** **

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

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**FORM 10-Q**

** **

| **(Mark  One)**                                                                         | ** **                                                                                    | ** ** |
|-----------------------------------------------------------------------------------------|-----------------------------------------------------------------------------------------------|------------|
| ** **                                                                              | ** **                                                                                    | ** ** |
| **x**                                                                                   | **QUARTERLY REPORT PURSUANT TO SECTION 12 OR 15(d)  OF THE SECURITIES EXCHANGE ACT OF 1934**  |
| ** **                                                                              | ** **                                                                                    | ** ** |
| ** **                                                                              | **For the  quarterly period ended September 30, 2007**                                   |
| ** **                                                                              | ** **                                                                                    | ** ** |
| **o**                                                                                   | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
| ** **                                                                              | ** **                                                                                    |
| **For the  transition period from          to** |
| **Commission  File No. 000-50593******                                             |

 

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**Cherokee International Corporation**

(Exact name of Registrant as specified in its charter)

| **Delaware**                                                               | ** ** | **95-4745032**                           |
|----------------------------------------------------------------------------|------------|------------------------------------------|
| (State or Other  Jurisdiction of  Incorporation of Organization)           |       | (I.R.S. Employer  Identification Number) |
|                                                                       |       |                                     |
| **2841 Dow Avenue Tustin,  California**                                    | ** ** | **92780**                                |
| (address of the  principal executive offices)                              |       | (zip code)                               |
|                                                                       |       |                                     |
| Registrant’s telephone  number, including area code**(714) 544-6665** |
| Securities registered  pursuant to Section 12(b) of the Act:     |

 

| **Title  of Class**             | ** ** | **Name of  Exchange on which Registered** |
|---------------------------------|------------|-------------------------------------------|
| Common Stock, $0.001  par value |       | The NASDAQ Stock  Market, LLC             |

 

Securities registeredpursuant to Section 12(g) of the Act:

**None**

Indicateby check mark whether the registrant; (1) has filed all reports requiredto be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theRegistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days.  

(1) Yes x  No o    (2) Yes x  No o

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, or a non-accelerated filer. See definition of “acceleratedfiler” and “large accelerated filer” in Rule 12b-2 of the Exchange Act.(Check one):
| Large Accelerated  Filer  o | Accelerated  Filer  o | Non-Accelerated  Filer  x |
|---------------------------------------|---------------------------------|-------------------------------------|

Indicateby check mark whether the registrant is a shell company (as defined inRule 12b-2 of the Exchange Act).  Yes o  No x

As ofOctober 31, 2007, 19,414,855 shares of the registrant’s common stock,$0.001 par value, were outstanding.

 

 

 

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**TABLE OFCONTENTS**
| 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 | 16     |   |
| Item 3.  Quantitative and Qualitative Disclosures About Market Risk                                 | 27     |   |
| Item  4. Controls and Procedures                                                                    | 27     |   |
| PART II  OTHER INFORMATION                                                                     | 29     |   |
| Item  1. Legal Proceedings                                                                          | 29     |   |
| Item 1A. Risk Factors                                                                               | 29     |   |
| Item 4. Submission of Matters to A Vote of Security  Holders                                        | 29     |   |
| Item 6. Exhibits                                                                                    | 30     |   |
| Signatures                                                                                          | 31     |   |
|                                                                                                |   |   |

 

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** **

**PART I.   FINANCIAL INFORMATION**

**Item1.   FINANCIAL STATEMENTS**

**CHEROKEEINTERNATIONAL CORPORATION AND SUBSIDIARIES**

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

**(InThousands, Except Share and Per Share Data)(Unaudited)**
| ** **                                                                                                                                                                                       | ** ** | **September 30, 2007** | ** ** | **December 31, 2006** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| **ASSETS**                                                                                                                                                                                       |       |                             |       |                            |       |
| **CURRENT ASSETS:**                                                                                                                                                                              |       |                             |       |                            |       |
| Cash and cash equivalents                                                                                                                                                                        |       | $                                | 7,309      |                            | $          | 8,881 |   |
| Accounts receivable, net of allowance for doubtful accounts of $265  and $292 at September 30, 2007 and December 31, 2006, respectively                                                     |       | 25,768                           |       | 27,403                          |       |
| Inventories, net                                                                                                                                                                                 |       | 31,349                           |       | 29,991                          |       |
| Prepaid expenses and other current assets                                                                                                                                                        |       | 1,375                            |       | 2,503                           |       |
| Total current assets                                                                                                                                                                             |       | 65,801                           |       | 68,778                          |       |
| Property and equipment, net                                                                                                                                                                      |       | 19,511                           |       | 19,888                          |       |
| Deposits and other assets                                                                                                                                                                        |       | 1,476                            |       | 1,376                           |       |
| Deferred financing costs, net of accumulated amortization of $461 and  $364 at September 30, 2007 and December 31, 2006, respectively                                                       |       | 119                              |       | 216                             |       |
| Deferred income taxes-long-term portion                                                                                                                                                          |       | 342                              |       | 318                             |       |
| Goodwill                                                                                                                                                                                         |       | 6,317                            |       | 6,317                           |       |
| Total Assets                                                                                                                                                                                     |       | $                                | 93,566     |                            | $          | 96,893 |   |
|                                                                                                                                                                                             |       |                             |       |                            |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                                    |       |                             |       |                            |       |
| **CURRENT LIABILITIES:**                                                                                                                                                                         |       |                             |       |                            |       |
| Accounts payable                                                                                                                                                                                 |       | $                                | 13,102     |                            | $          | 13,944 |   |
| Accrued liabilities                                                                                                                                                                              |       | 2,587                            |       | 4,968                           |       |
| Accrued compensation and benefits                                                                                                                                                                |       | 8,118                            |       | 7,882                           |       |
| Accrued restructuring costs                                                                                                                                                                      |       | 472                              |       | 879                             |       |
| Other short-term borrowings                                                                                                                                                                      |       | 286                              |       | —                          |       |
| Borrowings under revolving line of credit                                                                                                                                                        |       | 3,308                            |       | —                          |       |
| Total current liabilities                                                                                                                                                                        |       | 27,873                           |       | 27,673                          |       |
| Long-term debt                                                                                                                                                                                   |       | 24,485                           |       | 24,485                          |       |
| Long-term debt payable to affiliates                                                                                                                                                             |       | 22,145                           |       | 22,145                          |       |
| Total long-term debt                                                                                                                                                                             |       | 46,630                           |       | 46,630                          |       |
| Other long-term liabilities                                                                                                                                                                      |       | 6,524                            |       | 6,715                           |       |
| Total Liabilities                                                                                                                                                                                |       | 81,027                           |       | 81,018                          |       |
|                                                                                                                                                                                             |       |                             |       |                            |       |
| Commitments and contingencies (Note 9)                                                                                                                                                           |       |                             |       |                            |       |
|                                                                                                                                                                                             |       |                             |       |                            |       |
| **STOCKHOLDERS’ EQUITY:**                                                                                                                                                                   |       |                             |       |                            |       |
| Common stock: $0.001 par value; 60,000,000 shares authorized;  19,414,855 and 19,337,709 shares issued and outstanding at  September 30, 2007 and December 31, 2006, respectively |       | 19                               |       | 19                              |       |
| Paid-in capital                                                                                                                                                                                  |       | 185,633                          |       | 184,813                         |       |
| Accumulated deficit                                                                                                                                                                              |       | (174,335                         | )          | (169,373                        | )          |
| Accumulated other comprehensive income                                                                                                                                                           |       | 1,222                            |       | 416                             |       |
| Total stockholders’ equity                                                                                                                                                                  |       | 12,539                           |       | 15,875                          |       |
| Total Liabilities and Stockholders’ Equity                                                                                                                                                  |       | $                                | 93,566     |                            | $          | 96,893 |   |

 

Seenotes to condensed consolidated financial statements.

 

1

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** **

**CHEROKEEINTERNATIONAL CORPORATION AND SUBSIDIARIES**

**CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS**

**(In Thousands, Except Per ShareAmounts)(Unaudited)**
| ** **                               | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                               | ** ** | **September 30, 2007** | ** ** | **October 1, 2006**        | ** ** | **September 30, 2007** | ** ** | **October 1, 2006** | ** ** |
| Net sales                                |       | $                                | 30,401     |                            | $          | 33,051 |   | $ | 89,995 |   | $ | 107,462 |   |
| Cost of sales                            |       | 24,670                           |       | 26,676                          |       | 72,996 |   | 84,436 |   |
| Gross profit                             |       | 5,731                            |       | 6,375                           |       | 16,999 |   | 23,026 |   |
| Operating expenses:                      |       |                             |       |                            |       |   |   |   |   |
| Engineering and development              |       | 2,561                            |       | 2,244                           |       | 8,040 |   | 6,887 |   |
| Selling and marketing                    |       | 1,510                            |       | 1,721                           |       | 5,247 |   | 4,742 |   |
| General and administrative               |       | 2,660                            |       | 2,809                           |       | 9,177 |   | 8,873 |   |
| Restructuring costs                      |       | —                           |       | 275                             |       | 155 |   | 275 |   |
| Asset impairment                         |       | —                           |       | 285                             |       | — |   | 285 |   |
| Total operating expenses                 |       | 6,731                            |       | 7,334                           |       | 22,619 |   | 21,062 |   |
| Operating income (loss)                  |       | (1,000                           | )          | (959                            | )          | (5,620 | ) | 1,964 |   |
| Interest expense                         |       | (707                             | )          | (744                            | )          | (2,084 | ) | (2,098 | ) |
| Gain on sale of Mexico Facility building |       | —                           |       | —                          |       | 430 |   | — |   |
| Other income (expense), net              |       | (23                              | )          | 129                             |       | 291 |   | 321 |   |
| Income (loss) before income taxes        |       | (1,730                           | )          | (1,574                          | )          | (6,983 | ) | 187 |   |
| Provision (benefit) for income taxes     |       | (421                             | )          | (200                            | )          | (1,999 | ) | 382 |   |
| Net loss                                 |       | $                                | (1,309     | )                               | $          | (1,374 | ) | $ | (4,984 | ) | $ | (195 | ) |
| Net loss per share:                      |       |                             |       |                            |       |   |   |   |   |
| Basic                                    |       | $                                | (0.07      | )                               | $          | (0.07 | ) | $ | (0.26 | ) | $ | (0.01 | ) |
| Diluted                                  |       | $                                | (0.07      | )                               | $          | (0.07 | ) | $ | (0.26 | ) | $ | (0.01 | ) |
| Weighted average shares outstanding:     |       |                             |       |                            |       |   |   |   |   |
| Basic                                    |       | 19,414                           |       | 19,292                          |       | 19,371 |   | 19,281 |   |
| Diluted                                  |       | 19,414                           |       | 19,292                          |       | 19,371 |   | 19,281 |   |

 

Seenotes to condensed consolidated financial statements.

2

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** **

**CHEROKEEINTERNATIONAL CORPORATION AND SUBSIDIARIES**

**CONDENSEDCONSOLIDATED STATEMENTS OF COMPREHENSIVE OPERATIONS**

** (In Thousands)**

**(Unaudited)**
| ** **                                                    | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|---------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                    | ** ** | **September 30, 2007** | ** ** | **October 1, 2006**   | ** ** | **September 30, 2007** | ** ** | **October 1, 2006** | ** ** |
| Net loss                                                      |       | $                                | (1,309     | )                               | $          | (1,374 | ) | $ | (4,984 | ) | $ | (195 | ) |
| Other comprehensive income:                                   |       |                             |       |                            |       |   |   |   |   |
| Foreign currency translation adjustments                      |       | 567                              |       | (76                             | )          | 865 |   | 1,077 |   |
| Income tax effect of foreign currency transaction adjustments |       | —                           |       | (861                            | )          | — |   | (861 | ) |
| Comprehensive income (loss)                                   |       | $                                | (742       | )                               | $          | (2,311 | ) | $ | (4,119 | ) | $ | 21 |   |

 

Seenotes to condensed consolidated financial statements.

3

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** **

**CHEROKEEINTERNATIONAL CORPORATION AND SUBSIDIARIES**

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

**(InThousands)**

**(Unaudited)**
| ** **                                                                                 | ** ** | **Nine Months Ended**  | ** ** |
|--------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                 | ** ** | **September 30, 2007** | ** ** | **October 1, 2006** | ** ** |
| **CASH FLOWS FROM OPERATING ACTIVITIES:**                                                  |       |                             |       |   |   |
| Net loss                                                                                   |       | $                                | (4,984     | ) | $ | (195 | ) |
| Adjustments to reconcile net loss to net cash (used in) provided by operating  activities: |       |                             |       |   |   |
| Depreciation and amortization                                                              |       | 2,397                            |       | 2,474 |   |
| Asset impairment charge                                                                    |       | —                           |       | 285 |   |
| Gain on sale of property and equipment                                                     |       | (430                             | )          | — |   |
| Amortization of deferred financing costs                                                   |       | 97                               |       | 97 |   |
| Stock-based compensation                                                                   |       | 589                              |       | 505 |   |
| Net change in operating assets and liabilities:                                            |       |                             |       |   |   |
| Accounts receivable, net                                                                   |       | 2,385                            |       | (115 | ) |
| Inventories, net                                                                           |       | (834                             | )          | (2,863 | ) |
| Prepaid expenses and other current assets                                                  |       | 1,180                            |       | (93 | ) |
| Deposits and other assets                                                                  |       | (77                              | )          | (24 | ) |
| Accounts payable                                                                           |       | (1,200                           | )          | (804 | ) |
| Accrued liabilities and restructuring costs                                                |       | (3,647                           | )          | (1,347 | ) |
| Accrued compensation and benefits                                                          |       | (95                              | )          | 1,993 |   |
| Accrued interest payable                                                                   |       | 636                              |       | 607 |   |
| Other long-term obligations                                                                |       | (624                             | )          | 466 |   |
| Net cash (used in) provided by operating activities                                        |       | (4,607                           | )          | 986 |   |
| **CASH FLOWS FROM INVESTING ACTIVITIES:**                                                  |       |                             |       |   |   |
| Additions to property and equipment                                                        |       | (2,152                           | )          | (2,353 | ) |
| Proceeds from sale of property and equipment                                               |       | 1,229                            |       | — |   |
| Net cash used in investing activities                                                      |       | (923                             | )          | (2,353 | ) |
| **CASH FLOWS FROM FINANCING ACTIVITIES:**                                                  |       |                             |       |   |   |
| Other short-term borrowings                                                                |       | 286                              |       | — |   |
| Borrowings on revolving lines of credit                                                    |       | 3,308                            |       | — |   |
| Net proceeds from employee stock purchases and the exercise of stock  options              |       | 231                              |       | 82 |   |
| Net cash provided by financing activities                                                  |       | 3,825                            |       | 82 |   |
| Effect of exchange rate changes on cash and cash equivalents                               |       | 133                              |       | 409 |   |
| Net decrease in cash and cash equivalents                                                  |       | (1,572                           | )          | (876 | ) |
| Cash and cash equivalents, beginning of period                                             |       | 8,881                            |       | 10,543 |   |
| Cash and cash equivalents, end of period                                                   |       | $                                | 7,309      |   | $ | 9,667 |   |
| **SUPPLEMENTAL INFORMATION**                                                               |       |                             |       |   |   |
| Cash paid during the period for interest                                                   |       | $                                | 1,330      |   | $ | 1,248 |   |
| Cash paid during the period for income taxes                                               |       | $                                | 239        |   | $ | 641 |   |

 

See notes tocondensed consolidated financial statements.

