**SECURITIESAND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

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**FORM10-Q**

 

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| **(mark  one)** |                                                                                         |
|-----------------|----------------------------------------------------------------------------------------------|
| **ý**      | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|            |                                                                                         |   |

 

**Forthe quarterly period ended September 30, 2002**

 

**OR**

 
| **o** | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|-------|-----------------------------------------------------------------------------------------------|

 

**Forthe transition period from         to         **

 

**Commissionfile number: 333-82713**

 

**CHEROKEEINTERNATIONAL, LLC**

(Exact name ofregistrant as specified in its charter)

 

| **CALIFORNIA**                                                                      |   | **33-0696451**                        |
|-------------------------------------------------------------------------------------|--------|---------------------------------------|
| (State or other  jurisdiction of incorporation or organization)                     |   | (I.R.S. Employer  Identification No.) |
|                                                                                |   |                                  |
| **2841  DOW AVENUE  TUSTIN, CALIFORNIA 92780**                                      |
| (Address of  principal executive offices)                                           |
|                                                                                |
| **(714)  544-6665**                                                                 |
| (Registrant’s  telephone number, including area code)                          |
|                                                                                |   |                                  |
| **N/A**                                                                             |
| (Former name,  former address and former fiscal year, if changed since last report) |

 

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 the past 12months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days.  Yes ý   No  o

 

 

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CHEROKEE INTERNATIONAL, LLC

 

TABLE OF CONTENTS

 
| PART I—FINANCIAL  INFORMATION                                                                         |                                                                                                                   |
|------------------------------------------------------------------------------------------------------------|------------------------------------------------------------------------------------------------------------------------|
|                                                                                                       |                                                                                                                   |
| Item 1.   Consolidated Financial Statements:                                                          |                                                                                                                   |
|                                                                                                       | Condensed  Consolidated Balance Sheets—September 30, 2002 and December 31, 2001                                   |
|                                                                                                       |                                                                                                                   |
|                                                                                                       | Condensed  Consolidated Statements of Operations—For the Three and Nine Months Ended  September 30, 2002 and 2001 |
|                                                                                                       |                                                                                                                   |
|                                                                                                       | Condensed  Consolidated Statements of Cash Flows—For the Nine Months Ended September 30,  2002 and 2001           |
|                                                                                                       |                                                                                                                   |
|                                                                                                       | 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  6.  Exhibits and Reports on Form 8-K                                                            |
|                                                                                                       |
| SIGNATURES                                                                                                 |
|                                                                                                       |
| CERTIFICATIONS                                                                                             |
|                                                                                                       |                                                                                                                   |   |

 

 

2

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

 

CHEROKEEINTERNATIONAL, LLC AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited)

 
|                                                                                                                                                                   |   | **September  30,  2002** |       | **December 31,  2001** |   |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------------|------------|-----------------------------|--------|
|                                                                                                                                                                   |   |                     |       |                        |   |
| ASSETS                                                                                                                                                                 |   |                     |       |                        |   |
| CURRENT ASSETS:                                                                                                                                                        |   |                     |       |                        |   |
| Cash and cash equivalents                                                                                                                                              |   | $                        | 4,799,961  |                        | $      | 2,592,489 |   |
| Short-term investments                                                                                                                                                 |   | 1,064,857                |       | 1,155,096                   |   |
| Accounts receivable, net of allowance for doubtful  accounts of $279,539 and $237,307 as of September 30, 2002 and December  31, 2001, respectively               |   | 17,770,868               |       | 17,587,062                  |   |
| Inventories, net                                                                                                                                                       |   | 15,860,597               |       | 21,291,787                  |   |
| Prepaid expenses and other current assets                                                                                                                              |   | 913,256                  |       | 1,108,833                   |   |
|                                                                                                                                                                   |   |                     |       |                        |   |
| Total current assets                                                                                                                                                   |   | 40,409,539               |       | 43,735,267                  |   |
| PROPERTY AND EQUIPMENT, net of accumulated  depreciation and amortization of $15,879,729 and $13,146,218 as of September  30, 2002 and December 31, 2001, respectively |   | 13,501,670               |       | 14,690,370                  |   |
| DEPOSITS                                                                                                                                                               |   | 406,237                  |       | 402,990                     |   |
| DEFERRED INCOME TAXES                                                                                                                                                  |   | 296,469                  |       | 316,237                     |   |
| DEFERRED FINANCING COSTS, net of accumulated  amortization of $3,388,027 and $2,530,698 as of September 30, 2002 and  December 31, 2001, respectively                  |   | 2,881,651                |       | 3,583,480                   |   |
| GOODWILL                                                                                                                                                               |   | 6,316,922                |       | 40,916,922                  |   |
|                                                                                                                                                                   |   |                     |       |                        |   |
|                                                                                                                                                                   |   | $                        | 63,812,488 |                        | $      | 103,645,266 |   |
|                                                                                                                                                                   |   |                     |       |                        |   |
| LIABILITIES AND MEMBERS’ EQUITY (DEFICIT)                                                                                                                         |   |                     |       |                        |   |
| CURRENT LIABILITIES:                                                                                                                                                   |   |                     |       |                        |   |
| Accounts payable                                                                                                                                                       |   | $                        | 6,976,154  |                        | $      | 6,325,785 |   |
| Accrued liabilities                                                                                                                                                    |   | 7,603,716                |       | 6,758,971                   |   |
| Accrued compensation and benefits                                                                                                                                      |   | 6,522,004                |       | 6,044,568                   |   |
| Accrued interest payable                                                                                                                                               |   | 4,503,355                |       | 2,214,097                   |   |
| Revolving lines of credit                                                                                                                                              |   | 8,521,073                |       | 13,182,146                  |   |
| Current portion of long-term debt                                                                                                                                      |   | 142,308,189              |       | 7,728,098                   |   |
| Current portion of capital lease obligations                                                                                                                           |   | 2,305,831                |       | 1,156,795                   |   |
| Deferred income taxes                                                                                                                                                  |   | 349,239                  |       | 372,505                     |   |
|                                                                                                                                                                   |   |                     |       |                        |   |
| Total current liabilities                                                                                                                                              |   | 179,089,561              |       | 43,782,965                  |   |
| LONG-TERM DEBT, net of current portion                                                                                                                                 |   | —                   |       | 134,073,166                 |   |
| CAPITAL LEASE OBLIGATIONS, net of current portion                                                                                                                      |   | —                   |       | 1,921,018                   |   |
| MEMBERS’ EQUITY (DEFICIT)                                                                                                                                         |   |                     |       |                        |   |
| Class A units: 347,671 units issued and outstanding                                                                                                                    |   | 354,371                  |       | 354,371                     |   |
| Class B units: 36,035,065 units issued and  outstanding                                                                                                                |   | 37,037,827               |       | 37,037,827                  |   |
| Paid-in capital                                                                                                                                                        |   | 5,330,000                |       | 5,330,000                   |   |
| Retained earnings (deficit)                                                                                                                                            |   | (158,392,285             | )          | (118,064,169                | )      |
| Accumulated other comprehensive income (loss)                                                                                                                          |   | 393,014                  |       | (789,912                    | )      |
|                                                                                                                                                                   |   |                     |       |                        |   |
| Total members’ deficit                                                                                                                                            |   | (115,277,073             | )          | (76,131,883                 | )      |
|                                                                                                                                                                   |   |                     |       |                        |   |
|                                                                                                                                                                   |   | $                        | 63,812,488 |                        | $      | 103,645,266 |   |

 

See notes tocondensed consolidated financial statements.

 

 

3

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CHEROKEEINTERNATIONAL, LLC AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

