**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C.  20549**

 

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**FORM 10-Q**

 

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

 

**For the quarterly period ended June 27,2004**

 

**OR**

 

**o****TRANSITION REPORT PURSUANT TO SECTION 13 OR15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For the transition period             to            **

 

**Commission file number 000-50593**

 

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**CHEROKEE INTERNATIONAL CORPORATION**

**(Exact name of Registrant as specified in its charter)**

 

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

 

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

 

**N/A**

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

 

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

 

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

 

Indicate the number ofshares outstanding of each of the issuer’s classes of common stock, as of thelatest practicable date.

 

| **Class**                      | ** ** | **Outstanding at July 31, 2004** |
|--------------------------------|------------|---------------------------------------|
| Common stock, $0.001 par value |       | 19,182,254                            |

 

 

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TABLE OF CONTENTS

 
| PART  I—FINANCIAL INFORMATION                                                                         | 3                                                                                                                                   |
|------------------------------------------------------------------------------------------------------------|-------------------------------------------------------------------------------------------------------------------------------------|
|                                                                                                       |                                                                                                                                |
| Item  1.  Condensed Consolidated Financial  Statements (unaudited):                                   | 3                                                                                                                                   |
|                                                                                                       |                                                                                                                                |
|                                                                                                       | Condensed  Consolidated Balance Sheets—June 30, 2004 and December 31, 2003                                           | 3 |
|                                                                                                       |                                                                                                                                |   |
|                                                                                                       | Condensed  Consolidated Statements of Operations—For the Three and Six Months Ended  June 30, 2004 and 2003               | 4 |
|                                                                                                       |                                                                                                                                |   |
|                                                                                                       | Condensed  Consolidated Statements of Comprehensive Operations—For the Three and Six  Months Ended June 30, 2004 and 2003 | 5 |
|                                                                                                       |                                                                                                                                |   |
|                                                                                                       | Condensed  Consolidated Statements of Cash Flows—For the Six Months Ended June 30,  2004 and 2003                         | 6 |
|                                                                                                       |                                                                                                                                |   |
|                                                                                                       | Notes  to Condensed Consolidated Financial Statements                                                                               | 7 |
|                                                                                                       |                                                                                                                                |   |
| Item  2.  Management’s Discussion and Analysis of Financial Condition and  Results of Operations | 13                                                                                                                                  |
|                                                                                                       |                                                                                                                                |   |
| Item  3.  Quantitative and Qualitative Disclosures About Market Risk                                  | 20                                                                                                                                  |
|                                                                                                       |                                                                                                                                |   |
| Item 4.  Controls and Procedures                                                                      | 20                                                                                                                                  |
|                                                                                                       |                                                                                                                                |   |
| PART II—OTHER INFORMATION                                                                             | 21                                                                                                                                  |
|                                                                                                       |                                                                                                                                |   |
| Item 1.  Legal Proceedings                                                                            | 21                                                                                                                                  |
|                                                                                                       |                                                                                                                                |   |
| Item 2.  Changes in Securities, Use of  Proceeds and Issuer Purchases of Equity Securities            | 21                                                                                                                                  |
|                                                                                                       |                                                                                                                                |   |
| Item 6.  Exhibits and Reports on Form 8-K                                                             | 21                                                                                                                                  |
|                                                                                                       |                                                                                                                                |   |
| Signatures                                                                                                 | 22                                                                                                                                  |
|                                                                                                            |                                                                                                                                     |  |  |

 

2

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PART I.  FINANCIALINFORMATION

**Item 1.  Condensed Consolidated FinancialStatements.**

 

CHEROKEE INTERNATIONAL CORPORATION AND SUBSIDIARIES

CONDENSEDCONSOLIDATED BALANCE SHEETS

(In Thousands, Except Share Data)

(Unaudited)

 
| ** **                                                                                                                                                                         | ** ** | **June 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
|                                                                                                                                                                               |       |                    |       |                        |       |
| ASSETS                                                                                                                                                                             |       |                    |       |                        |       |
| CURRENT ASSETS:                                                                                                                                                                    |       |                    |       |                        |       |
| Cash and cash equivalents                                                                                                                                                          |       | $                       | 16,223     |                        | $          | 4,887 |   |
| Short-term investments                                                                                                                                                             |       | —                  |       | 91                          |       |
| Accounts receivable, net                                                                                                                                                           |       | 26,449                  |       | 25,579                      |       |
| Inventories                                                                                                                                                                        |       | 26,210                  |       | 24,932                      |       |
| Prepaid expenses and other current assets                                                                                                                                          |       | 2,974                   |       | 1,842                       |       |
| Total current assets                                                                                                                                                               |       | 71,856                  |       | 57,331                      |       |
|                                                                                                                                                                               |       |                    |       |                        |       |
| Property and equipment, net                                                                                                                                                        |       | 13,450                  |       | 12,781                      |       |
| Deposits and other assets                                                                                                                                                          |       | 1,005                   |       | 250                         |       |
| Deferred financing costs, net                                                                                                                                                      |       | 527                     |       | 536                         |       |
| Goodwill                                                                                                                                                                           |       | 6,317                   |       | 6,317                       |       |
|                                                                                                                                                                               |       |                    |       |                        |       |
|                                                                                                                                                                               |       | $                       | 93,155     |                        | $          | 77,215 |   |
| LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT)                                                                                                                                |       |                    |       |                        |       |
| CURRENT LIABILITIES:                                                                                                                                                               |       |                    |       |                        |       |
| Accounts payable                                                                                                                                                                   |       | $                       | 12,342     |                        | $          | 12,854 |   |
| Accrued liabilities                                                                                                                                                                |       | 7,346                   |       | 7,073                       |       |
| Accrued restructuring costs                                                                                                                                                        |       | 221                     |       | 1,144                       |       |
| Accrued compensation and benefits                                                                                                                                                  |       | 6,546                   |       | 7,346                       |       |
| Accrued interest payable                                                                                                                                                           |       | 456                     |       | 746                         |       |
| Revolving lines of credit                                                                                                                                                          |       | —                  |       | 6,132                       |       |
| Current portion of long-term debt                                                                                                                                                  |       | —                  |       | 2,562                       |       |
| Current portion of capital lease obligations                                                                                                                                       |       | 356                     |       | 848                         |       |
| Total current liabilities                                                                                                                                                          |       | 27,267                  |       | 38,705                      |       |
|                                                                                                                                                                               |       |                    |       |                        |       |
| Long-term debt, net of current portion                                                                                                                                             |       | 46,630                  |       | 162,893                     |       |
| Other long-term obligations                                                                                                                                                        |       | 3,867                   |       | 5,585                       |       |
|                                                                                                                                                                               |       |                    |       |                        |       |
| COMMITMENTS AND CONTINGENCIES (Note 11)                                                                                                                                            |       |                    |       |                        |       |
|                                                                                                                                                                               |       |                    |       |                        |       |
| STOCKHOLDERS’ EQUITY (DEFICIT)                                                                                                                                                |       |                    |       |                        |       |
| 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; 19,182,254 and 2,213,754  shares issued and outstanding at June 30, 2004 and December 31, 2003,  respectively |       | 19                      |       | 2                           |       |
|                                                                                                                                                                               |       |                    |       |                        |       |
| Paid-in capital                                                                                                                                                                    |       | 183,549                 |       | 43,710                      |       |
| Accumulated deficit                                                                                                                                                                |       | (169,578                | )          | (176,107                    | )          |
| Accumulated other comprehensive income                                                                                                                                             |       | 1,401                   |       | 2,427                       |       |
|                                                                                                                                                                               |       |                    |       |                        |       |
| Net stockholders’ equity (deficit)                                                                                                                                            |       | 15,391                  |       | (129,968                    | )          |
|                                                                                                                                                                               |       |                    |       |                        |       |
|                                                                                                                                                                               |       | $                       | 93,155     |                        | $          | 77,215 |   |

 

Seenotes to condensed consolidated financial statements.

 

3

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CHEROKEEINTERNATIONAL CORPORATION AND SUBSIDIARIES

CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS

(InThousands, Except Per Share Amounts)

(Unaudited)

 
| ** **                                  | ** ** | **Three Months Ended**  | ** ** | **Six Months Ended**    | ** ** |
|---------------------------------------------|------------|-------------------------|------------|-------------------------|------------|
| ** **                                  | ** ** | **June 30,  2004** | ** ** | **June 30,  2003** | ** ** | **June 30,  2004** | ** ** | **June 30,  2003** | ** ** |
|                                        |       |                    |       |                    |       |   |   |   |   |
| Net sales                                   |       | $                       | 38,622     |                    | $          | 27,649 |   | $ | 75,454 |   | $ | 48,690 |   |
| Cost of sales                               |       | 26,270                  |       | 19,586                  |       | 51,179 |   | 35,806 |   |
| Gross profit                                |       | 12,352                  |       | 8,063                   |       | 24,275 |   | 12,884 |   |
| Operating Expenses:                         |       |                    |       |                    |       |   |   |   |   |
| Engineering and development                 |       | 2,335                   |       | 2,223                   |       | 4,666 |   | 4,262 |   |
| Selling and marketing                       |       | 2,000                   |       | 1,645                   |       | 3,830 |   | 2,803 |   |
| General and administrative                  |       | 2,014                   |       | 1,677                   |       | 4,101 |   | 3,310 |   |
| Restructuring costs                         |       | —                  |       | 4,474                   |       | — |   | 4,474 |   |
| Total operating expenses                    |       | 6,349                   |       | 10,019                  |       | 12,597 |   | 14,849 |   |
|                                        |       |                    |       |                    |       |   |   |   |   |
| Operating income (loss)                     |       | 6,003                   |       | (1,956                  | )          | 11,678 |   | (1,965 | ) |
|                                        |       |                    |       |                    |       |   |   |   |   |
| Interest expense                            |       | (715                    | )          | (4,160                  | )          | (3,796 | ) | (8,248 | ) |
| Other income (expense), net                 |       | (50                     | )          | (242                    | )          | (53 | ) | 554 |   |
| Income (loss) before income taxes           |       | 5,238                   |       | (6,358                  | )          | 7,829 |   | (9,659 | ) |
| Provision for income taxes                  |       | 869                     |       | 39                      |       | 1,300 |   | 68 |   |
| Net income (loss)                           |       | $                       | 4,369      |                    | $          | (6,397 | ) | $ | 6,529 |   | $ | (9,727 | ) |
|                                        |       |                    |       |                    |       |   |   |   |   |
| Net income (loss) per share:                |       |                    |       |                    |       |   |   |   |   |
| Basic                                       |       | $                       | 0.23       |                    | $          | (3.09 | ) | $ | 0.46 |   | $ | (4.69 | ) |
| Diluted                                     |       | $                       | 0.22       |                    | $          | (3.09 | ) | $ | 0.42 |   | $ | (4.69 | ) |
|                                        |       |                    |       |                    |       |   |   |   |   |
| Weighted average common shares outstanding: |       |                    |       |                    |       |   |   |   |   |
| Basic                                       |       | 19,182                  |       | 2,073                   |       | 14,241 |   | 2,073 |   |
| Diluted                                     |       | 19,710                  |       | 2,073                   |       | 17,819 |   | 2,073 |   |

