**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

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**FORM 10-Q**

**(Mark One)**

**    **x                                      QuarterlyReport Pursuant to Section 13 or 15(d) of the Securities Exchange Actof 1934

**Forthe quarterly period ended April 2, 2006**

**    **o                                         TransitionReport Pursuant to Section 13 or 15(d) of the Securities ExchangeAct of 1934

**Forthe transition period from                   to**

**CommissionFile No. 000-50593**

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**Cherokee International Corporation**

(Exact name of Registrantas specified in its charter)

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

 

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

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

**None**

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

**CommonStock, $0.001 par value**

Indicate by check markwhether the registrant; (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the Registrant was required tofile such reports), and (2) has been subject to such filing requirementsfor the past 90 days.   Yes x   No o

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer. See definition of “accelerated filer” and “largeaccelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large Accelerated Filer o   AcceleratedFiler o   Non-Accelerated Filer x

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

As of April 30, 2006,19,259,612 shares of the registrant’s common stock, $0.001 par value, wereoutstanding.

 

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**TABLEOF CONTENTS**

| PART I FINANCIAL  INFORMATION                                                                  |   | 3  |
|-----------------------------------------------------------------------------------------------------|--------|----|
| Item  1. Financial Statements:                                                                      |   | 3  |
| Condensed Consolidated Balance Sheets                                                               |   | 3  |
| Condensed Consolidated Statements of Operations                                                     |   | 4  |
| Condensed Consolidated Statements of Comprehensive  Operations                                      |   | 5  |
| Condensed Consolidated Statements of Cash Flows                                                     |   | 6  |
| Notes to Condensed Consolidated Financial Statements                                                |   | 7  |
| Item 2. Management’s Discussion and Analysis of  Financial Condition and Results of Operations |   | 17 |
| Item 3. Quantitative and Qualitative Disclosures About  Market Risk                                 |   | 25 |
| Item  4. Controls and Procedures                                                                    |   | 26 |
| PART II  OTHER INFORMATION                                                                     |   | 27 |
| Item  1. Legal Proceedings                                                                          |   | 27 |
| Item  1A. Risk Factors                                                                              |   | 27 |
| Item 6.  Exhibits                                                                                   |   | 28 |
| Signatures                                                                                          |   | 30 |

 

2

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**PART I. FINANCIALINFORMATION**

**Item 1. FinancialStatements.**

**CHEROKEEINTERNATIONAL CORPORATION AND SUBSIDIARIESCONDENSED CONSOLIDATED BALANCE SHEETS(In Thousands, Except Share Data)(Unaudited)**

| ** **                                                                                                                                                 | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| ASSETS                                                                                                                                                     |       |                     |       |                        |       |   |   |
| CURRENT ASSETS:                                                                                                                                            |       |                     |       |                        |       |   |   |
| Cash and cash  equivalents                                                                                                                                 |       | $                        | 12,446     |                        |       | $ | 10,543 |   |   |
| Accounts  receivable, net                                                                                                                                  |       | 25,483                   |       |                        | 24,999     |   |   |
| Inventories, net                                                                                                                                           |       | 29,523                   |       |                        | 26,851     |   |   |
| Prepaid expenses  and other current assets                                                                                                                 |       | 2,390                    |       |                        | 1,698      |   |   |
| Total current assets                                                                                                                                       |       | 69,842                   |       |                        | 64,091     |   |   |
| Property and equipment, net                                                                                                                                |       | 18,820                   |       |                        | 19,268     |   |   |
| Deposits and  other assets                                                                                                                                 |       | 1,356                    |       |                        | 1,296      |   |   |
| Deferred  financing costs, net                                                                                                                             |       | 314                      |       |                        | 346        |   |   |
| Goodwill                                                                                                                                                   |       | 6,317                    |       |                        | 6,317      |   |   |
|                                                                                                                                                       |       | $                        | 96,649     |                        |       | $ | 91,318 |   |   |
| LIABILITIES AND  STOCKHOLDERS’ EQUITY                                                                                                                 |       |                     |       |                        |       |   |   |
| CURRENT LIABILITIES:                                                                                                                                       |       |                     |       |                        |       |   |   |
| Accounts payable                                                                                                                                           |       | $                        | 14,342     |                        |       | $ | 11,658 |   |   |
| Accrued  liabilities                                                                                                                                       |       | 5,825                    |       |                        | 6,028      |   |   |
| Accrued  compensation and benefits                                                                                                                         |       | 6,213                    |       |                        | 5,326      |   |   |
| Accrued  restructuring costs                                                                                                                               |       | 406                      |       |                        | 424        |   |   |
| Total current liabilities                                                                                                                                  |       | 26,786                   |       |                        | 23,436     |   |   |
| Long-term debt                                                                                                                                             |       | 24,485                   |       |                        | 24,485     |   |   |
| Long-term debt  payable to affiliates                                                                                                                      |       | 22,145                   |       |                        | 22,145     |   |   |
| Total long-term debt                                                                                                                                       |       | 46,630                   |       |                        | 46,630     |   |   |
| Other long-term obligations                                                                                                                                |       | 5,430                    |       |                        | 4,790      |   |   |
| COMMITMENTS AND  CONTINGENCIES (Note 9)                                                                                                                    |       |                     |       |                        |       |   |   |
| STOCKHOLDERS’  EQUITY:                                                                                                                                |       |                     |       |                        |       |   |   |
| Common stock:  $0.001 par value; 60,000,000 shares authorized; 19,259,612 shares issued and  outstanding at March 31, 2006 and December 31, 2005 |       | 19                       |       |                        | 19         |   |   |
| Paid-in capital                                                                                                                                            |       | 184,022                  |       |                        | 183,871    |   |   |
| Accumulated  deficit                                                                                                                                       |       | (168,071                 | )          |                        | (168,898   | ) |   |
| Accumulated other  comprehensive income                                                                                                                    |       | 1,833                    |       |                        | 1,470      |   |   |
| Net stockholders’ equity                                                                                                                              |       | 17,803                   |       |                        | 16,462     |   |   |
|                                                                                                                                                       |       | $                        | 96,649     |                        |       | $ | 91,318 |   |   |

 

See notes to condensed consolidated financial statements.

 

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**CHEROKEEINTERNATIONAL CORPORATION AND SUBSIDIARIESCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS(In Thousands, Except Per Share Amounts)(Unaudited)**

| ** **                                   | ** ** | **Three Months Ended** | ** ** |
|----------------------------------------------|------------|----------------------------------|------------|
| ** **                                   | ** ** | **March 31,  2006**         | ** ** | **March 31,  2005** | ** ** |
| Net sales                                    |       |                             | $          | 36,097 |   |   |   | $ | 32,010 |   |   |
| Cost of sales                                |       |                             | 27,581     |   |   |   | 24,368 |   |   |
| Gross profit                                 |       |                             | 8,516      |   |   |   | 7,642 |   |   |
| Operating Expenses:                          |       |                             |       |   |   |   |   |   |   |
| Engineering and  development                 |       |                             | 2,320      |   |   |   | 2,356 |   |   |
| Selling and  marketing                       |       |                             | 1,313      |   |   |   | 1,962 |   |   |
| General and  administrative                  |       |                             | 3,004      |   |   |   | 3,220 |   |   |
| Gain from  insurance proceeds                |       |                             | —     |   |   |   | (2,490 | ) |   |
| Total operating expenses                     |       |                             | 6,637      |   |   |   | 5,048 |   |   |
| Operating income                             |       |                             | 1,879      |   |   |   | 2,594 |   |   |
| Interest expense                             |       |                             | (697       | ) |   |   | (694 | ) |   |
| Other income  (expense), net                 |       |                             | 91         |   |   |   | (27 | ) |   |
| Income before income taxes                   |       |                             | 1,273      |   |   |   | 1,873 |   |   |
| Provision for income  taxes                  |       |                             | 446        |   |   |   | 1,248 |   |   |
| Net income                                   |       |                             | $          | 827 |   |   |   | $ | 625 |   |   |
| Net income per  share:                       |       |                             |       |   |   |   |   |   |   |
| Basic                                        |       |                             | $          | 0.04 |   |   |   | $ | 0.03 |   |   |
| Diluted                                      |       |                             | $          | 0.04 |   |   |   | $ | 0.03 |   |   |
| Weighted average  common shares outstanding: |       |                             |       |   |   |   |   |   |   |
| Basic                                        |       |                             | 19,260     |   |   |   | 19,206 |   |   |
| Diluted                                      |       |                             | 19,531     |   |   |   | 19,408 |   |   |

 

See notes to condensed consolidated financial statements.