 
|                                                                                           |   | **Three  Months Ended**  |       | **Nine  Months Ended**   |   |
|------------------------------------------------------------------------------------------------|--------|--------------------------|------------|--------------------------|--------|
|                                                                                           |   | **September  30,  2002** |       | **September  30,  2001** |   | **September  30,  2002** |   | **September  30,  2001** |   |
|                                                                                           |   |                     |       |                     |   |   |   |   |   |
| NET SALES                                                                                      |   | $                        | 23,608,729 |                     | $      | 25,994,675 |   | $ | 73,507,500 |   | $ | 98,277,765 |   |
| COST OF SALES                                                                                  |   | 17,128,292               |       | 19,770,104               |   | 53,900,128 |   | 72,999,232 |   |
|                                                                                           |   |                     |       |                     |   |   |   |   |   |
| GROSS PROFIT                                                                                   |   | 6,480,437                |       | 6,224,571                |   | 19,607,372 |   | 25,278,533 |   |
| OPERATING EXPENSES:                                                                            |   |                     |       |                     |   |   |   |   |   |
| Engineering and development                                                                    |   | 1,803,507                |       | 1,589,561                |   | 5,119,703 |   | 5,200,763 |   |
| Selling and marketing                                                                          |   | 1,250,529                |       | 983,736                  |   | 3,600,362 |   | 3,081,427 |   |
| General and administrative                                                                     |   | 1,556,862                |       | 1,685,049                |   | 4,498,038 |   | 4,863,855 |   |
| Amortization of goodwill                                                                       |   | —                   |       | 761,000                  |   | — |   | 2,281,000 |   |
|                                                                                           |   |                     |       |                     |   |   |   |   |   |
| Total operating expenses                                                                       |   | 4,610,898                |       | 5,019,346                |   | 13,218,103 |   | 15,427,045 |   |
|                                                                                           |   |                     |       |                     |   |   |   |   |   |
| OPERATING INCOME                                                                               |   | 1,869,539                |       | 1,205,225                |   | 6,389,269 |   | 9,851,488 |   |
|                                                                                           |   |                     |       |                     |   |   |   |   |   |
| Interest expense                                                                               |   | (3,733,837               | )          | (4,066,543               | )      | (11,188,559 | ) | (12,608,115 | ) |
| Debt restructuring costs                                                                       |   | (782,000                 | )          | —                   |   | (782,000 | ) | — |   |
| Other income                                                                                   |   | 18,991                   |       | 111,894                  |   | 48,704 |   | 192,380 |   |
|                                                                                           |   |                     |       |                     |   |   |   |   |   |
| Loss before income taxes and cumulative effect of a  change in accounting principle            |   | (2,627,307               | )          | (2,749,424               | )      | (5,532,586 | ) | (2,564,247 |  ) |
| Provision for income taxes                                                                     |   | 68,821                   |       | 66,820                   |   | 195,530 |   | 221,424 |   |
| Net loss before cumulative effect of a change in  accounting principle                         |   |                     | (2,696,128 | )                        |   | (2,816,244 | ) |   | (5,728,116 | ) |   | (2,785,671 | )  |
| Cumulative effect of a change in accounting  principle: goodwill impairment                    |   | —                   |       | —                   |   | (34,600,000 | ) |  

— |   |
| NET LOSS                                                                                       |   | $                        | (2,696,128 | )                        | $      | (2,816,244 | ) | $ | (40,328,116  | ) | $ | (2,785,671  | ) |
| Net loss per unit, before cumulative effect of a  change in accounting principle               |   |                     |       |                     |   |   |   |   |   |   |   |   |   |
| Basic                                                                                |   | $                        | (.07       | )                        | $      | (.08 | ) | $ | (.16 | ) | $ | (.08 | ) |
| Diluted                                                                                        |   | $                        | (.07       | )                        | $      | (.08 | ) | $ | (.16 | ) | $ | (.08 | ) |
| Loss per unit from cumulative effect of  a change in accounting principle: goodwill impairment |   |                     |       |                     |   |   |   |   |   |   |   |   |   |
| Basic                                                                                          |   | $                        | —     |                     | $      | — |   | $ | (.95 | ) | $ | — |   |
| Diluted                                                                                        |   | $                        | —     |                     | $      | — |   | $ | (.95 | ) | $ | — |   |
| Net  loss per unit                                                                             |   |                     |       |                     |   |   |   |   |   |   |   |   |   |
| Basic                                                                                          |   | $                        | (.07       | )                        | $      | (.08 | ) | $ | (1.11 | ) | $ | (.08 | ) |
| Diluted                                                                                        |   | $                        | (.07       | )                        | $      | (.08 | ) | $ | (1.11 | ) | $ | (.08 | ) |
|                                                                                           |   |                     |       |                     |   |   |   |   |   |
| Weighted average units outstanding                                                             |   |                     |       |                     |   |   |   |   |   |
| Basic                                                                                          |   | 36,382,736               |       | 36,382,736               |   | 36,382,736 |   | 36,382,736 |   |
| Diluted                                                                                        |   | 36,382,736               |       | 36,382,736               |   | 36,382,736 |   | 36,382,736 |   |

 

See notes tocondensed consolidated financial statements

 

 

4

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CHEROKEEINTERNATIONAL, LLC AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

 
|                                                                                   |           | **Nine  Months Ended**   |        |
|----------------------------------------------------------------------------------------|----------------|--------------------------|-------------|
|                                                                                   |           | **September  30,  2002** |        | **September  30,  2001** |   |
|                                                                                   |           |                     |        |   |   |
| CASH FLOWS FROM OPERATING ACTIVITIES:                                                  |           |                     |        |   |   |
| Net loss                                                                               |           | $                        | (40,328,116 | ) | $ | (2,785,671 | ) |
| Adjustments to reconcile net loss to net cash   provided by operating activities: |           |                     |        |   |   |
| Depreciation and amortization                                                          |           | 2,567,440                |        | 5,044,438 |   |
| Amortization of deferred financing costs                                               |           | 857,329                  |        | 728,253 |   |
| Cumulative effect of a  change in accounting principle: goodwill impairment            |           | 34,600,000               |        | — |   |
| Other, net                                                                             |           | 38,200                   |        | — |   |
| Net change in operating assets and liabilities:                                        |           |                     |        |   |   |
| Accounts receivable, net                                                               |           | 841,827                  |        | 11,006,074 |   |
| Inventories, net                                                                       |           | 6,361,242                |        | 10,658,571 |   |
| Prepaid expenses and other current assets                                              |           | 239,288                  |        | (297,219 | ) |
| Deposits                                                                               |           | (48,289                  | )           | (127,523 | ) |
| Accounts payable                                                                       |           | 113,308                  |        | (10,998,352 | ) |
| Accrued liabilities                                                                    |           | 416,081                  |        | 201,922 |   |
| Accrued compensation and benefits                                                      |           | (19,297                  | )           | (1,024,923 | ) |
| Accrued interest payable                                                               |           | 2,289,326                |        | 2,407,476 |   |
| Net cash provided by operating activities                                              |           | 7,928,339                |        | 14,813,046 |   |
|                                                                                   |           |                     |        |   |   |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                                  |           |                     |        |   |   |
| Additions to property and equipment                                                    |           | (729,664                 | )           | (955,161 | ) |
| Net change in short-term investments                                                   |           | 90,239                   |        | (155,090 | ) |
|                                                                                   |           |                     |        |   |   |
| Net cash used in investing activities                                                  |           | (639,425                 | )           | (1,110,251 | ) |
|                                                                                   |           |                     |        |   |   |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                                  |           |                     |        |   |   |
| Borrowings on revolving lines of credit                                                |           | 16,133,052               |        | 14,675,736 |   |
| Payments on revolving lines of credit                                                  |           | (18,741,600              | )           | (19,376,000 | ) |
| Payments on obligations under capital leases                                           |           | (883,192                 | )           | (804,869 | ) |
| Payments on long-term debt                                                             |           | (1,830,200               | )           | (4,585,502 | ) |
| Deferred financing costs                                                               |           | (155,500                 | )           | (177,817 | ) |
| Equity distribution                                                                    |  

  | —                   |        | (2,118,000 | ) |
|                                                                                   |           |                     |        |   |   |
| Net cash used in financing activities                                                  |           | (5,477,440               | )           | (12,386,452 | ) |
| Cash effect of exchange rate changes                                                   |           | 395,998                  |        | 7,000 |   |
|                                                                                   |           |                     |        |   |   |
| NET INCREASE IN CASH AND CASH EQUIVALENTS                                              |           | 2,207,472                |        | 1,323,343 |   |
| CASH AND CASH EQUIVALENTS, beginning of period                                         |           | 2,592,489                |        | 852,966 |   |
|                                                                                   |           |                     |        |   |   |
| CASH AND CASH EQUIVALENTS, end of period                                               |           | $                        | 4,799,961   |   | $ | 2,176,309 |   |

 

See notes tocondensed consolidated financial statements.

 

 

5

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CHEROKEEINTERNATIONAL, LLC AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

1.             Basis of Presentation

 

The information set forth in the accompanyingcondensed consolidated financial statements is unaudited and, in the opinion ofmanagement, reflects all adjustments, consisting only of normal recurringadjustments, necessary to present fairly the financial position, results ofoperations and cash flows of Cherokee International, LLC (the “Company”) forthe periods indicated.

 

Results of operations for the interim nine monthsended September 30, 2002 and 2001 are not necessarily indicative of the resultsof operations for the full fiscal year. The Company’s third quarter representedthe 13-week periods ended on September 29 in 2002 and September 30 in 2001. Forpresentation purposes, these fiscal quarters have been referred to as ending onSeptember 30.

 

The condensed consolidated financial statementsinclude the financial statements of the Company and its wholly-ownedsubsidiaries. One such subsidiary, Cherokee International Corporation(formerly, Cherokee International Finance, Inc.), was formed in April 1999 as awholly-owned finance subsidiary to act as a co-obligor of the 101⁄2% seniorsubordinated notes and has no independent assets or operations. All significantintercompany accounts and transactions have been eliminated.

 

Certain information normally included in footnotedisclosure to the financial statements has been condensed or omitted inaccordance with the rules and regulations of the Securities and ExchangeCommission. Accordingly, the financial statements do not include all theinformation and note disclosures normally included in annual consolidatedfinancial statements prepared in accordance with accounting principlesgenerally accepted in the United States of America. These unaudited condensedconsolidated financial statements should be read in conjunction with the otherdisclosures contained herein and with the Company’s audited consolidatedfinancial statements and notes thereto contained in the Company’s Form 10-K forthe year ended December 31, 2001.