4

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** **

**CHEROKEEINTERNATIONAL CORPORATION AND SUBSIDIARIES**

**NOTESTO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**(Unaudited)**

**1.      NATURE OFOPERATIONS**

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

**2.      BASIS OFPRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**

*Basis of Presentation*

The accompanying condensed consolidated financialstatements of Cherokee International Corporation have been prepared in accordancewith accounting principles generally accepted in the United States of Americafor interim financial information and in accordance with the instructions toForm 10-Q and Article 10 of Regulation S-X.  Accordingly, they do notinclude certain 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.

Results of operations for the three months and ninemonths ended September 30, 2007, are not necessarily indicative of the resultsto be expected for the entire fiscal year ending December 30, 2007 (“fiscal2007”). The accompanying condensed consolidated financial statements should beread in conjunction with the audited consolidated financial statements for thefiscal year ended December 31, 2006, included in the Company’s AnnualReport on Form 10-K (File No. 000-50593) filed on May 23, 2007.

*Useof Estimates*

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

*Stock-BasedCompensation*

In December 2004,SFAS 123R, *Share-Based Payment*,was issued. SFAS 123R is a revision of SFAS 123, *Accounting for Stock Based Compensation*,and supersedes APB 25. Among other items, SFAS 123R eliminates the use ofAPB 25 and the intrinsic value method of accounting for stock basedcompensation, and requires companies to recognize the cost of employee servicesreceived in exchange for awards of equity instruments, based on the grant datefair value of those awards, in the financial statements. The Company wasrequired to adopt SFAS 123R effective on January 2, 2006. SFAS 123Rpermits 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 of SFAS 123 forall unvested awards granted prior to the effective date of SFAS 123R. Under the“*modified retrospective*” method,the requirements are the same as under the “*modifiedprospective*’’ method, but also permits entities to restate financialstatements of previous periods based on proforma disclosures made in accordancewith SFAS 123.

The Company currentlyuses the Black-Scholes standard option-pricing model to measure the fair valueof stock options granted to employees and non-employees. While SFAS 123Rpermits the Company to continue to use such a model, the standard also permitsthe use of a “*lattice*” model. TheCompany is continuing to use the Black-Scholes model to measure the fair valueof employee stock options upon the adoption of SFAS 123R.

5

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SFAS 123R also requires that the benefits associatedwith the tax deductions in excess of recognized compensation cost be reportedas a financing cash flow, rather than as an operating cash flow as requiredunder prior literature. This requirement will reduce net operating cash flowsand increase net financing cash flows in periods after the effective date.These future amounts cannot be estimated, because they depend on, among otherthings, when employees exercise stock options.

The Company adopted SFAS123R on January 2, 2006 using the “*modified prospective*”method as permitted by SFAS 123R. Under this transition method, stockcompensation cost recognized beginning in the first quarter of fiscal year 2006includes:  (a) compensation cost for all share-based payments grantedsubsequent to February 25, 2004 and prior to January 2, 2006 but notyet vested as of January 2, 2006, based on the grant-date fair valueestimated in accordance with the provisions of SFAS 123R, and(b) compensation cost for all share-based payments granted subsequent toJanuary 1, 2006, based on the grant-date fair value estimated inaccordance with the provisions of SFAS 123R. In accordance with the “*modified prospective*” method of adoption, the Company’sresults of operations and financial position for prior periods have not beenrestated. At the date of the adoption, the unamortized expense for optionsissued prior to January 2, 2006 was $2.3 million, which will be amortizedas stock compensation costs through December 2010.  Stock based compensation costs expensedduring the quarters ended September 30, 2007 and October 1, 2006, were $0.2million and $0.2 million, respectively. During the nine months ended September 30, 2007 and October 1, 2006 thecosts recorded were $0.6 million and $0.5 million, respectively.

All grants are made atprices based on the fair market value of the stock on the date of grant.Outstanding options generally vest over four years from the grant date withcertain limited exceptions and subject to accelerated vesting in the event of achange in control of the Company, and expire up to ten years after the grantdate.

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 toJanuary 2, 2006, the Company used the expected option life of 5 years. Foroptions granted following the Company’s adoption of SFAS 123R, the expectedlife was increased to 6.25 years using the “simplified method” under SAB 107(an expected term based on the mid-point between the vesting date and the endof the contractual term). The options have a maximum contractual term of 10years and generally vest as to 25% of the underlying stock on each anniversaryof the date of grant, subject to accelerated vesting in the event of a changein control of the Company.  The risk-freerate is based on the U.S. Treasury yield curve in effect at the time of grantfor the estimated life of the option.

Thefollowing weighted-average assumptions were used to estimate the fair value ofoptions granted during the three and nine-month periods endedSeptember 30, 2007 and October 1, 2006, using the Black-Scholesoption pricing formula:

| ** **              | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-------------------------|------------|----------------------------------|------------|---------------------------------|------------|
|                    |       | **September 30, 2007** | ** ** | **October 1, 2006**   | ** ** | **September  30, 2007** | ** ** | **October  1, 2006** |   |
| Dividend yield          |       | 0.0                              | %          | 0.0                             | %          | 0.0 | % | 0.0 | % |
| Expected volatility     |       | 54.7                             | %          | 58.5                            | %          | 54.8 | % | 58.8 | % |
| Risk free interest rate |       | 4.59                             | %          | 4.64                            | %          | 4.97 | % | 4.81 | % |
| Expected lives          |       | 6.25  years                      |       | 6.25  years                     |       | 6.25  years |   | 6.25  years |   |
| Forfeiture rates        |       | 11.74  - 21.88                   | %          | 8.51  - 20.41                   | %          | 11.74  - 21.88 | % | 8.51  - 20.41 | % |

 

The followingtable summarizes the Company’s activities with respect to its stock optionplans for the nine months ended September 30, 2007 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 31, 2006                                |       | 2,297,054              |       | $                                                           | 6.23       |                                                                  | 7.84       |                            | $          | 671,221 |   |
| Granted                                                         |       | 745,500                |       | $                                                           | 4.95       |                                                                  | 9.75       |                            | $          | — |   |
| Exercised                                                       |       | (30,000                | )          | $                                                           | 3.19       |                                                                  | 8.20       |                            | $          | 48,063 |   |
| Forfeited                                                       |       | (200,975               | )          | $                                                           | 5.62       |                                                                  | 6.96       |                            | $          | — |   |
| Outstanding at September 30, 2007                               |       | 2,811,579              |       | $                                                           | 5.97       |                                                                  | 7.75       |                            | $          | 142,830 |   |
| Vested and expected to vest in the future at September 30, 2007 |       | 2,444,324              |       | $                                                           | 6.15       |                                                                  | 7.53       |                            | $          | 125,313 |   |
| Exercisable at September 30, 2007                               |       | 1,279,905              |       | $                                                           | 7.24       |                                                                  | 6.44       |                            | $          | 31,682 |   |

 

 

6

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Since its inception onFebruary 16, 2004, a total of 400,000 shares of common stock have beenreserved for issuance under the 2004 Employee Stock Purchase Plan (“ESPP”),subject to annual increases as described under Note 11 below. Under the termsof the ESPP, the Company’s U.S. employees, nearly all of whom are eligible toparticipate, can choose to have up to a maximum of 15% of their eligible annualbase earnings withheld, subject to an annual maximum of $25,000 or 2,100 sharesper offering period, to purchase our common stock. The purchase price of thestock is 85% of the lower of the closing price at the beginning of eachsix-month offering period or at the end of each six-month offering period. TheCompany recognizes compensation cost for its ESPP under SFAS 123R.

In accordance with SFAS 148, and as required by SFAS123R, the required pro forma disclosure, for options granted in periods priorto adoption of SFAS 123R, is shown below (in thousands except per shareamounts):
| ** **                                                                                                                                                      | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                                                                                                                      | ** ** | **September 30, 2007**      | ** ** | **October 1, 2006**   | ** ** | **September 30, 2007** | ** ** | **October 1, 2006** | ** ** |
| Net loss, as reported                                                                                                                                           |       | $                                | (1,309     | )                               | $          | (1,374 | ) | $ | (4,984 | ) | $ | (195 | ) |
| 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                              | )          | (117                            | )          | (286 | ) | (381 | ) |
| Net loss—pro forma                                                                                                                                         |       | $                                | (1,405     | )                               | $          | (1,491 | ) | $ | (5,270 | ) | $ | (576 | ) |
| Net loss per share, as reported:                                                                                                                                |       |                             |       |                            |       |   |   |   |   |
| Basic                                                                                                                                                           |       | $                                | (0.07      | )                               | $          | (0.07 | ) | $ | (0.26 | ) | $ | (0.01 | ) |
| Diluted                                                                                                                                                         |       | $                                | (0.07      | )                               | $          | (0.07 | ) | $ | (0.26 | ) | $ | (0.01 | ) |
| Pro forma net loss per share:                                                                                                                                   |       |                             |       |                            |       |   |   |   |   |
| Basic                                                                                                                                                           |       | $                                | (0.07      | )                               | $          | (0.08 | ) | $ | (0.27 | ) | $ | (0.03 | ) |
| Diluted                                                                                                                                                         |       | $                                | (0.07      | )                               | $          | (0.08 | ) | $ | (0.27 | ) | $ | (0.03 | ) |

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(a) During 2007and 2006, the Company accounted for stock-based compensation for optionsgranted prior to February 25, 2004, the date of our initial publicoffering, to employees and directors using the intrinsic value methodprescribed in APB 25 and adopted the disclosure-only alternative of SFAS 123,as amended by SFAS 148 for these options.

*Translationof Foreign Currency*

Foreign subsidiary assets and liabilities denominatedin foreign currencies are translated at the exchange rate on the balance sheetdate. Revenues, costs and expenses are translated at the average exchange rateduring the period. Transaction gains and losses are included in results ofoperations and have not been significant for the periods presented. Thefunctional currency of the Company’s operating subsidiary in Europe, CherokeeEurope SCA (“Cherokee Europe”), is the Euro. The functional currency ofthe Company’s operating subsidiaries in India (Cherokee India Pvt. Ltd.. or“Cherokee India” and Powertel India Pvt. Ltd. or “Cherokee Powertel”), and inChina (Cherokee International (China) Power Supply Co. Ltd. or “CherokeeChina”) is the U.S. dollar, as the majority of transactions are denominated inU.S. dollars.  Translation adjustments,as well as the income tax effect of currency gains or losses on certainintercompany loans, related to Cherokee Europe are reflected as a component ofcomprehensive income (loss) and included in stockholders’ equity as accumulatedother comprehensive income (loss).

*RecentAccounting Pronouncements*

In June 2006, theFASB issued FIN 48, *Accounting for Uncertaintyin Income Taxes*. FIN 48 clarifies the accounting for uncertainty inincome taxes recognized in an enterprise’s financial statements in accordancewith SFAS 109, *Accounting for IncomeTaxes*, by prescribing a recognition threshold and measurementattribute for the financial statement recognition and measurement of a taxposition taken or expected to be taken in a tax return. Under FIN 48, thefinancial statement effects of a tax position should initially be recognizedwhen it is more likely than not, based on the technical merits, that theposition will be sustained upon examination. A tax position that meets themore-likely-than-not recognition threshold should initially, and subsequently,be measured as the largest amount of tax benefit that has a greater than 50percent likelihood of being realized upon ultimate settlement with a taxingauthority. FIN 48 is effective for fiscal years beginning afterDecember 15, 2006. 

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In accordance withthe adoption of FIN 48 on January 1, 2007, we recognized a cumulative-effectadjustment of less than $0.1 million to the opening balance of accumulateddeficit. See Note 3, “Income Taxes,” for additional information.

InSeptember 2006, the FASB issued SFAS 157, *Fair ValueMeasurements*, which defines fair value, establishes a framework formeasuring fair value in generally accepted accounting principles (GAAP), andexpands disclosures about fair value measurements. This Statement applies inconjunction with other accounting pronouncements that require or permit fairvalue measurements. This Statement shall be effective for financial statementsissued for fiscal years beginning after November 15, 2007. We arecurrently evaluating the impact that the adoption of SFAS 157 will have on theCompany’s consolidated financial position and result of operations.

InFebruary 2007, the FASB issued SFAS 159, *The FairValue Option for Financial Assets and Financial Liabilities – Including anAmendment of FASB Statement No. 115*. SFAS 159 permits entitiesto choose to measure certain financial instruments and other eligible items atfair value when the items are not otherwise currently required to be measuredat fair value. Entities that elect the fair value option will report unrealizedgains and losses in earnings at each subsequent reporting date. The fair valueoption may be elected on an instrument-by-instrument basis, with fewexceptions. SFAS 159 also establishes presentation and disclosurerequirements to facilitate comparisons between companies that choose differentmeasurement attributes for similar assets and liabilities. The provisions ofSFAS 159 are effective for fiscal years beginning after November 15,2007. The Company is currently evaluating the impact of adoption ofSFAS 159 on the consolidated financial statements.

