**UNITEDSTATES********SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C.  20549**

 

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**FORM 10-Q**

 

**ý****  QUARTERLY REPORT PURSUANT TOSECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**Forthe quarterly period ended April 3, 2005**

 

**OR**

 

**o****  TRANSITION REPORT PURSUANT TOSECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**Forthe transition period from                     to                    **

 

**Commission file****number 000-50593**

 

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**CHEROKEEINTERNATIONAL CORPORATION**

(Exact name ofRegistrant as specified in its charter)

 
| **Delaware**                                                     | ** ** | **95-4745032**                           |
|------------------------------------------------------------------|------------|------------------------------------------|
| (State or other  jurisdiction of  incorporation or organization) |       | (I.R.S. Employer  Identification Number) |
|                                                             |       |                                     |
| **2841  Dow Avenue, Tustin, California**                         | ** ** | **92780**                                |
| (Address of  principal executive office)                         |       | (Zip Code)                               |

 

**(714)544-6665**

(Registrant’stelephone number, including area code)

 

**N/A**

(Former name,former address and former fiscal year, if changed since last report)

 

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Indicate by check markwhether the registrant: (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding 12months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements forthe past 90 days:   Yes   ý          No   o

 

Indicate by check markwhether the registrant is an accelerated filer (as defined in Rule 12b-2of the Exchange Act). Yes   o          No   ý

 

As of April 30,2005, 19,206,207 shares of the registrant’s common stock, $0.001 par value,were outstanding.

 

 

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TABLE OF CONTENTS

 
| PART I  FINANCIAL INFORMATION                                                                   | 3      |
|------------------------------------------------------------------------------------------------------|--------|
|                                                                                                 |   |
| Item  1. Condensed Consolidated Financial Statements (unaudited):                                    | 3      |
|                                                                                                 |   |
| Condensed  Consolidated Balance Sheets                                                               | 3      |
|                                                                                                 |   |
| Condensed  Consolidated Statements of Operations                                                     | 4      |
|                                                                                                 |   |
| Condensed  Consolidated Statements of Comprehensive Operations                                       | 5      |
|                                                                                                 |   |
| Condensed  Consolidated Statements of Cash Flows                                                     | 6      |
|                                                                                                 |   |
| Notes  to Condensed Consolidated Financial Statements                                                | 7      |
|                                                                                                 |   |
| Item  2. Management’s Discussion and Analysis of Financial Condition and Results of  Operations | 15     |
|                                                                                                 |   |
| Item  3. Quantitative and Qualitative Disclosures About Market Risk                                  | 21     |
|                                                                                                 |   |
| Item 4. Controls and  Procedures                                                                     | 22     |
|                                                                                                 |   |
| PART II OTHER  INFORMATION                                                                      | 22     |
|                                                                                                 |   |
| Item 1. Legal Proceedings                                                                            | 22     |
|                                                                                                 |   |
| Item  2. Unregistered Sales of Equity Securities and Use of Proceeds                                 | 22     |
|                                                                                                 |   |
| Item  6. Exhibits                                                                                    | 23     |
|                                                                                                 |   |
| Signatures                                                                                           | 24     |

 

2

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PART I.  FINANCIAL INFORMATION

 

**Item 1.****  Condensed Consolidated FinancialStatements.**

 

CHEROKEE INTERNATIONALCORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATEDBALANCE SHEETS

(In Thousands, ExceptShare Data)

(Unaudited)

 
| ** **                                                                                                                                                 | ** ** | **March 31,  2005** | ** ** | **December 31,  2004** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
|                                                                                                                                                       |       |                     |       |                        |       |
| ASSETS                                                                                                                                                     |       |                     |       |                        |       |
| CURRENT ASSETS:                                                                                                                                            |       |                     |       |                        |       |
| Cash and cash  equivalents                                                                                                                                 |       | $                        | 16,122     |                        | $          | 14,585 |   |
| Short-term  investments                                                                                                                                    |       | 5,162                    |       | 4,178                       |       |
| Accounts  receivable, net                                                                                                                                  |       | 25,529                   |       | 27,929                      |       |
| Inventories, net                                                                                                                                           |       | 28,333                   |       | 28,278                      |       |
| Prepaid expenses  and other current assets                                                                                                                 |       | 1,719                    |       | 2,056                       |       |
| Total current  assets                                                                                                                                      |       | 76,865                   |       | 77,026                      |       |
|                                                                                                                                                       |       |                     |       |                        |       |
| Property and  equipment, net                                                                                                                               |       | 15,067                   |       | 15,028                      |       |
| Deposits and  other assets                                                                                                                                 |       | 1,224                    |       | 965                         |       |
| Deferred  financing costs, net                                                                                                                             |       | 443                      |       | 476                         |       |
| Goodwill                                                                                                                                                   |       | 6,317                    |       | 6,317                       |       |
|                                                                                                                                                       |       |                     |       |                        |       |
|                                                                                                                                                       |       | $                        | 99,916     |                        | $          | 99,812 |   |
| LIABILITIES AND  STOCKHOLDERS’ EQUITY                                                                                                                 |       |                     |       |                        |       |
| CURRENT  LIABILITIES:                                                                                                                                      |       |                     |       |                        |       |
| Accounts payable                                                                                                                                           |       | $                        | 12,093     |                        | $          | 12,803 |   |
| Accrued  liabilities                                                                                                                                       |       | 8,470                    |       | 6,733                       |       |
| Accrued  compensation and benefits                                                                                                                         |       | 6,442                    |       | 6,987                       |       |
| Accrued  restructuring costs                                                                                                                               |       | 246                      |       | 259                         |       |
| Total current  liabilities                                                                                                                                 |       | 27,251                   |       | 26,782                      |       |
|                                                                                                                                                       |       |                     |       |                        |       |
| Long-term debt,  net of current portion                                                                                                                    |       | 46,630                   |       | 46,630                      |       |
| Other long-term  obligations                                                                                                                               |       | 4,222                    |       | 4,266                       |       |
|                                                                                                                                                       |       |                     |       |                        |       |
| COMMITMENTS AND  CONTINGENCIES (Note 10)                                                                                                                   |       |                     |       |                        |       |
|                                                                                                                                                       |       |                     |       |                        |       |
| STOCKHOLDERS’  EQUITY:                                                                                                                                |       |                     |       |                        |       |
| Preferred stock:  $0.001 par value; 10,000,000 shares authorized; none issued and outstanding                                                              |       | —                   |       | —                      |       |
| Common stock:  $0.001 par value; 60,000,000 shares authorized; 19,206,207 shares issued and  outstanding at March 31, 2005 and December 31, 2004 |       | 19                       |       | 19                          |       |
|                                                                                                                                                       |       |                     |       |                        |       |
| Paid-in capital                                                                                                                                            |       | 183,713                  |       | 183,713                     |       |
| Accumulated  deficit                                                                                                                                       |       | (165,041                 | )          | (165,666                    | )          |
| Accumulated  other comprehensive income                                                                                                                    |       | 3,122                    |       | 4,068                       |       |
|                                                                                                                                                       |       |                     |       |                        |       |
| Net  stockholders’ equity                                                                                                                             |       | 21,813                   |       | 22,134                      |       |
|                                                                                                                                                       |       |                     |       |                        |       |
|                                                                                                                                                       |       | $                        | 99,916     |                        | $          | 99,812 |   |

 

See notes to condensed consolidated financial statements.