 

The preparation of financial statements in conformitywith generally accepted accounting principles necessarily requires managementto make estimates and assumptions that affect the reported amounts of assetsand liabilities and disclosure of contingent assets and liabilities at the dateof the financial statements and the reported amounts of revenues and expensesduring the reporting periods. Actual results could differ from these estimates.

 

Certain reclassifications have been made to the 2001presentation to conform with the 2002 presentation. In addition, during thesecond quarter of 2002 the Company changed the classification of certainexpenses incurred by Cherokee Europe to be more consistent with theclassification of similar expenses incurred by the North American operations.Such expenses were reclassified for the three and nine month periods endedSeptember 30, 2001.  A summary of the effect of such reclassification forthe three and nine months ended September 30, 2001 is as follows:

 
|                        |   | **As  Previously Reported**                  |       | **As  Reclassified**                        |   |
|-----------------------------|--------|----------------------------------------------|------------|---------------------------------------------|--------|
|                        |   | **Three  Months  Ended  September 30, 2001** |       | **Nine  Months  Ended  September 30, 2001** |   | **Three  Months  Ended  September 30, 2001** |   | **Nine  Months  Ended  September 30, 2001** |   |
|                        |   |                                         |       |                                        |   |   |   |   |   |
| Cost of sales               |   | $                                            | 18,840,104 |                                        | $      | 70,030,232 |   | $ | 19,770,104 |   | $ | 72,999,232 |   |
| Engineering and development |   | 1,530,561                                    |       | 5,021,763                                   |   | 1,589,561 |   | 5,200,763 |   |
| Selling and marketing       |   | 900,736                                      |       | 2,789,427                                   |   | 983,736 |   | 3,081,427 |   |
| General and administrative  |   | 2,757,049                                    |       | 8,303,855                                   |   | 1,685,049 |   | 4,863,855 |   |
|                        |   |                                         |       |                                        |   |   |   |   |   |   |   |   |   |

 

As shown in the accompanying condensed consolidatedfinancial statements, the Company incurred a net loss of $40,328,116 for thenine months ended September 30, 2002, which includes the cumulative effect of achange in accounting principle: goodwill impairment of $34,600,000 (see Note7), and had negative working capital of $138,680,022 at September 30, 2002,which reflects the effect of reclassifying $135,757,137 of debt from long-termto short-term at September 30, 2002 (see Note 8).  In addition, theCompany was not in compliance with certain debt covenants at September 30,2002; however, such noncompliance was waived, subject to certain conditions, inOctober 2002 in connection with the Company’s implementation of a plan torestructure its outstanding debt as described in more detail in Note 8below.  These negative trends have resulted from unfavorable economicconditions and reduced capital spending by industries in which the Companyoperates.  If the unfavorable economic conditions continue, the Company’sfinancial condition and operating results could be adversely affected.  Based onpresent expectations, the Company anticipates that the restructuringtransactions described in Note 8 below will close in November 2002 and that, asa result of the reduced principal amortization and cash debt servicerequirements, cash flow from operations and available borrowing capacity shouldbe adequate to meet the Company's anticipated cash requirements for the nexttwelve months.  All of the restructuringtransactions are, however, subject to closing conditions, including executionof definitive documentation, and the closings are cross conditioned.  Accordingly, if any of the restructuringtransactions described in Note 8 below is not consummated, the Company will bein default under its credit agreement and will be in default under theindenture governing its senior subordinated notes as a result of its failure tomake the November 1, 2002 interest payment thereon (currently scheduled to bepaid upon consummation of the restructuring transactions).  Even if the restructuring transactions areconsummated, there can be no assurances that the Company's operating andfinancial performance will improve or that the other expected benefits of therestructuring will be realized.  If anevent of default were to occur under the credit agreement or the indenturegoverning the senior subordinated notes, the lenders under the credit agreementwould become entitled to certain rights, including the right to accelerate thedebt and foreclose on the collateral securing the obligations thereunder.  In addition, holders of the seniorsubordinated notes would be entitled to accelerate the obligations thereunder.

 

In connection with the restructuringtransactions, the Company incurred approximately $937,500 of costs throughSeptember 30, 2002, of which $782,000 was directly expensed and $155,500 wascapitalized as deferred financing costs.

 

2.              Inventories

 

Inventories are valued at the lower of cost (first-in,first-out) or market. Inventory costs include the cost of material, labor andmanufacturing overhead and consist of the following:

 
|            |   | **September  30, 2002** |       | **December  31, 2001** |   |
|-----------------|--------|-------------------------|------------|------------------------|--------|
|            |   |                    |       |                   |   |
| Raw material    |   | $                       | 12,025,254 |                   | $      | 14,061,789 |   |
| Work-in-process |   | 2,024,329               |       | 3,526,256              |   |
| Finished goods  |   | 1,811,014               |       | 3,703,742              |   |
|            |   |                    |       |                   |   |
|            |   | $                       | 15,860,597 |                   | $      | 21,291,787 |   |

 

6

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3.             Income Taxes

 

The Company is a limited liability company under theprovisions of the federal and state tax codes. Under federal laws, taxesbased on income of a limited liability company are payable by theCompany’s individual members. Accordingly, no provision for U.S. federalincome taxes has been provided in the accompanying financial statements.Provisions for California franchise tax and fees are not significant for anyperiod presented. The Company’s provision for income taxes primarily relates tooperations in Mexico, Belgium and India which are subject to income taxes onearnings generated in those countries.

 

4.             Comprehensive Loss

 

Comprehensive loss is defined as all changes in acompany’s net assets except changes resulting from transactions withshareholders. It differs from net loss in that certain items currently recordedthrough equity are included in comprehensive loss. Comprehensive loss for thenine months ended September 30, 2002 was $39,145,190, which included a net lossof $40,328,116 (including a goodwill impairment charge of $34,600,000) and again from foreign currency translation adjustments of $1,182,926. Comprehensiveloss for the nine months ended September 30, 2001 was $3,059,977, whichincluded net loss of $2,785,671 and a loss from foreign currency translationadjustments of  $274,306.

 

5.             NetLoss Per Unit

 

The following table sets forth the computation ofbasic and diluted loss per unit:

 
|                                                                                           |   | **Three  Months Ended** |       | **Nine  Months Ended**  |   |
|------------------------------------------------------------------------------------------------|--------|-------------------------|------------|-------------------------|--------|
|                                                                                           |   | **September  30, 2002** |       | **September  30, 2001** |   | **September  30, 2002** |   | **September  30, 2001** |   |
| Net loss before  cumulative effect of a change in accounting principle                         |   | $                       | (2,696,128 | )                       | $      | (2,816,244 | ) | $ | (5,728,116 | ) | $ | (2,785,671 | ) |
| Cumulative effect of a change in accounting  principle: goodwill impairment                    |   | —                  |       | —                  |   | (34,600,000 | ) | — |   |
| Net loss                                                                                       |   | $                       | (2,696,128 | )                       | $      | (2,816,244 | ) | $ | (40,328,116 | ) | $ | (2,785,671 |  ) |
|                                                                                           |   |                    |       |                    |   |   |   |   |   |
| Units:                                                                                         |   |                    |       |                    |   |   |   |   |   |
| Weighted-average units outstanding—basic                                                  |   | 36,382,736              |       | 36,382,736              |   | 36,382,736 |   | 36,382,736 |   |
| Effect of dilutive options                                                                     |   | —                  |       | —                  |   | — |   | — |   |
| Weighted-average units outstanding—diluted                                                |   | 36,382,736              |       | 36,382,736              |   | 36,382,736 |   | 36,382,736 |   |
|                                                                                           |   |                    |       |                    |   |   |   |   |   |
| Net loss per unit,  before cumulative effect of a change in accounting principle               |   |                    |       |                    |   |   |   |   |   |
| Basic                                                                                          |   | $                       | (.07       | )                       | $      | (.08 | ) | $ | (.16 | ) | $ | (.08 | ) |
| Diluted                                                                                        |   | $                       | (.07       | )                       | $      | (.08 | ) | $ | (.16 | ) | $ | (.08 | ) |
| Loss per unit from cumulative effect of a change in  accounting principle: goodwill impairment |   |                    |       |                    |   |   |   |   |   |
| Basic                                                                                          |   | —                  |       | —                  |   | $ | (.95  | ) | — |   |
| Diluted                                                                                        |   | —                  |       | —                  |   | $ | (.95  | ) | — |   |
| Net loss per unit                                                                              |   |                    |       |                    |   |   |   |   |   |   |   |   |   |
| Basic                                                                                          |   | $                       | (.07       | )                       | $      | (.08 | ) | $ | (1.11 | ) | $ | (.08 | ) |
| Diluted                                                                                        |   | $                       | (.07       | )                       | $      | (.08 | ) | $ | (1.11 | ) | $ | (.08 | ) |
|                                                                                                |        |                         |            |                         |        |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

In calculating net loss per unit for the three andnine months ended September 30, 2002 and 2001, the effect of dilutive options,which was not significant,  is excluded because it is antidilutive.