*Inventories*

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

| ** **       | ** ** | **September 30, 2007** | ** ** | **December 31, 2006** | ** ** |
|------------------|------------|-----------------------------|------------|---------------------------------|------------|
| Raw material     |       | $                           | 17,973     |                            | $          | 20,991 |   |
| Work-in-process  |       | 4,125                       |       | 4,034                           |       |
| Finished goods   |       | 9,251                       |       | 4,966                           |       |
| Inventories, net |       | $                           | 31,349     |                            | $          | 29,991 |   |

 

As of September 30, 2007 and December 31, 2006,the reserve for inventory surplus and obsolescence was $3.3 million and $4.4million, respectively, including management’s assessment of reserves forsurplus and obsolescence for non-compliant material related to the Restrictionof Hazardous Substances in Electrical and Electronic Equipment directive.

Thefollowing are two European Economic Community (“EEC”) directives that arehaving an effect on the entire electronics industry, including the Company:

(1)    Restriction of Hazardous Substances inElectrical and Electronic Equipment, more commonly known as RoHS. This Europeandirective 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 beganmanufacturing compliant products in 2006, and continues to work actively withits customers to ensure compliance.  TheCompany is focused on consuming all non-compliant material on-hand within areasonable 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.

(2)    Waste Electrical and Electronic Equipment,also known as WEEE. This directive requires manufacturers and importers toproperly recycle or dispose of such equipment at the end of its useful life.This directive became effective on August 13, 2005. The Company believesit has limited 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.

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** **

**3.      INCOMETAXES**

The Company accounts for income taxes in accordancewith SFAS 109, *Accounting for IncomeTaxes*. In accordance with SFAS 109, deferred tax assets andliabilities are recorded for the estimated future tax effects of temporarydifferences between the carrying value of assets and liabilities for financialreporting and their tax basis, and carry-forwards to the extent they arerealizable.  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 ofDecember 31, 2006, deferred tax assets include $32.7 million relating to atax basis step up from a re-capitalization transaction in 1999 and $24.2million of net operating loss (“NOL”) carry-forwards.  The Company hasrecorded a valuation allowance against a significant portion of its deferredtax assets.

Benefit for income taxes for the three months ended September30, 2007 and the comparable period of October 1, 2006, were $0.4 million, and$0.2 million, respectively.   Income taxes for the nine months endedSeptember 30, 2007 and the comparable period of October 1, 2006, were a $2.0million benefit and a $0.4 million provision, respectively.  The benefit for the nine months endedSeptember 30, 2007 is higher by $2.4 million than the comparable period ofOctober 1, 2006 due to operating losses generated in tax jurisdictions whichwere taxable in prior year.  Based on available evidence, managementexpects the benefit to be recognized as a deferred tax asset at year-end.

Provision (benefit) for income taxes for the three andnine months ended September 30, 2007 and the comparable period of October 1,2006, was calculated by estimating taxable income (loss) for certain taxjurisdictions using actual year to date operating results which represents thebest estimate of the effective tax rate for the full fiscal year.

The Company adopted FIN 48, *Accounting for Uncertainty in Income Taxes* onJanuary 1, 2007.  As a result of adoption, the Company recognized acumulative effect adjustment of less than $0.1 million to the January 1,2007 accumulated deficit balance.  At January 1, 2007, we had $1.8million of gross unrecognized tax benefits, of which $0.6 million wouldreduce our effective tax rate if recognized.  Of the total unrecognizedtax benefits at the adoption date, $1.2 million was recorded as a reduction todeferred tax assets, which caused a corresponding reduction in our valuationallowance of $1.2 million.  To the extent such portion of unrecognized taxbenefits is recognized at a time such valuation allowance no longer exists, therecognition would impact our effective tax rate.  The Company’s continuingpractice is to recognize interest and/or penalties related to income taxmatters in income tax expense.  As of September 30, 2007, we haveapproximately $0.1 million of accrued interest and penalties related touncertain tax positions.

The tax years 1997 to 2006remain 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 is scheduled to begin an Internal Revenue Serviceexamination of the 2005 tax year and a Mexican Tax Authority examination of the2004 tax year.  ****During********the second quarter of 2007 the Company effectivelysettled a Netherlands examination of years 2002 through 2006. As a result ofthe Netherlands settlement, the Company reduced the liability for unrecognizedtax benefits by $0.3 million during second quarter 2007.********The Company received $0.2 million ofrefunds from the Dutch government during the current quarter.  The Company does not believe the amount ofunrecognized tax benefits as of September 30, 2007 will significantly increaseor decrease within the next twelve months.

United States income taxes are not provided onundistributed earnings from certain foreign subsidiaries. Those earnings areconsidered to be permanently re-invested in accordance with the AccountingPrinciples Board (APB) Opinion 23.

**4.     ****NET INCOME (LOSS) PER SHARE**

In accordance withSFAS 128, *Earnings Per Share*,basic income (loss) per share is based upon the weighted average number ofcommon shares outstanding. For the three and nine months ended September 30,2007 and October 1, 2006, all outstanding stock options for shares of2,811,579, and 2,282,833, respectively, were excluded from the calculation ofdiluted loss per share as their exercise prices would render them anti-dilutivedue to the net loss for the periods.

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Thefollowing table sets forth the computation of basic and diluted net loss pershare (in thousands, except per share amounts):

| ** **                                              | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|---------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
|                                                    |       | **September 30, 2007** | ** ** | **October 1, 2006**   | ** ** | **September 30, 2007** | ** ** | **October 1, 2006** |   |
| Net loss                                                |       | $                                | (1,309     | )                               | $          | (1,374 | ) | $ | (4,984 | ) | $ | (195 | ) |
| Shares:                                                 |       |                             |       |                            |       |   |   |   |   |
| Weighted-average common shares outstanding—basic   |       | 19,414                           |       | 19,292                          |       | 19,371 |   | 19,281 |   |
| Effect of dilutive securities:                          |       |                             |       |                            |       |   |   |   |   |
| Stock options                                           |       | —                           |       | —                          |       | — |   | — |   |
| Weighted-average common shares outstanding—diluted |       | 19,414                           |       | 19,292                          |       | 19,371 |   | 19,281 |   |
| Net loss per share:                                     |       |                             |       |                            |       |   |   |   |   |
| Basic                                                   |       | $                                | (0.07      | )                               | $          | (0.07 | ) | $ | (0.26 | ) | $ | (0.01 | ) |
| Diluted                                                 |       | $                                | (0.07      | )                               | $          | (0.07 | ) | $ | (0.26 | ) | $ | (0.01 | ) |

**5.      DEFERRED FINANCING COSTS**

The Company capitalizescosts directly related to financing agreements and certain qualified debtrestructuring costs, and amortizes these costs as additional interest expenseover the terms of the related debt. These costs will be fully amortized by August 2008.

Net deferred financingcosts are comprised of the following as of September 30, 2007 andDecember 31, 2006 (in thousands):

| ** **                    | ** ** | **September 30, 2007** | ** ** | **December 31, 2006** | ** ** |
|-------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| Deferred financing costs      |       | $                                | 580        |                            | $          | 580 |   |
| Accumulated amortization      |       | (461                             | )          | (364                            | )          |
| Deferred financing costs, net |       | $                                | 119        |                            | $          | 216 |   |

**6.      DEBT**

Long-term debt consistsof the following at September 30, 2007 and December 31, 2006 (inthousands):

| ** **                                  | ** ** | **September 30, 2007** | ** ** | **December 31, 2006** | ** ** |
|---------------------------------------------|------------|-----------------------------|------------|---------------------------------|------------|
| 5.25% senior notes payable to third parties |       | $                           | 24,485     |                            | $          | 24,485 |   |
| 5.25% senior notes payable to affiliates    |       | 22,145                      |       | 22,145                          |       |
| Total long-term debt                        |       | $                           | 46,630     |                            | $          | 46,630 |   |

As of September 30, 2007, all of the Company’slong-term debt is scheduled to be repaid in 2008.

Long-term debt includesthe Company’s senior notes, which mature on November 1, 2008. Interest onthe senior notes is payable in cash on May 1 and November 1 of eachyear. The senior notes are secured by a second-priority lien on substantiallyall of the Company’s domestic assets and by a pledge of 65% of the equity ofcertain of the Company’s foreign subsidiaries. As of September 30, 2007, theCompany was in compliance with all of the covenants set forth in the principalagreements governing the 5.25% senior secured notes due in 2008. The Company isactively seeking to refinance this obligation, however, given the currentcredit market conditions the Company does not foresee refinancing thisobligation until 2008.  The Companyacknowledges that it may not be able to refinance this obligation at comparableinterest rates to the 5.25% annual interest rate in the past, and could beconsiderably more.

The Company’s primaryline of credit is its senior revolving credit facility with General ElectricCapital Corporation (the “Credit Facility”). In order to increase borrowingcapacity that was in effect lowered by historical earnings before interest,taxes, depreciation and amortization expense (“EBITDA”) covenant, the Companyapproached General Electric Capital Corporation on re-negotiating our CreditFacility.  On November 1, 2007, theCompany and General Electric Capital Corporation amended the credit agreementfor the revolving line of credit dated February 24, 2004. The amended CreditFacility provides for borrowings of up to the lesser of $7.5 million or 85% ofeligible domestic accounts receivable. As of September 30, 2007, our borrowing base was $7.5 million, oureligible accounts receivable was $7.6 million. The Credit Facility matures inAugust 2008. At September 30, 2007 and prior, the borrowings 

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bore interest, at the Company’s option, at a rate perannum equal to LIBOR plus 2.5% or the agent bank’s base rate plus 1.0%.Effective November 1, 2007, the borrowings bear interest, at the Company’soption, at a rate per annum equal to LIBOR plus 3.5% or the agent bank’s baserate plus 2.0%. In addition to paying interest on outstanding principal, theCompany is required to pay a commitment fee to the lenders under the creditfacility in respect of the average daily balance of unused loan commitments ata rate of 1.0% per annum effective November 1, 2007. Prior to November 1, 2007the rate was 0.5% per annum. In lieu of a maximum senior leverage multiplecovenant, the new amended Credit Facility effective November 1, 2007 includes aminimum EBITDA target for the fourth quarter of 2007. Quarterly minimum EBITDAtargets for 2008 will be established after the Company completes its 2008business plan in December 2007. Prior to November 1, 2007, the EBITDA covenantlimited our borrowing to the lower of the borrowing base or two times ourEBITDA as defined by the prior credit agreement.  The Credit Facility is secured by afirst-priority lien, subject to permitted encumbrances, on substantially all ofthe Company’s domestic assets and by a pledge of 65% of the equity of certainof the Company’s foreign subsidiaries. The Credit Facility contains certainrestrictive covenants including the minimum EBITDA target. As of September 30,2007, there were no borrowings outstanding under the Credit Facility, and theCompany was in compliance with all of the covenants under the Credit Facility.

Cherokee Europe maintainsa working capital line of credit of approximately $4.3 million, expressed asEuros 3.0 million, with Bank Brussels Lambert, a subsidiary of ING Belgie NV, abank in Brussels, which is denominated in Euros, collateralized by a pledge infirst and second rank over a specific amount of business assets, requiresCherokee Europe to maintain a certain specific minimum solvency ratio and iscancelable at any time. Our access to the line is limited to $3.8 millionbecause $0.5 million is committed to minimum guarantees on specific collectionsand payments. During the three months ended September 30, 2007, Cherokee Europeborrowed $2.0 million from the line of credit which remained outstanding as ofSeptember 30, 2007. In August 2007, ING Belgie NV temporarily limited theCompany’s usage of the line of credit to $2.0 million. However, in November2007, after meeting with the Company's management to discuss Cherokee Europe'sfinancial results and prospects, ING Belgie NV restored the line of credit backto its full availability of $4.3 million, less any borrowings outstanding.  As of September 30, 2007, Cherokee Europe wasin compliance with all covenants.

In January 2007,Cherokee China entered into a loan contract with Industrial and Commercial Bankof China Ltd. (“ICBC”) for a working capital line of credit. Pursuant to thecontract, ICBC agreed to make advances up to the equivalent of approximately$3.3 million, expressed as RMB 25.0 million. The line of credit iscollateralized by the Company’s building in Shanghai, China. The term endsJanuary 29, 2008 but is cancelable at any time. 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, which was 6.55% at January 29, 2007 and 6.04% atMarch 20, 2007, based on dates amounts were borrowed. Beginning with itsinitial borrowing under the contract, Cherokee China has agreed to deposit inthe ICBC Shanghai Branch at least 90% of the operating revenue it collects. Thecash from these deposits made into our bank account are not restricted from ourusage of these funds.  As of September30, 2007, Cherokee China had $1.3 million of borrowings under the line ofcredit and was in compliance with all covenants.

In July 2007, CherokeeEurope borrowed short-term funds of $0.6 million from ING Belgie NV, and paid$0.3 million back during the three months ended September 30, 2007.  The loan arrangement is over six months, withmonthly payments of $96,000 to be paid off by December 25, 2007.  The loan bears a 5.3% interest rate. As ofSeptember 30, 2007, the outstanding balance owed was $0.3 million.

**7.      OTHER LONG-TERMOBLIGATIONS**

Other long-termobligations consist of the following at September 30, 2007 andDecember 31, 2006 (in thousands):

| ** **                                   | ** ** | **September 30, 2007** | ** ** | **December 31, 2006** | ** ** |
|----------------------------------------------|------------|-----------------------------|------------|---------------------------------|------------|
| 1999 Europe restructuring liabilities        |       | $                           | 425        |                            | $          | 486 |   |
| 2003 Europe restructuring liabilities        |       | 1,118                       |       | 1,161                           |       |
| Long service award liabilities               |       | 873                         |       | 795                             |       |
| Pension liability-SFAS 158                   |       | 2,878                       |       | 2,671                           |       |
| Deferred compensation                        |       | 696                         |       | 1,105                           |       |
| Advances for research & development |       | 534                         |       | 497                             |       |
| Total other long-term obligations            |       | $                           | 6,524      |                            | $          | 6,715 |   |

 

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The Company has agreements with a local governmentagency in Belgium for funding in advances to Cherokee Europe for research anddevelopment expenses. These advances are expected to be repaid to the agency;either as a percentage of the revenues generated by the products developed orthrough a minimum fixed amount on an annual basis. These advances are interestfree.

