Tableof Contents

 

 

 

**SECURITIESAND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

----

 

**FORM 10-Q**

 
| **(Mark One)** |
|----------------|
| **x**          | ** ** | **Quarterly Report Pursuant to  Section 13 or 15(d) of the Securities Exchange Act of 1934** |
| ** **     | ** ** | **For the quarterly period ended September 28, 2008** |
| ** **     | ** ** | ** ** |
| **or**         |
| ** **     | ** ** | ** ** |
| **o**          | ** ** | **Transition Report Pursuant to  Section 13 or 15(d) of the Securities Exchange Act of 1934** |
| ** **     | ** ** | **For the transition period  from                    to                    ** |

 

**CommissionFile No. 000-50593**

 

----

 

**Cherokee International Corporation**

(Exact name ofRegistrant as specified in its charter)

 

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

 

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

 

Indicate by check mark whether the registrant (1) has filed allreports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorterperiod that the Registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days.

 

Yes x  No o

 

Indicate by check mark whether the registrant is a large acceleratedfiler, an accelerated filer, a non-accelerated filer, or a smaller reportingcompany. See definitions of “large accelerated filer,” “accelerated filer,” and“smaller reporting company” in Rule 12b-2 of the Exchange Act. (Checkone):

 
| Large  accelerated filer o |   | Accelerated filer o |   | Non-accelerated filer o                  |   | Smaller reporting company x |
|---------------------------------|--------|--------------------------|--------|-----------------------------------------------|--------|----------------------------------|
|                            |   |                     |   | (Do not check if a smaller reporting company) |   |                             |

 

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

 

Indicate the number of shares outstanding of each of the issuer’sclasses of common stock, as of the latest practicable date.

 

| **Title**                                | ** ** | **Shares Outstanding as of October 31, 2008** |
|------------------------------------------|------------|-----------------------------------------------------------------------------|
| Common Stock, par value $0.001 per share |       | 19,475,892 shares                                                           |

 

 

 

----

Table of Contents

 

TABLE OF CONTENTS

 
| ** **                                                                                          | **Page** |
|-----------------------------------------------------------------------------------------------------|----------|
| PART I. FINANCIAL INFORMATION                                                                  | 1        |
| Item 1. Financial Statements:                                                                       | 1        |
| Condensed Consolidated Balance Sheets (unaudited)                                                   | 1        |
| Condensed Consolidated Statements of Operations (unaudited)                                         | 2        |
| Condensed Consolidated Statements of Comprehensive Operations  (unaudited)                          | 3        |
| Condensed Consolidated Statements of Cash  Flows (unaudited)                                        | 4        |
| Notes to Condensed Consolidated Financial  Statements (unaudited)                                   | 5        |
| Item 2. Management’s Discussion and  Analysis of Financial Condition and Results of Operations | 19       |
| Item 3. Quantitative and Qualitative  Disclosures About Market Risk                                 | 29       |
| Item 4T. Controls and Procedures                                                                    | 29       |
| PART II OTHER INFORMATION                                                                      | 31       |
| Item 1. Legal Proceedings                                                                           | 31       |
| Item 1A. Risk Factors                                                                               | 32       |
| Item 6. Exhibits                                                                                    | 39       |
| Signatures                                                                                          | 40       |

 

----

Table of Contents

 

PART I.  FINANCIAL INFORMATION

 

Item 1.  FINANCIAL STATEMENTS.

 

CHEROKEEINTERNATIONAL CORPORATION AND SUBSIDIARIES

CONDENSEDCONSOLIDATED BALANCE SHEETS

(In Thousands, Except Share andPer Share Data)

(Unaudited)

 
| ** **                                                                                                                                                                                       | ** ** | **September 28, 2008** | ** ** | **December 30, 2007** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ASSETS                                                                                                                                                                                           |       |                             |       |                            |       |
| CURRENT ASSETS:                                                                                                                                                                                  |       |                             |       |                            |       |
| Cash and cash equivalents                                                                                                                                                                        |       | $                                | 15,301     |                            | $          | 8,484 |   |
| Accounts receivable, net of allowance for  doubtful accounts of $280 and $297 at September 28, 2008 and  December 30, 2007, respectively                                          |       | 29,579                           |       | 31,237                          |       |
| Inventories, net                                                                                                                                                                                 |       | 29,395                           |       | 28,021                          |       |
| Prepaid expenses and other current assets                                                                                                                                                        |       | 1,509                            |       | 1,583                           |       |
| Deferred income taxes                                                                                                                                                                            |       | —                           |       | 363                             |       |
| Total current assets                                                                                                                                                                             |       | 75,784                           |       | 69,688                          |       |
|                                                                                                                                                                                             |       |                             |       |                            |       |
| Property and equipment, net                                                                                                                                                                      |       | 17,540                           |       | 19,194                          |       |
| Deposits and other assets                                                                                                                                                                        |       | 1,126                            |       | 1,515                           |       |
| Deferred financing costs, net of  accumulated amortization of $580 and $494 at September 28, 2008 and  December 30, 2007, respectively                                            |       | —                           |       | 86                              |       |
| Deferred income taxes-long-term portion                                                                                                                                                          |       | —                           |       | 1,257                           |       |
| Goodwill                                                                                                                                                                                         |       | —                           |       | 1,120                           |       |
| Total Assets                                                                                                                                                                                     |       | $                                | 94,450     |                            | $          | 92,860 |   |
|                                                                                                                                                                                             |       |                             |       |                            |       |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                                        |       |                             |       |                            |       |
| CURRENT LIABILITIES:                                                                                                                                                                             |       |                             |       |                            |       |
| Accounts payable                                                                                                                                                                                 |       | $                                | 15,825     |                            | $          | 15,140 |   |
| Accrued liabilities                                                                                                                                                                              |       | 4,732                            |       | 4,667                           |       |
| Accrued compensation and benefits                                                                                                                                                                |       | 6,983                            |       | 6,876                           |       |
| Accrued restructuring costs                                                                                                                                                                      |       | 410                              |       | 431                             |       |
| Other short-term borrowings                                                                                                                                                                      |       | 198                              |       | —                          |       |
| Borrowings under revolving line of credit                                                                                                                                                        |       | 3,796                            |       | 3,395                           |       |
| Current debt                                                                                                                                                                                     |       | 24,485                           |       | 24,485                          |       |
| Current debt payable to affiliates                                                                                                                                                               |       | 22,145                           |       | 22,145                          |       |
| Total current liabilities                                                                                                                                                                        |       | 78,574                           |       | 77,139                          |       |
|                                                                                                                                                                                             |       |                             |       |                            |       |
| Other long-term liabilities                                                                                                                                                                      |       | 4,212                            |       | 4,534                           |       |
| Total Liabilities                                                                                                                                                                                |       | 82,786                           |       | 81,673                          |       |
|                                                                                                                                                                                             |       |                             |       |                            |       |
| Commitments and contingencies (Note 9)                                                                                                                                                           |       |                             |       |                            |       |
|                                                                                                                                                                                             |       |                             |       |                            |       |
| STOCKHOLDERS’ EQUITY:                                                                                                                                                                       |       |                             |       |                            |       |
| Common stock: $0.001 par value; 60,000,000  shares authorized; 19,475,892 and 19,453,557 shares issued and outstanding at  September 28, 2008 and December 30, 2007, respectively |       | 19                               |       | 19                              |       |
| Paid-in capital                                                                                                                                                                                  |       | 186,789                          |       | 186,035                         |       |
| Accumulated deficit                                                                                                                                                                              |       | (178,754                         | )          | (178,323                        | )          |
| Accumulated other comprehensive income                                                                                                                                                           |       | 3,610                            |       | 3,456                           |       |
| Total stockholders’ equity                                                                                                                                                                  |       | 11,664                           |       | 11,187                          |       |
| Total Liabilities and Stockholders’ Equity                                                                                                                                                  |       | $                                | 94,450     |                            | $          | 92,860 |   |

 

See notes to condensed consolidated financialstatements.

 

1

----

Table of Contents

 

CHEROKEEINTERNATIONAL CORPORATION AND SUBSIDIARIES

CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS

(In Thousands, Except Per ShareAmounts)(Unaudited)

 
| ** **                               | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended**  | ** ** |
|------------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| ** **                               | ** ** | **September 28, 2008** | ** ** | **September 30, 2007** | ** ** | **September 28, 2008** | ** ** | **September 30, 2007** | ** ** |
| Net sales                                |       | $                                | 36,402     |                             | $          | 30,401 |   | $ | 111,689 |   | $ | 89,995 |   |
| Cost of sales                            |       | 27,170                           |       | 24,670                           |       | 82,481 |   | 72,996 |   |
| Gross profit                             |       | 9,232                            |       | 5,731                            |       | 29,208 |   | 16,999 |   |
| Operating expenses:                      |       |                             |       |                             |       |   |   |   |   |
| Engineering and development              |       | 2,618                            |       | 2,561                            |       | 8,299 |   | 8,040 |   |
| Selling and marketing                    |       | 1,682                            |       | 1,510                            |       | 5,517 |   | 5,247 |   |
| General and administrative               |       | 4,152                            |       | 2,660                            |       | 11,141 |   | 9,177 |   |
| Goodwill impairment                      |       | —                           |       | —                           |       | 1,120 |   | — |   |
| Restructuring costs                      |       | —                           |       | —                           |       | — |   | 155 |   |
| Total operating expenses                 |       | 8,452                            |       | 6,731                            |       | 26,077 |   | 22,619 |   |
| Operating income (loss)                  |       | 780                              |       | (1,000                           | )          | 3,131 |   | (5,620 | ) |
| Interest expense                         |       | (707                             | )          | (707                             | )          | (2,166 | ) | (2,084 | ) |
| Gain on sale of Mexico Facility building |       | —                           |       | —                           |       | — |   | 430 |   |
| Other income (loss), net                 |       | 66                               |       | (23                              | )          | 305 |   | 291 |   |
| Income (loss) before income taxes        |       | 139                              |       | (1,730                           | )          | 1,270 |   | (6,983 | ) |
| Income tax provision (benefit)           |       | 13                               |       | (421                             | )          | 1,701 |   | (1,999 | ) |
| Net income (loss)                        |       | $                                | 126        |                             | $          | (1,309 | ) | $ | (431 | ) | $ | (4,984 | ) |
| Net income (loss) per share:             |       |                             |       |                             |       |   |   |   |   |
| Basic                                    |       | $                                | 0.01       |                             | $          | (0.07 | ) | $ | (0.02 | ) | $ | (0.26 | ) |
| Diluted                                  |       | $                                | 0.01       |                             | $          | (0.07 | ) | $ | (0.02 | ) | $ | (0.26 | ) |
| Weighted average shares outstanding:     |       |                             |       |                             |       |   |   |   |   |
| Basic                                    |       | 19,476                           |       | 19,414                           |       | 19,465 |   | 19,371 |   |
| Diluted                                  |       | 19,480                           |       | 19,414                           |       | 19,465 |   | 19,371 |   |

 

See notes to condensed consolidated financialstatements.

 

2

----

Table of Contents

 

CHEROKEEINTERNATIONAL CORPORATION AND SUBSIDIARIES

CONDENSEDCONSOLIDATED STATEMENTS OF COMPREHENSIVE OPERATIONS

(InThousands)

(Unaudited)

 
| ** **                               | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended**  | ** ** |
|------------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| ** **                               | ** ** | **September 28, 2008** | ** ** | **September 30, 2007** | ** ** | **September 28, 2008** | ** ** | **September 30, 2007** | ** ** |
| Net income (loss)                        |       | $                                | 126        |                             | $          | (1,309 | ) | $ | (431 | ) | $ | (4,984 | ) |
| Other comprehensive income (loss):       |       |                             |       |                             |       |   |   |   |   |
| Foreign currency translation adjustments |       | (517                             | )          | 567                              |       | 154 |   | 865 |   |
| Comprehensive loss                       |       | $                                | (391       | )                                | $          | (742 | ) | $ | (277 | ) | $ | (4,119 | ) |

 

See notes to condensed consolidated financialstatements.

 

3

----

Tableof Contents

 

CHEROKEEINTERNATIONAL CORPORATION AND SUBSIDIARIES

CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS

(InThousands)

(Unaudited)

 
| ** **                                                                                 | ** ** | **Nine Months Ended**  | ** ** |
|--------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                 | ** ** | **September 28, 2008** | ** ** | **September 30, 2007** | ** ** |
| CASH FLOWS FROM OPERATING ACTIVITIES:                                                      |       |                             |       |   |   |
| Net loss                                                                                   |       | $                                | (431       | ) | $ | (4,984 | ) |
| Adjustments to reconcile net loss to net  cash provided by (used in) operating activities: |       |                             |       |   |   |
| Depreciation and amortization                                                              |       | 2,044                            |       | 2,397 |   |
| Goodwill impairment                                                                        |       | 1,120                            |       | — |   |
| Gain on sale of property and equipment                                                     |       | —                           |       | (430 | ) |
| Amortization of deferred financing costs                                                   |       | 86                               |       | 97 |   |
| Stock-based compensation                                                                   |       | 707                              |       | 589 |   |
| Deferred income taxes                                                                      |       | 1,650                            |       | — |   |
| Net change in operating assets and  liabilities:                                           |       |                             |       |   |   |
| Accounts receivable, net                                                                   |       | 1,562                            |       | 2,385 |   |
| Inventories, net                                                                           |       | (1,457                           | )          | (834 | ) |
| Prepaid expenses and other current assets                                                  |       | 71                               |       | 1,180 |   |
| Deposits and other assets                                                                  |       | 388                              |       | (77 | ) |
| Accounts payable                                                                           |       | 737                              |       | (1,200 | ) |
| Accrued liabilities and restructuring costs                                                |       | (508                             | )          | (3,647 | ) |
| Accrued compensation and benefits                                                          |       | 136                              |       | (95 | ) |
| Accrued interest payable                                                                   |       | 555                              |       | 636 |   |
| Other long-term liabilities                                                                |       | (287                             | )          | (624 | ) |
| Net cash provided by (used in) operating  activities                                       |       | 6,373                            |       | (4,607 | ) |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                                      |       |                             |       |   |   |
| Additions to property and equipment                                                        |       | (417                             | )          | (2,152 | ) |
| Proceeds from sale of property and  equipment                                              |       | —                           |       | 1,229 |   |
| Net cash used in investing activities                                                      |       | (417                             | )          | (923 | ) |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                                      |       |                             |       |   |   |
| Other short-term borrowings, net                                                           |       | 296                              |       | 286 |   |
| Borrowings on revolving lines of credit,  net                                              |       | 417                              |       | 3,308 |   |
| Net proceeds from employee stock purchases  and the exercise of stock options              |       | 47                               |       | 231 |   |
| Net cash provided by financing activities                                                  |       | 760                              |       | 3,825 |   |
| Effect of exchange rate changes on cash                                                    |       | 101                              |       | 133 |   |
| Net increase (decrease) in cash and cash  equivalents                                      |       | 6,817                            |       | (1,572 | ) |
| Cash and cash equivalents, beginning of  period                                            |       | 8,484                            |       | 8,881 |   |
| Cash and cash equivalents, end of period                                                   |       | $                                | 15,301     |   | $ | 7,309 |   |
| SUPPLEMENTAL INFORMATION                                                                   |       |                             |       |   |   |
| Cash paid during the period for interest                                                   |       | $                                | 1,541      |   | $ | 1,330 |   |
| Cash paid during the period for income  taxes                                              |       | $                                | 299        |   | $ | 239 |   |

 

See notes to condensed consolidated financialstatements.

 

4

----

Tableof Contents

 

CHEROKEE INTERNATIONALCORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

1.      NATURE OF OPERATIONS

 

CherokeeInternational Corporation (the “Company”) is a designer and manufacturer ofpower supplies for original equipment manufacturers (“OEMs”). Its advancedpower supply products are typically custom designed into mid- to high-endcommercial applications in the computing and storage, wireless infrastructure,enterprise networking, telecom, medical and industrial markets.

 

2.       BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

Basis of Presentation

 

Theaccompanying condensed consolidated financial statements of CherokeeInternational Corporation have been prepared in accordance with accountingprinciples generally accepted in the United States of America for interimfinancial information and in accordance with the instructions to Form 10-Qand Article 10 of Regulation S-X.  Accordingly, they do not includecertain footnotes and financial presentations normally required underaccounting principles generally accepted in the United States of America forcomplete financial reporting.  The interim financial information isunaudited, but reflects all normal adjustments and accruals, which are, in theopinion of management, considered necessary to provide a fair presentation forthe interim periods presented.  The condensed consolidated financialstatements include the financial statements of the Company and its wholly ownedsubsidiaries.  All intercompany balances and transactions have beeneliminated in the accompanying condensed consolidated financial statements.

 

Resultsof operations for the three and nine months ended September 28, 2008 and September 30,2007, are not necessarily indicative of the results to be expected for theentire fiscal year ending December 28, 2008 (“fiscal 2008”). Theaccompanying condensed consolidated financial statements should be read inconjunction with the audited consolidated financial statements for the fiscalyear ended December 30, 2007, included in the Company’s Annual Report on Form 10-K(File No. 000-50593) filed on March 28, 2008.

 

Going Concern

 

The accompanying condensed consolidatedfinancial statements have been prepared assuming that the Company will continueas a going concern.

 

On November 1, 2008, the$46.6 million aggregate principal amount outstanding under our 5.25%Senior Notes became due and payable.  Aspreviously disclosed, the Company did not have sufficient cash available torepay this indebtedness.  The Companymade the interest payment due on November 1 but was unable to pay theprincipal amount outstanding at maturity and a payment default occurred.  As a result of the payment default, inaddition to the aggregate principal amount outstanding under the Senior Notes,the Company is required to pay interest on overdue principal at the default rateof 6.25% per annum. It is anticipated that the previously announced merger(the “Merger”) pursuant to the Agreement and Plan of Merger, dated as of September 24,2008 (the “Merger Agreement”), by and among Lineage Power Holdings, Inc.,a Delaware corporation (“Parent”), Birdie Merger Sub, Inc., a Delawarecorporation and a wholly owned subsidiary of Lineage (“Merger Sub”), and theCompany, as the agreement may be amended from time to time, will close on orabout November 21, 2008, after stockholders vote on the Merger at theSpecial Meeting of Stockholders to be held on November 18, 2008.  Asa result of the Merger, pursuant to which Merger Sub will be merged with andinto the Company, with the Company surviving as a wholly owned subsidiary ofLineage, the Senior Notes will remain an obligation of the Company.  The Company anticipates that the outstandingamounts due and payable under the Senior Notes, together with default intereston overdue principal, will be paid in full at or after the closing of the Merger.  If the Merger fails to be consummated we may be forced to refinance onterms that are materially less favorable, seek funds through other means suchas a sale of our assets, or otherwise significantly alter our operating plan,any of which could have a material adverse effect on our business, financialcondition and results of operation and our ability to continue as a goingconcern. There can be no assurance that any refinancing or sale of assets wouldbe available on satisfactory terms, if at all, or that the Company would beable to continue as a going concern. Accordingly, if the Merger fails to be consummated, the Company could beforced to file for bankruptcy protection and thereby reorganize or liquidateits assets, resulting in material adverse consequences for the Company’s stockholders,creditors and employees.

 

The accompanying condensed consolidatedfinancial statements do not include any adjustments relating to therecoverability and classification of asset carrying amounts or the amount andclassification of liabilities that might result should we be unable to continueas a going concern.