 

Seenotes to condensed consolidated financial statements.

 

4

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CHEROKEEINTERNATIONAL CORPORATION AND SUBSIDIARIES

CONDENSEDCONSOLIDATED STATEMENTS OF COMPREHENSIVE OPERATIONS

(InThousands)

(Unaudited)

 
| ** **                               | ** ** | **Three Months Ended**  | ** ** | **Six Months Ended**    | ** ** |
|------------------------------------------|------------|-------------------------|------------|-------------------------|------------|
| ** **                               | ** ** | **June 30,  2004** | ** ** | **June 30,  2003** | ** ** | **June 30,  2004** | ** ** | **June 30,  2003** | ** ** |
|                                     |       |                    |       |                    |       |   |   |   |   |
| Net income (loss)                        |       | $                       | 4,369      |                    | $          | (6,397 | ) | $ | 6,529 |   | $ | (9,727 | ) |
| Other comprehensive income (loss):       |       |                    |       |                    |       |   |   |   |   |
| Foreign currency translation adjustments |       | (724                    | )          | 1,606                   |       | (1,026 | ) | 1,396 |   |
| Comprehensive income (loss)              |       | $                       | 3,645      |                    | $          | (4,791 | ) | $ | 5,503 |   | $ | (8,331 | ) |

 

Seenotes to condensed consolidated financial statements.

 

5

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CHEROKEEINTERNATIONAL CORPORATION AND SUBSIDIARIES

CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS

(InThousands)

(Unaudited)

 
| ** **                                                                            | ** ** | **Six Months Ended**    | ** ** |
|---------------------------------------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                                            | ** ** | **June 30,  2004** | ** ** | **June 30,  2003** | ** ** |
|                                                                                  |       |                    |       |   |   |
| CASH FLOWS FROM OPERATING ACTIVITIES:                                                 |       |                    |       |   |   |
| Net income (loss)                                                                     |       | $                       | 6,529      |   | $ | (9,727 | ) |
| Adjustments to reconcile net income (loss) to net  cash used in operating activities: |       |                    |       |   |   |
| Depreciation and amortization                                                         |       | 1,569                   |       | 1,807 |   |
| Gain on sale of land                                                                  |       | —                  |       | (367 | ) |
| Amortization of deferred financing costs                                              |       | 86                      |       | 137 |   |
| Write-off of unamortized deferred financing costs  and debt discount                  |       | 224                     |       | — |   |
| Paid-in-kind interest converted to debt                                               |       | —                  |       | 2,541 |   |
| Net change in operating assets and liabilities:                                       |       |                    |       |   |   |
| Accounts receivable, net                                                              |       | (1,195                  | )          | (4,055 | ) |
| Inventories, net                                                                      |       | (1,454                  | )          | (858 | ) |
| Prepaid expenses and other current assets                                             |       | (1,150                  | )          | 215 |   |
| Deposits and other assets                                                             |       | (755                    | )          | (127 | ) |
| Accounts payable                                                                      |       | (344                    | )          | 1,313 |   |
| Accrued liabilities and accrued restructuring  costs                                  |       | (1,656                  | )          | (2,105 | ) |
| Accrued compensation and benefits                                                     |       | (695                    | )          | 559 |   |
| Accrued interest payable                                                              |       | (290                    | )          | (1,564 | ) |
| Other long-term obligations                                                           |       | (1,642                  | )          | 6,541 |   |
| Net cash used in operating activities                                                 |       | (773                    | )          | (5,690 | ) |
|                                                                                  |       |                    |       |   |   |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                                 |       |                    |       |   |   |
| Additions to property and equipment                                                   |       | (2,403                  | )          | (607 | ) |
| Net change in short-term investments                                                  |       | 91                      |       | 272 |   |
| Proceeds from sale of land                                                            |       | —                  |       | 516 |   |
| Net cash (used in) provided by investing  activities                                  |       | (2,312                  | )          | 181 |   |
|                                                                                  |       |                    |       |   |   |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                                 |       |                    |       |   |   |
| Borrowings on revolving lines of credit                                               |       | 11,301                  |       | 31,065 |   |
| Payments on revolving lines of credit                                                 |       | (17,433                 | )          | (28,580 | ) |
| Payments on obligations under capital leases                                          |       | (480                    | )          | (659 | ) |
| Payments on long-term debt                                                            |       | (65,519                 | )          | (2,025 | ) |
| Deferred financing costs                                                              |       | (236                    | )          | — |   |
| Proceeds from the exercise of warrants and stock  options                             |       | 16                      |       | — |   |
| Net proceeds from sale of common stock                                                |       | 87,570                  |       | — |   |
| Net cash provided by (used in) financing  activities                                  |       | 15,219                  |       | (199 | ) |
|                                                                                  |       |                    |       |   |   |
| Cash effect of exchange rate changes                                                  |       | (798                    | )          | 707 |   |
|                                                                                  |       |                    |       |   |   |
| Net increase (decrease) in cash and cash  equivalents                                 |       | 11,336                  |       | (5,001 | ) |
| Cash and cash equivalents, beginning of period                                        |       | 4,887                   |       | 8,504 |   |
|                                                                                  |       |                    |       |   |   |
| Cash and cash equivalents, end of period                                              |       | $                       | 16,223     |   | $ | 3,503 |   |
|                                                                                  |       |                    |       |   |   |
| SUPPLEMENTAL INFORMATION                                                              |       |                    |       |   |   |
| Conversion of senior convertible notes into common  stock                             |       | $                       | 53,370     |   | $ | — |   |
| Accrued initial public offering costs netted  against paid-in capital                 |       | 1,100                   |       | — |   |

 

Seenotes to condensed consolidated financial statements.

 

6

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CHEROKEE INTERNATIONAL CORPORATION ANDSUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIALSTATEMENTS

(Unaudited)

 

1.                                       Natureof Operations

 

CherokeeInternational Corporation (the “Company”) is a designer and manufacturer ofpower supplies for original equipment manufacturers (OEMs). Its advanced powersupply products are typically custom designed into mid- to high-end commercialapplications in the computing and storage, wireless infrastructure, enterprisenetworking, medical and industrial markets.

 

*Initial Public Offering*

 

The Company completed its initial publicoffering of 6,600,000 shares of its common stock, par value $0.001 per share(“Common Stock”), on February 25, 2004, at a price of $14.50 pershare.  The net proceeds to the Companyfrom this offering after paid and accrued offering costs of $9.2 million were$86.5 million.  The Company usedapproximately $73.2 million of the net proceeds to repay certain outstandingindebtedness and accrued interest. Immediately prior to the consummation of the offering, the Companycompleted a 1 for 3.9 reverse stock split of its outstanding Common Stock.  All share and per share amounts for allperiods presented in this report reflect this split.  Also in connection with the offering, theCompany issued 6,283,796 shares of Common Stock upon conversion of the originalprincipal amount of its outstanding senior convertible notes of $53.4 million,and issued 4,071,114 shares of Common Stock upon the exercise of outstandingwarrants.

 

2.                                       Basisof Presentation and Summary of Significant 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 sixmonths ended June 30, 2004 and 2003 are not necessarily indicative of theresults of operations for the full fiscal year. The Company’s second quarterrepresented the 13-week periods ended on June 27, 2004 and June 29,2003. For presentation purposes, these fiscal quarters, and the six-monthperiods then ended have been referred to as ending on June 30.

 

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

 

Certain information normally included infootnote disclosures to the financial statements has been condensed or omittedin accordance 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 31,2003, contained in Amendment No. 5 to the Company’s Registration Statement onForm S-1 (File No. 333-110723) filed on February 18, 2004.

 

*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 differ from such estimates.

 

*Reclassifications*

 

Certain items in the prior periodconsolidated financial statements have been reclassified to conform to thecurrent period presentation.

 

7

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*Stock BasedCompensation*

 

Aspermitted by SFAS No. 123, “Accounting for Stock-Based Compensation,” theCompany accounts for its employee stock-based compensation plan using theintrinsic value method under APB Opinion No. 25 and provides the expandeddisclosures specified in SFAS No. 123, as amended by SFAS No. 148.