**8.      CUSTOMERCONCENTRATION**

For the quarter ended September 30, 2007, one customeraccounted for 13.1% of net sales, and no other customer accounted for more than10% of net sales. For the quarter ended October 1, 2006, no customer accountedfor 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 customer accountedfor more than 10% of net sales. For the nine months ended October 1, 2006, onecustomer accounted for 10.8% of net sales, and no other customer accounted formore than 10% of net sales.  For thefiscal year ended December 31, 2006, no customer accounted for more than10% of net sales. A decision by a major customer to decrease the amountpurchased from the Company or to cease purchasing the Company’s products couldhave a material adverse effect on the Company’s financial position and resultsof operations.

As of September 30, 2007, one customer accounted for11.6% and another customer accounted for 11.2% of accounts receivable, and noother customer accounted for more than 10% of accounts receivable. As ofDecember 31, 2006, no customer accounted for more than 10% of accountsreceivable.

**9.      COMMITMENTS ANDCONTINGENCIES**

*Guaranteesand Indemnities*

The Company has agreed toindemnify the former owners of Cherokee Europe for product liability,environmental hazard and employment practice claims relating solely topost-acquisition business. The Company also indemnifies its directors andofficers to the maximum extent permitted under the laws of the State ofDelaware, and various lessors in connection with facility leases for certainclaims arising from such facility or lease. The maximum amount of potentialfuture 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 30, 2007 and December 31, 2006.

***Cash Incentive Compensation Program and Severance Agreements***

The Company adopted a cash incentive program forcertain executives, which provides for cash incentive payments of up to 120% ofbase salary subject to attainment of corporate goals and objectives approved bythe Company’s board of directors. In addition, the Company has entered intoseverance agreements with certain executives, which provide payments to theexecutive if the executive is terminated other than for cause, as defined inthe applicable severance agreement. Certain of the severance agreements provideadditional benefits, including acceleration of stock options, in the event oftermination in connection with a change of control, as defined in theapplicable severance agreement.

*Other Matters*

In the first quarter of2006, we executed a mutual release agreement with a former business partner.The agreement released both parties from obligations arising from pasttransactions. As a result of this agreement, we made a one-time adjustment toreduce our selling and marketing expense by $0.4 million during the threemonths ended April 2, 2006.

*IndiaMatter*

In late March 2006,the Company learned that employees of its Indian subsidiary manufacturingoperations had made certain unauthorized payments that may have been inviolation of the Foreign Corrupt Practices Act and local laws. The facility inIndia is used for the sole purpose of manufacturing products for other Companylocations and, as such, does not generate revenue or issue invoices to externalcustomers. It manufactures approximately 6% (by volume) of the products offeredby the Company.

The subject payments, inthe aggregate, amounted to approximately $40,000 in each of the years endedJanuary 2, 2005 and January 1, 2006, and less than $10,000 in theyear ended December 31, 2006. The Company retained outside counsel whoconducted an internal investigation into these payments. In January 2007,the Company’s outside counsel met with the SEC to discuss the results of theinternal investigation.  The Companyconsiders this matter closed.

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**10.   COMPLETION OF RESTRUCTURING AND CLOSURE OFGUADALAJARA, MEXICO FACILITY**

Duringthe three months ended October 1, 2006, the Company announced the plannedclosure of its Mexican facilities and a related restructuring plan, which wasaccounted for in accordance with SFAS 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 andclosure of our Mexico Facility was completed by the end of the second quarterof 2007. The cumulative costs for the closure of the Mexico Facility were $1.5million ($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 threemonths ended July 1, 2007, there was a reversal of $38,000 to severance costsdue to the transfer and relocation of an employee from the Mexico Facility toour Tustin Facility.  The remainingaccrued balance for severance and stay bonuses was paid on July 1, 2007 tothe remaining employees.

*Assetsheld for sale- Mexico Facility building sold*

The Company beganactively searching for a buyer for the Mexico Facility building during thethree months 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 ceasedoperations in Mexico in March 2007, and reclassified the net book value of$0.7 million for the building and the related assets to *assets held for sale* on the condensed consolidated balancesheet as of April 1, 2007, in accordance with SFAS 144.  In addition, depreciation of the assetsrelated to this sale was suspended as of April 1, 2007.   There was no impairment charge to therelated assets because management determined that the measurement value, thenet book value, was lower than the estimated fair value less cost to sell.

On February 22,2007, Cherokee Electronica, S.A. de C.V. (“Cherokee Mexico”), a subsidiary ofCherokee International Corporation, a Delaware corporation (the “Company”),entered into a Purchase and Sale Agreement (the “Agreement”) with InmobiliariaHondarribia, S.A. de C.V. (the “Buyer”) for the sale of Cherokee Mexico’s35,000-foot manufacturing facility in Guadalajara, Mexico. The Agreementprovided that the Buyer pay Cherokee Mexico an aggregate purchase price ofapproximately 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 theremaining 85% of the sales price was transferred into the Company’s bankaccount. The Company also collected the value added tax on the building inaddition to the sales price and paid the taxes collected to the Mexicangovernment in June 2007.  The net gain ofthe sale recorded during the three months ended July 1, 2007, was$0.4 million, net of $0.1 million related to the cost to sell the assetswhich was deducted from the gain.

***Asset Impairment Charges related to Other Assets***

**Duringthe three months ended October 1, 2006, the Company performed an impairmentreview in accordance with SFAS 144,  *Accounting for the Impairment and Disposal of Long-Lived Assets,*to determine whether any of its long-lived assets located at the MexicoFacility were impaired. The Company identified certain long-lived assetsassociated with the restructuring and closure of the Mexico Facility whosecarrying value would not be recoverable from future cash flows and recorded animpairment charge of $0.3 million for these assets. These assets consisted ofmachinery and equipment, computer technology and equipment, and officefurniture and equipment. The majority of these assets were written off becausethe Company considered them to have no market value. None of the impairmentcharges included cash components.**

***Restructuring Costs***

In accordance with SFAS146, employee severance, contract termination and other exit costs are recordedat their estimated fair value when they are incurred. During the three monthsended July 1, 2007, there was a reversal of $38,000 to severance costs due tothe transfer and relocation of an employee from the Mexico Facility to our TustinFacility.

 

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There were $0.2 millionof employee severance and stay bonus costs during the first six months of 2007,which included a pro-rata portion from August 10, 2006, the communicationdate, through July 1, 2007, of an estimated amount of statutorily requiredseverance payments and management performance stay-on bonuses incurred foremployees at the Mexico Facility.  TheCompany paid $0.6 million of severance and related expenses to the remainder ofemployees terminated during the three months ended July 1, 2007.   All severance charges were settled with cashas of July 1, 2007.

A summary of therestructuring costs and reserve activity during the nine months ended September30, 2007 is as follows (in thousands):

|                      |   | **Restructuring  Liabilities at December 31, 2006** | ** ** | **Restructuring  Charges** | ** ** | **Cash Paid** | ** ** | **Restructuring  Liabilities at September 30, 2007** |   |
|---------------------------|--------|--------------------------------------------------------------------|------------|----------------------------|------------|--------------------|------------|----------------------------------------------------------------|--------|
| Severance and bonuses     |   | $                                                                  | 429        |                       | $          | 155                |       | $                                                              | (584   | ) | $ | — |   |
| Total Restructuring Costs |   | $                                                                  | 429        |                       | $          | 155                |       | $                                                              | (584   | ) | $ | — |   |

**11.****   STOCK AND DEFERREDCOMPENSATION PLANS**

***2002 Stock Option Plan***

In July 2003, theCompany adopted the Cherokee International Corporation 2002 Stock Option Plan(the “2002 Stock Option Plan”) under which up to 1,410,256 shares of theCompany’s common stock may be issued pursuant to the grant of non-qualifiedstock options to the directors, officers, employees, consultants and advisorsof the Company and its subsidiaries. In connection with the adoption of the2002 Stock Option Plan, the Company granted 1,087,327 stock options. Theoptions typically vest over a four-year period, have a ten-year contractuallife, range in exercise price from $5.85 to $10.34 per share and were grantedwith exercise prices at or above fair value as determined by Cherokee’s Boardof Directors based on income and market valuation methodologies. InFebruary 2004, the Company granted options to purchase 328,320 shares ofcommon stock at an exercise price of $14.50 and terminated the 2002 StockOption Plan. As of September 30, 2007, the Company had granted a total of1,415,647 options to purchase shares of common stock under the 2002 StockOption Plan, which includes options to purchase shares that were cancelled andsubsequently re-granted.

***2004 Omnibus Stock Incentive Plan***

On February 16,2004, the Company adopted the 2004 Omnibus Stock Incentive Plan (the “2004Plan”), which provided for the issuance of 800,000 shares of common stock. The2004 Plan also provides for an annual increase to be**added on the first day of the Company’s fiscal year equalto the lesser of (i) 450,000 shares or (ii) 2% of the number ofoutstanding shares on the last day of the immediately preceding fiscalyear.  As of September 30, 2007, a totalof 2,926,070 shares of the Company’s common stock were reserved for issuanceunder the 2004 Plan. Any officer, director, employee, consultant or advisor ofthe Company is eligible to participate in the 2004 Plan. The 2004 Plan providesfor the issuance of stock-based incentive awards, including stock options, stockappreciation rights, restricted stock, deferred stock, and performance shares.As of September 30, 2007, the Company had granted options to purchase 2,329,489shares of common stock under the 2004 Plan, which includes options to purchaseshares that were cancelled and subsequently re-granted.  Of the cumulative options granted as ofSeptember 30, 2007, 308,153 options were issued as partial compensation tonon-employee directors.

During the three monthsand nine months ended September 30, 2007, 3,750, and 30,000, shares,respectively were issued through the exercise of outstanding vestedoptions.  The Company granted a total of90,000, and 745,500 of options to purchase shares of common stock under the2004 Plan during the three and nine months ended September 30, 2007,respectively. The aggregate fair value of these options granted during thethree and nine months ended September 30, 2007 was $257,000, and $2,143,000,respectively, which will be amortized as stock compensation costs over 4 years.

At the Annual Meeting ofStockholders (the “Annual Meeting”) the Company held on July 17, 2007, thestockholders of the Company approved an amendment to the 2004 Plan to increasethe number of shares of the Company’s common stock reserved for issuance underthe 2004 Plan by 1,000,000 shares.

 *2004 Employee StockPurchase Plan*

On February 16,2004, the Company adopted the 2004 Employee Stock Purchase Plan (the “ESPP”).The ESPP provides for an annual increase to be added on the first day of theCompany’s fiscal year equal to the lesser of (i) 250,000 shares or(ii) 1% of the number of outstanding shares on the last day of theimmediately preceding fiscal year. As of September 30, 2007, a total of 780,721shares of common stock were available for issuance and unissued under the plan.The ESPP, which is intended to qualify as an “employee stock purchase plan”under Section 423 of the Internal Revenue Code of 1986, is implementedutilizing six-month offerings with purchases occurring at six-month intervals,with a new offering period commencing on the first trading day on or afterMay 15 and November 15 and ending on the last trading day on orbefore November 14 or May 14, respectively. The Compensation 

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Committee of theCompany’s Board of Directors oversees administration of the ESPP. Employees areeligible to participate if they are employed for at least 20 hours per week andmore than 5 months in a calendar year by the Company, subject to certainrestrictions. The ESPP permits eligible employees to purchase common stockthrough payroll deductions, which may not exceed 15% of an employee’scompensation. The price of common stock purchased under the ESPP is 85% of thelower of the fair market value of the common stock at the beginning of eachsix-month offering period or on the applicable purchase date. Employees may endtheir participation in an offering at any time during the offering period, andparticipation ends automatically upon termination of employment. The CompensationCommittee may at any time amend or terminate the ESPP, except that no suchamendment or termination may adversely affect shares previously issued underthe ESPP. As of September 30, 2007, a total of 197,314 shares of common stockhad been issued under the ESPP.

*Deferred Compensation Plans*

On February 16,2004, the Company adopted two executive deferred compensation plans for thebenefit of certain designated employees and non-employee directors of theCompany. The plans allow participating employees and non-employee directors tomake pre-tax deferrals of up to 100% of their annual base salary and bonuses,and retainer fees and meeting fees, respectively. The plans allow the Companyto make matching contributions and employer profit sharing credits at the solediscretion of the Company.  Aparticipant’s interest in each matching contribution and employer profitsharing credit, if any, vests in full no later than after 3 years.

As of September 30, 2007,the Company has recorded a liability of $1.4 million, for employee andnon-employee director contributions and investment activity to date, thecurrent portion of which is recorded under accrued compensation and benefitsand the long-term portion of which is recorded in other long-term liabilities.The Company has provided no matching contributions during the quarter endedSeptember 30, 2007 and the prior years.

In January 2008 we have$0.6 million of scheduled distributions to be paid to participants from thedeferred compensation plan.