 

3

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CHEROKEE INTERNATIONALCORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATEDSTATEMENTS OF OPERATIONS

(In Thousands, Except PerShare Amounts)

(Unaudited)

 
| ** **                                   | ** ** | **Three Months Ended**   | ** ** |
|----------------------------------------------|------------|--------------------------|------------|
| ** **                                   | ** ** | **March 31,  2005** | ** ** | **March 31,  2004** | ** ** |
|                                         |       |                     |       |   |   |
| Net sales                                    |       | $                        | 32,010     |   | $ | 36,832 |   |
| Cost of sales                                |       | 24,368                   |       | 24,909 |   |
| Gross profit                                 |       | 7,642                    |       | 11,923 |   |
| Operating  Expenses:                         |       |                     |       |   |   |
| Engineering and  development                 |       | 2,356                    |       | 2,331 |   |
| Selling and  marketing                       |       | 1,962                    |       | 1,830 |   |
| General and  administrative                  |       | 3,220                    |       | 2,087 |   |
| Gain from  insurance proceeds                |       | (2,490                   | )          | — |   |
| Total operating  expenses                    |       | 5,048                    |       | 6,248 |   |
|                                         |       |                     |       |   |   |
| Operating income                             |       | 2,594                    |       | 5,675 |   |
|                                         |       |                     |       |   |   |
| Interest expense                             |       | (694                     | )          | (3,081 | ) |
| Other income  (expense), net                 |       | (27                      | )          | (3 | ) |
|                                         |       |                     |       |   |   |
| Income before  income taxes                  |       | 1,873                    |       | 2,591 |   |
| Provision for  income taxes                  |       | 1,248                    |       | 431 |   |
| Net income                                   |       | $                        | 625        |   | $ | 2,160 |   |
|                                         |       |                     |       |   |   |
| Net income per  share:                       |       |                     |       |   |   |
| Basic                                        |       | $                        | 0.03       |   | $ | 0.23 |   |
| Diluted                                      |       | $                        | 0.03       |   | $ | 0.20 |   |
|                                         |       |                     |       |   |   |
| Weighted average  common shares outstanding: |       |                     |       |   |   |
| Basic                                        |       | 19,206                   |       | 9,299 |   |
| Diluted                                      |       | 19,408                   |       | 15,931 |   |

 

See notes to condensed consolidated financial statements.

 

4

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CHEROKEE INTERNATIONALCORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATEDSTATEMENTS OF COMPREHENSIVE OPERATIONS

(In Thousands)

(Unaudited)

 
| ** **                                | ** ** | **Three Months Ended**   | ** ** |
|-------------------------------------------|------------|--------------------------|------------|
| ** **                                | ** ** | **March 31,  2005** | ** ** | **March 31,  2004** | ** ** |
|                                      |       |                     |       |   |   |
| Net income                                |       | $                        | 625        |   | $ | 2,160 |   |
| Other  comprehensive loss:                |       |                     |       |   |   |
| Foreign currency  translation adjustments |       | (946                     | )          | (302 | ) |
| Comprehensive  income (loss)              |       | $                        | (321       | ) | $ | 1,858 |   |

 

See notes to condensed consolidated financial statements.

 

5

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CHEROKEE INTERNATIONALCORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATEDSTATEMENTS OF CASH FLOWS

(In Thousands)

(Unaudited)

 
| ** **                                                                                   | ** ** | **Three Months Ended**   | ** ** |
|----------------------------------------------------------------------------------------------|------------|--------------------------|------------|
| ** **                                                                                   | ** ** | **March 31,  2005** | ** ** | **March 31,  2004** | ** ** |
|                                                                                         |       |                     |       |   |   |
| CASH FLOWS FROM  OPERATING ACTIVITIES:                                                       |       |                     |       |   |   |
| Net income                                                                                   |       | $                        | 625        |   | $ | 2,160 |   |
| Adjustments to  reconcile net income to net cash provided by (used in) operating activities: |       |                     |       |   |   |
| Depreciation and  amortization                                                               |       | 769                      |       | 881 |   |
| Amortization of  deferred financing costs                                                    |       | 32                       |       | 55 |   |
| Write-off of  unamortized deferred financing costs and debt discount                         |       | —                   |       | 224 |   |
| Net change in  operating assets and liabilities:                                             |       |                     |       |   |   |
| Accounts  receivable, net                                                                    |       | 1,756                    |       | 1,131 |   |
| Inventories, net                                                                             |       | (442                     | )          | 614 |   |
| Prepaid expenses  and other current assets                                                   |       | 273                      |       | (1,988 | ) |
| Deposits and  other assets                                                                   |       | (260                     | )          | (71 | ) |
| Accounts payable                                                                             |       | (351                     | )          | 164 |   |
| Accrued  liabilities and restructuring costs                                                 |       | 1,237                    |       | (1,201 | ) |
| Accrued  compensation and benefits                                                           |       | (308                     | )          | (954 | ) |
| Accrued interest  payable                                                                    |       | 610                      |       | 298 |   |
| Other long-term  obligations                                                                 |       | 125                      |       | (1,830 | ) |
| Net cash  provided by (used in) operating activities                                         |       | 4,066                    |       | (517 | ) |
|                                                                                         |       |                     |       |   |   |
| CASH FLOWS FROM  INVESTING ACTIVITIES:                                                       |       |                     |       |   |   |
| Additions to  property and equipment                                                         |       | (1,185                   | )          | (1,148 | ) |
| Net change in  short-term investments                                                        |       | (984                     | )          | (8 | ) |
| Net cash used in  investing activities                                                       |       | (2,169                   | )          | (1,156 | ) |
|                                                                                         |       |                     |       |   |   |
| CASH FLOWS FROM  FINANCING ACTIVITIES:                                                       |       |                     |       |   |   |
| Borrowings on  revolving lines of credit                                                     |       | —                   |       | 11,301 |   |
| Payments on  revolving lines of credit                                                       |       | —                   |       | (17,433 | ) |
| Payments on  obligations under capital leases                                                |       | —                   |       | (306 | ) |
| Payments on  long-term debt                                                                  |       | —                   |       | (65,519 | ) |
| Deferred  financing costs                                                                    |       | —                   |       | (175 | ) |
| Proceeds from  the exercise of warrants and stock options                                    |       | —                   |       | 16 |   |
| Net proceeds from sale of common stock                                                       |       | —                   |       | 89,001 |   |
| Net cash  provided by financing activities                                                   |       | —                   |       | 16,885 |   |
|                                                                                         |       |                     |       |   |   |
| Cash effect of  exchange rate changes                                                        |       | (360                     | )          | (35 | ) |
|                                                                                         |       |                     |       |   |   |
| Net increase in  cash and cash equivalents                                                   |       | 1,537                    |       | 15,177 |   |
| Cash and cash  equivalents, beginning of period                                              |       | 14,585                   |       | 4,887 |   |
|                                                                                         |       |                     |       |   |   |
| Cash and cash  equivalents, end of period                                                    |       | $                        | 16,122     |   | $ | 20,064 |   |
|                                                                                         |       |                     |       |   |   |
| SUPPLEMENTAL  INFORMATION                                                                    |       |                     |       |   |   |
| Conversion of  senior convertible notes into common stock                                    |       | $                        | —     |   | $ | 53,370 |   |
| Accrued initial  public offering costs netted against paid-in capital                        |       | —                   |       | 2,531 |   |

 

See notes to condensed consolidated financial statements.

 

6

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CHEROKEE INTERNATIONALCORPORATION AND SUBSIDIARIES

NOTES TO CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

1.                                       Natureof Operations

 

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

 

*InitialPublic Offering*

 

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

 

2.                                       Basisof Presentation and Summary of Significant Accounting Policies

 

*Basisof Presentation*

 

The information set forthin the accompanying condensed consolidated financial statements is unauditedand, in the opinion of management, reflects all adjustments, consisting only ofnormal recurring adjustments, considered necessary to present fairly thefinancial position, results of operations and cash flows of the Company for theperiods indicated.

 

Results of operations forthe interim three months ended March 31, 2005 and 2004 are not necessarilyindicative of the results of operations for the full fiscal year. The Company’sfirst quarter represented the 13-week periods ended on April 3, 2005 and March 28,2004. For presentation purposes, these fiscal quarters have been referred to asending on March 31.

 

The condensedconsolidated financial statements include the financial statements of theCompany and its wholly owned subsidiaries. All intercompany accounts andtransactions have been eliminated.

 

Certain informationnormally included in footnote disclosures to the financial statements has beencondensed or omitted in accordance with the rules and regulations of theSecurities and Exchange Commission. Accordingly, the financial statements donot include all the information and note disclosures normally included inannual consolidated financial statements prepared in accordance with accountingprinciples generally accepted in the United States of America. These unauditedcondensed consolidated financial statements should be read in conjunction withthe other disclosures contained herein and with the Company’s auditedconsolidated financial statements and notes thereto for the year ended December 31,2004, contained in the Company’s Annual Report on Form10-K (File No. 000-50593) filed on April 1, 2005.

 

*Useof Estimates*

 

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

 

7

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*Stock-BasedCompensation*

 

As permitted by SFAS No. 123,“Accounting for Stock-Based Compensation,” the Company accounts for itsemployee stock-based compensation plan using the intrinsic value method underAPB Opinion No. 25, “Accounting for Stock Issued to Employees,” andprovides the expanded disclosures specified in SFAS No. 123, as amended bySFAS No. 148, “Accounting for Stock-Based Compensation—Transition andDisclosure.”