 

Thetable below reconciles net income (loss) as reported and pro forma net income(loss) had compensation cost been determined using the provisions of SFAS No.123 for the three and six months ended (in thousands except per share data):

 
| ** **                                                                                                                | ** ** | **Three Months Ended**  | ** ** | **Six Months Ended**    | ** ** |
|---------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|
| ** **                                                                                                                | ** ** | **June 30,  2004** | ** ** | **June 30,  2003** | ** ** | **June 30,  2004** | ** ** | **June 30,  2003** | ** ** |
| Net income (loss), as reported                                                                                            |       | $                       | 4,369      |                    | $          | (6,397 | ) | $ | 6,529 |   | $ | (9,727 | ) |
| 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 |       | (208                    | )          | (38                     | )          | (325 | ) | (76 | ) |
| Net income (loss)-pro forma                                                                                               |       | $                       | 4,161      |                    | $          | (6,435 | ) | $ | 6,204 |   | $ | (9,803 | ) |
|                                                                                                                      |       |                    |       |                    |       |   |   |   |   |
| Net income (loss) per share, as reported:                                                                                 |       |                    |       |                    |       |   |   |   |   |
| Basic                                                                                                                     |       | $                       | 0.23       |                    | $          | (3.09 | ) | $ | 0.46 |   | $ | (4.69 | ) |
| Diluted                                                                                                                   |       | $                       | 0.22       |                    | $          | (3.09 | ) | $ | 0.42 |   | $ | (4.69 | ) |
| Pro forma net income (loss) per share:                                                                                    |       |                    |       |                    |       |   |   |   |   |
| Basic                                                                                                                     |       | $                       | 0.22       |                    | $          | (3.10 | ) | $ | 0.44 |   | $ | (4.73 | ) |
| Diluted                                                                                                                   |       | $                       | 0.21       |                    | $          | (3.10 | ) | $ | 0.41 |   | $ | (4.73 | ) |

 

For the purpose of estimating thecompensation cost of the Company’s option grants in accordance with SFAS No.123, the fair value of each option grant is estimated on the date of grantusing the Black-Scholes option-pricing model, with the following weightedaverage assumptions used for grants during the six months ended June 30,2004: expected stock price volatility of 52%; risk-free interest rate of 3.66%;no dividends; and expected lives of five years. The assumptions used for the six months ended June 30, 2003 were:expected stock price volatility of zero; risk-free interest rate of 2.73%; nodividends; and expected lives of five years.

 

*Translation of Foreign Currency*

 

Foreign subsidiary assets and liabilitiesdenominated in foreign currencies are translated at the exchange rate on thebalance sheet date.  Revenues, costs andexpenses are translated at the average exchange rate during the period.  Transaction gains and losses are included inresults of operations and have not been significant for the periodspresented.  The functional currency ofthe Company’s operating subsidiary in Europe, Cherokee Europe SCA (“CherokeeEurope”), is the Euro.  The functionalcurrency of the Company’s operating subsidiaries in Mexico (CherokeeElectronica, S.A. DE C.V.) and in India (Cherokee India Pvt. Ltd. and PowertelIndia Pvt. Ltd.) is the U.S. dollar, as the majority of transactions aredenominated in U.S. dollars.  Translationadjustments related to Cherokee Europe are reflected as a component ofstockholders’ equity (deficit) in other comprehensive operations.

 

*Recent Accounting Pronouncements*

 

In January 2003, the FASB issued FIN 46, “Consolidation ofVariable Interest Entities.”  In general,a variable interest entity is a corporation, partnership, trust or any otherlegal structure used for business purposes that either (a) does not have equityinvestors with voting rights or (b) has equity investors that do not providesufficient financial resources for the entity to support its activities.  FIN 46 requires a variable interest entity tobe consolidated by a company if that company is subject to a majority of therisk of loss from the variable interest entity’s activities or entitled toreceive a majority of the entity’s residual returns or both.  The consolidation requirements of FIN 46apply immediately to variable interest entities created after January 31,2003.  The consolidation requirementsapply to older entities in the first fiscal year or interim period beginningafter December 15, 2003.  Certain ofthe disclosure requirements apply in all financial statements issued afterJanuary 31, 2003, regardless of when the variable interest entity wasestablished.  The Company did not haveany variable interest entities as of June 30, 2004.  The early adoption of FIN 46 did not have amaterial impact on the Company’s consolidated results of operations orfinancial position.  With respect tovariable interest entities created before January 31, 2003, inDecember 2003 the FASB issued FIN 46R which, among other things, revisedthe implementation date to first fiscal years or interim periods ending afterMarch 15, 2004, with the exception of Special Purpose Entities (“SPE”).The consolidated requirements apply to all SPE’s in the first fiscal year orinterim period ending after December 15, 2003. As the Company hasdetermined that it does not have any SPE’s to which these interpretationsapply, the Company adopted FIN 46R in the first quarter of 2004, and suchadoption did not have a material impact on its financial statements.

 

8

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3.                                       Inventories

 

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

 
| ** **      | ** ** | **June 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|-----------------|------------|-------------------------|------------|-----------------------------|------------|
|            |       |                    |       |                        |       |
| Raw material    |       | $                       | 18,257     |                        | $          | 16,244 |   |
| Work-in-process |       | 4,717                   |       | 4,662                       |       |
| Finished goods  |       | 3,236                   |       | 4,026                       |       |
|            |       |                    |       |                        |       |
|            |       | $                       | 26,210     |                        | $          | 24,932 |   |

 

As of June 30, 2004 andDecember 31, 2003, the reserve for inventory obsolescence was $4.5 millionand $4.2 million, respectively.

 

4.                                       IncomeTaxes

 

The Company accounts for income taxes inaccordance with SFAS No. 109, “Accounting for Income Taxes.”  In accordance with SFAS No. 109, deferred taxassets and liabilities are recorded for the estimated future tax effects oftemporary differences between the carrying value of assets and liabilities forfinancial reporting and their tax basis, and carryforwards to the extent theyare realizable.  A deferred tax provisionor benefit results from the net change in deferred tax assets and liabilitiesduring the period.  A deferred tax assetvaluation allowance is recorded if it is more likely than not that all or aportion of the recorded deferred tax assets will not be realized.  As of December 31, 2003, deferred taxassets include $42.7 million relating to a tax basis step up from arecapitalization transaction in 1999 and $12.5 million of net operating losscarryforwards.  The Company has recordeda full valuation allowance against its deferred tax assets.

 

The provision for income taxes of $1.3 million for the six months endedJune 30, 2004 fully was calculated using an estimated effective tax ratefor 2004 of 16.6%, which reflects estimated taxable income in Belgium afterfully using available net operating losses relating to Belgium in 2004.  Income generated in the United States during2004 is expected to be fully offset by available net operating losses,resulting in the relatively low effective tax rate for the year.

 

5.                                       NetIncome (Loss) Per Share

 

In accordance with SFAS No. 128, “Earnings Per Share”, basic earnings(loss) per share is based upon the weighted average number of common sharesoutstanding.  Diluted earnings (loss) pershare is based upon the weighted average number of common and potential sharesof common stock for each period presented. Potential common shares include the dilutive effect of stock options andwarrants under the treasury stock method and senior convertible notes under theif-converted method.  For purposes of thediluted earnings (loss) per share calculation for the six months endedJune 30, 2004, the senior convertible notes are assumed to have beenconverted at the beginning of the period, and as a result, net income has beenincreased by $1.0 million for the reduction in interest expense related to thesenior convertible notes.

 

The following table sets forth the computation of basic and diluted netincome (loss) per share (in thousands, except per share amounts):

 
| ** **                                               | ** ** | **Three Months Ended**  | ** ** | **Six Months Ended**    | ** ** |
|----------------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|
| ** **                                               | ** ** | **June 30,  2004** | ** ** | **June 30,  2003** | ** ** | **June 30,  2004** | ** ** | **June 30,  2003** | ** ** |
|                                                     |       |                    |       |                    |       |   |   |   |   |
| Net income (loss)                                        |       | $                       | 4,369      |                    | $          | (6,397 | ) | $ | 6,529 |   | $ | (9,727 | ) |
|                                                     |       |                    |       |                    |       |   |   |   |   |
| Shares:                                                  |       |                    |       |                    |       |   |   |   |   |
| Weighted-average common shares  outstanding—basic   |       | 19,182                  |       | 2,073                   |       | 14,241 |   | 2,073 |   |
| Effect of dilutive securities:                           |       |                    |       |                    |       |   |   |   |   |
| Senior convertible notes and warrants                    |       | —                  |       | —                  |       | 3,015 |   | — |   |
| Outstanding stock options                                |       | 528                     |       | —                  |       | 563 |   | — |   |
| Weighted-average common shares  outstanding—diluted |       | 19,710                  |       | 2,073                   |       | 17,819 |   | 2,073 |   |
|                                                     |       |                    |       |                    |       |   |   |   |   |
| Net income (loss) per share:                             |       |                    |       |                    |       |   |   |   |   |
| Basic                                                    |       | $                       | .23        |                    | $          | (3.09 | ) | $ | .46 |   | $ | (4.69 | ) |
| Diluted                                                  |       | $                       | .22        |                    | $          | (3.09 | ) | $ | .42 |   | $ | (4.69 | ) |

 

9

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6.                                       DeferredFinancing Costs

 

Net deferred financing costs are comprised ofthe following as of June 30, 2004 and December 31, 2003 (inthousands):

 
| ** **                    | ** ** | **June 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|-------------------------------|------------|-------------------------|------------|-----------------------------|------------|
|                          |       |                    |       |                        |       |
| Deferred financing costs      |       | $                       | 567        |                        | $          | 834 |   |
| Accumulated amortization      |       | (40                     | )          | (298                        | )          |
|                          |       |                    |       |                        |       |
| Deferred financing costs, net |       | $                       | 527        |                        | $          | 536 |   |

 

The Company amortizes deferred financingcosts over the life of the related debt, which is currently 4.5 years.  During the six months ended June 30,2004, the Company wrote-off unamortized deferred financing costs of $0.2million and fully amortized deferred financing costs of $0.3 million, as aresult of the repayment of outstanding indebtedness in connection with theinitial public offering.