**12.    RETIREMENTPLANS**

Cherokee Europe maintainsa pension plan for certain levels of staff and management that include adefined benefit feature. The following represents the amounts related to thisdefined benefit plan for the three months and nine months ended September 30,2007 and October 1, 2006, respectively (in thousands):

| ** **                                                           | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|----------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| **Components of Net Periodic Benefit Cost** | ** ** | **September 30, 2007**      | ** ** | **October 1, 2006**   | ** ** | **September 30, 2007** | ** ** | **October 1, 2006** | ** ** |
| Service cost                                                         |       | $                                | 103        |                            | $          | 45 |   | $ | 280 |   | $ | 137 |   |
| Interest cost                                                        |       | 175                              |       | 67                              |       | 382 |   | 182 |   |
| Expected return on plan assets                                       |       | (97                              | )          | (31                             | )          | (213 | ) | (92 | ) |
| Net periodic benefit cost                                            |       | $                                | 181        |                            | $          | 81 |   | $ | 449 |   | $ | 227 |   |

 

**13.  ****SUBSEQUENT EVENTS**

On November 1, 2007, theCompany and General Electric Capital Corporation amended the Credit Facilityfor the revolving line of credit dated February 24, 2004. The amended CreditFacility provides for borrowings of up to the lesser of $7.5 million or 85% ofeligible domestic accounts receivable.  As of September 30, 2007, eligible accounts receivable was $7.6million.  The Credit Facility matures inAugust 2008.  At September 30, 2007and prior, the borrowings bore interest, at the Company’s option, at a rate perannum equal to LIBOR plus 2.5% or the agent bank’s base rate plus 1.0%.Effective November 1, 2007, the borrowings bear interest, at the Company’soption, at a rate per annum equal to LIBOR plus 3.5% or the agent bank’s baserate plus 2.0%. In addition to paying interest on outstanding principal, theCompany is required to pay a commitment fee to the lenders under the creditfacility in respect of the average daily balance of unused loan commitments ata rate of 1.0% per annum effective November 1, 2007. Prior to November 1, 2007the rate was 0.5%  per annum. In lieu ofthe maximum senior leverage multiple covenant, the new amended Credit Facilityeffective November 1, 2007 includes a minimum EBITDA target for the fourthquarter of 2007. Quarterly minimum EBITDA targets for 2008 will be establishedafter the Company completes its 2008 business plan in December 2007. The CreditFacility is secured by a first-priority lien, subject to permittedencumbrances, on substantially all of the Company’s domestic assets and by apledge of 65% of the equity of certain of the Company’s foreign subsidiaries.The Credit Facility contains certain restrictive covenants including theminimum EBITDA target. As of September 30, 2007, there were no borrowingsoutstanding under the Credit Facility, and the Company was in compliance withall of the covenants under the Credit Facility.

 

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**Item 2.   MANAGEMENT’S DISCUSSSIONAND ANALYSIS OF FINANACIAL CONDITION AND RESULTS OF OPERATIONS**

**FORWARD-LOOKING STATEMENTS**

Certain statements inthis Quarterly Report on Form 10-Q, other than purely historicalinformation, including estimates, projections, statements relating to ourbusiness plans, objectives and expected operating results, and the assumptionsupon which those statements are based, are “forward-looking statements” withinthe meaning of the Private Securities Litigation Reform Act of 1995,Section 27A of the Securities Act of 1933 and Section 21E of theSecurities Exchange Act of 1934. These forward-looking statements are based uponour current expectations about future events. When used in this QuarterlyReport, the words “believes,” “projects,” “expects,” “anticipates,”“estimates,” “intends,” “strategy,” “plan,” “may,” “will,” “would,” “will be,”“will continue,” “will likely result,” and similar expressions, or the negativeof such words and expressions, are intended to identify forward-lookingstatements, although not all forward-looking statements contain such words orexpressions. These forward-looking statements generally relate to our plans,objectives and expectations for future operations. However, these statementsare subject to a number of risks and uncertainties affecting our business. Youshould read this Quarterly Report completely and with the understanding thatactual future results may be materially different from what we expect as aresult of these risks and uncertainties and other factors, which include, butare not limited to:  (1) changes ingeneral economic and business conditions, domestically and internationally,(2) reductions in sales to, or the loss of, any of the Company’ssignificant customers or in customer capacity generally, (3) the Company’sinability to realize expected cost savings by shifting production to itsShanghai facility, (4) changes in the Company’s sales mix to lower marginproducts, (5) increased competition in the Company’s industry,(6) disruptions of the Company’s established supply channels, (7) theCompany’s level of debt restrictions imposed by its debt agreements, and therisk that the Company may not be successful in refinancing debt that comes duein 2008, and (8) the additional risk factors in our filings with theSecurities and Exchange Commission, including our Annual Report onForm 10-K (Commission File No. 000-50593).  Except as required by law, the Companyundertakes no obligation to update any forward-looking statements, even thoughthe Company’s situation may change in the future.

**OVERVIEW**

**Business**

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

We operateworldwide and have facilities in Orange County, California; Bombay, India;Wavre, Belgium (Europe) and Shanghai, China. In August 2006, we announcedour intention to close our facility in Guadalajara, Mexico, and we ceasedoperations there in March 2007. 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. In June 2000,we acquired Cherokee Europe, which added a manufacturing facility in Wavre,Belgium to our manufacturing capacity and enabled us to better serve theEuropean market.

We generate all ofour sales in four market sectors; datacom, telecom, industrial, and medical.For the nine months ended September 30, 2007, our revenues by market sectorconsisted of 46% datacom, 29% telecom, and 25% industrial, medical and other.

During the first nine months of 2007, our NorthAmerican markets were down approximately 6% compared to the prior period in2006. Our European operation was down approximately 32% with one large customercontributing up to 62% of the revenue shortfall from the first nine months of2006.

**Basis of Reporting**

***Principles of Consolidation***

The consolidatedfinancial statements include the financial statements of the Company and itswholly owned subsidiaries, Cherokee Europe SCA and related entities (“CherokeeEurope”), Cherokee Electronica, S.A. DE C.V. (“Cherokee Mexico”), CherokeeIndia Pvt. Ltd. (“Cherokee India”), Powertel India Pvt. Ltd.(“Powertel”), and Cherokee International (China) Power Supply LLC (“CherokeeChina”). Inter-company accounts and transactions have been eliminated.

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*Net Sales*

We recognize revenue whenpersuasive evidence of an arrangement exists, title transfer has occurred, theprice is fixed or readily determinable, and collectibility is probable. Werecognize revenue in accordance with Staff Accounting Bulletin No. 104, *Revenue Recognition.*Salesare recorded net of discounts, which are estimated at the time of shipmentbased upon historical data. Changes in assumptions regarding the rate of salesdiscounts earned by our customers could impact our results.

We generally recognizerevenue at the time of shipment because this is the point at which revenue isearned and realizable and the earnings process is complete. For most shipments,title to shipped goods transfers at the shipping point, so the risks andrewards of ownership transfer once the product leaves our facility orthird-party hub. Revenue is only recognized when collectibility is reasonablyassured. Shipping and handling fees are included in revenue, with related costsrecorded to cost of sales.

*Cost ofSales*

The principal elementscomprising cost of sales are raw materials, labor and manufacturing overhead.Raw materials 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 expensesinclude engineering costs, selling and marketing costs and general andadministrative expenses. Engineering costs primarily include salaries andbenefits of engineering personnel, safety approval and quality certificationfees, and depreciation on equipment and consulting and professional services.Selling and marketing expenses primarily include salaries and benefits toaccount managers and commissions to independent sales representatives.Administrative expenses primarily include salaries and benefits for certainmanagement and administrative personnel, professional fees and informationsystem costs. Operating expenses also include the direct expense and allocationof costs attributable to these departments for lease costs, depreciation onproperty, plant and equipment, utilities, property taxes and repairs andmaintenance.

**Critical Accounting Policies**

We prepare our condensedconsolidated financial statements in conformity with accounting principlesgenerally accepted in the United States. As such, we are required to makecertain estimates, judgments and assumptions that we believe are reasonablebased upon the information currently available. These estimates and assumptionsaffect the reported amounts of assets and liabilities at the date of 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 whenpersuasive evidence of an arrangement exists, title transfer has occurred, theprice is fixed or readily determinable, and collectibility is probable. Werecognize revenue in accordance with Staff Accounting Bulletin No. 104, *Revenue Recognition.*Sales are recordednet of discounts, which are estimated at the time of shipment based uponhistorical data. Changes in assumptions regarding the rate of sales discountsearned by our customers could impact our results.

We generally recognizerevenue at the time of shipment because this is the point at which revenue isearned and realizable and the earnings process is complete. For most shipments,title to shipped goods transfers at the shipping point, so the risks andrewards of ownership transfer once the product leaves our facility orthird-party hub. Revenue is only recognized when collectibility is reasonablyassured. Shipping and handling fees are included in revenue with related costsrecorded to cost of sales.

 

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The Company has enteredinto arrangements with certain customers whereby products are delivered to athird-party warehouse location for interim storage until subsequently shippedand accepted by our customers. Revenues from these sales are recognized uponshipment from the third-party warehouse location to the customers, when titlehas passed. The Company generally offers a one-year warranty for defectiveproducts. Warranty charges have been insignificant during the periodspresented.

*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. A significant portion of our accounts receivable are concentrated in asmall number of customers. A significant change in the liquidity or financialposition of any one of these customers could have a material adverse effect onthe collectibility of our accounts receivable, our liquidity and our futureoperating results. As of September 30, 2007, and December 31, 2006, our top tencustomers accounted for approximately 57% and 41% of our accounts receivables,respectively.

*CreditRisk*

The Company performsongoing credit evaluations of its customers and generally does not requirecollateral. The Company maintains reserves for estimated credit losses. TheCompany generally does not charge interest on customer balances.

***Translation of Foreign Currencies***

Foreign subsidiary assetsand liabilities denominated in foreign currencies are translated at theexchange rate in effect on the balance sheet date. Revenues, costs and expensesare translated at the average exchange rate during the period. Transactiongains and losses are included in results of operations and have not beensignificant for the periods presented. The functional currency of CherokeeEurope is the Euro. The functional currency of Cherokee Mexico, Cherokee India,Powertel and Cherokee China is the U.S. dollar, as the majority of transactionsare denominated in U.S. dollars. Translation adjustments related to CherokeeEurope are reflected as a component of stockholders’ equity in othercomprehensive income (loss).

*Inventories*

We value our inventory atthe lower of the actual cost to purchase and/or manufacture the inventory andthe current estimated market value of the inventory using the weighted averagecost method. We regularly review inventory quantities on hand and record aprovision for excess and obsolete inventory based primarily on our historicalusage data and estimates of future demand. Since substantially all of ourproducts are manufactured according to firm purchase orders and customerforecasts, we evaluate the potential of recovery from our customers whencustomized products approach end-of-life. Our customers are generally liablefor inventory costs we incur for order cancellations that occur after we havecommitted resources to procure or manufacture product. We also regularlyevaluate inventory that is non-compliant with the RoHS directive to determineif additional reserves are needed to cover for potential obsolescence. We havenot established a separate reserve for non-RoHS compliant inventory above whatour normal calculations would require.

Our industry ischaracterized by rapid technological change, frequent new product development,and rapid product obsolescence that could result in an increase in the amountof obsolete inventory quantities on hand. As demonstrated during the past fiveyears, demand for our products can fluctuate significantly. A significantincrease in the demand for our products could result in a short-term increasein the cost of inventory purchases while a significant decrease in demand couldresult in an increase in the amount of excess inventory quantities on hand. Inaddition, our estimates of future product demand may prove to be inaccurate, inwhich case we may have understated or overstated the provision required forexcess and obsolete inventory. In the future, if our inventory were determinedto be overvalued, we would be required to recognize additional expense in ourcost of sales at the time of such determination. Likewise, if our inventory isdetermined to be undervalued, we may have over reported our costs of sales inprevious periods and would be required to recognize additional operating incomeat the time such inventory is sold. Therefore, although we 

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make every reasonableeffort to ensure the accuracy of our estimates of future product demand, anysignificant unanticipated changes in demand or technological developments couldhave a material effect on the value of our inventory and our reported operatingresults.

*Deferred Taxes*

We recognize deferred tax assets and liabilities basedon the differences between the financial statement carrying values and the taxbases of assets and liabilities. We regularly review our deferred tax assetsfor recoverability and establish a valuation allowance based on historicaltaxable income, projected future taxable income, and the expected timing of thereversals of existing temporary differences. If our future taxable income issignificantly higher than expected and/or we are able to utilize our taxcredits, we may be required to reverse all or a significant part of ourvaluation allowance against such deferred tax assets which could substantially reduceour effective tax rate for such period. Therefore, any significant changes instatutory tax rates or the amount of our valuation allowance could have amaterial effect on the value of our deferred tax assets and liabilities and ourreported financial results. The preparation of condensed consolidated financialstatements in conformity with generally accepted accounting principles in theUnited States requires us to make estimates and assumptions that affect thereported amount of tax-related assets and liabilities and income taxprovisions. The Company’s effective tax rate may be subject to fluctuationsduring the fiscal year as new information is obtained which may affect theassumptions management uses to estimate the annual effective tax rate includingmix of pre-tax earnings in the various tax jurisdictions in which it operates.

 The Companyadopted the provisions of FASB Interpretation (FIN) 48, *Accounting for Uncertainty in Income Taxes*(FIN 48) on January 1, 2007. FIN 48 clarifies the accounting foruncertainty in income taxes recognized in an enterprise’s financial statementsin accordance with SFAS 109, *Accountingfor Income Taxes*, by prescribing a recognition threshold andmeasurement attribute for the financial statement recognition and measurementof a tax position taken or expected to be taken in a tax return. Under FIN 48,the financial statement effects of a tax position should initially berecognized when it is more likely than not, based on the technical merits, thatthe position will be sustained upon examination. A tax position that meets themore-likely-than-not recognition threshold should initially and subsequently bemeasured as the largest amount of tax benefit that has a greater than fiftypercent likelihood of being realized upon ultimate settlement with a taxingauthority. FIN 48 is effective for fiscal years beginning afterDecember 15, 2006. See Note 3, “Provision for Income Taxes” in Notes toUnaudited Condensed Consolidated Financial Statements for additional informationregarding the impact of adoption.

United States income taxes are not provided onundistributed earnings from certain foreign subsidiaries. Those earnings areconsidered to be permanently re-invested in accordance with the AccountingPrinciples Board (APB) Opinion 23.

***Other Comprehensive Income***

Belgium taxes forunrealized foreign exchange gains on an intercompany loan consideredpermanently re-invested are provided for as a component of other comprehensiveincome. Foreign exchange gains were recognized as Belgium taxable income in2005 and 2006 from repayments of the loan.

