEvent-Borrowed Against our Line of Credit (under the Credit Facility) withGeneral Electric Capital Corporation

In October 2006, theCompany borrowed $1.0 million against our line of credit with General ElectricCapital Corporation.

**Item 2.   Management’sDiscussion and Analysis of Financial Condition and Results of Operations.**

**FORWARD-LOOKINGSTATEMENTS**

Certain statementscontained in this Quarterly Report on Form 10-Q, other than purely historicalinformation, are forward-looking statements. These forward-looking statementsare based upon our current expectations about future events. When used in thisQuarterly Report, the words “believe,” “anticipate,” “intend,” “estimate,” “expect”and similar expressions, or the negative of such words and expressions, areintended to identify forward-looking statements, although not allforward-looking statements contain such words or expressions. Theseforward-looking statements generally relate to our plans, objectives andexpectations for future operations. However, these statements are subject to anumber of risks and uncertainties affecting our business. You should read thisQuarterly Report completely and with the understanding that actual futureresults may be materially different from what we expect as a result of theserisks and uncertainties and other factors, which include, but are not limitedto: (1) changes in general economic and business conditions, domestically andinternationally, (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) disruptionsof the Company’s established supply channels, (7) the Company’s level of debtand restrictions imposed by its debt agreements, and (8) the additional riskfactors identified in the Company’s filings with the Securities and ExchangeCommission, including its annual report on Form 10-K. Except as required bylaw, 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 designer andmanufacturer of power supplies for original equipment manufactures(OEMs). Our advanced power supply products are typically custom designedinto mid- to high-end commercial applications in the computing and storage,wireless infrastructure, enterprise networking, telecom, medical and industrialmarkets.

We operate worldwide andhave facilities in Orange County, California; Bombay, India; Wavre, Belgium andShanghai, China. In August 2006, we announced our intention to close ourfacility in Guadalajara, Mexico by March 2007. We were founded in 1978 in Orange County, California. As we expanded ourbusiness and customer base, we opened facilities in Bombay, India, Guadalajara,Mexico, and Shanghai, China. In June 2000, we acquired Cherokee Europe,which added a manufacturing facility in Wavre, Belgium to our manufacturingcapacity and enabled us to better serve the European market.

**Basis of Reporting**

*NetSales*

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 recorded net of discounts,which are estimated at the time of shipment based upon historical data. Changesin assumptions regarding the rate of sales discounts earned by our customerscould impact our results.

We generally recognizerevenue at the time of shipment because this is the point at which revenue is earnedand realizable and the earnings process is complete. For most shipments, titleto shipped goods transfers at the shipping point, so the risks and rewards ofownership transfer once the product leaves our facility or third-party hub.Revenue is only

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recognized whencollectibility is reasonably assured. Shipping and handling fees are includedin revenue, with related costs recorded to cost of sales.

*Cost ofSales*

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 include costs ofhourly employees. Manufacturing overhead includes salaries, and the directexpense and allocation of costs attributable to manufacturing for lease costs,depreciation on property, plant and equipment, utilities, property taxes andrepairs 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 AccountingPolicies**

We prepare ourconsolidated 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 thefinancial statements and the reported amounts of revenues and expenses duringthe periods presented. Any future changes to these estimates and assumptionscould have a material effect on our reported amounts of revenue, expenses,assets and liabilities. The significant accounting policies that we believe arethe most critical to aid in fully understanding and evaluating our reportedfinancial results include the following:

*Revenue Recognition*

We recognize revenue fromproduct sales at the time of shipment and passage of title. We also offer ourcustomers the right to return products that do not function properly within alimited time after delivery. We monitor and track product returns and record aprovision for warranty based on historical experience, which historically hasbeen insignificant to our financial condition and results of operations. Anysignificant increase in product failure rates could have a material adverseeffect on our operating results for the period or periods in which those returnsmaterialize.

*Accounts Receivable*

We perform ongoing creditevaluations of our customers and adjust credit limits based upon paymenthistory, the customer’s current credit worthiness and various other factors, asdetermined by our review of their current credit information. We continuouslymonitor collections and payments from our customers and maintain a provisionfor estimated credit losses based upon our historical experience and anyspecific customer collection issues that we have identified. While creditlosses have historically been within our expectations and the provisionsestablished, we might not continue to experience the same credit loss ratesthat we have in the past. A significant change in the liquidity or financialposition of any one of these customers could have a material adverse effect onthe collectibility of our accounts receivable, our liquidity and our futureoperating results. As of October 1, 2006, no customer accounted for more than10% of net accounts receivable. At January 1, 2006, one customer accountedfor 10.3% and no other customer accounted for more than 10% of net accountsreceivable.

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*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 liable for inventory costs we incur fororder cancellations that occur after we have committed resources to procure ormanufacture 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 have not established a separate reservefor non-RoHS compliant inventory above what our normal calculations wouldrequire.