 

5

----

Tableof Contents

 

Pending Merger withLineage Power Holdings, Inc.

 

Asdescribed above, on September 24, 2008, the Company entered into theMerger Agreement with Parent andMerger Sub, pursuant to which Merger Subwill be merged with and into the Company, with the Company continuing after theMerger as the surviving corporation and a wholly owned subsidiary ofParent.  The Company’s board of directors has unanimously approved theadoption of the Merger Agreement and the Merger and has recommended that theCompany’s stockholders approve and adopt the Merger Agreement.

 

Pursuantto the Merger Agreement, upon consummation of the Merger:  (1) eachissued and outstanding share of common stock of the Company (the “Shares”), other than Shares owned bythe Company, Parent, Merger Sub or any wholly owned subsidiary of the Company,Parent or Merger Sub, or by any stockholders who are entitled to and whoproperly exercise appraisal rights under Delaware law, will be cancelled andconverted into the right to receive $3.20 in cash, without interest ; (2) eachunexercised stock option that is outstanding at the effective time of theMerger (whether or not then vested) will be cancelled and converted into theright to receive an amount in cash (subject to applicable withholding taxes)equal to (x) the excess, if any, of $3.20 per share over the per shareexercise or purchase price of such outstanding stock option, multiplied by (y) thenumber of shares of common stock underlying such stock option; and (3) sharesof common stock purchased under the Company’s Employee Stock Purchase Programwill be cancelled and converted into the right to receive $3.20 per share.

 

TheCompany has made customary representations, warranties and covenants in theMerger Agreement, including, among others, covenants: (1) to, during theinterim period between the execution of the Merger Agreement and consummationof the Merger, carry on its business in the usual, regular and ordinary coursein the same manner as previously conducted; (2) not to engage in certainkinds of transactions during such period; and (3) to cause a stockholdermeeting to be held to consider approval of the Merger and the othertransactions contemplated by the Merger Agreement.

 

Additionally,the Company has agreed not to (1) solicit, initiate or encourage proposalsrelating to alternative business combination transactions or (2) subjectto certain exceptions, enter into discussions concerning alternative businesscombination transactions.  In addition, the Merger Agreement may beterminated by the Company and Parent under certain circumstances, including bythe Company if its board of directors determines in good faith that it hasreceived an unsolicited bona fide “superior proposal,” as defined in the MergerAgreement, and otherwise complies with certain terms of the Merger Agreement.In connection with suchtermination, the Company must pay a fee of $2,500,000 to Parent.  TheCompany may also be required to pay Parent a fee of $2,500,000 under otherspecified circumstances in connection with a termination of the Merger Agreement.

 

Consummationof the Merger is subject to the satisfaction or waiver (if applicable) of anumber of conditions, including: (1) approval of the Company’sstockholders; (2) subject to certain exceptions, the absence of a materialadverse effect with respect to the Company during the interim period betweenthe execution of the Merger Agreement and consummation of the Merger; (3) expirationof the waiting period and approval under any applicable antitrust laws; and (4) norestraints of any governmental entity prohibiting the consummation of theMerger.  In addition, each party’s obligation to consummate the Merger issubject to the accuracy of the representations and warranties of the otherparty, subject to a material adverse effect condition, and material complianceof the other party with its covenants.

 

Inconnection with the Merger Agreement, certain stockholders of the Company withcontrolling voting power of approximately 50.3% of the Shares have entered intoa voting agreement with Parent, Merger Sub and the Company (the “VotingAgreement”) pursuant to which those stockholders have agreed to vote in favorof the transactions contemplated by the Merger Agreement and not to transfertheir shares except under certain circumstances.  The Voting Agreement willterminate upon any termination of the Merger Agreement.

 

Use of Estimates

 

The preparation of financial statements in accordance with accountingprinciples generally accepted in the United States of America requiresmanagement to make estimates and assumptions that affect the reported amountsof assets and liabilities and disclosure of contingent liabilities at the dateof the financial statements and the amounts of revenues and expenses during thereporting period. Actual results could differ from such estimates.

 

Stock-Based Compensation

 

In December 2004, SFAS 123R, *Share-Based Payment*, was issued.SFAS 123R is a revision of SFAS 123, *Accountingfor Stock Based Compensation*, and supersedes APB 25. Amongother items, SFAS 123R eliminates the use of APB 25 and the intrinsicvalue method of accounting, and requires companies to recognize the cost ofemployee services received in exchange for awards of equity instruments, basedon the grant-date fair value of those awards, in the financial statements. The Companywas required to adopt SFAS 123R effective on January 2, 2006.SFAS 123R permits companies to adopt its requirements using either a “*modified prospective*” method, or a “*modified retrospective*” method. Under the“*modified prospective*” method,compensation cost is recognized in the financial statements beginning with theeffective date, based on the requirements of SFAS 123R for all share-basedpayments granted after that date, and based on the requirements ofSFAS 123 for all unvested awards granted prior to the effective date ofSFAS 123R. Under the “*modifiedretrospective*” method, the requirements are the same as under the “*modified prospective*” method, but alsopermit entities to restate financial statements of previous periods based onproforma disclosures made in accordance with SFAS 123.

 

6

----

Tableof Contents

 

SFAS 123R permits the use of either theBlack-Scholes model or a “lattice” model. The Company used the Black-Scholes standard option-pricing model tomeasure the fair value of stock options granted to employees and nonemployeesprior to its adoption of SFAS 123R and continued its use thereafter.

 

SFAS 123R requires that the benefitsassociated with the tax deductions in excess of recognized compensation cost bereported as a financing cash flow, rather than as an operating cash flow asrequired under prior literature. This requirement will reduce net operatingcash flows and increase net financing cash flows in periods after the effectivedate. These future amounts cannot be estimated, because they depend on, amongother things, when employees exercise stock options.

 

The Company adopted SFAS 123R on January 2,2006 using the “modified prospective” method as permitted by SFAS 123R.Under this transition method, stock compensation cost recognized beginning inthe first quarter of fiscal year 2006 includes: (a) compensation cost forall share-based payments granted subsequent to February 25, 2004 and priorto January 1, 2006 but not yet vested as of January 1, 2006, based onthe grant-date fair value estimated in accordance with the provisions ofSFAS 123R, and (b) compensation cost for all share-based paymentsgranted subsequent to January 1, 2006, based on the grant-date fair valueestimated in accordance with the provisions of SFAS 123R. In accordancewith the modified prospective method of adoption, the Company’s results ofoperations and financial position for prior periods have not been restated. Atthe date of the adoption, the unamortized expense for options issued prior to January 2,2006 was $2.3 million, which will be amortized as stock compensation coststhrough December 2010. Stock-based compensation costs expensed during thequarters ended September 28, 2008 and September 30, 2007, were $0.2million and $0.2 million, respectively. During the nine months ended September 28,2008 and September 30, 2007, the costs recorded were $0.7 million and $0.6million, respectively.

 

All grants are made at prices based on thefair market value of the stock on the date of grant. Outstanding optionsgenerally vest over periods ranging from two to four years from the grant dateand generally expire up to ten years after the grant date.

 

The Company recordscompensation expense for employee stock options based on the estimated fairvalue of the options on the date of grant using the Black-Scholes optionpricing formula with the assumptions included in the table below. The Companyuses historical data, among other factors, to estimate the expected pricevolatility and the expected forfeiture rate. For options granted prior to January 2,2006, the Company used the expected option life of 5 years. For optionsgranted following the Company’s adoption of SFAS 123R, the expected lifewas increased to 6.25 years using the “simplified method” underSAB 107 (an expected term based on the mid-point between the vesting dateand the end of the contractual term). The use of the simplified method requiresour option plan to be consistent with a “plain vanilla” plan and was originallypermitted through December 31, 2007 under SAB 107. In December 2007,the SEC issued SAB 110, *Share-BasedPayment*, to amend the SEC’s views discussed in SAB 107regarding the use of the simplified method in developing an estimate ofexpected life of share options in accordance with SFAS 123R. SAB 110was effective for the Company beginning December 31, 2007. The Companywill continue to use the simplified method until it has the historical datanecessary to provide a reasonable estimate of expected life, in accordance withSAB 107, as amended by SAB 110. The options have a maximumcontractual term of 10 years and generally vest pro-rata over two to fouryears. The risk-free rate is based on the U.S. Treasury yield curve in effectat the time of grant for the estimated life of the option.

 

The followingweighted-average assumptions were used to estimate the fair value of optionsgranted during the three- and nine-month periods ended September 28, 2008and September 30, 2007, using the Black-Scholes option pricing formula.

 

7

----

Tableof Contents

 
| ** **              | ** ** | **Quarter Ended**           | ** ** | **Nine Months Ended**  | ** ** |
|-------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| ** **              | ** ** | **September 28, 2008** | ** ** | **September 30, 2007** | ** ** | **September 28, 2008** | ** ** | **September 30, 2007** | ** ** |
| Dividend yield          |       | 0.0                              | %          | 0.0                              | %          | 0.0 | % | 0.0 | % |
| Expected volatility     |       | 67.1                             | %          | 54.7                             | %          | 61.5 | % | 54.8 | % |
| Risk-free interest rate |       | 3.85                             | %          | 4.59                             | %          | 3.99 | % | 4.97 | % |
| Expected lives          |       | 6.25 years                       |       | 6.25 years                       |       | 6.25 years |   | 6.25 years |   |
| Forfeiture rates        |       | 10.65% - 24.78                   | %          | 11.74% - 21.88                   | %          | 10.65% - 24.78 | % | 11.74% - 21.88 | % |

 

Thefollowing table summarizes the Company’s activities with respect to its stockoption plans for the nine months ended September 28, 2008 as follows:

 
| **Options**                                                           | ** ** | **Number  of  Shares** | ** ** | **Weighted-  Average  Exercise Price  Per Share** | ** ** | **Weighted-  Average  Remaining  Contractual  Term  (in years)** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
|-----------------------------------------------------------------------|------------|------------------------|------------|-------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|---------------------------------|------------|
| Outstanding at December 30, 2007                                 |       | 2,791,579              |       | $                                                           | 5.97       |                                                                  | 7.49       |                            | $          | — |   |
| Granted                                                               |       | 70,000                 |       | $                                                           | 2.33       |                                                                  | 9.69       |                            | $          | 45,700 |   |
| Exercised                                                             |       | —                 |       | $                                                           | —     |                                                                  | —     |                            | $          | — |   |
| Forfeited                                                             |       | (246,653               | )          | $                                                           | 6.97       |                                                                  | 6.05       |                            | $          | — |   |
| Outstanding at September 28, 2008                                |       | 2,614,926              |       | $                                                           | 5.78       |                                                                  | 6.87       |                            | $          | 46,625 |   |
| Vested and expected to vest in the future  at September 28, 2008 |       | 2,401,996              |       | $                                                           | 5.90       |                                                                  | 6.72       |                            | $          | 26,720 |   |
| Exercisable at September 28, 2008                                |       | 1,591,601              |       | $                                                           | 6.70       |                                                                  | 6.04       |                            | $          | 387 |   |

 

Since its inception on February 16,2004, a total of 400,000 shares of common stock have been reserved for issuanceunder the 2004 Employee Stock Purchase Plan (“ESPP”), subject to annualincreases as described under Note 11 below. Under the terms of the ESPP, theCompany’s U.S. employees, nearly all of whom are eligible to participate, canchoose to have up to a maximum of 15% of their eligible annual base earningswithheld, subject to an annual maximum of $25,000 or 2,100 shares per offeringperiod, to purchase our common stock. The purchase price of the stock is 85% ofthe lower of the closing price at the beginning of each six-month offeringperiod or at the end of each six-month offering period. The Company recognizescompensation cost for its ESPP under SFAS 123R.

 

8

----

Tableof Contents

 

In accordance with SFAS 148, and as required by SFAS 123R, the requiredpro forma disclosure for options granted in periods prior to adoption of SFAS123R is shown below (in thousands except per share amounts):

 
| ** **                                                                                                                                                           | ** ** | **Quarter Ended**           | ** ** | **Nine Months Ended**  | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| ** **                                                                                                                                                           | ** ** | **September 28, 2008** | ** ** | **September 30, 2007** | ** ** | **September 28, 2008** | ** ** | **September 30, 2007** | ** ** |
| Net income (loss), as reported                                                                                                                                       |       | $                                | 126        |                             | $          | (1,309 | ) | $ | (431 | ) | $ | (4,984 | ) |
| Stock-based employee compensation related  to stock options included in net income (loss), as reported, net of tax                                                   |       | —                           |       | —                           |       | — |   | — |   |
| Total stock-based employee compensation  expense determined under the fair value based method for all awards  (under provisions of APB 25), net of tax (a) |       | —                           |       | (96                              | )          | (40 | ) | (286 | ) |
| Net income (loss)—pro forma                                                                                                                                     |       | $                                | 126        |                             | $          | (1,405 | ) | $ | (471 | ) | $ | (5,270 | ) |
| Net income (loss) per share, as reported:                                                                                                                            |       |                             |       |                             |       |   |   |   |   |
| Basic                                                                                                                                                                |       | $                                | 0.01       |                             | $          | (0.07 | ) | $ | (0.02 | ) | $ | (0.26 | ) |
| Diluted                                                                                                                                                              |       | $                                | 0.01       |                             | $          | (0.07 | ) | $ | (0.02 | ) | $ | (0.26 | ) |
| Pro forma net income (loss) per share:                                                                                                                               |       |                             |       |                             |       |   |   |   |   |
| Basic                                                                                                                                                                |       | $                                | 0.01       |                             | $          | (0.07 | ) | $ | (0.02 | ) | $ | (0.27 | ) |
| Diluted                                                                                                                                                              |       | $                                | 0.01       |                             | $          | (0.07 | ) | $ | (0.02 | ) | $ | (0.27 | ) |

 

----

(a)    During 2008 and2007, the Company accounted for stock-based compensation for options grantedprior to February 25, 2004, the date of our initial public offering, toemployees and directors using the intrinsic value method prescribed in APB 25and adopted the disclosure-only alternative of SFAS 123, as amended by SFAS 148for these options.

 

Translation of Foreign Currency

 

Foreign subsidiary assets and liabilitiesdenominated in foreign currencies are translated at the exchange rate in effecton the balance sheet date. Revenues, costs and expenses are translated at theaverage exchange rate during the period. Transaction gains and losses areincluded in results of operations and have not been significant for the periodspresented. The functional currency of Cherokee Europe is the Euro. Thefunctional currency of Cherokee India, Powertel and Cherokee China is the U.S.dollar, as the majority of transactions are denominated in U.S. dollars.Translation adjustments related to Cherokee Europe are reflected as a componentof stockholders’ equity in other comprehensive income (loss).

 

Recent Accounting Pronouncements

 

In September 2006, the FASB issuedSFAS 157, *Fair Value Measurements*.This Statement defines fair value, establishes a framework for measuring fairvalue in generally accepted accounting principles (GAAP), and expandsdisclosures about fair value measurements. This Statement applies to accountingpronouncements that require or permit fair value measurements, except forshare-based payments transactions under FASB Statement No. 123 (Revised), *Share-Based Payment*. This Statement iseffective for financial statements issued for fiscal years beginning after November 15,2007, except for non-financial assets and liabilities, for which this Statementwill be effective for years beginning after November 15, 2008. The Companyadopted SFAS 157 on December 31, 2007, and the impact of this adoption onour financial position and results of operations was immaterial.

 

In October 2008, FASB issued Staff Position No. FAS157-3 (“FSP 157-3”)**,***Determining the Fair Value of a FinancialAsset When the Market for that Asset is not Active*, which clarifiesthe application of SFAS 157 in a market that is not active and provides anexample to illustrate key considerations in determining the fair value of afinancial asset when the market for that financial asset is not active.  FSP 157-3 was effective October 10, 2008 and for prior periodsfor which financial statements have not been issued.  The adoption ofFSP 157-3 did not have a material impact on our results of operationsor our financial position.

 

9

----

Tableof Contents

 

In February 2007, the FASB issuedSFAS 159, *The Fair Value Option forFinancial Assets and Financial Liabilities*. This Statement permitsentities to choose to measure many financial instruments and certain otheritems at fair value that are not currently required to be measured at fairvalue. The Statement also establishes presentation and disclosure requirementsdesigned to facilitate comparisons between entities that choose differentmeasurement attributes for similar types of assets and liabilities.SFAS 159 is effective for financial statements issued for fiscal yearsbeginning after November 15, 2007, although early application is allowed.The Company did not elect the fair value option for financial assets orliabilities existing on our adoption date of December 31, 2007. TheCompany will consider the applicability of the fair value option for assetsacquired or liabilities incurred in future transactions.

 

In December 2007, the FASB issuedSFAS 141(R), *Business Combinations*,and SFAS 160, *Noncontrolling Interestsin Consolidated Financial Statements, an amendment of ARB No. 51*.These pronouncements are required to be adopted concurrently and are effectivefor business combination transactions for which the acquisition date is on orafter the beginning of the first annual reporting period beginning on or after December 15,2008. Early adoption is prohibited; thus the provisions of these pronouncementswill be effective for us in fiscal year 2009. We do not have any minorityinterests. We do not expect the adoption of SFAS 141(R) and SFAS 160to have a material effect on our financial position or results of operations.

 

In December 2007, the SEC publishedSAB 110, *Share-Based Payment*.The interpretations in SAB 110 express the SEC staff’s views regarding theacceptability of the use of a “simplified” method, as discussed inSAB 107, in developing an estimate of expected term of share options inaccordance with FASB Statement No. 123 (Revised), *Share-Based Payment*. The use of thesimplified method requires our option plan to be consistent with a “plainvanilla” plan and was originally permitted through December 31, 2007 underSAB 107. SAB 110 was effective for the Company beginning December 31,2007. The Company will continue to use the simplified method until it has thehistorical data necessary to provide a reasonable estimate of expected life, inaccordance with SAB 107, as amended by SAB 110.

 

In March 2008, the FASB issuedSFAS 161, *Disclosures about DerivativeInstruments and Hedging Activities,* an amendment of SFAS 133.This Statement requires enhanced disclosures about derivative instruments andhedging activities within an entity by requiring the disclosure of the fairvalues of derivative instruments and their gains and losses in a tabularformat. It provides more information about an entity’s liquidity by requiringdisclosure of derivative features that are credit risk-related, and it requirescross-referencing within footnotes to enable financial statement users tolocate important information about derivative instruments. It is effective forfinancial statements issued for fiscal years and interim periods beginning afterNovember 15, 2008, with early adoption permitted. The Company isevaluating the impact of the adoption of SFAS 161 and believes there willbe no material impact on our consolidated financial statements or financialoperations.

 

In May 2008, the FASB issued SFAS 162, *The Hierarchy of Generally Accepted AccountingPrinciples*. SFAS 162 identifies the sources of accounting principlesand the framework for selecting the principles to be used in the preparation offinancial statements of nongovernmental entities that are presented inconformity with generally accepted accounting principles in the UnitedStates.  It is effective 60 days following the SEC’s approval of thePublic Company Accounting Oversight Board amendments to AU Section 411, *The Meaning of Present Fairly in Conformity WithGenerally Accepted Accounting Principles*. The adoption of thisStatement is not expected to have a material effect on the Company’sconsolidated financial statements.

