** **

**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSIONWashington, D.C.  20549**

** **

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**FORM10-Q**

** **

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

 

**For the quarterly period ended March 31, 2004**

** **

**OR**

 

**o****TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OFTHE SECURITIES EXCHANGE ACT OF 1934**

 

**For the transition period            to            **

** **

**Commissionfile number 000-50593**

 

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**CHEROKEEINTERNATIONAL CORPORATION**(Exact name ofRegistrant as specified in its charter)

 

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

** **

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

 

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**N/A**

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

 

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Indicate by check mark whether the registrant: (1) hasfiled all reports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days:   Yes o   No  ý

 

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

 

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

 

| **Class**                      |   | **Outstanding at April 30, 2004** |
|--------------------------------|--------|-----------------------------------|
| Common stock, $0.001 par value |   | 19,182,254                        |

 

 

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TABLEOF CONTENTS

 
| PART  I—FINANCIAL INFORMATION                                                                         |                                                                                                                    | 3      |
|------------------------------------------------------------------------------------------------------------|-------------------------------------------------------------------------------------------------------------------------|--------|
|                                                                                                       |                                                                                                                    |   |
| Item  1.  Condensed Consolidated Financial  Statements (unaudited):                                   | 3                                                                                                                       |
|                                                                                                       |                                                                                                                    |
|                                                                                                       | Condensed  Consolidated Balance Sheets—March 31, 2004 and December 31, 2003                                        | 3      |
|                                                                                                       |                                                                                                                    |   |
|                                                                                                       | Condensed  Consolidated Statements of Operations—For the Three Months Ended March 31, 2004  and 2003               | 4      |
|                                                                                                       |                                                                                                                    |   |
|                                                                                                       | Condensed  Consolidated Statements of Comprehensive Operations—For the Three Months  Ended March 31, 2004 and 2003 | 5      |
|                                                                                                       |                                                                                                                    |   |
|                                                                                                       | Condensed  Consolidated Statements of Cash Flows—For the Three Months Ended March 31,  2004 and 2003               | 6      |
|                                                                                                       |                                                                                                                    |   |
|                                                                                                       | Notes  to Condensed Consolidated Financial Statements                                                                   | 7      |
|                                                                                                       |                                                                                                                    |   |
| Item  2.  Management’s Discussion and Analysis of Financial Condition and Results  of Operations | 13                                                                                                                      |
|                                                                                                       |                                                                                                                    |   |
| Item  3.  Quantitative and Qualitative Disclosures About Market Risk                                  | 20                                                                                                                      |
|                                                                                                       |                                                                                                                    |   |
| Item  4.  Controls and Procedures                                                                     |                                                                                                                    | 20     |
|                                                                                                       |                                                                                                                    |   |
| PART  II—OTHER INFORMATION                                                                            |                                                                                                                    | 21     |
|                                                                                                       |                                                                                                                    |   |
| Item 1.  Legal Proceedings                                                                            |                                                                                                                    | 21     |
|                                                                                                       |                                                                                                                    |   |
| Item 2.  Changes in  Securities, Use of Proceeds and Issuer Purchases of Equity Securities            | 21                                                                                                                      |
|                                                                                                       |                                                                                                                    |   |
| Item 4.  Submission of  Matters to a Vote of Security Holders                                         | 21                                                                                                                      |
|                                                                                                       |                                                                                                                    |   |
| Item 6.  Exhibits and Reports  on Form 8-K                                                            |                                                                                                                    | 21     |
|                                                                                                       |                                                                                                                    |   |
| Signatures                                                                                                 |                                                                                                                    | 23     |
|                                                                                                            |                                                                                                                         |        |  |

 

2

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PARTI.  FINANCIALINFORMATION

**Item 1****.  Consolidated Financial Statements.**

 

CHEROKEEINTERNATIONAL CORPORATION AND SUBSIDIARIES

CONDENSEDCONSOLIDATED BALANCE SHEETS

(InThousands, Except Share Data)

(Unaudited)

 
|                                                                                                                                                                               |   | **March 31,  2004** |   | **December 31,  2003** |   |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|---------------------|--------|-----------------------------|--------|
|                                                                                                                                                                               |   |                |   |                        |   |
| ASSETS                                                                                                                                                                             |   |                |   |                        |   |
| CURRENT ASSETS:                                                                                                                                                                    |   |                |   |                        |   |
| Cash and cash equivalents                                                                                                                                                          |   | $                   | 20,064 |                        | $      | 4,887 |   |
| Short-term investments                                                                                                                                                             |   | 98                  |   | 91                          |   |
| Accounts receivable, net                                                                                                                                                           |   | 24,065              |   | 25,579                      |   |
| Inventories                                                                                                                                                                        |   | 24,111              |   | 24,932                      |   |
| Prepaid expenses and other current assets                                                                                                                                          |   | 3,120               |   | 1,842                       |   |
| Total current assets                                                                                                                                                               |   | 71,458              |   | 57,331                      |   |
|                                                                                                                                                                               |   |                |   |                        |   |
| Property and equipment, net                                                                                                                                                        |   | 12,856              |   | 12,781                      |   |
| Deposits                                                                                                                                                                           |   | 321                 |   | 250                         |   |
| Deferred financing costs, net                                                                                                                                                      |   | 497                 |   | 536                         |   |
| Goodwill                                                                                                                                                                           |   | 6,317               |   | 6,317                       |   |
|                                                                                                                                                                               |   |                |   |                        |   |
|                                                                                                                                                                               |   | $                   | 91,449 |                        | $      | 77,215 |   |
| LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT)                                                                                                                                |   |                |   |                        |   |
| CURRENT LIABILITIES:                                                                                                                                                               |   |                |   |                        |   |
| Accounts payable                                                                                                                                                                   |   | $                   | 12,820 |                        | $      | 12,854 |   |
| Accrued liabilities                                                                                                                                                                |   | 8,512               |   | 7,073                       |   |
| Accrued restructuring costs                                                                                                                                                        |   | 235                 |   | 1,144                       |   |
| Accrued compensation and benefits                                                                                                                                                  |   | 6,268               |   | 7,346                       |   |
| Accrued interest payable                                                                                                                                                           |   | 1,044               |   | 746                         |   |
| Revolving lines of credit                                                                                                                                                          |   | —              |   | 6,132                       |   |
| Current portion of long-term debt                                                                                                                                                  |   | —              |   | 2,562                       |   |
| Current portion of capital lease obligations                                                                                                                                       |   | 528                 |   | 848                         |   |
| Total current liabilities                                                                                                                                                          |   | 29,407              |   | 38,705                      |   |
|                                                                                                                                                                               |   |                |   |                        |   |
| Long-term debt, net of current portion                                                                                                                                             |   | 46,630              |   | 162,893                     |   |
| Other long-term obligations                                                                                                                                                        |   | 3,666               |   | 5,585                       |   |
|                                                                                                                                                                               |   |                |   |                        |   |
| COMMITMENTS AND CONTINGENCIES (Note 12)                                                                                                                                            |   |                |   |                        |   |
|                                                                                                                                                                               |   |                |   |                        |   |
| STOCKHOLDERS’ EQUITY (DEFICIT)                                                                                                                                                |   |                |   |                        |   |
| Preferred stock:  $0.001 par  value; 10,000,000 shares authorized; none issued and outstanding                                                                                |   | —              |   | —                      |   |
| Common stock:  $0.001 par  value; 60,000,000 shares authorized; 19,182,254 and 2,213,754 shares issued and  outstanding at March 31, 2004 and December 31, 2003, respectively |   | 19                  |   | 2                           |   |
|                                                                                                                                                                               |   |                |   |                        |   |
| Paid-in capital                                                                                                                                                                    |   | 183,549             |   | 43,710                      |   |
| Accumulated deficit                                                                                                                                                                |   | (173,947            | )      | (176,107                    | )      |
| Accumulated other comprehensive income                                                                                                                                             |   | 2,125               |   | 2,427                       |   |
|                                                                                                                                                                               |   |                |   |                        |   |
| Net stockholders’ equity (deficit)                                                                                                                                            |   | 11,746              |   | (129,968                    | )      |
|                                                                                                                                                                               |   |                |   |                        |   |
|                                                                                                                                                                               |   | $                   | 91,449 |                        | $      | 77,215 |   |

 

See notes to condensedconsolidated financial statements.