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 taxassets and liabilities based on the differences between the financial statementcarrying values and the tax bases of assets and liabilities. We regularlyreview our deferred tax assets for recoverability and establish a valuationallowance based on historical taxable income, projected future taxable income,and the expected timing of the reversals of existing temporary differences. Ifour future taxable income is significantly higher than expected and/or we areable to utilize our tax credits, we may be required to reverse all or asignificant part of our valuation allowance against such deferred tax assetswhich could substantially reduce our effective tax rate for such period.Therefore, any significant changes in statutory tax rates or the amount of ourvaluation allowance could have a material effect on the value of our deferredtax assets and liabilities, and our reported financial results.

The preparation ofconsolidated financial statements in conformity with generally acceptedaccounting principles requires us to make estimates and assumptions that affectthe reported amount of tax-related assets and liabilities and income taxprovisions.  The Company’s effective taxrate may be subject to fluctuations during the fiscal year as new informationis obtained which may affect the assumptions management uses to estimate theannual effective tax rate including mix of pre-tax earnings in the various taxjurisdictions in which it operates.  In2006, the Company has determined that the actual effective tax rate for theyear to date period is the best estimate of the annual effective tax rate toprovide for income taxes in an interim period because management does notbelieve that taxable income can be reliably estimated for the quarterly andannual periods.

The Company currently hasan income tax contingency related to its India operations.  In 2003, the Company paid and expensed anincome tax assessment of $0.4 million for three tax years for which anunfavorable ruling was rendered by the Indian tax authority.  In addition, the Company accrued a taxcontingency reserve of $0.9 million in 2003 for potential additional exposureon the same issue related to subsequent years for which an assessment had notbeen received.  In 2005, the Companyreceived a favorable ruling on one of the three tax years upon our appeal ofthis decision to the Indian Tribunal. Since the timing and the certainty of the $0.4 million favorable rulingare not probable, the Company has determined to recognize any gain contingencyas and when monies are received.  Inaddition, the $0.9 million tax contingency reserve is evaluated quarterly andmay be adjusted based on current facts and circumstances.

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The Company is currentlyundergoing an audit in the Netherlands. We will continue to evaluate the need for additional tax contingencieson a quarterly basis. The Company does not believe that the outcome will have amaterial adverse effect on the Company’s consolidated financial position orresults of operations.

United States incometaxes are not provided on undistributed earnings from certain foreignsubsidiaries.  Those earnings areconsidered to be permanently re-invested in accordance with the AccountingPrinciples Board (APB) Opinion 23.

*Goodwill and 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 an impairmentof goodwill has possibly occurred. The determination of whether any potentialimpairment of goodwill exists is based upon a comparison of the fair value ofthe reporting unit to the carrying 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 theforecasted undiscounted future net cash flows from the operations to which theassets relate, utilizing our best estimates, appropriate assumptions andprojections at the time. These projected future cash flows may varysignificantly over time as a result of increased competition, changes in technology,fluctuations in demand, consolidation of our customers and reductions inaverage selling prices. If the carrying value is determined not to berecoverable from future operating cash flows, the asset would be deemedimpaired and an impairment loss would be recognized to the extent the carryingvalue exceeded the estimated fair market value of the asset.

*StockCompensation Expense*

Effective January 2,2006, we adopted SFAS 123R using the “modified prospective” transition method.Under the transition method, compensation cost recognized in the six monthsended July 2, 2006 includes (a) compensation cost for all share-based paymentsgranted prior to, but not yet vested as of, January 2, 2006 based on thegrant-fair value estimated in accordance with the original provisions of SFAS123 and (b) compensation cost for all share-based payments granted subsequentto January 2, 2006, based on grant-date fair value estimated in accordance withthe provisions of SFAS 123R.  Resultsfrom prior periods have not been restated. As a result of adopting SFAS 123R, our stock compensation costs for thenine months ended October 1, 2006 were $0.5 million.

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. The Company uses historical data, among other factors, toestimate the expected price volatility and the expected forfeiture rate. Foroptions granted prior to January 2, 2006, the Company used the expected optionlife of 5 years.  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 methodis permitted through December 31, 2007. We will convert to Company-specific experience on or before January 1,2008. The options have a maximum contractual term of 10 years and vest pro-rataover four years.  The risk-free rate isbased on the U.S. Treasury yield curve in effect at the time of grant for theestimated life of the option.

**RESULTS OF OPERATIONS**

**THREE MONTHS ENDEDOCTOBER 1, 2006 COMPARED TO THREE MONTHS ENDED OCTOBER 2, 2005**

**NET SALES**

Net sales increased byapproximately 25.1%, or $6.6 million, to $33.0 million for the three monthsended October 1, 2006 from $26.4 million for the three months ended October 2,2005.

The increase in net salesfor the three months ended October 1, 2006 compared to the three months endedOctober 2, 2005 was mainly due to a 27.9% increase in telecom and a 21.3%increase in datacom end markets.  Overallnet sales were higher in all markets for the quarter compared to the prior yearperiod.  However, net sales for thisquarter-end were less

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comparedto the first and second quarters of 2006 due to a decline in our Europe telecomsales as a result of a decrease in demand by one of our major customers, aswell as a two-week holiday shut down during the summer.