 

The table belowreconciles net income as reported and pro forma net income had compensationcost been determined using the provisions of SFAS No. 123 for the threemonths ended March 31, 2005 and 2004 (in thousands, except per sharedata):

 
| ** **                                                                                                                | ** ** | **March 31,  2005** | ** ** | **March 31,  2004** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|--------------------------|------------|
| Net income as reported                                                                                                    | ** ** | $                        | 625        | ** **               | $          | 2,160 | ** ** |
| Stock-based  employee compensation included in net income, net of tax                                                     |       | —                   |       | —                   |       |
| Total  stock-based employee compensation expense determined under the fair value  based method for all awards, net of tax |       | (291                     | )          | (117                     | )          |
| Net income – pro  forma                                                                                              |       | $                        | 334        |                     | $          | 2,043 |   |
| Pro forma net  income per share:                                                                                          |       |                     |       |                     |       |
| Basic                                                                                                                     |       | $                        | 0.02       |                     | $          | 0.22 |   |
| Diluted                                                                                                                   |       | $                        | 0.02       |                     | $          | 0.19 |   |

 

For the purpose of estimatingthe compensation cost of the Company’s option grants in accordance with SFAS No. 123,the fair value of each option grant is estimated on the date of grant using theBlack-Scholes option-pricing model. The number of shares to be granted underthe employee stock purchase plan is estimated until the period in whichsettlement occurs, as the actual number of shares awarded and purchase priceare not known until settlement.

 

*Translationof Foreign Currency*

 

Foreign subsidiary assetsand liabilities denominated in foreign currencies are translated at theexchange rate on the balance sheet date.  Revenues, costs and expenses aretranslated at the average exchange rate during the period.  Transactiongains and losses are included in results of operations and have not beensignificant for the periods presented.  The functional currency of theCompany’s operating subsidiary in Europe, Cherokee Europe SCA (“Cherokee Europe”),is the Euro.  The functional currency of the Company’s operatingsubsidiaries in Mexico (Cherokee Electronica, S.A. DE C.V.) and in India(Cherokee India Pvt. Ltd. and Powertel India Pvt. Ltd.) is the U.S. dollar, asthe majority of transactions are denominated in U.S. dollars.  Translationadjustments related to Cherokee Europe are reflected as a component ofstockholders’ equity in accumulated other comprehensive income.

 

8

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*RecentAccounting Pronouncements*

 

In November 2004,the Financial Accounting Standards Board (“FASB”) issued SFAS No. 151, “InventoryCosts—an amendment of ARB No. 43, Chapter 4.” This statement amends theguidance in ARB No. 43, Chapter 4, “Inventory Pricing,” to clarify theaccounting for abnormal amounts of idle facility expense, freight, handlingcosts, and wasted material (spoilage). Abnormal amounts of these costs shouldbe recognized as current period charges rather than as a portion of inventorycosts. In addition, SFAS 151 requires that allocation of fixed productionoverheads to the costs of manufacturing be based on the normal capacity of theproduction facilities. The provisions of SFAS 151 are effective for inventorycosts incurred during fiscal years beginning after June 15, 2005. TheCompany is currently evaluating the effect that the adoption of this new standardmay have on the Company’s consolidated financial position and results ofoperations.

 

In December 2004,the FASB issued SFAS 123R (Revised 2004), “Share-Based Payment,” which requiresthat the compensation cost relating to share-based payment transactions berecognized in financial statements based on the fair value of the award on thedate of grant. The cost will be recognized over the period during which theemployee is required to provide service in exchange for the award (usually thevesting period). The Company currently discloses pro forma compensation expensequarterly and annually. Upon adoption, the pro forma disclosures previouslypermitted under SFAS 123 will no longer be an alternative to financialstatement recognition. The provisions of SFAS 123R are effective as of thebeginning of the first interim or annual reporting period that begins after December 15,2005. The Company is currently evaluating the method of adoption and the effectthat the adoption of SFAS 123R will have on the Company’s consolidatedfinancial position and results of operations.

 

In December 2004,the FASB issued SFAS No. 153, “Exchanges of Nonmonetary Assets”—anamendment of APB Opinion No. 29. The amendment eliminates the exception tofair value accounting for nonmonetary exchanges of similar productive assetsand replaces it with a broader exception for exchanges of nonmonetary assetsthat do not have commercial substance. Under APB 29, accounting for an exchangeof a productive asset for a similar productive asset or an equivalent interestin the same or similar productive asset is to be based upon the recorded amountof the asset relinquished (carryover basis with no gain or loss recognition).The transaction will now be accounted for based upon the fair value of the assetsexchanged. The Statement is effective for exchanges occurring in fiscal yearsbeginning after June 15, 2005 and is to be applied prospectively. Theadoption of SFAS 153 is not expected to have a material impact on the Company’sconsolidated financial position and results of operations.

 

In December 2004, theFASB issued Staff Position No. 109-2, “Accounting and Disclosure Guidancefor the Foreign Earnings Repatriation Provision within the American JobsCreation Act of 2004” (“FSP 109-2”). In October 2004, the American JobsCreation Act of 2004 (the “Act”) was signed into law. The Act contains a numberof provisions that may affect the Company’s future effective income tax rate.The most significant provision would allow the Company to elect to deduct fromits taxable income 85% of certain eligible dividends received by the Companyfrom its non-U.S. subsidiaries before the end of 2005. FSP 109-2 providesentities additional time, beyond the financial reporting period in which theAct was enacted, to evaluate the effects of the Act on the Company’s plan forreinvestment or repatriation of foreign earnings.  The Company has not yet completed itsevaluation of the impact, if any, of the repatriation provisions of this Actnor has it determined the related range of income tax effects of suchrepatriation. That evaluation is expected to be complete by the end of fiscal2005.

 

*Inventories*

 

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

 
| ** **       | ** ** | **March 31,  2005** | ** ** | **December 31,  2004** | ** ** |
|------------------|------------|--------------------------|------------|-----------------------------|------------|
|             |       |                     |       |                        |       |
| Raw material     |       | $                        | 19,814     |                        | $          | 20,788 |   |
| Work-in-process  |       | 4,843                    |       | 4,741                       |       |
| Finished goods   |       | 3,676                    |       | 2,749                       |       |
|             |       |                     |       |                        |       |
| Inventories, net |       | $                        | 28,333     |                        | $          | 28,278 |   |

 

9

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As of March 31, 2005and December 31, 2004, the reserve for inventory obsolescence was $4.5million.

 

3.                                       IncomeTaxes

 

The Company accounts forincome taxes in accordance with SFAS No. 109, “Accounting for IncomeTaxes.”  In accordance with SFAS No. 109, deferred tax assets andliabilities are recorded for the estimated future tax effects of temporarydifferences between the carrying value of assets and liabilities for financialreporting and their tax basis, and carryforwards to the extent they arerealizable.  A deferred tax provision or benefit results from the netchange in deferred tax assets and liabilities during the period.  A deferredtax asset valuation allowance is recorded if it is more likely than not thatall or a portion of the recorded deferred tax assets will not berealized.  As of December 31, 2004, deferred tax assets include $38.5million relating to a tax basis step up from a recapitalization transaction in1999 and $15.0 million of net operating loss carryforwards.  The Companyhas recorded a full valuation allowance against its deferred tax assets.

 

Provision for incometaxes of $1.2 million for the three months ended March 31, 2005 was calculatedusing an estimated effective tax rate for 2005 of 66.7%, compared to a rate of16.6% used in the comparable period of 2004. The rate increase from 2004 is duelargely to a higher percentage of taxable income for 2005 being generated intax jurisdictions without operating loss carryforwards, combined with projectedtaxable losses in certain tax jurisdictions, with no available tax benefitrelated to these losses included in the provision for income taxes.

 

4.                                       NetIncome Per Share

 

In accordance with SFAS No. 128,“Earnings Per Share,” basic earnings per share isbased upon the weighted average number of common shares outstanding.  Diluted earnings per share is based upon the weightedaverage number of common and potential shares of common stock for each periodpresented.  Potential common shares include the dilutive effect, if any,of stock options and warrants under the treasury stock method and seniorconvertible notes under the if-converted method.  For purposes of thediluted earnings per share calculation for the three months ended March 31,2004, the senior convertible notes are assumed to have been converted at thebeginning of the period, and as a result, net income has been increased by $1.0million for the reduction in interest expense related to the senior convertiblenotes.