 

In May 2008, the FASB issued SFAS 163, *Accounting for Financial Guarantee InsuranceContracts — An interpretation of FASB Statement No. 60*.  SFAS 163 requires that an insurance enterprise recognize a claimliability prior to an event of default when there is evidence that creditdeterioration has occurred in an insured financial obligation. It alsoclarifies how Statement 60 applies to financial guarantee insurance contracts,including the recognition and measurement to be used to account for premiumrevenue and claim liabilities, and requires expanded disclosures aboutfinancial guarantee insurance contracts. It is effective for financialstatements issued for fiscal years beginning after December 15, 2008,except for some disclosures about the insurance enterprise’s risk-managementactivities.****SFAS 163 requiresthat disclosures about the risk-management activities of the insuranceenterprise be effective for the first period beginning after issuance. Exceptfor those disclosures, earlier application is not permitted.  Theadoption of this Statement is not expected to have a material effect on theCompany’s consolidated financial statements.

 

Inventories

 

Inventoriesare valued at the lower of weighted average cost or market. Inventory costsinclude the costs of material, labor and manufacturing overhead and consist ofthe following, net of reserve for surplus and obsolescence (in thousands):

 

10

----

Tableof Contents

 
| ** **       | ** ** | **September 28, 2008** | ** ** | **December 30, 2007** | ** ** |
|------------------|------------|----------------------------------|------------|---------------------------------|------------|
| Raw material     |       | $                                | 16,933     |                            | $          | 16,547 |   |
| Work-in-process  |       | 4,578                            |       | 4,696                           |       |
| Finished goods   |       | 7,884                            |       | 6,778                           |       |
| Inventories, net |       | $                                | 29,395     |                            | $          | 28,021 |   |

 

As of September 28,2008 and December 30, 2007, the reserve for excess inventory andobsolescence was $2.9 million and $3.1 million, respectively, includingmanagement’s assessment of reserves for surplus and obsolescence fornon-compliant material related to the Restriction of Hazardous Substances inElectrical and Electronic Equipment directive.

 

The following are two European EconomicCommunity (“EEC”) directives that are having an effect on the entireelectronics industry, including the Company:

 

(1)  Restriction of Hazardous Substancesin Electrical and Electronic Equipment, more commonly known as RoHS. ThisEuropean directive bans the use of certain elements that are commonly found incomponents used to manufacture electrical and electronic assemblies. Thisdirective became effective on July 1, 2006. The Company began manufacturingcompliant products in 2006 and continues to work actively with its customers toensure compliance. The Company is focused on consuming all non-compliantmaterials on-hand within a reasonable period. However, the Company may have todispose of non-compliant materials in the future, which could adversely affectthe financial performance of the Company. There is also a risk of finesassociated with non-compliance with the RoHS directive; however, the Company isnot aware of any specific potential fines, and the Company anticipatescomplying with all provisions of this legislation.

 

(2)  Waste Electrical and ElectronicEquipment, also known as WEEE. This directive became effective August 13,2005 and requires manufacturers and importers to properly recycle or dispose ofsuch equipment at the end of its useful life. The Company believes it haslimited exposure to the WEEE directive because its products are usuallyinstalled into another user’s system, but this directive may be interpreted andenforced differently in the future. If so, the Company may face significantrisk of fines and costs associated with non-compliance with the existing lawsand regulations in the European Union. The Company began manufacturingcompliant products in 2005, and continues to work actively with its customersto ensure compliance.

 

As of September 28,2008, the Company does not foresee any material estimated capital expendituresfor environmental remediation or related costs to its manufacturing facilitiesin the future.

 

3.      INCOME TAXES

 

The Company accounts forincome taxes in accordance with SFAS 109, *Accountingfor Income Taxes*. In accordance with SFAS 109, deferred taxassets and liabilities are recorded for the estimated future tax effects oftemporary differences between the carrying value of assets and liabilities forfinancial reporting and their tax basis, and carry-forwards to the extent theyare realizable.  A deferred tax provision or benefit results from the netchange in deferred tax assets and liabilities during the period.  Avaluation 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 30,2007 and September 28, 2008, deferred tax assets included $27.8 millionrelating to a tax basis step up from a re-capitalization transaction in 1999and $22.8 million of net operating loss carry-forwards.  The Company hasrecorded a valuation allowance against all of its deferred tax assets.

 

Provision (benefit) forincome taxes for the three months ended September 28, 2008 and thecomparable period of September 30, 2007, was less than $0.1 million inprovision, and $0.4 million in benefit, respectively.   Income taxesfor the nine months ended September 28, 2008 and the comparable period of September 30,2007, was $1.7 million in provision and $2.0 million in benefit for incometaxes, respectively.  The provision for the nine months ended September 28,2008 is higher by $3.7 million than the comparable period of September 30,2007 due to the recording of a valuation allowance against the Company’sEuropean deferred tax assets as a discrete event in the quarter ended June 29,2008 equal to $1.6 million.  Based on available evidence, management cannot conclude it is more likely than not that the deferred tax assets will berealizable.

 

Provision (benefit) forincome taxes for the three and nine months ended September 28, 2008 wascalculated using an effective tax rate of less than one percent for the fullfiscal year in addition to the valuation allowance recorded as a discrete eventin the quarter ended June 29, 2008.

 

The Company adopted FIN 48, *Accounting for Uncertainty in Income Taxes,*on January 1, 2007.  As a result of adoption, the Company recognizeda cumulative effect adjustment of less than $0.1 million to the January 1,2007 accumulated deficit balance.  

 

11

----

Tableof Contents

 

As of September 28,2008, we have approximately $0.3 million of gross unrecognized tax benefits, ofwhich $0.3 million would reduce our effective tax rate if recognized.  TheCompany’s continuing practice is to recognize interest and/or penalties relatedto income tax matters in income tax expense.

 

The tax years 2000 to 2007remain open to examination by the major taxing jurisdictions to which we aresubject. The Company is currently under examination in India for certain yearsbetween 2000 and 2005 and Belgium for years 2005 and 2006.  The Companydoes not believe the amount of unrecognized tax benefits as of September 28,2008 will significantly increase or decrease within the next twelve months.

 

United States income taxesare not provided on undistributed earnings from certain foreign subsidiaries.Those earnings are considered to be permanently re-invested in accordance withthe Accounting Principles Board (APB) Opinion 23.

 

4.      NET INCOME(LOSS) PER SHARE

 

In accordancewith SFAS 128, *Earnings Per Share*,basic income (loss) per share is based upon the weighted average number ofcommon shares outstanding. For the quarter ended September 28, 2008,2,610,877 shares subject to outstanding stock options were excluded from thecalculation of diluted income (loss) per share as their exercise prices wouldrender them anti-dilutive. For the nine months ended September 28, 2008,stock options to purchase 2,614,926 shares of our common stock were excludedfrom the calculation of diluted income (loss) per share as their effect would havebeen anti-dilutive due to the net loss for the period. For the quarter and ninemonths ended September 30, 2007, stock options to purchase 2,811,579shares of our common stock were excluded from the calculation of diluted income(loss) per share as their effect would have been anti-dilutive due to the netloss for the periods. The following table sets forth the computation of basicand diluted net income (loss) per share (in thousands, except per shareamounts):

 
| ** **                                               | ** ** | **Quarter Ended**           | ** ** | **Nine Months Ended**  | ** ** |
|----------------------------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| ** **                                               | ** ** | **September 28, 2008** | ** ** | **September 30, 2007** | ** ** | **September 28, 2008** | ** ** | **September 30, 2007** | ** ** |
| Net income (loss)                                        |       | $                                | 126        |                             | $          | (1,309 | ) | $ | (431 | ) | $ | (4,984 | ) |
| Shares:                                                  |       |                             |       |                             |       |   |   |   |   |
| Weighted-average common shares  outstanding—basic   |       | 19,476                           |       | 19,414                           |       | 19,465 |   | 19,371 |   |
| Effect of dilutive securities:                           |       |                             |       |                             |       |   |   |   |   |
| Stock options                                            |       | 4                                |       | —                           |       | — |   | — |   |
| Weighted-average common shares  outstanding—diluted |       | 19,480                           |       | 19,414                           |       | 19,465 |   | 19,371 |   |
| Net income (loss) per share:                             |       |                             |       |                             |       |   |   |   |   |
| Basic                                                    |       | $                                | 0.01       |                             | $          | (0.07 | ) | $ | (0.02 | ) | $ | (0.26 | ) |
| Diluted                                                  |       | $                                | 0.01       |                             | $          | (0.07 | ) | $ | (0.02 | ) | $ | (0.26 | ) |

 

5.                  DEFERRED FINANCING COSTS

 

The Companycapitalizes costs directly related to financing agreements and certainqualified debt restructuring costs, and amortizes these costs as additionalinterest expense over the terms of the related debt.

 

Net deferredfinancing costs are comprised of the following as of September 28, 2008and December 30, 2007 (in thousands):

 
| ** **                         | ** ** | **September 28, 2008** | ** ** | **December 30, 2007** | ** ** |
|------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| Deferred financing costs |       | $                                | 580        |                            | $          | 580 |   |
| Accumulated amortization           |       | (580                             | )          | (494                            | )          |
| Deferred financing costs, net      |       | $                                | —     |                            | $          | 86 |   |

 

For thequarter ended September 28, 2008, the Company wrote off $0.4 million offinancing costs related to the refinancing of the Senior Notes due to mature onNovember 1, 2008 since the refinancing efforts were discontinued as aresult of the Agreement and Plan Merger (the “Merger Agreement”) entered intowith Lineage Power Holdings, Inc., a portfolio company of The Gores Group,LLC, on September 24, 2008.

 

12

----

Tableof Contents

 

6.      DEBT

 

Debt consistsof the following at September 28, 2008 and December 30, 2007 (inthousands):

 
| ** **                                             | ** ** | **September 28, 2008** | ** ** | **December 30, 2007** | ** ** |
|--------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| 5.25% Senior Notes, current portion                    |       | $                                | 24,485     |                            | $          | 24,485 |   |
| 5.25% Senior Notes, current portion due to  affiliates |       | 22,145                           |       | 22,145                          |       |
| Total debt                                             |       | $                                | 46,630     |                            | $          | 46,630 |   |

 

The debt includes the Company’s Senior Notes,which matured on November 1, 2008. Interest on the Senior Notes waspayable in cash on May 1 and November 1 of each year. The SeniorNotes are secured by a second-priority lien on substantially all of the Company’sdomestic assets and by a pledge of 65% of the equity of certain of the Company’sforeign subsidiaries. The Company paid the November 1stinterest payment of $1.2 million to the bondholders on October 30, 2008.However, the Company did not pay the principal balance due on the Senior Noteson November 1, 2008 and a payment default occurred.  As a result of the payment default, inaddition to the aggregate principal amount outstanding under the Senior Notes,the Company is required to pay interest on overdue principal at the defaultrate of 6.25% per annum. As described under Note 2 under the heading “GoingConcern,” the Company entered into the Merger Agreement with Lineage Power Holdings, Inc. on September 24, 2008.  It is anticipated that the Merger will closeon or about November 21, 2008, after stockholders vote on the Merger atthe Special Meeting of Stockholders to be held on November 18, 2008.  As a result of the Merger, pursuant to whichMerger Sub will be merged with and into the Company, with the Company survivingas a wholly owned subsidiary of Lineage, the Senior Notes will remain anobligation of the Company.  The Companyanticipates that the outstanding amounts due and payable under the SeniorNotes, together with default interest on overdue principal, will be paid infull at or after the closing of the Merger. If the Merger fails to beconsummated, the Company may be forced to refinance on terms that arematerially less favorable, seek funds through other means such as a sale of theCompany’s assets, or otherwise significantly alter the Company’s operatingplan, any of which could have a material adverse effect on the Company’sbusiness, financial condition and results of operation and the ability of theCompany to continue as a going concern. There can be no assurance that any refinancing or sale of assets wouldbe available on satisfactory terms, if at all, or that the Company would beable to continue as a going concern. Accordingly, if the Merger fails to be consummated, the Company could beforced to file for bankruptcy protection and thereby reorganize or liquidateits assets, resulting in material adverse consequences for the Company’sstockholders, creditors and employees.

 

The Company’s primary line of credit was itssenior revolving credit facility with General Electric Capital Corporation (the“Credit Facility”). The Credit Facility expired on August 25, 2008.

 

Prior to the new factoring arrangement madeon October 8, 2008, Cherokee Europe maintained a working capital line ofcredit of approximately $4.4 million, expressed as Euros 3.0 million,with Bank Brussels Lambert, a subsidiary of ING Belgie NV, a bank inBrussels, which was denominated in Euros, collateralized by a pledge in firstand second rank over a specific amount of business assets, requiring CherokeeEurope to maintain a certain specific minimum solvency ratio and was cancelableat any time. Our access to the line was limited to $3.9 million because$0.5 million was committed to minimum guarantees on specific collectionsand payments. In November 2007, ING Belgie NV restricted the Companyfrom transferring funds from Europe to the U.S. in the form of management anddividend fees. During the quarter ended September 30, 2007, CherokeeEurope borrowed $2.0 million from the line of credit with an interest rateof 6.02%, subject to changes upon quarterly renewals, which remainedoutstanding as of September 28, 2008. The interest rate for the secondquarter of 2008 was renewed at 6.08%.  OnApril 28, 2008, Cherokee Europe borrowed $0.8 million, with an interestrate of 5.65%, subject to changes upon quarterly renewals, from its line ofcredit with ING Belgie NV. The outstanding balance on the line of credit as of September 28,2008 was $2.8 million. As of September 28, 2008, Cherokee Europe was incompliance with all covenants.

 

On October 8, 2008, Cherokee Europe’s lineof credit arrangement was converted into a new factoring arrangement with INGBelgie NV.  The arrangement is based onthe factoring of 80% of Cherokee Europe’s current outstanding accountsreceivable balances with an aging of 90 days or less at each borrowing date upto a maximum of 25% of the total assigned accounts receivables at any giventime or up to a maximum of $7.3 million expressed as Euros 5.0 million. Theeffective interest rate of the new factoring arrangement will be Euribor plus1% on current balances and arrears interest of 3% per month to be calculated onoverdue balances, whereby any new month started shall be calculated as onecomplete month. There will also be a 0.08% loan fee on the outstanding accountsreceivable balance at each borrowing.

 

In January 2008, Cherokee Europeborrowed short-term funds of $0.6 million from ING Belgie NV. Theloan arrangement is over twelve months, with monthly payments of $50,000 to berepaid by December 26, 2008. The loan bears a 6.3% interest rate. Theoutstanding balance as of September 28, 2008 was $0.2 million.

 

As described under Note 14 to theaccompanying Notes to the Condensed Consolidated Financial Statements includedin Item 1, “Financial Statements” Cherokee Europe was sold to athird-party on October 18, 2008.

 

In January 2007, Cherokee China enteredinto a loan contract with Industrial and Commercial Bank of China Ltd. (“ICBC”)for a working capital line of credit. Pursuant to the contract, ICBC agreed tomake advances up to the equivalent of approximately $3.6 million,expressed as RMB 25.0 million. The line of credit is collateralized by theCompany’s building in Shanghai, China. 

 

13

----

Tableof Contents

 

In April 2008, Cherokee China renegotiated the borrowing capacityon its line of credit with ICBC, from RMB 25 million to RMB 28 million toreflect the increased market value of the building, with the interest rate ofLIBOR plus 12%, which is effective from April 21, 2008 through April 20,2011.  As of September 28, 2008, RMB28.0 million was equivalent to $4.1 million in US dollars. Interest is payablemonthly at a fixed rate based on the transaction date of our borrowings; therates vary according to the specific dates and are announced by the People’sBank of China. Beginning with its initial borrowing under the contract,Cherokee China agreed to deposit in the ICBC Shanghai Branch at least 90% ofthe operating revenue it collects. Our usage of the cash from these depositsmade into our bank account is not restricted. During May 2008, CherokeeChina borrowed $0.5 million on its line of credit with an interest rate of6.8985% for the subsequent six-month period. During August 2008, we borrowed an additional $0.5 million on theline of credit with an interest rate of 7.8435% for the subsequent twelve-monthperiod. As of September 28, 2008, the outstanding balance on the line ofcredit was $1.0 million, and Cherokee China was in compliance with all of thecovenants.

 

7.      OTHER LONG-TERM OBLIGATIONS

 

Other long-term liabilities consist of the following at September 28,2008 and December 30, 2007 (in thousands):

 
| ** **                                   | ** ** | **September 28, 2008** | ** ** | **December 30, 2007** | ** ** |
|----------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| 1999 Europe restructuring liabilities        |       | $                                | 229        |                            | $          | 397 |   |
| 2003 Europe restructuring liabilities        |       | 948                              |       | 1,064                           |       |
| Long service award liabilities               |       | 936                              |       | 910                             |       |
| Pension liability-SFAS 158                   |       | 1,326                            |       | 1,337                           |       |
| Deferred compensation                        |       | 179                              |       | 237                             |       |
| Advances for research & development |       | 594                              |       | 589                             |       |
| Total other long-term liabilities            |       | $                                | 4,212      |                            | $          | 4,534 |   |

 

Prior to thesale of Cherokee Europe, the Company had agreements with a local governmentagency in Belgium for funding in advances to Cherokee Europe for research anddevelopment expenses. These advances were interest free and expected to berepaid to the agency either as a percentage of the revenues generated by theproducts developed or through a minimum fixed amount on an annual basis.  As described under Note 14 to the accompanyingNotes to the Condensed Consolidated Financial Statements included inItem 1, “Financial Statements” Cherokee Europe was sold to a third-partyon October 18, 2008.

 

As of September 28,2008, the Company has a recorded liability of $0.3 million, for employee andnon-employee contributions and investment activity to date under the deferredcompensation plan; the current portion of $0.1 million is recorded underaccrued compensation and benefits and the long-term portion of $0.2 million isrecorded in other long-term liabilities.

 

8.      CUSTOMER CONCENTRATION

 

For thequarter ended September 28, 2008, one customer accounted for 15.4% of netsales, and no other customer accounted for more than 10% of net sales. For thequarter ended September 30, 2007, one customer accounted for 13.1% of netsales, and no other customer accounted for more than 10% of net sales. For thenine months ended September 28, 2008, one customer accounted for 12.5% ofnet sales, and no other customer accounted for more than 10% of net sales.  For the nine months ended September 30,2007, one customer accounted for 11.6% of net sales, and no other customeraccounted for more than 10% of net sales. All net sales above were from UScustomers; none of the sales were generated by customers under Cherokee Europe.A decision by a major customer to decrease the amount purchased from theCompany or to cease purchasing the Company’s products could have a materialadverse effect on the Company’s financial position and results of operations.

 

As of September 28,2008, one Cherokee US customer accounted for 14.9% of net accounts receivableand no other customer accounted for more than 10% of net accountsreceivable.  As of December 30,2007, one Cherokee Europe customer accounted for 10.9% of net accountsreceivable, and one Cherokee US customer accounted for 10.6% of net accountsreceivable.

 

14

----

Tableof Contents

 

9.      COMMITMENTS AND CONTINGENCIES

 

Guarantees and Indemnities

 

The Company 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 ofpotential future payments under such indemnifications is not determinable.

 

The Company has notincurred significant amounts related to these guarantees and indemnifications,and no liability has been recorded in the consolidated financial statements forguarantees and indemnifications as of September 28, 2008 and December 30,2007.