Our business remainslargely dependent upon the limited number of customers within the computing andstorage, wireless infrastructure, enterprise networking, medical and industrialmarkets, and we cannot guarantee that we will continue to be successful inattracting new customers or retaining or increasing business with our existingcustomers. As a result, our revenues could be significantly reduced if a largecustomer reduced its demand for our products.

A number of factors havepreviously caused delays and may cause future delays in new computing andstorage, wireless infrastructure, enterprise networking, medical and industrialinfrastructures and upgrade deployment schedules throughout the world,including deployments in the United States, Mexico, Europe, and Asia. Inaddition, a number of factors may cause original equipment manufacturers toalter their outsourcing strategy concerning certain products, which could causesuch original equipment manufacturers to reduce or eliminate their demand forexternal supplies of such products or shift their demand to alternativesuppliers or internal suppliers. Such factors include lower perceived internalmanufacturing costs and competitive reasons to remain vertically integrated.Due to the possible uncertainties associated with infrastructure deploymentsand original equipment manufacturer demand, we have experienced and expect tocontinue to experience significant fluctuations in demand from our originalequipment manufacturer and customers. Such fluctuations have previously causedand may in the future cause significant reductions in our revenues and/oroperating results, which has adversely impacted and may continue to adverselyimpact our business, financial condition and results of operations.

**GROSS PROFIT**

Gross profit increased byapproximately 36.7%, or $1.7 million, to $6.4 million for the three monthsended October 1, 2006 from $4.7 million for the three months ended October 1,2005. Gross margin for the three months ended October 1, 2006 increased to19.3% from 17.7% in the prior year period. The increases in gross profit andgross margin were due primarily to the increase in company-wide revenues as aresult of an increase in the market segments stated above under Net Sales, aswell as our better utilization of direct labor and reduced overhead costs.

During the three monthsended October 1, 2006, the Company recorded $0.3 million, or 0.8% of net sales,provision for excess and obsolete inventory related to the restructuring andclosure of the Guadalajara, Mexico facility due to the potential decrease infuture customer demand of product from that facility.

**OPERATING EXPENSES**

Operating expenses forthe three months ended October 1, 2006 increased by approximately 16.3%, or$1.0 million, to $7.3 million from $6.3 million for the three months endedOctober 2, 2005. As a percentage of net sales, operating expenses decreased to22.2% from 23.9% in the prior year period.

During the three monthsended October 1, 2006, the Company incurred $0.3 million of restructuring costsfor severance in accordance with SFAS 146, and $0.3 million of impairment costsfor assets impaired in accordance with SFAS 144. The charges were a result ofour plan to realign and consolidate our Mexico operations into our Chinaoperations. The Company also incurred $0.2 million of stock-based compensationexpense during the three months ended October 1, 2006. The remaining $0.4million increase in operating expenses compared to the prior year quarterrelates primarily to higher sales commissions on higher revenues and theestablishment of engineering and sales functions at our China facility,partially offset by a decrease in Sarbanes-Oxley costs as discussed below.

During the three monthsended October 2, 2005, we incurred $0.2 million of related professional feesand costs in relation to the readiness efforts for compliance withSection 404 of the Sarbanes-Oxley Act, compared to no expenses during thethree months ended October 1, 2006.  OnJune 30, 2006, based on unaffiliated market capitalization guidelines, theCompany’s compliance deadline for complying with Section 404 of theSarbanes-Oxley Act was deferred until fiscal year-end 2007.

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**OPERATING INCOME**

As a result of thefactors discussed above, the operating loss decreased by $0.6 million to $1.0million for the three months ended October 1, 2006, from an operating loss of$1.6 million for the three months ended October 2, 2005. Operating margin was anegative 2.9% for the three months ended October 1, 2006, compared to anegative 6.2% in the prior year period.

**INTEREST EXPENSE**

Interest expense for thethree months ended October 1, 2006 was $0.7 million compared to $0.6 millionfor the three months ended October 2, 2005. The interest expense is mainlyrelated to our 5.25% senior notes and commitment fees on our senior revolvingcredit line.

**INCOME TAXES**

Provision for incometaxes for three months ended October 1, 2006 was $0.2 million benefit comparedto a $0.1 million benefit for the three months ended October 2, 2005.

Provision for incometaxes for the three and nine months ended October 1, 2006 was calculated byestimating taxable income for certain tax jurisdictions using actual year todate operating results as management has determined that it can no longerreliably estimate the taxable income (loss) for the full year; therefore, theactual year to date effective tax rate was determined to represent the bestestimate of the effective tax rate for the full fiscal year 2006.