 

7.                                       Long-TermDebt

 

Long-term debt consists of the following atJune 30, 2004 and December 31, 2003 (in thousands):

 
| ** **                                 | ** ** | **June 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|--------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| Term loans                                 |       | $                       | —     |                        | $          | 12,463 |   |
| 14.5% second lien notes                    |       | —                  |       | 46,652                      |       |
| 5.25% senior notes                         |       | 46,630                  |       | 46,630                      |       |
| 12% senior convertible notes               |       | —                  |       | 59,774                      |       |
|                                       |       | 46,630                  |       | 165,519                     |       |
| Less debt discount                         |       | —                  |       | (64                         | )          |
| Total long-term debt, net of debt discount |       | 46,630                  |       | 165,455                     |       |
| Less current portion                       |       | —                  |       | (2,562                      | )          |
| Total long-term debt                       |       | $                       | 46,630     |                        | $          | 162,893 |   |

 

Presented below is a breakdown of ourlong-term debt payable to third parties and affiliates at June 30, 2004and December 31, 2003 (in thousands):

 
| ** **                                 | ** ** | **June 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|--------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| Long-term debt payable to third parties:   |       |                    |       |                        |       |
| Current                                    |       | $                       | —     |                        | $          | 2,562 |   |
| Non-current                                |       | 24,485                  |       | 48,992                      |       |
| Long-term debt payable to affiliates:      |       |                    |       |                        |       |
| Current                                    |       | —                  |       | —                      |       |
| Non-current                                |       | 22,145                  |       | 113,901                     |       |
| Total long-term debt, net of debt discount |       | $                       | 46,630     |                        | $          | 165,455 |   |

 

As of June 30, 2004, all of theCompany’s long-term debt was scheduled to be repaid in 2008.

 

In connection with the Company’s initialpublic offering, the Company amended and restated its existing senior revolvingcredit facility with General Electric 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 $14.4million at June 30, 2004.  TheCredit Facility has a term of 4.5 years 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 additionto paying interest on outstanding principal, the Company is required to pay acommitment fee to the lenders under the amended facility in respect of theaverage daily balance of unused loan commitments at a rate of 0.5% perannum.  The Credit Facility is secured bya first-priority lien, subject to permitted encumbrances, on substantially allof the Company’s domestic assets and by a pledge of 65% of the equity ofcertain of the Company’s foreign subsidiaries. The Credit Facility contains restrictive covenants requiring the Companyto, among other things, maintain certain senior leverage ratios.  As of June 30, 2004, there were noborrowings outstanding under the Credit Facility, and the Company was incompliance with all of the covenants under the Credit Facility.

 

As of June 30, 2004, the Company was incompliance with all of the covenants set forth in the principal agreementsgoverning the 5.25% senior notes.

 

10

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Cherokee Europe maintains a working capitalline of credit of approximately $3.7 million with a Belgian bank, BBL, which isdenominated in Euros, collateralized by a pledge in first and second rank overa specific amount of business assets, requires Cherokee Europe to maintain acertain specific minimum solvency ratio and is cancellable at any time.  As of June 30, 2004, Cherokee Europe hadno outstanding borrowings under the line of credit and was in compliance withall covenants.

 

8.                                       OtherLong-Term Liabilities

 

Other long-term liabilities consist of thefollowing (in thousands):

 

| ** **                                                                                           | ** ** | **June 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| Long-term portion of restructuring cost  liabilities                                                 |       | $                       | 1,579      |                        | $          | 1,670 |   |
| Long service award liabilities                                                                       |       | 1,700                   |       | 1,515                       |       |
| Interest payable related to the 14.5%  second lien notes and the  12% senior convertible  notes |       | —                  |       | 2,400                       |       |
| Deferred compensation                                                                                |       | 588                     |       | —                      |       |
|                                                                                                 |       | $                       | 3,867      |                        | $          | 5,585 |   |

 

 

9.               Cherokee EuropeRestructuring

 

In June 2003, the Company receivedapproval for a restructuring plan (the “European Restructuring”) of itsoperations in Europe from the Workers Union and the appropriate governmentalauthorities in Belgium.  The EuropeanRestructuring involved the elimination of 61 operational and administrativepositions at the Cherokee Europe facility in Belgium due to unfavorableeconomic conditions in that market.  Allof the terminations were completed in 2003. Pursuant to the European Restructuring, the Company recorded arestructuring charge of $4.5 million in operating expenses in the statement ofoperations during the six months ended June 30, 2003.  The European Restructuring costs arecomprised entirely of one-time termination benefits to be paid through2010.  The Company paid $1.0 millionduring the six months ended June 30, 2004 under the EuropeanRestructuring.

 

A reconciliation of the EuropeanRestructuring accrual for the period January 1, 2004 through June 30,2004 is as follows (in thousands):

 

| Balance as of January 1, 2004 |   | $      | 2,814  |   |   |   |
|------------------------------------|--------|--------|--------|--------|--------|--------|
| Payments                           |   | (1,014 | )      |   |   |
| Balance as of June 30, 2004   |   | 1,800  |   |   |   |
| Less current portion               |   | (221   | )      |   |   |
| Due after one year                 |   | $      | 1,579  |   |   |   |

 

10.                                 CustomerConcentration

 

For the quarter and six months endedJune 30, 2004, the Company’s largest customer accounted for 20% and 23% ofnet sales, respectively, and no other customer accounted for more than 10% ofnet sales.  For the quarter endedJune 30, 2003, the Company’s largest customer accounted for 17% of netsales, and for the six months ended June 30,2003, the Company’s two largest customers accounted for 15% and 10% of netsales, and no other customer accounted for more than 10% of net sales.  A decision by a major customer to decreasethe amount purchased from the Company or to cease purchasing the Company’sproducts could have a material adverse effect on the Company’s financialposition and results of operations.

 

As of June 30, 2004, the Company had onecustomer that accounted for 22% of net accounts receivable.

 

11.                                 Commitmentsand Contingencies

 

*Guarantees and Indemnities*

 

The Company has agreed to indemnify theformer owners of Cherokee Europe for product liability, environmental hazardand employment practice claims relating solely to post-acquisitionbusiness.  The Company also indemnifiesits directors and officers to the maximum extent permitted under the laws ofthe State of Delaware, and various lessors in connection with facility leasesfor certain claims arising from such facility or lease.  The maximum amount of potential futurepayments under such indemnifications is not determinable.

 

The Company has not incurred significantamounts related to these guarantees and indemnifications, and no liability hasbeen recorded in the financial statements for guarantees and indemnificationsas of June 30, 2004.

 

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12.                                 Stockand Deferred Compensation Plans

 

*2004 Employee Stock Purchase Plan*

 

On February 16, 2004, the Company adopted the 2004 Employee StockPurchase Plan (the ‘‘ESPP’’). The ESPP provides that a total of 400,000 sharesof Common Stock are reserved for issuance under the plan, plus an annual increaseto be added on the first day of the Company’s fiscal year (beginning 2005)equal to the lesser of (i) 250,000 shares or (ii) 1% of the number ofoutstanding shares on the last day of the immediately preceding fiscal year.The ESPP, which is intended to qualify as an ‘‘employee stock purchase plan’’under Section 423 of the Code, is implemented utilizing six-monthofferings with purchases occurring at six-month intervals, with a new offeringperiod commencing on the first trading day on or after May 15 (beginning in theyear 2005) and November 15 (beginning in the year 2004) and ending on thelast trading day on or before November 14 or May 14, respectively. TheCompany’s Board of Directors oversees the ESPP administration.  Employees are eligible to participate if theyare employed for at least 20 hours per week and more than 5 months in acalendar year by the Company, subject to certain restrictions as defined. TheESPP permits eligible employees to purchase Common Stock through payrolldeductions, which may not exceed 15% of an employee’s compensation. The priceof Common Stock purchased under the ESPP will be 85% of the lower of the fairmarket value of the Common Stock at the beginning of each six-month offeringperiod or on the applicable purchase date. Employees may end theirparticipation in an offering at any time during the offering period, andparticipation ends automatically upon termination of employment. The Company’sBoard of Directors may at any time amend or terminate the ESPP, except that nosuch amendment or termination may adversely affect shares previously grantedunder the ESPP.  As of June 30,2004, no shares have been issued under the ESPP.

 

*2004 Omnibus Stock Incentive Plan*

 

On February 16, 2004, the Company adopted the 2004 Omnibus StockIncentive Plan (the ‘‘2004 Plan’’). The 2004 Plan provides that a total of800,000 shares of the Company’s Common Stock are reserved for issuance underthe 2004 Plan, plus an annual increase to be added on the first day of theCompany’s fiscal year (beginning 2005) equal to the lesser of (i) 450,000shares or (ii) 2% of the number of outstanding shares on the last day of theimmediately preceding fiscal year. Any officer, director, employee, consultantor advisor of the Company is eligible to 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 June 30, 2004, no shares have beenissued from the 2004 Plan.

 

*Deferred Compensation Plans*

 

On February 16, 2004, the Companyadopted two executive deferred compensation plans for the benefit of certaindesignated employees 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.  As of June 30, 2004, the Company hasrecorded a liability of $588,000 for contributions and investment activity todate, which is recorded in other long-term liabilities, and the Company hasprovided no matching contributions.