 

**Cash Incentive Compensation Programand Severance Agreements**

** **

The Company adopted acash incentive program for certain executives, which provides for cashincentive payments of up to 123% of base salary subject to attainment ofcorporate goals and objectives approved by the Company’s board of directors. Inaddition, the Company has entered into severance agreements with certainexecutives and managers, which provide payments to the executives or managersif they are terminated (i) other than for cause or (ii) because of achange in control, as defined in the applicable severance agreement. Certain ofthe severance agreements provide additional benefits, including acceleration ofstock options, in the event of termination in connection with a change ofcontrol, as defined in the applicable severance agreement.

 

On February 29, 2008, the Companyentered into an amendment to the Company’s existing severance agreement witheach of Jeffrey M. Frank, the Company’s President and Chief Executive Officer,Linster W. Fox, the Company’s Executive Vice President, Chief Financial Officerand Secretary, and Mukesh Patel, the Company’s Executive Vice President ofGlobal Operations. These executives’ severance agreements provide for certainseverance payments to be made in the event that the Company terminates theexecutive’s employment without cause. The amendments provide that, if severanceis triggered under the executive’s severance agreement, the executive’sseverance benefit will consist of a cash payment equal to two times theexecutive’s current base salary at the time of termination and continuedmedical benefits for up to two years. In the case of Mr. Patel, theamendment further amends his severance agreement to provide that if heterminates his employment with the Company for good reason within one yearfollowing a change in control event, he will be entitled to the severancebenefits described above. The amendments further amend Mr. Frank’s and Mr. Fox’sseverance agreements to provide that in the event the executive’s employment isterminated by the Company without cause or by the executive for any reasonwithin two years following a change in control of the Company, or by theCompany within six months prior to a change in control and such termination wasin connection with the change in control, the executive will be entitled to: acash payment equal to two times the executive’s current base salary at the timeof termination; a pro rata cash payment equal to the executive’s annual bonusat the time of termination (calculated as if the Company achieved financialperformance equal to that set forth in the then-most current budget approved bythe Company’s board of directors); immediate vesting of all outstanding stockoptions; continued medical benefits for up to two years; a cash payment equalto the amount forfeited by the executive under the Company’s 401(k) orsimilar plan; use of an executive outplacement service in an amount not toexceed $50,000 or a lump-sum cash payment in lieu thereof; and any additionalbenefits then due or earned under applicable plans or programs of the Company.The severance agreements also include certain confidentiality, non-solicitationand inventions covenants in favor of the Company.

 

On February 29, 2008, the Company alsoentered into a severance agreement with Alex Patel, the Company’s VicePresident of Engineering. The severance agreement provides that, in the event Mr. Patel’semployment is terminated either by the Company without cause or by Mr. Patelfor good reason within one year following a change in control event, Mr. Patelwill be entitled to receive a cash payment equal to one times his then currentannual base salary and continued medical benefits for up to one year. Mr. Patel’sright to receive severance benefits under the severance agreement is subject tohis execution of a release of claims in favor of the Company upon the terminationof his employment. The severance agreement also includes certainconfidentiality, non-solicitation and inventions covenants in favor of theCompany.

 

Transaction Bonus Agreements

 

On April 14, 2008, the Company entered into transaction bonusagreements with each of Jeffrey M. Frank, the Company’s President and ChiefExecutive Officer, Linster W. Fox, the Company’s Executive Vice President,Chief Financial Officer and Secretary, and Mukesh Patel, the Company’sExecutive Vice President of Global Operations (each, an “executive”).  Thetransaction bonus agreements provide that, in the event of a company sale(defined in the agreements as a sale in one or a series of related transactionsof all or substantially all of the Company’s assets, or of more than 50% of theissued and outstanding voting equity securities of the Company other than tothe Company or certain major shareholders), the executive will be entitled toreceive a transaction bonus, provided that the executive is either employed bythe Company at the time of the company sale, the Company terminates theexecutive’s employment without cause (as defined in the agreements) within sixmonths prior to the company sale, or the executive terminates his employmentfor good reason (as defined in the agreements) within six months prior to thecompany sale.

 

15

----

Tableof Contents

 

If the executive terminates his employment with the Company voluntarilyor is terminated by the Company for cause prior to the company sale, theexecutive is not eligible for a bonus under the transaction bonusagreement.  Further, the executive must execute a general release ofclaims in favor of the Company following the company sale in order to receivehis transaction bonus.

 

Theamount of the transaction bonus for which each executive is eligible pursuantto his agreement varies and is tied to the net proceeds received by the sellingstockholders in the company sale. Based upon information available as of thedate of the recent proxy statement, the following executive officers would beentitled to the following cash payments under their respective transactionbonus agreements assuming the eligibility conditions described in the agreementare satisfied in connection with the Merger: Messrs. Frank, Fox andPatel is $1.3 million, $0.8 million and $117,000, respectively, based on a netsales price of $3.20 per share.  The agreements also contain anon-solicitation covenant in favor of the Company.  These amounts have not been accrued as of September 28,2008 because they have not been earned, since the merger has not beenconsummated

 

SynQor

 

On November 16, 2007, SynQor announcedthat it had filed a lawsuit against several of its competitors, including theCompany who was named in the complaint, for infringement of two patentsrelating to bus converters and/or non-isolated point of load converters used inintermediate bus architectures. The patents at issue are U.S. patents 7,072,190and 7,272,021. The suit was filed in Federal Court in the Eastern District ofTexas. The Company intends to and continues to vigorously defend this lawsuit.Although the ultimate aggregate amount of monetary liability or financialimpact with respect to this lawsuit is subject to many uncertainties and istherefore not predictable with assurance, the final outcome of this lawsuit, ifadverse, could have a material adverse effect on our financial position,results of operations or cash flows.

 

10.    RESTRUCTURING COSTS AND ASSETIMPAIRMENT CHARGES FOR CLOSURE OF GUADALAJARA, MEXICO FACILITY

 

During the quarter ended October 1,2006, the Company announced the planned closure of its Mexican facilities and arelated restructuring plan, which was accounted for in accordance withSFAS 146, *Accounting for CostsAssociated with Exit or Disposal Activities*. The Mexico Facilityencompassed 35,000 square feet in one building and had been in operation since1988, employing approximately 250 full-time and temporary employees in theproduction of power supplies.

 

The restructuring and closure of our MexicoFacility was completed by the end of the second quarter of 2007. The cumulativecosts for the closure of the Mexico Facility were $1.5 million($1.3 million of which were recorded in 2006). This was made up of$0.9 million restructuring, $0.3 million asset impairment and$0.3 million additional excess and obsolescence reserve. During the secondquarter ended July 1, 2007, there was a reversal of $38,000 to severancecosts due to the transfer and relocation of an employee from the MexicoFacility to our Tustin Facility. The remaining accrued balance for severanceand stay bonuses was paid on July 1, 2007 to the remaining employees.

 

*Assets held for sale—Mexico Facility building sold*

 

The Company began actively searching for abuyer for the Mexico Facility building during the quarter ended October 1,2006; however, in accordance with SFAS 144, *Accounting for the Impairment or Disposal of Long-Lived Assets*,the related assets were not classified as assets held for sale in the condensedconsolidated balance sheets prior to April 1, 2007, because the Companydid not meet the criterion that “the asset (disposal group) is available forimmediate sale in its present condition subject only to terms that are usualand customary for sales of such assets,” due to our continued utilization ofassets in our ongoing operations at our Mexico Facility.

 

The Company ceased operations in Mexico in March 2007,and reclassified the net book value of $0.7 million for the building andthe related assets to *assets held for sale*on the condensed consolidated balance sheet as of April 1, 2007, inaccordance with SFAS 144. In addition, depreciation of the assets relatedto this sale was suspended as of April 1, 2007. There was no impairmentcharge to the related assets because management determined that the measurementvalue, the net book value, was lower than the estimated fair value less cost tosell.

 

On February 22, 2007, CherokeeElectronica, S.A. de C.V. (“Cherokee Mexico”), a subsidiary of theCompany, entered into a Purchase and Sale Agreement (the “Agreement”) withInmobiliaria Hondarribia, S.A. de C.V. (the “Buyer”) for the sale ofCherokee Mexico’s 35,000-foot manufacturing facility in Guadalajara, Mexico.The Agreement provided that the Buyer pay Cherokee Mexico an aggregate purchaseprice of approximately US $1.2 million of which a 15% deposit,approximately US $182,000, was paid on February 22, 2007. On May 24,2007, the sale of the building was completed, and the remaining 85% of thesales price was transferred into the Company’s bank account. The Company alsocollected the value added tax on the building in addition to the sales priceand paid the taxes collected to the Mexican government in June 2007. Thenet gain of the sale recorded during the quarter ended July 1, 2007, was$0.4 million, net of $0.1 million related to the cost to sell theassets which was deducted from the gain.

 

16

----

Tableof Contents

 

*Sale of MexicoCorporation*

 

On December 12,2007, the Company sold its ownership in the capital stock of Cherokee Mexico.The Company received the proceeds from the sale on December 13, 2007. Thenet gain of the sale was $0.4 million.

 

*Asset Impairment Charges related to OtherAssets*

 

During the quarter ended October 1,2006, the Company performed an impairment review in accordance withSFAS 144, *Accounting for the Impairmentand Disposal of Long-Lived Assets,* to determine whether any of itslong-lived assets located at the Mexico Facility were impaired. The Companyidentified certain long-lived assets associated with the restructuring andclosure of the Mexico Facility whose carrying value would not be recoverablefrom future cash flows and recorded an impairment charge of $0.3 millionfor these assets. These assets consisted of machinery and equipment, computertechnology and equipment, and office furniture and equipment. The majority ofthese assets were written off because the Company considered them to have nomarket value. None of the impairment charges included cash components.

 

*Restructuring Costs*

 

In accordance with SFAS 146, employeeseverance, contract termination and other exit costs are recorded at theirestimated fair value when they are incurred. During the quarter ended July 1,2007, there was a reversal of $38,000 to severance costs due to the transferand relocation of an employee from the Mexico Facility to our Tustin Facility.

 

There were $0.2 million of employeeseverance and stay bonus costs during the first six months of 2007, whichincluded a pro-rata portion from the commencement date of August 10, 2006through July 1, 2007, of an estimated amount of statutorily requiredseverance payments and management performance stay-on bonuses incurred foremployees at the Mexico Facility. The Company paid $0.6 million ofseverance and related expenses to the remainder of employees terminated duringthe quarter ended July 1, 2007. All severance charges were settled withcash as of July 1, 2007.

 

11.    STOCK AND DEFERRED COMPENSATION PLANS

 

2002 Stock Option Plan

 

In July 2003, the Company adopted theCherokee International Corporation 2002 Stock Option Plan (the “2002 StockOption Plan”) under which up to 1,410,256 shares of the Company’s common stockmay be issued pursuant to the grant of non-qualified stock options to thedirectors, officers, employees, consultants and advisors of the Company and itssubsidiaries. In connection with the adoption of the 2002 Stock Option Plan,the Company granted 1,087,327 stock options. The options typically vest over afour-year period, have a ten-year contractual life, range in exercise pricefrom $5.85 to $10.34 per share and were granted with exercise prices at orabove fair value as determined by the Company’s board of directors based onincome and market valuation methodologies. In February 2004, the Companygranted options to purchase 328,320 shares of common stock at an exercise priceof $14.50 and terminated the 2002 Stock Option Plan. As of September 28,2008, the Company had granted a total of 1,415,647 options to purchase sharesof common stock under the 2002 Stock Option Plan, which includes options topurchase shares that were cancelled and subsequently re-granted.

 

2004 Omnibus Stock Incentive Plan

 

On February 16,2004, the Company adopted the 2004 Omnibus Stock Incentive Plan (the “2004 Plan”),which provided for the issuance of 800,000 shares of common stock. The 2004Plan also provides for an annual increase to be added on the first day of theCompany’s fiscal year equal to the lesser of (i) 450,000 shares or (ii) 2%of the number of outstanding shares on the last day of the immediatelypreceding fiscal year. As of September 28, 2008, a total of 3,315,141shares of the Company’s common stock were reserved for issuance under the 2004Plan. Any officer, director, employee, consultant or advisor of the Company iseligible to participate in the 2004 Plan. The 2004 Plan provides for theissuance of stock-based incentive awards, including stock options, stockappreciation rights, restricted stock, deferred stock, and performance shares.As of September 28, 2008, the Company had granted options to purchase2,399,489 shares of common stock under the 2004 Plan, which included 375,589options issued as partial compensation to non-employee directors. During thequarter ended September 28, 2008 the Company did not grant any options topurchase stock.  During the nine monthsended September 28, 2008, the Company granted options to purchase 70,000shares to non-employee directors.

 

17

----

Tableof Contents

 

2004 Employee Stock Purchase Plan

 

On February 16, 2004, the Companyadopted the ESPP. The ESPP provides for an annual increase to be added on thefirst day of the Company’s fiscal year equal to the lesser of (i) 250,000shares or (ii) 1% of the number of outstanding shares on the last day ofthe immediately preceding fiscal year. As of September 28, 2008, a totalof 914,220 shares of common stock was reserved for issuance under the plan. TheESPP, which is intended to qualify as an “employee stock purchase plan” under Section 423of the Internal Revenue Code of 1986, 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 and November 15and ending on the last trading day on or before November 14 or May 14,respectively. The Compensation Committee of the Company’s Board of Directorsoversees administration of the ESPP. Employees are eligible to participate ifthey are employed for at least 20 hours per week and more than5 months in a calendar year by the Company, subject to certainrestrictions.

 

The ESPP permits eligible employees topurchase common stock through payroll deductions, which may not exceed 15% ofan employee’s compensation. The price of common stock purchased under the ESPPis 85% of the lower of the fair market value of the common stock at thebeginning of each six-month offering period or at the end of each six-month offeringperiod. Employees may end their participation in an offering at any time duringthe offering period, and participation ends automatically upon termination ofemployment. The Compensation Committee may at any time amend or terminate theESPP, except that no such amendment or termination may adversely affect sharespreviously issued under the ESPP. As of September 28, 2008, 258,351 sharesof common stock had been issued under the ESPP.

 

Deferred Compensation Plan

 

On February 16, 2004, the Company adoptedtwo executive deferred compensation plans for the benefit of certain designatedemployees and non-employee directors of the Company. The plans were amended on January 1,2008 to comply with the regulations for nonqualified deferred compensationarrangements under Internal Revenue Code Section 409A. 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 credit, if any, vests in full no later than after three years.

 

As of September 28, 2008, the Companyhas a recorded liability of $0.3 million for employee and non-employeedirector contributions and investment activity to date; the current portion of$0.1 million is recorded under accrued compensation and benefits and thelong-term portion of $0.2 million is recorded in other long-termliabilities. As of December 30, 2007, the Company had a recorded liabilityof $1.4 million, of which $1.1 million was recorded under accruedcompensation and benefits and the long-term portion of $0.2 million wasrecorded in other long-term liabilities. The Company has not provided anymatching contributions under the plans.

 

During the nine months ended September 28,2008, the Company paid $0.9 million of scheduled distributions to participantsfrom the deferred compensation plan.  TheCompany made two partial surrenders on the insurance policies during 2008.  The first partial surrenders made were on twopolicies during the first quarter of 2008 in the amount of $0.4 million.  The second partial surrenders made were onall five policies for $0.3 million in October 2008.  The partial surrenders did not change theface amount of the policies.

 

12.    RETIREMENT PLANS

 

CherokeeEurope maintains a pension plan for certain levels of staff and management thatinclude a defined benefit feature. The following represents the amounts relatedto this defined benefit plan for the quarter and nine months ended September 28,2008 and September 30, 2007(in thousands):

 
| ** **                                                           | ** ** | **Quarter Ended**           | ** ** | **Nine Months Ended**  | ** ** |
|----------------------------------------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| **Components of Net Periodic Benefit Cost** | ** ** | **September 28, 2008** | ** ** | **September 30, 2007** | ** ** | **September 28, 2008** | ** ** | **September 30, 2007** | ** ** |
| Service cost                                                         |       | $                                | 57         |                             | $          | 103 |   | $ | 203 |   | $ | 280 |   |
| Interest cost                                                        |       | 86                               |       | 175                              |       | 305 |   | 382 |   |
| Expected return on plan assets                                       |       | (53                              | )          | (97                              | )          | (190 | ) | (213 | ) |
| Net periodic benefit cost                                            |       | $                                | 90         |                             | $          | 181 |   | $ | 318 |   | $ | 449 |   |

 

18

----

Tableof Contents

 

As described under Note 14 to the accompanying Notes to theCondensed Consolidated Financial Statements included in Item 1, “FinancialStatements” Cherokee Europe was sold to a third-party on October 18, 2008.

 

13.    GOODWILLIMPAIRMENT CHARGE

 

Based on our annual assessment of the fairvalue of our Cherokee Europe subsidiary in accordance with SFAS 142, werecorded a goodwill impairment charge of $5.2 million during the yearended December 30, 2007, to properly report goodwill at its fair value atthat period in time.

 

Due to the decline in our European operation’srevenue volumes during the six months ended June 29, 2008, the Companyperformed a revised forecast for the remaining year of 2008 and the next threeyears.  Since our actual and futurerevenues were trending lower than anticipated revenues of our original businessplan, the Company engaged a professional consulting firm to perform a SFAS 142valuation and analysis study of our goodwill. As a result of this study, an impairment charge of $1.1 million was recordedduring the quarter ended June 29, 2008 due to the decrease in fair valueof our Cherokee Europe subsidiary.  As ofSeptember 28, 2008 the Company no longer has any goodwill recorded. Asdescribed under Note 14 to the accompanying Notes to the CondensedConsolidated Financial Statements included in Item 1, “FinancialStatements” Cherokee Europe was sold to a third-party on October 18, 2008.

 

14.    SUBSEQUENTEVENT

 

On October 18, 2008, pursuant to an Agreementfor the Sale and Purchase of All of the Issued and Outstanding Shares ofCherokee SPRL dated October 18, 2008 (the “Purchase Agreement”), CherokeeNetherlands II BV (the “Seller”), a subsidiary of the Company, sold all of theissued and outstanding shares of Cherokee Europe SPRL, a private limited liabilitycompany incorporated under Belgian law, and all of the issued and outstandingshares of Cherokee Europe SCA, a partnership limited by shares incorporatedunder Belgian law (together with Cherokee Europe SPRL, the “Europe Companies”),to Mr. Eric Brouwers, acting in his own name or in the name of a companyin the process of incorporation under Belgian law.  Mr. Brouwers wasthe general manager of Cherokee’s European operations prior to the sale.  Mr. Brouwerspaid 1Euro for the shares of the Europe Companies, in exchange for hisagreement to purchase such shares without representations or warranties from,and without recourse to, the Seller.  The terms of the transaction weredetermined in arm’s-length negotiations by the parties.