 

3

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CHEROKEE INTERNATIONALCORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATEDSTATEMENTS OF OPERATIONS

(In Thousands, Except PerShare Amounts)

(Unaudited)

 
|                                        |   | **Three  Months Ended** |   |
|---------------------------------------------|--------|-------------------------|--------|
|                                        |   | **March 31,  2004**     |   | **March 31,  2003** |   |
|                                        |   |                    |   |   |   |
| Net sales                                   |   | $                       | 36,832 |   | $ | 21,041 |   |
| Cost of sales                               |   | 24,909                  |   | 16,220 |   |
| Gross profit                                |   | 11,923                  |   | 4,821 |   |
| Operating Expenses:                         |   |                    |   |   |   |
| Engineering and development                 |   | 2,331                   |   | 2,039 |   |
| Selling and marketing                       |   | 1,830                   |   | 1,158 |   |
| General and administrative                  |   | 2,087                   |   | 1,633 |   |
| Total operating expenses                    |   | 6,248                   |   | 4,830 |   |
|                                        |   |                    |   |   |   |
| Operating income (loss)                     |   | 5,675                   |   | (9 | ) |
|                                        |   |                    |   |   |   |
| Interest expense                            |   | (3,081                  | )      | (4,088 | ) |
| Other income (expense), net                 |   | (3                      | )      | 796 |   |
| Income (loss) before income taxes           |   | 2,591                   |   | (3,301 | ) |
| Provision for income taxes                  |   | 431                     |   | 29 |   |
| Net income (loss)                           |   | $                       | 2,160  |   | $ | (3,330 | ) |
|                                        |   |                    |   |   |   |
| Net income (loss) per share:                |   |                    |   |   |   |
| Basic                                       |   | $                       | 0.23   |   | $ | (1.61 | ) |
| Diluted                                     |   | $                       | 0.20   |   | $ | (1.61 | ) |
|                                        |   |                    |   |   |   |
| Weighted average common shares outstanding: |   |                    |   |   |   |
| Basic                                       |   | 9,299                   |   | 2,073 |   |
| Diluted                                     |   | 15,931                  |   | 2,073 |   |

 

See notes to condensedconsolidated financial statements.

 

4

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CHEROKEE INTERNATIONALCORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATEDSTATEMENTS OF COMPREHENSIVE OPERATIONS

(In Thousands)

(Unaudited)

 
|                                     |   | **Three  Months Ended** |   |
|------------------------------------------|--------|-------------------------|--------|
|                                     |   | **March 31,  2004**     |   | **March 31,  2003** |   |
|                                     |   |                    |   |   |   |
| Net income (loss)                        |   | $                       | 2,160  |   | $ | (3,330 | ) |
| Other comprehensive loss:                |   |                    |   |   |   |
| Foreign currency translation adjustments |   | (302                    | )      | (210 | ) |
| Comprehensive income (loss)              |   | $                       | 1,858  |   | $ | (3,540 | ) |

 

See notes to condensedconsolidated financial statements.

 

5

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CHEROKEE INTERNATIONALCORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATEDSTATEMENTS OF CASHFLOWS

(In Thousands)

(Unaudited)

 
|                                                                                  |   | **Three  Months Ended** |   |
|---------------------------------------------------------------------------------------|--------|-------------------------|--------|
|                                                                                  |   | **March 31,  2004**     |   | **March 31,  2003** |   |
|                                                                                  |   |                    |   |   |   |
| CASH FLOWS FROM OPERATING ACTIVITIES:                                                 |   |                    |   |   |   |
| Net income (loss)                                                                     |   | $                       | 2,160  |   | $ | (3,330 | ) |
| Adjustments to reconcile net income (loss) to net cash used in  operating activities: |   |                    |   |   |   |
| Depreciation and amortization                                                         |   | 881                     |   | 898 |   |
| Gain on sale of land                                                                  |   | —                  |   | (367 | ) |
| Amortization of deferred financing costs                                              |   | 55                      |   | 69 |   |
| Write-off of unamortized deferred financing costs and debt discount                   |   | 224                     |   | — |   |
| Net change in operating assets and liabilities:                                       |   |                    |   |   |   |
| Accounts receivable, net                                                              |   | 1,131                   |   | 1,310 |   |
| Inventories, net                                                                      |   | 614                     |   | 9 |   |
| Prepaid expenses and other current assets                                             |   | (1,988                  | )      | 138 |   |
| Deposits                                                                              |   | (71                     | )      | (91 | ) |
| Accounts payable                                                                      |   | 164                     |   | (871 | ) |
| Accrued liabilities and accrued restructuring costs                                   |   | (1,201                  | )      | (1,537 | ) |
| Accrued compensation and benefits                                                     |   | (954                    | )      | 366 |   |
| Accrued interest payable                                                              |   | 298                     |   | (974 | ) |
| Other long-term obligations                                                           |   | (1,830                  | )      | 4,175 |   |
| Net cash used in operating activities                                                 |   | (517                    | )      | (205 | ) |
|                                                                                  |   |                    |   |   |   |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                                 |   |                    |   |   |   |
| Additions to property and equipment                                                   |   | (1,148                  | )      | (342 | ) |
| Net change in short-term investments                                                  |   | (8                      | )      | 294 |   |
| Proceeds from sale of land                                                            |   | —                  |   | 517 |   |
| Net cash provided by (used in) investing activities                                   |   | (1,156                  | )      | 469 |   |
|                                                                                  |   |                    |   |   |   |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                                 |   |                    |   |   |   |
| Borrowings on revolving lines of credit                                               |   | 11,301                  |   | 13,860 |   |
| Payments on revolving lines of credit                                                 |   | (17,433                 | )      | (11,597 | ) |
| Payments on obligations under capital leases                                          |   | (306                    | )      | (320 | ) |
| Payments on long-term debt                                                            |   | (65,519                 | )      | (513 | ) |
| Deferred financing costs                                                              |   | (175                    | )      | — |   |
| Proceeds from the exercise of warrants and stock options                              |   | 16                      |   | — |   |
| Net proceeds from sale of common stock                                                |   | 89,001                  |   | — |   |
| Net cash provided by financing activities                                             |   | 16,885                  |   | 1,430 |   |
|                                                                                  |   |                    |   |   |   |
| Cash effect of exchange rate changes                                                  |   | (35                     | )      | (456 | ) |
|                                                                                  |   |                    |   |   |   |
| Net increase in cash and cash equivalents                                             |   | 15,177                  |   | 1,238 |   |
| Cash and cash equivalents, beginning of period                                        |   | 4,887                   |   | 8,504 |   |
|                                                                                  |   |                    |   |   |   |
| Cash and cash equivalents, end of period                                              |   | $                       | 20,064 |   | $ | 9,742 |   |
|                                                                                  |   |                    |   |   |   |
| SUPPLEMENTAL INFORMATION                                                              |   |                    |   |   |   |   |   |
| Conversion of senior convertible notes into common stock                              |   | $                       | 53,370 |   | $ | — |   |
| Accrued initial public offering costs netted against paid-in capital                  |   | 2,531                   |   | — |   |

 

See notes to condensedconsolidated financial statements.

 

6

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CHEROKEE INTERNATIONAL CORPORATION AND SUBSIDIARIES

NOTES TOCONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

1.                                       Natureof Operations

 

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

 

*Initial Public Offering*

 

The Company completed its initial public offering of 6,600,000 sharesof its common stock, par value $0.001 per share (“Common Stock”), on February25, 2004, at a price of $14.50 per share. The net proceeds to the Company from this offering were $89.0 million,before offering costs of $2.5 million. The Company used $73.2 million to repay outstanding indebtedness andaccrued interest relating to the term loans, revolving lines of credit, secondlien notes, as well as accrued interest and interest added to the principalamount of its senior convertible notes. Immediately prior to the consummation of the offering, the Companycompleted a 1 for 3.9 reverse stock split of its outstanding Common Stock.  All share and per share amounts for allperiods presented in this report reflect this split.  Also in connection with the offering, the Company issued6,283,796 shares of Common Stock upon conversion of the original principalamount of its outstanding senior convertible notes of $53.4 million, and issued4,071,114 shares of Common Stock upon the exercise of outstanding warrants.

 

2.                                       Basisof Presentation and Summary of Significant Accounting Policies

 

*Basisof Presentation*

 

The information set forth in the accompanying condensed consolidatedfinancial statements is unaudited and, in the opinion of management, reflectsall adjustments, consisting only of normal recurring adjustments, considerednecessary to present fairly the financial position, results of operations andcash flows of the Company for the periods indicated.