 

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**CHEROKEEINTERNATIONAL CORPORATION AND SUBSIDIARIES**CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE OPERATIONS(In Thousands)(Unaudited)

| ** **                               | ** ** | **Three Months Ended** | ** ** |
|------------------------------------------|------------|----------------------------------|------------|
| ** **                               | ** ** | **March 31,  2006**         | ** ** | **March 31,  2005** | ** ** |
| Net income                               |       |                             | $          | 827 |   |   |   | $ | 625 |   |   |
| Other comprehensive  income (loss):      |       |                             |       |   |   |   |   |   |   |
| Foreign currency translation adjustments |       |                             | 363        |   |   |   | (946 | ) |   |
| Comprehensive income  (loss)             |       |                             | $          | 1,190 |   |   |   | $ | (321 | ) |   |

 

See notes to condensed consolidated financial statements.

 

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**CHEROKEE INTERNATIONAL CORPORATION AND SUBSIDIARIESCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS(In Thousands)(Unaudited)**

| ** **                                                                         | ** ** | **Three Months Ended** | ** ** |
|------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                         | ** ** | **March 31,  2006**         | ** ** | **March 31,  2005** | ** ** |
| CASH FLOWS FROM  OPERATING ACTIVITIES:                                             |       |                             |       |   |   |   |   |   |   |
| Net income                                                                         |       |                             | $          | 827 |   |   |   | $ | 625 |   |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |                             |       |   |   |   |   |   |   |
| Depreciation and amortization                                                      |       |                             | 811        |   |   |   | 769 |   |   |
| Amortization of deferred financing costs                                           |       |                             | 32         |   |   |   | 32 |   |   |
| Stock-based compensation                                                           |       |                             | 151        |   |   |   | — |   |   |
| Net change in  operating assets and liabilities:                                   |       |                             |       |   |   |   |   |   |   |
| Accounts receivable, net                                                           |       |                             | (256       | ) |   |   | 1,756 |   |   |
| Inventories, net                                                                   |       |                             | (2,491     | ) |   |   | (442 | ) |   |
| Prepaid expenses and other current assets                                          |       |                             | (665       | ) |   |   | 273 |   |   |
| Deposits and other assets                                                          |       |                             | (60        | ) |   |   | (260 | ) |   |
| Accounts payable                                                                   |       |                             | 2,687      |   |   |   | (351 | ) |   |
| Accrued liabilities and restructuring costs                                        |       |                             | (887       | ) |   |   | 1,237 |   |   |
| Accrued compensation and benefits                                                  |       |                             | 794        |   |   |   | (308 | ) |   |
| Accrued interest payable                                                           |       |                             | 589        |   |   |   | 610 |   |   |
| Other long-term obligations                                                        |       |                             | 542        |   |   |   | 125 |   |   |
| Net cash provided by operating activities                                          |       |                             | 2,074      |   |   |   | 4,066 |   |   |
| CASH FLOWS FROM  INVESTING ACTIVITIES:                                             |       |                             |       |   |   |   |   |   |   |
| Additions to property and equipment                                                |       |                             | (295       | ) |   |   | (1,185 | ) |   |
| Net change in short-term investments                                               |       |                             | —     |   |   |   | (984 | ) |   |
| Net cash used in investing activities                                              |       |                             | (295       | ) |   |   | (2,169 | ) |   |
| CASH FLOWS FROM  FINANCING ACTIVITIES:                                             |       |                             | —     |   |   |   | — |   |   |
| CASH EFFECT OF EXCHANGE RATE CHANGES                                               |       |                             | 124        |   |   |   | (360 | ) |   |
| NET INCREASE IN CASH AND CASH EQUIVALENTS                                          |       |                             | 1,903      |   |   |   | 1,537 |   |   |
| CASH AND CASH  EQUIVALENTS, BEGINNING OF PERIOD                                    |       |                             | 10,543     |   |   |   | 14,585 |   |   |
| CASH AND CASH EQUIVALENTS, END OF PERIOD                                           |       |                             | $          | 12,446 |   |   |   | $ | 16,122 |   |   |
| SUPPLEMENTAL  INFORMATION                                                          |       |                             |       |   |   |   |   |   |   |
| Cash paid during  the period for interest                                          |       |                             | $          | 330 |   |   |   | $ | 224 |   |   |
| Cash paid during  the period for income taxes                                      |       |                             | $          | 41 |   |   |   | $ | 46 |   |   |
| Noncash:                                                                           |       |                             |       |   |   |   |   |   |   |
| Additions to property  and equipment                                               |       |                             | $          | 32 |   |   |   | $ | — |   |   |

 

See notes to condensed consolidated financial statements.

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**CHEROKEE INTERNATIONAL CORPORATION AND SUBSIDIARIESNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Unaudited)**

**1.**                 Natureof Operations

Cherokee InternationalCorporation (the “Company”) is a designer and manufacturer of power suppliesfor original equipment manufacturers (OEMs). Its advanced power supply productsare typically custom designed into mid- to high-end commercial applications inthe computing and storage, wireless infrastructure, enterprise networking,medical and industrial markets.

*Initial PublicOffering*

The Company completed itsinitial public offering of 6,600,000 shares of its common stock, par value$0.001 per share (“Common Stock”), on February 25, 2004, at a price of$14.50 per share. The net proceeds to the Company from this offering afteroffering costs of $9.2 million were $86.5 million. The Company usedapproximately $73.2 million of the net proceeds to repay certain outstandingindebtedness and accrued interest. Immediately prior to the consummation of theoffering, the Company completed a 1 for 3.9 reverse stock split of itsoutstanding Common Stock. All share and per share amounts for all periodspresented in this report reflect this reverse stock split. Also in connectionwith the offering, the Company issued 6,283,796 shares of Common Stock uponconversion of the $53.4 million original principal amount of its outstandingsenior convertible notes, and issued 4,071,114 shares of Common Stock upon theexercise of outstanding warrants.

**2.**                 Basisof Presentation and Summary of Significant Accounting Policies

*Basis ofPresentation*

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

Results of operations for the interim three monthsended March 31, 2006 and 2005 are not necessarily indicative of theresults of operations for the full fiscal year. The Company’s first quarterrepresented the 13-week periods ended on April 2, 2006 and April 3,2005. For presentation purposes, these fiscal quarters have been referred to asending on March 31.

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

Certain informationnormally included in footnote disclosures to the financial statements has beencondensed or omitted in accordance with the rules and regulations of theSecurities and Exchange Commission. Accordingly, the financial statements donot include all the information and note disclosures normally included inannual consolidated financial statements prepared in accordance with accountingprinciples generally accepted in the United States of America. These unauditedcondensed consolidated financial statements should be read in conjunction withthe other disclosures contained herein and with the Company’s auditedconsolidated financial statements and notes thereto for the year ended December 31,2005, contained in the Company’s Annual Report on Form 10-K(File No. 000-50593) filed on April 18, 2006.

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*Use of Estimates*

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

*Stock-BasedCompensation*

In December 2004, SFAS 123R, *Share-Based Payment*, was issued. SFAS 123Ris a revision of SFAS 123, *Accountingfor Stock Based Compensation*, and supersedes APB 25. Among otheritems, SFAS 123R eliminates the use of APB 25 and the intrinsic valuemethod of accounting, and requires companies to recognize the cost of employeeservices received in exchange for awards of equity instruments, based on thegrant date fair value of those awards, in the financial statements. The Companywas required to adopt SFAS 123R effective fiscal 2006. SFAS 123R permitscompanies to adopt its requirements using either a “*modified prospective*” method, or a “*modified retrospective*” method. Under the “*modified prospective*” method, compensationcost is recognized in the financial statements beginning with the effectivedate, based on the requirements of SFAS 123R for all share-based paymentsgranted after that date, and based on the requirements of SFAS 123 for allunvested awards granted prior to the effective date of SFAS 123R. Under the “*modified retrospective*” method, therequirements are the same as under the “*modifiedprospective*’’method, but also permits entities to restate financial statements of previousperiods based on proforma disclosures made in accordance with SFAS 123.

The Company currently uses the Black-Scholes standardoption-pricing model to measure the fair value of stock options granted toemployees. While SFAS 123R permits the Company to continue to use such a model,the standard also permits the use of a “*lattice*”model. The Company is continuing to use the Black-Scholes model to measure thefair value of employee stock options upon the adoption of SFAS 123R.

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

The Company adopted SFAS 123R on January 1, 2006.The Company is using the “modified prospective” method as permitted by SFAS123R. Under this transition method, compensation cost recognized in the firstquarter of the fiscal 2006 includes:  (a) compensationcost for all share-based payments granted subsequent to February 25, 2004and prior to December 31, 2005 but not yet vested as of December 31,2005, based on the grant-date fair value estimated in accordance with theprovisions of SFAS 123R, and (b) compensation cost for all share-basedpayments granted subsequent to December 31, 2005, based on the grant-datefair value estimated in accordance with the provisions of SFAS 123R. Inaccordance with the modified perspective method of adoption, the Company’sresults of operations and financial position for prior periods have not beenrestated.