 

The following table setsforth the computation of basic and diluted net income per share (in thousands,except per share amounts):

 
| ** **                                               | ** ** | **Three Months  Ended  March 31,  2005** | ** ** | **Three Months  Ended  March 31,  2004** | ** ** |
|----------------------------------------------------------|------------|-----------------------------------------------|------------|-----------------------------------------------|------------|
|                                                     |       |                                          |       |                                          |       |
| Net income                                               |       | $                                             | 625        |                                          | $          | 2,160 |   |
|                                                     |       |                                          |       |                                          |       |
| Shares:                                                  |       |                                          |       |                                          |       |
| Weighted-average  common shares outstanding—basic   |       | 19,206                                        |       | 9,299                                         |       |
| Effect of  dilutive securities:                          |       |                                          |       |                                          |       |
| Senior  convertible notes and warrants                   |       | —                                        |       | 6,031                                         |       |
| Stock options                                            |       | 202                                           |       | 601                                           |       |
| Weighted-average  common shares outstanding—diluted |       | 19,408                                        |       | 15,931                                        |       |
|                                                     |       |                                          |       |                                          |       |
| Net income per  share:                                   |       |                                          |       |                                          |       |
| Basic                                                    |       | $                                             | .03        |                                          | $          | .23 |   |
| Diluted                                                  |       | $                                             | .03        |                                          | $          | .20 |   |

 

10

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5.                                       DeferredFinancing Costs

 

Net deferred financingcosts are comprised of the following as of March 31, 2005 and December 31,2004 (in thousands):

 
| ** **                     | ** ** | **March 31,  2005** | ** ** | **December 31,  2004** | ** ** |
|--------------------------------|------------|--------------------------|------------|-----------------------------|------------|
|                           |       |                     |       |                        |       |
| Deferred  financing costs      |       | $                        | 580        |                        | $          | 580 |   |
| Accumulated  amortization      |       | (137                     | )          | (104                        | )          |
|                           |       |                     |       |                        |       |
| Deferred  financing costs, net |       | $                        | 443        |                        | $          | 476 |   |

 

The Company amortizesdeferred financing costs over the life of the related debt.

 

6.                                       Long-TermDebt

 

Long-term debt consistsof the following at March 31, 2005 and December 31, 2004 (inthousands):

 
| ** **                                   | ** ** | **March 31,  2005** | ** ** | **December 31,  2004** | ** ** |
|----------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
|                                         |       |                     |       |                        |       |   |   |
| 5.25% senior  notes payable to third parties |       | $                        | 24,485     |                        | $          | 24,485 |   |
| 5.25% senior  notes payable to affiliates    |       | 22,145                   |       | 22,145                      |       |
|                                         |       |                     |       |                        |       |   |   |
| Total long-term  debt                        |       | $                        | 46,630     |                        | $          | 46,630 |   |

 

The senior notes matureon November 1, 2008.  Interest on the senior notes is payable in cashon May 1 and November 1 of each year.  The senior notes aresecured by a second priority lien on substantially all of the Company’sdomestic assets and by a pledge of 65% of the equity of certain of its foreignsubsidiaries.  As of March 31, 2005, the Company was in compliancewith all of the covenants set forth in the principal agreements governing the5.25% senior notes.

 

In connection with theCompany’s initial public offering completed February 25, 2004, the Companyamended and restated its existing senior revolving credit facility with GeneralElectric Capital Corporation. The amended facility (the “Credit Facility”)provides for borrowings of up to $20.0 million that are subject to a borrowingbase comprised of eligible accounts receivable and inventory, which was $13.1million at March 31, 2005. The Credit Facility matures in August 2008and borrowings bear interest, at the Company’s option, at a rate per annumequal to LIBOR plus 2.5% or the agent bank’s base rate plus 1.0%. In additionto paying interest on outstanding principal, the Company is required to pay acommitment fee to the lenders under the credit facility in respect of theaverage daily balance of unused loan commitments at a rate of 0.5% per annum.The Credit Facility is secured by a first-priority lien, subject to permittedencumbrances, on substantially all of the Company’s domestic assets and by apledge of 65% of the equity of certain of the Company’s foreign subsidiaries.The Credit Facility contains restrictive covenants requiring the Company to,among other things, maintain certain senior leverage ratios. As of March 31,2005, there were no borrowings outstanding under the Credit Facility, and theCompany was in compliance with all of the covenants under the Credit Facility.

 

Cherokee Europe maintainsa working capital line of credit of approximately $3.9 million with a Belgianbank, BBL, which is denominated in Euros, collateralized by a pledge in firstand second rank over a specific amount of business assets, requires CherokeeEurope to maintain a certain specific minimum solvency ratio and is cancelableat any time.  As of March 31, 2005, Cherokee Europe had nooutstanding borrowings under the line of credit and was in compliance with allcovenants.

 

11

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7.                                       OtherLong-Term Obligations

 

Other long-termobligations consist of the following at March 31, 2005 and December 31,2004 (in thousands):

 
| ** **                                                    | ** ** | **March 31,  2005** | ** ** | **December 31,  2004** | ** ** |
|---------------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
|                                                          |       |                     |       |                        |       |
| Long term portion of European restructuring cost  liabilities | ** ** | $                        | 1,338      | ** **                  | $          | 1,508 | ** ** |
| Long service  award liabilities                               |       | 2,013                    |       | 2,057                       |       |
| Deferred  compensation                                        |       | 871                      |       | 701                         |       |
|                                                          |       |                     |       |                        |       |
| Total other  long-term obligations                            |       | $                        | 4,222      |                        | $          | 4,266 |   |

 

8.                                       CherokeeEurope Restructuring

 

In June 2003, theCompany received approval for a restructuring plan (the “European Restructuring”)of its operations in Europe from the Workers Union and the appropriategovernmental authorities in Belgium.  The European Restructuring involvedthe elimination of 61 operational and administrative positions at the CherokeeEurope facility in Belgium due to unfavorable economic conditions in thatmarket.  All of the terminations were completed in 2003.  Pursuant tothe European Restructuring, the Company recorded a restructuring charge of $4.5million in operating expenses in the statement of operations during fiscal2003.  The European Restructuring costs are comprised entirely of one-timetermination benefits to be paid through 2010.  The Company paid $0.1million during the three months ended March 31, 2005 under the EuropeanRestructuring.

 

A reconciliation of theEuropean Restructuring accrual for the period January 1, 2005 through March 31,2005 is as follows (in thousands):

 
| Balance as of  December 31, 2004 |   | $      | 1,767  |   |
|---------------------------------------|--------|--------|--------|--------|
|                                  |   |   |   |
| Provision                             |   | — |   |
| Payments                              |   | (100   | )      |
| Foreign exchange  rate effect         |   | (82    | )      |
|                                  |   |   |   |
| Balance as of  March 31, 2005    |   | 1,585  |   |
| Less current  portion                 |   | (247   | )      |
|                                  |   |   |   |   |
| Due after one  year                   |   | $      | 1,338  |   |

 

9.                                       CustomerConcentration

 

For the quarter ended March 31,2005, two customers accounted for 16% and 13% of net sales, respectively. Forthe quarter ended March 31, 2004, the Company’s largest customer accountedfor 25% of net sales, and no other customer accounted for more than 10% of netsales. A decision by a major customer to decrease the amount purchased from theCompany or to cease purchasing the Company’s products could have a materialadverse effect on the Company’s financial position and results of operations.

 

As of March 31,2005, two customers accounted for 12% and 11%, respectively, of net accountsreceivable, and no other customer accounted for more than 10% of net accountsreceivable.

 

12

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10.                                 Commitmentsand Contingencies

 

*Guaranteesand Indemnities*

 

The Company has agreed toindemnify the former owners of Cherokee Europe for product liability,environmental hazard and employment practice claims relating solely topost-acquisition business.  The Company also indemnifies its directors andofficers to the maximum extent permitted under the laws of the State ofDelaware, and various lessors in connection with facility leases for certain claims arising from such facility or lease.  No claimsare currently pending against the Company for such indemnifications. The maximumamount of potential future payments under such indemnifications is notdeterminable.

 

The Company has notincurred significant amounts related to these guarantees and indemnifications,and no liability has been recorded in the financial statements for guaranteesand indemnifications as of March 31, 2005.