Provision for incometaxes for the three and nine months ended October 2, 2005 was calculated byestimating full-year 2005 taxable income separately for each tax jurisdictionand allocating the related income tax provision to the quarter during which theincome was generated.  The Company recorded an income tax provisiondespite reporting a pre-tax loss, because a portion of taxable income for 2005was generated in tax jurisdictions without operating loss carryforwards, and aportion generated losses in certain other tax jurisdictions, with no availabletax benefit related to these losses included in the provision for income taxes.

**NET INCOME**

As a result of thefactors discussed above, we recorded a net loss of $1.4 million for the threemonths ended October 1, 2006, compared to a net loss of $2.2 million for thethree months ended October 2, 2005.

**NINE MONTHS ENDED OCTOBER1, 2006 COMPARED TO NINE MONTHS ENDED OCTOBER 2, 2005**

**NET SALES**

Net sales increased byapproximately 20.2%, or $18.0 million, to $107.5million for the nine monthsended October 1, 2006 from $89.4 million for the nine months ended October 2,2005. For the nine months ended October 1, 2006 one customer accounted for 11%of net sales.  For the nine months endedOctober 2, 2005 a different customer accounted for 11% of net sales.

The increase in net salesfor the nine months ended October 1, 2006 compared to the nine months endedOctober 2, 2005 was due to an 32.9% increase in datacom and an 13.4% increasein telecom end markets. Overall net sales were higher in all markets for thenine months ended October 1, 2006 compared to the prior year period.

**GROSS PROFIT**

Gross profit increased byapproximately 23.7%, or $4.4 million, to $23.0 million for the nine monthsended October 1, 2006 from $18.6 million for the nine months ended October 2,2005. Gross margin for the nine months ended October 1,  2006 increased to 21.4% from 20.8% in theprior year period. The increases in gross profit and gross margin were dueprimarily to the increases in company-wide revenues as a result of an increasein the market segments stated above under Net Sales, as well as our betterutilization of direct labor and reduced overhead costs.

25

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During the nine monthsended October 1, 2006, the Company recorded $0.3 million, or 0.3% of net sales,provision for excess and obsolete inventory related to the restructuring andclosure of the Guadalajara, Mexico facility due to the potential decrease infuture customer demand of product from that facility.

**OPERATING EXPENSES**

Operating expenses forthe nine months ended October 1, 2006, increased by approximately 12.6%, or$2.4 million, to $21.1 million from $18.7 million for the nine months endedOctober 2, 2005.  As a percentage of sales, operating expenses decreasedto 19.6% from 20.9% in the prior year period.

The increase in operatingexpenses in 2006 compared to 2005 was due to the following reasons: $0.4million of stock-based compensation expense during the nine months endedOctober 1, 2006, due to the adoption of SFAS 123R, and $0.4 million of legaland professional fees related to the India investigation.  As a result of our plan to realign andconsolidate our Mexico operations into our China operations, we accruedrestructuring costs of $0.3 million for severance in accordance with SFAS 146,$0.3 million of impairment costs for assets impaired in accordance with SFAS144, and $0.1 million increase in other miscellaneous expenses. This increasein operating expenses was partially offset by a $0.4 million decrease inselling and marketing expense during the first quarter in 2006 due to a mutualrelease agreement with a former business partner, and a decrease of $0.3million in operational costs in running our European sales branches.

In 2005 there was a $2.5million gain from insurance proceeds recorded for the fire damage experiencedby the Company’s Belgium facility in February 2004. This gain was partiallyoffset by $0.9 million of professional fees and other related costs to thereadiness efforts for compliance with Section 404 of the Sarbanes-Oxley Act.  In 2006 there were no insurance gains orexpenses incurred in relation to compliance with Section 404 of theSarbanes-Oxley Act.  On June 30, 2006,based on unaffiliated market capitalization guidelines, the Company’scompliance deadline for complying with Section 404 of the Sarbanes-Oxley Actwas deferred until fiscal year-end 2007.

**OPERATING INCOME**

As a result of thefactors discussed above, operating income increased to $2.0 million for thenine months ended October 1, 2006 compared to a loss of $0.1 million for thenine months ended October 2, 2005.  Operating margin increased to apositive 1.8% from a negative 0.1% in the prior year period.

**INTEREST EXPENSE**

Interest expense for thenine months ended October 1, 2006 was $2.1 million compared to $2.0 million forthe nine months ended October 2, 2005.  The interest expense is mainlyrelated to our 5.25% senior notes and commitment fees on our senior revolvingcredit line.

**INCOME TAXES**

Provision for incometaxes for the nine months ended October 1, 2006 and the comparable period of2005, were $0.4 million, and $1.3 million, respectively. The provision for thenine months ended October 1, 2006 is lower due to a higher percentage oftaxable income for 2006 being generated in tax jurisdictions with operatingloss carryforwards.

Provision for incometaxes for the three and nine months ended October 1, 2006 was calculated byestimating taxable income for certain tax jurisdictions using actual year todate operating results as management has determined that it can no longerreliably estimate the taxable income (loss) for the full year; therefore, theactual year to date effective tax rate was determined to represent the bestestimate of the effective tax rate for the full fiscal year 2006.