All grants are made at prices based on the fair marketvalue of the stock on the date of grant. Outstanding options generally vestover periods ranging from two to four years from the grant date and generallyexpire up to ten years after the grant date. The Company recorded $151,000 ofcompensation expense relating to outstanding options during the quarter ended March 31,2006. No compensation expense was recorded related to outstanding optionsduring the quarter ended March 31, 2005.

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TheCompany records compensation expense for employee stock options based on theestimated fair value of the options on the date of grant using theBlack-Scholes option pricing formula with the assumptions included in the tablebelow. The Company uses historical data, among other factors, to estimate theexpected price volatility, the expected option life and the expected forfeiturerate. The risk-free rate is based on the U.S. Treasury yield curve in effect atthe time of grant for the estimated life of the option. The followingweighted-average assumptions were used to estimate the fair value of optionsgranted during the three-months ended March 31, 2006 and 2005 using theBlack-Scholes option pricing formula.

| ** **               | ** ** | **Three-Months Ended  March 31,** | ** ** |
|--------------------------|------------|---------------------------------------------|------------|
| ** **               | ** ** | **2006**                                    | ** ** | **2005** | ** ** |
| Dividend yield           |       | 0.0                                         | %          | 0.0 | % |
| Expected  volatility     |       | 46.7                                        | %          | 38.2 | % |
| Risk free  interest rate |       | 4.63                                        | %          | 3.65 | % |
| Expected lives           |       | 5.0 years                                   |       | 5.0 years |   |

 

Thefollowing table summarizes the Company’s activities with respect to its stockoption plans for the first three months of 2006 as follows:

| **Options**                                                       | ** ** | ** ** | ** ** | **Number  of  Shares** | ** **                            | **Weighted-  Average  Exercise Price  Per Share** | ** ** | **Weighted-  Average  Remaining  Contractual  Term  (in years)** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
|-------------------------------------------------------------------|------------|------------|------------|------------------------|---------------------------------------|-------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|---------------------------------|------------|
| Outstanding at  January 1, 2006                              |       | 2,270,115  |       |                   | $                                     | 6.47                                                        |       |                                                                  |       | 8.73                            |       |   | $ | 1,510,311 |   |
| Granted                                                           |       | —     |       |                   |       — |                                                        |       |                                                                  | —     |                            |       | — |   |
| Exercised                                                         |       | —     |       |                   |       — |                                                        |       |                                                                  | —     |                            |       | — |   |
| Forfeited                                                         |       | (23,474    | )          |                   |   9.67                           |                                                        |       |                                                                  | —     |                            |       | — |   |
| Outstanding at  March 31, 2006                               |       | 2,246,641  |       |                   | $                                     | 6.43                                                        |       |                                                                  |       | 8.49                            |       |   | $ | 2,340,645 |   |
| Vested and  expected to vest in the future at March 31, 2006 |       | 2,034,356  |       |                   | $                                     | 6.53                                                        |       |                                                                  |       | 8.43                            |       |   | $ | 2,772,974 |   |
| Exercisable at  March 31, 2006                               |       | 834,142    |       |                   | $                                     | 8.03                                                        |       |                                                                  |       | 7.59                            |       |   | $ | — |   |

 

No options were exercisedfor the three-months ended March 31, 2006 and 2005, respectively.Therefore there was no actual tax benefit realized relating to stock optionexercises in the three-months ended March 31, 2006 and 2005.

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*Pro Forma EmployeeShare-Based Compensation Expense*

Prior to December31, 2005, the Company accounted for share-based employee compensationarrangements in accordance with  SFAS  123,*Accounting for Stock-Based Compensation,*the Company accounts for its employee stock-based compensation plan using theintrinsic value method under APB Opinion No. 25, *Accountingfor Stock Issued to Employees,* and provides the expanded disclosuresspecified in SFAS  123, as amended by SFAS  148, *Accountingfor Stock-Based Compensation—Transition and Disclosure*.

Asrequired by SFAS 123R, the required pro forma disclosure, for periods prior toadoption of SFAS 123R, is shown below (in thousands, except per share data):

| ** **                                                                                                                | ** ** | **March 31,  2005** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|
| Net income as  reported                                                                                                   |       |                     | $          | 625 |   |   |
| Stock-based  employee compensation included in net income, net of tax                                                     |       |                     | —     |   |   |
| Total stock-based  employee compensation expense determined under the fair value based method  for all awards, net of tax |       |                     | (291       | ) |   |
| Net income—pro  forma                                                                                                |       |                     | $          | 334 |   |   |
| Pro forma net  income per share:                                                                                          |       |                     |       |   |   |
| Basic                                                                                                                     |       |                     | $          | 0.02 |   |   |
| Diluted                                                                                                                   |       |                     | $          | 0.02 |   |   |

 

*Translation ofForeign Currency*

Foreign subsidiary assetsand liabilities denominated in foreign currencies are translated at theexchange rate on the balance sheet date. Revenues, costs and expenses aretranslated at the average exchange rate during the period. Transaction gainsand losses are included in results of operations and have not been significantfor the periods presented. The functional currency of the Company’s operatingsubsidiary in Europe, Cherokee Europe SCA (“Cherokee Europe”), is theEuro. The functional currency of the Company’s operating subsidiaries inMexico (Cherokee Electronica, S.A. de C.V.), in India (Cherokee India Pvt. Ltd.and Powertel India Pvt. Ltd.), and in China (Cherokee International (China)Power Supply LLC) is the U.S. dollar, as the majority of transactions aredenominated in U.S. dollars. Translation adjustments related to Cherokee Europeare reflected as a component of stockholders’ equity in accumulated othercomprehensive income.

*Recent AccountingPronouncements*

In November 2004, the FASB issued SFAS 151,*Inventory Costs*, which amends theguidance in ARB 43, Chapter 4,*Inventory Pricing*. This amendment clarifies the accounting forabnormal amounts of idle facility expense, freight, handling costs and wastedmaterial (spoilage). SFAS 151 requires that those items be recognized ascurrent-period charges, regardless of whether they meet the criteria specifiedin ARB 43 of *so abnormal*. Inaddition, SFAS 151 requires that allocation of fixed production overheads tothe costs of conversion be based on normal capacity of the productionfacilities. SFAS 151 is effective for financial statements for fiscal yearsbeginning after June 15, 2005. The Company adopted SFAS 151 duringthe three-month period ended December 31, 2005.

In December 2004, SFAS 123R, *Share-Based Payment*, was issued. SFAS 123Ris a revision of SFAS 123, *Accountingfor Stock Based Compensation*, and supersedes APB 25. Among otheritems, SFAS 123R eliminates the use of APB 25 and the intrinsic valuemethod of accounting, and requires companies to recognize the cost of employeeservices received in exchange for awards of equity instruments, based on thegrant date fair value of those awards, in the financial statements. The Companyadopted SFAS 123R effective fiscal 2006. SFAS 123R permits companies to adoptits requirements using 

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either a “*modified prospective*” method or a “*modified retrospective*” method. Under the “*modified prospective*” method, compensationcost is recognized in the financial statements beginning with the effectivedate, based on the requirements of SFAS 123R for all share-based paymentsgranted after that date, and based on the requirements of SFAS 123 for allunvested awards granted prior to the effective date of SFAS 123R. Under the “*modified retrospective*” method, therequirements are the same as under the “*modifiedprospective”* method, but also permits entities to restate financialstatements of previous periods based on pro forma disclosures made inaccordance with SFAS 123.

The Company currently uses the Black-Scholes standardoption-pricing model to measure the fair value of stock options granted toemployees. While SFAS 123R permits the Company to continue to use such a model,the standard also permits the use of a “*lattice*”model. The Company is continuing to use the Black-Scholes model to measure thefair value of employee stock options upon the adoption of SFAS 123R.

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

The Company adopted SFAS 123R on January 1, 2006using the “modified prospective” method. The adoption of SFAS 123R’s fair valuemethod impacted the Company’s results of operations, although it had no impacton the overall financial position and cash flows. As the result of theadoption, $151,000 of stock based compensation costs were expensed for thequarter ended March 31, 2006.

In December 2004, the FASB issued SFAS 153, *Exchanges of Non-monetary Assets*—*an amendment of APB Opinion 29*. The amendment eliminates theexception to fair value accounting for non-monetary exchanges of similarproductive assets and replaces it with a broader exception for exchanges ofnon-monetary assets that do not have commercial substance. Under APB 29,accounting for an exchange of a productive asset for a similar productive assetor an equivalent interest in the same or similar productive asset is to bebased upon the recorded amount of the asset relinquished (carry-over basis withno gain or loss recognition). Such transactions will now be accounted for basedupon the fair value of the assets exchanged. SFAS 153 is effective forexchanges occurring in fiscal years beginning after June 15, 2005 and isto be applied prospectively. This statement is not expected to have a materialimpact on the Company’s financial statements.