 

Results of operations for the interim three months ended March 31, 2004and 2003 are not necessarily indicative of the results of operations for thefull fiscal year. The Company’s first quarter represented the 13-week periodsended on March 28, 2004 and March 30, 2003. For presentation purposes, thesefiscal quarters have been referred to as ending on March 31.

 

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

 

Certain information normally included in footnote disclosure to thefinancial statements has been condensed or omitted in accordance with the rulesand regulations of the Securities and Exchange Commission. Accordingly, thefinancial statements do not include all the information and note disclosuresnormally included in annual consolidated financial statements prepared inaccordance with accounting principles generally accepted in the United Statesof America. These unaudited condensed consolidated financial statements shouldbe read in conjunction with the other disclosures contained herein and with theCompany’s audited consolidated financial statements and notes thereto for theyear ended December 31, 2003, contained in the Company’s Registration Statementon Form S-1 (File No. 333-110723) filed on February 19, 2004.

 

*Use of Estimates*

 

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

 

7

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*Reclassifications*

 

Certain items in the prior period consolidated financial statementshave been reclassified to conform to the current period presentation.

 

*Stock Based Compensation*

 

As permitted by SFAS No.123, “Accounting for Stock-Based Compensation,” the Company accounts for itsemployee stock-based compensation plan using the intrinsic value method underAPB Opinion No. 25 and provides the expanded disclosures specified in SFAS No. 123,as amended by SFAS No. 148.

 

The table belowreconciles net income (loss) as reported and pro forma net income (loss) hadcompensation cost been determined using the provisions of SFAS No. 123 for thethree months ended March 31, 2004 and 2003 (in thousands).

 

|                                                                                                                      |   | **March 31,  2004** |    | **March 31,  2003** |    |
|---------------------------------------------------------------------------------------------------------------------------|--------|---------------------|---------|---------------------|---------|
| Net income (loss) as reported                                                                                             |   | $                   | 2,160   |                | $       | (3,330 | ) |
| Stock-based employee compensation included  in net income (loss), net of tax                                              |   | —              |    | —              |    |
| Total stock-based employee compensation  expense determined under the fair value based method for all awards, net of  tax |   | (210                | )  | (38                 | )  |
| Net income (loss)-pro forma                                                                                               |   | $                   | 1,950   |                | $       | (3,368 | ) |
| Pro forma net income (loss) per share:                                                                                    |   |                |    |                |    |
| Basic                                                                                                                     |   | $                   | 0.21    |                | $       | (1.62 | ) |
| Diluted                                                                                                                   |   | $                   | 0.19    |                | $       | (1.62 | ) |

 

For the purpose of estimating the compensation cost of the Company’soption grants in accordance with SFAS No. 123, the fair value of each optiongrant is estimated on the date of grant using the Black-Scholes option-pricingmodel, with the following weighted average assumptions used for grants duringthe three months ended March 31, 2004: expected stock price volatility of 52%;risk-free interest rate of 3.66%; no dividends; and expected lives of fiveyears.  The assumptions used for thethree months ended March 31, 2003 were: expected stock price volatility ofzero; risk-free interest rate of 5%; no dividends; and expected lives of fiveyears.

 

*Translation of Foreign Currency*

 

Foreign subsidiary assets and liabilities denominated in foreigncurrencies are translated at the exchange rate on the balance sheet date.  Revenues, costs and expenses are translatedat the average exchange rate during the period.  Transaction gains and losses are included in results of operationsand have not been significant for the periods presented.  The functional currency of the Company’soperating subsidiary in Europe, Cherokee Europe SCA (“Cherokee Europe”), is theEuro.  The functional currency of theCompany’s operating subsidiaries in Mexico (Cherokee Electronica, S.A. DE C.V.)and in India (Cherokee India Pvt. Ltd. and Powertel India Pvt. Ltd.) is theU.S. dollar as the majority of transactions are denominated in U.S.dollars.  Translation adjustmentsrelated to Cherokee Europe are reflected in other comprehensive operations.

 

3.                                       Inventories

 

Inventories are valued at the lower of cost (first-in, first-out) ormarket. Inventory costs include the cost of material, labor and manufacturingoverhead and consist of the following, net of reserve for obsolescence (inthousands):

 
|            |   | **March 31,  2004** |   | **December  31,  2003** |   |
|-----------------|--------|---------------------|--------|-------------------------|--------|
|            |   |                |   |                    |   |
| Raw material    |   | $                   | 16,066 |                    | $      | 16,244 |   |
| Work-in-process |   | 4,873               |   | 4,662                   |   |
| Finished goods  |   | 3,172               |   | 4,026                   |   |
|            |   |                |   |                    |   |
|            |   | $                   | 24,111 |                    | $      | 24,932 |   |

 

As of March 31, 2004 and December 31, 2003, the reserve for inventoryobsolescence was $4.3 million and $4.2 million, respectively.

 

8

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4.                                       IncomeTaxes

 

The Company accounts for income taxes in accordance with SFAS No. 109,“Accounting for Income Taxes.”  Inaccordance with SFAS No. 109, deferred tax assets and liabilities are recordedfor the estimated future tax effects of temporary differences between thecarrying value of assets and liabilities for financial reporting and their taxbasis, and carryforwards to the extent they are realizable.  A deferred tax provision or benefit resultsfrom the net change in deferred tax assets and liabilities during theperiod.  A deferred tax asset valuationallowance is recorded if it is more likely than not that all or a portion ofthe recorded deferred tax assets will not be realized.  As of March 31, 2004, deferredtax assets include $42.7 million relating to a tax basis step up from arecapitalization transaction in 1999 and $12.5 million of net operating losscarryforwards.  The Company has recordeda full valuation allowance against its deferred tax assets.

 

The provision for income taxes of $0.4million for the three months ended March 31, 2004 was calculated using anestimated effective tax rate for 2004 of 16.6%, which reflects estimatedtaxable income in Belgium after using available net operating losses in2004.  Income generated in the UnitedStates during 2004 is expected to be fully offset by available net operatinglosses, resulting in the relatively low effective tax rate for the year.

 

5.                                       NetIncome (Loss) Per Share

 

In accordance with SFAS No. 128, “Earnings Per Share”, basic earnings(loss) per share is based upon the weighted average number of common sharesoutstanding.  Diluted earnings (loss)per share is based upon the weighted average number of common and potentialcommon shares for each period presented. Potential common shares include the dilutive effect of stock options andwarrants under the treasury stock method and senior convertible notes under theif-converted method.  For purposes ofthe diluted earnings (loss) per share calculation for the three months endedMarch 31, 2004, the senior convertible notes are assumed to have been convertedat the beginning of the period, and as a result, net income has been increasedby $1.0 million for the reduction in interest expense related to the seniorconvertible notes.

 

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

 
|                                                     |   | **Three  Months  Ended  March 31, 2004** |   | **Three  Months  Ended  March 31, 2003** |   |
|----------------------------------------------------------|--------|------------------------------------------|--------|------------------------------------------|--------|
|                                                     |   |                                     |   |                                     |   |
| Net income (loss)                                        |   | $                                        | 2,160  |                                     | $      | (3,330 | ) |
|                                                     |   |                                     |   |                                     |   |
| Shares:                                                  |   |                                     |   |                                     |   |
| Weighted-average common shares  outstanding—basic   |   | 9,299                                    |   | 2,073                                    |   |
| Effect of dilutive securities:                           |   |                                     |   |                                     |   |
| Senior convertible notes and warrants                    |   | 6,031                                    |   | —                                   |   |
| Outstanding stock options                                |   | 601                                      |   | —                                   |   |
| Weighted-average common shares  outstanding—diluted |   | 15,931                                   |   | 2,073                                    |   |
|                                                     |   |                                     |   |                                     |   |
| Net income (loss) per share:                             |   |                                     |   |                                     |   |
| Basic                                                    |   | $                                        | .23    |                                     | $      | (1.61 | ) |
| Diluted                                                  |   | $                                        | .20    |                                     | $      | (1.61 | ) |

 

6.                                       RecentAccounting Pronouncements

 

In January 2003, the FASB issued FIN 46, “Consolidation of VariableInterest Entities.”  In general, avariable interest entity is a corporation, partnership, trust or any otherlegal structure used for business purposes that either (a) does not have equityinvestors with voting rights or (b) has equity investors that do not providesufficient financial resources for the entity to support its activities.  FIN 46 requires a variable interest entityto be consolidated by a company if that company is subject to a majority of therisk of loss from the variable interest entity’s activities or entitled toreceive a majority of the entity’s residual returns or both.  The consolidation requirements of FIN 46apply immediately to variable interest entities created after January 31, 2003.  The consolidation requirements apply toolder entities in the first fiscal year or interim period beginning afterDecember 15, 2003.  Certain of thedisclosure requirements apply in all financial statements issued after January31, 2003, regardless of when the variable interest entity was established.  The Company did not have any variableinterest entities as of March 31, 2004. The early adoption of FIN 46 did not have a material impact on theCompany’s consolidated results of operations or financial position.  With respect to variable interest entitiescreated before January 31, 2003, in December 2003 the FASB issued FIN 46Rwhich, among other things, revised the implementation date to first fiscalyears or interim periods ending after March 15, 2004, with the exception ofSpecial Purpose Entities (“SPE”). The consolidated requirements apply to allSPE’s in the first fiscal year or interim period ending after December 15,2003. As the Company has determined that it does not have any SPE’s to whichthese interpretations apply, the Company adopted FIN 46R in the first quarterof 2004 and such adoption did not have a material impact on its financialstatements.