 

11.                                 Stockand Deferred Compensation Plans

 

*2004Employee Stock Purchase Plan*

 

On February 16,2004, the Company adopted the 2004 Employee Stock Purchase Plan (the ‘‘ESPP’’).The ESPP provides that, as of March 31, 2005, a total of 592,062 shares ofCommon Stock are reserved for issuance under the plan, plus an annual increaseto be added on the first day of the Company’s fiscal year equal to the lesserof (i) 250,000 shares or (ii) 1% of the number of outstanding shareson the last day of the immediately preceding fiscal year. The ESPP, which isintended to qualify as an ‘‘employee stock purchase plan’’ under Section 423of the Code, is implemented utilizing six-month offerings with purchasesoccurring at six-month intervals, with a new offering period commencing on thefirst trading day on or after May 15 and November 15 and ending onthe last trading day on or before November 14 or May 14,respectively. The Company’s Compensation Committee of the Board of Directorsoversees the ESPP administration. Employees are eligible to participate if theyare employed for at least 20 hours per week and more than 5 months in acalendar year by the Company, subject to certain restrictions as defined. TheESPP permits eligible employees to purchase Common Stock through payrolldeductions, which may not exceed 15% of an employee’s compensation. The priceof Common Stock purchased under the ESPP is 85% of the lower of the fair marketvalue of the Common Stock at the beginning of each six-month offering period oron the applicable purchase date. Employees may end their participation in anoffering at any time during the offering period, and participation endsautomatically upon termination of employment. The Company’s CompensationCommittee may at any time amend or terminate the ESPP, except that no suchamendment or termination may adversely affect shares previously granted underthe ESPP. As of March 31, 2005, 18,666 shares have been issued under theESPP.

 

*2004Omnibus Stock Incentive Plan*

 

On February 16,2004, the Company adopted the 2004 Omnibus Stock Incentive Plan (the ‘‘2004Plan’’). The 2004 Plan provides that, as of March 31, 2005, a total of 1,184,124shares of the Company’s Common Stock are reserved for issuance under the 2004Plan, plus an annual increase to be added on the first day of the Company’sfiscal year equal to the lesser of (i) 450,000 shares or (ii) 2% ofthe number of outstanding shares on the last day of the immediately precedingfiscal year. Any officer, director, employee, consultant or advisor of theCompany is eligible to participate in the 2004 Plan. The 2004 Plan provides forthe issuance of stock-based incentive awards, including stock options, stockappreciation rights, restricted stock, deferred stock, and performance shares. Asof March 31, 2005, the Company has granted options to purchase 621,000 sharesof common stock under the 2004 Plan, which included 60,000 options issued aspartial compensation to non-employee directors. As of March 31, 2005, noshares have been issued under the 2004 Plan.

 

13

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*DeferredCompensation Plans*

 

On February 16,2004, the Company adopted two executive deferred compensation plans for thebenefit of certain designated employees and non-employee directors of theCompany. The plans allow participating employees and non-employee directors tomake pre-tax deferrals of up to 100% of their annual base salary and bonusesand retainer fees and meeting fees, respectively. The plans allow the Companyto make matching contributions and employer profit sharing credits at the solediscretion of the Company. A participant’s interest in eachmatching contribution and employer profit sharing credits, if any, vests infull no later than after 3 years. As of March 31, 2005, the Companyhas recorded a liability of $0.9 million for employee and non-employee directorcontributions and investment activity to date, which is recorded in otherlong-term liabilities, and the Company has provided no matching contributionsfor the quarter ended March 31, 2005.

 

12.                                 RetirementPlans

 

Cherokee Europe maintainsa pension plan for certain levels of staff and management that includes a defined benefit feature.  The followingrepresents the amounts related to this defined benefit plan for the threemonths ended March 31, 2005 and 2004 (in thousands):

 
| ** **                                  | ** ** | **Three Months  Ended**  | ** ** | **Three Months  Ended**  | ** ** |
|---------------------------------------------|------------|--------------------------|------------|--------------------------|------------|
| **Components of Net Periodic Benefit Cost** | ** ** | **March 31,  2005** | ** ** | **March 31,  2004** | ** ** |
|                                        |       |                     |       |                     |       |
| Service cost                                |       | $                        | 40         |                     | $          | 38 |   |
| Interest cost                               |       | 65                       |       | 59                       |       |
| Expected return  on plan assets             |       | (36                      | )          | (34                      | )          |
|                                        |       |                     |       |                     |       |
| Net periodic  benefit cost                  |       | $                        | 69         |                     | $          | 63 |   |

 

Cherokee Europe presentlyanticipates contributing $0.3 million to fund its pension plan in 2005.

 

13.                                 GainFrom Insurance Proceeds

 

On January 19, 2004,the Company experienced a fire in part of its facility in Belgium, whichdestroyed certain inventory, property and equipment. As of March 31, 2005,the Company has received $6.3 million in insurance proceeds to date, of which$2.9 million was received in the quarter ended March 31, 2005. Included inthe statement of operations for the first quarter of 2005 is a gain frominsurance proceeds of $2.5 million, which represents the excess of insuranceproceeds received over the net book value of assets destroyed and relatedexpenditures.

 

14

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**Item2.****  Management’s Discussionand Analysis of Financial Condition and Results of Operations.**

 

OVERVIEW

 

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

 

We operate worldwide andhave facilities in Orange County, California; Bombay, India; Guadalajara,Mexico; and Wavre, Belgium. We were founded in 1978 in Orange County,California. As we expanded our business and customer base, we opened facilitiesin Bombay, India and in Guadalajara, Mexico. In June 2000, we acquiredCherokee Europe, which added a manufacturing facility in Wavre, Belgium andenabled us to better serve the European market.

 

We generate a significantportion of our sales from OEMs in the communications and computing marketsegment, particularly the wireless infrastructure and networking sectors.During 2001, 2002 and the first quarter of 2003, our operating results werenegatively affected by unfavorable economic conditions and reduced capitalspending by communication service providers that purchase our customers’products. Although we saw improvement in these economic conditions throughoutthe balance of 2003 and into 2004, we experienced somewhat lower sales duringthe second half of 2004, which has continued into the first quarter of 2005. Ifconditions do not improve, or instead deteriorate further, our operatingresults and financial condition could be adversely affected.

 

Gross margins in thesecond half of 2004 and the first quarter of 2005 reflect a shift in our salesmix, with increased sales coming from certain programs with higher materialcost, combined with increased revenues from new programs.

 

We completed our initialpublic offering of 6,600,000 shares of our common stock on February 25, 2004.The net proceeds from the offering were $86.5 million. We used approximately$73.2 million of the net proceeds to repay outstanding indebtedness andrelated interest. In connection with the offering, we issued 6,283,796 sharesof our common stock upon conversion of the original principal amount of ourthen outstanding senior convertible notes, and issued 4,071,114 shares ofcommon stock upon exercise of outstanding warrants.

 

In addition, inconnection with the offering, we amended and restated our existing seniorrevolving credit facility with General Electric Capital Corporation. Theamended facility (the “Credit Facility”) provides for borrowings of up to $20.0million that are subject to a borrowing base comprised of eligible accountsreceivable and inventory, which was $13.1 million at March 31, 2005.Please refer to “Liquidity and Capital Resources” below for additionalinformation regarding our outstanding indebtedness.

 

During 2005 and early2006, we plan to establish operations in China by constructing a 100,000 squarefoot facility near Shanghai, which will result in capital expenditures in 2005being significantly higher than previous years’ levels.

 

BASIS OF REPORTING

 

*NetSales*

 

Net sales consist ofsales during the period presented, net of returns. Revenue is recognized fromproduct sales at the time of shipment and passage of title.

 

*Costof Sales*

 

The principal elementscomprising cost of sales are raw materials, labor and manufacturing overhead.Raw materials account for a large majority of costs of sales. Raw materialsinclude magnetic sub-assemblies, sheet metal, electronic and other components,mechanical parts and electrical wires. Direct labor costs include costs ofhourly employees. Manufacturing overhead includes salaries and the direct expenseand allocation of costs attributable to manufacturing for lease costs,depreciation on property, plant and equipment, utilities, property taxes andrepairs and maintenance.