In May 2005, theFASB issued SFAS 154, *AccountingChanges and Error Corrections*, which replaced APB Opinion No. 20,*Accounting Changes*, and SFAS No. 3,*Reporting Changes in Interim FinancialStatements*. SFAS 154 requires retrospective application to priorperiods’ financial statements of voluntary changes in accounting principles andchanges required by a new accounting standard when the standard does notinclude specific transition provisions. Previous guidance required mostvoluntary changes in accounting principle to be recognized by including in netincome of the period in which the change was made the cumulative effect ofchanging to the new accounting principle. SFAS 154 carries forward existingguidance regarding the reporting of the correction of an error and a change inaccounting estimate. SFAS 154 is effective for accounting changes andcorrections of errors made in fiscal years beginning after December 15,2005. The Company adopted  SFAS 154 as ofJanuary 1, 2006; this statement did not have a material effect on theCompany’s consolidated financial position or results of operations.

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*Inventories*

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

| ** **       | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|------------------|------------|--------------------------|------------|-----------------------------|------------|
| Raw material     |       |                     | $          | 20,195                      |       |   |   | $ | 18,855 |   |   |
| Work-in-process  |       |                     | 4,011      |                        |       |   | 3,599 |   |   |
| Finished goods   |       |                     | 5,317      |                        |       |   | 4,397 |   |   |
| Inventories, net |       |                     | $          | 29,523                      |       |   |   | $ | 26,851 |   |   |

 

As of March 31, 2006and December 31, 2005, the reserve for inventory obsolescence was $3.5million and $3.8 million, respectively.

Thefollowing are two recent European Economic Community (“EEC”) directives thatare having an effect on the entire electronics industry:

(1)   Restriction of Hazardous Substances in Electrical and ElectronicEquipment (more commonly known as “RoHS”). This European directive bans the useof certain elements that are commonly found in components used to manufactureelectrical and electronic assemblies. This directive will become effective on July 1,2006. The Company is actively working with its customers to ensure compliancewhere required. The Company is focused on consuming all non-compliant materialon-hand within a reasonable period. However, the Company may have to dispose ofnon-compliant materials in the future, which could adversely affect thefinancial performance of the Company. There is also a risk of fines associatedwith non-compliance with the RoHS directive; however, the Company anticipatescomplying with all provisions of this legislation.

(2)   Waste Electrical and Electronic Equipment, also known as WEEE.This directive requires manufacturers and importers to properly recycle ordispose of such equipment at the end of its useful life. This directive becameeffective August 13, 2005. The Company believes it has limited exposure tothe WEEE directive because its products are usually installed into another user’ssystem, but this directive may be interpreted and enforced differently in thefuture. If so, the Company may face significant risk of fines and costsassociated with non-compliance with the existing laws and regulations in theEuropean Union.

**3.**                 Income Taxes

The Company accounts forincome taxes in accordance with SFAS 109, *Accountingfor Income Taxes*. In accordance with SFAS 109, deferred taxassets and liabilities are recorded for the estimated future tax effects oftemporary differences between the carrying value of assets and liabilities forfinancial reporting and their tax basis, and carry-forwards to the extent theyare realizable. A deferred tax provision or benefit results from the net changein deferred tax assets and liabilities during the period. A valuation allowanceis recorded if it is more likely than not that all or a portion of the recordeddeferred tax assets will not be realized. As of December 31, 2005,deferred tax assets include $36.9 million relating to a tax basis step up froma re-capitalization transaction in 1999 and $19.9 million of net operating loss(“NOL”) carry-forwards. The Company has recorded a valuation allowance againsta significant portion of its deferred tax assets.

Provision for income taxesfor the three months ended March 31, 2006 and the comparable period of2005, were $0.5 million, and $1.2 million, respectively. The provision for thethree months ended March 31, 2005 is higher due to a higher percentage oftaxable income for 2005 being generated in tax jurisdictions without operatingloss carryforwards, combined with projected losses in certain taxjurisdictions, with no available tax benefit related to these losses includedin the provision for income taxes.

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**4.**                 NetIncome Per Share

In accordance with SFAS 128, *Earnings Per Share*, basic income per shareis based upon the weighted average number of common shares outstanding. Dilutedincome per share is based upon the weighted average number of common andpotential shares of common stock for each period presented. Potential commonshares include the dilutive effect of stock options.

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

| ** **                                               | ** ** | **Three Months  Ended  March 31,  2006** | ** ** | **Three Months  Ended  March 31,  2005** | ** ** |
|----------------------------------------------------------|------------|----------------------------------------------------|------------|----------------------------------------------------|------------|
| Net income                                               |       |                                               | $          | 827                                                |       |   |   | $ | 625 |   |   |
| Shares:                                                  |       |                                               |       |                                               |       |   |   |   |   |
| Weighted-average common shares outstanding—basic    |       |                                               | 19,260     |                                               |       |   | 19,206 |   |   |
| Effect of dilutive  securities:                          |       |                                               |       |                                               |       |   |   |   |   |
| Stock options                                            |       |                                               | 271        |                                               |       |   | 202 |   |   |
| Weighted-average  common shares outstanding—diluted |       |                                               | 19,531     |                                               |       |   | 19,408 |   |   |
| Net income per share:                                    |       |                                               |       |                                               |       |   |   |   |   |
| Basic                                                    |       |                                               | $          | 0.04                                               |       |   |   | $ | 0.03 |   |   |
| Diluted                                                  |       |                                               | $          | 0.04                                               |       |   |   | $ | 0.03 |   |   |

 

**5.**                 DeferredFinancing Costs

Netdeferred financing costs are comprised of the following as of March 31,2006 and December 31, 2005 (in thousands):

| ** **                     | ** ** | **March 31,  2005** | ** ** | **December 31,  2005** | ** ** |
|--------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| Deferred  financing costs      |       |                     | $          | 580                         |       |   |   | $ | 580 |   |   |
| Accumulated  amortization      |       |                     | (266       | )                           |       |   | (234 | ) |   |
| Deferred financing  costs, net |       |                     | $          | 314                         |       |   |   | $ | 346 |   |   |

 

The Company amortizes deferred financing costs overthe life of the related debt; these costs will be fully amortized byAugust 2008.

**6.**                 Long-TermDebt

Long-termdebt consists of the following at March 31, 2006 and December 31,2005 (in thousands):

| ** **                                   | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|----------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| 5.25% senior  notes payable to third parties |       |                     | $          | 24,485                      |       |   |   | $ | 24,485 |   |   |
| 5.25% senior  notes payable to affiliates    |       |                     | 22,145     |                        |       |   | 22,145 |   |   |
| Total long-term debt                         |       |                     | $          | 46,630                      |       |   |   | $ | 46,630 |   |   |

 

As of March 31, 2006, all of the Company’slong-term debt is scheduled to be repaid in 2008.

The agreements governing the Credit Facility and seniornotes contain covenants that restrict the Company’s business operations,including covenants limiting the Company’s ability to make investments, enterinto mergers or acquisitions, dispose of assets, incur additional debt, grantliens, enter into transactions with affiliates, redeem or repurchase  capital stock, repay other debt and paydividends, and 

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contains a financial ratiotest based on senior leverage. They also contain customary events of default,including defaults in the payment of principal or interest, defaults in thecompliance with the covenants contained in the agreements governing theCompany’s debt, cross defaults to other material debt and bankruptcy or otherinsolvency events.

Long-term debt includes the Company’s senior notes,which mature on November 1, 2008. Interest on the senior notes is payablein cash on May 1 and November 1 of each year. The senior notes aresecured by a second-priority lien on substantially all of the Company’s domesticassets and by a pledge of 65% of the equity of certain of the Company’s foreignsubsidiaries. As of March 31, 2006, the Company was in compliance with allof the covenants set forth in the principal agreements governing the 5.25%senior secured notes due in 2008.

In connection with the Company’s initial publicoffering, the Company amended and restated its existing senior revolving creditfacility with General Electric Capital Corporation. The amended facility (the “CreditFacility”) provides for borrowings of up to $20.0 million that are subject to aborrowing base comprised of eligible accounts receivable and inventory, whichwas $13.8 million at March 31, 2006. The Credit Facility matures in August 2008and borrowings bear interest, at the Company’s option, at a rate per annumequal to LIBOR plus 2.5% or the agent bank’s base rate plus 1.0%. In additionto paying interest on outstanding principal, the Company is required to pay acommitment fee to the lenders under the credit facility in respect of theaverage daily balance of unused loan commitments at a rate of 0.5% per annum.The Credit Facility is secured by a first-priority lien, subject to permittedencumbrances, on substantially all of the Company’s domestic assets and by apledge of 65% of the equity of certain of the Company’s foreign subsidiaries.The Credit Facility contains restrictive covenants requiring the Company to,among other things, maintain certain senior leverage ratios. As of March 31,2006, there were no borrowings outstanding under the Credit Facility, and theCompany was in compliance with all of the covenants under the Credit Facility.