 

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7.                                       DeferredFinancing Costs

 

Net deferred financing costs are comprised of the following as of March31, 2004 and December 31, 2003 (in thousands):

 
|                          |   | **March 31,  2004** |   | **December  31,  2003** |   |
|-------------------------------|--------|---------------------|--------|-------------------------|--------|
|                          |   |                |   |                    |   |
| Deferred financing costs      |   | $                   | 506    |                    | $      | 834 |   |
| Accumulated amortization      |   | (9                  | )      | (298                    | )      |
|                          |   |                |   |                    |   |
| Deferred financing costs, net |   | $                   | 497    |                    | $      | 536 |   |

 

The Company amortizes deferred financing costs over the life of therelated debt, which is currently 4.5 years. During the three months ended March 31, 2004, the Company wrote-offunamortized deferred financing costs of $0.2 million and fully amortizeddeferred financing costs of $0.3 million, as a result of the repayment ofoutstanding indebtedness.

 

8.                                       Long-TermDebt

 

Long-term debt consists of the following at March 31, 2004 and December31, 2003 (in thousands):

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

 

Presented below is a breakdown of our long-term debt payable to thirdparties and affiliates at March 31, 2004 and December 31, 2003 (in thousands):

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

 

As of March 31, 2004, all of the Company’s long-term debt was scheduledto be repaid in 2008.

 

In connection with the Company’s initial public offering, the Companyamended and restated its existing senior revolving credit facility with GeneralElectric Capital Corporation.  Thefacility (the “Credit Facility”) provides for borrowings of up to $20.0 millionthat are subject to a borrowing base comprised of eligible accounts receivable andinventory, which was $11.6 million at March 31, 2004.  The Credit Facility has a term of 4.5 years and borrowings bearinterest, at the Company’s option, at a rate per annum equal to the LIBOR Rateplus 2.5% or the agent bank’s base rate plus 1.0%.  In addition to paying interest on outstanding principal, theCompany is required to pay a commitment fee to the lenders under the amendedfacility in respect of the average daily balance of unused loan commitments ata rate of 0.5% per annum.  The CreditFacility is secured by a first-priority lien, subject

 

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to permitted encumbrances, onsubstantially all of the Company’s domestic assets and by a pledge of 65% ofthe equity of certain of the Company’s foreign subsidiaries.  The Credit Facility contains restrictivecovenants requiring the Company to, among other things, maintain certain seniorleverage ratios (as defined in the Credit Facility).  As of March 31, 2004, there were no borrowings outstanding underthe Credit Facility, and the Company was in compliance with all of thefinancial covenants under the Credit Facility.

 

As of March 31, 2004, the Company was in compliance with all of thecovenants set forth in the principal agreements governing the 51⁄4% Senior Notes.

 

Cherokee Europe maintains a working capital line of credit ofapproximately $3.7 million with a Belgian bank, BBL, which is denominated inEuros, collateralized by a pledge in first and second rank over a specificamount of business assets, requires Cherokee Europe to maintain a certainspecific minimum solvency ratio and is cancellable at any time.  As of March 31, 2004, Cherokee Europe had nooutstanding borrowings under the line of credit and was in compliance with allloan covenants.

 

9.               Other Long-Term Liabilities

 

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

 

|                                                                                |   | **March 31,  2004** |   | **December  31,  2003** |   |
|-------------------------------------------------------------------------------------|--------|---------------------|--------|-------------------------|--------|
| Long-term portion of restructuring cost  liabilities                                |   | $                   | 1,664  |                    | $      | 1,670 |   |
| Long service award liabilities                                                      |   | 1,432               |   | 1,515                   |   |
| Interest payable related to the Second Lien  Notes and the Senior Convertible Notes |   | —              |   | 2,400                   |   |
| Deferred compensation                                                               |   | 570                 |   | —                  |   |
|                                                                                |   | $                   | 3,666  |                    | $      | 5,585 |   |

 

10.         Cherokee Europe Restructuring

 

In June 2003, the Company received approval for a restructuring plan(the “European Restructuring”) of its operations in Europe from the WorkersUnion and the appropriate governmental authorities in Belgium.  The European Restructuring involved theelimination of 61 operational and administrative positions at the CherokeeEurope facility in Belgium due to unfavorable economic conditions in thatmarket.  All of the terminations werecompleted in 2003.  Pursuant to theEuropean Restructuring, the Company recorded a restructuring charge of $4.5million in operating expenses in the statement of operations during the yearended December 31, 2003.  The EuropeanRestructuring costs are comprised entirely of one-time termination benefits tobe paid through 2010.  The Company haspaid $0.9 million for the three months ended March 31, 2004 under the EuropeanRestructuring.

 

A reconciliation of the European Restructuring accrual for the periodJanuary 1, 2004 through March 31, 2004 is as follows (in thousands):

 
| Balance as of January 1, 2004 |   | $     | 2,814   |   |
|-------------------------------|--------|-------|---------|--------|
| Payments                      |   | (915  | )       |
| Balance as of March 31, 2004  |   | 1,899 |    |
| Less current portion          |   | (235  | )  |
| Due after one year            |   | $     | 1,664   |   |

 

11.                                 Customer Concentration

 

For the quarter ended March 31, 2004, the Company’s largest customeraccounted for 25% of net sales, and no other customer accounted for more than10% of net sales.  For the quarter endedMarch 31, 2003, the Company’stwo largest customers accounted for 13% and 11% of net sales,respectively.  Although not currentlyanticipated, a decision by a major customer to decrease the amount purchasedfrom the Company or to cease purchasing the Company’s products could have amaterial adverse effect on the Company’s financial position and results ofoperations.

 

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As of March 31, 2004, the Company had one customer that accounted for33% of net accounts receivable.

 

12.                                 Commitments andContingencies

 

*Guarantees and Indemnities*

 

The Company has agreed to indemnify the former owners of CherokeeEurope for product liability, environmental hazard and employment practiceclaims relating solely to post-acquisition business.  The Company also indemnifies its directors and officers to themaximum extent permitted under the laws of the State of Delaware, and variouslessors in connection with facility leases for certain claims arising from suchfacility or lease.  The maximum amountof potential future payments under such indemnifications is not determinable.

 

The Company has not incurred significant amounts related to theseguarantees and indemnifications and no liability has been recorded in thefinancial statements for guarantees and indemnifications as of March 31, 2004.

 

13.         Stock and DeferredCompensation Plans

 

# *2004 Employee Stock Purchase Plan*

# * *

On February 16, 2004, theCompany adopted the 2004 Employee Stock Purchase Plan (the ‘‘ESPP’’). The ESPPprovides that a total of 400,000 shares of Common Stock are reserved forissuance under the plan, plus an annual increase to be added on the first dayof the Company’s fiscal year (beginning 2005) equal to the lesser of (i)250,000 shares or (ii) 1% of the number of outstanding shares on the last dayof the immediately preceding fiscal year. The ESPP, which is intended toqualify as an ‘‘employee stock purchase plan’’ under Section 423 of the Code,is implemented utilizing six-month offerings with purchases occurring atsix-month intervals, with a new offering period commencing on the first tradingday on or after May 15 (beginning in the year 2005) and November 15 (beginningin the year 2004) and ending on the last trading day on or before November 14or May 14, respectively. The Board of Directors oversees the ESPPadministration.  Employees are eligibleto participate if they are employed for at least 20 hours per week and morethan 5 months in a calendar year by the Company, subject to certainrestrictions as defined. The ESPP permits eligible employees to purchase CommonStock through payroll deductions, which may not exceed 15% of an employee’scompensation. The price of Common Stock purchased under the ESPP will be 85% ofthe lower 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 Board mayat any time amend or terminate the ESPP, except that no such amendment ortermination may adversely affect shares previously granted under the ESPP.  As of March 31, 2004, no shares have beenissued under the ESPP.

