**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C.  20549**

 

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**FORM 10-Q**

 

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

 

**For thequarterly period ended July 3, 2005**

 

**OR**

 

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

 

**For thetransition period             to**

 

**Commissionfile number 000-50593**

 

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**CHEROKEEINTERNATIONAL CORPORATION**

(Exact name of Registrant asspecified 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’s telephonenumber, including area code)

 

**N/A**

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

 

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

 

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

 

As of July 31, 2005, 19,232,111 shares of theregistrant’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 | 16                                                             |
|                                                                                                |                                                           |
| Item 3.  Quantitative and Qualitative Disclosures About Market Risk                                 | 26                                                             |
|                                                                                                |                                                           |
| Item 4. Controls  and Procedures                                                                    | 26                                                             |
|                                                                                                |                                                           |
| PART II OTHER  INFORMATION                                                                     | 27                                                             |
|                                                                                                |                                                           |
| Item 1. Legal  Proceedings                                                                          | 27                                                             |
|                                                                                                |                                                           |
| Item 2. Unregistered Sales of Equity Securities and  Use of Proceeds                                | 27                                                             |
|                                                                                                |                                                           |
| Item 4.  Submission of Matters to a Vote of Security Holders                                        | 28                                                             |
|                                                                                                |                                                           |
| Item 6. Exhibits                                                                                    | 29                                                             |
|                                                                                                |                                                           |
| Signatures                                                                                          | 29                                                             |

 

2

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PARTI.  FINANCIAL INFORMATION

**Item 1.  Condensed Consolidated FinancialStatements.**

 

CHEROKEE INTERNATIONALCORPORATION AND SUBSIDIARIES

CONDENSEDCONSOLIDATED BALANCE SHEETS(In Thousands, Except Share Data)

(Unaudited)

 
| ** **                                                                                                                                                                              | ** ** | **June 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|-----------------------------|------------|
|                                                                                                                                                                                    |       |               |       |                        |       |
| ASSETS                                                                                                                                                                                  |       |               |       |                        |       |
| CURRENT ASSETS:                                                                                                                                                                         |       |               |       |                        |       |
| Cash and cash equivalents                                                                                                                                                               |       | $                  | 14,181     |                        | $          | 14,585 |   |
| Short-term investments                                                                                                                                                                  |       | 332                |       | 4,178                       |       |
| Accounts receivable, net                                                                                                                                                                |       | 24,445             |       | 27,929                      |       |
| Inventories, net                                                                                                                                                                        |       | 28,349             |       | 28,278                      |       |
| Prepaid expenses and other current assets                                                                                                                                               |       | 1,493              |       | 2,056                       |       |
| Total current assets                                                                                                                                                                    |       | 68,800             |       | 77,026                      |       |
|                                                                                                                                                                                    |       |               |       |                        |       |
| Property and equipment, net                                                                                                                                                             |       | 15,979             |       | 15,028                      |       |
| Deposits and other assets                                                                                                                                                               |       | 1,258              |       | 965                         |       |
| Deferred financing costs, net                                                                                                                                                           |       | 411                |       | 476                         |       |
| Goodwill                                                                                                                                                                                |       | 6,317              |       | 6,317                       |       |
|                                                                                                                                                                                    |       |               |       |                        |       |
|                                                                                                                                                                                    |       | $                  | 92,765     |                        | $          | 99,812 |   |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                               |       |               |       |                        |       |
| CURRENT LIABILITIES:                                                                                                                                                                    |       |               |       |                        |       |
| Accounts payable                                                                                                                                                                        |       | $                  | 9,740      |                        | $          | 12,803 |   |
| Accrued liabilities                                                                                                                                                                     |       | 7,917              |       | 6,733                       |       |
| Accrued compensation and benefits                                                                                                                                                       |       | 5,610              |       | 6,987                       |       |
| Accrued restructuring costs                                                                                                                                                             |       | 228                |       | 259                         |       |
| Total current liabilities                                                                                                                                                               |       | 23,495             |       | 26,782                      |       |
|                                                                                                                                                                                    |       |               |       |                        |       |
| Long-term debt, net of current portion                                                                                                                                                  |       | 46,630             |       | 46,630                      |       |
| Other long-term obligations                                                                                                                                                             |       | 4,026              |       | 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; 19,232,111 and 19,206,207 shares issued and  outstanding at June 30, 2005 and December 31, 2004, respectively |       | 19                 |       | 19                          |       |
|                                                                                                                                                                                    |       |               |       |                        |       |
| Paid-in capital                                                                                                                                                                         |       | 183,803            |       | 183,713                     |       |
| Accumulated deficit                                                                                                                                                                     |       | (166,814           | )          | (165,666                    | )          |
| Accumulated other comprehensive income                                                                                                                                                  |       | 1,606              |       | 4,068                       |       |
|                                                                                                                                                                                    |       |               |       |                        |       |
| Net stockholders’ equity                                                                                                                                                           |       | 18,614             |       | 22,134                      |       |
|                                                                                                                                                                                    |       |               |       |                        |       |
|                                                                                                                                                                                    |       | $                  | 92,765     |                        | $          | 99,812 |   |

 

See notes to condensedconsolidated financial statements.

 

3

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CHEROKEE INTERNATIONALCORPORATION AND SUBSIDIARIES

CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS(In Thousands, Except Per Share Amounts)

(Unaudited)

 
| ** **                                  | ** ** | **Three Months Ended**  | ** ** | **Six Months Ended**    | ** ** |
|---------------------------------------------|------------|-------------------------|------------|-------------------------|------------|
| ** **                                  | ** ** | **June 30,  2005** | ** ** | **June 30,  2004** | ** ** | **June 30,  2005** | ** ** | **June 30,  2004** | ** ** |
|                                        |       |                    |       |                    |       |   |   |   |   |
| Net sales                                   |       | $                       | 30,992     |                    | $          | 38,622 |   | $ | 63,002 |   | $ | 75,454 |   |
| Cost of sales                               |       | 24,680                  |       | 26,270                  |       | 49,048 |   | 51,179 |   |
|                                        |       |                    |       |                    |       |   |   |   |   |
| Gross profit                                |       | 6,312                   |       | 12,352                  |       | 13,954 |   | 24,275 |   |
| Operating Expenses:                         |       |                    |       |                    |       |   |   |   |   |
| Engineering and development                 |       | 2,350                   |       | 2,335                   |       | 4,706 |   | 4,666 |   |
| Selling and marketing                       |       | 2,040                   |       | 2,000                   |       | 4,002 |   | 3,830 |   |
| General and administrative                  |       | 2,956                   |       | 2,014                   |       | 6,176 |   | 4,101 |   |
| Gain from insurance proceeds                |       | —                  |       | —                  |       | (2,490 | ) | — |   |
| Total operating expenses                    |       | 7,346                   |       | 6,349                   |       | 12,394 |   | 12,597 |   |
|                                        |       |                    |       |                    |       |   |   |   |   |
| Operating income (loss)                     |       | (1,034                  | )          | 6,003                   |       | 1,560 |   | 11,678 |   |
|                                        |       |                    |       |                    |       |   |   |   |   |
| Interest expense                            |       | (698                    | )          | (715                    | )          | (1,392 | ) | (3,796 | ) |
| Other income (expense), net                 |       | 52                      |       | (50                     | )          | 25 |   | (53 | ) |
| Income (loss) before income taxes           |       | (1,680                  | )          | 5,238                   |       | 193 |   | 7,829 |   |
| Provision for income taxes                  |       | 93                      |       | 869                     |       | 1,341 |   | 1,300 |   |
| Net income (loss)                           |       | $                       | (1,773     | )                       | $          | 4,369 |   | $ | (1,148 | ) | $ | 6,529 |   |
|                                        |       |                    |       |                    |       |   |   |   |   |
| Net income (loss) per share:                |       |                    |       |                    |       |   |   |   |   |
| Basic                                       |       | $                       | (0.09      | )                       | $          | 0.23 |   | $ | (0.06 | ) | $ | 0.46 |   |
| Diluted                                     |       | $                       | (0.09      | )                       | $          | 0.22 |   | $ | (0.06 | ) | $ | 0.42 |   |
|                                        |       |                    |       |                    |       |   |   |   |   |
| Weighted average common shares outstanding: |       |                    |       |                    |       |   |   |   |   |
| Basic                                       |       | 19,221                  |       | 19,182                  |       | 19,214 |   | 14,241 |   |
| Diluted                                     |       | 19,221                  |       | 19,710                  |       | 19,214 |   | 17,819 |   |

 

See notes to condensedconsolidated financial statements.