Cherokee Europe maintainsa working capital line of credit of approximately $3.7 million with INGBelgium, a bank in Belgium, Brussels, which is denominated in Euros, iscollateralized by a pledge in first and second rank over a specific amount ofbusiness assets, requires Cherokee Europe to maintain a certain specificminimum solvency ratio and is cancelable at any time. As of March 31,2006, Cherokee Europe had no outstanding borrowings under the line of creditand was in compliance with all covenants.

**7.**                 OtherLong-Term Obligations

Otherlong-term obligations consist of the following at March 31, 2006 and December 31,2005 (in thousands):

| ** **                                    | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|-----------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| 1999 Europe  restructuring liabilities        |       |                     | $          | 560                         |       |   |   | $ | 585 |   |   |
| 2003 Europe  restructuring liabilities        |       |                     | 1,188      |                        |       |   | 1,213 |   |   |
| Long service award  liabilities               |       |                     | 2,162      |                        |       |   | 2,075 |   |   |
| Deferred  compensation                        |       |                     | 977        |                        |       |   | 917 |   |   |
| Advances for  research & development |       |                     | 543        |                        |       |   | — |   |   |
| Total other long-term  obligations            |       |                     | $          | 5,430                       |       |   |   | $ | 4,790 |   |   |

 

The Company has agreementswith a local government agency in Belgium for funding in advances to CherokeeEurope for research and development expenses. These advances are expected to berepaid to the agency; either as a percentage of the revenues generated by theproducts developed or through a minimum fixed amount on an annual basis. Theseadvances are interest free.

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**8.**                 CustomerConcentration

For the quarter ended March 31, 2006, onecustomer accounted for 15% of net sales, and no other customer accounted formore than 10%. For the quarter ended March 31, 2005, two customersaccounted for 16% and 13% of net sales, respectively. For the 2006 fiscal year,the Company does not anticipate any single customer to account for more than10% of sales for the year. At December 31, 2005 year end, one customeraccounted for 10% of our net sales for the fiscal year. A decision by a majorcustomer to decrease the amount purchased from the Company or to ceasepurchasing the Company’s products could have a material adverse effect on theCompany’s financial position and results of operations.

As of March 31, 2006,one customer accounted for 11%, and no other customer accounted for more than10% of net accounts receivable. At the end of March 31, 2005, twocustomers accounted for 12% and 11%, of net accounts receivable, respectively.

**9.**                 Commitmentsand Contingencies

*Guarantees andIndemnities*

The Company has agreed to indemnify the former ownersof Cherokee Europe for product liability, environmental hazard and employmentpractice claims relating solely to post-acquisition business. The Company alsoindemnifies its directors and officers to the maximum extent permitted underthe laws of the State of Delaware, and various lessors in connection withfacility leases for certain claims arising from such facility or lease. Noclaims are currently pending against the Company for such indemnifications. Themaximum amount of potential future payments under such indemnification is notdeterminable.

The Company has notincurred significant amounts related to these guarantees and indemnificationobligations, and no liability has been recorded in the financial statements forguarantees and indemnification as of March 31, 2006.

*Employment andSeverance Agreements*

The Company has enteredinto employment agreements with certain executives, which provide for annualbase salaries and cash incentive payments of up to 120% of base salary subjectto attainment of corporate goals and objectives pursuant to incentivecompensation programs approved by the Company’s board of directors. Inaddition, the Company has entered into severance agreements with certainexecutives, which provide payments to the executive if the executive isterminated other than for cause or terminates for good reason as defined.

*Other Matters*

In the first quarter of2006, we executed a mutual release agreement with a former business partner. Theagreement released both parties from obligations arising from past transactions.As a result of this agreement, we made a one-time adjustment to reduce ourselling and marketing expense by $0.4 million during the quarter.

*India Matter*

In late March 2006, the Company learned thatemployees of its Indian subsidiary manufacturing operations had made certainunauthorized payments that may have been in violation of the Foreign CorruptPractices Act and local laws. The facility in India is used for the solepurpose of manufacturing products for other Company locations and, as such,does not generate revenue or issue invoices to external customers. Itmanufactures approximately 6% (by volume) of the products offered by theCompany.

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The subject payments, inthe aggregate, amount to approximately $40,000 in each year during 2004 and2005, and less than $10,000 in 2006. The Company retained outside counsel whoconducted an internal investigation into these payments. The Company hasnotified the Department of Justice and the Securities and Exchange Commissionof this matter, and will cooperate fully with any investigations that may beconducted by such regulatory agencies. The Company believes that this matterwill not have a material impact on its consolidated financial statements.

**10.**          Stockand Deferred Compensation Plans

*2002 Stock OptionPlan*

In July 2003, the Company adopted the CherokeeInternational Corporation 2002 Stock Option Plan (the “2002 Stock Option Plan”)under which up to 1,410,256 shares of the Company’s common stock may be issuedpursuant to the grant of non-qualified stock options to the directors,officers, employees, consultants and advisors of the Company and itssubsidiaries. In connection with the adoption of the 2002 Stock Option Plan,the company granted 1,087,327 stock options. The options typically vest over afour-year period, have a 10 year contractual life, range in exercise pricefrom $5.85 to $10.34 per share and were granted with exercise prices at orabove fair value as determined by Cherokee’s Board of Directors based on incomeand market valuation methodologies. In February 2004, the Company grantedoptions to purchase 328,320 shares of common stock at an exercise price of$14.50 and terminated the 2002 Stock Option Plan. No additional shares havebeen issued under the 2002 Stock Option Plan since February 2004. As of March 31,2006, the Company granted a total of 1,415,647 options to purchase shares ofcommon stock under the 2002 Stock Option Plan.

*2004 Employee StockPurchase Plan*

On February 16, 2004,the Company adopted the 2004 Employee Stock Purchase Plan (the ‘‘ESPP’’). TheESPP provides for an annual increase to be added on the first day of theCompany’s fiscal year equal to the lesser of (i) 250,000 shares or (ii) 1%of the number of outstanding shares on the last day of the immediatelypreceding fiscal year. As of March 31, 2006, a total of 712,587 shares ofCommon Stock are reserved for issuance under the plan. The ESPP, which isintended to qualify as an ‘‘employee stock purchase plan’’ under Section 423of the Internal Revenue Code of 1986, is implemented utilizing six-monthofferings with purchases occurring at six-month intervals, with a new offeringperiod commencing on the first trading day on or after May 15 and November 15and ending on the last trading day on or before November 14 or May 14,respectively. The Company’s Compensation Committee of the Board of Directorsoversees administration of the ESPP. Employees are eligible to participate ifthey are employed for at least 20 hours per week and more than 5 months in acalendar year by the Company, subject to certain restrictions. The ESPP permitseligible employees to purchase Common Stock through payroll deductions, whichmay not exceed 15% of an employee’s compensation. The price of Common Stockpurchased under the ESPP is 85% of the lower of the fair market value of theCommon Stock at the beginning of each six-month offering period or on theapplicable purchase date. Employees may end their participation in an offeringat any time during the offering period, and participation ends automaticallyupon termination of employment. The Compensation Committee may at any timeamend or terminate the ESPP, except that no such amendment or termination mayadversely affect shares previously granted under the ESPP. As of March 31,2006, 72,071 shares of Common Stock had been issued under the ESPP.

*2004 Omnibus StockIncentive Plan*

On February 16, 2004,the Company adopted the 2004 Omnibus Stock Incentive Plan (the ‘‘2004 Plan’’).The 2004 Plan provides for an annual increase to be added on the first day ofthe Company’s fiscal year equal to the lesser of (i) 450,000 shares or (ii) 2%of the number of outstanding shares on the last day of the immediatelypreceding fiscal year. As of March 31, 2006, a total of 142,827 shares ofthe Company’s 

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CommonStock are reserved for issuance under the 2004 Plan. Any officer, director,employee, consultant or advisor of the Company is eligible to participate inthe 2004 Plan. The 2004 Plan provides for the issuance of stock-based incentiveawards, including stock options, stock appreciation rights, restricted stock,deferred stock, and performance shares. As of March 31, 2006, the Companyhas granted options to purchase 1,426,489 shares of common stock under the 2004Plan, which included 138,153 options issued as partial compensation to non-employeedirectors. As of March 31, 2006, no shares had been issued under the 2004Plan.