 

# *2004 Omnibus Stock Incentive Plan*

# * *

On February 16, 2004, theCompany adopted the 2004 Omnibus Stock Incentive Plan (the ‘‘2004 Plan’’). The2004 Plan provides that a total of 800,000 shares of the Company’s Common Stockare reserved for issuance under the 2004 Plan, plus an annual increase to beadded on the first day of the Company’s fiscal year (beginning 2005) equal tothe lesser of (i) 450,000 shares or (ii) 2% of the number of outstanding shareson the last day of the immediately preceding fiscal year. Any officer,director, employee, consultant or advisor of the Company is eligible toparticipate in the 2004 Plan.  The 2004Plan provides for the issuance of stock-based incentive awards, including stockoptions, stock appreciation rights, restricted stock, deferred stock, andperformance shares.  As of March 31,2004, no shares have been issued from the 2004 Plan.

 

*Deferred Compensation Plans*

 

On February 16, 2004, the Company adopted two executive deferredcompensation plans for the benefit of certain designated employees andnon-employee directors of the Company. The plans allow participating employeesand non-employee directors to make pre-tax deferrals of up to 100% of theirannual base salary and bonuses and retainer fees and meeting fees,respectively. The plans allow the Company to make matching contributions andemployer profit sharing credits at the sole discretion of the Company. Aparticipant’s interest in each matching contribution and employer profitsharing credits, if any, vests in full no later than after 3 years.  As of March 31, 2004, participants havecontributed $570,000 to the plan, which is recorded in other long-termliabilities, and the company has provided no matching contributions to date.

 

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14.         Retirement Plans

 

Cherokee Europe maintains a pension plan for certain levels of staffand management that includes a defined benefit feature.  The following represents the amounts relatedto this defined benefit plan for the three months ended (in thousands):

 
| **Components of Net Periodic  Benefit Cost** |   | **March 31,  2004** |   | **March 31,  2003** |   |
|----------------------------------------------|--------|---------------------|--------|---------------------|--------|
| Service cost                                 |   | $                   | 38     |                | $      | 28 |   |
| Interest cost                                |   | 59                  |   | 52                  |   |
| Expected return on plan assets               |   | (34                 | )      | (40                 | )      |
| Net periodic benefit cost                    |   | $                   | 63     |                | $      | 40 |   |

 

As of March 31, 2004, $0.1 million of pension plan contributions havebeen made.  Cherokee Europe presentlyanticipates contributing an additional $0.1 million to fund its pension plan in2004 for a total of $0.2 million.

 

15.         Cherokee Europe Fire

 

On January 19, 2004 the Company experienced a fire in part of itsfacility in Belgium, which destroyed some inventory, property andequipment.  The Company was fullyinsured for the destroyed items at the replacement value for the destroyeditems, subject to a $5,000 deductible, and the facility returned to fullproduction the next day.  Withinoperating expenses for the three months ended March 31, 2004, the Companyrecorded a loss related to the destroyed inventory, property and equipment of$2.6 million, which has been fully offset by $1.0 million in proceeds receivedfrom the insurance company and $1.6 million of expected recoveries from theinsurance company, which has been recorded in prepaid and other current assets.  Any additional amounts received from theinsurance company in excess of the $1.6 million will be recognized as a gainwhen received.

 

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

 

**Item 2****.  Management’sDiscussion and Analysis of Financial Condition and Results of Operations.**

 

OVERVIEW

 

We are a designer andmanufacturer of power supplies for OEMs. Our advanced power supply products aretypically custom designed into mid- to high-end commercial applications in thecomputing and storage, wireless infrastructure, enterprise networking, medicaland industrial markets.

 

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

 

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

 

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In November 2002, weconsummated the Restructuring Transactions, resulting in the restructuring ofour debt capital structure and the reorganization of our company from aCalifornia limited liability company into a Delaware corporation.  As part of the Restructuring Transactions,we amended our then-existing credit facility and entered into new senior creditfacilities providing, in the aggregate, for $15.0 million of term loans (the“Term Loans”) and a revolving credit facility of up to $7.6 million (the “OldRevolving Facility”), in each case maturing November 30, 2005. As of December31, 2003, two of the Term Loans bore interest at an annual rate of 5.49% andthe remaining two Term Loans bore interest at an annual rate of 5.91%.Borrowings under the Old Revolving Facility bore interest at an annual rate of6.75% as of such date. As part of the Restructuring Transactions, we alsoissued approximately $41.0 million original principal amount of 14 1/2%pay-in-kind second lien notes due 2006 (“Second Lien Notes”), together withwarrants to purchase 2,447,813 shares of our common stock at $0.039 per share.Interest on the Second Lien Notes was paid in kind from issuance. We alsocompleted an exchange offer with respect to all of our outstanding $100.0million of 10 1/2% senior subordinated notes due 2009. In exchange for thesenior subordinated notes, we issued (1) $46.6 million of 5 1/4% senior notesdue 2008, (“Senior Notes”) together with warrants to purchase 1,633,714 sharesof our common stock at $0.039 per share and (2) $53.4 million of 12% seniorconvertible notes due 2008 (“Senior Convertible Notes”), which were convertibleinto 6,283,796 shares of our common stock at approximately $8.49 per share.From issuance, interest on the Senior Notes was paid in cash.  Interest on the Senior Convertible Notes wasadded to the principal amount from the date of issuance. Amounts added to theprincipal in respect of interest payments on the Senior Convertible Notes werenot convertible into shares of our common stock.  In connection with our initial public offering described below,we amended and restated our senior credit facility, repaid the Second LienNotes in full and repaid $4.4 million in accrued interest and $12.1 millionin interest added to the principal amount of our Senior Convertible Notes.  In addition, all of the outstanding warrantswere exercised and the original principal amount of the Senior ConvertibleNotes was converted into shares of Common Stock.

 

Prior to theRestructuring Transactions in November 2002, we were organized as a Californialimited liability company and treated as a partnership for United Statesfederal income tax purposes. As a result of being reorganized into a Delawarecorporation, Cherokee is now subject to United States federal income taxation.

 

We completedour initial public offering of 6,600,000 shares of common stock on February 25,2004.  The net proceeds from thisoffering were $89.0 million, before offering costs of $2.5 million.  We used $73.2 million to repay outstandingindebtedness, including the Term Loans, the Old Revolving Facility, the SecondLien Notes, related interest on these obligations, as well as accrued interestand interest added to the principal amount of our Senior ConvertibleNotes.  In connection with the offering,we issued 6,283,796 shares of our common stock upon conversion of the originalprincipal amount of our outstanding Senior Convertible Notes, and issued 4,071,114shares of common stock upon exercise of all outstanding warrants. 

 

In addition, in connection with the offering, we amended and restatedour existing senior revolving credit facility with General Electric CapitalCorporation.  The amended facility (the“Credit Facility”) provides for borrowings of up to $20.0 million that aresubject to a borrowing base comprised of eligible accounts receivable andinventory, which was $11.6 million at March 31, 2004.  Please refer to “–Liquidity and Capital Resources” below foradditional information regarding our outstanding indebtedness.

 

We generate a significant portion of our sales from OEMs in thecommunications and computing market segment, particularly the wirelessinfrastructure and networking sectors. During 2001, 2002 and the first quarter of 2003, our operating resultswere negatively affected by unfavorable economic conditions and reduced capitalspending by communication service providers that purchase our customers’products.  Although we have seen improvementin these economic conditions throughout 2003 and the first quarter of 2004,there are no assurances that these improvements will continue or aresustainable.  If conditions do notcontinue to improve or, instead, deteriorate, our operating results andfinancial condition could be adversely affected.

 

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BASIS OF REPORTING

 

*Net Sales*

 

Net sales consists of sales during the period presented net ofreturns.  Revenue is recognized fromproduct sales at the time of shipment and passage of title.

 

*Cost of Sales*

 

The principal elements comprising cost of sales are raw materials,labor and manufacturing overhead.  Rawmaterials account for a majority of cost of sales.  Raw materials include magnetic sub-assemblies, sheet metal,electronic and other components, mechanical parts and electrical wires.  Direct labor costs include costs of hourlyemployees. Manufacturing overhead includes salaries, lease costs, depreciationon property, plant and equipment, utilities, property taxes and repairs andmaintenance.