 

13.         RetirementPlans

 

Cherokee Europe maintains a pension plan forcertain levels of staff and management that includes a defined benefitfeature.  The following represents theamounts related to this defined benefit plan for the three and six months ended(in thousands):

 
| ** **                                   | ** ** | **Three Months Ended**  | ** ** | **Six Months Ended**    | ** ** |
|----------------------------------------------|------------|-------------------------|------------|-------------------------|------------|
| **Components  of Net Periodic Benefit Cost** | ** ** | **June 30,  2004** | ** ** | **June 30,  2003** | ** ** | **June 30,  2004** | ** ** | **June 30,  2003** | ** ** |
| Service cost                                 |       | $                       | 39         |                    | $          | 28 |   | $ | 77 |   | $ | 56 |   |
| Interest cost                                |       | 60                      |       | 52                      |       | 119 |   | 104 |   |
| Expected return on plan assets               |       | (35                     | )          | (40                     | )          | (69 | ) | (80 | ) |
| Net periodic benefit cost                    |       | $                       | 64         |                    | $          | 40 |   | $ | 127 |   | $ | 80 |   |

 

As of June 30, 2004, $0.1 million ofpension plan contributions have been made. Cherokee Europe presently anticipates contributing an additional $0.1million to fund its pension plan in 2004 for a total of $0.2 million.

 

14.         Cherokee Europe Fire

 

On January 19, 2004, the Companyexperienced a fire in part of its facility in Belgium, which destroyed someinventory, property and equipment.  TheCompany was fully insured at the replacement value for the destroyed items,subject to a $5,000 deductible, and the facility returned to full productionthe next day.  Within operating expensesfor the six months ended June 30,

 

12

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2004, the Company recorded a loss related to the destroyed inventory,property and equipment.  This loss hasbeen fully offset by partial proceeds received and expected recoveries from theinsurance company, which have been recorded in prepaid expenses and othercurrent assets.  Any amounts receivedfrom the insurance company in excess of the book value will be recognized as again when received.

 

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTSOF OPERATIONS

 

**Item2.  Management’s Discussion and Analysisof Financial Condition and Results of Operations.**

 

OVERVIEW

 

We are a designer andmanufacturer of power supplies for Original Equipment Manufacturers, or OEMs.Our advanced power supply products are typically custom designed into mid- tohigh-end commercial applications in the computing and storage, wireless infrastructure,enterprise networking, medical and industrial markets.

 

We generate a significant portion of oursales from OEMs in the communications and computing market segment,particularly the wireless infrastructure and networking sectors.  During 2001, 2002 and the first quarter of2003, our operating results were negatively affected by unfavorable economicconditions and reduced capital spending by communication service providers thatpurchase our customers’ products. Although we saw improvement in these economic conditions throughout 2003and during the six months ended June 30, 2004, these improvements may notcontinue or may not be sustainable.  Ifconditions do not continue to improve or, instead, deteriorate, our operatingresults and financial condition could be adversely affected.

 

We operate worldwide andhave facilities in Orange County, California; Bombay, India; Guadalajara,Mexico; and Wavre, Belgium. We were founded in 1978 in Orange County,California. As we expanded our business and customer base, we opened facilitiesin Bombay, India in January 1984 and Guadalajara, Mexico inAugust 1988. In June 2000, we acquired Cherokee Europe, which added amanufacturing facility in Wavre, Belgium and enabled us to better serve theEuropean market.

 

On April 30, 1999, aninvestor group led by affiliates of Oaktree Capital Management, LLC (“Oaktree”)and GFI Energy Ventures, LLC (“GFI”) acquired 60% of our then-outstandingequity.

 

In November 2002, weconsummated a series of transactions, resulting in the restructuring of ourdebt capital structure and the reorganization of our company from a Californialimited liability company into a Delaware corporation (the “RestructuringTransactions”).  As part of theRestructuring Transactions, we amended our then-existing credit facility andentered into new senior credit facilities providing, in the aggregate, for$15.0 million of term loans (the “Term Loans”) and a revolving credit facilityof up to $7.6 million (the “Old Revolving Facility”), in each case maturing November 30,2005. As of December 31, 2003, two of the Term Loans bore interest at anannual rate of 5.49% and the remaining two Term Loans bore interest at anannual rate of 5.91%. Borrowings under the Old Revolving Facility bore interestat an annual rate of 6.75% as of such date. As part of the RestructuringTransactions, we also issued approximately $41.0 million original principalamount of 14 1/2% pay-in-kind second lien notes due 2006 (“Second Lien Notes”),together with warrants to purchase 2,447,813 shares of our common stock at$0.039 per share. Interest on the Second Lien Notes was paid in kind fromissuance. We also completed an exchange offer with respect to all of ouroutstanding $100.0 million of 10 1/2% senior subordinated notes due 2009. In exchangefor the senior subordinated notes, we issued (1) $46.6 million of 5 1/4% seniornotes due 2008, (“Senior Notes”) together with warrants to purchase 1,633,714shares of our common stock at $0.039 per share and (2) $53.4 million of 12%senior convertible notes due 2008 (“Senior Convertible Notes”), which wereconvertible into 6,283,796 shares of our common stock at approximately $8.49per share. From issuance, interest on the Senior Notes was paid in cash.  Interest on the Senior Convertible Notes wasadded to the principal amount from the date of issuance. Amounts added to theprincipal in respect of interest payments on the Senior Convertible Notes werenot convertible into shares of our common stock.  In connection with our initial publicoffering described below, we amended and restated our senior credit facility,repaid the Second Lien Notes in full and repaid $4.4 million in accruedinterest and $12.1 million in interest added to the principal amount of ourSenior Convertible Notes.  In addition, allof the outstanding warrants were exercised and the original principal amount ofthe Senior Convertible Notes was converted into shares of our Common Stock.

 

Prior to theRestructuring Transactions in November 2002, we were organized as aCalifornia limited liability company and treated as a partnership for UnitedStates federal income tax purposes. As a result of being reorganized into aDelaware corporation, Cherokee became subject to United States federal incometaxation.

 

We completedour initial public offering of 6,600,000 shares of our common stock onFebruary 25, 2004.  The net proceedsfrom the offering were $86.5 million.  Weused approximately $73.2 million of the net proceeds to repay outstandingindebtedness, including the Term Loans, the Old Revolving Facility, the SecondLien Notes, related interest on these obligations, as well as accrued interestand interest added to the principal amount of our Senior ConvertibleNotes.  In connection with the offering,we issued 6,283,796 shares of our common stock upon conversion of the originalprincipal amount of our outstanding Senior Convertible Notes, and issued4,071,114 shares of common stock upon exercise of all outstanding warrants.

 

13

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In addition, in connection with the offering,we amended and restated our existing senior revolving credit facility withGeneral Electric Capital Corporation. The amended facility (the “Credit Facility”) provides for borrowings ofup to $20.0 million that are subject to a borrowing base comprised of eligibleaccounts receivable and inventory, which was $14.4 million at June 30,2004.  Please refer to “–Liquidity andCapital Resources” below for additional information regarding our outstandingindebtedness.

 

On January 19, 2004 the Company experienced a fire in part of itsfacility in Belgium, which destroyed some inventory, property andequipment.  The Company was fully insuredat the replacement value for the destroyed items, subject to a $5,000deductible, and the facility returned to full production the next day.  See further discussion of the Cherokee EuropeFire in Note 14 to the accompanying financial statements.

 

BASIS OF REPORTING

 

*Net Sales*

 

Net sales consists of sales during the periodpresented net of returns.  Revenue isrecognized from product sales at the time of shipment and passage of title.

 

*Cost of Sales*

 

The principal elements comprising cost ofsales are raw materials, labor and manufacturing overhead.  Raw materials account for a majority of cost ofsales.  Raw materials include magneticsub-assemblies, sheet metal, electronic and other components, mechanical partsand electrical wires.  Direct labor costsinclude costs of hourly employees. Manufacturing overhead includes salaries,and the direct expense and allocation of costs attributable to manufacturingfor lease costs, depreciation on property, plant and equipment, utilities,property taxes and repairs and maintenance.

 

*Operating Expenses*

 

Operating expenses include engineering costs,selling and marketing costs and general and administrative expenses.  Engineering costs primarily include salariesand benefits of engineering personnel, safety approval and qualitycertification fees, depreciation on equipment and subcontract costs forthird-party contracting services. Selling and marketing expenses primarily include salaries and benefitsto account managers and commissions to independent sales representatives.  Administrative expenses primarily includesalaries and benefits for certain management and administrative personnel,professional fees and information system costs. Operating expenses also include the direct expense and allocation ofcosts attributable to these departments for lease costs, depreciation onproperty, plant and equipment, utilities, property taxes and repairs andmaintenance.

 

CRITICAL ACCOUNTING POLICIES

 

We prepare our consolidated financial statements in conformity withaccounting principles generally accepted in the United States of America.  As such, we are required to make certainestimates, judgments and assumptions that we believe are reasonable based uponthe information currently available. These estimates and assumptions affect the reported amounts of assetsand liabilities at the date of the financial statements and the reportedamounts of revenues and expenses during the periods presented.  Any future changes to these estimates andassumptions could have a material effect on our reported amounts of revenue,expenses, assets and liabilities.  Thesignificant accounting policies that we believe are the most critical to aid infully understanding and evaluating our reported financial results include thefollowing:

 

*Revenue Recognition*

 

We recognize revenue from product sales at the time of shipment andpassage of title.  We also offer ourcustomers the right to return products that do not function properly within alimited time after delivery.  We monitorand track product returns and record a provision for warranty based onhistorical experience, which has been insignificant to our financial conditionand results of operations.  Anysignificant increase in product failure rates could have a material adverseeffect on our operating results for the period or periods in which those returnsmaterialize.