 

Item 2.    MANAGEMENT’S DISCUSSSION ANDANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

FORWARD-LOOKING STATEMENTS

 

Certain statements in this Quarterly Reporton Form 10-Q, other than purely historical information, includingestimates, projections, statements relating to our business plans, objectivesand expected operating results, and the assumptions upon which those statementsare based, are “forward-looking statements” within the meaning of the PrivateSecurities Litigation Reform Act of 1995, Section 27A of the SecuritiesAct of 1933 and Section 21E of the Securities Exchange Act of 1934. Theseforward-looking statements are based upon our current expectations about futureevents. When used in this Quarterly Report, the words “believes,” “projects,” “expects,”“anticipates,” “estimates,” “intends,” “strategy,” “plan,” “may,” “will,” “would,”“will be,” “will continue,” “will likely result,” and similar expressions, orthe negative of such words and expressions, are intended to identifyforward-looking statements, although not all forward-looking statements containsuch words or expressions. These forward-looking statements generally relate toour plans, objectives and expectations for future operations and includestatements in this Quarterly Report regarding the following: our expectationsthat cash flows will be sufficient to meeting our operating requirements for atleast the next twelve months; our expectations regarding our working capitaland capital expenditure requirements; and our expectations regarding thepayment of our Senior Note obligations. However, these statements are subjectto a number of risks and uncertainties affecting our business. You should readthis Quarterly Report completely and with the understanding that actual futureresults may be materially different from what we expect as a result of theserisks and uncertainties and other factors, which include, but are not limitedto: (1) the potential delisting of the Company’s common stock from theNASDAQ Global Market, (2) changes in general economic and businessconditions, domestically and internationally, (3) reductions in sales to,or the loss of, any of the Company’s significant customers or in customercapacity generally, (4) changes in the Company’s sales mix to lower marginproducts, (5) increased competition in the Company’s industry, (6) disruptionsof the Company’s established supply channels, (7) the Company’s level ofdebt and restrictions imposed by its debt agreements, and (8) mattersrelated to the proposed Merger, and (9) the additional risk factorsincluded in Part II, Item 1A of this Quarterly Report. Except as requiredby law, the Company undertakes no obligation to update any forward-lookingstatements, even though the Company’s situation may change in the future.

 

19

----

Tableof Contents

 

INTRODUCTION

 

The following discussion should be read inconjunction with the unaudited condensed consolidated financial statement andnotes of the Company included above in this Quarterly Report on Form 10-Qand with the audited financial statements, footnotes and Management Discussionand Analysis of Financial Condition and Results of Operations included in theCompany’s Annual Report on Form 10-K.

 

OVERVIEW

 

Business

 

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

 

We operate worldwide and as of September 28,2008, we have facilities in Orange County, California; Bombay, India; andShanghai, China. In March 2007, we closed our facility in Guadalajara,Mexico (the “Mexico Facility”). In May 2007, we sold our manufacturingfacility in Guadalajara, Mexico and on December 12, 2007, we sold oursubsidiary, Cherokee Electronica, S.A. de C.V. (“Cherokee Mexico”).

 

We were founded in 1978 in Orange County,California. As we expanded our business and customer base, we opened facilitiesin Bombay, India, Guadalajara, Mexico, and Shanghai, China and Wavre, Belgium(Europe).

 

On September 24, 2008, the Company and LineagePower Holdings, Inc. (“Parent”),a portfolio company of The Gores Group, LLC, entered into an Agreement and Planof Merger (the “Merger Agreement”)by and among Parent, Birdie Merger Sub, Inc., a Delaware corporation andwholly-owned subsidiary of Parent (“MergerSub”), and the Company, pursuant to which Merger Sub will be merged withand into the Company, with the Company continuing after the merger as thesurviving corporation and a wholly owned subsidiary of Parent (the “Merger”).  The Companyanticipates that the majority of its stockholders will adopt and approve theMerger Agreement proposal on November 18, 2008 at a Special Meeting ofStockholders.

 

In addition, on October 18, 2008,pursuant to an Agreement for the Sale and Purchase of All of the Issued and OutstandingShares of Cherokee SPRL dated October 18, 2008 (the “Purchase Agreement”),we sold all of the issued and outstanding shares of Cherokee Europe SPRL, aprivate limited liability company incorporated under Belgian law, and all ofthe issued and outstanding shares of Cherokee Europe SCA, a partnership limitedby shares incorporated under Belgian law (together, “Cherokee Europe”).  See Note 14, “Subsequent Event,” in theaccompanying Notes to Condensed Consolidated Financial Statements included inItem 1, “Financial Statements,” for additional information regarding the saleof the Cherokee Europe.  Because the saleof Cherokee Europe occurred following the Company’s third quarter ended September 28,2008, the results of operations of Cherokee Europe are included in thediscussion of the Company’s consolidated results of operations below.

 

We generate the majority of our sales in fourmarket sectors, datacom, telecom, industrial and medical. For the quarter endedSeptember 28, 2008, our revenues by market sector consisted of 58%datacom, 15% telecom, and 27% for the industrial and medical sectors.

 

Basis of Reporting

 

**Principles of Consolidation**

** **

The condensed consolidated financialstatements include the financial statements of the Company and its wholly ownedsubsidiaries, Cherokee Europe, Cherokee India Pvt. Ltd. (“Cherokee India”),Powertel India Pvt. Ltd. (“Powertel”), and Cherokee International (China)Power Supply LLC (“Cherokee China”), and the financial statements of itsformerly owned subsidiary Cherokee Mexico were included in the year ended December 30,2007. Inter-company accounts and transactions have been eliminated.

 

20

----

Tableof Contents

 

Net Sales

 

See**Revenue Recognition of CriticalAccounting Policies section below for Company description.

 

Cost of Sales

 

The principal elements comprisingcost of sales are raw materials, labor and manufacturing overhead. Rawmaterials account for a large majority of our costs of sales. Raw materialsinclude magnetic sub-assemblies, sheet metal, electronic and other components,mechanical parts and electrical wires. Direct labor costs primarily includecosts of hourly employees. Manufacturing overhead includes salaries, and thedirect expense and allocation of costs attributable to manufacturing for leasecosts, depreciation on property, plant and equipment, utilities, property taxesand repairs and maintenance.

 

Operating Expenses

 

Operating expenses include engineering costs,selling and marketing costs and general and administrative expenses.Engineering costs primarily include salaries and benefits of engineeringpersonnel, safety approval and quality certification fees, and depreciation onequipment and consulting and professional services. Selling and marketingexpenses primarily include salaries and benefits to account managers andcommissions to independent sales representatives. Administrative expensesprimarily include salaries and benefits for certain management andadministrative personnel, professional fees and information system costs.Operating expenses also include the direct expense and allocation of costsattributable to these departments for lease costs, depreciation on property,plant and equipment, utilities, property taxes and repairs and maintenance.

 

Critical Accounting Policies

 

We prepare our condensed consolidatedfinancial statements in conformity with accounting principles generallyaccepted in the United States. 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 thereported amounts of assets and liabilities at the date of the condensedconsolidated financial statements and the reported amounts of revenues andexpenses during the periods presented. Any future changes to these estimatesand assumptions could have a material effect on our reported amounts ofrevenue, expenses, assets and liabilities. The significant accounting policiesthat we believe are the most critical to aid in fully understanding andevaluating our reported financial results include the following:

 

Revenue Recognition

 

We recognize revenue when persuasive evidenceof an arrangement exists, title transfer has occurred, the price is fixed orreadily determinable, and collectability is probable. We recognize revenue inaccordance with Staff Accounting Bulletin No. 104, *Revenue Recognition*. Sales are recorded net of discounts, which are estimated atthe time of shipment based upon historical data. Changes in assumptionsregarding the rate of sales discounts earned by our customers could impact ourresults.

 

We generally recognize revenue at the time ofshipment because this is the point at which revenue is earned and realizableand the earnings process is complete. For most shipments, title to shippedgoods transfers at the shipping point, so the risks and rewards of ownershiptransfer once the product leaves our facility or third-party hub. Revenue isonly recognized when collectability is reasonably assured. Shipping andhandling fees are included in revenue with related costs recorded to cost ofsales.

 

The Company has entered into arrangementswith certain customers whereby products are delivered to a third-partywarehouse location for interim storage until subsequently shipped and acceptedby our customers. Revenues from these sales are recognized upon shipment fromthe third-party warehouse location to the customers, when title has passed. TheCompany generally offers a one-year warranty for defective products. Warrantycharges have been insignificant during the periods presented.

 

Accounts Receivable

 

In our North American andEuropean operations we perform ongoing credit evaluations of our customers, thecustomer’s current credit worthiness and various other factors, as determinedby our review of their current credit information. We continuously monitorcollections and payments from our customers and maintain a provision forestimated credit losses based upon our historical experience and any specificcustomer collection issues that we have identified. While credit losses havehistorically been within our expectations and the provisions established, wemight not continue to experience the same credit loss rates that we have in thepast. 

 

21

----

Tableof Contents

 

A significant portion of our accounts receivable areconcentrated in a small number of customers. A significant change in theliquidity or financial position of any one of these customers could have amaterial adverse effect on the collectability of our accounts receivable, ourliquidity and our future operating results. As of September 28, 2008 and December 30, 2007, our top tencustomers accounted for 38% and 50% of our accounts receivables, respectively.

 

**CreditRisk**

** **

The Company performs ongoing creditevaluations of its customers and generally does not require collateral. TheCompany maintains reserves for estimated credit losses. The Company generallydoes not charge interest on customer balances.

 

**Translation of Foreign Currencies**

** **

Foreign subsidiary assets and liabilitiesdenominated in foreign currencies are translated at the exchange rate in effecton the balance sheet date. Revenues, costs and expenses are translated at theaverage exchange rate during the period. Transaction gains and losses areincluded in results of operations and have not been significant for the periodspresented. The functional currency of Cherokee Europe is the Euro. Thefunctional currency of Cherokee India, Powertel and Cherokee China is the U.S.dollar, as the majority of transactions are denominated in U.S. dollars.Translation adjustments related to Cherokee Europe are reflected as a componentof stockholders’ equity in other comprehensive income (loss).

 

Inventories

 

We value our inventory at the lower of theactual cost to purchase and/or manufacture the inventory and the currentestimated market value of the inventory using the weighted average cost method.We regularly review inventory quantities on hand and record a provision forexcess and obsolete inventory based primarily on our historical usage data andestimates of future demand. Since substantially all of our products aremanufactured according to firm purchase orders and customer forecasts, weevaluate the potential of recovery from our customers when customized productsapproach end-of-life. Our customers are generally liable for inventory costs weincur for order cancellations that occur after we have committed resources to procureor manufacture product. We also regularly evaluate inventory that isnon-compliant with the European Commission’s RoHS directive regarding hazardoussubstances in electric and electronic equipment, to determine if additionalreserves are needed to cover for potential obsolescence. We have notestablished a separate reserve for non-RoHS compliant inventory above what ournormal calculations would require.

 

Our industryis 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 during thepast five years, demand for our products 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. In addition, our estimates of future product demandmay prove to be inaccurate, in which case we may have understated or overstatedthe provision required for excess and obsolete inventory. In the future, if ourinventory were determined to be overvalued, we would be required to recognizeadditional expense in our cost of sales at the time of such determination.Likewise, if our inventory is determined to be undervalued, we may have overreported our costs of sales in previous periods and would be required torecognize additional operating income at the time such inventory is sold.Therefore, although we make every reasonable effort to ensure the accuracy ofour estimates of future product demand, any significant unanticipated changesin demand or technological developments could have a material effect on thevalue of our inventory and our reported operating results.

 

Deferred Taxes

 

We recognize deferred taxassets and liabilities based on the differences between the financial statementcarrying values and the tax bases of assets and liabilities. We regularlyreview our deferred tax assets for recoverability and establish a valuationallowance based on historical taxable income, projected future taxable income,and the expected timing of the reversals of existing temporary differences. Ifour future taxable income is significantly higher than expected and/or we areable to utilize our tax credits, we may be required to reverse all or asignificant part of our valuation allowance against such deferred tax assetswhich could substantially reduce our effective tax rate for such period.Therefore, any significant changes in statutory tax rates or the amount of ourvaluation allowance could have a material effect on the value of our deferredtax assets and liabilities and our reported financial results. The preparationof condensed consolidated financial statements in conformity with generallyaccepted accounting principles in the United States requires us to makeestimates and assumptions that affect the reported amount of tax-related assetsand liabilities and income tax provisions.  The Company’s effective tax rate may besubject to fluctuations during the fiscal year as new information is obtainedwhich may affect the assumptions management uses to estimate the annualeffective tax rate including mix of pre-tax earnings in the various taxjurisdictions in which it operates.

 

22

----

Tableof Contents

 

The Company adopted the provisionsof FASB Interpretation (FIN) 48, *Accountingfor Uncertainty in Income Taxes* (“FIN 48”) on January 1, 2007.FIN 48 clarifies the accounting for uncertainty in income taxes recognized inan enterprise’s financial statements in accordance with SFAS 109, *Accounting for Income Taxes*, byprescribing a recognition threshold and measurement attribute for the financialstatement recognition and measurement of a tax position taken or expected to betaken in a tax return. Under FIN 48, the financial statement effects of a taxposition should initially be recognized when it is more likely than not, basedon the technical merits, that the position will be sustained upon examination.A tax position that meets the more-likely-than-not recognition threshold shouldinitially and subsequently be measured as the largest amount of tax benefitthat has a greater than fifty percent likelihood of being realized uponultimate settlement with a taxing authority. FIN 48 is effective for fiscalyears beginning after December 15, 2006. See Note 3, “Income Taxes,” inthe accompanying Notes to Condensed Consolidated Financial Statements includedin Item 1, “Financial Statements,” for additional information regarding theimpact of adoption.

 

United States income taxesare not provided on undistributed earnings from certain foreign subsidiaries.Those earnings are considered to be permanently re-invested in accordance withthe Accounting Principles Board (APB) Opinion 23.

 

OtherComprehensive Income

 

Belgiumtaxes for unrealized foreign exchange gains on an intercompany loan consideredpermanently re-invested are provided for as a component of other comprehensiveincome or loss.

 

Goodwilland Long Lived Assets

 

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

 

We also review the recoverability of thecarrying value of long-lived assets whenever events or changes in circumstancesindicate that the carrying amount 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 management’s best estimates, based on appropriate assumptionsand current projections.

 

These projected future cash flows may varysignificantly over time as a result of increased competition, changes intechnology, fluctuations in demand, consolidation of our customers andreductions in average selling prices. If the carrying value is determined notto be recoverable from future operating cash flows, the asset would be deemedimpaired and an impairment loss would be recognized on the date ofdetermination to the extent the carrying value exceeded the estimated fairmarket value of the asset.

 

Based on our annual assessment of the fairvalue of our Cherokee Europe subsidiary in accordance with SFAS 142, werecorded a goodwill impairment charge of $5.2 million during the yearended December 30, 2007, to properly report goodwill at its fair value atthat period in time.

 

During the quarter ended June 29, 2008,the remaining balance of $1.1 million of goodwill was deemed impaired. Animpairment charge was recorded due to the decrease in fair value of ourCherokee Europe subsidiary due to lower revenues than anticipated.  As of September 28, 2008, the Company nolonger has any goodwill recorded. Details are included under Note 13, “Goodwill Impairment Charge,” to theaccompanying Notes to Condensed Consolidated Financial Statements included inItem 1, “Financial Statements.” See also Note 14, “Subsequent Event” to theaccompanying Notes to Condensed Consolidated Financial Statements included inItem 1, “Financial Statements.”

 

**Stock-Based Compensation**

** **

The Company adopted SFAS 123R on January 2,2006 using the “modified prospective” method as permitted by SFAS 123R.Under this transition method, stock compensation cost recognized beginning inthe first quarter of fiscal year 2006 includes: (a) compensation cost forall share-based payments granted subsequent to February 25, 2004 and priorto January 2, 2006 but not yet vested as of January 2, 2006, based onthe grant-date fair value estimated in accordance with the provisions ofSFAS 123R, and (b) compensation cost for all share-based payments grantedsubsequent to January 1, 2006, based on the grant-date fair valueestimated in accordance with the provisions of SFAS 123R. In accordancewith the modified prospective method of adoption, the Company’s results ofoperations and financial position for prior periods have not been restated. Atthe date of the adoption, the unamortized expense for options issued prior to January 2,2006 was $2.3 million, which will be amortized as stock compensation coststhrough December 2010. All grants are made at prices based on the fairmarket value of the stock on the date of grant. Outstanding options generallyvest four years from the grant date, with certain limited exceptions, andexpire up to ten years after the grant date.

 

23

----

Tableof Contents

 

The Companyrecords compensation expense for employee stock options based on the estimatedfair value of the options on the date of grant using the Black-Scholes optionpricing formula with the assumptions included in the table under “Stock-BasedCompensation” in Note 2 to the accompanying Notes to CondensedConsolidated Financial Statements.  TheCompany uses historical data, among other factors, to estimate the expectedprice volatility and the expected forfeiture rate. For options granted prior toJanuary 2, 2006, the Company used the expected option life of5 years. For options granted following the Company’s adoption ofSFAS 123R, the expected life was increased to 6.25 years using the “simplifiedmethod” under SAB 107 (an expected term based on the mid-point between thevesting date and the end of the contractual term). The options have a maximumcontractual term of 10 years and generally vest as to 25% of theunderlying stock on each anniversary of the date of grant, subject toaccelerated vesting in the event of a change in control of the Company. Therisk-free rate is based on the U.S. Treasury yield curve in effect at the time ofgrant for the estimated life of the option.

 

**RESULTSOF OPERATIONS FOR THE QUARTER ENDED SEPTEMBER 28, 2008 COMPARED TO THE QUARTERENDED SEPTEMBER 30, 2007**

** **

NET SALES

 

Net sales increased byapproximately 19.7%, or $6.0 million, to $36.4 million for the quarter ended September 28,2008 from $30.4 million for the quarter ended September 30, 2007. Duringthe quarter ended September 28, 2008, net datacom sales were higher by$7.3 million, primarily driven by new programs from previous design wins.  Telecom net sales were less by $3.9 million,primarily driven by one large triple play customer. Industrial, medical andother net sales were higher by $2.6 million from the prior period due to newcustomers and new programs. Overall, revenues from all of our markets werehigher for the quarter ended September 28, 2008 compared to the quarterended September 30, 2007. Included in the above increases is a $0.7million benefit related to the foreign currency exchange rate fluctuations fromour Cherokee Europe operations.

 

GROSS PROFIT

 

Gross profit increased byapproximately 61.1%, or $3.5 million, to $9.2 million for the quarter ended September 28,2008 from $5.7 million for the quarter ended September 30, 2007. Grossmargin for the quarter ended September 28, 2008 increased to 25.4% from18.9% in the prior year period.  Grossprofit was higher during the quarter ended September 28, 2008 dueprimarily to higher net sales from new programs with better gross margins whichprovided better absorption of fixed costs. Gross margins were better due toincreased production volumes in China, the introduction of new models whichrepresented a positive mix and better overall volumes of products.

 

OPERATING EXPENSES

 

Operatingexpenses for the quarter ended September 28, 2008 increased approximately25.6%, or $1.8 million, to $8.5 million from $6.7 million for the quarter endedSeptember 30, 2007. As a percentage of net sales, operating expensesincreased to 23.2% from 22.1% in the prior year period. The increase inoperating expenses in 2008 from 2007 is as follows:

 

Engineering anddevelopment costs increased by $0.1 million in foreign currency exchange ratefluctuations from our Cherokee Europe operations.

 

Selling and marketingexpense increased by $0.2 million due to an increase of $0.1 million in bonusesand commissions and $0.1 million in foreign currency exchange rate fluctuationsfrom our Cherokee Europe operation.