 

*Operating Expenses*

 

Operating expenses include engineering costs, selling and marketingcosts and general and administrative expenses. Engineering costs primarily include salaries and benefits of engineeringpersonnel, safety approval and quality certification fees, depreciation onequipment and subcontract costs for third-party contracting services.  Selling and marketing expenses primarilyinclude salaries and benefits to account managers and commissions toindependent sales representatives.  Administrativeexpenses primarily include salaries and benefits for certain management andadministrative personnel, professional fees and information system costs.

 

CRITICALACCOUNTING POLICIES

 

We prepare ourconsolidated financial statements in conformity with accounting principlesgenerally accepted in the United States of America.  As such, we are required to make certain estimates, judgments andassumptions that we believe are reasonable based upon the information currentlyavailable.  These estimates andassumptions affect the reported amounts of assets and liabilities at the dateof the financial statements and the reported amounts of revenues and expensesduring the periods presented.  Anyfuture changes to these estimates and assumptions could have a material effecton our reported amounts of revenue, expenses, assets and liabilities.  The significant accounting policies that webelieve are the most critical to aid in fully understanding and evaluating ourreported financial results include the following:

 

*Revenue Recognition*

 

We recognizerevenue from product sales at the time of shipment and passage of title.  We also offer our customers the right toreturn products that do not function properly within a limited time afterdelivery.  We monitor and track productreturns and record a provision for warranty based on historical experience,which has been insignificant to our financial condition and results ofoperations.  Any significant increase inproduct failure rates could have a material adverse effect on our operatingresults for the period or periods in which those returns materialize.

 

*Accounts Receivable*

 

We performongoing credit evaluations of our customers and adjust credit limits based uponpayment history, the customer’s current credit worthiness and various otherfactors, as determined by our review of their current credit information.  We continuously monitor collections andpayments from our customers and maintain a provision for estimated credit lossesbased upon our historical experience, and any specific customer collectionissues that we have identified.  Whilecredit losses have historically been within our expectations and the provisionsestablished, we may not continue to experience the same credit loss rates thatwe have in the past.  A significantportion of our accounts receivable are concentrated in a small number ofcustomers.  A significant change in theliquidity or financial position of any one of these customers could have amaterial adverse effect on the collectibility of our accounts receivables, ourliquidity and our future operating results.

 

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*Inventories*

 

We value ourinventory at the lower of the actual cost to purchase and/or manufacture theinventory and the current estimated market value of the inventory using thefirst-in, first-out method.  Weregularly review inventory quantities on hand and record a provision for excessand obsolete inventory based primarily on our historical usage data andestimates of future demand.  Ourindustry is characterized by rapid technological change, frequent new productdevelopment, and rapid product obsolescence that could result in an increase inthe amount of obsolete inventory quantities on hand.  As demonstrated in the past, demand for our products canfluctuate 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 onhand.  In addition, our estimates offuture product demand may prove to be inaccurate, in which case we may haveunderstated or overstated the provision required for excess and obsoleteinventory.  In the future, if our inventoryis determined to be overvalued, we would be required to recognize additionalexpense in our cost of goods sold at the time of such determination.  Likewise, if our inventory is determined tobe undervalued, we may have over reported our costs of goods sold in previousperiods and would be required to recognize additional operating income at thetime such inventory is sold.  Therefore,although we make every reasonable effort to ensure the accuracy of our estimatesof future product demand, any significant unanticipated changes in demand ortechnological developments could have a material effect on the value of ourinventory and our reported operating results.

 

*Deferred Taxes*

 

We recognizedeferred tax assets and liabilities based on the differences between thefinancial statement carrying values and the tax bases of assets andliabilities.  We regularly review ourdeferred tax assets for recoverability and establishes a valuation allowancebased on historical taxable income, projected future taxable income, and theexpected timing of the reversals 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 substantiallyreduce our effective tax rate for such period. Therefore, any significant changes in statutory tax rates or the amountof our valuation allowance could have a material effect on the value of ourdeferred tax assets and liabilities, and our reported financial results.

 

*Goodwill and Long Lived Assets*

 

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

 

We also reviewthe recoverability of the carrying value of long-lived assets whenever eventsor changes in circumstances indicate that the carrying amount of an asset maynot be recoverable.  Recoverability ofthese assets is determined based upon the forecasted undiscounted future netcash flows from the operations to which the assets relate, utilizing our bestestimates, appropriate assumptions and projections at the time.  These projected future cash flows may varysignificantly over time as a result of increased competition, changes intechnology, fluctuations in demand, consolidation of our customers andreductions in average selling prices. If the carrying value is determined not to be recoverable from futureoperating cash flows, the asset would be deemed impaired and an impairment losswould be recognized to the extent the carrying value exceeded the estimatedfair market value of the asset.

 

RESULTS OFOPERATIONS

 

THREE MONTHSENDED MARCH 31, 2004 COMPARED TO THREE MONTHS ENDED MARCH 31, 2003

 

NET SALES

 

Net sales increased by approximately 75.0%, or $15.8 million, to $36.8million for the three months ended March 31, 2004 from $21.0 million for thethree months ended March 31, 2003.

 

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This sales increase was primarily attributable to increased sales froma broad base of customers in the datacom and telecom industries, includingseveral new customers that have engaged Cherokee in recent quarters.  Our largest customer, which is in thewireless infrastructure market, accounted for approximately $5.5 million of oursales increase over the first quarter of 2003. Also contributing to the sales increase was a favorable foreign currencyexchange rate effect of $2.3 million due to a stronger Euro in the firstquarter of 2004 compared to the first quarter of 2003.

 

GROSS PROFIT

 

Gross profit increased by approximately 147.3%, or $7.1 million, to$11.9 million for the three months ended March 31, 2004 from $4.8 million forthe three months ended March 31, 2003. Gross margin for the three months endedMarch 31, 2004 increased to 32.4% from 22.9% in the prior year’s period.

 

Of the $7.1 increase in gross profit, $3.6 million was attributable tothe higher sales level and the remaining $3.5 million was attributable to theincreased gross margin.  The increase ingross margin was primarily due to lower direct labor and overhead costs as apercentage of sales.  For the firstquarter of 2004, direct labor and factory overhead at Cherokee Europe improvedsignificantly as a percentage of sales, reflecting increased efficiencies dueto higher production volumes, as well as a lower manufacturing cost structureresulting from the restructuring plan implemented in June 2003.

 

OPERATINGEXPENSES

 

Operating expenses for the three months ended March 31, 2004 increasedby approximately 29.4%, or $1.4 million, to $6.2 million from $4.8 million forthe three months ended March 31, 2003. As a percentage of sales, operating expenses decreased to 17.0% from23.0% in the prior year’s period.

 

We experienced increases in engineering and development, selling andmarketing, and general and administrative expensesof $0.3 million, $0.7 million and $0.4 million, respectively, primarily tosupport the significantly higher sales volume and related business activitiescompared to a year ago.  Of the $1.4million increase in total operating expenses, approximately $0.4 million wasattributable to a stronger Euro versus the first quarter of 2003, $0.3 millionwas attributable to higher sales commissions, and the remaining increaserelated primarily to increased payroll and related costs, including higherincentive compensation expense.

 

OPERATINGINCOME

 

As a result of the factors discussed above, operating income increasedto $5.7 million for the three months ended March 31, 2004 compared to breakevenresults for the three months ended March 31, 2003.  Operating margin increased to 15.4% from 0.0% in the prior year’speriod.

 

INTERESTEXPENSE

 

Interest expense for the three months ended March 31, 2004 was $3.1million compared to $4.1 million for the three months ended March 31,2003.  The decrease in interest expensewas primarily due to the pay down of debt and conversion to equity of our seniorconvertible notes in connection with our initial public offering.

 

OTHER INCOME(EXPENSE)

 

Other income (expense) for the three months ended March 31, 2004 wasinsignificant compared to other income of $0.8 million for the three monthsended March 31, 2003.  The amount forthe first quarter of 2003 included a gain on the sale of land of $0.4 millionand foreign currency exchange gains of $0.4 million attributable to a strongerEuro.

 

INCOME TAXES

 

The provision for income taxes of $0.4 million for the three monthsended March 31, 2004 was calculated using an estimated effective tax rate for2004 of 16.6%, which reflects estimated taxable income in Belgium after usingavailable net operating losses in 2004. Income generated in the United States during 2004 is expected to befully offset by available net operating losses, resulting in the relatively loweffective tax rate for the year.