 

6.            New AccountingPronouncements

 

In August 2001, the Financial Accounting StandardsBoard ("FASB") issued SFAS No. 144, “Accounting for Impairment orDisposal of Long-Lived Assets.” This statement addresses financial accountingand reporting for the impairment of long-lived assets and for long-lived assetsto be disposed of. SFAS No. 144 supersedes SFAS No. 121, “Accounting for theImpairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of,”and is effective for fiscal years beginning after December 15, 2001.  Theadoption of this standard at January 1, 2002 did not have a material impact onthe Company’s financial position and results of operations.

 

In July 2002, the FASB issued SFAS No. 146,"Accounting for Costs Associated with Exit or Disposal Activities,"which addresses financial accounting and reporting for costs associated withexit or disposal activities and supersedes Emerging Issues Task Force("EITF") Issue 94-3, "Liability Recognition for Certain EmployeeTermination Benefits and Other Costs to Exit an Activity (including CertainCosts Incurred in a Restructuring)."  SFAS No. 146 requires that aliability for a cost associated with an exit or disposal activity be recognizedwhen the liability is incurred.  Under Issue 94-3, a liability for an exitcost as defined in EITF 94-3 was recognized at the date of an entity'scommitment to an exit plan.  SFAS No. 146 also establishes that theliability should initially be measured and recorded at fair value.  TheCompany will adopt the provisions of SFAS No. 146 for exit or disposalactivities that are initiated after December 31, 2002.

 

7

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7.             Goodwill

 

In June 2001, the FASB issued two new pronouncements:SFAS No. 141, “Business Combinations”, and SFAS No. 142, “Goodwill and OtherIntangible Assets”.  SFAS No. 141 prohibits the use of thepooling-of-interest method for business combinations initiated after June 30,2001 and also applies to all business combinations accounted for by thepurchase method that are completed after June 30, 2001.  There are alsotransition provisions that apply to business combinations completed beforeJuly 1, 2001, that were accounted for by the purchase method.  The Companyhas adopted SFAS No. 141 and there was no material impact on the consolidatedfinancial statements as a result of the adoption.  The Company adoptedSFAS No. 142 effective January 1, 2002.   SFAS No. 142 requires thatgoodwill and other intangible assets with indefinite useful lives no longer beamortized, but instead be tested for impairment annually or when events orcircumstances indicate that their carrying value may be impaired. The adoptionof SFAS No. 142 resulted in reduced amortization expense of approximately$2,281,000 for the nine months ended September 30, 2002 compared to the ninemonths ended September 30, 2001.

 

In compliance with the requirements of SFAS No. 142,the Company completed its transitional impairment test as of January 1,2002.  Based on an independentvaluation, utilizing discounted cash flow and industry market multiplevaluation methodologies, the carrying value of the Cherokee Europe reportingunit exceeded its fair value.  Based onthis valuation, and unfavorable economic trends in the industries in whichCherokee Europe operates, the Company concluded in October 2002 that goodwillin the amount of $34,600,000 was impaired. Accordingly, the Company recorded a non-cash charge of $34,600,000 toreduce the carrying value of its goodwill. Such impairment charge is non-operational in nature and is reflected asthe cumulative effect of a change in accounting principle as of January 1, 2002in the accompanying Condensed Consolidated Statements of Operations.

 

Summarized below is the effect on net loss per sharedata, if the Company had followed the amortization provisions ofSFAS No. 142 for all periods presented (in thousands, except per unitamounts):

 
|                               |   | **Three  Months Ended** |   | **Nine  Months Ended**  |   |
|------------------------------------|--------|-------------------------|--------|-------------------------|--------|
|                               |   | **September  30, 2002** |   | **September  30, 2001** |   | **September  30, 2002** |   | **September  30, 2001** |   |
| Net loss:                          |   |                    |   |                    |   |   |   |   |   |
| As reported                        |   | $                       | (2,696 | )                       | $      | (2,816 | ) | $ | (40,328 | ) | $ | (2,786 | )  |
| Add: goodwill amortization         |   | —                  |   | 761                     |   | — |   | 2,281 |   |
| Adjusted net loss                  |   | $                       | (2,696 | )                       | $      | (2,055 | ) | $ | (40,328 | ) | $ | (505 |  ) |
| Basic net loss per unit:           |   |                    |   |                    |   |   |   |   |   |
| As reported                        |   | $                       | (.07   | )                       | $      | (.08 | ) | $ | (1.11 | ) | $ | (.08 | )  |
| Add: goodwill amortization         |   | —                  |   | .02                     |   | — |   | .06 |   |
| Adjusted basic net loss per unit:  |   | $                       | (.07   | )                       | $      | (.06 | ) | $ | (1.11 | ) | $ | (.02 | ) |
| Diluted net loss per unit:         |   |                    |   |                    |   |   |   |   |   |
| As reported                        |   | $                       | (.07   | )                       | $      | (.08 | ) | $ | (1.11 | ) | $ | (.08 | )  |
| Add: goodwill amortization         |   | —                  |   | .02                     |   | — |   | .06 |   |
| Adjusted diluted net loss per unit |   | $                       | (.07   | )                       | $      | (.06 | ) | $ | (1.11 | ) | $ | (.02 |  ) |

 

As a result of thecumulative effect of a change in accounting principle: goodwill impairmentrecognized  upon initial adoption ofSFAS No. 142, net loss and per unit data for the three months ended March 31,2002 have been restated as follows (in thousands, except per unit amounts):

 
|                                                                        |   | **Three  months ended  March 31, 2002** |    |
|-----------------------------------------------------------------------------|--------|-----------------------------------------|---------|
| Net loss, as reported                                                       |   | $                                       | (1,427  | ) |
| Cumulative effect of a change in accounting principle: goodwill  impairment |   |                                    | (34,600 | ) |
| Net loss, as restated                                                       |   | $                                       | (36,027 | ) |
| Basic and diluted net loss per   unit, as reported                          |   | $                                       | (.04    | ) |
| Cumulative effect of a change in accounting principle: goodwill  impairment |   | $                                       | (.95    | ) |
| Basic and diluted net loss   per unit, as restated                          |   | $                                       | (.99    | ) |

 

8

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8.             Long-Term Debt

 

The Company's long-term debt at September 30, 2002consisted of $100 million of senior subordinated notes, $31.8 million of termloans under the Company's credit agreement with its lenders, and $10.5 millionowed to guarantors of the Company's obligations under the credit agreement.

 

In September 2001, the Company's credit agreement wasamended to waive the Company's failure to comply with certain financialcovenants and to, among other things: (1) require that some of the Company'sunitholders, or their equity members, guarantee up to $10.5 million of theCompany's obligations under the credit agreement, in exchange for the Companybeing permitted to make the November 2001 and May 2002 scheduled interestpayments totaling $10.5 million on its $100 million of senior subordinatednotes, (2) modify certain financial covenants from and after September 2001 and(3) restrict the Company's ability to make its interest payment due in November2002 relating to its senior subordinated notes until certain financial testsare satisfied.

 

In August 2002, the Company's credit agreement wasfurther modified to, among other things, waive compliance with certaincovenants.  In connection with that waiver, certain of the Company'sunitholders, or their equity members, paid to the lenders the remaining $8.7million of the $10.5 million guaranty ($1.8 million of the guaranty waspreviously paid on July 1, 2002 to enable the Company to meet the scheduledamortization payment under the credit agreement) and the Company agreed to,among other things, (a) restructure its 101⁄2% senior subordinated notes in amanner satisfactory to the required lenders, (b) shorten the maturity date of the credit agreement, (c) reduce thesize of the revolving loan commitment and (d) provide that approximately $8.1million of payments under the $10.5 million guaranty referred to above will beapplied to reduce term loans with the remainder applied to reduce revolvingloans and overadvance borrowings.  The $8.7 million guaranty payment wouldhave otherwise been payable in August 2002 as a result of the breach of financialcovenants under the credit agreement described above.  The guarantors aresubrogated to the rights of the lenders under the senior credit agreement, on abasis senior to the senior subordinated notes.

 

In October 2002, the Company beganimplementation of a plan to restructure its existing debt.  In connection with the restructuring plan,the Company intends to reincorporate as a Delaware corporation by merging intoits wholly owned subsidiary, Cherokee International Corporation("Cherokee"), the co-obligor on the senior subordinated notes.  As part of the restructuring program, onOctober 28, 2002, Cherokee commenced an exchange offer and consentsolicitation, pursuant to which it offered to exchange the 101⁄2% seniorsubordinated notes for either: (1) units, consisting of Cherokee's 51⁄4% seniorsecured notes and warrants to purchase shares of its common stock, or (2)Cherokee's 12% pay-in-kind senior secured convertible notes.  Obligations under the senior notes and thesenior convertible notes would be secured by third and fourth-priority liens,respectively, on substantially all of Cherokee's domestic assets.  In addition, Cherokee solicited consentsfrom holders of the senior subordinated notes to certain amendments to theindenture governing those notes that would, among other things, eliminatesubstantially all of the restrictive covenants in the indenture.  The exchange offer and consent solicitationis currently scheduled to expire on November 25, 2002.