 

4

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CHEROKEE INTERNATIONALCORPORATION AND SUBSIDIARIES

CONDENSEDCONSOLIDATED STATEMENTS OF COMPREHENSIVE OPERATIONS(In Thousands)

(Unaudited)

 
| ** **                               | ** ** | **Three Months Ended**   | ** ** | **Six Months Ended**     | ** ** |
|------------------------------------------|------------|--------------------------|------------|--------------------------|------------|
| ** **                               | ** ** | **June 30,   2005** | ** ** | **June 30,   2004** | ** ** | **June 30,   2005** | ** ** | **June 30,   2004** | ** ** |
|                                     |       |                     |       |                     |       |   |   |   |   |
| Net income (loss)                        |       | $                        | (1,773     | )                        | $          | 4,369 |   | $ | (1,148 | ) | $ | 6,529 |   |
| Other comprehensive income (loss):       |       |                     |       |                     |       |   |   |   |   |
| Foreign currency translation adjustments |       | (1,516                   | )          | (724                     | )          | (2,462 | ) | (1,026 | ) |
| Comprehensive income (loss)              |       | $                        | (3,289     | )                        | $          | 3,645 |   | $ | (3,610 | ) | $ | 5,503 |   |

 

See notes to condensedconsolidated financial statements.

 

5

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CHEROKEE INTERNATIONALCORPORATION AND SUBSIDIARIES

CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS(In Thousands)

(Unaudited)

 
| ** **                                                                                          | ** ** | **Six Months Ended**    | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                                                          | ** ** | **June 30,  2005** | ** ** | **June 30,  2004** | ** ** |
|                                                                                                |       |                    |       |   |   |
| CASH FLOWS FROM OPERATING ACTIVITIES:                                                               |       |                    |       |   |   |
| Net income (loss)                                                                                   |       | $                       | (1,148     | ) | $ | 6,529 |   |
| Adjustments to reconcile net income (loss)  to net cash provided by (used in) operating activities: |       |                    |       |   |   |
| Depreciation and amortization                                                                       |       | 1,537                   |       | 1,569 |   |
| Gain on sale of property and equipment                                                              |       | (30                     | )          | — |   |
| Amortization of deferred financing costs                                                            |       | 64                      |       | 86 |   |
| Write-off of unamortized deferred financing  costs and debt discount                                |       | —                  |       | 224 |   |
| Net change in operating assets and  liabilities:                                                    |       |                    |       |   |   |
| Accounts receivable, net                                                                            |       | 1,900                   |       | (1,195 | ) |
| Inventories, net                                                                                    |       | (1,025                  | )          | (1,454 | ) |
| Prepaid expenses and other current assets                                                           |       | 407                     |       | (1,150 | ) |
| Deposits and other assets                                                                           |       | (292                    | )          | (755 | ) |
| Accounts payable                                                                                    |       | (2,185                  | )          | (344 | ) |
| Accrued liabilities and accrued  restructuring costs                                                |       | 1,449                   |       | (1,656 | ) |
| Accrued compensation and benefits                                                                   |       | (794                    | )          | (695 | ) |
| Accrued interest payable                                                                            |       | 9                       |       | (290 | ) |
| Other long-term obligations                                                                         |       | 176                     |       | (1,642 | ) |
| Net cash provided by (used in) operating  activities                                                |       | 68                      |       | (773 | ) |
|                                                                                                |       |                    |       |   |   |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                                               |       |                    |       |   |   |
| Additions to property and equipment                                                                 |       | (3,401                  | )          | (2,403 | ) |
| Net change in short-term investments                                                                |       | 3,845                   |       | 91 |   |
| Proceeds from sale of property and  equipment                                                       |       | 34                      |       | — |   |
| Net cash provided by (used in) investing  activities                                                |       | 478                     |       | (2,312 | ) |
|                                                                                                |       |                    |       |   |   |
| 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                                                       |       | —                  |       | (480 | ) |
| Payments on long-term debt                                                                          |       | —                  |       | (65,519 | ) |
| Deferred financing costs                                                                            |       | —                  |       | (236 | ) |
| Proceeds from employee stock purchases and  the exercise of warrants and stock options              |       | 90                      |       | 16 |   |
| Net proceeds from sale of common stock                                                              |       | —                  |       | 87,570 |   |
| Net cash provided by financing activities                                                           |       | 90                      |       | 15,219 |   |
|                                                                                                |       |                    |       |   |   |
| Cash effect of exchange rate changes                                                                |       | (1,040                  | )          | (798 | ) |
|                                                                                                |       |                    |       |   |   |
| Net increase (decrease) in cash and cash  equivalents                                               |       | (404                    | )          | 11,336 |   |
| Cash and cash equivalents, beginning of  period                                                     |       | 14,585                  |       | 4,887 |   |
|                                                                                                |       |                    |       |   |   |
| Cash and cash equivalents, end of period                                                            |       | $                       | 14,181     |   | $ | 16,223 |   |
|                                                                                                |       |                    |       |   |   |
| SUPPLEMENTAL INFORMATION                                                                            |       |                    |       |   |   |
| Conversion of senior convertible notes into  common stock                                           |       | $                       | —     |   | $ | 53,370 |   |
| Accrued initial public offering costs  netted against paid-in capital                               |       | —                  |       | 1,100 |   |

 

See notes to condensedconsolidated financial statements.

 

6

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CHEROKEE INTERNATIONALCORPORATION AND SUBSIDIARIES

NOTESTO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Unaudited)

 

1.             Nature of Operations

 

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

 

*Initial Public Offering*

 

The Company completed its initial public offering of6,600,000 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 netproceeds to the Company from this offering after offering costs of $9.2 millionwere $86.5 million.  The Company used approximately $73.2 million of thenet proceeds to repay certain outstanding indebtedness and accruedinterest.  Immediately prior to the consummation of the offering, theCompany completed a 1 for 3.9 reverse stock split of its outstanding CommonStock.  All share and per share amounts for all periods presented in thisreport reflect this reverse stock split.  Also in connection with theoffering, the Company issued 6,283,796 shares of Common Stock upon conversionof the original principal amount of its outstanding senior convertible notes of$53.4 million, and issued 4,071,114 shares of Common Stock upon the exercise ofoutstanding warrants.

 

2.             Basis of Presentation and Summary ofSignificant Accounting Policies

 

*Basis of Presentation*

 

The information set forth in the accompanyingcondensed consolidated financial statements is unaudited and, in the opinion ofmanagement, reflects all adjustments, consisting only of normal recurringadjustments, considered necessary to present fairly the financial position,results of operations and cash flows of the Company for the periods indicated.

 

Results of operations for the interim three monthand six month periods ended June 30, 2005 and 2004 are not necessarilyindicative of the results of operations for the full fiscal year. The Company’ssecond quarters in 2005 and 2004 represented the 13-week periods ended on July3, 2005 and June 27, 2004. For presentation purposes, these fiscal quarters,and the six month periods then ended, have been referred to as ending on June30.

 

The condensed consolidated financial statementsinclude the financial statements of the Company and its wholly ownedsubsidiaries. All intercompany accounts and transactions have been eliminated.

 

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

 

7

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*Use of Estimates*

 

The preparation of financial statements inaccordance with accounting principles generally accepted in the United Statesof America requires management to make estimates and assumptions that affectthe reported amounts of assets and liabilities and disclosure of contingentliabilities at the date of the financial statements and the amounts of revenuesand expenses during the reporting period.  Actual results could differfrom such estimates.

 

*Stock-Based Compensation*

 

As permitted by SFAS No. 123, “Accounting forStock-Based Compensation,” the Company accounts for its employee stock-basedcompensation plan using the intrinsic value method under APB OpinionNo. 25, “Accounting for Stock Issued to Employees,” and provides theexpanded disclosures specified in SFAS No. 123, as amended by SFASNo. 148, “Accounting for Stock-Based Compensation—Transition andDisclosure.”

 

The table below reconciles net income (loss) asreported and pro forma net income (loss) had compensation cost been determinedusing the provisions of SFAS No. 123 for the three month and six monthperiods ended June 30, 2005 and 2004 (in thousands, except per share data):

 
| ** **                                                                                                                | ** ** | **Three Months Ended**  | ** ** | **Six Months Ended**    | ** ** |
|---------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|
| ** **                                                                                                                | ** ** | **June 30,  2005** | ** ** | **June 30,  2004** | ** ** | **June 30,  2005** | ** ** | **June 30,  2004** | ** ** |
| Net income (loss), as reported                                                                                            |       | $                       | (1,773     | )                       | $          | 4,369 |   | $ | (1,148 | ) | $ | 6,529 |   |
| Stock-based employee compensation included  in net income (loss), net of tax                                              |       | —                  |       | —                  |       | — |   | — |   |
| Total stock-based employee compensation  expense determined under the fair value based method for all awards, net of  tax |       | (324                    | )          | (208                    | )          | (616 | ) | (325 | ) |
| Net income (loss)-pro forma                                                                                               |       | $                       | (2,097     | )                       | $          | 4,161 |   | $ | (1,764 | ) | $ | 6,204 |   |
|                                                                                                                      |       |                    |       |                    |       |   |   |   |   |
| Net income (loss) per share, as reported:                                                                                 |       |                    |       |                    |       |   |   |   |   |
| Basic                                                                                                                     |       | $                       | (0.09      | )                       | $          | 0.23 |   | $ | (0.06 | ) | $ | 0.46 |   |
| Diluted                                                                                                                   |       | $                       | (0.09      | )                       | $          | 0.22 |   | $ | (0.06 | ) | $ | 0.42 |   |
| Pro forma net income (loss) per share:                                                                                    |       |                    |       |                    |       |   |   |   |   |
| Basic                                                                                                                     |       | $                       | (0.11      | )                       | $          | 0.22 |   | $ | (0.09 | ) | $ | 0.44 |   |
| Diluted                                                                                                                   |       | $                       | (0.11      | )                       | $          | 0.21 |   | $ | (0.09 | ) | $ | 0.41 |   |

 

For the purpose of estimating the compensation costof the Company’s option grants in accordance with SFAS No. 123, the fairvalue 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.