*DeferredCompensation Plans*

On February 16, 2004,the Company adopted two executive deferred compensation plans for the benefitof certain designated employees and non-employee directors of the Company. Theplans allow participating employees and non-employee directors to make pre-taxdeferrals of up to 100% of their annual base salary and bonuses and retainerfees and meeting fees, respectively. The plans allow the Company to makematching contributions and employer profit sharing credits at the solediscretion of the Company. A participant’s interest in each matchingcontribution and employer profit sharing credits, if any, vests in full nolater than after 3 years. As of March 31, 2006, the Company has recorded aliability of $1.0 million for employee and non-employee director contributionsand investment activity to date, which is recorded in other long-termliabilities, and the Company has provided no matching contributions for thequarter ended March 31, 2006.

**11.**          RetirementPlans

CherokeeEurope maintains a pension plan for certain levels of staff and management thatincludes a defined benefit feature. The following represents the amountsrelated to this defined benefit plan for the three months ended March 31,2006 and 2005 (in thousands):

| ** **                                                           | ** ** | **Three Months  Ended** | ** ** | **Three Months  Ended** | ** ** |
|----------------------------------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| **Components of Net Periodic Benefit Cost** | ** ** | ** **                   | ** ** | **March 31,  2006**     | ** ** | **March 31,  2005** | ** ** |
| Service cost                                                         |       |                         | $          | 44                           |       |   |   | $ | 40 |   |   |
| Interest cost                                                        |       |                         | 58         |                         |       |   | 65 |   |   |
| Expected return  on plan assets                                      |       |                         | (31        | )                            |       |   | (36 | ) |   |
| Net periodic benefit  cost                                           |       |                         | $          | 71                           |       |   |   | $ | 69 |   |   |
|                                                                      |            |                              |            |                              |            |  |  |  |  |  |  |  |  |

 

Cherokee Europe presentlydoes not anticipate a contribution to the pension plan fund in 2006.

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

**FORWARD-LOOKINGSTATEMENTS**

Certain statements in thisQuarterly Report on Form 10-Q, other than purely historicalinformation, including estimates, projections, statements relating to ourbusiness plans, objectives and expected operating results, and the assumptionsupon which those statements are based, are “forward-looking statements” withinthe meaning of the Private Securities Litigation Reform Act of 1995, Section 27Aof the Securities Act of 1933 and Section 21E of the Securities ExchangeAct of 1934. These forward-looking statements generally are identified by thewords “believes,” “projects,” “expects,” “anticipates,” “estimates,” “intends,”“strategy,” “plan,” “may,” “will,” “would,” “will be,” “will continue,” “willlikely result,” and similar expressions. Forward-looking statements are basedon current expectations and assumptions that are subject to risks anduncertainties, which may cause actual results to differ materially from theforward-looking statements. Such factors include, among others, (1) changesin general economic and business conditions, domestically and internationally, (2) reductionsin sales to, or the loss of, any of 

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oursignificant customers or in customer capacity generally, (3) changes inour sales mix to lower margin products, (4) increased competition in ourindustry, (5) disruptions of our established supply channels, (6) ourlevel of debt and restrictions imposed by our debt agreements, and (7) theadditional risk factors in our filings with the Securities and ExchangeCommission, including our Annual Report on Form 10-K (CommissionFile No. 000-50593). Except as required by law, we undertake noobligation to update any forward-looking statements even though our situationmay change in the future.

**OVERVIEW**

**Business**

We are a designer and manufacturer of power suppliesfor original equipment manufactures (OEMs). Our advanced power supplyproducts are typically custom designed into mid- to high-end commercialapplications in the computing and storage, wireless infrastructure, enterprisenetworking, medical and industrial markets.

We operate worldwide and have facilities in OrangeCounty, California; Bombay, India; Guadalajara, Mexico; Wavre, Belgium andShanghai, China. We were founded in 1978 in Orange County, California. As weexpanded our business and customer base, we opened facilities in Bombay, India,Guadalajara, Mexico, and Shanghai, China. In June 2000, we acquiredCherokee Europe, which added a manufacturing facility in Wavre, Belgium to ourmanufacturing capacity and enabled us to better serve the European market.

We generate a significantportion of our sales from OEMs in the communications and computing marketsegment. Our operating results and financial condition continue to be adverselyaffected by unfavorable economic conditions and reduced capital spending by thecommunication service providers that purchase our customers’ products. Theseconditions have caused our revenues to soften in 2006 and 2005. In addition,gross margins in 2006 and 2005 reflect, among other things, a shift in oursales mix during that period to programs with products with relatively highermaterial cost.

**Basis of Reporting**

*Net Sales*

Net sales consist of salesduring the period presented, net of returns. Revenue is recognized from productsales at the time of shipment and passage of title.

*Cost of Sales*

The principal elementscomprising cost of sales are raw materials, labor and manufacturing overhead.Raw materials account for a large majority of our costs of sales. Raw materialsinclude magnetic sub-assemblies, sheet metal, electronic and other components,mechanical parts and electrical wires. Direct labor costs include costs ofhourly employees. Manufacturing overhead includes salaries, and the directexpense and allocation of costs attributable to manufacturing for lease costs,depreciation on property, plant and equipment, utilities, property taxes andrepairs and maintenance.

*Operating Expenses*

Operating expenses includeengineering costs, selling and marketing costs and general and administrativeexpenses. Engineering costs primarily include salaries and benefits ofengineering personnel, safety approval and quality certification fees, anddepreciation on equipment and subcontract costs for third-party contractingservices. Selling and marketing expenses primarily include salaries andbenefits to account managers and commissions to independent salesrepresentatives. Administrative expenses primarily include salaries andbenefits for certain management and administrative personnel, professional feesand information system costs. Operating expenses also include the directexpense and 

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allocationof costs attributable to these departments for lease costs, depreciation onproperty, plant and equipment, utilities, property taxes and repairs andmaintenance.

**Critical AccountingPolicies**

We prepare ourconsolidated financial statements in conformity with accounting principlesgenerally accepted in the United States. As such, we are required to makecertain estimates, judgments and assumptions that we believe are reasonablebased upon the information currently available. These estimates and assumptionsaffect the reported amounts of assets and liabilities at the date of thefinancial statements and the reported amounts of revenues and expenses duringthe periods presented. Any future changes to these estimates and assumptionscould have a material effect on our reported amounts of revenue, expenses,assets and liabilities. The significant accounting policies that we believe arethe most critical to aid in fully understanding and evaluating our reportedfinancial results include the following:

*Revenue Recognition*

We recognize revenue fromproduct sales at the time of shipment and passage of title. We also offer ourcustomers the right to return products that do not function properly within alimited time after delivery. We monitor and track product returns and record aprovision for warranty based on historical experience, which historically hasbeen insignificant to our financial condition and results of operations. Anysignificant increase in product failure rates could have a material adverseeffect on our operating results for the period or periods in which those returnsmaterialize.

*Accounts Receivable*

We perform ongoing creditevaluations of our customers and adjust credit limits based upon paymenthistory, the customer’s current credit worthiness and various other factors, asdetermined by our review of their current credit information. We continuouslymonitor collections and payments from our customers and maintain a provisionfor estimated credit losses based upon our historical experience and anyspecific customer collection issues that we have identified. While creditlosses have historically been within our expectations and the provisionsestablished, we might not continue to experience the same credit loss ratesthat we have in the past. A significant portion of our accounts receivable areconcentrated in a small number of customers. A significant change in theliquidity or financial position of any one of these customers could have amaterial adverse effect on the collectibility of our accounts receivable, ourliquidity and our future operating results. As of March 31, 2006, onecustomer accounted for 11% of net accounts receivable, and no other customeraccounted for more than 10%. At the end of March 31, 2005, two customersaccounted for 12% and 11%, of net accounts receivable, respectively.

*Inventories*

We value our inventory atthe lower of the actual cost to purchase and/or manufacture the inventory andthe current estimated market value of the inventory using the weighted averagecost method. We regularly review inventory quantities on hand and record a provisionfor excess and obsolete inventory based primarily on our historical usage dataand estimates of future demand. Our industry is characterized by rapidtechnological change, frequent new product development, and rapid productobsolescence that could result in an increase in the amount of obsoleteinventory quantities on hand. As demonstrated during the past five years,demand for our products can fluctuate significantly. A significant increase inthe demand for our products could result in a short-term increase in the costof inventory purchases while a significant decrease in demand could result inan increase in the amount of excess inventory quantities on hand. In addition,our estimates of future product demand may prove to be inaccurate, in which casewe may have understated or overstated the provision required for excess andobsolete inventory. In the future, if our inventory were determined to beovervalued, we would be required to recognize additional expense 

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in ourcost of goods sold at the time of such determination. Likewise, if ourinventory is determined to be undervalued, we may have over reported our costsof goods sold in previous periods and would be required to recognize additionaloperating income at the time such inventory is sold. Therefore, although wemake every reasonable effort to ensure the accuracy of our estimates of futureproduct 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 recognize deferred taxassets and liabilities based on the differences between the financial statementcarrying values and the tax bases of assets and liabilities. We regularlyreview our deferred tax assets for recoverability and establish a valuationallowance based on historical taxable income, projected future taxable income,and the expected timing of the reversals of existing temporary differences. Ifour future taxable income is significantly higher than expected and/or we areable to utilize our tax credits, we may be required to reverse all or asignificant part of our valuation allowance against such deferred tax assetswhich could substantially reduce our effective tax rate for such period. Therefore,any significant changes in statutory tax rates or the amount of our valuationallowance could have a material effect on the value of our deferred tax assetsand liabilities, and our reported financial results.