 

General andadministrative expense increased by $1.5 million due to $0.8 million ofprofessional and legal fees related to the Merger Agreement, $0.4 million ofprofessional and legal fees related to efforts to refinance the Senior Notesprior to entering into the Merger Agreement, $0.2 million in legal expensesrelated to our defense of the SynQor litigation, and $0.1 million in foreigncurrency exchange rate fluctuations from our Cherokee Europe operation.

 

24

----

Tableof Contents

 

OPERATING INCOME (LOSS)

 

As a result ofthe factors discussed above, operating income increased by $1.8 million to $0.8million for the quarter ended September 28, 2008, compared to a loss of$1.0 million for the quarter ended September 30, 2007. Operating marginincreased to 2.1% income from a 3.3% loss in the prior year period.

 

INTEREST EXPENSE

 

Interest expense for bothquarters ended September 28, 2008 and September 30, 2007 was $0.7million.  The interest expense isprimarily related to interest payments on our $46.6 million of Senior Notes,which bear interest at 5.25% annually. As described under Notes 2 and 6 to theaccompanying Notes to the Condensed Consolidated Financial Statements includedin Item 1, we made the interest payment of 5.25% due on November 1but we were unable to pay the principal amount outstanding at maturity and apayment default occurred. The default interest rate as of November 1, 2008until the Senior Notes are paid is 6.25% (5.25% interest rate plus a premium of1%). As described under Note 2 under the heading “Going Concern,” the Companyentered into the Merger Agreement with Lineage on September 24, 2008.  It is anticipated that the Merger will closeon or about November 21, 2008, after stockholders vote on the Merger at theSpecial Meeting of Stockholders to be held on November 18, 2008.  As a result of the Merger, pursuant to whichMerger Sub will be merged with and into the Company, with the Company survivingas a wholly owned subsidiary of Lineage, the Senior Notes will remain anobligation of the Company.  The Companyanticipates that the outstanding amounts due and payable under the SeniorNotes, together with default interest on overdue principal, will be paid infull at or after the closing of the Merger. If the Merger fails to beconsummated, we may be forced to refinance on terms that are materially lessfavorable, seek funds through other means such as a sale of assets, orotherwise significantly alter our operating plan, any of which could have amaterial adverse effect on our business, financial condition and results ofoperation and our ability to continue as a going concern. There can be noassurance that any refinancing or sale of assets would be available onsatisfactory terms, if at all, or that the Company would be able to continue asa going concern.  Accordingly, if theMerger fails to be consummated, the Company could be forced to file forbankruptcy protection and thereby reorganize or liquidate its assets, resultingin material adverse consequences for the Company’s stockholders, creditors andemployees. 

 

INCOME TAXES

 

Provision (benefit) forincome taxes for the quarter ended September 28, 2008 and the comparableperiod of September 30, 2007, was less than $0.1 in million provision, and$0.4 million in benefit, respectively. The provision for the quarter ended September 28,2008 is higher by $0.5 million than the comparable period of September 30,2007. The benefit from the comparable period of September 30, 2007 wasprimarily a result of the European operating loss.  Based on availableevidence, management can no longer conclude that it is more likely than notthat the Company will realize its deferred tax assets.  No benefit was recognized for the Europeanoperating loss for the quarter ended September 28, 2008.

 

NET INCOME (LOSS)

 

As a result ofthe factors discussed above, we recorded net income of $0.1 million for thequarter ended September 28, 2008, compared to a net loss of $1.3 millionfor the quarter ended September 30, 2007.

 

**RESULTS OF OPERATIONS FOR THE NINE MONTHS ENDEDSEPTEMBER 28, 2008 COMPARED TO THE NINE MONTHS ENDED SEPTEMBER 30, 2007**

** **

NETSALES

 

Netsales increased by approximately 24.1%, or $21.7 million, to $111.7 million forthe nine months ended September 28, 2008 from $90.0 million for the ninemonths ended September 30, 2007. During the nine months ended September 28, 2008, datacom sales werehigher by $12.3 million, primarily driven by new programs from previous designwins, net telecom sales were higher by $1.6 million, primarily driven by onelarge triple play customer and industrial, medical and other net sales werehigher by $7.8 million due to new customers and new programs. Overall, revenuesfrom all of our markets were higher for the nine months ended September 28,2008 compared to the nine months ended September 30, 2007. Included in theabove increases is a $4.0 million benefit related to foreign currency exchangerate fluctuations from our Cherokee Europe operations.

 

GROSS PROFIT

 

Grossprofit increased by approximately 71.8%, or $12.2 million, to $29.2 million forthe nine months ended September 28, 2008 from $17.0 million for the ninemonths ended September 30, 2007. Gross margin for the nine months ended September 28,2008 increased to 26.2% from 18.9% in the prior year period.

 

The increase in grossprofit for the nine months ended September 28, 2008 compared to the ninemonths ended September 30, 2007 was primarily related to overall higherrevenues this year which provided better absorption of fixed costs. Gross marginswere better due to increased production volumes in China, the introduction ofnew models and better overall volumes of products.

 

25

----

Tableof Contents

 

Included in the increasein gross profit for the nine months ended September 28, 2008 is $0.5million of foreign currency exchange rate fluctuations related to our CherokeeEurope operations.

 

OPERATINGEXPENSES

 

Operatingexpenses for the nine months ended September 28, 2008 increased byapproximately 15.3%, or $3.5 million, to $26.1 million from $22.6 million forthe nine months ended September 30, 2007.  As a percentage of netsales, operating expenses decreased to 23.3% from 25.1% in the prior yearperiod.

 

For the nine months endedSeptember 28, 2008, engineering and development expense increased by $0.3million compared to the nine months ended September 30, 2007, due to anincrease in foreign currency exchange rate fluctuations related to our CherokeeEurope operations.

 

Selling and marketingexpense consists primarily of sales salaries and commissions, travel,advertising and marketing expenses. For the nine months ended September 28,2008, selling and marketing expense increased by $0.3 million compared to thenine months ended September 30, 2007. Bonuses and commissions were higher by $0.2 million for the nine monthsended September 28, 2008 compared to the nine months ended September 30,2007 due to higher sales.  For the ninemonths ended September 28, 2008, the increase in selling and marketingexpense included $0.3 million of foreign currency exchange rate fluctuationsrelated to our Cherokee Europe operations. Offsetting these increases were a decrease of $0.2 million in customerpromotional and marketing expenses.

 

General andadministrative expense consists primarily of salaries and other expense formanagement, finance, human resources and information systems. For the ninemonths ended September 28, 2008, general and administrative expenseincreased by $2.0 million compared to the nine months ended September 30,2007, due to an increase of $0.9 million of professional and legal fees relatedto the Merger Agreement, $0.4 million of professional and legal fees related toefforts to refinance the Senior Notes prior to entering the Merger Agreement,$0.4 million in foreign currency exchange rate fluctuations from our CherokeeEurope operations and $0.3 million in legal expenses in our defense in the SynQorlitigation.

 

During the quarter ended June 29,2008, the remaining balance of $1.1 million of goodwill was deemed impaired. Animpairment charge was recorded due to the decrease in fair value of ourCherokee Europe subsidiary due to lower revenues than anticipated.  Details are included under Note 13 to theaccompanying Notes to the Condensed Consolidated Financial Statements includedin Item 1, “Financial Statements.”

 

For the six months ended July 1,2007, there was $0.2 million of operating costs related to severance andfacility closure costs for the Mexico Facility, compared to no expense in 2008.

 

OPERATINGINCOME (LOSS)

 

As aresult of the factors discussed above, operating income was $3.1 million forthe nine months ended September 28, 2008 compared to an operating loss of$5.6 million for the nine months ended September 30, 2007.  Operatingmargin increased to income of 2.8% from a loss of 6.2% in the prior yearperiod.

 

INTERESTEXPENSE

 

Interestexpense for the nine months ended September 28, 2008 was $2.2 millioncompared to $2.1 million for the nine months ended September 30,2007.  The interest expense is mainly related to our 5.25% senior notesand commitment fees on our senior revolving credit line.

 

OTHERINCOME

 

Forthe nine months ended September 30, 2007, the Company recorded a net gainof $0.4 million to other income related to the sale of the Mexico Facilitybuilding.  See Note 10 to theaccompanying Notes to Condensed Consolidated Financial Statements included inItem 1, “Financial Statements,” for additional information.

 

INCOMETAXES

 

Provision (benefit) forincome taxes for the nine months ended September 28, 2008 and thecomparable period of September 30, 2007 was a $1.7 million provision and a$2.0 million benefit, respectively. The provision for the nine months ended September 28,2008 is higher by $3.7 million than the comparable period of September 30,2007 due to the recording of a valuation allowance against the Company’sEuropean deferred tax assets as a discrete event in the quarter ended June 29,2008 equal to $1.6 million.  

 

26

----

Tableof Contents

 

Based on available evidence,management cannot conclude it is more likely than not that the deferred taxassets will be realizable.

 

Provision for income taxesfor the nine months ended September 28, 2008 was calculated using aneffective tax rate of less than one percent for the full fiscal year inaddition to the valuation allowance of $1.6 million recorded as a discreteevent in the quarter ended June 29, 2008.

 

NETINCOME (LOSS)

 

 Asa result of the factors discussed above, we recorded a net loss of $0.4 millionfor the nine months ended September 28, 2008, compared to the net loss of$5.0 million for the nine months ended September 30, 2007.

 

LIQUIDITYAND CAPITAL RESOURCES

 

CASH FLOWS

 

**FOR THE NINE MONTHS ENDEDSEPTEMBER 28, 2008 COMPARED TO THE NINE MONTHS ENDED SEPTEMBER 30, 2007**

** **

Netcash provided by operating activities for the nine months ended September 28,2008 was $6.4 million compared to net cash used in operating activities of $4.6million for the nine months ended September 30, 2007.

 

Netcash provided by operating activities for the nine months ended September 28,2008 reflected a net loss of $0.4 million, $2.0 million in depreciation andamortization, $1.1 million in goodwill impairment, $0.1 million in amortizationof deferred financing costs, $0.7 million of stock-based compensation, a$1.7 million increase in the valuation allowance for deferred income taxes, a$1.6 million decrease in accounts receivable, a $0.1 million decrease inprepaid expenses and other current assets, a $0.4 million decrease in depositsand other assets, a $0.7 million increase in accounts payable, a $0.1 millionincrease in accrued compensation and benefits and a $0.6 million increase inaccrued interest payable.  This wasoffset by a $1.5 million increase in inventories, a $0.5 million decrease inaccrued liabilities and restructuring costs, and a $0.3 million decrease inother long-term obligations.

 

Netcash used in operating activities for the nine months ended September 30,2007 reflected a net loss of $5.0 million which was primarily a result of $17.5million lower revenues in 2007 compared to the comparable period in 2006,offset by a $0.4 million gain in the sale of assets held for sale related tothe sale of the Mexico Facility building, a $0.8 million increase in inventory,$0.1 million increase in deposits and other assets, a $1.2 million decrease inaccounts payable, a $3.6 million decrease in accrued liabilities andrestructuring costs, a $0.1 million decrease in accrued compensation, and adecrease of $0.6 million in other long-term obligations.  This was offset by $2.4 million indepreciation and amortization, $0.1 million in amortization of deferredfinancing costs, $0.6 million of stock-based compensation related to SFAS 123R,a $2.4 million decrease in accounts receivable, a $1.2 million decrease inprepaid expenses and other current assets, and a $0.6 million increase ininterest payable.

 

Netcash used in investing activities for the nine months ended September 28,2008 was $0.4 million, which was related to capital expenditures.

 

Netcash used in investing activities for the nine months ended September 30,2007 was $0.9 million, in which $2.2 million was related to capitalexpenditures.  We invested $2.1 millionin our China facility. We received $1.2 million of proceeds from the sale ofthe Mexico Facility building in 2007.

 

Netcash provided by financing activities for the nine months ended September 28,2008 was $0.8 million, which included a $1.3 million payment with respect toCherokee’s China’s line of credit with Industrial and Commercial Bank of ChinaLtd., or ICBC, during the first quarter of 2008, or ICBC, and payments of $0.3million by Cherokee Europe on its short-term loan.  This was offset by Cherokee Europe’sborrowing of $0.6 million in a short-term loan and $0.8 million borrowings fromits line of credit with ING Belgie NV, and $1.0 million borrowings by CherokeeChina from its line of credit with Industrial and Commercial Bank of China Ltd.

 

Net cash provided byfinancing activities for the nine months ended September 30, 2007 was $3.8million.  In July 2007, CherokeeEurope borrowed short-term funds of $0.6 million from ING Belgie NV.  The loan arrangement was for six months andended December 25, 2007. The loan bore a 5.3% interest rate. As of September 30,2007, the outstanding balance owed was $0.3 million. During the three monthsended September 30, 2007, Cherokee Europe borrowed $2.0 million from theline of credit with Bank Brussels Lambert, a subsidiary of ING Belgie NV.  In January 2007, we opened a creditfacility with ICBC, which advanced up to the equivalent of approximately $3.3million, expressed as RMB 25.0 million. The line is collateralized by theCompany’s building in Shanghai, China. During the first three months of 2007,Cherokee China borrowed $1.3 million under this credit facility to supportworking capital requirements as our China subsidiary builds inventory andincurs value-added tax on local purchases. As of September 30, 2007, theoutstanding balance of $1.3 million due to ICBC remained due. During the ninemonths ended September 30, 2007, $0.2 million of employee stock purchaseplan proceeds were received.

 

27

----

Tableof Contents

 

LIQUIDITY

 

We expect our liquidity requirements will beprimarily for working capital and capital expenditures, including repayment of principaland default interest on overdue principal of our Senior Notes that were due on November 1,2008. As of September 28, 2008, we had cash and cash equivalents of$15.3 million and negative working capital of $2.8 million due to the$46.6 million of senior notes in payment default as of November 1,2008, as described under Notes 2 and 6 to the accompanying Notes to theCondensed Consolidated Financial Statements included in Item 1, beingclassified to current liabilities.  Ourrevolving line of credit with General Electric Capital Corporation matured on August 25,2008. We currently do not have an existing line of credit for our US domesticcompany.  Historically, we have financedour operations with cash from operations supplemented by borrowings from creditfacilities and debt and equity issuances.

 

In January 2007, we opened a creditfacility with ICBC, as described under Note 6 to the accompanying Notes tothe Condensed Consolidated Financial Statements included in Item 1, “FinancialStatements.”  This facility is intendedfor working capital requirements in China, especially as our China subsidiarybuilds inventory for export to the United States and Europe and incursvalue-added tax on local purchases that can only be recovered throughin-country sales of our product. During the quarter ended September 28,2008, Cherokee China borrowed $0.5 million from its line of credit.  As of September 28, 2008, Cherokee Chinahad outstanding borrowings of $1.0 million under this line of credit.

 

Subject to the refinancing risk describedabove, we believe our cash flow from operations and our credit line in Chinaare sufficient to meet our operating cash requirements for at least the nexttwelve months. However, this assumes that the Merger Agreement will be approvedby our stockholders and the Merger will be consummated, in which case theCompany anticipates that the outstanding amounts due and payable under our SeniorNotes, together with default interest on overdue principal, will be paid infull at or after the closing of the Merger.  If the Merger fails to be consummated, theCompany may be forced to refinance on terms that are materially less favorable,seek funds through other means such as a sale of the Company’s assets, orotherwise significantly alter the operating plan of the Company, any of whichcould have a material adverse effect on the Company’s business, financialcondition and results of operations and the ability of the Company to continueas a going concern. There can be no assurance that any refinancing orsale of assets would be available on satisfactory terms, if at all, or that theCompany would be able to continue as a going concern.  Accordingly, if the Merger fails to beconsummated, the Company could be forced to file for bankruptcy protection andthereby reorganize or liquidate its assets, resulting in material adverseconsequences for the Company’s stockholders, creditors and employees.

 

Having completed the China plantconstruction, ongoing current and future liquidity needs are expected to ariseprimarily from working capital requirements and historical level capitalexpenditures, assuming we successfully repay or renegotiate our Senior Notesobligation. Our capital expenditures in 2007 were $2.3 million. In 2008, weexpect our capital expenditures to range between $1.7 million and$2.1 million.

 

***CONTRACTUAL OBLIGATIONS***

*** ***

As of September 28, 2008, our borrowings consisted ofapproximately $46.6 million of senior notes, $2.8 million of outstandingborrowings on our Cherokee Europe line of credit, $0.2 million of outstandingborrowings of short-term funds, and $1.0 million of outstanding borrowingsunder Cherokee China’s credit facility and line of credit.  For a more detailed discussion related to thefinancial instruments and obligations, see Note 6, “Debt” to theaccompanying Notes to the Condensed Consolidated Financial Statements includedin Item 1, “Financial Statements.”

 

We have operating lease obligations relatingto our facilities in Tustin and Irvine, California and Bombay, India.

 

We have purchase commitments primarily withvendors and suppliers for the purchase of inventory and for other goods,services, and equipment as part of the normal course of business. Thesecommitments are generally evidenced by purchase orders that may or may notinclude 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 consolidated financial condition orresults of operations.

 

28

----

Tableof Contents

 

The remaining balance of $0.3 million in thedeferred compensation plan has been reserved and deposited into an investmentaccount with funds that closely mirror investment funds similar to theparticipants’ investment selections.

 

The maturities of our long-term debt, including capital leases, andfuture payments relating to our operating leases and other obligations as of September 28,2008 are as follows (in thousands):

 
| **Contractual Obligations**      | ** ** | **September 28, 2008 to  December 28, 2008** | ** ** | **2009** | ** ** | **2010** | ** ** | **2011** | ** ** | **2012** | ** ** | **Thereafter** | ** ** | **Total** | ** ** |
|---------------------------------------|------------|-----------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------------|------------|-----------|------------|
| Debt-senior notes                     |       | $                                                                     | 46,630     |     | $          | —   |       | $        | —     |     | $          | —         |       | $         | —     |   | $ | — |   | $ | 46,630 |   |
| Operating leases                      |       | 403                                                                   |       | 568      |       | 43       |       | 18       |       | —   |       | 109            |       | 1,141     |       |
| Purchase order commitments            |       | 18,556                                                                |       | —   |       | —   |       | —   |       | —   |       | —         |       | 18,556    |       |
| 1999 Europe restructuring             |       | 52                                                                    |       | 344      |       | 57       |       | —   |       | —   |       | —         |       | 453       |       |
| 2003 Europe restructuring             |       | 55                                                                    |       | 261      |       | 241      |       | 198      |       | 154      |       | 224            |       | 1,133     |       |
| Long service award                    |       | 17                                                                    |       | 117      |       | 219      |       | 25       |       | 21       |       | 585            |       | 984       |       |
| Deferred compensation                 |       | 45                                                                    |       | 53       |       | 19       |       | 19       |       | 19       |       | 122            |       | 277       |       |
| Advances for research and development |       | 22                                                                    |       | 60       |       | 60       |       | 62       |       | 64       |       | 348            |       | 616       |       |
| Unrecognized tax benefits             |       | —                                                                |       | 307      |       | —   |       | —   |       | —   |       | —         |       | 307       |       |
| Total                                 |       | $                                                                     | 65,780     |     | $          | 1,710    |       | $        | 639        |     | $          | 322            |       | $         | 258        |   | $ | 1,388 |   | $ | 70,097 |   |

 

The long-term liability for accrued pensioncosts included on the condensed consolidated balance sheet is excluded from thetable above. The Company is unable to estimate the timing of payments for thesecosts. During the nine months ended September 28, 2008, the Companycontributed approximately $0.3 million. In 2008, the Company expects to contribute $0.4 million.