 

*Translation of Foreign Currency*

 

Foreign subsidiary assets and liabilitiesdenominated in foreign currencies are translated at the exchange rate on thebalance sheet date.  Revenues, costs and expenses are translated at theaverage exchange rate during the period.  Transaction gains and losses areincluded in results of operations and have not been significant for the periodspresented.  The functional currency of the Company’s operating subsidiaryin Europe, Cherokee Europe SCA (“Cherokee Europe”), is the Euro.  Thefunctional currency of the Company’s operating subsidiaries in Mexico (CherokeeElectronica, S.A. DE C.V.), India (Cherokee India Pvt. Ltd. and Powertel IndiaPvt. Ltd.), and China (Cherokee International (China) Power Supply Ltd.) is theU.S. dollar, as the majority of transactions are denominated in U.S.dollars.  Translation adjustments related to Cherokee Europe are

 

8

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reflectedas a component of stockholders’ equity in accumulated other comprehensiveincome.

 

*Recent Accounting Pronouncements*

 

In November 2004, the Financial AccountingStandards Board (“FASB”) issued SFAS No. 151, “Inventory Costs—anamendment of ARB No. 43, Chapter 4.” This statement amends the guidance inARB No. 43, Chapter 4, “Inventory Pricing,” to clarify the accounting forabnormal amounts of idle facility expense, freight, handling costs, and wastedmaterial (spoilage). Abnormal amounts of these costs should be recognized ascurrent period charges rather than as a portion of inventory costs. Inaddition, SFAS 151 requires that allocation of fixed production overheads tothe costs of manufacturing be based on the normal capacity of the productionfacilities. The provisions of SFAS 151 are effective for inventory costsincurred during fiscal years beginning after June 15, 2005. The Company iscurrently evaluating the effect that the adoption of this new standard may haveon the Company’s consolidated financial position and results of operations.

 

In December 2004, the FASB issued SFAS 123R(Revised 2004), “Share-Based Payment,” which requires that the compensationcost relating to share-based payment transactions be recognized in financialstatements based on the fair value of the award on the date of grant. The costwill be recognized over the period during which the employee is required toprovide service in exchange for the award (usually the vesting period). TheCompany currently discloses pro forma compensation expense quarterly andannually. Upon adoption, the pro forma disclosures previously permitted underSFAS 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.The Company is currently evaluating the method of adoption and the effect thatthe adoption of SFAS 123R will have on the Company’s consolidated financialposition and results of operations.

 

In December 2004, the FASB issued SFASNo. 153, “Exchanges of Nonmonetary Assets—an amendment of APB OpinionNo. 29.” The amendment eliminates the exception to fair value accountingfor nonmonetary exchanges of similar productive assets and replaces it with abroader exception for exchanges of nonmonetary assets that do not havecommercial substance. Under APB 29, accounting for an exchange of a productiveasset for a similar productive asset or an equivalent interest in the same orsimilar productive asset is to be based upon the recorded amount of the assetrelinquished (carryover basis with no gain or loss recognition). Thetransaction 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, the FASB issued Staff PositionNo. 109-2, “Accounting and Disclosure Guidance for the Foreign EarningsRepatriation Provision within the American Jobs Creation Act of 2004” (“FSP 109-2”).In October 2004, the American Jobs Creation Act of 2004 (the “Act”) was signedinto law. The Act contains a number of provisions that may affect the Company’sfuture effective income tax rate. The most significant provision would allowthe Company to elect to deduct from its taxable income 85% of certain eligibledividends received by the Company from its non-U.S. subsidiaries before the endof 2005. FSP 109-2 provides entities additional time, beyond the financialreporting period in which the Act was enacted, to evaluate the effects of theAct on the Company’s plan for reinvestment or repatriation of foreign earnings. The Company has not yet completed its evaluation of the impact, if any,of the repatriation provisions of this Act nor has it determined the relatedrange of income tax effects of such repatriation. That evaluation is expectedto be complete by the end of fiscal year 2005.

 

In June 2005,the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections,”which changes the requirements for the accounting for and reporting ofvoluntary changes in accounting principle. SFAS 154 requires retrospectiveapplication to prior periods’ financial statements of changes in accountingprinciple, unless impracticable. SFAS 154 supersedes Accounting Principles BoardOpinion No. 20, Accounting Change (APB 20), which previously required thatmost voluntary changes in accounting principle be recognized by including inthe current period’s net income the cumulative effect of changing to the newaccounting principle. SFAS 154 also makes a distinction between retrospectiveapplication of an accounting principle and the restatement of financialstatements to reflect correction of an error. SFAS 154 carries forward withoutchanging the guidance contained in APB 20 for reporting the correction of anerror in previously issued financial statements and a change in accountingestimate. SFAS 154 applies to voluntary changes in accounting principle thatare made in fiscal years beginning after December 15, 2005. The adoptionof SFAS 154 is not expected to have a material impact on the Company’sfinancial condition or results of operations.

 

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*Inventories*

 

Inventories are valued at the lower of weightedaverage cost or market. Inventory costs include the cost of material, labor andmanufacturing overhead and consist of the following, net of reserve forobsolescence (in thousands):

 
| ** **       | ** ** | **June 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|------------------|------------|-------------------------|------------|-----------------------------|------------|
|             |       |                    |       |                        |       |
| Raw material     |       | $                       | 18,268     |                        | $          | 20,788 |   |
| Work-in-process  |       | 4,872                   |       | 4,741                       |       |
| Finished goods   |       | 5,209                   |       | 2,749                       |       |
|             |       |                    |       |                        |       |
| Inventories, net |       | $                       | 28,349     |                        | $          | 28,278 |   |

 

As of June 30, 2005 and December 31, 2004,the reserve for inventory obsolescence was $4.4 million and $4.5 million,respectively.

 

3.             Income Taxes

 

The Company accounts for income taxes in accordancewith SFAS No. 109, “Accounting for Income Taxes.”  In accordance withSFAS No. 109, deferred tax assets and liabilities are recorded for theestimated future tax effects of temporary differences between the carrying valueof assets and liabilities for financial reporting and their tax basis, andcarryforwards to the extent they are realizable.  A deferred tax provisionor benefit results from the net change in deferred tax assets and liabilitiesduring the period.  A deferred tax asset valuation allowance is recordedif it is more likely than not that all or a portion of the recorded deferredtax assets will not be realized.  As of December 31, 2004, deferredtax assets include $38.5 million relating to a tax basis step up from arecapitalization transaction in 1999 and $15.0 million of net operating losscarryforwards.  The Company has recorded a full valuation allowanceagainst its deferred tax assets.

 

Provision for income taxes of $1.3 million for thesix months ended June 30, 2005 was calculated by estimating full-year 2005taxable income separately for each tax jurisdiction and allocating the relatedincome tax provision to the period during which the income was generated.  For the six months ended June 30, 2005, provisionfor income taxes of $1.3 million was larger than operating income of $0.2million, because a portion of taxable income for 2005 is generated in taxjurisdictions without operating loss carryforwards, while taxable losses aregenerated in certain other tax jurisdictions, with no available tax benefitrelated to these losses included in the provision for income taxes.

 

4.             Net Income (Loss) Per Share

 

In accordance with SFAS No. 128, “Earnings PerShare,” basic earnings per share is based upon the weighted average number ofcommon shares outstanding.  Diluted earnings per share is based upon theweighted average number of common and potential shares of common stock for eachperiod presented, except for periods that reflect net losses, in which case addingpotential shares of common stock would be anti-dilutive.  Potential commonshares include the dilutive effect, if any, of stock options, warrants and theemployee stock purchase plan under the treasury stock method and seniorconvertible notes under the if-converted method.  For purposes of thediluted earnings per share calculation for the three month and six monthperiods ended June 30, 2005, potential common shares of 12,000 and 72,000,respectively, were excluded because their effect would be anti-dilutive.  For purposes of the diluted earnings pershare calculation for the three month and six month periods ended June 30,2004, 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.