*Goodwill and LongLived Assets*

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

We also review therecoverability of the carrying value of long-lived assets whenever events orchanges in circumstances indicate that the carrying amount of an asset may notbe recoverable. Recoverability of these assets is determined based upon theforecasted undiscounted future net cash flows from the operations to which theassets relate, utilizing our best estimates, appropriate assumptions andprojections at the time. These projected future cash flows may varysignificantly over time as a result of increased competition, changes intechnology, fluctuations in demand, consolidation of our customers andreductions in average selling prices. If the carrying value is determined notto be recoverable from future operating cash flows, the asset would be deemedimpaired and an impairment loss would be recognized to the extent the carryingvalue exceeded the estimated fair market value of the asset.

**RESULTS OFOPERATIONS**

**THREE MONTHS ENDED MARCH 31,2006 COMPARED TO THREE MONTHS ENDED MARCH 31, 2005**

**NET SALES**

Net sales increased by approximately 12.8%, or $4.1million, to $36.1 million for the three months ended March 31, 2006 from$32.0 million for the three months ended March 31, 2005.

The increase in net salesin 2006 is due primarily to an increase in European revenues.

Our business remains largely dependent upon thelimited number of customers within the computing and storage, wirelessinfrastructure, enterprise networking, medical and industrial markets, and wecannot guarantee that we will continue to be successful in attracting newcustomers or retaining or increasing business with our existing customers. As aresult, our revenues could be significantly reduced if a large customer reducedits demand for our products.

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A number of factors havepreviously caused delays and may cause future delays in new computing andstorage, wireless infrastructure, enterprise networking, medical and industrialinfrastructures and upgrade deployment schedules throughout the world,including deployments in the United States, Mexico, Europe, and Asia. Inaddition, a number of factors may cause original equipment manufacturers toalter their outsourcing strategy concerning certain products, which could causesuch original equipment manufacturers to reduce or eliminate their demand forexternal supplies of such products or shift their demand to alternativesuppliers or internal suppliers. Such factors include lower perceived internalmanufacturing costs and competitive reasons to remain vertically integrated.Due to the possible uncertainties associated with infrastructure deploymentsand original equipment manufacturer demand, we have experienced and expect tocontinue to experience significant fluctuations in demand from our originalequipment manufacturer and customers. Such fluctuations have previously causedand may in the future cause significant reductions in our revenues and/oroperating results, which has adversely impacted and may continue to adverselyimpact our business, financial condition and results of operations.

**GROSS PROFIT**

Gross profit increased byapproximately 11.4%, or $0.9 million, to $8.5 million for the three monthsended March 31, 2006 from $7.6 million for the three months ended March 31,2005. Gross margin for the three months ended March 31, 2006 decreased to23.6% from 23.9% in the prior year period. The increase in gross profit was dueprimarily to the increase in European revenues.

**OPERATING EXPENSES**

Operating expenses for thethree months ended March 31, 2006 increased by approximately 31.5%, or$1.6 million, to $6.6 million from $5.0 million for the three months ended March 31,2005. As a percentage of net sales, operating expenses increased to 18.4% from15.8% in the prior year period. In the first quarter of 2006, we executed amutual release agreement with a former business partner. The agreement releasedboth parties from obligations arising from past transactions. As a result ofthis agreement, we made a one-time adjustment to reduce our selling andmarketing expense by $0.4 million during the quarter.

The increase in operatingexpenses is primarily due to a gain from insurance proceeds of $2.5 million inthe prior year period related to the fire damage experienced by our Belgiumfacility in February 2004. The Company also incurred $151,000 ofstock-based compensation expense during the three months ended March 31,2006, due to the adoption of SFAS 123R.

During the first quarterof 2005, we incurred an increase in professional fees and costs related to thereadiness efforts for compliance with Section 404 of the Sarbanes-OxleyAct, even though we were not required to comply with Section 404 of theSarbanes-Oxley Act in 2005. We incurred $0.2 million of related professionalfees and costs during the quarter ended March 31, 2005, compared to noexpenses during the quarter ended March 31, 2006. We continue to monitorand measure our market capitalization and the requirements under Section 404of the Sarbanes-Oxley Act. The recent strength in our Company’s stock pricesince December 31, 2005, may expedite the deadline of when the Company isrequired to comply with the requirements of Section 404 of theSarbanes-Oxley Act. Management believes a stock price in excess ofapproximately $8.00 on June 30, 2006, may require us to be compliant withthe requirements of Section 404 of the Sarbanes-Oxley Act by December 31,2006. The Company anticipates being compliant with all sections of the legislationwhen it is required. We estimate additional costs of approximately $1.0 millionto be incurred.

**OPERATING INCOME**

As a result of the factors discussed above, operatingincome decreased $0.7 million to $1.9 million for the three months ended March 31,2006, from $2.6 million for the three months ended March 31, 2005. Operatingmargin decreased to 5.2% from 8.1% in the prior year period.

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**INTEREST EXPENSE**

Interest expense for thethree months ended March 31, 2006 was $0.7 million compared to $0.7million for the three months ended March 31, 2005.

**INCOME TAXES**

Provision for income taxes for the three months ended March 31,2006 was $0.5 million compared to $1.2 million for the three months ended March 31,2005.

Provision for income taxesof $0.5 million for the three months ended March 31, 2006 was calculatedusing an estimated effective tax rate for 2006 of 35.0%, compared to a rate of66.7% for the comparable period of 2005. The rate decrease in 2006 from 2005 isdue largely to a higher percentage of taxable income for 2006 being generatedin tax jurisdictions with operating loss carryforwards.

**NET INCOME**

As a result of the factorsdiscussed above, we recorded net income of $0.8 million for the three monthsended March 31, 2006, compared to $0.6 million for the three months ended March 31,2005.

**LIQUIDITY ANDCAPITAL RESOURCES**

**CASH FLOWS**

**THREE MONTHS ENDED MARCH 31,2006 COMPARED TO THREE MONTHS ENDED MARCH 31, 2005**

Net cash provided by operating activities was $2.1million for the three months ended March 31, 2006, compared to net cashprovided by operating activities of $4.1 million for the three months ended March 31,2005. Net cash provided by operating activities for the three months ended March 31,2006 reflected the positive effect of $0.8 million in net income, $0.8 millionof depreciation and amortization, $0.2 million of stock-based compensationrelated to SFAS 123R, an increase in accounts payable of $2.7 million, a$0.8 million increase in accrued compensation and benefits, a $0.6 millionincrease in accrued interest payable, and a $0.5 million increase in otherlong-term obligations. These amounts were partially offset by a $0.3 millionincrease in accounts receivable, a $2.5 million increase in inventories, a $0.7million increase in prepaid expenses and other current assets, a $0.1 millionincrease in deposits and other assets, and a $0.9 million decrease inaccrued liabilities and restructuring costs. Cash provided by operatingactivities for the first quarter of 2005 was $4.1 million. Net cash provided byoperating activities for the three months ended March 31, 2005 reflectedthe positive effect of $0.6 million in net income, $0.8 million of depreciationand amortization, a $1.8 million reduction in accounts receivable, a $0.3million decrease in prepaid expenses and other current assets, a $1.2 millionincrease in accrued liabilities and restructuring costs, a $0.6 million increasein accrued interest payable, and an increase of $0.1 million in other long-termliabilities. Included in net income for the three months ended March 31,2005 is a gain from insurance proceeds of $2.5 million. These amounts werepartially offset by an increase in inventories of $0.4 million, anincrease of $0.3 million in deposits and other assets, a decrease of $0.4million in accounts payable, and a decrease in accrued compensation andbenefits of  $0.3 million. The decreasein accounts receivable was due primarily to the reduction in sales for thequarter, and the increase in accrued liabilities was due primarily to theprovision for income taxes.

Net cash used in investing activities for the threemonths ended March 31, 2006 was $0.3 million related to capitalexpenditures. Net cash used in investing activities for the three months ended March 31,2005 was $2.2 million, reflecting  $1.2million spent in capital expenditures, and an increase in short terminvestments of $1.0 million.

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Net cash provided byfinancing activities for the three months ended March 31, 2006 and thethree months ended March 31, 2005 was zero.