Provision for incometaxes for the three and nine months ended October 2, 2005 was calculated byestimating full-year 2005 taxable income separately for each tax jurisdictionand allocating the related income tax provision to the quarter during which theincome was generated.  The Company recorded an income tax provisiondespite reporting a pre-tax loss, because a portion of taxable income for 2005was generated in tax jurisdictions without operating loss carryforwards, and aportion generated losses in certain other tax jurisdictions, with no availabletax benefit related to these losses included in the provision for income taxes.

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**NET INCOME (LOSS)**

As a result of thefactors discussed above, we recorded a net loss of $0.2 million for the ninemonths ended October 1, 2006, compared to a net loss of $3.3 million for thenine months ended October 2, 2005.

**LIQUIDITY AND CAPITALRESOURCES**

**CASH FLOWS**

**NINE MONTHS ENDEDOCTOBER 1, 2006 COMPARED TO NINE MONTHS ENDED OCTOBER 2, 2005**

Net cash provided byoperating activities for the nine months ended October 1, 2006, was $1.0million, compared to net cash used in operating activities of $2.7 million forthe nine months ended October 2, 2005. Net cash provided by operating activities for the nine months endedOctober 1, 2006 reflected the positive effect of $2.3 million of net incomebefore depreciation and amortization due to higher revenues, $0.3 million ofimpairment charges in relation to the future closure of the Guadalajara, Mexicofacility, $0.5 million of stock-based compensation related to SFAS 123R, a $2.0million increase in accrued compensation and benefits mainly due to the increasein bonus accrual, $0.6 million increase in interest payable related to thesenior notes payment due in November, and an increase of $0.5 million inlong-term obligations.  These amountswere partially offset by a $0.1 million increase in net accounts receivable dueto an increase in our days sales outstanding at October 1, 2006, a$2.9 million increase in net inventories due to delayed shipments and ahigher backlog, $0.8 million decrease in accounts payable, a $1.3 milliondecrease in accrued liabilities and restructuring costs. Net cash used inoperating activities for the nine months ended October 2, 2005 was $2.7million. Cash used in operating activities for the nine months ended October 2,2005 reflected a reduction in accounts payable of $3.5 million, due to lowerrevenue levels during the third quarter of 2005, an increase in inventories of$1.1 million, due primarily to an increase in consignment hub inventoriespartially offset by a decrease in raw materials, and a net loss beforedepreciation and amortization of $1.0 million. These items were partiallyoffset by a decrease in accounts receivable of $2.0 million, due to lowerrevenue levels during the third quarter of 2005, increase in accruedliabilities and accrued restructuring costs of $0.6 million, as well as anincrease of $0.6 million in interest payable related to the senior notes.

Net cash used ininvesting activities for the nine months ended October 1, 2006 was $2.3 millionrelated to capital expenditure purchases. Net cash used in investing activitiesfor the nine months ended October 2, 2005 was $0.9 million. Net cash used ininvesting activities for the nine months ended October 2, 2005 reflected netsales of short-term investments of $3.9 million, more than offset by capitalexpenditures of $4.8 million related to manufacturing equipment,construction-in-progress in China, and leasehold improvements.

Net cash provided byfinancing activities for the nine months ended October 1, 2006 was $0.1million. Net cash provided by financing activities for the nine months endedOctober 2, 2005 was $1.3 million and was related primarily to a short-termadvance of $1.2 million received from the industrial park in China inconnection with the construction costs of the Company’s new facility in China.

**LIQUIDITY**

As of October 1, 2006, wehad cash and cash equivalents of $9.7 million, working capital of$42.0 million and no borrowings under the Credit Facility. In October2006, the Company borrowed $1.0 million under the Credit Facility.  Historically, we have financed our operationswith cash from operations supplemented by borrowings from credit facilities anddebt and equity issuances. Our current and future liquidity needs primarilyarise from working capital requirements and capital expenditures. Our historicalcapital expenditures have primarily resulted from investments in equipment toincrease manufacturing capacity and to improve manufacturing efficiencies. For2006, we expect capital expenditures to be approximately $3.6 million, whichwill relate primarily to our investments in manufacturing equipment at ourfacilities of which $2.5 million will be for our Shanghai, China facility. In2005, we spent $8.1 million in capital expenditures of which $5.5 million wasinvested in the development of our new China facility.  During the next three months of this year, weexpect to invest an additional $1.5 million in working capital into our Chinafacility through raw material inventory purhases, which would increase ourinventory balance to approximately $4.0 million by year-end.  We believe that the majority of start-upcosts in developing our China operations will be completed by this year.

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As of October 1,2006, our borrowings consisted of approximately $46.6 million of senior notesbearing interest at 5.25% annually, and no borrowings under the CreditFacility. We are required to make semi-annual interest payments to holders ofthe 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 financial condition or results ofoperations.