 

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NET INCOME(LOSS)

 

As a result of the factors discussed above, we recorded a net income of$2.2 million for the three months ended March 31, 2004, compared to a net lossof $3.3 million for the three months ended March 31, 2003.

 

LIQUIDITY ANDCAPITAL RESOURCES

 

CASH FLOWS

 

THREE MONTHSENDED MARCH 31, 2004 COMPARED TO THREE MONTHS ENDED MARCH 31, 2003

 

Net cash used in operating activities was $0.5 million for the threemonths ended March 31, 2004, compared to net cash used in operating activitiesof $0.2 million for the three months ended March 31, 2003.  Cash used in operating activities for thefirst quarter of 2004 reflects the positive effect of $2.2 million in netincome, $0.9 million of depreciation and amortization,  a $1.1 million decrease in accountsreceivable due mainly to an improvement in our days sales outstanding and adecrease in inventory levels of $0.6 million. These items were offset by an increase of $2.0 million in prepaidexpenses and other current assets due mainly to D&O insurance premiumpayments and recording an insurance indemnity receivable due to the fire in ourBelgium facility, and a decrease in other long-term obligations of $1.8 milliondue primarily to the payment of accrued paid-in-kind interest with the proceedsfrom the initial public offering and a decrease in accrued liabilities andaccrued restructuring costs of $1.2 million. Cash used in operating activities for the first quarter of 2003 reflectsa net loss of approximately $3.3 million, depreciation and amortization of $0.9million, and a decrease in receivables, accounts payable and accrued interestpayable of $1.3 million,  $0.9 millionand $1.0 million, respectively, and an increase in other long-term obligationsof $4.2 million.

 

Net cash used in investing activities of $1.2 million for the threemonths ended March 31, 2004 primarily reflects additions to property andequipment.  Net cash provided byinvesting activities of $0.5 million for the three months ended March 31, 2003primarily reflects proceeds from sale of land of $0.5 million.

 

Net cash provided by financing activities of $16.9 million for thethree months ended March 31, 2004 reflects the proceeds from our initial publicoffering of $89.0 million, offset by payments on long-term debt of $65.5million and net payments under the revolving lines of credit of $6.1million.  Net cash provided by financing activities of $1.4 million forthe three months ended March 31, 2003 primarily reflects net borrowings underthe revolving lines of credit of $2.3 million and $0.8 million of payments onlong-term debt and capital leases.

 

LIQUIDITY

 

We completed our initial public offering of 6,600,000 shares of commonstock on February 25, 2004.  The netproceeds of this offering were $89.0 million, before offering costs of $2.5million. We used $73.2 million of the proceeds to repay outstandingindebtedness, including the Term Loans, the Old Revolving Facility, the SecondLien Notes, related interest on these obligations, as well as accrued interestand interest added to the principal amount of our Senior ConvertibleNotes.  The remainder of the netproceeds is held in high-grade commercial paper with an original maturity ofthree months or less, and reflected in our cash increase of $15.2 million forthe first quarter of 2004.

 

As of March 31, 2004, we had cash and cash equivalents of $20.1million, working capital of $42.1 million and no borrowings under the CreditFacility.  Historically, the Company hasfinanced its operations with cash from operations supplemented by borrowingsfrom credit facilities and debt issuances. The Company’s current and future liquidity needs primarily arise fromworking capital requirements and capital expenditures.  The Company’s historical capitalexpenditures have primarily resulted from investments in equipment to increasemanufacturing capacity and improve manufacturing efficiencies. For fiscal 2004,the Company expects capital expenditures to be approximately $3 million, whichwill relate primarily to investments in manufacturing equipment.

 

As of March 31, 2004, the Company’s borrowings consisted ofapproximately $46.6 million of Senior Notes and no borrowings under the CreditFacility.  The Company is required tomake scheduled interest payments to holders of the Senior Notes.

 

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The maturities of our long-term debt, including capital leases, andfuture payments under our capital and operating leases as of March 31, 2004 areas follows (in millions):

 
| **Contractual obligation** |   | **Apri1 to  December 31,  2004** |   | **2005** |   | **2006** |   | **2007** |   | **2008** |   | **Thereafter** |   | **Total** |   |
|----------------------------|--------|----------------------------------|--------|----------|--------|----------|--------|----------|--------|----------|--------|----------------|--------|-----------|--------|
| Senior Notes               |   | $                                | — |     | $      | —   |   | $        | — |     | $      | —         |   | $         | 46.6   |   | $ | — |   | $ | 46.6 |   |
| Capital leases             |   | 0.5                              |   | —   |   | —   |   | —   |   | —   |   | —         |   | 0.5       |   |
| Operating leases           |   | 1.0                              |   | 1.1      |   | 1.1      |   | 1.1      |   | 1.1      |   | 0.6            |   | 6.0       |   |
| Purchase order commitments |   | 19.3                             |   | 1.4      |   | —   |   | —   |   | —   |   | —         |   | 20.7      |   |
| Total                      |   | $                                | 20.8   |     | $      | 2.5      |   | $        | 1.1    |     | $      | 1.1            |   | $         | 47.7   |   | $ | 0.6 |   | $ | 73.8 |   |

 

The Senior Notes mature on November 1, 2008.  Interest on the Senior Notes is payable in cash on May 1 andNovember 1 of each year.  The 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.

 

In connection with the Company’s initial public offering, the Companyhas amended and restated its existing senior revolving credit facility withGeneral Electric Capital Corporation. The Credit Facility provides for borrowings of up to $20.0 million thatare subject to a borrowing base comprised of eligible accounts receivable andinventory.  The Company plans to usefunds available under the amended facility to finance our working capital asneeded.  The amended facility has a termof 4.5 years and bears interest, at our option, at a rate per annum equal toLIBOR plus 2.5% or the agent bank’s base rate plus 1.0%.  In addition to paying interest onoutstanding principal, we are required to pay a commitment fee to the lendersunder the amended facility in respect of the average daily balance of unusedloan commitments at a rate of 0.5% per annum. The Credit Facility is our senior obligation and ranks equal in right ofpayment with our existing and future permitted senior debt, and senior in rightof payment to our future permitted subordinated debt.  The Credit Facility is secured by a first-priority lien, subjectto permitted encumbrances, on substantially all of our domestic assets and by apledge of 65% of the equity of certain of our foreign subsidiaries.  The Credit Facility contains covenants thatrestrict our business operations, including covenants limiting our ability tomake investments, 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.  The amended facility contains customary eventsof defaults, including defaults in the payment of principal or interest,defaults in the compliance with the covenants contained in the documentsevidencing the Credit Facility, cross defaults to other material debt andbankruptcy or other insolvency events.  

 

As of March 31, 2004, the Company was in compliance with all of thefinancial covenants set forth in the principal agreements governing its debt.

 

Based on our present expectations, we believe that our existing cashbalances and cash equivalents, working capital, cash flow from operations andavailable borrowing capacity at March 31, 2004 will be sufficient to meet ouranticipated cash requirements for the next twelve months, including operatingrequirements, contractual obligations, planned capital expenditures and debtservice, and that the payments associated with these commitments will not havea material adverse effect on our liquidity.

 

RECENTACCOUNTING PRONOUNCEMENTS

 

In January 2003, the FASB issued FIN 46, “Consolidation of Variable InterestEntities.”  In general, a variableinterest entity is a corporation, partnership, trust or any other legalstructure used for business purposes that either (a) does not have equityinvestors with voting rights or (b) has equity investors that do not providesufficient financial resources for the entity to support its activities.  FIN 46 requires a variable interest entityto be consolidated by a company if that company is subject to a majority of theentity’s residual returns or both.  Theconsolidation requirements of FIN 46 apply immediately to variable interestentities created after January 31, 2003. The consolidation requirements apply to older entities in the firstfiscal year or interim period beginning after December 15, 2003.  Certain of the disclosure requirements applyin all financial statements issued after January 31, 2003, regardless of whenthe variable interest entity was established. We did not have any variable interest entities as of March 31,2004.  The early adoption of FIN 46 didnot have a material impact on our consolidated results of operations or ourfinancial position.  With respect tovariable interest entities created before January 31, 2003, in December 2003the FASB issued FIN 46R which, among other things, revised the implementationdate to first fiscal years or interim periods ending after March 15, 2004, withthe exception of Special Purpose Entities (“SPE”). The consolidatedrequirements apply to all SPE's in the first fiscal year or interim periodending after December 15, 2003. As the Company has determined that it does nothave any SPE's to which these interpretations apply, the Company adopted FIN46R in the first quarter of 2004 and such adoption did not have a materialimpact on its financial statements.  