 

In connection with the exchange offer andconsent solicitation, the Company received commitments from various lenders torefinance its existing credit agreement. In addition, the lenders under the existing credit agreement waived theCompany's non-compliance with certain financial covenants as of September 30,2002, subject to completion of the restructuring transactions.  Under the commitments, upon repayment ofcertain outstanding amounts, the existing credit agreement would be amended toprovide for term loans in an aggregate principal amount of $5 million and arevolving credit facility with a commitment of up to $7.6 million, which wouldbe undrawn at closing.  The creditagreement, as amended, would mature on November 30, 2005.  In addition, Cherokee would enter into a newcredit agreement with a new lender that would provide for term loans in anaggregate principal amount of $10 million, with terms substantially identicalto those under the amended credit facility. Interest on these credit agreements would be payable in cash based onLIBOR plus an applicable margin ranging from 4.0% to 4.75%.  Obligations under the credit agreementswould be secured by a first-priority lien on substantially all of Cherokee'sdomestic assets.  Under additionalcommitments, Cherokee would issue second-lien notes to certain lenders in anaggregate principal amount of approximately $41 million and would also issuewarrants to purchase shares of its common stock to these lenders in connectionwith issuing the notes.  These notes wouldmature on February 28, 2006, and interest of 14.5% per year would be payable inkind for the first two years and in cash thereafter at 12.5% per year, subjectto certain conditions.  Obligationsunder the notes would be secured by a second-priority lien on substantially allof Cherokee's domestic assets.  Thelenders under the new credit agreement and the second lien notes includeaffiliates of Cherokee.  

 

Based on presentexpectations, the Company anticipates that the restructuring transactions willclose in November 2002 and that, as a result of the reduced principalamortization and cash debt service requirements, cash flow from operations andavailable borrowing capacity should be adequate to meet the Company'santicipated cash requirements for the next twelve months.  All of the restructuring transactions are,however, subject to closing conditions, including execution of definitivedocumentation, and the closings are cross conditioned.  Accordingly, if the exchange offer andconsent solicitation is not successful, or the refinancing of the existingcredit agreement is not consummated, the Company will be in default under thecredit agreement and will be in default under the indenture governing thesenior subordinated notes as a result of its failure to make the November 1,2002 interest payment thereon (currently scheduled to be paid upon consummationof the exchange offer and consent solicitation).  Even if the restructuring transactions are consummated, there canbe no assurances that the Company's operating and financial performance willimprove or that the other expected benefits of the restructuring will berealized.  If an event of default wereto occur under the credit agreement or the indenture governing the seniorsubordinated notes, the lenders under the credit agreement would becomeentitled to certain rights, including the right to accelerate the debt andforeclose on the collateral securing the obligations thereunder.  In addition, holders of the seniorsubordinated notes would be entitled to accelerate the obligations thereunder.

 

Because of the subjective acceleration clausesincluded in the August 2002 amendment to the credit agreement described above,combined with the uncertainties about the Company's ability to meet itsfinancial covenants for the next twelve months if the restructuringtransactions are not consummated, the Company has classified the long-termportion of its senior bank debt, as well as its subordinated debt and capitallease obligations (which contain cross default/acceleration terms), as currentliabilities at September 30, 2002 in accordance with FASB Technical Bulletin79-3, *Subjective Acceleration Clauses inLong-Term Debt Agreements*. The total long-term portions of debt andcapital lease obligations classified as current at September 30, 2002 were $134,708,714and $1,048,423, respectively.

 

9.             Unit Option Plan

 

Effective March 15, 2002, the Company has made anoffer to all option holders to cancel all outstanding options to purchase ClassB Units with an exercise price equal to or greater than $4.00 per unit inreliance on the Company’s intent to grant new options of an equal number priorto the end of fiscal 2002.  As a result of this offer, 2,126,500 of suchoptions were cancelled.

 

9

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

ITEM 2.       Management’s Discussion and Analysis of Financial Condition and Results ofOperations.

 

OVERVIEW

 

Cherokee is a leadingdesigner and manufacturer of a broad range of switch mode power supplies fororiginal equipment manufacturers (OEM’s) primarily in the telecommunications,networking and high-end workstation industries. The Company produces itsproducts and related components in sophisticated manufacturing facilitieslocated in Tustin and Irvine, California; Wavre, Belgium; Guadalajara, Mexico;and Bombay, India.

 

The principal elementscomprising cost of sales are raw materials, labor and manufacturing overhead.Raw materials account for a majority of cost of sales. Raw materials includemagnetic subassemblies, sheet metal, electronic and other components,mechanical parts and electrical wires. Labor costs include employee costs ofsalaried and hourly employees. Manufacturing overhead includes lease costs,depreciation on property, plant and equipment, utilities, property taxes andrepairs and maintenance.

 

Operating expensesinclude engineering costs, selling and marketing costs and administrativeexpenses. Engineering costs primarily include salaries and benefits ofengineering personnel, safety approval and quality certification fees,depreciation on equipment and subcontract costs for third party contractingservices. Selling and marketing expenses primarily include salaries andbenefits to account managers, commissions to independent sales representatives,and advertising costs. Administrative expenses primarily include salaries andbenefits for certain management and administrative personnel, professional feesand information system costs.

 

During the second quarterof 2002 the Company changed the classification of certain expenses incurred byCherokee Europe to be more consistent with the classification of similarexpenses incurred by the North American operations. Such expenses werereclassified for the three and nine month periods ended September 30, 2001 toconform with the presentation for the three and nine months ended September 30,2002.  See Note 1 of Notes to Condensed Consolidated Financial Statements.

 

During 2001 and the firstnine months of 2002, the Company continued to generate a significantportion of its sales from the communications market segment, particularly thenetworking and telecommunications sectors.   As a result ofunfavorable economic conditions and reduced capital spending by communicationservice providers that purchase our customers’ products, the Company’s salesdecreased in each quarter of 2001, compared to the immediately precedingquarter.  The Company has not experienced any significant improvement insales during 2002 and believes unstable and unpredictable economic and industryconditions may continue.  If these conditions persist, the Company’soperating results and financial condition could be adversely affected, whichcould result in failure by the Company to satisfy its debt obligations andacceleration of maturity of the Company's indebtedness.

 

RESULTS OF OPERATIONS

 

THREE MONTHS ENDED SEPTEMBER 30, 2002 COMPARED TOTHREE MONTHS ENDED SEPTEMBER 30, 2001

 

NET SALES

 

Net sales decreased byapproximately 9.2% or $2.4 million to $23.6 million for the three months endedSeptember 30, 2002 from last year’s $26.0 million for the three months endedSeptember 30, 2001.  Sales of our North American operations decreased byapproximately 19.1% or $2.7 million compared to the prior year, while sales ofCherokee Europe increased by approximately 2.2% or $0.3 million. The salesdecrease in North America was primarily due to lower customer demand as aresult of unfavorable economic conditions and reduced capital spending bycommunication service providers.

 

 

10

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GROSS PROFIT

 

Gross profit increased byapproximately 4.1% or $0.3 million to $6.5 million for the three months endedSeptember 30, 2002 from $6.2 million for the three months ended September 30,2001. Gross margin for the quarter increased to 27.4% from 23.9% in the prioryear’s quarter.

 

The increase in grossprofit was primarily due to increased gross profit contributed by CherokeeEurope due mainly to a more favorable product mix, partially offset by lowergross profit contributed by the North American operations resulting from thelower sales.  The increase in gross margin compared to the prior year wasprimarily a result of higher gross margins for Cherokee Europe due to thefavorable change in product mix.  Thegross margin for the North American operations was about even with the prioryear as the effect of a favorable change in product mix was substantiallyoffset by an increase in factory overhead expenses as a percentage of netsales.

 

OPERATING EXPENSES

 

Operating expenses forthe three months ended September 30, 2002 decreased by approximately 8.1% or$0.4 million to $4.6 million from $5.0 million for the three months endedSeptember 30, 2001. As a percentage of sales, operating expenses increased to19.5% from 19.3% in the prior year’s quarter.

 

The decrease in operatingexpenses was primarily attributable to the absence of goodwill amortization inthe current year’s quarter as a result of adopting SFAS No. 142 as of January1, 2002.  Amortization of goodwill in the prior year’s quarter wasapproximately $0.8 million.  This was partially offset by increases inengineering and development and selling and marketing expenses due primarily tovarious initiatives in 2002 relating to new product introductions and expansionof the Company’s customer base.

 

OPERATING INCOME

 

Operating incomeincreased by approximately 55.1% or $0.7 million to $1.9 million for the threemonths ended September 30, 2002 from $1.2 million for the three months endedSeptember 30, 2001. Operating margin increased to 7.9% for the quarter from4.6% in the prior year’s quarter.