 

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*OperatingExpenses*

 

Operating expensesinclude engineering costs, selling and marketing costs and general andadministrative expenses. Engineering costs primarily include salaries andbenefits of engineering personnel, safety approval and quality certificationfees, depreciation on equipment and subcontract costs for third-partycontracting services. Selling and marketing expenses primarily include salariesand benefits to account managers and commissions to independent salesrepresentatives. Administrative expenses primarily include salaries andbenefits for certain management and administrative personnel, professional feesand information system costs. Operating expenses also include the directexpense and allocation of costs attributable to these departments for leasecosts, depreciation on property, plant and equipment, utilities, property taxesand repairs and maintenance.

 

CRITICAL ACCOUNTINGPOLICIES

 

We prepare ourconsolidated financial statements in conformity with accounting principlesgenerally accepted in the United States. As such, we are required to makecertain estimates, judgments and assumptions that we believe are reasonablebased upon the information currently available. These estimates and assumptionsaffect the reported amounts of assets and liabilities at the date of thefinancial statements and the reported amounts of revenues and expenses duringthe periods presented. Any future changes to these estimates and assumptionscould have a material effect on our reported amounts of revenue, expenses,assets and liabilities. The significant accounting policies that we believe arethe most critical to aid in fully understanding and evaluating our reportedfinancial results include the following:

 

*Revenue Recognition*

 

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

 

*Accounts Receivable*

 

We perform ongoing creditevaluations of our customers and adjust credit limits based upon paymenthistory, the customer’s current credit worthiness and various other factors, asdetermined by our review of their current credit information. We continuouslymonitor collections and payments from our customers and maintain a provisionfor estimated credit losses based upon our historical experience and anyspecific customer collection issues that we have identified. While creditlosses have historically been within our expectations and the provisionsestablished, we may not continue to experience the same credit loss rates thatwe have in the past. A significant portion of our accounts receivable isconcentrated in a small number of customers. A significant change in theliquidity or financial position of any one of these customers could have amaterial adverse effect on the collectibility of our accounts receivable, ourliquidity and our future operating results.

 

*Inventories*

 

We value our inventory atthe lower of the actual cost to purchase and/or manufacture the inventory andthe current estimated market value of the inventory using the weighted averagecost method. We regularly review inventory quantities on hand and record aprovision for excess and obsolete inventory based primarily on our historicalusage data and estimates of future demand. Our industry is characterized byrapid technological change, frequent new product development, and rapid productobsolescence that could result in an increase in the amount of obsoleteinventory quantities on hand. As demonstrated during the past five years,demand for our products can fluctuate significantly. A significant increase inthe demand for our products could result in a short-term increase in the costof inventory purchases while a significant decrease in demand could result inan increase in the amount of excess inventory quantities on hand. In addition,our estimates of future product demand may prove to be inaccurate, in whichcase we may have understated or overstated the provision required for excessand obsolete inventory. In the future, if our inventory is determined to beovervalued, we would be required to recognize additional expense in our cost ofgoods sold at the time of such determination. Likewise, if our inventory isdetermined to be undervalued, we may have over reported our costs of goods soldin previous periods and would be required to recognize additional operatingincome at the time such inventory is sold. Therefore, although we make everyreasonable effort to ensure the accuracy of our estimates of future productdemand, any significant unanticipated changes in demand or technologicaldevelopments could have a material effect on the value of our inventory and ourreported operating results.

 

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*Deferred Taxes*

 

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

 

*Goodwill and Long Lived Assets*

 

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

 

We also review therecoverability of the carrying value of long-lived assets whenever events orchanges in circumstances indicate that the carrying amount of an asset may notbe recoverable. Recoverability of these assets is determined based upon theforecasted undiscounted future net cash flows from the operations to which theassets relate, utilizing our best estimates, appropriate assumptions andprojections at the time. These projected future cash flows may varysignificantly over time as a result of increased competition, changes intechnology, fluctuations in demand, consolidation of our customers andreductions in average selling prices. If the carrying value is determined notto be recoverable from future operating cash flows, the asset would be deemedimpaired and an impairment loss would be recognized to the extent the carryingvalue exceeded the estimated fair market value of the asset.

 

RESULTS OF OPERATIONS

 

THREE MONTHS ENDED MARCH 31,2005 COMPARED TO THREE MONTHS ENDED MARCH 31, 2004

 

NET SALES

 

Net sales decreased byapproximately 13.1%, or $4.8 million, to $32.0 million for the three monthsended March 31, 2005 from $36.8 million for the three months ended March 31,2004.

 

The decrease in net salesis due primarily to a reduction in demand from a number of our major datacomcustomers.  Also contributing to thedecline were the effect of material shortages and the transitioning of certaincustomer programs to consignment hub arrangements. Shipments to these new hubswill delay revenue recognition on those shipments until the customer pulls theproduct from the hub for their production requirements. These items werepartially offset by a stronger Euro.

 

17

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GROSS PROFIT

 

Gross profit decreased byapproximately 35.9%, or $4.3 million, to $7.6 million for the three monthsended March 31, 2005 from $11.9 million for the three months ended March 31,2004. Gross margin for the three months ended March 31, 2005 decreased to23.9% from 32.4% in the prior year period.

 

The decreases in grossprofit was due primarily to the decrease in revenues and the resulting loss ofcontribution margin on those revenues, combined with a change in product mixduring the first quarter of 2005 that included programs with higher materialcontent than the year-earlier period.  Thedecrease in gross margin was due primarily to the change in product mix,combined with higher labor and overhead costs as a percentage of net salesresulting from the lower revenue level.

 

OPERATING EXPENSES

 

Operating expenses for the three months ended March31, 2005 decreased by approximately 19.2%, or $1.2 million, to $5.0 millionfrom $6.2 million for the three months ended March 31, 2004.  As a percentage of net sales, operatingexpenses decreased to 15.8% from 17.0% in the prior year period.

 

The decrease in operatingexpenses is primarily due to a gain from insurance proceeds of $2.5 millionrelated to the fire damage experienced in the Belgium facility in February2004. This was partially offset by increased general and administrativeexpenses associated with operating as a new publicly traded company.  During the first quarter of 2005, we incurreda significant increase in audit fees and insurance costs compared to the firstquarter of 2004.  In addition, weincurred professional fees during the first quarter of 2005 to begin compliancewith the requirements of Section 404 of the Sarbanes-Oxley Act.  Also contributing to the increased expenseswere a stronger Euro and start-up costs related to establishing a manufacturingoperation in China.

 

OPERATING INCOME

 

As a result of thefactors discussed above, operating income decreased $3.1 million to $2.6million for the three months ended March 31, 2005, from $5.7 million forthe three months ended March 31, 2004.  Operating margin decreased to8.1% from 15.4% in the prior year period.

 

INTEREST EXPENSE

 

Interest expense for thethree months ended March 31, 2005 was $0.7 million compared to $3.1million for the three months ended March 31, 2004.  The decrease ininterest expense was due primarily to the repayment of debt and conversion toequity of our senior convertible notes in connection with our initial publicoffering completed in February of 2004.

 

INCOME TAXES

 

Provision for incometaxes for the three months ended March 31, 2005 was $1.2 million comparedto $ 0.4 million for the three months ended March 31, 2004.

 

Provision for incometaxes of $1.2 million for the three months ended March 31, 2005 wascalculated using an estimated effective tax rate for 2005 of 66.7%, compared toa rate of 16.6% used in the comparable period of 2004. The rate increase from2004 is due largely to a higher percentage of taxable income for 2005 beinggenerated in tax jurisdictions without operating loss carryforwards, combinedwith projected taxable losses in certain tax jurisdictions, with no availabletax benefit related to theses losses included in the provision for incometaxes.

 

NET INCOME

 

As a result of thefactors discussed above, we recorded net income of $0.6 million for the threemonths ended March 31, 2005, compared to $2.2 million for the three monthsended March 31, 2004.