The maturities of ourlong-term debt and future payments relating to our operating leases and otherobligations as of October 1, 2006 are as follows (in thousands):
| Contractual Obligations           | ** ** | **October 2, 2006 to  December 31, 2006** | ** ** | **2007** | ** ** | **2008** | ** ** | **2009** | ** ** | **2010** | ** ** | **Thereafter** | ** ** | **Total** | ** ** |
|----------------------------------------|------------|--------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------------|------------|-----------|------------|
| Long-term debt                         |       | $                                                                  | —     |     | $          | —   |       | $        | 46,630     |     | $          | —         |       | $         | —     |   | $ | — |   | $ | 46,630 |   |
| Operating leases                       |       | 393                                                                |       | 1,583    |       | 1,579    |       | 526      |       | 2        |       | 114            |       | 4,197     |       |
| Purchase order  commitments            |       | 18,114                                                             |       | 19       |       | —   |       | —   |       | —   |       | —         |       | 18,133    |       |
| 1999 Europe  restructuring             |       | 58                                                                 |       | 139      |       | 126      |       | 91       |       | 245      |       | —         |       | 659       |       |
| 2003 Europe  restructuring             |       | 70                                                                 |       | 206      |       | 208      |       | 202      |       | 185      |       | 474            |       | 1,345     |       |
| Long service  award                    |       | —                                                             |       | 67       |       | 159      |       | 256      |       | 535      |       | 1,373          |       | 2,390     |       |
| Deferred  compensation                 |       | —                                                             |       | —   |       | —   |       | —   |       | —   |       | 1,002          |       | 1,002     |       |
| Advances for  research and development |       | 116                                                                |       | 90       |       | 56       |       | 52       |       | 52       |       | 317            |       | 683       |       |
| Total                                  |       | $                                                                  | 18,751     |     | $          | 2,104    |       | $        | 48,758     |     | $          | 1,127          |       | $         | 1,019      |   | $ | 3,280 |   | $ | 75,039 |   |

 

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.

In connection with ourinitial public offering in February of 2004, we amended our existingsenior revolving credit facility with General Electric Capital Corporation. TheCredit Facility provides for borrowings of up to $20.0 million, subject to aborrowing base comprised of eligible accounts receivable and inventory, whichwas $15.3 million at October 1, 2006. We plan to use funds available under thiscredit facility to finance working capital and other cash requirements asneeded. The credit facility matures in August 2008 and bears interest, atour option, at a rate per annum equal to LIBOR plus 2.5% or the agent bank’sbase rate plus 1.0%. In addition to paying interest on outstanding principal,we are required to pay a commitment fee to the lenders under the creditfacility in respect of the average daily balance of unused loan commitments ata rate of 0.5% per annum. The Credit Facility is our senior obligation andranks equal in right of payment with our existing and future permitted seniordebt (including our senior notes), and senior in right of payment to our futurepermitted subordinated debt. The Credit Facility is secured by a first-prioritylien, subject to permitted encumbrances, on substantially all of our domesticassets and by a pledge of 65% of the equity of certain of our foreignsubsidiaries.

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.

As of October 1, 2006, wewere in compliance with all covenants set forth in the principal agreementsgoverning our debt. Based on our present expectations, we believe that ourexisting cash and cash equivalents, working capital and available borrowingcapacity at October 1, 2006 will be sufficient to meet our anticipated cashrequirements for at least the next twelve months, including operatingrequirements, contractual obligations, planned capital expenditures and debtservice.

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**RECENT ACCOUNTINGPRONOUNCEMENTS**

For a discussion of theimpact of recently issued accounting pronouncements, see “Item 1:  Financial Statements” under “Note 2 of theNotes to Condensed Consolidated Financial Statements” entitled “RecentAccounting Pronouncements.”

**Item3.**   Quantitativeand 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 October 1, 2006.

We had no variable ratedebt outstanding at October 1, 2006. However, any debt we incur under theCredit Facility and Cherokee Europe line of credit with Bank Brussels Lambert,a subsidiary of ING Belgie NV, will bear interest at a variable rate. We cannotpredict market fluctuations in interest rates and their impact on any variablerate debt we may incur in the future, nor can there be any assurance that fixedrate long-term debt will be available to us at favorable rates, if at all.

The functional currencyfor our European operations is the Euro. We are, therefore, subject to acertain degree of market risk associated with changes in foreign currencyexchange rates. This risk is mitigated by the fact that our revenues andexpenses are generally both transacted in Euros, thereby reducing the risk offoreign currency fluctuation on our European operations. Historically, we havenot actively engaged in exchange rate-hedging activities.

**Item4.**   Controlsand Procedures

*Disclosure Controls and Procedures*

Our management, with theparticipation of our President and Chief Executive Officer, and our ExecutiveVice President, Chief Financial Officer and Secretary, has evaluated theeffectiveness of our disclosure controls and procedures (as such term isdefined in Rules 13a-15(e) and 15d-15(e) under theSecurities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the endof the period covered by this report. Based on such evaluation, our Presidentand Chief Executive Officer, and our Executive Vice President, Chief FinancialOfficer and Secretary have concluded that, as of the end of such period, ourdisclosure controls and procedures were effective.