 

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The following table sets forth the computation ofbasic and diluted net income per share (in thousands, except per shareamounts):

 
| ** **                                               | ** ** | **Three Months Ended**  | ** ** | **Six Months Ended**    | ** ** |
|----------------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|
| ** **                                               | ** ** | **June 30,  2005** | ** ** | **June 30,  2004** | ** ** | **June 30,  2005** | ** ** | **June 30,  2004** | ** ** |
|                                                     |       |                    |       |                    |       |   |   |   |   |
| Net income (loss)                                        |       | $                       | (1,773     | )                       | $          | 4,369 |   | $ | (1,148 | ) | $ | 6,529 |   |
|                                                     |       |                    |       |                    |       |   |   |   |   |
| Shares:                                                  |       |                    |       |                    |       |   |   |   |   |
| Weighted-average common shares  outstanding—basic   |       | 19,221                  |       | 19,182                  |       | 19,214 |   | 14,241 |   |
| Effect of dilutive securities:                           |       |                    |       |                    |       |   |   |   |   |
| Senior convertible notes and warrants                    |       | —                  |       | —                  |       | — |   | 3,015 |   |
| Outstanding stock options                                |       | —                  |       | 528                     |       | — |   | 563 |   |
| Weighted-average common shares  outstanding—diluted |       | 19,221                  |       | 19,710                  |       | 19,214 |   | 17,819 |   |
|                                                     |       |                    |       |                    |       |   |   |   |   |
| Net income (loss) per share:                             |       |                    |       |                    |       |   |   |   |   |
| Basic                                                    |       | $                       | (0.09      | )                       | $          | .23 |   | $ | (0.06 | ) | $ | .46 |   |
| Diluted                                                  |       | $                       | (0.09      | )                       | $          | .22 |   | $ | (0.06 | ) | $ | .42 |   |

 

5.             Deferred Financing Costs

 

Net deferred financing costs are comprised of thefollowing as of June 30, 2005 and December 31, 2004 (in thousands):

 
| ** **                    | ** ** | **June 30,  2005** | ** ** | **December 31, 2004** | ** ** |
|-------------------------------|------------|--------------------|------------|----------------------------|------------|
|                          |       |               |       |                       |       |
| Deferred financing costs      |       | $                  | 580        |                       | $          | 580 |   |
| Accumulated amortization      |       | (169               | )          | (104                       | )          |
|                          |       |               |       |                       |       |
| Deferred financing costs, net |       | $                  | 411        |                       | $          | 476 |   |

 

The Company amortizes deferred financing costs overthe life of the related debt.

 

6.             Long-Term Debt

 

Long-term debt consists of the following at June 30,2005 and December 31, 2004 (in thousands):

 
| ** **                                    | ** ** | **June 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|-----------------------------------------------|------------|--------------------|------------|-----------------------------|------------|
| 5.25% senior notes payable to third  parties: |       |               |       |                        |       |
| Non-current                                   |       | $                  | 24,485     |                        | $          | 24,485 |   |
| 5.25% senior notes payable to affiliates:     |       |               |       |                        |       |
| Non-current                                   |       | 22,145             |       | 22,145                      |       |
| Total long-term debt                          |       | $                  | 46,630     |                        | $          | 46,630 |   |

 

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The senior notes mature on November 1,2008.  Interest on the senior notes is payable in cash on May 1 andNovember 1 of each year.  The senior notes are secured by a secondpriority lien on substantially all of the Company’s domestic assets and by apledge of 65% of the equity of certain of its foreign subsidiaries.  As ofJune 30, 2005, the Company was in compliance with all of the covenants setforth in the principal agreements governing the 5.25% senior notes.

 

Inconnection with the Company’s initial public offering completedFebruary 25, 2004, the Company amended and restated its 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 $13.6 million at June 30, 2005. The CreditFacility matures in August 2008 and borrowings bear interest, at theCompany’s option, at a rate per annum equal to LIBOR plus 2.5% or the agentbank’s base rate plus 1.0%. In addition to paying interest on outstandingprincipal, the Company is required to pay a commitment fee to the lenders underthe credit facility in respect of the average daily balance of unused loancommitments at a rate of 0.5% per annum. The Credit Facility is secured by afirst-priority lien, subject to permitted encumbrances, on substantially all ofthe Company’s domestic assets and by a pledge of 65% of the equity of certainof the Company’s foreign subsidiaries. The Credit Facility contains restrictivecovenants requiring the Company to, among other things, maintain certain seniorleverage ratios. As of June 30, 2005, there were no borrowings outstandingunder the Credit Facility, and the Company was in compliance with all of thecovenants under the Credit Facility.

 

Cherokee Europe maintains a working capital line ofcredit of approximately $3.6 million with a Belgian bank, BBL, which is denominatedin Euros, collateralized by a pledge in first and second rank over a specificamount of business assets, requires Cherokee Europe to maintain a certainspecific minimum solvency ratio and is cancelable at any time.  As of June30, 2005, Cherokee Europe had no outstanding borrowings under the line ofcredit and was in compliance with all covenants.

 

7.             Other Long-Term Obligations

 

Other long-term obligations consist of the followingat June 30, 2005 and December 31, 2004 (in thousands):

 
| ** **                                                    | ** ** | **June 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|---------------------------------------------------------------|------------|--------------------|------------|-----------------------------|------------|
| Long term portion of European restructuring  cost liabilities |       | $                  | 1,243      |                        | $          | 1,508 |   |
| Long service award liabilities                                |       | 1,912              |       | 2,057                       |       |
| Deferred compensation                                         |       | 871                |       | 701                         |       |
| Total other long-term obligations                             |       | $                  | 4,026      |                        | $          | 4,266 |   |

 

8.             Cherokee Europe Restructuring

 

In June 2003, the Company received approval fora restructuring plan (the “European Restructuring”) of its operations in Europefrom the Workers Union and the appropriate governmental authorities inBelgium.  The European Restructuring involved the elimination of 61operational and administrative positions at the Cherokee Europe facility inBelgium due to unfavorable economic conditions in that market.  All of theterminations were completed in 2003.  Pursuant to the European Restructuring,the Company recorded a restructuring charge of $4.5 million in operatingexpenses in the statement of operations during fiscal year 2003.  TheEuropean Restructuring costs are comprised entirely of one-time terminationbenefits to be paid through 2010.  The Company has paid $0.2 millionduring the six month period ended June 30, 2005 under the EuropeanRestructuring.

 

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A reconciliation of the European Restructuringaccrual for the period January 1, 2005 through June 30, 2005 is as follows(in thousands):

 
| Balance as  of December 31, 2004 |   | $      | 1,767  |   |
|----------------------------------|--------|--------|--------|--------|
| Provision                        |   | — |   |
| Payments                         |   | (178   | )      |
| Foreign exchange rate effect     |   | (206   | )      |
| Balance as of June 30, 2005      |   | 1,383  |   |
| Less current portion             |   | (140   | )      |
| Due after one year               |   | $      | 1,243  |   |

 

9.             Customer Concentration

 

For the quarter ended June 30, 2005, one customeraccounted for 13% of net sales, and no other customer accounted for more than10% of net sales.  For the six months ended June 30, 2005, two customersaccounted for 13% and 11% of net sales, respectively.  For the quarter and six months endedJune 30, 2004, one customer accounted for 20% and 23% of net sales,respectively, and no other customer accounted for more than 10% of netsales.  A decision by a major customer to decrease the amount purchasedfrom the Company or to cease purchasing the Company’s products could have amaterial adverse effect on the Company’s financial position and results ofoperations.

 

As of June 30, 2005, the Company had onecustomer that accounted for 13% of net accounts receivable, and no othercustomer accounted for more than 10% of net accounts receivable.

 

10.           Commitments and Contingencies

 

*Guarantees and Indemnities*

 

The Company has agreed to indemnify the formerowners of Cherokee Europe for product liability, environmental hazard andemployment practice claims relating solely to post-acquisition business. The Company also indemnifies its directors and officers to the maximum extentpermitted under the laws of the State of Delaware, and various lessors inconnection with facility leases for certain claims arising from such facilityor lease.  No claims are currently pending against the Company for suchindemnifications. The maximum amount of potential future payments under such indemnificationsis not determinable.

 

The Company has not incurred significant amountsrelated to these guarantees and indemnifications, and no liability has beenrecorded in the financial statements for guarantees and indemnifications as ofJune 30, 2005.

 

11.           Stock and Deferred Compensation Plans

 

*2004 Employee Stock Purchase Plan*

 

On February 16, 2004, the Company adopted the2004 Employee Stock Purchase Plan (the ‘‘ESPP’’).  As of June 30, 2005, a total of 592,062 sharesof Common Stock were authorized for issuance under the plan.  The number of shares authorized under the planwill increase annually on the first day of the Company’s fiscal year in anamount equal to the lesser of (i) 250,000 shares or (ii) 1% of thenumber of outstanding shares on the last day of the immediately precedingfiscal year. The ESPP utilizes six-month offerings with employee 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

 

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May 14,respectively. The Compensation Committee of the Company’s Board of Directorsoversees administration of the ESPP. Employees are eligible to participate ifthey are employed for at least 20 hours per week and more than 5 months in acalendar year by the Company, subject to certain restrictions.  The ESPP permits eligible employees topurchase Common Stock through payroll deductions, which may not exceed 15% ofan employee’s compensation. The price of Common Stock purchased under the ESPPis 85% of the lower of the fair market value of the Common Stock at thebeginning of each six-month offering period or on the applicable purchase date.Employees may end their participation in an offering at any time during theoffering period, and participation ends automatically upon termination ofemployment. The Compensation Committee may at any time amend or terminate theESPP, except that no such amendment or termination may adversely affect sharespreviously granted under the ESPP. As of June 30, 2005, 44,570 shares have beenissued under the ESPP.