 

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LIQUIDITY AND CAPITALRESOURCES

 

CASH FLOWS

 

THREE MONTHS ENDED MARCH 31,2005 COMPARED TO THREE MONTHS ENDED MARCH 31, 2004

 

Net cash provided by operatingactivities was $4.1 million for the three months ended March 31, 2005,compared to net cash used in operating activities of $0.5 million for the threemonths ended March 31, 2004.  Net cash provided by operatingactivities for the three months ended March 31, 2005 reflected thepositive effect of $0.6 million in net income, $0.8 million of depreciation andamortization, a $1.8 million reduction in accounts receivable, a $1.2 millionincrease in accrued liabilities and restructuring costs, and a $0.6 millionincrease in accrued interest payable. Included in net income for the threemonths ended March 31, 2005 is a gain from insurance proceeds of $2.5 million.These amounts were partially offset by an increase in inventories of $0.4million and decreases in accounts payable and accrued compensation and benefitsof $0.4 million and $0.3 million respectively. The decrease in accountsreceivable was due primarily to the reduction in sales for the quarter, and theincrease in accrued liabilities was due primarily to the provision for incometaxes.  Cash used in operating activitiesfor the first quarter of 2004 reflects the positive effect of $2.2 million innet income, $0.9 million of depreciation and amortization, a $1.1 milliondecrease in accounts receivable due mainly to an improvement in our days sales outstanding, and a decrease in inventory levelsof $0.6 million.  These items were offsetby an increase of $2.0 million in prepaid expenses and other current assets duemainly to D&O insurance premium payments and recording an insuranceindemnity receivable due to the fire in our Belgium facility, a decrease inother long-term obligations of $1.8 million due primarily to the payment ofaccrued paid-in-kind interest with the proceeds from the initial publicoffering, and a decrease in accrued liabilities and restructuring costs of $1.2million.

 

Net cash used ininvesting activities of $2.2 million for the three months ended March 31,2005 reflected additions to property and equipment of $1.2 million and an increasein short term investments of $1.0 million.  Net cash used in investingactivities of $1.2 million during the three months ended March 31, 2004related to additions to property and equipment.

 

Net cash provided byfinancing activities for the three months ended March 31, 2005 was zerocompared to $16.9 million for the three months ended March 31, 2004. Theamounts in 2004 reflected the net proceeds from our initial public stockoffering of $86.5 million, partially offset by payments on long-term debt andrevolver borrowings.

 

LIQUIDITY

 

As of March 31,2005, we had cash and cash equivalents of $16.1 million, working capital of$49.6 million and no borrowings under the Credit Facility.  Historically,we have financed our operations with cash from operations supplemented byborrowings from credit facilities and debt issuances.  Our current andfuture liquidity needs primarily arise from working capital requirements andcapital expenditures, including our planned expansion into China.  Our historicalcapital expenditures have primarily resulted from investments in equipment toincrease manufacturing capacity and to improve manufacturing efficiencies. For2005, we expect capital expenditures to be approximately $8 million to $9million, which will relate primarily to our purchase of land, building andequipment in China and investments in manufacturing equipment at otherfacilities. We spent $1.2 million on property, plant and equipment during thefirst quarter of 2005.

 

 As of March 31,2005, our borrowings consisted of approximately $46.6 million of senior notesbearing interest at 5.25% annually, and no borrowings under the CreditFacility. We are required to make semi-annual interest payments to holders ofthe senior notes.

 

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

 

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

 

The maturities of ourlong-term debt and future payments relating to our operating leases and otherobligations as of March 31, 2005 are as follows (in thousands):

 
| **Contractual Obligations** | ** ** | **April to  December  2005** | ** ** | **2006** | ** ** | **2007** | ** ** | **2008** | ** ** | **2009** | ** ** | **Thereafter** | ** ** | **Total** | ** ** |
|----------------------------------|------------|-----------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------------|------------|-----------|------------|
|                             |       |                              |       |     |       |     |       |     |       |     |       |           |       |      |       |   |   |   |   |   |   |   |
| Long-term debt                   |       | $                                 | —     |     | $          | —   |       | $        | —     |     | $          | 46,630         |       | $         | —     |   | $ | — |   | $ | 46,630 |   |
| Operating leases                 |       | 1,069                             |       | 1,459    |       | 1,471    |       | 1,482    |       | 497      |       | —         |       | 5,978     |       |
| Purchase order  commitments      |       | 18,936                            |       | 3,366    |       | —   |       | —   |       | —   |       | —         |       | 22,302    |       |
| European  restructuring          |       | 222                               |       | 243      |       | 217      |       | 194      |       | 187      |       | 522            |       | 1,585     |       |
| Long service  award              |       | 22                                |       | 51       |       | 102      |       | 198      |       | 315      |       | 1,347          |       | 2,035     |       |
| Deferred  compensation           |       | —                            |       | —   |       | —   |       | —   |       | —   |       | 871            |       | 871       |       |
|                             |       |                              |       |     |       |     |       |     |       |     |       |           |       |      |       |
| Total                            |       | $                                 | 20,249     |     | $          | 5,119    |       | $        | 1,790      |     | $          | 48,504         |       | $         | 999        |   | $ | 2,740 |   | $ | 79,401 |   |

 

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

 

In connection with ourinitial public offering in February of 2004, we amended our existingsenior revolving credit facility with General Electric Capital Corporation. TheCredit Facility provides for borrowings of up to $20.0 million, subject to aborrowing base comprised of eligible accounts receivable and inventory, whichwas $13.1 million at March 31, 2005. We plan to use funds available underthis credit facility to finance working capital and other cash requirements asneeded. The credit facility matures in August 2008 and bears interest, atour option, at a rate per annum equal to LIBOR plus 2.5% or the agent bank’sbase rate plus 1.0%. In addition to paying interest on outstanding principal,we are required to pay a commitment fee to the lenders under the creditfacility in respect of the average daily balance of unused loan commitments ata rate of 0.5% per annum. The Credit Facility is our senior obligation andranks equal in right of payment with our existing and future permitted seniordebt (including our senior notes), and senior in right of payment to our futurepermitted subordinated debt. The Credit Facility is secured by a first-prioritylien, subject to permitted encumbrances, on substantially all of our domesticassets and by a pledge of 65% of the equity of certain of our foreignsubsidiaries.

 

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

 

As of March 31,2005, we were in compliance with all of the financial covenants set forth inthe principal agreements governing our debt. Based on our present expectations,we believe that our existing cash and cash equivalents, working capital andavailable borrowing capacity at March 31, 2005 will be sufficient to meetour anticipated cash requirements for the next twelve months, includingoperating requirements, contractual obligations, planned capital expendituresand debt service.

 

RECENT ACCOUNTINGPRONOUNCEMENTS

 

In November 2004,the FASB issued SFAS No. 151, “Inventory Costs—an amendment of ARB No. 43,Chapter 4”. This statement amends the guidance in ARB No. 43, Chapter 4, “InventoryPricing,” to clarify the accounting for abnormal amounts of idle facilityexpense, freight, handling costs, and wasted material (spoilage). Abnormalamounts of these costs should be recognized as current period charges ratherthan as a portion of inventory costs. In addition, SFAS 151 requires thatallocation of fixed production overheads to the costs of manufacturing be basedon the normal capacity of the production facilities. The provisions of SFAS 151are effective for inventory costs incurred during fiscal years beginning after June 15,2005. We are currently evaluating the effect that the adoption of this newstandard may have on our consolidated financial position and results ofoperations.

 

In December 2004,the FASB issued SFAS 123R (Revised 2004), “Share-Based Payment,” which requiresthat the compensation cost relating to share-based payment transactions berecognized in financial statements based on the fair value of the award on thedate of grant. The cost will be recognized over the period during which theemployee is required to provide service in exchange for the award (usually thevesting period). We currently disclose pro forma compensation expense quarterlyand annually. Upon adoption, the pro forma disclosures previously permittedunder SFAS 123 will no longer be an alternative to financial statement recognition.The provisions of SFAS 123R are effective as of the beginning of the firstinterim or annual reporting period that begins after December 15, 2005. Weare currently evaluating the method of adoption and the effect that theadoption of SFAS 123R will have on our consolidated financial position andresults of operations.

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In December 2004,the FASB issued SFAS No. 153, “Exchanges of Nonmonetary Assets”—anamendment of APB Opinion No. 29. The amendment eliminates the exception tofair value accounting for nonmonetary exchanges of similar productive assetsand replaces it with a broader exception for exchanges of nonmonetary assetsthat do not have commercial substance. Under APB 29, accounting for an exchangeof a productive asset for a similar productive asset or an equivalent interestin the same or similar productive asset is to be based upon the recorded amountof the asset relinquished (carryover basis with no gain or loss recognition).The transaction will now be accounted for based upon the fair value of theassets exchanged. The Statement is effective for exchanges occurring in fiscalyears beginning after June 15, 2005 and is to be applied prospectively.The adoption of SFAS 153 is not expected to have a material impact on ourconsolidated financial position and results of operations.