*Changes in Internal Control Over Financial Reporting*

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, amount to approximately $40,000 in 2004 and 2005, and less than$10,000 in 2006. The Company retained outside counsel who conducted an internalinvestigation into these payments. The Company has notified the Department ofJustice and the Securities and Exchange Commission of this matter, and willcooperate fully with any investigations that may be conducted by suchregulatory agencies. The Company believes that this matter will not have amaterial impact on its consolidated financial statements.  The Company has directed that no suchpayments be made without prior approval of U.S. management and has enhanced itsexisting policies and procedures to ensure compliance with applicable laws.

*MaterialWeakness in Internal Control over Financial Reporting*

A material weakness is acontrol deficiency or a combination of control deficiencies that results inmore than a remote likelihood that a material misstatement of the annual orinterim consolidated financial statements will not be prevented ordetected.  As of October 1, 2006, theCompany identified the following material weakness in its internal controls:

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*Insufficientcontrols over the preparation of the income tax provision*

As previously disclosedin the Company’s quarterly report on form 10-Q, management identified aweakness in internal controls over the determination and reporting of theprovision for income taxes for the quarterly period ended July 2, 2006.  Specifically, the Company did not maintaineffective controls to review and monitor the accuracy of significant estimatesthat impacted the components of the income tax provision calculations. Thiscontrol deficiency resulted in a material adjustment during the preparation ofthe unaudited consolidated financial statements as of and for the three monthsended July 2, 2006. Additionally, this control deficiency could result in amisstatement of the income tax provision or related deferred income taxbalances that would result in a material misstatement to the annual or interimconsolidated financial statements that would not be prevented or detected.  Accordingly, management determined that thiscontrol deficiency constituted a material weakness.

*Remediationof Material Weakness*

The Company hasremediated this material weakness reported above by retaining third-partyconsultants with significant tax and financial reporting experience to provideassistance in complying with United States Generally Accepted AccountingPrinciples (“GAAP”) and Securities and Exchange Commission reportingrequirements. The Company has revised its quarterly closing procedures toensure an improved flow of information obtained from foreignjurisdictions.  In addition, the Companyhas refined its methodology for calculating the quarterly provision to moreaccurately reflect and minimize its reliance on future estimated taxable incomeby jurisdiction.  The Company beganimprovement efforts subsequent to the quarter ended July 2, 2006 and prior tothe filing of its Quarterly Report on Form 10-Q for that quarter. The Companybelieves, as of October 1, 2006 it has fully remediated this material weakness.

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) and 15d-15(f) underthe Exchange Act) during our October 1, 2006 quarter-end that have materiallyaffected, or are reasonably likely to materially affect, our internal controlover financial reporting.

**PART II   OTHERINFORMATION**

**Item 1.**   LegalProceedings

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, amount to approximately $40,000 in 2004 and 2005, and less than$10,000 in 2006. The Company retained outside counsel who conducted an internalinvestigation into these payments. The Company has notified the Department ofJustice and the Securities and Exchange Commission of this matter, and willcooperate fully with any investigations that may be conducted by suchregulatory agencies. The Company believes that this matter will not have amaterial impact on its consolidated financial statements.

During the quarter endedOctober 1, 2006, we were not a party to any material legal proceedings. We areoccasionally a party to lawsuits relating to routine matters incidental to ourbusiness. As with all litigation, we can provide no assurance as to the outcomeof any particular lawsuit, and we note that litigation inherently involvessignificant costs.

**Item 1A.****   RiskFactors**

There have been nomaterial changes to the Company’s risk factors from those disclosed in theCompany’s 2005 Annual Report on Form 10-K.