 

*2004 Omnibus Stock Incentive Plan*

 

On February 16, 2004, the Company adopted the2004 Omnibus Stock Incentive Plan (the ‘‘2004 Plan’’).  As of June 30, 2005, a total of 1,184,124shares of the Company’s Common Stock were authorized for issuance under the2004 Plan. The number of shares authorized under the 2004 Plan will increaseannually on the first day of the Company’s fiscal year in an amount equal tothe lesser of (i) 450,000 shares or (ii) 2% of the number ofoutstanding shares on the last day of the immediately preceding fiscal year.Any officer, director, employee, consultant or advisor of the Company is eligibleto participate in the 2004 Plan. The 2004 Plan provides for the issuance ofstock-based incentive awards, including stock options, stock appreciationrights, restricted stock, deferred stock, and performance shares. As of June30, 2005, the Company has granted options to purchase 741,000 shares of Common Stockunder the 2004 Plan, which included 130,000 options granted to non-employeedirectors. As of June 30, 2005, no shares have been issued under the 2004 Plan.

 

*Deferred Compensation Plans*

 

On February 16, 2004, the Company adopted twoexecutive deferred compensation plans for the benefit of certain designatedemployees and non-employee directors of the Company. The plans allowparticipating employees and non-employee directors to make pre-tax deferrals ofup to 100% of their annual base salary and bonuses and retainer fees andmeeting fees, respectively. The plans allow the Company to make matchingcontributions and employer profit sharing credits at the sole discretion of theCompany. A participant’s interest in each matching contribution and employerprofit sharing credits, if any, vests in full no later than after 3 years. Asof June 30, 2005, the Company has recorded a liability of $0.9 million foremployee and non-employee director contributions and investment activity todate, which is recorded in other long-term liabilities.  The Company has provided no matchingcontributions for the quarter ended June 30, 2005.

 

12.           Retirement Plans

 

Cherokee Europe maintains a pension plan for certainlevels of staff and management that includes a defined benefit feature. The following represents the amounts related to this defined benefit plan forthe three month and six month periods ended June 30, 2005 and 2004 (inthousands):

 
| ** **                                   | ** ** | **Three Months Ended**  | ** ** | **Six Months Ended**    | ** ** |
|----------------------------------------------|------------|-------------------------|------------|-------------------------|------------|
| **Components of Net Periodic  Benefit Cost** | ** ** | **June 30,  2005** | ** ** | **June 30,  2004** | ** ** | **June 30,  2005** | ** ** | **June 30,  2004** | ** ** |
| Service cost                                 |       | $                       | 38         |                    | $          | 39 |   | $ | 78 |   | $ | 77 |   |
| Interest cost                                |       | 62                      |       | 60                      |       | 127 |   | 119 |   |
| Expected return on plan assets               |       | (35                     | )          | (35                     | )          | (71 | ) | (69 | ) |
| Net periodic benefit cost                    |       | $                       | 65         |                    | $          | 64 |   | $ | 134 |   | $ | 127 |   |

 

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

 

13.           Gain From Insurance Proceeds

 

On January 19, 2004, the Company experienced afire in part of its facility in Belgium, which destroyed certain inventory,property and equipment. As of June 30, 2005, the Company has received $6.3million in insurance proceeds.  Includedin the statement of operations for the six months ended June 30, 2005 is a gainfrom insurance proceeds of $2.5 million, which represents the excess ofinsurance proceeds received over the net book value of assets destroyed andrelated expenditures.

 

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MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

**Item 2.  Management’s Discussion and Analysis ofFinancial Condition and Results of Operations.**

 

OVERVIEW

 

 We are a designer and manufacturer of powersupplies for OEMs. Our advanced power supply products are typically customdesigned into mid- to high-end commercial applications in the computing andstorage, wireless infrastructure, enterprise networking, medical and industrialmarkets.

 

We operate worldwide and have facilities in OrangeCounty, California; Bombay, India; Guadalajara, Mexico; Wavre, Belgium; andShanghai, China. We were founded in 1978 in Orange County, California. As weexpanded our business and customer base, we opened facilities in Bombay, Indiaand in Guadalajara, Mexico. In June 2000, we acquired Cherokee Europe,which added a manufacturing facility in Wavre, Belgium and enabled us to betterserve the European market.  In 2005, westarted operations in China to better serve that market and improve ourmaterials sourcing.

 

We generate a significant portion of our sales fromOEMs in the communications and computing market segment, particularly thewireless infrastructure and networking sectors. During 2001, 2002 and the firstquarter of 2003, our operating results were negatively affected by unfavorableeconomic conditions and reduced capital spending by communication serviceproviders that purchase our customers’ products. Although we saw improvement inthese economic conditions throughout the balance of 2003 and into 2004, weexperienced lower sales during the second half of 2004, which has continuedinto the first half of 2005. If conditions do not improve, or insteaddeteriorate further, our operating results and financial condition could beadversely affected.

 

Gross margins in the second half of 2004 and thefirst half of 2005 reflect a shift in our sales mix, with increased salescoming from certain programs with higher material cost, combined with increasedrevenues from new programs, which typically have higher material and laborcosts in the early stages of production.

 

We completed our initial public offering of6,600,000 shares of our common stock on February 25, 2004. The netproceeds 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, in connection with the offering, weamended and restated our 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 $13.6million at June 30, 2005. Please refer to “Liquidity and Capital Resources”below for additional information regarding our outstanding indebtedness.

 

During 2005 and early 2006, we plan to expand operationsin China by constructing a 100,000 square foot facility near Shanghai, whichwill result in capital expenditures in 2005 being significantly higher thanprevious years’ levels.  We beganconstruction of this facility in the second quarter of 2005 and have recorded$1.0 million of construction-in-progress.

 

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BASISOF REPORTING

 

*Net Sales*

 

Net sales consist of sales during the periodpresented, net of returns. Revenue is recognized from product sales at the timeof shipment and passage of title.

 

*Cost of Sales*

 

The principal elements comprising cost of sales areraw materials, labor and manufacturing overhead. Raw materials account for alarge majority of costs of sales. Raw materials include magneticsub-assemblies, sheet metal, electronic and other components, mechanical partsand electrical wires. Direct labor costs include costs of hourly employees.Manufacturing overhead includes salaries and the direct expense and allocationof costs attributable to manufacturing for lease costs, depreciation onproperty, plant and equipment, utilities, property taxes and repairs andmaintenance.

* *

*Operating Expenses*

 

Operating expenses include engineering costs,selling and marketing costs and general and administrative expenses.Engineering costs primarily include salaries and benefits of engineeringpersonnel, safety approval and quality certification fees, depreciation onequipment and subcontract costs for third-party contracting services. Sellingand marketing expenses primarily include salaries and benefits to accountmanagers and commissions to independent sales representatives. Administrativeexpenses primarily include salaries and benefits for certain management andadministrative personnel, professional fees and information system costs.Operating expenses also include the direct expense and allocation of costsattributable to these departments for lease costs, depreciation on property,plant and equipment, utilities, property taxes and repairs and maintenance.

 

CRITICALACCOUNTING POLICIES

 

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

 

*Revenue Recognition*

 

We recognize revenue from product sales at the timeof shipment and passage of title. We also offer our customers the right toreturn products that do not function properly within a limited time afterdelivery. We monitor and track product returns and record a provision forwarranty costs based on historical experience, which has been insignificant toour financial condition and results of operations. Any significant increase inproduct failure rates could have a material adverse effect on our operating resultsfor the period or periods in which those returns materialize.

 

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*Accounts Receivable*

 

We perform ongoing credit evaluations of ourcustomers and adjust credit limits based upon payment history, the customer’scurrent credit worthiness and various other factors, as determined by ourreview of their current credit information. We continuously monitor collectionsand payments from our customers and maintain a provision for estimated creditlosses based upon our historical experience and any specific customercollection issues that we have identified. While credit losses havehistorically been within our expectations and the provisions established, wemay not continue to experience the same credit loss rates that we have in thepast. A significant portion of our accounts receivable is concentrated in asmall number of customers. A significant change in the liquidity or financialposition of any one of these customers could have a material adverse effect onthe collectibility of our accounts receivable, our liquidity and our futureoperating results.

 

*Inventories*

 

We value our inventory at the lower of the actualcost to purchase and/or manufacture the inventory and the current estimatedmarket value of the inventory using the weighted average cost method. Weregularly review inventory quantities on hand and record a provision for excessand obsolete inventory based primarily on our historical usage data andestimates of future demand. Our industry is characterized by rapidtechnological 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.

 

*Deferred Taxes*

 

We recognize deferred tax assets and liabilitiesbased on the differences between the financial statement carrying values andthe tax basis of assets and liabilities. We regularly review our deferred taxassets for recoverability and establish a valuation allowance based onhistorical taxable income, projected future taxable income, and the expectedtiming of the reversals of existing temporary differences. If our futuretaxable income is significantly higher than expected and/or we are able toutilize our tax credits, we may be required to reverse all or a significantpart of our valuation allowance against such deferred tax assets which couldsubstantially reduce our effective tax rate for such period. Therefore, anysignificant changes in statutory tax rates or the amount of our valuationallowance could have a material effect on the value of our deferred tax assetsand liabilities and our reported financial results.