*Goodwill and Long Lived Assets*

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

We also review the recoverabilityof the carrying value of long-lived assets whenever events or changes incircumstances indicate that the carrying amount of an asset may not berecoverable. Recoverability of these assets is determined based upon theforecasted undiscounted future net cash flows from the operations to which theassets relate, utilizing our best estimates, appropriate assumptions andprojections at the time.

These projected futurecash flows may vary significantly over time as a result of increasedcompetition, changes in technology, fluctuations in demand, consolidation ofour customers and reductions in average selling prices. If the carrying valueis determined not to be recoverable from future operating cash flows, the assetwould be deemed impaired and an impairment loss would be recognized to theextent the carrying value exceeded the estimated fair market value of theasset.

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*** ***

***Stock-Based Compensation***

The Company adopted SFAS123R on January 2, 2006 using the “modified prospective” method aspermitted by SFAS 123R. Under this transition method, stock compensation costrecognized beginning in the first quarter of fiscal year 2006 includes: (a) compensation cost for all share-based payments granted subsequent toFebruary 25, 2004 and prior to January 2, 2006 but not yet vested asof January 2, 2006, based on the grant-date fair value estimated in accordancewith the provisions of SFAS 123R, and (b) compensation cost for allshare-based payments granted subsequent to January 1, 2006, based on thegrant-date fair value estimated in accordance with the provisions of SFAS 123R.In accordance with the modified prospective method of adoption, the Company’sresults of operations and financial position for prior periods have not beenrestated. At the date of the adoption, the unamortized expense for optionsissued prior to January 2, 2006 was $2.3 million, which will be amortizedas stock compensation costs through December 2010. All grants are made atprices based on the fair market value of the stock on the date of grant.Outstanding options generally vest four years from the grant date, with certainlimited exceptions, and expire up to ten years after the grant date.

The Company records compensation expense for employeestock options based on the estimated fair value of the options on the date ofgrant using the Black-Scholes option pricing formula with the assumptionsincluded in the table under “Stock-Based Compensation” in Note 2 of the Notesto Unaudited Condensed Consolidated Financial Statements. The Company useshistorical data, among other factors, to estimate the expected price volatilityand the expected forfeiture rate. For options granted prior to January 2,2006, the Company used the expected option life of 5 years. For options grantedfollowing the Company’s adoption of SFAS 123R, the expected life was increasedto 6.25 years using the “simplified method” under SAB 107 (an expected termbased on the mid-point between the vesting date and the end of the contractualterm). The options have a maximum contractual term of 10 years and generallyvest as to 25% of the underlying stock on each anniversary of the date ofgrant, subject to accelerated vesting in the event of a change in control ofthe Company.  The risk-free rate is basedon the U.S. Treasury yield curve in effect at the time of grant for theestimated life of the option.

**RESULTSOF OPERATIONS FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2007 COMPARED TO THETHREE MONTHS ENDED OCTOBER 1, 2006**

**NETSALES**

Net sales decreased byapproximately 8.0%, or $2.7 million, to $30.4 million for the three monthsended September 30, 2007 from $33.1 million for the three months ended October 1,2006. Overall sales in the industrial and medical sector decreased by 20.0%, or$1.8 million, to $7.1 million for the three months ended September 30, 2007compared to $8.9 million for the three months ended October 1, 2006 mainly dueto logistical difficulties experienced during the transfer of a specific modelfrom our closed Mexico Facility to China. As of September 30, 2007, the Company had $1.7 million of finished goodsinventory in the newly established hub location necessary to retain business transferredfrom Mexico to China.   Overall sales inthe telecom sector were down 5%, or $0.5 million, to $9.4 million for the threemonths ended September 30, 2007 compared to $9.9 million for the three monthsended October 1, 2006.  Overall sales inthe datacom sector were down 3%, or $0.3 million, to $13.9 million for thethree months ended September 30, 2007 compared to $14.2 million for the threemonths ended October 1, 2006. For the three months ended September 30, 2007,currency fluctuations offset $0.9 million of the decrease in net sales due tosales in Europe by our Cherokee Europe operation.

**GROSSPROFIT**

Gross profit decreased byapproximately 10.1%, or $0.6 million, to $5.7 million for the three monthsended September 30, 2007 from $6.4 million for the three months ended October1, 2006. Gross margin for the three months ended September 30, 2007 decreasedto 18.9% from 19.3% in the prior year period.

For the three monthsended September 30, 2007, the decrease in gross profits was due to the overall lowersales volume and resulted in unfavorable absorption and labor rate efficienciescompared to the three months ended October 1, 2006. For the three months endedSeptember 30, 2007, currency fluctuations offset $0.1 million of the decreasein gross profit related to our Cherokee Europe operation.  During the three months ended September 30,2007, the Company recognized a savings in direct labor costs of $0.1 million asa result of its transfer of production from the Mexico facility to the Chinafacility.  The Company anticipatesincreased direct labor savings as production levels increase in China.

**OPERATINGEXPENSES**

Operating expenses for the three months endedSeptember 30, 2007 decreased by approximately 0.8%, or $0.6 million, to $6.7million from $7.3 million for the three months ended October 1, 2006. As apercentage of net sales, operating expenses decreased to 22.1% from 22.2% inthe prior year period. For the three months ended September 30, 2007, currencyfluctuations offset $0.2 million of the decrease in operating expenses relatedto our Cherokee Europe operation.

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Engineering anddevelopment expense consists primarily of engineering salaries for ongoingdesign and development of active projects. For the three months ended September30, 2007, engineering costs were higher by $0.3 million compared to the threemonths ended October 1, 2006, of which $0.1 million was related to theextensive engineering work performed on product design for one of our largesttelecom customers, and $0.1 million was related to the increase in headcount tosupport our increase in new product development. We currently have adevelopment team of 26 engineers in China compared to 6 in the prior yearperiod. This investment follows our strategic plan to increase the level of ourengineering resources in China to enable us to increase our design activity andallow us to market our product locally, and provide engineering support to ourNorth American and European operations. For the three months ended September30, 2007, currency fluctuations accounted for $0.1 million of the increase inengineering and development costs related to our Cherokee Europe operation.

Selling and marketingexpense consists primarily of sales salaries and commissions, travel,advertising and marketing expenses. For the three months ended September 30,2007, selling and marketing expense decreased by $0.2 million compared to thethree months ended October 1, 2006. During the three months ended September 30,2007, $0.1 million of the decrease was related to lower sales commissions dueto lower sales, and $0.1 million was related to a reduction in sales andmarketing personnel and overall compensation.

General andadministrative expense consists primarily of salaries and other expense formanagement, finance, human resources, and information systems, legal andprofessional fees. For the three months ended September 30, 2007, general andadministrative expense decreased by $0.1 million, of which savings of $0.1million was related to the transfer of operations from Mexico to China,compared to the three months ended October 1, 2006, and $0.1 million wasrelated to a decrease in bonus accruals and professional fees.  However, this decrease was offset by a $0.1million increase in expenses due to currency fluctuations related to CherokeeEurope.

During the three monthsended October 1, 2006, the Company incurred a one-time charge of $0.3 millionrestructuring costs for severance in accordance with SFAS 146, and $0.3 millionof impairment costs for assets impaired in accordance with SFAS 144 compared tono expenses during the three months ended September 30, 2007. The charges werea result of our plan to realign and consolidate our Mexico operations into our Chinaoperations.

**OPERATINGINCOME (LOSS)**

As a result of the factors discussed above, operatingloss for the three months ended September 30, 2007, and the three months endedOctober 1, 2006 was $1.0 million. Operating margin for the three months endedSeptember 30, 2007 increased to a loss of 3.3% from an operating loss of 2.9%in the prior year period. For the three months ended September 30, 2007,currency fluctuations accounted for $0.1 million of the decrease in operatingincome related to our Cherokee Europe operation.

**INTEREST EXPENSE**

Interest expense for thethree months ended September 30, 2007, and October 1, 2006 was $0.7 million foreach period.  The interest expense isprimarily related to payments for the $46.6 million of senior notes bearing interestat 5.25% annually.

**OTHER INCOME (EXPENSE)**

For the three monthsended September 30, 2007 there was less than $0.1 million of other expensecompared to $0.1 million recorded during the three months ended October 1,2006.

**INCOME TAXES**

Benefit for incometaxes for the three months ended September 30, 2007 and the comparable periodof October 1, 2006, was $0.4 million, and $0.2 million, respectively. Thebenefit for the three months ended September 30, 2007 is higher by $0.2 millionthan the comparable period of October 1, 2006 due to operating losses generatedin tax jurisdictions which were taxable in the prior year.  Based on available evidence, managementexpects the benefit to be recognized as a deferred tax asset at year-end.

 

 

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Benefit for incometaxes for the three months ended September 30, 2007 was calculated byestimating taxable income (loss) for certain tax jurisdictions using actualyear to date operating results which represents the best estimate of theeffective tax rate for the full fiscal year.

**NET INCOME (LOSS)**

As a result of thefactors discussed above, we recorded a net loss of $1.3 million for the threemonths ended September 30, 2007, compared to a net loss of $1.4 million for thethree months ended October 1, 2006.

**RESULTSOF OPERATIONS FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2007 COMPARED TO THE NINEMONTHS ENDED OCTOBER 1, 2006**

**NET SALES**

Net sales decreased by approximately 16.3%, or $17.5million, to $90.0 million for the nine months ended September 30, 2007 from$107.5 million for the nine months ended October 1, 2006.

Overall telecom salesdecreased by 34.3%, or $13.6 million, to $26.1 million for the nine monthsended September 30, 2007 compared to $39.7 million for the nine months endedOctober 1, 2006.  The decrease in telecomsales was mainly due to a large triple play customer’s delay in deployment oftheir product.  Overall sales in thedatacom sector were down 7.6%, or $3.5 million, to $41.3 million for the ninemonths ended September 30, 2007, compared to $44.8 million for the nine monthsended October 1, 2006.  Overall sales inthe industrial and medical sector were down 1.6%, or $0.4 million, to $22.6million for the three months ended September 30, 2007 compared to $23.0 millionfor the three months ended October 1, 2006. For the nine months ended September30, 2007, currency fluctuations offset $2.2 million of the decrease in netsales related to our Cherokee Europe operation.

**GROSS PROFIT**

Gross profit decreased by approximately 26.2%, or $6.0million, to $17.0 million for the nine months ended September 30, 2007 from$23.0 million for the nine months ended October 1, 2006. Gross margin for thenine months ended September 30, 2007 decreased to 18.9% from 21.4% in the prioryear period.

For the nine months endedSeptember 30, 2007, the decrease in gross profit was primarily related to theunfavorable absorption and labor rate efficiencies compared to the nine monthsended October 1, 2006, due to the overall lower sales volume. In addition, $0.3million was related to temporarily higher factory overhead costs caused byrunning dual operations in Mexico and China. For the nine months endedSeptember 30, 2007, currency fluctuations offset $0.3 million of the decreasein gross profit related to our Cherokee Europe operation.

**OPERATING EXPENSES**

Operating expenses forthe nine months ended September 30, 2007 increased by approximately 7.4%, or$1.6 million, to $22.7 million from $21.1 million for the nine months endedOctober 1, 2006.  As a percentage of sales, operating expenses increasedto 25.1% from 19.6% in the prior year period. For the nine months endedSeptember 30, 2007, currency fluctuations accounted for $0.6 million of theincrease in operating expenses related to our Cherokee Europe operation.

For the nine months endedSeptember 30, 2007, engineering and development costs increased by $1.2 millioncompared to the nine months ended October 1, 2006, due to the increase inheadcount to support our increase in new product development. Engineering anddevelopment expense was higher by $0.8 million in 2007 compared to the priorperiod in 2006 in our North America and Europe businesses due to ongoing designand development of active projects.  Expenses for our China operation were higher by $0.2 million during thenine months ended September 30, 2007 compared to the prior period in 2006.   We currently have a development team of 26engineers in China compared to 6 in September a year ago. This investmentfollows our strategic plan to increase the level of our engineering resourcesin China to enable us to increase our design activity and allow us to marketour product locally, and provide engineering support to our North American andEuropean operations  For the nine monthsended September 30, 2007, currency fluctuations accounted for $0.2 million ofthe increase in engineering and development costs related to our CherokeeEurope operation.

Selling and marketingexpense consists primarily of sales salaries and commissions, travel, advertisingand marketing expenses. For the nine months ended September 30, 2007, sellingand marketing expense increased by $0.5 million compared to the nine monthsended October 1, 2006, of which $0.4 million is related to a decrease duringthe prior period in 2006 due to a mutual release agreement made with a formerbusiness partner over sales commissions. The agreement released both partiesfrom obligations

 

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arising from pasttransactions. As a result of this agreement, we made a one-time adjustment toreduce our selling and marketing expense by $0.4 million during the threemonths ended April 2, 2006. For the nine months ended September 30, 2007,currency fluctuations accounted for $0.2 million of the increase in selling andmarketing expense related to our Cherokee Europe operation. However, thisincrease was offset by a decrease of $0.1 million in personnel expenses andsales commissions.

General andadministrative expense consists primarily of salaries and other expense formanagement, finance, human resources and information systems. For the ninemonths ended September 30, 2007, general and administrative expense increasedby $0.3 million compared to the nine months ended October 1, 2006.  Net professional fees were higher by $0.1million for the nine months ended September 30, 2007 compared to the priorperiod in 2006, of which $0.3 million was related to higher professional feesand out of pocket expenses from additional work required to file our Form 10-Kfor the year ended December 31, 2006, offset by a decrease of $0.2 million inlower professional fees for quarterly reviews and legal matters in 2007compared to 2006.  For the nine monthsended September 30, 2007, general and administrative expense for CherokeeEurope was higher by $0.2 million due to currency fluctuations.

During the three monthsended October 1, 2006, the Company announced the planned closure of its MexicoFacility. The Company incurred $0.2 million of operating costs related to severanceand facility closure costs for the nine months ended September 30, 2007,compared to $0.6 million in the prior period.