 

RECENT ACCOUNTING PRONOUNCEMENTS

 

For adiscussion of the impact of recently issued accounting pronouncements, see thesubsection entitled “Recent Accounting Pronouncements” contained in Note 2 ofthe Notes to Condensed Consolidated Financial Statements under Item 1. “FinancialStatements.”

 

Item3.   QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

Market risk relating to our operationsresults primarily from changes in foreign currency exchange rates andshort-term interest rates. We did not have any derivative financial instrumentsat September 28, 2008.

 

We had no variable rate debt outstanding at September 28,2008. We cannot predict market fluctuations in interest rates and their impacton any variable rate debt we may incur in the future, nor can there be anyassurance that fixed rate long-term debt will be available to us at favorablerates, if at all.

 

Item4T.   CONTROLS AND PROCEDURES

 

*Disclosure Controlsand Procedures*

 

Our management, with the participation of ourPresident and Chief Executive Officer, and our Executive Vice President andChief Financial Officer, has evaluated the effectiveness of our disclosurecontrols and procedures (as such term is defined in Rules 13a-15(e) and15d-15(e) under the Securities Exchange Act of 1934, as amended (the “ExchangeAct”)), as of the end of the period covered by this report. The evaluationincluded certain control areas in which we have made changes to improve andenhance controls. As described below, we have identified material weaknessesand significant deficiencies in our internal control over financial reportingas of December 30, 2007, and as of September 28, 2008, these materialweaknesses and significant deficiencies have not been fully remediated.

 

As a result,our President and Chief Executive Officer and our Executive Vice President andChief Financial Officer have concluded that, as of September 28, 2008, ourdisclosure controls and procedures were not effective.

 

A material weakness is a deficiency or acombination of deficiencies in internal control over financial reporting suchthat there is a reasonable possibility that a material misstatement of the annualor interim consolidated financial statements will not be prevented or detectedon a timely basis.  Since the Companyconducted its assessment of the effectiveness of our internal control overfinancial reporting as of December 30, 2007, our management hasimplemented some changes to its internal control over financial reporting inresponse to the following material weaknesses that were identified as of December 30,2007, as described below:

 

29

----

Table of Contents

 

*Architecture ofCompany’s IT systems does not presently support the financial reportingrequirements of the Company’s international operations*

 

Our subsidiaries in India and China stillmaintain disparate financial accounting systems that do not completelyinterface with the Company’s primary ERP system, resulting in duplicateaccounting entries on multiple systems. This causes a protracted reportingcycle which limits the oversight from corporate headquarters of transactionaldetails at our international sites. Site level financial statements aredelivered on spreadsheets to the corporate office for consolidation.

 

Our European operation has its own separateERP system that is integrated into the local accounting system; however thissystem does not automatically interface financially with our corporateheadquarters. Therefore, financial results are also delivered to our corporateoffice by means of spreadsheets, and the corporate office also has insufficientvisibility to transactional details.

 

The consolidation of all these local resultsdelivered on spreadsheets is in turn prepared on spreadsheets at our corporateoffice. Consolidations performed on spreadsheets are prone to human error andare difficult to review. As such, the existing consolidation process requiresadditional monitoring and oversight. Oversight and monitoring are discussed inmore detail below.

 

The Company has completed its development andimplementation of IT interface solutions for key activities in China. TheCompany will now begin to focus on determining what IT solutions will berequired for our other locations.  Untilthis is completed, the Company will continue to supplement these technical IT solutionswith additional staffing and internal monitoring procedures.

 

*The methodology andsupport for valuing and capitalizing inventory costs, and determining inventoryreserves*

 

As remediated in the second quarter of 2007,the Company now evaluates historical and projected labor and overhead costs todetermine their reasonableness. This process is subject to finance managementoversight and review. The Company still does not track labor by product modelat most locations.

 

*Oversight and monitoring controls*

 

The lack of an integrated financial reporting system creates the needfor significant manual intervention and staffing to prepare spreadsheets,create eliminating entries, make tax adjustments, and U.S. GAAPadjustments. Additionally, our remote locations, other than Europe, have onelocal controller with little more than clerical support to maintain the localaccounting system, transport information from the ERP system to their localbooks, report financial statements to our headquarters in the U.S. and performroutine functions such as account reconciliations. As part of our SarbanesOxley Act of 2002 (SOX) 404 compliance efforts, the Company is performing adetailed review of procedures and personnel at each site location. The Companyis committed to resolving all deficiencies identified.

 

We have identified and have performed or areworking on the following remediation to resolve the weakness in oversight andmonitoring controls over international financial reporting:

 

·     Theprocess of adding structure and uniformity of accounting standards and processamong our site controllers continues through distribution of corporate policiesand procedures, planned continued development and distribution of policies,reinforcement of management representations and corporate code of conduct, andregular visits by the corporate controller to various Company sites. Wecontinue critical self-review of how accounting is performed worldwide.

 

·     Dueto personnel changes, the Company expects to rely on outside professionals fora significant portion of its SOX compliance review.  During the second quarter, we engaged GrantThornton to assist the Company in its SOX compliance.  Initial planning has begun.

 

·     Animproved consolidated reporting package is now provided to corporate managementand significant items are being reviewed with local management.

 

30

----

Table of Contents

 

*SOX Compliance*

 

As a non-accelerated filer, 2007 marked thefirst year of SOX compliance for the Company. The Company completed an internalassessment of controls. While the vast majority of the Company’s controls wereoperating properly, the Company did identify control deficiencies forremediation. The corporate office worked closely with the site accountingpersonnel to remediate these deficiencies. The vast majority of thedeficiencies were remediated during 2007, but some did remain at year end. Whileefforts to remediate these deficiencies have continued into 2008, managementassessed the remaining deficiencies to determine if any additional materialweakness existed. The Company concluded that none of the open deficiencies at2007 fiscal year end could result in a material weakness but did believe thatone could be classified as a significant deficiency. A significant deficiencyis a deficiency, or combination of deficiencies, in internal control overfinancial reporting that is less severe than a material weakness; yet importantenough to merit the attention of those responsible for oversight over theCompany’s financial reporting. Since the Company conducted its assessment ofthe effectiveness of our internal control over financial reporting as of December 30,2007, our management has implemented the following changes to its internalcontrol over financial reporting in response to the significant deficienciesthat were identified as of December 30, 2007, as described below:

 

1)    Inadequatefixed asset management systems and procedures

 

During the second quarter, the Companyimplemented new IT system controls that we believe will remediate theinadequate controls over shipping cutoffs which were identified as asignificant deficiency during 2007 SOX compliance.  Remediation efforts on the fixed assetsystems are expected to continue over several periods.  The issues of IT systems, people and processare interrelated and difficult to separate. Striking the optimum balancebetween improved process, better trained and supervised staff and missioncritical IT improvements is essential for success.

 

The Company is committed to remediating allmaterial weaknesses and significant deficiencies presently identified and anyadditional deficiencies that may be identified in the future.

 

In connection with the Company’s filing ofits consolidated financial statements for its fiscal year ending December 28,2008, the Company’s internal control over financial reporting will not besubject to attestation by the Company’s registered public accounting firm dueto the deferral of the effective date of these requirements. This date has beendelayed for non-accelerated filers; the provision will now apply to fiscalyears ending on or after December 15, 2009.

 

*Changes in Internal Control Over FinancialReporting*

 

Except as described above, there have notbeen any changes in our internal control over financial reporting (as such termis defined in Rules 13a-15(f) and 15(d)-15(f) under the ExchangeAct) during our third fiscal quarter of 2008 that have materially affected, orare reasonably likely to materially affect, our internal control over financialreporting.

 

PART II.   OTHERINFORMATION

 

Item 1.   Legal Proceedings

 

On November 16, 2007, SynQor announcedthat it had filed a lawsuit against several of its competitors, including theCompany who was named in the complaint, for infringement of two patentsrelating to bus converters and/or non-isolated point of load converters used inintermediate bus architectures. The patents at issue are U.S. patents 7,072,190and 7,272,021. The suit was filed in Federal Court in the Eastern District ofTexas. The Company intends to and continues to vigorously defend this lawsuit.Although the ultimate aggregate amount of monetary liability or financialimpact with respect to this lawsuit is subject to many uncertainties and istherefore not predictable with assurance, the final outcome of this lawsuit, ifadverse, could have a material adverse effect on our financial position,results of operations or cash flows.

 

During the nine months ended September 28,2008, we were not a party to any other material legal proceedings. We areoccasionally a party to lawsuits relating to routine matters incidental to ourbusiness. As with all litigation, we can provide no assurance as to the outcomeof any particular lawsuit, and we note that litigation inherently involvessignificant costs.

 

31

----

Table of Contents

 

Item 1A.   RiskFactors

 

We have updated the riskfactors discussed in Item 1A of our Annual Report on Form 10-K forthe year ended December 30, 2007, as set forth below. Except for the riskfactor concerning the 5.25% Senior Notes and the pending Merger, we do notbelieve any of the updates constitute material changes from the risk factorspreviously disclosed in our Annual Report on Form 10-K for the year ended December 30,2007.

 

*The following riskfactors, among others, could cause our financial performance to differsignificantly from the goals, plans, objectives, intentions and expectationsexpressed in this Quarterly Report on Form 10-Q. If any of the followingrisks and uncertainties or other risks and uncertainties not currently known tous or not currently considered to be material actually occurs, our business,financial condition or operating results could be harmed substantially.*

 

**Risks Relating to Our Company and Industry**

 

**We are substantially dependent upon sales toa relatively small group of customers. The loss of one or more major customers,or the discontinuation or modification of these customers’ products, couldmaterially and adversely affect the results of our operations.**

 

Our top ten customers accounted for approximately49% of our net sales for the nine months ended September 28, 2008 andapproximately 50% of our net sales for the year ended December 30, 2007.In addition, one customer accounted for more than 10% of net sales in the ninemonths ended September 28, 2008 and for the year ended December 30,2007. The loss of any of our major customers could have a material adverseeffect on our financial condition or results of operations. We do not havelong-term contracts with our customers, and our customers use alternative powersupply providers for some or all of their products. We may not be able tomaintain our customer relationships, and our customers may reduce or canceltheir purchase orders, purchase power supplies elsewhere or developrelationships with additional providers of power supplies, any of which couldadversely affect our financial condition or results of operations. Asignificant change in the liquidity or financial position of any of thesecustomers could also have a material adverse effect on the collectibility ofour accounts receivables, our liquidity and our future operating results. Priorto, or at the end of, a product’s life cycle, any of our customers may decideto discontinue or modify any of its products. In that event, the customer mayno longer have a need for our products or may choose to integrate a competitor’spower supply into the customer’s new or modified product. The resulting loss ofrevenues could also adversely affect our financial condition or results of ouroperations.

 

**Failure by our customers or us to keep upwith rapid technological change in the electronic equipment industries couldresult in reduced sales for us.**

 

Many of our existing customers are in theelectronic equipment industries, especially wireless infrastructure andnetworking, and produce products that are subject to rapid technologicalchange, obsolescence and large fluctuations in world-wide product demand. Theseindustries are characterized by intense competition and end-user demand forincreased product performance at lower prices. We may not be able to properlyassess developments in the electronic equipment industries or identify productgroups or customers with the potential for continued and future growth. Factorsaffecting the electronic equipment industries, in general, or any of our majorcustomers or their products, in particular, could have a material adverseeffect on our financial condition or results of operations. For instance, as aprovider of power supplies to OEMs in the electronic equipment industries,our sales are dependent upon the success of the underlying products of whichour power supplies are a component. We have no control over the demand for orsuccess of these products. If our customers’ products are not well received by,or if demand for their products fails to develop among end-users, our customersmay discontinue or modify the product or reduce the production of the product.Any of these events could lead to the cancellation or reduction of orders forour power supplies that were previously made or anticipated, which couldmaterially adversely affect our financial condition or results of operation.See “Cancellations, reductions or delays in customers’ orders or commitments,or an increase in the number of warranty product returns could have a materialadverse impact on our financial condition and results of operations” for moreinformation. The markets for our products are characterized by rapidly changingtechnologies, increasing customer demands, evolving industry standards, frequentnew product introductions and shortening product life cycles. Generally, ourcustomers purchase our power supplies for the life cycle of a product, whichcan range anywhere from two to fifteen years. The development of new,technologically advanced products is a complex and uncertain process requiringhigh levels of innovation and cost, as well as the accurate anticipation oftechnological and market trends. As the lifecycle of our customers’ productsshorten, we will be required to bid on contracts for replacement or nextgeneration products to replace revenues generated from discontinued productsmore frequently. These bids may not be successful. Even if we are successful,we may not be able to successfully develop, introduce or manage the transitionof new products. Any failure or delay in anticipating technological advances ordeveloping and marketing new products that respond to any significanttechnological change or significant changes in customer demand could have amaterial adverse effect on our financial condition or results of operations.

 

32

----

Table of Contents

 

**We face significant competition, includingfrom some competitors with greater resources and geographic presence than us.Our failure to adequately compete could have a material adverse effect on ourbusiness.**

 

The design, manufacture and sale of powersupplies are highly competitive and characterized by increasing customerdemands for product performance, shorter manufacturing cycles and lower prices.Our competition includes numerous companies throughout the world, some of whichhave advantages over us in terms of labor and component costs and technology.Our principal competitors are Emerson Network Power, Delta Electronics, TDK(Lambda), Power One, Lineage Power, Murata, Eltek-Valere, and Vicor. Some ofour competitors have substantially greater net sales, resources and geographicpresence than we do. Competition from existing competitors or new marketentrants may increase at any time. We also face competition from current andprospective customers that may design and manufacture their own power supplies.In times of an economic downturn, or when dealing with high-volume orders,price may become a more important competitive factor, forcing us to reduceprices and thereby adversely affecting our financial results. Some of our majorcompetitors have also consolidated through merger and acquisition transactions.Consolidation among our competitors is likely to create companies withincreased market share, customer bases, proprietary technology and marketingexpertise, and an expanded sales force. These developments may adversely affectour ability to compete.

 

**Cancellations, reductions or delays incustomers’ orders or commitments, or an increase in the number of warrantyproduct returns could have a material adverse impact on our financial conditionand results of operations.**

 

We do not obtain long-term purchase orders orcommitments from our customers and customers may generally cancel, reduce orpostpone orders or commitments. A variety of conditions, both specific to theindividual customer and generally affecting the customer’s industry, may causecustomers to cancel, reduce or delay orders or commitments that were previouslymade or anticipated. At any time, a significant portion of our backlog may besubject to cancellation or postponement. For example, our entire$50.6 million backlog as of September 28, 2008 was subject tocancellation upon the payment by our customers of cancellation fees that varydepending on individual purchase orders. We also enter into certain warehousingarrangements with some of our customers, whereby we agree to bear the risk andcost of carrying inventory. Under these arrangements, we deliver the powersupplies ordered by such customers to a third-party location, permit thesecustomers to take delivery of the power supplies within a specified time periodafter our delivery of the products, and invoice these customers for theproducts only after they have taken ultimate delivery and title has passed. Wemay not be able to replace cancelled, delayed or reduced orders or commitmentsin a timely manner or at all and in some instances may need to write offinventory. Significant or numerous cancellations, as well as reductions ordelays in orders or commitments, including as a result of delays in or thefailure to take delivery of products that are subject to such arrangements, bya customer or group of customers, could materially adversely affect ourfinancial condition or results of operations.

 

We also offer our customers a warranty forproducts that do not function properly within a limited time after delivery. Weregularly monitor and track warranty product returns and record a provision forthe estimated amount of future warranty returns based on historical experienceand any notification we receive of pending warranty returns. We may experiencegreater warranty return rates than we have in the past. Any significantincrease in product failure rates and the resulting warranty credit returnscould have a material adverse effect on our operating results for the period orperiods in which those warranty returns occur.

 

**Our international manufacturing operationsand our international sales subject us to risks associated with foreign laws,policies, economies and exchange rate fluctuations.**

 

We have manufacturing operations located inIndia, and China and had manufacturing operations in Europe until we soldCherokee Europe in October 2008. We may expand our operations into otherforeign countries in the future. In addition, international sales have been,and are expected to continue to be, an important component of our total sales.International sales represented 54% of our net sales for the year ended September 28,2008 and 50% of our net sales for the year ended December 30, 2007. Ourmanufacturing operations and international sales are subject to inherent risks,all of which could have a material adverse effect on our financial condition orresults of operations. Other risks affecting our international operationsinclude:

 

·                  differences or unexpected changes inregulatory requirements;

 

·                  political and economic instability;

 

33

----

Table of Contents

 

·                  terrorism and civil unrest;

 

·                  work stoppages or strikes;

 

·                  interruptions in transportation;

 

·                  restrictions on the export or import oftechnology;

 

·                  difficulties in staffing and managinginternational operations;

 

·                  variations in tariffs, quotas, taxes andother market barriers;

 

·                  longer payment cycles;

 

·                  problems in collecting accounts receivables;

 

·                  changes in economic conditions in theinternational markets in which our products are sold; and

 

·                  greater fluctuations in sales to customers indeveloping countries.

 

Although we transact business primarily inU.S. dollars, a portion of our sales and expenses, including labor costs, aredenominated in the Indian rupee, the Chinese renminbi (“RMB”). For the ninemonths ended and the year ended September 28, 2008 and December 30,2007, net sales in Europe accounted for 31% and 35% of our net sales,respectively. Declines in the value of the U.S. dollar relative to the Euroimpacted our revenue, cost of goods sold and operating margins for theseperiods and resulted in foreign currency transaction gains and losses. Foreigncurrency translation gains or losses recorded in other comprehensive income, acomponent of equity, for the nine months ended September 28, 2008 and forthe year ended December 30, 2007 were a gain of $0.2 million and again of $1.2 million, respectively. Historically, we have not activelyengaged in substantial exchange rate hedging activities and do not intend to doso in the future.

 

**An interruption in delivery of componentsupplies could lead to supply shortages or a significant increase in our costof materials.**

 

We are dependent on our suppliers for timelyshipments of components, including components manufactured by us in our Indiafacilities. We typically use a primary source of supply for each component usedin our products. Changing suppliers or establishing alternate primary sourcesof supply, if needed, could take a significant period of time, which in turncould result in supply shortages and increased prices. In some cases, we sourcecomponents from only one manufacturer. Substantially all of our revenues arederived from the sale of products that include components that we source fromonly one manufacturer. In addition, many of our suppliers are located outsideof the United States, and timely delivery from these suppliers may not occurdue to interruptions in transportation, import-export controls, tariffs, quotas,taxes and other market barriers, and political and economic stability in thecountry in which the components used in our products are produced or thesurrounding region. An interruption in supply could have a material adverseeffect on our operations. Any shortages of particular components could increaseproduct delivery times and costs associated with manufacturing, therebyreducing gross margins. Additionally, these shortages could cause a substantialloss of business due to shipment delays. Any significant shortages or priceincreases of components could have a material adverse effect on our financialcondition or results of operations.