 

*Goodwill and Long Lived Assets*

 

We review the recoverability of the carrying valueof goodwill on an annual basis or more frequently when an event occurs orcircumstances change to indicate that an impairment of goodwill has possiblyoccurred. The determination of whether any potential impairment of goodwillexists is based upon a comparison of the fair value of the reporting unit tothe accounting value of its net assets.

 

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We also review the recoverability of the carryingvalue of long-lived assets whenever events or changes in circumstances indicatethat the carrying amount of an asset may not be recoverable. Recoverability ofthese assets is determined based upon the forecasted undiscounted future netcash flows from the operations to which the assets relate, utilizing our bestestimates, appropriate assumptions and projections at the time. These projectedfuture cash flows may vary significantly over time as a result of increasedcompetition, changes in technology, fluctuations in demand, consolidation ofour customers and reductions in average selling prices. If the carrying valueis determined not to be recoverable from future operating cash flows, the assetwould be deemed impaired and an impairment loss would be recognized to theextent the carrying value exceeded the estimated fair market value of theasset.

 

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RESULTSOF OPERATIONS

 

THREEMONTHS ENDED JUNE 30, 2005 COMPARED TO THREE MONTHS ENDED JUNE 30, 2004

 

NETSALES

 

Net sales decreased by approximately 19.8%, or $7.6million, to $31.0 million for the three months ended June 30, 2005 from $38.6million for the three months ended June 30, 2004.

 

The decrease in net sales is due primarily to areduction in demand from a number of our datacom and telecom customers,partially offset by a stronger Euro compared to the second quarter of2004.  Sales to one of our largestcustomers declined by $3.6 million compared to the prior year’s quarter.

 

GROSSPROFIT

 

Gross profit decreased by approximately 48.9%, or$6.0 million, to $6.3 million for the three months ended June 30, 2005 from$12.4 million for the three months ended June 30, 2004. Gross margin for thethree months ended June 30, 2005 decreased to 20.4% from 32.0% in the prioryear period.

 

The decrease in gross profit was due primarily tothe decrease in revenues and the resulting loss of contribution margin on thoserevenues, combined with a change in product mix during the second quarter of2005 that included programs with higher material content than the year-earlierperiod.  The decrease in gross margin was due primarily to higher laborand overhead costs as a percentage of net sales resulting from the lowerrevenue level, combined with the change in product mix.  Higher logistics costs related to certainmaterials sourcing issues experienced during the second quarter of 2005 alsocontributed to the gross margin decline.

 

OPERATINGEXPENSES

 

Operating expenses for the three months ended June30, 2005, increased by approximately 15.8%, or $1.0 million, to $7.3 millionfrom $6.3 million for the three months ended June 30, 2004.  As apercentage of sales, operating expenses increased to 23.7% from 16.4% in theprior year period.

 

The increase in operating expenses is due primarilyto increased general and administrative expenses associated with operating as anew publicly traded company.  During the second quarter of 2005, weincurred an increase in professional fees associated with compliance with therequirements of Section 404 of the Sarbanes-Oxley Act.  Also contributingto the increased expenses were severance costs related to certain employeeterminations, a stronger Euro, and start-up expenses related to establishing amanufacturing operation in China, partially offset by certain expensereductions attributable to lower revenue levels.

 

OPERATINGINCOME (LOSS)

 

As a result of the factors discussed above, we reportedan operating loss of $1.0 million for the three months ended June 30, 2005compared to operating income of $6.0 million for the three months ended June30, 2004.  Operating margin decreased to (3.3)% from 15.5% in the secondquarter of 2004.

 

INTERESTEXPENSE

 

Interest expense for the three months ended June 30,2005 was $0.7 million compared to $0.7 million for the three months ended June30, 2004. There was no appreciable change compared to the prior year’squarter.

 

20

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INCOMETAXES

 

Provision for income taxes was $0.1 million for thethree months ended June 30, 2005 compared to $0.9 million for the comparableperiod in 2004.  Provision for incometaxes for the three months ended June 30, 2005 was calculated by estimatingfull-year 2005 taxable income separately for each tax jurisdiction andallocating the related income tax provision to the quarter during which theincome was generated.  For the threemonths ended June 30, 2005, we recorded an income tax provision despitereporting a pre-tax loss, because a portion of our taxable income for 2005 isbeing generated in tax jurisdictions without operating loss carryforwards,while we are generating taxable losses in certain other tax jurisdictions, withno available tax benefit related to these losses included in the provision forincome taxes.

 

NETINCOME (LOSS)

 

As a result of the factors discussed above, werecorded a net loss of $1.8 million for the three months ended June 30, 2005,compared to net income of $4.4 million for the three months ended June 30,2004.

 

SIXMONTHS ENDED JUNE 30, 2005 COMPARED TO SIX MONTHS ENDED JUNE 30, 2004

 

NETSALES

 

Net sales decreased by approximately 16.5%, or $12.5million, to $63.0 million for the six months ended June 30, 2005 from $75.5million for the six months ended June 30, 2004.

 

The decrease in net sales is due primarily to areduction in demand from a number of our datacom and telecom customers.  Sales to one of our largest customersdeclined by $8.8 million compared to the prior year’s period.  Also contributing to the decline were theeffect of material shortages and the transitioning of certain customer programsto consignment hub arrangements. Revenue recognition on shipments to theconsignment hubs is delayed until the customer pulls the product from the hubfor their production requirements. These items were partially offset by astronger Euro compared to the prior year’s period.

 

GROSSPROFIT

 

Gross profit decreased by approximately 42.5%, or$10.3 million, to $14.0 million for the six months ended June 30, 2005 from$24.3 million for the six months ended June 30, 2004. Gross margin for the sixmonths ended June 30, 2005 decreased to 22.2% from 32.2% in the prior yearperiod.

 

The decrease in gross profit was due primarily tothe decrease in revenues and the resulting loss of contribution margin on thoserevenues, combined with a change in product mix during the first half of 2005that included programs with higher material content than the year-earlierperiod.  The decrease in gross margin was due primarily to higher laborand overhead costs as a percentage of net sales resulting from the lowerrevenue level, combined with the change in product mix.  Higher logistics costs related to certainmaterials sourcing issues experienced during the first half of 2005 alsocontributed to the gross margin decline.

 

OPERATINGEXPENSES

 

Operating expenses for the six months ended June 30,2005, decreased by approximately 1.6%, or $0.2 million, to $12.4 million from$12.6 million for the six months ended June 30, 2004.  As a percentage ofsales, operating expenses increased to 19.7% from 16.7% in the prior yearperiod.

 

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The decrease in operating expenses is primarily dueto a gain from insurance proceeds of $2.5 million related to the fire damageexperienced in the Belgium facility in February 2004. This was mostly offset byincreased general and administrative expenses associated with operating as anew publicly traded company.  During the first half of 2005, we incurred asignificant increase in audit fees and insurance costs, as well as professionalfees associated with compliance with the requirements of Section 404 of theSarbanes-Oxley Act. Also contributing to the increased expenses were astronger Euro and start-up costs related to establishing a manufacturingoperation in China.

 

OPERATINGINCOME

 

As a result of the factors discussed above,operating income decreased to $1.6 million for the six months ended June 30,2005 compared to $11.7 million for the six months ended June 30, 2004. Operating margin decreased to 2.5% from 15.5% in the prior year period.

 

INTERESTEXPENSE

 

Interest expense for the six months ended June 30,2005 was $1.4 million compared to $3.8 million for the six months ended June30, 2004.  The decrease in interest expense is due to the repayment ofdebt and conversion to equity of our senior convertible notes in connectionwith our initial public offering.

 

INCOMETAXES

 

 Provision for income taxes was $1.3 millionfor the six months ended June 30, 2005 compared to $1.3 million for thecomparable period in 2004.  Provision forincome taxes for the six months ended June 30, 2005 was calculated byestimating full-year 2005 taxable income separately for each tax jurisdictionand allocating the related income tax provision to the period during which theincome was generated.  For the six monthsended June 30, 2005, our provision for income taxes of $1.3 million was largerthan our pre-tax income of $0.2 million, because a portion of our taxableincome for 2005 is being generated in tax jurisdictions without operating losscarryforwards, while we are generating taxable losses in certain other taxjurisdictions, with no available tax benefit related to these losses includedin the provision for income taxes.

 

NETINCOME (LOSS)

 

As a result of the factors discussed above, werecorded a net loss of $1.1 million for the six months ended June 30, 2005,compared to net income of $6.5 million for the six months ended June 30, 2004.