**OPERATING INCOME (LOSS)**

As a result of the factors discussed above, operatingincome decreased to a loss of $5.6 million for the nine months ended September30, 2007 compared to income of $2.0 million for the nine months ended October1, 2006.  Operating margin decreased to a loss of 6.2% from income of 1.8%in the prior year period. For the nine months ended September 30, 2007, currencyfluctuations accounted for $0.3 million of the decrease in operating incomerelated to our Cherokee Europe operation.

**INTEREST EXPENSE**

Interest expense for the nine months ended September30, 2007 was $2.1 million compared to $2.1 million for the nine months endedOctober 1, 2006.  The interest expense is mainly related to our 5.25%senior notes and commitment fees on our senior revolving credit line.

**OTHER INCOME (EXPENSE)**

Other income for the ninemonths ended September 30, 2007 was $0.7 million compared to $0.3 million forthe nine months ended October 1, 2006. Other income increased by $0.4 million in 2007 compared to the priorperiod in 2006 due to a net gain of $0.4 million from the sale of the MexicoFacility building.  See Note 10 to theNotes to Unaudited Condensed Consolidated Financial Statements for additionalinformation.

** **

**INCOMETAXES**

** **

Provision (benefit) for income taxes for the ninemonths ended September 30, 2007 and the comparable period of October 1, 2006was a $2.0 million benefit and a $0.4 million expense, respectively. Thebenefit for the nine months ended September 30, 2007 is higher by $2.4 millionthan the comparable period of October 1, 2006 due to operating losses generatedin tax jurisdictions which were taxable in the prior year.  Based onavailable evidence, management expects the benefit to be recognized as adeferred tax asset at year-end.

 

Provision (benefit) for income taxes for the ninemonths ended September 30, 2007 was calculated by estimating taxable income(loss) for certain tax jurisdictions using actual year to date operatingresults which represents the best estimate of the effective tax rate for thefull fiscal year.

**NET LOSS**

 As a result of the factors discussed above, werecorded a net loss of $5.0 million for the nine months ended September 30,2007, compared to the net loss of $0.2 million for the nine months endedOctober 1, 2006.

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**LIQUIDITYAND CAPITAL RESOURCES**

**CASHFLOWS**

**FOR THE NINEMONTHS ENDED SEPTEMBER 30, 2007 COMPARED TO THE NINE MONTHS ENDED OCTOBER1, 2006**

Net cash used by operating activities for the ninemonths ended September 30, 2007 was $4.6 million, compared to net cash providedby operating activities of $1.0 million for the nine months ended October 1,2006.

Net cash used in operating activities for the ninemonths ended September 30, 2007 reflected a net loss of $5.0 million which wasprimarily a result of $17.5 million lower revenues in 2007 compared to thecomparable period in 2006, offset by a $0.4 million gain in the sale of assetsheld for sale related to the sale of the Mexico Facility building, a $0.8million increase in inventory, $0.1 million increase in deposits and otherassets, a $1.2 million decrease in accounts payable, a $3.6 million decrease inaccrued liabilities and restructuring costs, a $0.1 million decrease in accruedcompensation, and a decrease of $0.6 million in other long-termobligations.  This was offset by $2.4million in depreciation and amortization, $0.1 million in amortization ofdeferred financing costs, $0.6 million of stock-based compensation related toSFAS 123R, a $2.4 million decrease in accounts receivable, a $1.2 milliondecrease in prepaid expenses and other current assets, and a $0.6 millionincrease in interest payable.

Net cash provided by operating activities for the ninemonths ended October 1, 2006 was $1.0 million. Net cash provided by operating activities for the nine months endedOctober 1, 2006 reflected the positive effect of $2.3 million of net incomebefore depreciation and amortization due to higher revenues, $0.3 million ofimpairment charges in relation to the future closure of the Guadalajara, Mexicofacility, $0.5 million of stock-based compensation related to SFAS 123R, a $2.0million increase in accrued compensation and benefits mainly due to theincrease in bonus accrual, $0.6 million increase in interest payable related tothe senior notes payment that was due in November 2006, and an increase of $0.5million in long-term obligations.  These amounts were partially offset bya $0.1 million increase in net accounts receivable due to an increase in ourdays sales outstanding at October 1, 2006, a $2.9 million increase in netinventories due to delayed shipments and a higher backlog, a $0.8 milliondecrease in accounts payable, and a $1.3 million decrease in accruedliabilities and restructuring costs.

Net cash used in investing activities for the ninemonths ended September 30, 2007 was $0.9 million, in which $2.2 million wasrelated to capital expenditures.  Weinvested $2.1 million in our China facility. We received $1.2 million ofproceeds from the sale of the Mexico Facility building in 2007. Net cash usedin investing activities for the nine months ended October 1, 2006 was $2.3 millionrelated to capital expenditure purchases, of which $2.1 million was invested inour China facility.

Net cash provided by financing activities for the ninemonths ended September 30, 2007 and the nine months ended October 1, 2006 was$3.8 million and $0.1 million, respectively. In July 2007, Cherokee Europe borrowed short-term funds of $0.6 millionfrom ING Belgie NV, and paid $0.3 million back during the three months endedSeptember 30, 2007.  The loan arrangementis for six months, with monthly payments of $96,000 to continue until December25, 2007.  The loan bears a 5.3% interestrate. As of September 30, 2007, the outstanding balance owed was $0.3million.   During the three months endedSeptember 30, 2007, Cherokee Europe borrowed $2.0 million from the line ofcredit with Bank Brussels Lambert, a subsidiary of ING Belgie NV.  In January 2007, we opened a credit facilitywith the Industrial and Commercial Bank of China Ltd., or ICBC.  Pursuant to the loan contract, ICBC willadvance up to the equivalent of approximately $3.3 million, expressed as RMB25.0 million. The line is collateralized by the Company’s building in Shanghai,China. During the first three months of 2007, Cherokee China borrowed $1.3million under this credit facility to support working capital requirements asour China subsidiary builds inventory and incur value-added tax on localpurchases. As of September 30, 2007, the outstanding balance of $1.3 milliondue to ICBC remained due. During the nine months ended September 30, 2007, andthe nine months ended October 1, 2006, $0.2 million, and $0.1 million,respectively, of employee stock purchase plan proceeds were received.

**LIQUIDITY**

We expect our liquidity requirements will be primarilyfor working capital and capital expenditures. As of September 30, 2007, we hadcash and cash equivalents of $7.3 million, working capital of$37.9 million, no outstanding borrowings under our main revolving creditfacility and borrowing base availability of $7.5 million under the samefacility.  The Company also experiencedan increase in inventory of $0.8 million since the year ended December 31,2006, driven by an increase in finished goods. Part of the increase is relatedto finished goods inventory shipped to third-party warehouses (hub locations). Revenuesfrom these sales will be

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recognized upon shipment from the hub locations to thecustomers, when title has passed.  Theother part of the increase in inventory was to maximize the utilization of ourrelatively fixed manufacturing labor pool in Europe in anticipation offorecasted customer demand. Historically, we have financed our operations withcash from operations supplemented by borrowings from credit facilities and debtand equity issuances. Besides our credit line in the United States, CherokeeEurope also maintains a working capital line of credit of approximately $4.3million, expressed as Euros 3.0 million, with Bank Brussels Lambert, asubsidiary of ING Belgie NV, a bank in Brussels, which is denominated in Euros,and is collateralized by a pledge in first and second rank over a specificamount of business assets. Our access to the line is limited to $3.8 millionbecause $0.5 million is committed to minimum guarantees on specific collectionsand payments. The facility requires Cherokee Europe to maintain a certainsolvency ratio and is cancelable at any time. However, in August 2007, ING Belgie NV temporarily limited the Company’susage of the line of credit to $2.0 million, which presently prevents us fromany additional borrowing, with the condition that they will review ourcompany’s performance over the next few months to determine when to restore theborrowing availability back to $4.3 million. During the three months ended September 30, 2007, Cherokee Europeborrowed $2.0 million from the line of credit which remained outstanding as ofSeptember 30, 2007.

In January 2007, weopened a credit facility with the Industrial and Commercial Bank of China Ltd.,or ICBC. Pursuant to the contract, ICBC will advance up to the equivalent ofapproximately $3.3 million, expressed as RMB 25.0 million. The line iscollateralized by the Company’s building in Shanghai, China. Interest ispayable monthly at a fixed rate based on the transaction date of our borrowings,the rates vary according to the specific dates and are announced by thePeople’s Bank of China. This facility is intended for working capitalrequirements in China, especially as our China subsidiary builds inventory forexport to the United States and Europe and incur value-added tax on localpurchases that can only be recovered through in-country sales of ourproduct.  As of September 30, 2007,Cherokee China had $1.3 million of borrowings under this line of credit, whichremained unchanged as of April 1, 2007.

Subject to therefinancing risk described below under Contractual Obligations and Item 1A.Risk Factors, we believe our cash flow from operations and our credit lines inthe United States, Europe and China, are sufficient to meet our operating cashrequirements for at least the next twelve months.

The prior two years, 2006and 2005, were unusual in that we financed the building, capital expendituresand start-up working capital requirements of our new Shanghai facility entirelyfrom internally generated cash. Our ongoing current and future liquidity needsprimarily arise from working capital requirements and capital expenditures thathave now returned to comparable historical levels as we have completed theconstruction of our plant in China. Our historical capital expenditures haveprimarily resulted from investments in equipment to increase or replacemanufacturing capacity and to improve manufacturing efficiencies.

For 2007, we originallyexpected global capital expenditures to be approximately $2.9 million.  However, after our most recent forecast ofour capital expenditures requirements for the year, we currently expect tospend $2.6 million.  Most of this spendingwill be in our investments in our manufacturing equipment at our facilities, ofwhich $2.4 million will be for our China facility.  Our required capital investment in Chinastarted decreasing in 2006 and 2007, we expect this decrease to continue at amore rapid rate in the near future.. In 2006, our China facility required $3.0million and in 2005, our initial investment into our China facility required$5.5 million, over two times the anticipated spending for 2007.

As of September 30, 2007,we had approximately $46.6 million of senior notes bearing an annual interestrate of 5.25%, payable semi-annually. These notes become due on November 1, 2008.

***Contractual Obligations***

As of September 30, 2007, our borrowingsconsisted of approximately $46.6 million of senior notes, and no outstandingborrowings under our revolving credit facility.

Our senior notes bearinterest at 5.25% annually, and mature on November 1, 2008. We arerequired to make semi-annual interest payments to holders of the senior notes,payable in cash on May 1 and November 1 of each year. The seniornotes are secured by a second-priority lien on substantially all of ourdomestic assets and by a pledge of 65% of the equity of certain of our foreignsubsidiaries. The Company is actively seeking to refinance this obligation,however, given the current credit market conditions the Company does notforesee refinancing this obligation until 2008. The Company acknowledges that it may not be able to refinance thisobligation at comparable interest rates to the 5.25% annual interest rate inthe past, and could be considerably more.

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On November 1, 2007, theCompany and General Electric Capital Corporation amended the Credit Facilityfor the revolving line of credit dated February 24, 2004. Under our amendedagreement, as of September 30, 2007, our borrowing base was $7.5 million underthe Credit Facility, our eligible accounts receivable was $7.6 million. TheCredit Facility matures in August 2008. We plan to use funds availableunder the Credit Facility to finance working capital and other cashrequirements as needed. The Credit Facility is our senior obligation and ranksequal in right of payment with our existing and future permitted senior debt(including our senior notes), and senior in right of payment to our future permittedsubordinated debt. The Credit Facility is secured by a first-priority lien,subject to permitted encumbrances, on substantially all of our domestic assetsand by a pledge of 65% of the equity of certain of our foreign subsidiaries.

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

During the three months ended September 30, 2007, CherokeeEurope borrowed $2.0 million from the line of credit which remained outstandingas of September 30, 2007. In August 2007, Ing Belgie NV temporarily limited theCompany’s usage of the line of credit to $2.0 million. However, in November2007, after meeting with the Company's management to discuss Cherokee Europe'sfinancial results and prospects, ING Belgie NV restored the line of credit backto its full availability of $4.3 million, less any borrowings outstanding.

As of September 30, 2007,Cherokee China had $1.3 million of borrowings under this line of credit, noadditional borrowings were made since the first quarter of 2007.

As of September 30, 2007,we were in compliance with all of the covenants set forth in the principalagreements governing our debt.

In July 2007, CherokeeEurope borrowed short-term funds of $0.6 million from ING Belgie NV, and paid$0.3 million back during the three months ended September 30, 2007.  The loan arrangement is over six months, withmonthly payments of $96,000 to be paid off by December 25, 2007.  As of September 30, 2007, the outstandingbalance owed was $0.3 million.

For a more detailed discussion related to the abovefinancial instruments and obligations, see the subsection entitled “Debt”contained in Note 6 of the Notes to Unaudited Condensed Consolidated FinancialStatements under “Item 1. Financial Statements.”

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

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

In January 2008 we have$0.6 million of scheduled distributions to be paid to participants from thedeferred compensation plan.

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Thematurities of our long-term debt, including capital leases, and future paymentsrelating to our operating leases and other obligations as of September 30, 2007are as follows (in thousands):
| **Contractual Obligations**      | ** ** | **October 1, 2007 to  December 30, 2007** | ** ** | **2008** | ** ** | **2009** | ** ** | **2010** | ** ** | **2011** | ** ** | **Thereafter** | ** ** | **Total** | ** ** |
|---------------------------------------|------------|----------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------------|------------|-----------|------------|
| Long-term debt                        |       | $                                                        | —     |     | $          | 46,630   |       | $        | —     |     | $          | —         |       | $         | —     |   | $ | — |   | $ | 46,630 |   |
| Operating leases                      |       | 406                                                      |       | 1,634    |       | 592      |       | 30       |       | 20       |       | 112            |       | 2,794     |       |
| Purchase order commitments            |       | 15,372                                                   |       | 86       |       | —   |       | —   |       | —   |       | —         |       | 15,458    |       |
| 1999 Europe restructuring             |       | 70                                                       |       | 166      |       | 323      |       | 60       |       | —   |       | —         |       | 619       |       |
| 2003 Europe restructuring             |       | 84                                                       |       | 256      |       | 250      |       | 230      |       | 189      |       | 386            |       | 1,395     |       |
| Long service award                    |       | 10                                                       |       | 56       |       | 108      |       | 204      |       | 23       |       | 523            |       | 924       |       |
| Deferred compensation                 |       | 63                                                       |       | 642      |       | 75       |       | 49       |       | 68       |       | 505            |       | 1,402     |       |
| Advances for research and development |       | 13                                                       |       | 62       |       | 59       |       | 59       |       | 59       |       | 359            |       | 611       |       |
| Total                                 |       | $                                                        | 16,018     |     | $          | 49,532   |       | $        | 1,407      |     | $          | 632            |       | $         | 359        |   | $ | 1,885 |   | $ | 69,833 |   |

The long-term liability for accrued pension costs included on theconsolidated balance sheet is excluded from the table above. Cherokee is unableto estimate the timing of payments for these costs. During the nine monthsended September 30, 2007, the Company contributed approximately $0.2million.  Cherokee anticipates makingnon-U.S. pension contributions of approximately $0.3 million in 2007.