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**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.(4)                                                                                                                                                                                                                                                                                                               |
| 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)                                                                                                                                                                                                                                                                                                                                                  |
| *10.1            |       | Cherokee  International Corporation 2004 Omnibus Stock Incentive Plan.(3)                                                                                                                                                                                                                                                                                                                      |
| *10.2            |       | Form of  2004 Stock Option Agreement.(3)                                                                                                                                                                                                                                                                                                                                                  |
| *10.3            |       | Form of  Officer and Director Indemnification Agreement.(4)                                                                                                                                                                                                                                                                                                                               |
| *10.4            |       | Executive Deferred  Compensation Plan (and related schedule).(3)                                                                                                                                                                                                                                                                                                                               |
| 10.5             |       | Amended and  Restated Credit Agreement, dated as of February 25, 2004, by and between  Cherokee International Corporation and General Electric Capital Corporation,  in its individual capacity and as agent (the Agent) for all of the lenders named therein.(5)                                                                                                                         |
| 10.6             |       | Amended and  Restated Revolving Note, dated as of February 25, 2004, issued by  Cherokee International Corporation.(5)                                                                                                                                                                                                                                                                    |
| 10.7             |       | Amended and  Restated Security Agreement, dated as of February 25, 2004, by and  between Cherokee International Corporation and the Agent.(5)                                                                                                                                                                                                                                             |
| 10.8             |       | Registration  Rights Agreement, dated as of February 25, 2004, by and among Cherokee  International Corporation and the Securityholders party thereto.(6)                                                                                                                                                                                                                                 |
| 10.9             |       | Security  Agreement, dated as of November 27, 2002, between Cherokee International  Corporation and U.S. Bank, N.A., as agent (relating to the 5.25% Senior Note  Indenture).(2)                                                                                                                                                                                                          |
| 10.10            |       | Trademark  Security Agreement, dated as of November 27, 2002, between Cherokee  International Corporation and U.S. Bank, N.A., as agent (relating to the  5.25% Senior Note Indenture).(2)                                                                                                                                                                                                |
| 10.11            |       | Pledge  Agreement, dated as of November 27, 2002, between Cherokee International  Corporation and U.S. Bank, N.A., as agent (relating to the 5.25% Senior Note Indenture).(2)                                                                                                                                                                                                             |
| 10.12            |       | Pledge  Agreement, dated as of November 27, 2002, between Cherokee Netherlands I  B.V. and U.S. Bank, N.A., as agent (relating to the 5.25% Senior Note  Indenture).(2)                                                                                                                                                                                                                   |
| *10.13           |       | Cherokee  International Corporation 2002 Stock Option Plan.(2)                                                                                                                                                                                                                                                                                                                                 |
| *10.14           |       | Form of  2002 Stock Option Agreement.(2)                                                                                                                                                                                                                                                                                                                                                  |
| *10.15           |       | Severance  Agreement, dated as of March 31, 2005, between Cherokee International  Corporation and Jeffrey M. Frank.(7)                                                                                                                                                                                                                                                                    |
| 10.16            |       | Lease Agreement,  dated as of April 30, 1999, by and between Ganpat I. Patel and Manju G.  Patel, Trustees of the Patel Family Trust dated July 17, 1987, as to an  undivided two-thirds interest, and Kenneth O. King and Arlene King, husband  and wife as joint tenants, as to an undivided one-third interest, as tenants  in common, and Cherokee International Corporation.(2) |
| *10.17           |       | 2005 Cash  Incentive Compensation program for executive officers and other employees  dated as of March 14, 2005.(8)                                                                                                                                                                                                                                                                      |
| *10.18           |       | Severance  Agreement, dated as of June 16, 2005, between Cherokee International Corporation  and Mukesh Patel.(9)                                                                                                                                                                                                                                                                         |

 

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| Exhibit No. | ** ** | **Description**                                                                                                                                               |
|------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------|
| *10.19           |       | Letter  Agreement, dated as of October 14, 2005, between Cherokee International  Corporation and Linster W. Fox.(10)                                     |
| *10.20           |       | Severance  Agreement, dated as of October 14, 2005, between Cherokee International  Corporation and Linster W. Fox.(10)                                  |
| *10.21           |       | 2006 Cash  Incentive Compensation program for executive officers and other employees  dated as of January 06, 2006.(11)                                  |
| 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)             Incorporated byreference from the Registration Statement on Form S-8, filed by theRegistrant on March 16, 2004.

(2)             Incorporated byreference 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. 2 to the Registration Statement onForm S-1 (File No. 333-110723), filed by theRegistrant on February 4, 2004.

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

(5)             Incorporated byreference from the Quarterly Report on Form 10-Q, filed by theRegistrant on May 12, 2004.

(6)             Incorporated byreference from the Quarterly Report on Form 10-Q, filed by theRegistrant on August 9, 2004.

(7)             Previously filed asan exhibit to our Form 10-K on April 1, 2005.

(8)             Previously filed asan exhibit to our Form 8-K on March 21, 2005.

(9)             Previously filed asan exhibit to our Form 8-K on June 16, 2005.

(10)       Previously filed as anexhibit to our Form 8-K on October 31, 2005.

(11)       Previously filed as anexhibit to our Form 8-K on February 08, 2006.

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**SIGNATURES**

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned, thereuntoduly authorized.
|                              |   | CHEROKEE  INTERNATIONAL CORPORATION |
|------------------------------|--------|-------------------------------------|
|                         |   |                                |
| Date: November 14, 2006      |   | By:                                 | /s/ JEFFREY M.  FRANK |
|                         |   |                                | Jeffrey M. Frank |
|                         |   |                                | President, Chief  Executive Officer, and Director |
|                         |   |                                |   |
| Date: November 14, 2006 |   | By:                                 | /s/ LINSTER W.  FOX |
|                         |   |                                | Linster W. Fox |
|                         |   |                                | Executive Vice  President, Chief Financial Officer,  and Secretary |

 

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