 

Operating incomecontributed by Cherokee Europe in the third quarter increased from the prioryear due to the favorable change in product mix and the absence of goodwillamortization discussed above.  Operating income contributed by the NorthAmerican operations declined due primarily to the lower sales.  The increase in operating margin wasprimarily attributable to the absence of goodwill amortization.

 

INTEREST EXPENSE/DEBT RESTRUCTURING COSTS

 

Interest expense for thethree months ended September 30, 2002 was $3.7 million compared to $4.1 millionfor the three months ended September 30, 2001. The effect of decreased debt duringthe three months ended September 30, 2002 compared to the prior year’s quartercombined with lower interest rates on the Company’s revolver borrowings andterm loans in the current year compared to the prior year contributed to thedecrease in interest expense.

 

In connection with therestructuring transactions, the Company incurred approximately $937,500 ofcosts through September 30, 2002, of which $782,000 was directly expensed and$155,500 was capitalized as deferred financing costs.

 

NET LOSS

 

As a result of the itemsdiscussed above, the Company recorded a net loss of $2.7 million for the threemonths ended September 30, 2002 compared to a net loss of $2.8 million for thethree months ended September 30, 2001.

 

11

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NINE MONTHS ENDED SEPTEMBER 30, 2002 COMPARED TO NINEMONTHS ENDED SEPTEMBER 30, 2001

 

NET SALES

 

Net sales decreased byapproximately 25.2% or $24.8 million to $73.5 million for the nine months endedSeptember 30, 2002 from $98.3 million for the nine months ended September 30,2001.  Sales of our North American operations decreased by approximately33.6% or $19.4 million compared to the prior year, while sales of CherokeeEurope decreased by approximately 13.2% or $5.4 million. These decreases wereprimarily due to lower customer demand as a result of unfavorable economicconditions and reduced capital spending by communication service providers.

 

GROSS PROFIT

 

Gross profit decreased byapproximately 22.4% or $5.7 million to $19.6 million for the nine months endedSeptember 30, 2002 from $25.3 million for the nine months ended September 30,2001. Gross margin for the nine months ended September 30, 2002 increasedslightly to 26.7% from 25.7% in the prior year.

 

The decrease in grossprofit was primarily due to significantly lower gross profit contributed by theNorth American operations which was attributable to the lower sales, partiallyoffset by increased gross profit contributed by Cherokee Europe due mainly to amore favorable product mix.  The increase in gross margin compared to theprior year was primarily a result of the higher gross margins for CherokeeEurope due to the favorable change in product mix.  A lower gross margin for the North American operations was duemainly to an increase in factory overhead expenses as a percentage of netsales, partially offset by a favorable change in product mix.

 

OPERATING EXPENSES

 

Operating expenses forthe nine months ended September 30, 2002 decreased by approximately 14.3% or$2.2 million to $13.2 million from $15.4 million for the nine months endedSeptember 30, 2001. As a percentage of sales, operating expenses increased to18.0% from 15.7% in the prior year.

 

The decline in operatingexpenses was primarily attributable to decreased goodwill amortization of $2.3million as a result of adopting SFAS No. 142 as of January 1, 2002.  Reductions in our workforce and the effectof other cost control measures implemented mainly during 2001 in response tounfavorable economic conditions were substantially offset by an increase inselling and marketing expenses due primarily to various initiatives in 2002relating to new product introductions and expansion of the Company’s customerbase.

 

OPERATING INCOME

 

Operating incomedecreased by approximately 35.1% or $3.5 million to $6.4 million for the ninemonths ended September 30, 2002 from $9.9 million for the nine months endedSeptember 30, 2001. Operating margin decreased to 8.7% for the nine monthsended September 30, 2002 from 10.0% in the prior year.

 

The decrease in operatingincome was primarily attributable to a decline in operating income of the NorthAmerican operations due to the lower sales and decreased grossmargin.  Operating income contributed by Cherokee Europe increased from theprior year due to the favorable change in product mix and the absence ofgoodwill amortization discussed above.  The decrease in operating marginwas primarily attributable to higher operating expenses as a percentage ofsales.

 

INTEREST EXPENSE/DEBT RESTRUCTURING COSTS

 

Interest expense for thenine months ended September 30, 2002 was $11.2 million compared to $12.6million for the nine months ended September 30, 2001. The effect of decreaseddebt during the nine months ended September 30, 2002 compared to the prior yearcombined with lower interest rates on the Company’s revolver borrowings andterm loans in the current year compared to the prior year contributed to thedecrease in interest expense.

 

In connection with therestructuring transactions, the Company incurred approximately $937,500 ofcosts through September 30, 2002, of which $782,000 was directly expensed and$155,500 was capitalized as deferred financing costs.

 

12

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NET LOSS

 

As a result of the itemsdiscussed above, the Company recorded a $5.7 million net loss before thecumulative effect of a change in accounting principle for the nine months endedSeptember 30, 2002, compared to a net loss of $2.8 million for the nine months ended September 30, 2001.  Including the cumulative effect of a changein accounting principle: goodwill impairment of $34.6 million, which wasrecorded in connection with adopting SFAS No. 142 as of January 1, 2002, the netloss for the nine months ended September 30, 2002 was $40.3 million.

 

 

LIQUIDITY AND CAPITAL RESOURCES

 

CASH FLOWS

 

NINE MONTHS ENDED SEPTEMBER 30, 2002 COMPARED TO NINEMONTHS ENDED SEPTEMBER 30, 2001

 

Net cash provided byoperating activities was $7.9 million for the nine months ended September 30,2002 compared to $14.8 million for the nine months ended September 30, 2001.Cash provided by operating activities for 2002 reflects a net loss ofapproximately $40.3 million that includes a non-cash goodwill impairment chargeof $34.6 million, depreciation and amortization of $2.6 million,  a decrease in inventories of  $6.4million, and an increase of accrued interest payable of $2.3 million. Cashprovided by operating activities for 2001 reflects a net loss of approximately$2.8 million, depreciation and amortization of  $5.0 million, decreases of$11.0 million in accounts receivable and $10.7 million in inventory, and anincrease in accrued interest payable of $2.4 million, partially offset bydecreases of $11.0 million in accounts payable and $1.0 million in accruedcompensation and benefits.

 

Net cash used infinancing activities of $5.5 million for the nine months ended September 30,2002 primarily reflects a net reduction of $2.6 million in revolving creditborrowings and $1.8 million of payments on long-term debt.  Net cash usedin financing activities of $12.4 million for the nine months ended September30, 2001 primarily reflects $4.6 million of payments on long-term debt, anequity distribution of $2.1 million and net decrease in revolving creditborrowings of  $4.7 million.

 

LIQUIDITY

 

Historically, the Companyhas financed its operations with cash from operations supplemented byborrowings from credit facilities. The Company’s current and future liquidityneeds primarily arise from debt service on indebtedness, working capitalrequirements, capital expenditures and distributions to pay taxes.

 

The Company’s historicalcapital expenditures have substantially resulted from investments in equipmentto increase manufacturing capacity and improve manufacturing efficiencies. Forfiscal 2002, the Company expects capital expenditures to be approximately $1million.

 

As of September 30,2002, the Company’s borrowings consisted of $100 million of senior subordinatednotes and $50.8 million of borrowings under its various credit facilities,including $8.5 million drawn under its domestic revolving credit facility. TheCompany is not subject to any amortization requirements under the seniorsubordinated notes prior to maturity in 2009, but it is required to makescheduled principal payments under certain term loans.

 

In September 2001, theCompany's credit agreement was amended to waive the Company's failure to complywith certain financial covenants and to, among other things: (1) require that someof the Company's unitholders, or their equity members, guarantee up to $10.5million of the Company's obligations under the credit agreement, in exchangefor the Company being permitted to make the November 2001 and May 2002scheduled interest payments totaling $10.5 million on its $100 million ofsenior subordinated notes, (2) modify certain financial covenants from andafter September 2001 and (3) restrict the Company's ability to make itsinterest payment due in November 2002 relating to its senior subordinated notesuntil certain financial tests are satisfied.

 

In August 2002, theCompany's credit agreement was further modified to, among other things, waivecompliance with certain covenants.  In connection with that waiver,certain of the Company's unitholders, or their equity members, paid to thelenders the remaining $8.7 million of the $10.5 million guaranty ($1.8 millionof the guaranty was previously paid on July 1, 2002 to enable the Company tomeet the scheduled amortization payment under the credit agreement) and theCompany agreed to, among other things, (a) restructure its 101⁄2% seniorsubordinated notes in a manner satisfactory to the required lenders, (b)shorten the maturity date of the credit agreement, (c) reduce the size of therevolving loan commitment and (d) provide that approximately $8.1 million ofpayments under the $10.5 million guaranty referred to above will be applied toreduce term loans with the remainder applied to reduce revolving loans andoveradvance borrowings.  The $8.7 million guaranty payment would haveotherwise been payable in August 2002 as a result of the breach of financialcovenants under the credit agreement described above.  The guarantors aresubrogated to the rights of the lenders under the senior credit agreement, on abasis senior to the senior subordinated notes.