**RECENTACCOUNTING PRONOUNCEMENTS**

For a discussion of the impact of recently issuedaccounting pronouncements, see the subsection entitled “Recent AccountingPronouncements” contained in Note 2 of the Notes to Unaudited CondensedConsolidated Financial Statements under “Item 1. Financial Statements.”

**Item3.   QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

Market risk relating toour operations results primarily from changes in foreign currency exchangerates and short-term interest rates. We did not have any derivative financialinstruments at September 30, 2007.

We had no variable ratedebt outstanding at September 30, 2007. However, any debt we incur under theCredit Facility and the Cherokee Europe line of credit will bear interest at avariable rate. We cannot predict market fluctuations in interest rates andtheir impact on any variable rate debt we may incur in the future, nor canthere be any assurance that fixed rate long-term debt will be available to usat favorable rates, if at all.

Thefunctional currency for our European operations is the Euro. We are, therefore,subject to a certain degree of market risk associated with changes in foreigncurrency exchange rates. This risk is mitigated by the fact that our revenuesand expenses are generally both transacted in Euros, thereby reducing the riskof foreign currency fluctuation on our European operations. The net effect onour operating income for foreign currency exchange rate fluctuations as of andfor the three months ended September 30, 2007, was not material. However, thenet effect on our operating income for foreign currency exchange ratefluctuations as of and for the nine months ended September 30, 2007, accountedfor a $0.3 million decrease in our income. Historically, we have not activelyengaged in exchange rate-hedging activities.

**Item 4.   CONTROL AND PROCEDURES**

(a)    *Evaluationof Disclosure Controls and Procedures*

As of September 30, 2007, the end of the periodcovered by this Quarterly Report on Form 10-Q, our management, including ourChief Executive Officer and our Chief Financial Officer, reviewed and evaluatedthe effectiveness of our disclosure controls and procedures (as defined inSecurities Exchange Act of 1934, Rule 13a-15(e) and 15d-15(e)). Such disclosurecontrols and procedures are designed to ensure that material information wemust disclose in this report is recorded, processed, summarized, and filed orsubmitted on a timely basis. Based upon this evaluation and due to materialweaknesses existing in our internal controls as of December 31, 2006, whichhave not been fully remediated as of September 30, 2007, we have concludedthat, as of September 30, 2007, our disclosure controls and procedures wereineffective.

 

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(b)    *Changesin Internal Control over Financial Reporting*

A material weakness is a significant deficiency, orcombination of significant deficiencies, that results in more than a remotelikelihood that a material misstatement of the annual or interim financialstatements will not be prevented or detected.

As reported in Item 9A of our Annual Report onForm 10-K (for the year ended December 31, 2006) filed with the Securities andExchange Commission on May 23, 2007, and updated in Item 4 on Form 10-Q (forthe quarter ended July 1, 2007) filed with the Securities and Exchange Commissionon August 14, 2007, we determined that certain material weaknesses in internalcontrol over financial reporting existed, of which the following still exist asof September 30, 2007:

*Architecture of Company’s IT systems does notpresently support the financial reporting requirements of the Company’sinternational operations.*

Our subsidiaries in Indiaand China still maintain disparate financial accounting systems that do notcompletely interface with the Company’s primary ERP system, resulting induplicate accounting entries on multiple systems. This causes a protractedreporting cycle which limits the oversight from corporate headquarters oftransactional details at our international sites. Site level financialstatements are delivered on spreadsheets to the corporate office forconsolidation.

Our European operationhas its own separate ERP system that is integrated into the local accountingsystem; however this system does not automatically interface financially withour corporate headquarters. Therefore, financial results are also delivered toour corporate office by means of spreadsheets, and the corporate office alsohas insufficient visibility to transactional details.

The consolidation of allthese local results delivered on spreadsheets is in turn prepared onspreadsheets at our corporate office. Consolidations performed on spreadsheetsare prone to human error and are difficult to review. As such, the existingconsolidation process requires additional monitoring and oversight. Oversightand monitoring are discussed in more detail below.

The Company is continuingto develop IT interface solutions for key activities in China.  After these solutions are fully implemented,we will determine what IT solutions will be required for our other locations.   In the interim, the Company has supplementedthese technical IT solutions with additional staffing and improved internalmonitoring procedures.

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

*As remediated in second quarter of 2007, theCompany now evaluates historical and projected labor and overhead costs todetermine their reasonableness.  Thisprocess is subject to finance management oversight and review.  The Company still does not track labor byproduct model at most locations.*

*Oversight and monitoringcontrols*

The lack of an integratedfinancial reporting system creates the need for significant manual interventionand staffing to prepare spreadsheets, create eliminating entries, make taxadjustments, and U.S. GAAP adjustments. Additionally, our remote locations, other than Europe, have one localcontroller with little more than clerical support to maintain the localaccounting system, transport information from the ERP system to their local books,report financial statements to our headquarters in the U.S. and perform routinefunctions such as account reconciliations. As part of our SOX 404 compliance efforts, the Company is performing adetailed review of procedures and personnel at each site location.  The Company is committed to resolving alldeficiencies identified.

Wehave identified and have performed or are working on the following remediationto resolve the weakness in oversight and monitoring controls over internationalfinancial reporting:

•           The process of adding structure and uniformity ofaccounting standards and process among our site controllers continues throughdistribution of corporate policies and procedures, planned continueddevelopment and distribution of policies, reinforcement of managementrepresentations and corporate code of conduct, and regular visits by thecorporate controller to various company sites. We continue critical self-review of how accounting is performedworldwide.

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•           An internal audit department charter has been developedand approved by the Audit Committee. Internal audit is currently focused on site visits for Sarbanes-OxleyAct of 2002 compliance (“SOX”) and is also reviewing compliance with selectedkey corporate policies.  Specificfinancial audit testing is being performed in conjunction with the SOXcompliance efforts.

•           The corporate controller is visiting various company sitesto reinforce company accounting policies and financial statement closingprocedures with local controllers.  Thereis additional oversight at the corporate offices with a consolidated reportingpackage being provided to corporate management and significant items beingreviewed with local management.

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.

In addition, subject topreliminary Sarbanes-Oxley internal audits during the third quarter of 2007,significant deficiencies in controls have been identified in some of ourlocations.  These deficiencies include:inadequate fixed asset management systems and procedures in some locationswhich could adversely impact the value of fixed assets and/or depreciation onthe corporate books and inadequate system controls over shipping cutoffs whichtherefore require significant manual intervention to maintain.  Should our manual interventions fail, thisweakness could adversely impact the recording of revenue on the corporatebooks.  These weaknesses are beingactively worked on by the Company.

The continued remediationof the weaknesses identified above and their associated risks is dependent onthe Company’s ability to address these issues effectively. The issues of ITsystems, people and process are interrelated and difficult to separate. Striking the optimum balance betweenimproved process, better trained and supervised staff and mission critical ITimprovements is essential for success.

Except as noted above,there have not been any changes in our internal control over financialreporting (as such term is defined in Rules 13a-15(f) and15d-15(f) under the Exchange Act) during our September 30, 2007quarter-end that have materially affected, or are reasonably likely tomaterially affect, our internal control over financial reporting.

**PART II  OTHER INFORMATION**

**Item1.   Legal Proceedings**

During the quarter ended September 30, 2007, we werenot a party to any material legal proceedings. We are occasionally a party tolawsuits relating to routine matters incidental to our business. As with alllitigation, we can provide no assurance as to the outcome of any particularlawsuit, and we note that litigation inherently involves significant costs.

**Item1A.   Risk Factors**

Except for the updated risk factor described below, therehave been no material changes to the Company’s risk factors from thosedisclosed in the Company’s 2006 Annual Report on Form 10-K. Theinformation below updates, and should be read in conjunction with, the riskfactors and information disclosed in the Company's Form 10-K.

*Any inability to refinance our senior notes on terms favorable to us could have a material adverse effect on our financial condition or results of our operations.*

 

As of September 30, 2007, we had outstanding approximately $46.6 million of senior notes bearing interest at an annual rate of 5.25%.  These notes become due on November 1, 2008.  We intend to consider various alternatives for refinancing this debt before its stated maturity date.  However, our ability to refinance this debt may be negatively impacted by market conditions.  Recently, domestic financial markets have experienced unusual volatility and uncertainty. While these conditions have occurred most visibly within the “subprime” mortgage lending sector of the credit market, liquidity has tightened throughout domestic financial markets generally.  Consequently, our ability to access credit markets in order to refinance our senior notes on reasonable terms is uncertain, and no assurances can be given that we will be successful in arranging a refinancing in a timely manner, on terms satisfactory to us or at all.  Any inability to refinance our senior notes on terms favorable to us could have a material adverse effect on our financial condition or results of our operations.

 

**Item4.   Submission of matters to a vote ofsecurity holders**

At our annual meeting of stockholders, held July 17, 2007, there were 14,182,055 shares, or 73.30% of the 19,346,959 shares outstanding and entitled to vote, represented either in person or by proxy.  Three proposals were presented to a vote of stockholders:

 

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* *

*Proposal* 1.   To elect seven members to the board of directors, each to serve until the next annual meeting of stockholders and until his or her successor has been elected and qualified.  All nominees were elected.

 
| ** **

**Name of Director** | ** ** | ** **

**Position**    | ** ** | **Total Number of  Votes Cast For** | ** ** | **Total Number of  Votes Cast Against** | ** ** | **Total Number of  Votes Withheld** |
|----------------------------------|------------|-----------------------------|------------|-----------------------------------------------|------------|---------------------------------------------------|------------|-----------------------------------------------|
| Raymond Meyer                    |       | Chairman of the Board       |       | 13,897,527                                    |       | —                                            |       | 284,528                                       |
| Jeffrey Frank                    |       | President, CEO and Director |       | 14,154,860                                    |       | —                                            |       | 27,195                                        |
| Vincent Cebula                   |       | Director                    |       | 14,154,860                                    |       | —                                            |       | 27,195                                        |
| Clark Michael Crawford           |       | Director                    |       | 13,897,527                                    |       | —                                            |       | 284,528                                       |
| Daniel Lukas                     |       | Director                    |       | 14,141,797                                    |       | —                                            |       | 40,258                                        |
| Larry Schwerin                   |       | Director                    |       | 14,154,860                                    |       | —                                            |       | 27,195                                        |
| Edward Phillip Smoot             |       | Director                    |       | 13,895,627                                    |       | —                                            |       | 286,428                                       |

 

There were no broker non-votes and abstentions.

 

On October 29, 2007, Vincent Cebula resigned from the board of directors of Cherokee International Corporation (the "Company"). Mr. Cebula's decision to resign was based on his decision to leave Oaktree Capital Management, L.P., a

significant stockholder of the Company, and not the result ofany disagreement relating to the Company's operations, policies or practices.

*Proposal* 2.  To ratify the selection of Mayer Hoffman McCann P.C. as our independent auditors for the fiscal year ending December 30, 2007.

 

Voting to adopt were 14,145,837 shares. Voting against the adoption were 27,994 shares. There were no broker non-votes. Abstentions totaled 8,224 shares.

* *

*Proposal* 3.  To increase the number of shares of the Company’s common stock reserved for issuance under the Company’s 2004 Omnibus Stock Incentive Plan by 1,000,000 shares.

Votingto adopt were 7,554,071 shares. Voting against the adoption were 2,709,983shares. There were 3,913,208 broker non-votes. Abstentions totaled 4,793shares.

** **

**Item 6.   EXHIBITS**

**EXHIBIT INDEX**

Exhibits have heretoforebeen filed with the SEC and are incorporated herein by reference. Managementcontracts or compensatory plans or arrangements are marked with an asterisk.
| **Exhibit No.** | ** ** | **Description**                                                                                                                                                                           |
|----------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1                  |       | Restated Certificate of  Incorporation of Cherokee International Corporation.(1)                                                                                                          |
| 3.2                  |       | Amended and Restated  By-Laws of Cherokee International Corporation.(1)                                                                                                                   |
| 4.1                  |       | Specimen 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)                                                                                                                                             |
| 31.1                 |       | Certification of  President, Chief Executive Officer, and Director 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.                                        |

 

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(1)   Incorporated by reference fromthe Registration Statement on Form S-8, filed by the Registrant onMarch 16, 2004.

(2)   Incorporated by reference fromthe Registration Statement on Form S-1 (File No. 333-110723), filedby the Registrant on November 25, 2003.

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

 

 

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**SIGNATURES**

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned, thereunto duly authorized.
|                         | CHEROKEE INTERNATIONAL CORPORATION |                                                               |
|------------------------------|------------------------------------|--------------------------------------------------------------------|
|                         |                               |                                                               |   |
| Date: November 13, 2007 | By:                                | /s/ JEFFREY M. FRANK                                               |   |
|                         |                               | Jeffrey M. Frank                                                   |   |
|                         |                               | President, Chief Executive Officer, and Director                   |   |
| Date: November 13, 2007 | By:                                | /s/ LINSTER W. FOX                                                 |   |
|                         |                               | Linster W. Fox                                                     |   |
|                         |                               | Executive Vice President, Chief Financial Officer, 

and Secretary |   |

 

 

 

 

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