 

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LIQUIDITYAND CAPITAL RESOURCES

 

CASHFLOWS

 

Net cash provided by operating activities was $0.1million for the six months ended June 30, 2005, compared to net cash used inoperating activities of $0.8 million for the six months ended June 30,2004.  Cash provided by operating activities for the six months ended June30, 2005 reflected the positive effect of a decrease in accounts receivable of$1.9 million, due to lower revenue levels during the second quarter of 2005compared to the fourth quarter of 2004, as well as an increase in accruedliabilities and accrued restructuring costs of $1.4 million, due primarily to ashort-term advance of $0.9 million received to fund construction costs of the Company’snew facility in China.  These items weremostly offset by a reduction in accounts payable of $2.2 million, due to lowerrevenue levels during the second quarter of 2005 compared to the fourth quarterof 2004, and an increase in inventories of $1.0 million, due primarily to anincrease in consignment hub inventories partially offset by a decrease in rawmaterials.  Net cash used in operatingactivities of $0.8 million for the six months ended June 30, 2004 reflected thepositive effect of $6.5 million of net income and $1.6 million of depreciationand amortization, as well as the negative impact of increases in accountsreceivable, inventories, and prepaid expenses and other current assets of $1.2million, $1.5 million, and $1.2 million, respectively.  In addition, an increase in accruedliabilities and accrued restructuring costs of $1.7 million and an increase inother long-term obligations of $1.6 million contributed to net cash used inoperating activities for the six months ended June 30, 2004.

 

Net cash provided by investing activities for thesix months ended June 30, 2005 was $0.5 million compared to net cash used ininvesting activities of $2.3 million for the comparable period in 2004.  Net cash provided by investing activities forthe six months ended June 30, 2005 reflected net sales of short-terminvestments of $3.8 million, mostly offset by capital expenditures of $3.4million related to manufacturing equipment, construction-in-progress in China,and leasehold improvements. Net cash used in investing activities of $2.3million for the six months ended June 30, 2004 was comprised primarily ofcapital expenditures.

 

Net cash provided by financing activities for thesix months ended June 30, 2005 was $0.1 million and was related to employeestock purchase plan proceeds. Net cash provided by financing activities of$15.2 million for the six months ended June 30, 2004 reflected the net proceedsfrom our initial public offering of $87.6 million, excluding $1.1 million ofaccrued and unpaid offering costs, offset by payments on long-term debt of$65.5 million and net payments under the old revolving lines of credit of $6.1million.

 

LIQUIDITY

 

As of June 30, 2005, we had cash and cashequivalents of $14.2 million, working capital of $45.3 million and no borrowingsunder the Credit Facility. We believe these amounts, together with cash flowsfrom operations, will be sufficient to meet our cash requirements for at leastthe next twelve months.  Historically, wehave 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 current 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 $8.0 million to $9.0million, which will relate primarily to our purchase of a building andequipment in China and investments in manufacturing equipment at otherfacilities. We invested $3.4 million in property, plant and equipment duringthe first half of 2005, of which $1.0 million related to construction of ourChina facility.

 

 As of June 30, 2005, our borrowingsconsisted of approximately $46.6 million of senior notes bearing interest at5.25% annually, and no borrowings under the Credit Facility. We are required tomake semi-annual interest payments to holders of the senior notes.

 

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We have operating lease obligations relating to ourfacilities in Tustin and Irvine, California, and Bombay, India.

 

We have purchase commitments primarily with vendorsand suppliers for the purchase of inventory, and for other goods, services, andequipment as part of the normal course of business. These commitments aregenerally evidenced by purchase orders that may or may not include cancellationprovisions. Based on current expectations, we do not believe that anycancellation penalties we incur under these obligations would have a materialadverse effect on our financial condition or results of operations.

 

The maturities of our long-term debt and futurepayments relating to our operating leases and other obligations as of June 30,2005 are as follows (in thousands):

 
| **Contractual Obligations** | ** ** | **July to  December  2005** | ** ** | **2006** | ** ** | **2007** | ** ** | **2008** | ** ** | **2009** | ** ** | **Thereafter** | ** ** | **Total** | ** ** |
|----------------------------------|------------|----------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------------|------------|-----------|------------|
|                             |       |                             |       |     |       |     |       |     |       |     |       |           |       |      |       |
| Long-term debt                   |       | $                                | —     |     | $          | —   |       | $        | —     |     | $          | 46,630         |       | $         | —     |   | $ | — |   | $ | 46,630 |   |
| Operating leases                 |       | 751                              |       | 1,511    |       | 1,523    |       | 1,534    |       | 514      |       | —         |       | 5,833     |       |
| Purchase order  commitments      |       | 14,844                           |       | 1,578    |       | —   |       | —   |       | —   |       | —         |       | 16,422    |       |
| European  restructuring          |       | 60                               |       | 225      |       | 202      |       | 179      |       | 173      |       | 544            |       | 1,383     |       |
| Long service  award              |       | 10                               |       | 48       |       | 94       |       | 184      |       | 292      |       | 1,303          |       | 1,931     |       |
| Deferred  compensation           |       | —                           |       | —   |       | —   |       | —   |       | —   |       | 871            |       | 871       |       |
|                             |       |                             |       |     |       |     |       |     |       |     |       |           |       |      |       |
| Total                            |       | $                                | 15,665     |     | $          | 3,362    |       | $        | 1,819      |     | $          | 48,527         |       | $         | 979        |   | $ | 2,718 |   | $ | 73,070 |   |

 

Long-term debt includes our senior notes, whichmature on November 1, 2008. Interest on the senior notes is payable incash on May 1 and November 1 of each year. The senior notes aresecured by a second-priority lien on substantially all of our domestic assetsand by a pledge of 65% of the equity of certain of our foreign subsidiaries.

 

In connection with our initial public offering inFebruary of 2004, we amended our existing senior revolving credit facilitywith General Electric Capital Corporation. The Credit Facility provides forborrowings of up to $20.0 million, subject to a borrowing base comprised ofeligible accounts receivable and inventory, which was $13.6 million at June 30,2005. We plan to use funds available under this credit facility to financeworking capital and other cash requirements as needed. The credit facilitymatures in August 2008 and bears interest, at our option, at a rate perannum equal to LIBOR plus 2.5% or the agent bank’s base rate plus 1.0%. Inaddition to paying interest on outstanding principal, we are required to pay acommitment fee to the lenders under the credit facility in respect of theaverage daily balance of unused loan commitments at a rate of 0.5% per annum.The Credit Facility is our senior obligation and ranks equal in right ofpayment with our existing and future permitted senior debt (including oursenior notes), and senior in right of payment to our future permittedsubordinated debt. The Credit Facility is secured by a first-priority lien,subject to permitted encumbrances, on substantially all of our domestic assetsand by a pledge of 65% of the equity of certain of our foreign subsidiaries.

 

The agreements governing the Credit Facility and oursenior notes contain covenants that restrict our business operations, includingcovenants limiting our ability to make investments, enter into mergers oracquisitions, dispose of assets, incur additional debt, grant liens, enter intotransactions with affiliates, redeem or repurchase our capital stock, repayother debt and pay dividends. The agreements also contain a financial ratiotest based on senior leverage, and customary events of default, includingdefaults in the payment of principal or interest, defaults in the compliancewith the covenants described above, cross defaults to other material debt andbankruptcy or other insolvency events.

 

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As of June 30, 2005, we were in compliance with allof the financial covenants set forth in the principal agreements governing ourdebt. Based on our present expectations, we believe that our existing cash andcash equivalents, working capital and available borrowing capacity at June 30,2005 will be sufficient to meet our anticipated cash requirements for the nexttwelve months, including operating requirements, contractual obligations,planned capital expenditures and debt service.

 

RECENTACCOUNTING PRONOUNCEMENTS

 

In November 2004, the FASB issued SFASNo. 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 afterJune 15, 2005. We are currently evaluating the effect that the adoption ofthis new standard may have on our consolidated financial position and resultsof operations.

 

In December 2004, the FASB issued SFAS 123R(Revised 2004), “Share-Based Payment,” which requires that the compensationcost relating to share-based payment transactions be recognized in financialstatements based on the fair value of the award on the date of grant. The costwill be recognized over the period during which the employee is required toprovide service in exchange for the award (usually the vesting period). Wecurrently disclose pro forma compensation expense quarterly and annually. Uponadoption, the pro forma disclosures previously permitted under SFAS 123 will nolonger be an alternative to financial statement recognition. The provisions ofSFAS 123R are effective as of the beginning of the first interim or annualreporting period that begins after December 15, 2005. We are currentlyevaluating the method of adoption and the effect that the adoption of SFAS 123Rwill have on our consolidated financial position and results of operations.

 

In December 2004, the FASB issued SFASNo. 153, “Exchanges of Nonmonetary Assets—an amendment of APB OpinionNo. 29.” The amendment eliminates the exception to fair value accountingfor nonmonetary exchanges of similar productive assets and replaces it with abroader exception for exchanges of nonmonetary assets that do not havecommercial substance. Under APB 29, accounting for an exchange of a productiveasset for a similar productive asset or an equivalent interest in the same orsimilar productive asset is to be based upon the recorded amount of the assetrelinquished (carryover basis with no gain or loss recognition). Thetransaction 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. The adoptionof SFAS 153 is not expected to have a material impact on our consolidatedfinancial position and results of operations.