 

13

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                InOctober 2002, the Company began implementation of a plan to restructure itsexisting debt.  In connection with therestructuring plan, the Company intends to reincorporate as a Delawarecorporation by merging into its wholly owned subsidiary, Cherokee InternationalCorporation ("Cherokee"), the co-obligor on the senior subordinatednotes.  As part of the restructuringprogram, on October 28, 2002, Cherokee commenced an exchange offer and consentsolicitation, pursuant to which it offered to exchange the 101⁄2% seniorsubordinated notes for either (1) units, consisting of Cherokee's 51⁄4% seniorsecured notes and warrants to purchase shares of its common stock, or (2)Cherokee's 12% pay-in-kind senior secured convertible notes.  Obligations under the senior notes and thesenior convertible notes would be secured by third and fourth-priority liens,respectively, on substantially all of Cherokee's domestic assets.  In addition, Cherokee solicited consentsfrom holders of the senior subordinated notes to certain amendments to theindenture governing those notes that would, among other things, eliminatesubstantially all of the restrictive covenants in the indenture.  The exchange offer and consent solicitationis currently scheduled to expire on November 25, 2002.

 

                Inconnection with the exchange offer and consent solicitation, the Companyreceived commitments from various lenders to refinance its existing creditagreement.  In addition, the lendersunder the existing credit agreement waived the Company's non-compliance withcertain financial covenants as of September 30, 2002, subject to completion ofthe restructuring transactions.  Underthe commitments, upon repayment of certain outstanding amounts, the existingcredit agreement would be amended to provide for term loans in an aggregateprincipal amount of $5 million and a revolving credit facility with acommitment of up to $7.6 million, which would be undrawn at closing.  The credit agreement, as amended, wouldmature on November 30, 2005.  Inaddition, Cherokee would enter into a new credit agreement with a new lender thatwould provide for term loans in an aggregate principal amount of $10 million,with terms substantially identical to those under the amended creditfacility.  Interest on these creditagreements would be payable in cash based on LIBOR plus an applicable marginranging from 4.0% to 4.75%.  Obligationsunder the credit agreements would be secured by a first-priority lien onsubstantially all of Cherokee's domestic assets.  Under additional commitments, Cherokee would issue second-liennotes to certain lenders in an aggregate principal amount of approximately $41million and would also issue warrants to purchase shares of its common stock tothese lenders in connection with issuing the notes.  These notes would mature on February 28, 2006, and interest of14.5% per year would be payable in kind for the first two years and in cashthereafter at 12.5% per year, subject to certain conditions.  Obligations under the notes would be securedby a second-priority lien on substantially all of Cherokee's domesticassets.  The lenders under the newcredit agreement and the second lien notes include affiliates of Cherokee.  

 

                Basedon present expectations, the Company anticipates that the restructuringtransactions will close in November 2002 and that, as a result of the reducedprincipal amortization and cash debt service requirements, cash flow fromoperations and available borrowing capacity should be adequate to meet theCompany's anticipated cash requirements for the next twelve months.  All of the restructuring transactions are,however, subject to closing conditions, including execution of definitivedocumentation, and the closings are cross conditioned.  Accordingly, if the exchange offer andconsent solicitation is not successful, or the refinancing of the existingcredit agreement is not consummated, the Company will be in default under thecredit agreement and will be in default under the indenture governing thesenior subordinated notes as a result of its failure to make the November 1,2002 interest payment thereon (currently scheduled to be paid upon consummationof the exchange offer and consent solicitation).  Even if the restructuring transactions are consummated, there canbe no assurances that the Company's operating and financial performance willimprove or that the other expected benefits of the restructuring will berealized.  If an event of default wereto occur under the credit agreement or the indenture governing the seniorsubordinated notes, the lenders under the credit agreement would becomeentitled to certain rights, including the right to accelerate the debt andforeclose on the collateral securing the obligations thereunder.  In addition, holders of the seniorsubordinated notes would be entitled to accelerate the obligations thereunder. 

 

Inthe event any 101⁄2% senior subordinated notes remain outstanding after therestructuring transactions are complete, Cherokee may from time to time seek torepurchase the notes through open market or privately negotiated transactions,additional exchange or tender offers or otherwise as permitted by law and itsother debt instruments on terms that may differ materially from the terms ofthe exchange offer and consent solicitation. In addition, in the future, Cherokee may seek to further reduce itsoutstanding debt obligations by repurchasing or exchanging any of its otherthen-outstanding debt securities.

 

Because of the subjectiveacceleration clauses included in the August 2002 amendment to the creditagreement described above, combined with the uncertainties about the Company'sability to meet its financial covenants for the next twelve months if therestructuring transactions are not consummated, the Company has classified thelong-term portion of its senior bank debt, as well as its subordinated debt andcapital lease obligations (which contain cross default/acceleration terms), ascurrent liabilities at September 30, 2002 in accordance with FASB TechnicalBulletin 79-3, *Subjective AccelerationClauses in Long-Term Debt Agreements*. The total  long-term portions of debt and capital leaseobligations classified as current at September 30, 2002 were $134,708,714 and$1,048,423, respectively.

 

NEW ACCOUNTING PRONOUNCEMENTS

 

In June 2001, the FASBissued SFAS No. 141, “Business Combinations”, and SFAS No. 142, “Goodwill andOther Intangible Assets”.  The Company has adopted SFAS No. 141 and SFASNo. 142 effective January 1, 2002.  See Note 7 of Notes to CondensedConsolidated Financial Statements.

 

In August 2001, the FASBissued SFAS No. 144, “Accounting for Impairment or Disposal of Long-LivedAssets.” This statement addresses financial accounting and reporting for theimpairment of long-lived assets and for long-lived assets to be disposed of.SFAS No. 144 supersedes SFAS No. 121, “Accounting for the Impairment ofLong-Lived Assets and for Long-Lived Assets to be Disposed of,” and

 

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is effective for fiscal years beginning after December15, 2001. The adoption of this standard at January 1, 2002 did not have amaterial impact on the Company’s financial position and results of operations.

 

In July 2002, the FASBissued SFAS No. 146, “Accounting for Costs Associated with Exit orDisposal Activities,” which addresses financial accounting and reporting forcosts associated with exit or disposal activities and supersedes EITF Issue94-3, “Liability Recognition for Certain Employee Termination Benefits andOther Costs to Exit an Activity (including Certain Costs Incurred in aRestructuring).”  SFAS No. 146 requires that a liability for a costassociated with an exit or disposal activity be recognized when the liabilityis incurred.  Under Issue 94-3, a liability for an exit cost as defined inEITF 94-3 was recognized at the date of an entity’s commitment to an exitplan.  SFAS No. 146 also establishes that the liability should initiallybe measured and recorded at fair value.  The Company will adopt theprovisions of SFAS No. 146 for exit or disposal activities that areinitiated after December 31, 2002.

 

FORWARD-LOOKING STATEMENTS

 

Statements in this reportcontaining the words “believes,” “anticipates,”, “expects,” and words ofsimilar meaning, and any other statements which may be construed as aprediction of future performance or events, constitute “forward-lookingstatements” within the meaning of the Private Securities Litigation Reform Actof 1995. Such forward-looking statements involve known and unknown risks,uncertainties, and other factors that may cause the actual results,performance, or achievements of the Company, or industry results, to bematerially different from any future results, performance, or achievementsexpressed or implied by such forward-looking statements. Such factors include,among others, (1) restrictions imposed by the Company’s substantial leverageand restrictive covenants in its debt agreements, (2) reductions in sales to orthe loss of any of the Company’s significant customers or in customer capacitygenerally, (3) changes in the Company’s sales mix to lower margin products, (4)significant competition, (5) disruptions of the Company’s established supply channels,(6) changes in general economic and business conditions domestically andinternationally, (7) changes in political, social and economic conditions andlocal regulations with respect to the Company's international operations, and(8) the additional risk factors identified in the Company’s Annual Report onForm 10-K dated December 31, 2001 and those described from time to time in theCompany’s other filings with the SEC, press releases and other communications.The Company disclaims any obligations to update any such factors or to announcepublicly the result of any revisions to any of the forward-looking statementscontained or incorporated by reference herein to reflect future events ordevelopments.

 

 

ITEM 3.      QUANTITATIVE ANDQUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

Market risks relating toour operations result primarily from changes in short-term interest rates. TheCompany did not have any derivative financial instruments at September 30,2002.

 

The Company’s exposure tomarket risk for changes in interest rates relates primarily to its currentdomestic credit facility. In accordance with the credit facility, the Companyenters into variable rate debt obligations to support general corporatepurposes, including capital expenditures and working capital needs. The Companycontinuously evaluates its level of variable rate debt with respect to totaldebt and other factors, including assessment of the current and future economicenvironment.

 

The Company hadapproximately $51 million in variable rate debt outstanding at September 30,2002. Based upon these variable rate debt levels, a hypothetical 10% adversechange in interest rates would increase interest expense by approximately $0.4million on an annual basis, and likewise decrease our earnings and cash flows.The Company cannot predict market fluctuations in interest rates and theirimpact on its variable rate debt, nor can there be any assurance that fixedrate long-term debt will be available to the Company at favorable rates, if atall. Consequently, future results may differ materially from the estimatedadverse changes discussed above.