 

*Accounts Receivable*

 

We perform ongoing credit evaluations of our customers and adjustcredit limits based upon payment history, the customer’s current creditworthiness and various other factors, as determined by our review of theircurrent credit information.  We continuouslymonitor collections and payments from our customers and maintain a provisionfor estimated credit losses based upon our historical experience, and anyspecific customer collection issues that we have identified.  While credit losses have historically beenwithin our expectations and the provisions established, we may not continue toexperience the same credit loss rates that we have in the past.  A significant portion of our accountsreceivable are concentrated in a small number of customers.  A significant change in the liquidity orfinancial position of any one of these customers could have a material adverseeffect on the collectibility of our accounts

 

14

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receivables, our liquidity and our future operating results.

 

 *Inventories*

 

We value our inventory at the lower of the actual cost to purchaseand/or manufacture the inventory and the current estimated market value of theinventory using the first-in, first-out method. We regularly review inventory quantities on hand and record a provisionfor excess and obsolete inventory based primarily on our historical usage dataand estimates of future demand.  Ourindustry is characterized by rapid technological change, frequent new productdevelopment, and rapid product obsolescence that could result in an increase inthe amount of obsolete inventory quantities on hand.  As demonstrated in the past, demand for ourproducts can fluctuate significantly.  Asignificant increase in the demand for our products could result in ashort-term increase in the cost of inventory purchases while a significantdecrease in demand could result in an increase in the amount of excessinventory quantities on hand.  Inaddition, our estimates of future product demand may prove to be inaccurate, inwhich case we may have understated or overstated the provision required forexcess and obsolete inventory.  In thefuture, if our inventory is determined to be overvalued, we would be requiredto recognize additional expense in our cost of goods sold at the time of suchdetermination.  Likewise, if ourinventory is determined to be undervalued, we may have over reported our costsof goods sold in previous periods and would be required to recognize additionaloperating income at the time such inventory is sold.  Therefore, although we make every reasonableeffort to ensure the accuracy of our estimates of future product demand, anysignificant unanticipated changes in demand or technological developments couldhave a material effect on the value of our inventory and our reported operatingresults.

 

*Deferred Taxes*

 

We recognize deferred tax assets and liabilities based on thedifferences between the financial statement carrying values and the tax basesof assets and liabilities.  We regularlyreview our deferred tax assets for recoverability and establish a valuationallowance based on historical taxable income, projected future taxable income,and the expected timing of the reversals of existing temporary differences.  If our future taxable income is significantlyhigher than expected and/or we are able to utilize our tax credits, we may berequired to reverse all or a significant part of our valuation allowanceagainst such deferred tax assets which could substantially reduce our effectivetax 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 value of goodwill on anannual basis or more frequently when an event occurs or circumstances change toindicate that an impairment of goodwill has possibly occurred.  The determination of whether any potentialimpairment of goodwill exists is based upon a comparison of the fair value ofthe reporting unit to the accounting value of its net assets.

 

We also review the recoverability of the carrying value of long-livedassets whenever events or changes in circumstances indicate that the carryingamount of an asset may not be recoverable. Recoverability of these assets is determined based upon the forecastedundiscounted future net cash flows from the operations to which the assetsrelate, utilizing our best estimates, appropriate assumptions and projectionsat the time.  These projected future cashflows may vary significantly over time as a result of increased competition,changes in technology, fluctuations in demand, consolidation of our customersand reductions in average selling prices. If the carrying value is determined not to be recoverable from futureoperating cash flows, the asset would be deemed impaired and an impairment losswould be recognized to the extent the carrying value exceeded the estimatedfair market value of the asset.

 

RESULTS OF OPERATIONS

 

THREE MONTHS ENDED JUNE 30, 2004 COMPARED TO THREE MONTHS ENDEDJUNE 30, 2003

 

NET SALES

 

Net sales increased by approximately 39.7%,or $11.0 million, to $38.6 million for the three months ended June 30,2004 from $27.6 million for the three months ended June 30, 2003.

 

Our sales increase for the second quarter of2004 was primarily attributable to increased sales from a broad base ofcustomers in the datacom and telecom industries, including several newcustomers that have engaged Cherokee in recent quarters.  Our largest customer, which is in thewireless infrastructure market, accounted for approximately $2.4 million of oursales increase over the second quarter of 2003. We experienced some softness in demand from this customer during thesecond half of June 2004 and, given that sales to this customer maydecline sequentially, we anticipate that our third quarter net sales will beflat to down slightly compared to the second quarter.  Also contributing to the second quarter salesincrease was a favorable foreign currency exchange rate effect of $0.5 milliondue to a stronger Euro in the second quarter of 2004 compared to the secondquarter of 2003.  Additionally, theCompany recognized sales of $1.0 million in the second quarter of 2004attributable to the resolution of uncertainties related to customertransactions for which revenue had been previously deferred.

 

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GROSS PROFIT

 

Gross profit increased by approximately53.2%, or $4.3 million, to $12.4 million for the three months endedJune 30, 2004 from $8.1 million for the three months ended June 30,2003. Gross margin for the three months ended June 30, 2004 increased to32.0% from 29.2% in the prior year period.

 

Of the $4.3 million increase in gross profit,$3.2 million was attributable to the higher sales level and the remaining $1.1million was attributable to the increased gross margin.  The increase in gross margin was primarilyattributable to a 3.0% decrease in factory overhead and labor costs as apercentage of sales, which reflected increased efficiencies due to higherproduction volumes, as well as a lower manufacturing cost structure resultingfrom the Cherokee Europe restructuring plan implemented in June 2003, asdescribed below.  The increase in grossmargin was also favorably affected by the recognition of $1.0 million inpreviously deferred revenue.  Thesefavorable variances were partially offset by an increase in cost of materialsas a percentage of sales due primarily to additional provisions forinventory-related reserves.

 

OPERATING EXPENSES

 

Operating expenses for the three months endedJune 30, 2004, decreased by approximately 36.6%, or $3.7 million, to $6.3million from $10.0 million for the three months ended June 30, 2003.  As a percentage of sales, operating expensesdecreased to 16.4% from 36.2% in the prior year period.

 

The decrease in operating expenses of $3.7million was due to Cherokee Europe restructuring costs of $4.5 million recordedin June 2003, partially offset by increases in engineering and development,selling and marketing, and general and administrative expenses of $0.1 million,$0.4 million and $0.3 million, respectively, primarily to support thesignificantly higher sales volume and related business activities compared to ayear ago.  Of these increases,approximately $0.2 million was attributable to a stronger Euro versus thesecond quarter of 2003, $0.1 million was attributable to higher salescommissions, and the remaining increase resulted primarily from increasedpayroll and related costs, including higher incentive compensation expense.

 

RESTRUCTURING COSTS

 

During 2003, we implemented a restructuringplan involving the elimination of a number of operational and administrativepositions at the Cherokee Europe facility in Belgium due to unfavorableeconomic conditions in that market. Pursuant to the Cherokee Europe restructuring plan, we recorded a chargefor restructuring costs of $4.5 million for the three months endedJune 30, 2003.  The restructuringcosts were comprised entirely of one-time termination benefits to be paidthrough 2010.

 

An analysis of the Cherokee Europerestructuring accrual for the period January 1, 2003 through June 30, 2004 isas follows (in thousands):

 
| Balance as of January 1, 2003   |   | $      | — |   |
|---------------------------------|--------|--------|--------|--------|
| Restructuring costs recognized  |   | 4,474  |   |
| Payments                        |   | (1,660 | )      |
| Balance as of December 31, 2003 |   | 2,814  |   |
| Payments                        |   | (1,014 | )      |
| Balance as of June 30, 2004     |   | $      | 1,800  |   |

 

OPERATING INCOME

 

As a result of the factors discussed above,operating income increased to $6.0 million for the three months endedJune 30, 2004 compared to an operating loss of $2.0 million for the threemonths ended June 30, 2003. Operating margin increased to 15.5% from (7.1)% in the prior yearperiod.  The operating loss for the threemonths ended June 30, 2003 included the effect of the Cherokee Europerestructuring costs of $4.5 million.

 

INTEREST EXPENSE

 

Interest expense for the three months endedJune 30, 2004 was $0.7 million compared to $4.2 million for the threemonths ended June 30, 2003.  Thedecrease in interest expense was due to the repayment of debt and conversion toequity of our senior convertible notes in connection with our initial publicoffering.

 

INCOME TAXES

 

The provision for income taxes of $0.9 million for the three monthsended June 30, 2004 was calculated using an estimated effective tax ratefor 2004 of 16.6%.  The increase from2003 reflects estimated taxable income in Belgium after fully using availablenet operating losses relating to Belgium in 2004.  Income generated in the United States during2004 is expected to be fully offset by available net operating losses,resulting in the relatively low effective tax rate for the year.  See further discussion of the income taxprovision and net operaing loss carryforwards in Note 4 to the accompanyingfinancial statements.

 

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NET INCOME (LOSS)

 

As a result of the factors discussed above,we recorded net income of $4.4 million for the three months ended June 30,2004, compared to a net loss of $6.4 million for the three months endedJune 30, 2003.

 

SIX MONTHS ENDED JUNE 30, 2004 COMPARED TO SIX MONTHS ENDEDJUNE 30, 2003

 

NET SALES

 

Net sales increased by approximately 55.0%,or $26.8 million, to $75.5 million for the six months ended June 30, 2004from $48.7 million for the six months ended June 30, 2003.

 

This sales increase was primarilyattributable to increased sales from a broad base of customers in the datacomand telecom industries, including several new customers that have engagedCherokee in recent quarters.  Our largestcustomer, which is in the wireless infrastructure market, accounted for approximately$8.3 million of our sales increase over the first half of 2003.  We experienced some softness in demand fromthis customer during the second half of June 2004 and, given that sales tothis customer may decline sequentially, we anticipate that our third quarternet sales will be flat to down slightly compared to the second quarter.   Also contributing to the overall salesincrease was a favorable foreign currency exchange rate effect of $2.8 milliondue to a stronger Euro in the six months ended June 30, 2004 versus thecomparable period in 2003.