 

In December 2004, the FASB issued Staff PositionNo. 109-2, “Accounting and Disclosure Guidance for the Foreign EarningsRepatriation Provision within the American Jobs Creation Act of 2004” (“FSP109-2”). In October 2004, the American Jobs Creation Act of 2004 (the“Act”) was signed into law. The Act contains a number of provisions that mayaffect our future effective income tax rate. The most significant provisionwould allow us to elect to deduct from our taxable income 85% of certaineligible dividends received by us from our non-U.S. subsidiaries before the endof 2005. FSP 109-2 provides additional time, beyond the financial reportingperiod in which the Act was enacted, to evaluate the effects of the Act on ourplan for reinvestment or repatriation of foreign earnings. We have not yetcompleted our evaluation of the impact, if any, of the repatriation provisionsof this Act nor have we determined the related range of income tax effects ofsuch repatriation. Our evaluation is expected to be complete by the end offiscal year 2005.

 

In June 2005, the FASB issued SFAS No. 154,“Accounting Changes and Error Corrections,” which changes the requirements forthe accounting for and reporting of voluntary changes in accounting principle.SFAS 154 requires retrospective application to prior periods’ financialstatements of changes in accounting principle, unless impracticable. SFAS 154supersedes Accounting Principles Board Opinion No. 20, Accounting Change (APB20), which previously required that most voluntary changes in accountingprinciple be recognized by including in the current period’s net income thecumulative effect of changing to the new accounting principle. SFAS 154 alsomakes a distinction between retrospective application of an accountingprinciple and the restatement of financial statements to reflect correction ofan error. SFAS 154 carries forward without changing the guidance contained inAPB 20 for reporting the correction of an error in previously issued financialstatements and a change in accounting estimate. SFAS 154 applies to voluntarychanges in accounting principle that are made in fiscal years beginning afterDecember 15, 2005. The adoption of SFAS 154 is not expected to have a materialimpact on the Company’s financial condition or results of operations.

 

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FORWARD-LOOKINGSTATEMENTS

 

Statements in this report containing the words“believes,” “anticipates,” “estimates,” “expects,” and similar expressions, orthe negative of such words or expressions, and any other statements which maybe construed as a prediction of future performance or events, constitute“forward-looking statements” within the meaning of the Private SecuritiesLitigation Reform Act of 1995.  These forward-looking statements are basedupon our current expectations and projections about future events.  Suchforward-looking statements involve known and unknown risks, uncertainties, andother factors that may cause our actual results, performance, or achievements,or industry results, to be materially different from any future results,performance, or achievements expressed or implied by such forward-lookingstatements.  Such factors include, among others, (1) changes ingeneral economic and business conditions, domestically and internationally,(2) reductions in sales to, or the loss of, any of our significantcustomers or in customer capacity generally, (3) changes in our sales mixto lower margin products, (4) increased competition in our industry,(5) disruptions of our established supply channels, (6) our level ofdebt and restrictions imposed by our debt agreements, and (7) theadditional risk factors identified in our filings with the Securities andExchange Commission, including our Annual Report on Form 10-K (FileNo. 000-50593).  Except as required by law, we undertake noobligation to update any forward-looking statements even though our situationmay change in the future.

 

**Item 3.    Quantitativeand Qualitative Disclosures About Market Risk.**

 

Market risk relating to our operations resultprimarily from changes in foreign currency exchange rates and short-terminterest rates.  We did not have any derivative financial instruments atJune 30, 2005.

 

We had no variable rate debt outstanding at June 30,2005.  However, any debt we incur under the Credit Facility will bearinterest at a variable rate.  We cannot predict market fluctuations ininterest rates and their impact on any variable rate debt we may incur in thefuture, nor can there be any assurance that fixed rate long-term debt will beavailable to us at favorable rates, if at all.

 

The functional currency for our European operationsis the Euro.  We are, therefore, subject to a certain degree of marketrisk associated with changes in foreign currency exchange rates.  Thisrisk is mitigated by the fact that our European revenues, costs and expensesare all generally recorded in Euros, thereby reducing the risk of foreigncurrency translations on our European operations.  The effect of foreigncurrency exchange rate fluctuations on our operating results as of and for thethree months ended June 30, 2005, was not material.  Historically, we havenot actively engaged in exchange rate hedging activities.

 

**Item 4.    Controlsand Procedures.**

 

a)         *Disclosure Controls andProcedures*

 

Our management, with the participation of our ChiefExecutive Officer and Chief Financial Officer, has evaluated the effectivenessof our disclosure controls and procedures (as such term is defined inRules 13a-15(e) and 15d-15(e) under the Securities Exchange Actof 1934, as amended (the “Exchange Act”)) as of the end of the period coveredby this report.  The evaluation included certain control areas in which wehave made changes to improve and enhance controls.  Based on suchevaluation, our Chief Executive Officer and Chief Financial Officer haveconcluded that, as of the end of such period, our disclosure controls and procedureswere effective to ensure that information required to be disclosed in ourreports filed under the Exchange Act is recorded, summarized, and reportedwithin the time periods specified in the rules and forms of the Securities andExchange Commission.

 

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b)*         Internal Control OverFinancial Reporting*

 

As discussed in our Annual Report on Form 10-K forthe year ended December 31, 2004, we did not maintain sufficientdocumentation of the design or operation of our computer program change controlprocess relating to database software, systems software and network software,and in certain circumstances we did not maintain adequate user access controls.This was considered a material weakness as of December 31, 2004.  Duringthe second quarter of 2005, third party consultants assisted us in designingand implementing appropriate procedures and controls over computer programchanges as well as user access.

 

Based on their evaluation, the Chief ExecutiveOfficer and Chief Financial Officer have concluded that as of June30, 2005, internal controls over computer program changes and user accesshave been sufficiently remediated.

 

Except as noted above, there have not been anychanges in our internal control over financial reporting (as such term isdefined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act)during the fiscal quarter to which this report relates that have materiallyaffected, or are reasonably likely to materially affect, our internal controlover financial reporting.

 

PARTII.                OTHER INFORMATION

 

**Item 1.****                                  ****Legal Proceedings**

 

During the six months ended June 30, 2005, we werenot a party to any material legal proceedings.  We are occasionally aparty to lawsuits relating to routine matters incidental to our business. As with all litigation, we can provide no assurance as to the outcome of anyparticular lawsuit, and we note that litigation inherently involves significantcosts.

 

**Item 2.****                                  ****Unregistered Sales of EquitySecurities and Use of Proceeds.**

 

On February 25, 2004, we closed the sale of6,600,000 shares of our Common Stock at a price of $14.50 per share in a firmcommitment underwritten initial public offering.  The offering waseffected pursuant to a Registration Statement on Form S-1 (FileNo. 333-110723), which the Securities and Exchange Commission declaredeffective on February 19, 2004.

 

Of the $95.7 million in gross proceeds raised by usin the offering:

 

1.                                       Approximately $6.7 million was paid to theunderwriters in connection with the underwriting discount;

 

2.                                       Approximately $2.5 million was paid by us inconnection with offering fees and expenses;

 

3.                                       Approximately $73.2 million was used to repayprincipal and interest on our outstanding indebtedness;

 

4.                                       Approximately $7.3 million has been used asof June 30, 2005, for general corporate purposes; and

 

5.                                       Approximately $6.0 million has been retainedby us for general corporate purposes and is held in high-grade commercial paperwith an original maturity of three months or less.

 

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**Item 4.Submission of Matters to a Vote of Security Holders**

 

Our Annual Meeting ofStockholders was held on June 28, 2005. Two proposals were presented to a voteof the stockholders:

 

(1)                                  the election ofdirectors for the upcoming year; and

(2)                                  the ratification ofthe selection of Deloitte & Touche LLP as the Company’s independentauditors for the year ending December 31, 2005.

 

The following table sets forth the number of votescast for, against or withheld, as well as the number of abstentions and brokernon-votes, as to each matter as applicable:

 

ProposalNo. 1 – Election of Directors.

 
| **Director**            | ** ** | **Votes For** | ** ** | **Votes Against** | ** ** | **Votes Withheld** |
|-------------------------|------------|---------------|------------|-------------------|------------|--------------------|
|                    |       |          |       |              |       |               |
| Kenneth  Kilpatrick     |       | 13,475,501    |       | —            |       | 737,259            |
| Jeffrey  Frank          |       | 13,714,725    |       | —            |       | 498,035            |
| Anthony  Bloom          |       | 13,710,910    |       | —            |       | 501,850            |
| Christopher  Brothers   |       | 13,686,248    |       | —            |       | 526,512            |
| Clark  Michael Crawford |       | 13,475,501    |       | —            |       | 737,259            |
| Raymond  Meyer          |       | 13,475,501    |       | —            |       | 737,259            |
| Ian  Schapiro           |       | 13,700,560    |       | —            |       | 512,000            |

 

ProposalNo. 2 – Ratification of the selection of Deloitte & Touche LLP as theCompany’s independent auditors.

 
| ** ** | ** ** | **Votes For** | ** ** | **Votes Against** | ** ** | **Votes Withheld** | ** ** |
|------------|------------|---------------|------------|-------------------|------------|--------------------|------------|
|       |       |          |       |              |       |               |       |
|       |       | 14,205,360    |       | 7,400             |       | —             |       |

 

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**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)                                                                                                                |
| 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 |

 

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|   | (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. |

 

 

SIGNATURES

 

Pursuantto the requirements of the Securities Exchange Act of 1934, the Registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

 

 
| Dated:  August  17, 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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