 

As a result of theCherokee Europe acquisition in June 2000, the Company has European operationsand is, therefore, subject to a certain degree of market risk associated withchanges in foreign currency exchange rates. The Company has not activelyengaged in exchange rate hedging activities.

 

ITEM 4.          CONTROLS AND PROCEDURES

 

                (a) Evaluation of DisclosureControls and Procedures.  The Company'sChief Executive Officer and Chief Financial Officer have evaluated theeffectiveness of the Company's disclosure controls and procedures (as such termis defined in Rules 13a-14(c) and 15d-14(c) under the Securities Exchange Actof 1934, as amended (the "Exchange Act")) as of a date within 90 daysprior to the filing date of this quarterly report (the "EvaluationDate").  Based on such evaluation,such officers have concluded that, as of the Evaluation Date, the Company'sdisclosure controls and procedures are effective in alerting them on a timelybasis to material information relating to the Company (including itsconsolidated subsidiaries) required to be included in the Company's reportsfiled or submitted under the Exchange Act.

 

(b)  Changes inInternal Controls.  Since the EvaluationDate, there have not been any significant changes in the Company's internalcontrols or in other factors that could significantly affect such controls.

 

 

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PARTII.          OTHER INFORMATION

 

ITEM1.           LEGALPROCEEDINGS

 

The Company is subject todisputes and potential claims by third parties that are incidental to theconduct of its business. The Company does not believe that the outcome of anysuch matters pending at September 30, 2002 will have a material adverse effecton its financial condition or results of operations.

 

ITEM6.           EXHIBITS ANDREPORTS ON FORM 8-K
| (a)    |   | EXHIBITS:                                                                                                                                                          |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                               |
| 3.1*   |   | Second Amended and  Restated Operating Agreement of Cherokee International, LLC, dated as of  April 30, 1999.                                                      |
|   |   |                                                                                                                                                               |
| 3.2*   |   | Amendment No. 1 to the  Second Amended and Restated Operating Agreement of Cherokee International,  LLC, dated as of June 28, 1999.                                |
|   |   |                                                                                                                                                               |
| 3.3*   |   | Amendment No. 2 to the  Second Amended and Restated Operating Agreement of Cherokee International,  LLC, dated as of June 28, 1999.                                |
|   |   |                                                                                                                                                               |
| 3.4**  |   | Amendment No. 3 to the  Second Amended and Restated Operating Agreement of Cherokee International,  LLC, dated as of June 12, 2000.                                |
|   |   |                                                                                                                                                               |
| 3.5**  |   | Amendment No. 4 to the  Second Amended and Restated Operating Agreement of Cherokee International,  LLC, dated as of June 14, 2000.                                |
|   |   |                                                                                                                                                               |
| 3.6    |   |  Amendment No. 5  to the Second Amended and Restated Operating Agreement of Cherokee  International, LLC, dated as of September 26, 2001.                     |
|   |   |                                                                                                                                                               |
| 10.1   |   | Agreement, dated as of  October 27, 2002, among Cherokee International, LLC, Cherokee International  Corporation and each Consenting Noteholder signatory thereto. |
|   |   |                                                                                                                                                               |
| 99.1   |   | Certification of Chief  Executive Officer and Chief Financial Officer.                                                                                             |
|   |   |                                                                                                                                                               |
| (b)    |   | REPORTS ON FORM 8-K

None                                                                                                                                          |

 

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| *      |   | Incorporated by  reference to designated exhibit to the Company’s Registration  Statement  on Form S-4 (File No. 333-82713). |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                   |
| **     |   | Incorporated by  reference to designated exhibit to the Company’s Quarterly  Report on  Form 10-Q, dated July 2, 2000.       |

 

 

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SIGNATURES

 

Pursuant to therequirements of the Securities Exchange Act of 1934, as amended, the registranthas duly caused this report to be signed on its behalf by the undersignedthereunto duly authorized.

 
|                    | Cherokee International,  LLC  |
|-------------------------|-------------------------------|
|                    |                          |
| Date: November 13, 2002 | /s/ R. Van Ness  Holland, Jr. |   |
|                    |                          |
|                    | R. Van Ness Holland,  Jr.     |
|                    | Chief Financial Officer       |

 

 

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CERTIFICATIONS

I, Jeffrey M. Frank, certifythat:

 

1.                                       I have reviewedthis quarterly report on Form 10-Q of Cherokee International, LLC;

2.                                       Based on myknowledge, this quarterly report does not contain any untrue statement of amaterial fact or omit to state a material fact necessary to make the statementsmade, in light of the circumstances under which such statements were made, notmisleading with respect to the period covered by this quarterly report;

3.                                       Based on myknowledge, the financial statements, and other financial information includedin this quarterly report, fairly present in all material respects the financialcondition, results of operations and cash flows of the registrant as of, andfor, the periods presented in this quarterly report;

4.                                       Theregistrant's other certifying officers and I are responsible for establishingand maintaining disclosure controls and procedures (as defined in Exchange ActRules 13a-14 and 15d-14) for the registrant and we have:

a)                                      Designed suchdisclosure controls and procedures to ensure that material information relatingto the registrant, including its consolidated subsidiaries, is made known to usby others within those entities, particularly during the period in which thisquarterly report is being prepared;

b)                                     Evaluated theeffectiveness of the registrant's disclosure controls and procedures as of adate within 90 days prior to the filing date of this quarterly report (the"Evaluation Date"); and

c)                                      Presented inthis quarterly report our conclusions about the effectiveness of the disclosurecontrols and procedures based on our evaluation as of the Evaluation Date;

5.                                       Theregistrant's other certifying officers and I have disclosed, based on our mostrecent evaluation, to the registrant's auditors and the audit committee ofregistrant's board of directors (or persons performing the equivalentfunction):

a)                                      All significantdeficiencies in the design or operation of internal controls which couldadversely affect the registrant's ability to record, process, summarize andreport financial data and have identified for the registrant's auditors anymaterial weaknesses in internal controls; and 

b)                                     Any fraud,whether or not material, that involves management or other employees who have asignificant role in the registrant's internal controls; and 

6.                                       Theregistrant's other certifying officers and I have indicated in this quarterlyreport whether or not there were significant changes in internal controls or inother factors that could significantly affect internal controls subsequent tothe date of our most recent evaluation, including any corrective actions withregard to significant deficiencies and material weaknesses.

 
| Date:  November 13, 2002 |   |   | /s/ Jeffrey M. Frank    |
|-------------------------------|--------|--------|-------------------------|
|                          |   |   | Jeffrey M. Frank        |
|                          |   |   | Chief Executive Officer |

 

 

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I, R. Van Ness Holland, certify that:

 

1.                                       I have reviewedthis quarterly report on Form 10-Q of Cherokee International, LLC;

2.                                       Based on myknowledge, this quarterly report does not contain any untrue statement of amaterial fact or omit to state a material fact necessary to make the statementsmade, in light of the circumstances under which such statements were made, notmisleading with respect to the period covered by this quarterly report;

3.                                       Based on myknowledge, the financial statements, and other financial information includedin this quarterly report, fairly present in all material respects the financialcondition, results of operations and cash flows of the registrant as of, andfor, the periods presented in this quarterly report;

4.                                       Theregistrant's other certifying officers and I are responsible for establishingand maintaining disclosure controls and procedures (as defined in Exchange ActRules 13a-14 and 15d-14) for the registrant and we have:

a)                                      Designed suchdisclosure controls and procedures to ensure that material information relatingto the registrant, including its consolidated subsidiaries, is made known to usby others within those entities, particularly during the period in which thisquarterly report is being prepared;

b)                                     Evaluated theeffectiveness of the registrant's disclosure controls and procedures as of adate within 90 days prior to the filing date of this quarterly report (the"Evaluation Date"); and

c)                                      Presented inthis quarterly report our conclusions about the effectiveness of the disclosurecontrols and procedures based on our evaluation as of the Evaluation Date;

5.                                       Theregistrant's other certifying officers and I have disclosed, based on our mostrecent evaluation, to the registrant's auditors and the audit committee ofregistrant's board of directors (or persons performing the equivalentfunction):

a)                                      All significantdeficiencies in the design or operation of internal controls which couldadversely affect the registrant's ability to record, process, summarize andreport financial data and have identified for the registrant's auditors anymaterial weaknesses in internal controls; and 

b)                                     Any fraud,whether or not material, that involves management or other employees who have asignificant role in the registrant's internal controls; and 

6.                                       Theregistrant's other certifying officers and I have indicated in this quarterlyreport whether or not there were significant changes in internal controls or inother factors that could significantly affect internal controls subsequent tothe date of our most recent evaluation, including any corrective actions withregard to significant deficiencies and material weaknesses.
| Date:  November 13, 2002 |   |   | /s/ R. Van Ness Holland,  Jr. |
|-------------------------------|--------|--------|-------------------------------|
|                          |   |   | R. Van Ness Holland, Jr.      |
|                          |   |   | Chief Financial Officer       |

 

 

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