 

GROSS PROFIT

 

Gross profit increased by approximately88.4%, or $11.4 million, to $24.3 million for the six months endedJune 30, 2004 from $12.9 million for the six months ended June 30,2003. Gross margin for the six months ended June 30, 2004 increased to32.2% from 26.5% in the prior year period.

 

Of the $11.4 increase in gross profit, $7.1million was attributable to the higher sales level and the remaining $4.3million was attributable to the increased gross margin.  Substantially all of the increase in grossmargin was due to lower direct labor and overhead costs as a percentage ofsales.  For the six months endedJune 30, 2004, direct labor and factory overhead at Cherokee Europeimproved significantly as a percentage of sales, reflecting increasedefficiencies due to higher production volumes, as well as a lower manufacturingcost structure resulting from the restructuring plan implemented inJune 2003, as described below.

 

OPERATING EXPENSES

 

Operating expenses for the six months ended June 30,2004, decreased by approximately 15.2%, or $2.2 million, to $12.6 million from$14.8 million for the six months ended June 30, 2003.  As a percentage of sales, operating expensesdecreased to 16.7% from 30.5% in the prior year period.

 

The decrease in operating expenses of $2.2million was due to Cherokee Europe restructuring costs of $4.5 million recordedin June 2003, partially offset by increases in engineering and development,selling and marketing, and general and administrative expenses of $0.4 million,$1.0 million and $0.8 million, respectively, primarily to support thesignificantly higher sales volume and related business activities compared to ayear ago.  Of these increases,approximately $0.5 million was attributable to a stronger Euro versus the sixmonths ended June 30, 2003, $0.3 million was attributable to higher salescommissions, and the remaining increase resulted primarily from increasedpayroll and related costs, including higher incentive compensation expense.

 

RESTRUCTURING COSTS

 

During 2003, we implemented a restructuringplan involving the elimination of a number of operational and administrativepositions at the Cherokee Europe facility in Belgium due to unfavorableeconomic conditions in that market. Pursuant to the Cherokee Europe restructuring plan, we recorded a chargefor restructuring costs of $4.5 million for the six months ended June 30,2003.  The restructuring costs werecomprised entirely of one-time termination benefits to be paid through2010.  See the analysis of the CherokeeEurope restructuring accrual in the discussion of the three months comparativeresults of operations above.

 

OPERATING INCOME

 

As a result of the factors discussed above,operating income increased to $11.7 million for the six months ended June 30,2004 compared to an operating loss of $2.0 million for the six months endedJune 30, 2003.  Operating marginincreased to 15.5% from (4.0)% in the prior year period.  The operating loss for the six months endedJune 30, 2003 included the effect of the Cherokee Europe restructuring costs of$4.5 million.

 

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INTEREST EXPENSE

 

Interest expense for the six months endedJune 30, 2004 was $3.8 million compared to $8.2 million for the six monthsended June 30, 2003.  The decreasein interest expense was due to the repayment of debt and conversion to equityof our senior convertible notes in connection with our initial public offering.

 

OTHER INCOME (EXPENSE)

 

Other expense for the six months endedJune 30, 2004 was $0.1 million compared to other income of $0.6 millionfor the six months ended June 30, 2003. The amount for the six months ended June 30, 2003 included a gainon the sale of land of $0.4 million and foreign currency exchange gains of $0.4million.

 

INCOME TAXES

 

The provision for income taxes of $1.3 million for the six months endedJune 30, 2004 was calculated using an estimated effective tax rate for2004 of 16.6%.  The increase from 2003reflects estimated taxable income in Belgium after fully using available netoperating losses relating to Belgium in 2004. Income generated in the United States during 2004 is expected to befully offset by available net operating losses, resulting in the relatively loweffective tax rate for the year.  See furtherdiscussion of the income tax provision and net operating loss carryforwards inNote 4 to the accompanying financial statements.

 

NET INCOME (LOSS)

 

As a result of the factors discussed above,we recorded net income of $6.5 million for the six months ended June 30,2004, compared to a net loss of $9.7 million for the six months endedJune 30, 2003.

 

LIQUIDITY AND CAPITAL RESOURCES

 

CASH FLOWS

 

SIX MONTHS ENDED JUNE 30, 2004 COMPARED TO SIX MONTHS ENDEDJUNE 30, 2003

 

Net cash used in operating activities was$0.8 million for the six months ended June 30, 2004, compared to net cashused in operating activities of $5.7 million for the six months endedJune 30, 2003.  Cash used inoperating activities for the six months ended June 30, 2004 reflected thepositive effect of $6.5 million in net income and $1.6 million of non-cashdepreciation and amortization charges. These amounts were offset by a $1.2 million increase in accountsreceivable and $1.5 million increase in inventory levels due to increased salesand business activity, an increase of $1.2 million in prepaid expenses andother current assets due mainly to an insurance indemnity receivableattributable to the fire in our Belgium facility, an increase in deposits andother assets of $0.8 million due primarily to assets related to our deferredcompensation plan, a decrease in accrued liabilities and accrued restructuringcosts of $1.7 million due mainly to payments for restructuring costs, Belgiumincome tax and professional fees, a decrease in accrued compensation andbenefits of $0.7 million due primarily to the payout of 2003 incentivecompensation and a decrease in other long-term obligations of $1.6 million dueto the payment of accrued paid-in-kind interest with a portion of the netproceeds from the initial public offering. Cash used in operating activities for the six months ended June 30,2003 reflected a net loss of approximately $9.7 million, increases of $4.1million in receivables, $0.9 million in inventories and a $1.6 million decreasein accrued interest payable.  These werepartially offset by non-cash charges for depreciation and amortization of $1.8million and paid-in-kind interest of $2.5 million, and the positive impact of a$6.5 million increase in other long-term obligations and $1.3 million increasein accounts payable.

 

Net cash used in investing activities of $2.3million for the six months ended June 30, 2004 primarily reflectedadditions to property and equipment.  Netcash provided by investing activities of $0.2 million for the six months endedJune 30, 2003 reflected proceeds from sale of land of $0.5 million and anincrease in short-term investments of $0.3 million, offset by additions toproperty and equipment of $0.6 million.

 

Net cash provided by financing activities of$15.2 million for the six months ended June 30, 2004 reflected the netproceeds from our initial public offering of $87.6 million, excluding $1.1million of accrued and unpaid offering costs, offset by payments on long-termdebt of $65.5 million and net payments under the old revolving lines of creditof $6.1 million.  Net cash used in financing activities of $0.2 millionfor the six months ended June 30, 2003 reflected net borrowings under theold revolving lines of credit of $2.5 million, offset by $2.7 million ofpayments on long-term debt and capital leases.

 

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LIQUIDITY

 

We completed our initial public offering of6,600,000 shares of our common stock on February 25, 2004.  The net proceeds from the offering were $86.5million. We used approximately $73.2 million of the net proceeds to repayoutstanding indebtedness, including the Term Loans, the Old Revolving Facility,the Second Lien Notes, related interest on these obligations, as well asaccrued interest and interest added to the principal amount of our SeniorConvertible Notes.  The remainder of thenet proceeds is held in high-grade commercial paper with an original maturityof three months or less, and is reflected in our cash and cash equivalents increaseof $11.3 million for the six months ended June 30, 2004.

 

As of June 30, 2004, we had cash andcash equivalents of $16.2 million, working capital of $44.6 million and noborrowings under the Credit Facility. Historically, the Company has financed its operations with cash fromoperations supplemented by borrowings from credit facilities and debtissuances.  The Company’s current andfuture liquidity needs primarily arise from working capital requirements and capitalexpenditures.  The Company’s historicalcapital expenditures have primarily resulted from investments in equipment toincrease manufacturing capacity and improve manufacturing efficiencies. For2004, the Company expects capital expenditures to be approximately $3 millionto $4 million, which will relate primarily to investments in manufacturingequipment, and has spent $2.4 million in the first half of 2004.

 

As of June 30, 2004, the Company’sborrowings consisted of approximately $46.6 million of Senior Notes bearinginterest at 5.25% annually, and no borrowings under the Credit Facility.  The Company is required to make scheduledinterest payments to holders of the Senior Notes.

 

The Company has operating lease obligationsrelating to its facilities in Tustin and Irvine, California, and Bombay,India.  The Company has capital leaseobligations for manufacturing equipment, which will be paid in 2004.

 

We have purchase commitments primarily withvendors and suppliers for the purchase of inventory, and for other goods andservices, property and equipment as part of the normal course of business.   These commitments are generally evidenced bypurchase orders that may or may not include cancellation provisions.  Based on current expectations, we do notbelieve that any cancellation penalties we incur under these obligations wouldhave a material adverse effect on our financial condition and results ofoperations.

 

The maturities of our long-term debt,including capital leases, and future payments under our operating leases as ofJune 30, 2004 are as follows (in millions):

 
| **Contractual  obligation** | ** ** | **July to  December 31,  2004** | ** ** | **2005** | ** ** | **2006** | ** ** | **2007** | ** ** | **2008** | ** ** | **Thereafter** | ** ** | **Total** | ** ** |
|-----------------------------|------------|-------------------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------------|------------|-----------|------------|
| Senior Notes                |       | $                                         | —     |     | $          | —   |       | $        | —     |     | $          | —         |       | $         | 46.6       |   | $ | — |   | $ | 46.6 |   |
| Capital leases              |       | 0.4                                       |       | —   |       | —   |       | —   |       | —   |       | —         |       | 0.4       |       |
| Operating leases            |       | .7                                        |       | 1.2      |       | 1.3      |       | 1.3      |       | 1.2      |       | 0.6            |       | 6.3       |       |
| Purchase order commitments  |       | 17.2                                      |       | 2.7      |       | —   |       | —   |       | —   |       | —         |       | 19.9      |       |
| Total                       |       | $                                         | 18.3       |     | $          | 3.9      |       | $        | 1.3        |     | $          | 1.3            |       | $         | 47.8       |   | $ | 0.6 |   | $ | 73.2 |   |

 

The Senior Notes mature on November 1,2008.  Interest on the Senior Notes ispayable in cash on May 1 and November 1 of each year.  The Senior Notes are secured by asecond-priority lien on substantially all of our domestic assets and by apledge of 65% of the equity of certain of our foreign subsidiaries.