 

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FORWARD-LOOKINGSTATEMENTS

 

Statements in this report containing the words “believes,”“anticipates,” “estimates,” “expects,” and similar expressions, or the negativeof such words or expressions, and any other statements which may be construedas a prediction of future performance or events, constitute “forward-lookingstatements” within the meaning of the Private Securities Litigation Reform Actof 1995.  These forward-lookingstatements are based upon the Company’s current expectations and projectionsabout future events.  Suchforward-looking statements involve known and unknown risks, uncertainties, andother factors that may cause the actual results, performance, or achievementsof the Company, or industry results, to be materially different from any futureresults, performance, or achievements expressed or implied by suchforward-looking statements.  Suchfactors include, among others, (1) changes in general economic and businessconditions, domestically and internationally, (2) reductions in sales to, orthe loss of, any of the Company’s significant customers or in customer capacitygenerally, (3) changes in the Company’s sales mix to lower margin products, (4)increased competition in the Company’s industry, (5) disruptions of theCompany’s established supply channels, (6) the Company’s level of debt andrestrictions imposed by its debt agreements, and (7) the additional riskfactors identified in the Company’s filings with the Securities and Exchange Commissionincluding our Registration Statement on Form S-1 (File No. 333-110723). TheCompany undertakes no obligation to update any forward-looking statements eventhough the Company’s situation may change in the future.

 

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

 

Market risks relating to the Company’s operations result primarily fromchanges in foreign currency exchange rates and short-term interest rates.  The Company did not have any derivativefinancial instruments at March 31, 2004.

 

The Company had no variable rate debt outstanding at March 31,2004.  The Company cannot predict marketfluctuations in interest rates and their impact on its variable rate debt, ifany, nor can there be any assurance that fixed rate long-term debt will beavailable to the Company at favorable rates, if at all.

 

The Company has European operations and is, therefore, subject to acertain degree of market risk associated with changes in foreign currencyexchange rates.  This risk is mitigatedby the fact that the Company’s revenues and expenses are generally bothrecorded in Euros, thereby reducing the risk of foreign currency translationson our operations in Europe.  As ofMarch 31, 2004, the effect of foreign currency exchange rate fluctuations on theCompany’s operating results for the three months ended March 31, 2004, was notmaterial.  Historically, the Company hasnot actively engaged in exchange rate hedging activities.

 

**Item 4**.                                   Controlsand Procedures

** **

a)              *DisclosureControls and Procedures*

 

The Company’s management,with the participation of the Company’s Chief Executive Officer and ChiefFinancial Officer, has evaluated the effectiveness of the Company’s disclosurecontrols and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e)under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) asof the end of the period covered by this report.  Based on such evaluation, the Company’s Chief Executive Officerand Chief Financial Officer have concluded that, as of the end of such period,the Company’s disclosure controls and procedures are effective in recording,processing, summarizing and reporting, on a timely basis, information requiredto be disclosed by the Company in the reports that it files or submits under theExchange Act.

 

b)             *InternalControl Over Financial Reporting*

 

There have not been anychanges in the Company’s internal control over financial reporting (as suchterm is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) duringthe fiscal quarter to which

 

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this report relates that havematerially affected, or are reasonably likely to materially affect, theCompany’s internal control over financial reporting.

 

PART II.                OTHER INFORMATION

 

**Item 1.**                                   Legal Proceedings

** **

During the three monthsended March 31, 2004, we were not a party to any material legalproceedings.  We are occasionally aparty to lawsuits relating to routine matters incidental to our business.  As with all litigation, no assurance can beprovided as to the outcome of any particular lawsuit and we note thatlitigation inherently involves significant costs.

 

**Item 2.**                                   Changes in Securities, Use of Proceeds and IssuerPurchases of Equity Securities

 

In February2004, we issued 12,824 shares of common stock to six management employees ofCherokee Europe, for achieving specified financial performance targets duringthe second half of 2003.  The value ofthe consideration deemed received by us for each share issued was $0.01 pershare, in accordance with Delaware law. These securities were issued pursuant to an employee benefit plan, in atransaction exempt from the registration requirements of the Securities Act inreliance upon Rule 701 of the Securities Act. 

 

On February 25, 2004, we closed the sale of 6,600,000shares of our Common Stock at a price of $14.50 per share in a firm commitmentunderwritten initial public offering. In connection with the offering, certain of our stockholders (the “SellingStockholders”) granted an option to the underwriters to purchase up to anadditional 990,000 shares for up to 30 days after the offering to coverover-allotments, if any.  Theunderwriters exercised the over-allotment option in full and that transactionclosed on February 25, 2004 as well.  Wedid not receive any of the proceeds ($14,355,000 before underwriters’ discount)from any shares of our common stock sold by the Selling Stockholders.  The offering was effected pursuant to aRegistration Statement on Form S-1 (File No. 333-110723), which the Securitiesand Exchange Commission declared effective on February 19, 2004.  The managing underwriters in the offeringwere Credit Suisse First Boston, Lehman Brothers, UBS Investment Bank andStephens Inc.

 

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

 

1.             approximately $6.7 million was paid to the underwritersin connection with the underwriting discount;

 

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

 

3.             approximately $73.2 million was used to repay principaland interest on our outstanding indebtedness; and

 

4.             approximately $13.3 million has been retained by us forgeneral corporate purposes and is held in high-grade commercial paper with anoriginal maturity of three months or less.

 

**Item 4.    Submission of Matters to a Vote of SecurityHolders**

 

On February16, 2004, by a written consent in lieu of meeting of the stockholders of theCompany, the following matters were voted upon and approved by the requisitevote of the stockholders:  (1) theCompany’s 2002 Stock Option Plan, (2) the Company’s restated certificate ofincorporation, giving effect to, among other things a one-for-3.9 reverse stocksplit, (3) the Company’s 2004 Omnibus Stock Incentive Plan, (4) the Company’sEmployee Stock Purchase Plan, and (5) the Company’s form of indemnificationagreement with its directors and officers. The written consent was adopted by stockholders owning 5,819,994 shares,or 67.4%, of the Company’s outstanding Common Stock as of February 16, 2004.

 

**Item 6.**                                   Exhibits and Reports on Form 8-K

** **

(a)   Exhibits

 

EXHIBIT INDEX

 
| **Exhibit  No.** |   | **Description**                                                                                                                                                                                                                                                                |
|------------------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1              |   | Restated  Certificate of Incorporation of Cherokee International Corporation (1)                                                                                                                                                                                               |
| 3.2              |   | Amended and  Restated By-Laws of Cherokee International Corporation (1)                                                                                                                                                                                                        |
| 10.1             |   | Amended and  Restated Credit Agreement, dated as of February 25, 2004, by and between  Cherokee International Corporation and General Electric Capital Corporation,  in its individual capacity and as agent (the “Agent”) for all of the lenders  name of therein.* |
| 10.2             |   | Amended and  Restated Revolving Note, dated as of February 25, 2004, issued by Cherokee  International Corporation.*                                                                                                                                                           |
| 10.3             |   | Amended and  Restated Security Agreement, dated as of February 25, 2004, by and between  Cherokee International Corporation and the Agent.*                                                                                                                                    |
| 31.1             |   | Certification  of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act  of 2002.*                                                                                                                                                                         |
| 31.2             |   | Certification  of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act  of 2002.*                                                                                                                                                                         |
| 32.1             |   | Certification  of CEO and CFO Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002.*                                                                                                                                      |

 

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(1)           Previously filed with Amendment No. 2to the Form S-1 filed by the Registrant on February 11, 2004

 

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*              Filed herewith

 

(b)         Reports on Form 8-K

 

**The Company filed a Form 8-K on April 27,2004 announcing first quarter financial results.**

 

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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.

 
| Dated:  May 12, 2004 |                                |
|---------------------------|-------------------------------------|
|                      |                                |
|                      | CHEROKEE  INTERNATIONAL CORPORATION |
|                      |                                |   |
|                      |                                |   |
|                      | By:                                 | /s/ Jeffrey  M. Frank |   |
|                      |                                | Jeffrey M.  Frank |
|                      |                                | President  and Chief Executive Officer |
|                      |                                |   |
|                      |                                |   |
|                      | By:                                 | /s/ Van  Holland |   |
|                      |                                | Van Holland |
|                      |                                | Chief  Financial Officer |
|                      |                                | (Principal  Financial and Accounting Officer) |

 

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