 

In December 2004, the FASBissued Staff Position No. 109-2, “Accounting and Disclosure Guidance forthe Foreign Earnings Repatriation Provision within the American Jobs CreationAct of 2004” (“FSP 109-2”). In October 2004, the American Jobs CreationAct of 2004 (the “Act”) was signed into law. The Act contains a number ofprovisions that may affect our future effective income tax rate. The mostsignificant provision would allow us to elect to deduct from our taxable income85% of certain eligible dividends received by us from our non-U.S. subsidiariesbefore the end of 2005. FSP 109-2 provides additional time, beyond thefinancial reporting period in which the Act was enacted, to evaluate theeffects of the Act on our plan for reinvestment or repatriation of foreignearnings. We have not yet completed our evaluation of the impact, if any, ofthe repatriation provisions of this Act nor have we determined the relatedrange of income tax effects of such repatriation. Our evaluation is expected tobe complete by the end of fiscal 2005.

 

FORWARD-LOOKINGSTATEMENTS

 

Statements in this reportcontaining the words “believes,” “anticipates,” “estimates,” “expects,” andsimilar expressions, or the negative of such words or expressions, and anyother statements which may be construed as a prediction of future performanceor events, constitute “forward-looking statements” within the meaning of thePrivate Securities Litigation Reform Act of 1995.  These forward-lookingstatements are based upon our current expectations and projections about futureevents.  Such forward-looking statements involve known and unknown risks,uncertainties, and other factors that may cause our actual results, performance,or achievements, or industry results, to be materially different from anyfuture results, performance, or achievements expressed or implied by suchforward-looking statements.  Such factors include, among others, (1) changesin general economic and business conditions, domestically and internationally, (2) reductionsin sales to, or the loss of, any of our significant customers or in customercapacity generally, (3) changes in our sales mix to lower margin products,(4) increased competition in our industry, (5) disruptions of ourestablished supply channels, (6) our level of debt and restrictionsimposed by our debt agreements, and (7) the additional risk factorsidentified in our filings with the Securities and Exchange Commission,including our Annual Report on Form 10-K (File No. 000-50593). Except as required by law, we undertake no obligation to update anyforward-looking statements even though our situation may change in the future.

 

**Item3.****                       Quantitativeand Qualitative Disclosures About Market Risk.**

 

Marketrisk relating to our operations result primarily from changes in foreigncurrency exchange rates and short-term interest rates. We did not have any derivative financial instruments at March 31, 2005.

 

We had no variable ratedebt outstanding at March 31, 2005.  However, any debt we incur underthe Credit Facility will bear interest at a variable rate.  We cannotpredict market fluctuations in interest rates and their impact on any variablerate debt we may incur in the future, nor can there be any assurance that fixedrate long-term debt will be available to us at favorable rates, if at all.

 

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The functional currencyfor our European operations is the Euro.  We are, therefore, subject to acertain degree of market risk associated with changes in foreign currencyexchange rates.  This risk is mitigated by the fact that our revenues,costs and expenses are generally both recorded in Euros, thereby reducing therisk of foreign currency translations on our European operations.  Theeffect of foreign currency exchange rate fluctuations on our operating resultsas of and for the three months ended March 31, 2005, was notmaterial.  Historically, we have not actively engaged in exchange ratehedging activities.

 

**Item 4.****                       Controls and Procedures.**

 

a)                            *Disclosure Controls and Procedures*

 

Our management, with theparticipation of our Chief Executive Officer and Chief Financial Officer, hasevaluated the effectiveness of our disclosure controls and procedures (as suchterm is defined in Rules 13a-15(e) and 15d-15(e) under theSecurities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the endof the period covered by this report.  Theevaluation included certain control areas in which we have made, and arecontinuing to make, changes to improve and enhance controls.  Based on such evaluation, our Chief ExecutiveOfficer and Chief Financial Officer have concluded that, as of the end of suchperiod, our disclosure controls and procedures were not effective because of amaterial weakness discussed in our Annual Report on Form 10-K for the yearended December 31, 2004, specifically because we did not maintain sufficientdocumentation of the design or operation of our computer program change controlprocess relating to database software, systems software, network software, andin certain circumstances did not maintain adequate user access controls.  During the first quarter of 2005, we engagedthird party consultants to assist us in designing and implementing appropriateprocedures and controls over computer program changes as well as user access.  These remediation efforts will continue duringthe second quarter of 2005.

 

b)*                           InternalControl Over Financial Reporting*

 

As discussed in ourAnnual Report on Form 10-K for the year ended December 31, 2004, wedid not maintain documentation supporting certain inventory reserves and didnot analyze, reconcile and adjust certain accounts in our consolidation on atimely basis, both of which were considered material weaknesses as ofDecember 31, 2004.  During thefirst quarter of 2005, we established new procedures to ensure that inventoryreserves are properly documented and our consolidation accounts are analyzedand adjusted on a timely basis.  Based ontheir evaluation, the Chief Executive Officer and Chief Financial Officer haveconcluded that as of March 31, 2005, internal controls over inventoryreserves documentation and our consolidation procedures have been sufficientlyremediated.

 

Except as noted above, therehave not been any changes in our internal control over financial reporting (assuch term is defined in Rules 13a-15(f) and 15d-15(f) under theExchange Act) during the fiscal quarter to which this report relates that havematerially affected, or are reasonably likely to materially affect, ourinternal control over financial reporting.

 

PART II.                                                 OTHERINFORMATION

 

**Item1.****                                   Legal Proceedings.**

 

During the three monthsended March 31, 2005, we were not a party to any material legalproceedings.  We are occasionally a party to lawsuits relating to routinematters incidental to our business.  As with all litigation, we canprovide no assurance as to the outcome of any particular lawsuit, and we notethat litigation inherently involves significant costs.

 

**Item2.****                                   Unregistered Sales of Equity Securities and Use of Proceeds.**

 

On February 25,2004, we closed the sale of 6,600,000 shares of our Common Stock at a price of$14.50 per share in a firm commitment underwritten initial publicoffering.  The offering was effected pursuant to a Registration Statementon Form S-1 (File No. 333-110723), which the Securities and ExchangeCommission declared effective on February 19, 2004.

 

Of the $95.7 million ingross proceeds raised by us in the offering:

 

1.                                       approximately $6.7 million was paid to the underwriters inconnection with the underwriting discount;

 

2.                                       approximately $2.5 million was paid by us in connection withoffering fees and expenses;

 

3.                                       approximately $73.2 million was used to repay principal andinterest on our outstanding indebtedness;

 

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4.                                       approximately $5.3 million has been used as of March 31,2005, for general corporate purposes; and

 

5.                                       approximately $8.0 million has been retained by us forgeneral corporate purposes and is held in high-grade commercial paper with anoriginal maturity of three months or less.

 

**Item 6.****                                   Exhibits.**

 

EXHIBIT INDEX

 
| **Exhibit No.** | ** ** | **Description**                                                                                                                                   |
|----------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1                  |       | Restated Certificate of  Incorporation of Cherokee International Corporation (1)                                                                  |
| 3.2                  |       | Amended and Restated  By-Laws of Cherokee International Corporation (1)                                                                           |
| 4.1                  |       | Specimen of Stock  Certificate (2)                                                                                                                |
| 10.1                 |       | 2005 Cash Incentive  Compensation Plan                                                                                                            |
| 31.1                 |       | Certification of Chief  Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of  2002                                         |
| 31.2                 |       | Certification of Chief  Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of  2002                                         |
| 32.1                 |       | Certification of CEO  and CFO Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002 |
|                 |       |                                                                                                                                              |
|                      |
|                 | (1)        | Previously filed with  the Registration Statement on Form S-8 filed by the Registrant on  March 16, 2004.                               |
|                 | (2)        | Previously filed with  Amendment No. 4 to the Registration Statement on Form S-1 filed by  the Registrant on February 17, 2004.    |

 

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SIGNATURES

 

Pursuant to therequirements of the Securities Exchange Act of 1934, the Registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.

 

 
| Dated:  May 18,  2005 |                                |
|--------------------------------------|-------------------------------------|
|                                 |                                |
|                                 | CHEROKEE INTERNATIONAL  CORPORATION |
|                                 |                                |
|                                 |                                |
|                                 | By:                                 | /s/ Jeffrey M. Frank |   |
|                                 |                                | Jeffrey M. Frank |
|                                 |                                | President and Chief  Executive Officer |
|                                 |                                |
|                                 |                                |
|                                 | By:                                 | /s/ Van Holland |   |
|                                 |                                | Van Holland |
|                                 |                                | Chief Financial Officer |
|                                 |                                | (Principal Financial  and Accounting  Officer) |

 

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