 

The Credit Facility provides for borrowingsof up to $20.0 million that are subject to a borrowing base comprised ofeligible accounts receivable and inventory, which was $14.4 million atJune 30, 2004.  The Company plans touse funds available under the amended facility to finance its working capitalas needed.  The amended facility has aterm of 4.5 years and bears interest, at our option, at a rate per annum equalto LIBOR plus 2.5% or the agent bank’s base rate plus 1.0%.  In addition to paying interest on outstandingprincipal, we are required to pay a commitment fee to the lenders under theamended facility in respect of the average daily balance of unused loancommitments 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, and senior in rightof payment to our future permitted subordinated debt.  The Credit Facility is secured by afirst-priority lien, subject to permitted encumbrances, on substantially all ofour domestic assets and by a pledge of 65% of the equity of certain of ourforeign subsidiaries.  The CreditFacility contains 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, and contains a financial ratio test based onsenior leverage.  The amended facilitycontains customary events of defaults, including defaults in the payment ofprincipal or interest, defaults in the compliance with the covenants containedin the documents evidencing the Credit Facility, cross defaults to othermaterial debt and bankruptcy or other insolvency events.

 

As of June 30, 2004, the Company was incompliance with all of the financial covenants set forth in the principalagreements governing its debt.

 

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Based on our present expectations, we believethat our existing cash and cash equivalents, working capital and availableborrowing capacity at June 30, 2004 will be sufficient to meet ouranticipated cash requirements for the next twelve months, including operatingrequirements, contractual obligations, planned capital expenditures and debtservice.

 

RECENT ACCOUNTING PRONOUNCEMENTS

 

In January 2003, the FASB issued FIN 46,“Consolidation of Variable Interest Entities.” In general, a variable interest entity is a corporation, partnership,trust or any other legal structure used for business purposes that either (a)does not have equity investors with voting rights or (b) has equity investorsthat do not provide sufficient financial resources for the entity to supportits activities.  FIN 46 requires avariable interest entity to be consolidated by a company if that company issubject to a majority of the entity’s residual returns or both.  The consolidation requirements of FIN 46apply immediately to variable interest entities created after January 31,2003.  The consolidation requirementsapply to older entities in the first fiscal year or interim period beginningafter December 15, 2003.  Certain ofthe disclosure requirements apply in all financial statements issued after January 31,2003, regardless of when the variable interest entity was established.  We did not have any variable interestentities as of June 30, 2004.  Theearly adoption of FIN 46 did not have a material impact on our consolidatedresults of operations or our financial position.  With respect to variable interest entitiescreated before January 31, 2003, in December 2003 the FASB issued FIN46R which, among other things, revised the implementation date to first fiscalyears or interim periods ending after March 15, 2004, with the exceptionof Special Purpose Entities (“SPE”). The consolidated requirements apply to allSPE’s in the first fiscal year or interim period ending after December 15,2003. As the Company has determined that it does not have any SPE’s to whichthese interpretations apply, the Company adopted FIN 46R in the first quarterof 2004, and such adoption did not have a material impact on its financialstatements.

 

FORWARD-LOOKING STATEMENTS

 

Statements in this report containing thewords “believes,” “anticipates,” “estimates,” “expects,” and similarexpressions, or the negative of such words or expressions, and any otherstatements which may be construed as a prediction of future performance orevents, constitute “forward-looking statements” within the meaning of thePrivate Securities Litigation Reform Act of 1995.  These forward-looking statements are basedupon the Company’s current expectations and projections about future events.  Such forward-looking statements involve knownand unknown risks, uncertainties, and other factors that may cause the actualresults, performance, or achievements of the Company, or industry results, tobe materially different from any future results, performance, or achievementsexpressed or implied by such forward-looking statements.  Such factors include, among others, (1)changes in general economic and business conditions, domestically andinternationally, (2) reductions in sales to, or the loss of, any of theCompany’s significant customers or in customer capacity generally, (3) changesin the Company’s sales mix to lower margin products, (4) increased competitionin the Company’s industry, (5) disruptions of the Company’s established supplychannels, (6) the Company’s level of debt and restrictions imposed by its debtagreements, and (7) the additional risk factors identified in the Company’sfilings with the Securities and Exchange Commission, including its RegistrationStatement on Form S-1 (File No. 333-110723). Except as required by law, the Company undertakes no obligation toupdate any forward-looking statements even though the Company’s situation maychange in the future.

 

**Item3.  Quantitative and QualitativeDisclosures About Market Risk.**

 

Market risk relating to the Company’soperations result primarily from changes in foreign currency exchange rates andshort-term interest rates.  The Companydid not have any derivative financial instruments at June 30, 2004.

 

The Company had no variable rate debtoutstanding at June 30, 2004. However, any debt incurred by the Company under the Credit Facility willbear interest at a variable rate.  TheCompany cannot predict market fluctuations in interest rates and their impacton any variable rate debt the Company may incur in the future, nor can there beany assurance that fixed rate long-term debt will be available to the Companyat favorable rates, if at all.

 

The functional currency for the Company’sEuropean operations is the Euro.  TheCompany is, therefore, subject to a certain degree of market risk associated withchanges in foreign currency exchange rates. This risk is mitigated by the fact that the Company’s revenues andexpenses are generally both recorded in Euros, thereby reducing the risk offoreign currency translations on its European operations.  The effect of foreign currency exchange ratefluctuations on the Company’s operating results as of and for the six monthsended June 30, 2004, was not material. Historically, the Company has not actively engaged in exchange ratehedging activities.

 

**Item 4.**                                   Controlsand Procedures

** **

a)              *Disclosure Controls and Procedures*

 

The Company’smanagement, with the participation of the Company’s Chief Executive Officer andChief Financial Officer, has evaluated the effectiveness of the Company’sdisclosure controls and procedures (as such term is defined in Rules 13a-15(e)and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the“Exchange Act”)) as of the end of the period covered

 

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by this report.  Based on suchevaluation, the Company’s Chief Executive Officer and Chief Financial Officerhave concluded that, as of the end of such period, the Company’s disclosurecontrols and procedures are effective in recording, processing, summarizing andreporting, on a timely basis, information required to be disclosed by theCompany in the reports that it files or submits under the Exchange Act.

 

b)             *Internal Control Over Financial Reporting*

 

There have not been any changes in the Company’sinternal control over financial reporting (as such term is defined in Rules13a-15(f) and 15d-15(f) under the Exchange Act) during the fiscal quarter towhich this report relates that have materially affected, or are reasonablylikely to materially affect, the Company’s internal control over financialreporting.

 

 

PART II.                                                 OTHERINFORMATION

 

**Item 1.**                                   LegalProceedings

 

During the sixmonths ended June 30, 2004, we were not a party to any material legalproceedings.  We are occasionally a partyto lawsuits relating to routine matters incidental to our business.  As with all litigation, we can provide noassurance as to the outcome of any particular lawsuit, and we note thatlitigation inherently involves significant costs.

 

**Item 2.**                                   Changesin Securities, Use of Proceeds and Issuer Purchases of Equity Securities

 

On February 25,2004, we issued 769 shares of common stock to a retired employee upon exerciseof a stock option at a price of $10.335 per share.  These securities were issued pursuant to anemployee benefit plan, in a transaction exempt from the registrationrequirements of the Securities Act in reliance upon Rule 701 of the SecuritiesAct.

 

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

 

 Of the $95.7 million in gross proceeds raisedby us in the offering:

 

1.                                       approximately$6.7 million was paid to the underwriters in connection with the underwritingdiscount;

 

2.                                       approximately$2.5 million was paid or accrued by us in connection with offering fees andexpenses;

 

3.                                       approximately$73.2 million was used to repay principal and interest on our outstandingindebtedness;

 

4.                                       approximately$3.3 million has been used as of June 30, 2004, for general corporatepurposes; and

 

5.                                       approximately$10.0 million has been retained by us for general corporate purposes and isheld in high-grade commercial paper with an original maturity of three monthsor less.

 

**Item 6.**                                   Exhibitsand Reports on Form 8-K

(a)          Exhibits

EXHIBIT INDEX
| **Exhibit  No.** | ** ** | **Description**                                                                                                                                            |
|------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1              |       | Restated Certificate of Incorporation of Cherokee International  Corporation (1)                                                                           |
| 3.2              |       | Amended and Restated By-Laws of Cherokee International Corporation  (1)                                                                                    |
| 4.1              |       | Specimen of Stock Certificate (2)                                                                                                                          |
| 10.1             |       | Registration Rights Agreement, dated as of February 25, 2004, by  and among Cherokee International Corporation and the Securityholders party  thereto |
| 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 withAmendment No. 2 to the Registration Statement on Form S-1 filed by the Registranton February 11, 2004.

(2)                                  Previously filed withAmendment No. 4 to the Registration Statement on Form S-1 filed by theRegistrant on February 17, 2004.

 

(b)         Reportson Form 8-K

 

**The Companyfiled a Form 8-K on April 27, 2004 announcing its first quarter financialresults.**

 

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**SIGNATURES**

 

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

 
| Dated:  August 9, 2004 |                               |                                         |
|-----------------------------|------------------------------------|----------------------------------------------|
|                        |                               |                                         |
|                        | 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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