 

**Our quarterly sales may fluctuate while ourexpenditures remain relatively fixed, potentially resulting in lower grossmargins and volatility in our stock price.**

 

Our quarterly results of operations havefluctuated in the past and may continue to fluctuate in the future.Fluctuations in customer needs, cancellations, reductions and delays in ordersand commitments may cause our quarterly results to fluctuate. See the riskfactor above entitled “Cancellations, reductions or delays in customers’ ordersor commitments or an increase in the number of warranty product returns couldhave a material adverse impact on our financial condition and results ofoperations.” Variations in volume production orders and in the mix of productssold by us have also significantly affected sales and gross profit. Sales aregenerally impacted by a combination of these items and may also be affected byother factors. These factors include:

 

34

----

Tableof Contents

 

·                  the receipt and shipment of large orders orreductions in these orders (including the impact of any customer warehousingarrangements);

 

·                  raw material availability and pricing;

 

·                  product and price competition; and

 

·                  the length of sales cycles.

 

Many of these factors are outside of ourcontrol. In addition, a substantial portion of our sales in a given quarter maydepend on obtaining orders for products to be manufactured and shipped in thesame quarter in which those orders are received. As a result of this and otherfactors described above, sales for future quarters are difficult to predict andour financial condition or results of operations in a given quarter may bebelow our expectations and our gross margins may decrease. Our expense levelsare relatively fixed and are based, in part, on expectations of futurerevenues. If revenue levels are below expectations, the market price of our commonstock could fall substantially, and our financial condition or results ofoperations could be materially adversely affected.

 

**Our ability to successfully implement ourbusiness strategy is dependent on our ability to retain and attract keypersonnel.**

 

Our ability to successfully implement ourbusiness strategy depends to a significant degree on the efforts of Jeffrey M.Frank, President, Chief Executive Officer, and Director, Linster W. Fox,Executive Vice President, Chief Financial Officer and Secretary, and MukeshPatel, Executive Vice President, Global Operations, along with other members ofour senior management team. We believe that the loss of service of any of theseexecutives could have a material adverse effect on our business. In addition,we depend on highly skilled engineers and other personnel with technical skillsthat are in high demand and are difficult to replace. As a result, our abilityto maintain and enhance product and manufacturing technologies and to manageany future growth also depends on our success in attracting and retainingpersonnel with highly technical skills. The competition for these qualifiedtechnical personnel may be intense if the relatively limited number ofqualified and available power engineers continues. We may not be able toattract and retain qualified technical personnel.

 

**Changes in government regulations or productcertification could result in delays in shipment or loss of sales.**

 

Our operations are subject to general laws,regulations and government policies in the United States and abroad.Additionally, our product standards are certified by agencies in variouscountries, including, among others, the United States, Canada, Asia, Germanyand the United Kingdom. Changes in these laws, regulations, policies or certificationstandards could negatively affect the demand for our products, result in theneed to modify our existing products, increase time-to-production or affect thedevelopment of new products, each of which may involve substantial costs, orloss of or delayed sales, and could have a material adverse effect on ourfinancial condition or results of operations.

 

**Environmental compliance could requiresignificant expenditures and failure to so comply could result in fines orrevocation of licenses or permits, any of which could materially and adverselyaffect our financial condition or results of operations.**

 

We are subject to federal, state and localenvironmental laws and regulations (in both the United States and abroad) thatgovern the handling, transportation and discharge of materials into theenvironment, including into the air, water and soil. Environmental laws couldbecome even more stringent in the future, imposing greater compliance costs andincreasing risks and penalties associated with their violation or thecontamination of the environment. Should there be an environmental accident orviolation related to our operations, our financial condition or results ofoperations may be adversely affected. We could be held liable for significantpenalties and damages under environmental laws and could also be subject to arevocation of licenses or permits, which could materially and adversely affectour financial condition or results of operations.

 

The following are two European EconomicCommunity (“EEC”) directives that are having an effect on the entireelectronics industry, including the Company:

 

(1)  Restriction of HazardousSubstances in Electrical and Electronic Equipment, more commonly known as RoHS.This European directive bans the use of certain elements that are commonlyfound in components used to manufacture electrical and electronic assemblies.This directive became effective on July 1, 2006. The Company beganmanufacturing compliant products in 2006 and continues to work actively withits customers to ensure compliance. The Company is focused on consuming allnon-compliant material on-hand within a reasonable period. However, the Companymay have to dispose of non-compliant materials in the future, which couldadversely affect the financial performance of the Company. There is also a riskof fines associated with non-compliance with the RoHS directive; however, theCompany is not aware of any specific potential fines, and the Companyanticipates complying with all provisions of this legislation.

 

35

----

Tableof Contents

 

(2)  Waste Electrical andElectronic Equipment, also known as WEEE. This directive became effective August 13,2005 and requires manufacturers and importers to properly recycle or dispose ofsuch equipment at the end of its useful life. The Company believes it haslimited exposure to the WEEE directive because its products are usually installedinto another user’s system, but this directive may be interpreted and enforceddifferently in the future. If so, the Company may face significant risk offines and costs associated with non-compliance with the existing laws andregulations in the European Union. The Company began manufacturing compliantproducts in 2005, and continues to work actively with its customers to ensurecompliance.

 

**Our operations are vulnerable to interruptionby fire, earthquake, power loss, telecommunications failure and other eventsbeyond our control.**

 

Our operations are vulnerable to interruptionby earthquakes, fires, electrical blackouts, power losses, telecommunicationsfailures and other events beyond our control. Our executive offices and keymanufacturing and engineering facilities are located in Southern California.Because Southern California is an earthquake-prone area, we are particularlysusceptible to the risk of damage to, or total destruction of, our facilitiesin Southern California and the surrounding transportation infrastructure, whichcould affect our ability to make and transport our products. In addition,California continues to face periodic shortages in its power supply. If rollingblackouts or other disruptions in power were to occur, our business andoperations would be disrupted and our business would be adversely affected. Ourbusiness interruption insurance may not be sufficient to compensate us forlosses that may occur and would not compensate us for the loss of consumergoodwill due to disruption of service.

 

**Third parties may sue us for allegedinfringement of their proprietary rights.**

 

We have received, from time to time, noticesof alleged infringement and/or invitations to take licenses from third partiesasserting that they have patents (or other intellectual property rights) thatare relevant to our present or contemplated business operations. There is noguarantee that we will be able to avoid incurring litigation costs related tosuch assertions. Intellectual property claims could be successfully assertedagainst us, preventing us from using certain of our technologies, or forcing usto modify our technology or to pay license fees for use of that technology.Such additional engineering expenses or licensing costs could have an adverse effecton the results of our operations. In addition, we could incur substantialexpenses in defending against these claims, whether or not we ultimatelyprevail against these claims.

 

On November 16, 2007, SynQor announcedthat it had filed a lawsuit against several of its competitors, including theCompany who was named in the complaint, for infringement of two patentsrelating to bus converters and/or non-isolated point of load converters used inintermediate bus architectures. The patents at issue are U.S. patents 7,072,190and 7,272,021. The suit was filed in Federal Court in the Eastern District ofTexas. The Company intends to and continues to vigorously defend this lawsuit.Although the ultimate aggregate amount of monetary liability or financial impactwith respect to this lawsuit is subject to many uncertainties and is thereforenot predictable with assurance, the final outcome of this lawsuit, if adverse,could have a material adverse effect on our financial position, results ofoperations or cash flows.

 

**Provisions of the agreements governing ourdebt will restrict our business operations.**

 

Cherokee China entered into a loan contractin January 2007 with ICBC for a working capital line of credit. Pursuantto the contract, ICBC agreed to make advances up to the equivalent ofapproximately $4.1 million, expressed as RMB 28.0 million. The lineof credit is collateralized by the Company’s building in Shanghai, China.Beginning with its initial borrowing under the contract, Cherokee China hasagreed to deposit in the ICBC Shanghai Branch at least 90% of the operatingrevenue it collects. Our usage of the cash from these deposits made into ourbank account is not restricted. As of September 28, 2008, Cherokee Chinahad $1.0 million of outstanding borrowings under the line of credit andwas in compliance with all covenants.

 

We may need to incur additional debt tocontinue to grow our business in the future. The agreements governing our debtcontain a number of 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. As of September 28, 2008, we were incompliance with our covenants set forth in the agreements.

 

36

----

Tableof Contents

 

Our ability to comply with covenants underagreements governing our debt may be affected by events that are beyond ourcontrol, including prevailing economic, financial and industry conditions. Ourfailure to comply with the covenants or restrictions contained in agreementsgoverning our debt could result in an event of default under these agreements,which could result in our debt, together with accrued and unpaid interest,being declared immediately due and payable.

 

**Our 5.25% Senior Notes matured on November 1,2008, and we were unable to repay or refinance this indebtedness upon maturity.**

 

OnNovember 1, 2008, the $46.6 million aggregate principal amount outstandingunder our 5.25% Senior Notes became due and payable.  As previously disclosed, we did not havesufficient cash available to repay this indebtedness.. We made the interestpayment due on November 1, but we were unable to pay the principal amountoutstanding at maturity and a payment default occurred.  As a result of the payment default, inaddition to the aggregate principal amount outstanding under the Senior Notes,we are required to pay interest on overdue principal at the default rate of6.25% per annum.  It is anticipated thatthe Merger will close on or about November 21, 2008, after stockholdersvote on the Merger at the Special Meeting of Stockholders to be held on November 18,2008.  As a result of the Merger,pursuant to which Merger Sub will be merged with and into the Company, with theCompany surviving as a wholly owned subsidiary of Lineage, the Senior Noteswill remain an obligation of the Company. We anticipate that the outstanding amounts due and payable under theSenior Notes, together with default interest on overdue principal, will be paidin full at or after the closing of the Merger. If the Merger fails to be consummated, we may be forced to refinance onterms that are materially less favorable, seek funds through other means suchas a sale of assets, or otherwise significantly alter our operating plan, any ofwhich could have a material adverse effect on our business, financial conditionand results of operations and our ability to continue as a going concern. Therecan be no assurance that any refinancing or sale of assets would be availableon satisfactory terms, if at all, or that the Company would be able to continueas a going concern.  Accordingly, if theMerger fails to be consummated, the Company could be forced to file forbankruptcy protection and thereby reorganize or liquidate its assets, resultingin material adverse consequences for the Company’s stockholders, creditors andemployees. 

 

**Credit risks could materially and adverselyaffect our operations and financial condition.**

 

Negative or declining economic conditions canincrease our exposure to our customers’ credit risk. In particular, sales tolarger customers are sometimes made through contract manufacturers that do nothave the same resources as those customers. Additionally, if one of our majorcustomers experienced financial difficulties, losses could be in excess of ourcurrent allowance. At September 28, 2008, one of our Cherokee US customersaccounted for approximately 14.9% of our total net receivables and one of ourCherokee Europe customer accounted for 10.9% of our total net receivables at December 30,2007. For the periods ended September 28, 2008 and December 30, 2007,our accounts receivable write-offs amounted to less than 1% of our net accountsreceivable balance. In the event our customers or those contract manufacturersexperience financial difficulties and fail to meet their financial obligationsto us, or if our recorded bad debt provisions with respect to receivablesobligations do not accurately reflect future customer payment levels, we couldincur additional write-offs of receivables that are in excess of ourprovisions, which could have a material adverse effect on our operations andfinancial condition. In addition, we depend on the continuing willingness ofour suppliers to extend credit to us to finance our inventory purchases. Ifsuppliers become concerned about our ability to generate cash and service ourdebt, they may delay shipments to us or require payment in advance.

 

**If we fail to meet the listing requirementsof the NASDAQ Global Market and the NASDAQ determines to delist our commonstock, the delisting would adversely affect the liquidity of our common stockand the market price of our common stock could decline.**

 

Our common stock is listed on the NASDAQGlobal Market. In order to maintain that listing we must satisfy certainperiodic reporting requirements under Marketplace Rule 4310(c)(14). If wefail to file our Quarterly Reports on Form 10-Q or Annual Reports on Form 10-Ktimely, NASDAQ could delist our common stock from the NASDAQ Global Market. Ifour common stock is delisted from the NASDAQ Global Market, the price of ourcommon stock and the ability of our stockholders to trade in our common stockwould be adversely affected. In addition, such delisting could adversely affectour ability to obtain financing and could result in the loss of confidence byour investors, suppliers and employees.

 

**Failure to complete the proposed Merger could negatively impact ourstock price and future business and financial results because of, among otherthings, the disruption that would occur as a result of uncertainties relatingto a failure to complete the merger.**

 

If the proposed Merger is not completed, the price of our common stockmay decline to the extent that the current market price reflects a marketassumption that the merger will be completed and that the benefits of themerger will be realized, or as a result of the market’s perceptions that theproposed Merger is not consummated due to an adverse change in our business. Inaddition, our business may be harmed, and the price of our common stock maydecline, to the extent that customers, suppliers and others believe that wecannot compete in the marketplace as effectively without the Merger or otherwiseremain uncertain about our future prospects in the absence of the Merger. 

 

37

----

Tableof Contents

 

**While theproposed merger is pending, we will be subject to business uncertainties andcontractual restrictions that could adversely affect our business.**

 

Uncertainty about the effect of the proposed Merger on customers andsuppliers may have an adverse effect on us. These uncertainties could causecustomers, suppliers and others who deal with us to seek to change existingbusiness relationships. In addition, the Merger Agreement restricts ourability, without Lineage’s consent and subject to certain exceptions, fromtaking specified actions until the Merger is completed or the Merger Agreementterminates. These restrictions may prevent us from pursuing otherwiseattractive business opportunities and making other changes to our business thatmay arise prior to completion of the Merger or termination of the MergerAgreement.

 

Item3. Defaults Upon Senior Securities

 

OnNovember 1, 2008, the $46.6 million aggregate principal amount outstandingunder our 5.25% Senior Notes became due and payable.  As previously disclosed, we did not havesufficient cash available to repay this indebtedness.  We made the interest payment due on November 1,but we were unable to pay the principal amount outstanding at maturity and apayment default occurred.  As a result ofthe payment default, in addition to the aggregate principal amount outstandingunder the Senior Notes, we are required to pay interest on overdue principal atthe default rate of 6.25% per annum. As of the date of filing of this report,the aggregate outstanding principal and accrued interest of the 5.25% SeniorNotes was approximately $46,639,715.  Itis anticipated that the Merger, described in Note 2 in the accompanying Notesto Condensed Consolidated Financial Statements included in Part I, Item 1,“Financial Statements,” will close on or about November 21, 2008, afterstockholders vote on the Merger at the Special Meeting of Stockholders to beheld on November 18, 2008. As a result of the Merger, pursuant to whichMerger Sub will be merged with and into the Company, with the Company survivingas a wholly owned subsidiary of Parent, the Senior Notes will remain anobligation of the Company.   Weanticipate that the outstanding amounts due and payable under the Senior Notes,together with default interest on overdue principal, will be paid in full at orafter the closing of the Merger.  If themerger fails to be consummated, we may be forced to refinance on terms that arematerially less favorable, seek funds through other means such as a sale ofassets, or otherwise significantly alter our operating plan, any of which couldhave a material adverse effect on our business, financial condition and resultsof operations and our ability to continue as a going concern. There canbe no assurance that any refinancing or sale of assets would be available onsatisfactory terms, if at all, or that the Company would be able to continue asa going concern.  Accordingly, if theMerger fails to be consummated, the Company could be forced to file forbankruptcy protection and thereby reorganize or liquidate its assets, resultingin material adverse consequences for the Company’s stockholders, creditors andemployees.

 

38

----

Tableof Contents

 

Item 6.   EXHIBITS

 

EXHIBIT INDEX

 

Exhibits haveheretofore been filed with the SEC and are incorporated herein by reference.Management contracts or compensatory plans or arrangements are marked with anasterisk.

 

 
| **Exhibit No.** | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                                                               |
|----------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 2.1                  |       | Agreement and Plan of  Merger dated as of September 24, 2008, among Lineage Power  Holdings, Inc., Birdie Merger Sub, Inc. and Cherokee International  Corporation.(4)                                                                                                                                                                                                                         |
| 2.2                  |       | Agreement for the Sale and  Purchase of All of the Issued and Outstanding Shares of Cherokee SPRL dated  October 18, 2008, between Cherokee Netherlands II BV and Mr. Eric  Brouwers.(5)                                                                                                                                                                                                            |
| 3.1                  |       | Restated  Certificate of Incorporation of Cherokee International Corporation.(1)                                                                                                                                                                                                                                                                                                                              |
| 3.2                  |       | Amended and  Restated By-Laws of Cherokee International Corporation.(1)                                                                                                                                                                                                                                                                                                                                       |
| 4.1                  |       | Specimen  certificate for shares of common stock, par value $0.001 per share.(3)                                                                                                                                                                                                                                                                                                                              |
| 4.2                  |       | Indenture,  dated as of November 27, 2002, between Cherokee International  Corporation, as issuer, and U.S. Bank, N.A., as trustee, relating to the  5.25% Senior Notes due 2008.(2)                                                                                                                                                                                                                     |
| 4.3                  |       | Form of  5.25% Senior Notes due 2008.(2)                                                                                                                                                                                                                                                                                                                                                                 |
| *10.1                |       | Voting Agreement, dated as  of September 24, 2008, by and among GSCP (NJ), Inc., GSC Recovery  II, L.P., GSC Recovery IIA, L.P., GSC Partners CDO Fund, Limited, GSC  Partners CDO Fund II, Limited, OCM Principal Opportunities Fund, L.P. and  OCM/GFI Power Opportunities Fund, L.P., Cherokee International Corporation,  Lineage Power Holdings, Inc. and Birdie Merger Sub, Inc.(4) |
| 31.1                 |       | Certification of President and Chief Executive Officer pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                                                       |
| 31.2                 |       | Certification of Executive Vice President of Finance, Chief Financial  Officer and Secretary pursuant to Section 302 of the Sarbanes-Oxley Act  of 2002.                                                                                                                                                                                                                                                 |
| 32.1                 |       | Certification of CEO and CFO Pursuant to 18 U.S.C. Section 1350,  as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                             |

 

----

(1)                                  Incorporated byreference from the Registration Statement on Form S-8, filed by theRegistrant on March 16, 2004.

 

(2)                                  Incorporatedby reference from the Registration Statement on Form S-1 (File No. 333-110723),filed by the Registrant on November 25, 2003.

 

(3)                                  Incorporatedby reference from Amendment No. 4 to the Registration Statement on Form S-1(File No. 333-110723), filed by the Registrant on February 17, 2004.

 

(4)                                  Incorporatedby reference from the Current Report on Form 8-K filed by the Registranton September 30, 2008.

 

(5)                                  Incorporatedby reference from the Current Report on Form 8-K filed by the Registranton October 23, 2008.

 

39

----

Tableof Contents

 

SIGNATURES

 

Pursuant tothe requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned,thereunto duly authorized.

 
|                          | CHEROKEE  INTERNATIONAL CORPORATION |
|-------------------------------|-------------------------------------|
|                          |                                |
| Date:  November 12, 2008 | By:                                 | /s/ JEFFREY  M. FRANK |
|                          |                                | Jeffrey M.  Frank |
|                          |                                | President  and Chief Executive Officer |
|                          |                                | (Principal  Executive Officer) |
|                          |                                |   |
|                          |                                |   |
| Date:  November 12, 2008 | By:                                 | /s/ LINSTER  W. FOX |
|                          |                                | Linster W.  Fox |
|                          |                                | Executive  Vice President, Chief Financial Officer,  and Secretary  (Principal Financial and Accounting Officer) |

 

40

----