**LIQUIDITY**

As of March 31, 2006,we had cash and cash equivalents of $12.5 million, working capital of $43.1 millionand no borrowings under the Credit Facility. Historically, we have financed ouroperations with cash from operations supplemented by borrowings from creditfacilities and debt and equity issuances. Our current and future liquidityneeds primarily arise from working capital requirements and capitalexpenditures. Our historical capital expenditures have primarily resulted frominvestments in equipment to increase manufacturing capacity and to improvemanufacturing efficiencies. For 2006, we expect capital expenditures to be approximately$3.0 million, which will relate primarily to our investments in manufacturingequipment at our facilities. In 2005, we spent $8.1 million in capitalexpenditures of which $5.2 million was invested in the development of our newChina facility.

As of March 31, 2006, our borrowingsconsisted of approximately $46.6 million of senior notes bearing interest at5.25% annually, and no borrowings under the Credit Facility. We are required tomake semi-annual interest payments to holders of the senior notes.

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

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

Thematurities of our long-term debt and future payments relating to our operatingleases and other obligations as of March 31, 2006 are as follows (inthousands):

| **Contractual Obligations**       | ** ** | ** ** | ** ** | **April to  December  2006** | ** ** | **2007** | ** ** | **2008** | ** ** | **2009** | ** ** | **2010** | ** ** | **Thereafter** | ** ** | **Total** | ** ** |
|----------------------------------------|------------|------------|------------|-----------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------------|------------|-----------|------------|
| Long-term debt                         |       |       | $          | —                            |       |     | $          | —   |       | $        | 46,630     |     | $          | —         |       | $         | —     |   |   | $ | — |   |   | $ | 46,630 |   |
| Operating leases                       |       |       | 1,178      |                              |       | 1,583    |       | 1,579    |       | 526      |       | 2        |       |           | 114        |      |       | 4,982 |   |
| Purchase order  commitments            |       |       | 17,811     |                              |       | —   |       | —   |       | —   |       | —   |       |           | —     |      |       | 17,811 |   |
| 1999 Europe  restructuring             |       |       | 135        |                              |       | 158      |       | 120      |       | 87       |       | 235      |       |           | —     |      |       | 735 |   |
| 2003 Europe  restructuring             |       |       | 176        |                              |       | 221      |       | 198      |       | 193      |       | 177      |       |           | 454        |      |       | 1,419 |   |
| Long service  award                    |       |       | 10         |                              |       | 59       |       | 124      |       | 245      |       | 483      |       |           | 1,265      |      |       | 2,186 |   |
| Deferred  compensation                 |       |       | —     |                              |       | —   |       | —   |       | —   |       | —   |       |           | 977        |      |       | 977 |   |
| Advances for  research and development |       |       | 111        |                              |       | 86       |       | 53       |       | 50       |       | 50       |       |           | 304        |      |       | 654 |   |
| Total                                  |       |       | $          | 19,421                            |       |     | $          | 2,107    |       | $        | 48,704     |     | $          | 1,101          |       | $         | 947        |   |   | $ | 3,114 |   |   | $ | 75,394 |   |

 

Long-term debt includes our senior notes, which matureon November 1, 2008. Interest on the senior notes is payable in cash on May 1and November 1 of each year. The senior notes are secured by asecond-priority lien on substantially all of our domestic assets and by apledge of 65% of the equity of certain of our foreign subsidiaries.

In connection with our initial public offering in February of2004, we amended our existing senior revolving credit facility with GeneralElectric Capital Corporation. The Credit Facility provides for borrowings of upto $20.0 million, subject to a borrowing base comprised of eligible accountsreceivable 

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and inventory, which was$13.8 million at March 31, 2006. We plan to use funds available under thiscredit facility to finance working capital and other cash requirements asneeded. The credit facility matures in August 2008 and bears interest, atour option, at a rate per annum equal to LIBOR plus 2.5% or the agent bank’sbase rate plus 1.0%. In addition to paying interest on outstanding principal,we are required to pay a commitment fee to the lenders under the creditfacility in respect of the average daily balance of unused loan commitments ata rate of 0.5% per annum. The Credit Facility is our senior obligation andranks equal in right of payment with our existing and future permitted seniordebt (including our senior notes), and senior in right of payment to our futurepermitted subordinated debt. The Credit Facility is secured by a first-prioritylien, subject to permitted encumbrances, on substantially all of our domesticassets and by a pledge of 65% of the equity of certain of our foreignsubsidiaries.

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

As of March 31, 2006,we were in compliance with all covenants set forth in the principal agreementsgoverning our debt. Based on our present expectations, we believe that our existingcash and cash equivalents, working capital and available borrowing capacity at March 31,2006 will be sufficient to meet our anticipated cash requirements for at least thenext twelve months, including operating requirements, contractual obligations,planned capital expenditures and debt service.

**RECENT ACCOUNTINGPRONOUNCEMENTS**

In November 2004, the FASB issued SFAS 151,*Inventory Costs*, which amends theguidance in ARB 43, Chapter 4,*Inventory Pricing*. This amendment clarifies the accounting for abnormalamounts of idle facility expense, freight, handling costs and wasted material(spoilage). SFAS 151 requires that those items be recognized as current-periodcharges, regardless of whether they meet the criteria specified in ARB 43of *so abnormal*. In addition, SFAS151 requires that allocation of fixed production overheads to the costs ofconversion be based on normal capacity of the production facilities. SFAS 151is effective for financial statements for fiscal years beginning after June 15,2005. We adopted SFAS 151 during the three-month period ended December 31,2005.

In December 2004, SFAS 123R, *Share-Based Payment*, was issued. SFAS 123Ris a revision of SFAS 123, *Accountingfor Stock Based Compensation*, and supersedes APB 25. Among otheritems, SFAS 123R eliminates the use of APB 25 and the intrinsic valuemethod of accounting, and requires companies to recognize the cost of employeeservices received in exchange for awards of equity instruments, based on thegrant date fair value of those awards, in the financial statements. We adoptedSFAS 123R effective fiscal 2006. SFAS 123R permits companies to adopt itsrequirements using either a “*modifiedprospective*” method or a “*modifiedretrospective*” method. Under the “*modifiedprospective*” method, compensation cost is recognized in thefinancial statements beginning with the effective date, based on therequirements of SFAS 123R for all share-based payments granted after that date,and based on the requirements of SFAS 123 for all unvested awards granted priorto the effective date of SFAS 123R. Under the “*modifiedretrospective*” method, the requirements are the same as under the “*modified prospective”* method, but alsopermits entities to restate financial statements of previous periods based onpro forma disclosures made in accordance with SFAS 123.

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We currently use the Black-Scholes standardoption-pricing model to measure the fair value of stock options granted toemployees. While SFAS 123R permits us to continue to use such a model, thestandard also permits the use of a “*lattice*”model. We are continuing to use the Black-Scholes model to measure the fairvalue of employee stock options upon the adoption of SFAS 123R.

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

We adopted SFAS 123R on January 1, 2006 using the“modified prospective” method. The adoption of SFAS 123R’s fair value method impactedour results of operations, although it had no impact on our overall financialposition and cash flows. As the result of the adoption, $151,000 of stock-basedcompensation costs were expensed for the quarter ended March 31, 2006.

In December 2004, the FASB issued SFAS 153, *Exchanges of Non-monetary Assets*—*an amendment of APB Opinion 29*.  The amendment eliminates the exception tofair value accounting for non-monetary exchanges of similar productive assetsand replaces it with a broader exception for exchanges of non-monetary assetsthat do not have commercial substance. Under APB 29, accounting for an exchangeof a productive asset for a similar productive asset or an equivalent interestin the same or similar productive asset is to be based upon the recorded amountof the asset relinquished (carry-over basis with no gain or loss recognition).Such transactions will now be accounted for based upon the fair value of theassets exchanged. SFAS 153 is effective for exchanges occurring in fiscal yearsbeginning after June 15, 2005 and is to be applied prospectively. Thisstatement is not expected to have a material impact on our consolidatedfinancial position or results of operations.

In May 2005, theFASB issued SFAS 154, *AccountingChanges and Error Corrections*, which replaced APB Opinion No. 20,*Accounting Changes*, and SFAS No. 3,*Reporting Changes in Interim FinancialStatements*. SFAS 154 requires retrospective application to priorperiods’ financial statements of voluntary changes in accounting principles andchanges required by a new accounting standard when the standard does notinclude specific transition provisions. Previous guidance required mostvoluntary changes in accounting principle to be recognized by including in netincome of the period in which the change was made the cumulative effect ofchanging to the new accounting principle. SFAS 154 carries forward existingguidance regarding the reporting of the correction of an error and a change inaccounting estimate. SFAS 154 is effective for accounting changes andcorrections of errors made in fiscal years beginning after December 15,2005. We adopted  SFAS 154 on January 1,2006; this statement did not have a material effect on our consolidatedfinancial position or results of operations.

**Item 3.**              Quantitative andQualitative Disclosures About Market Risk

Market risk relating to our operations resultsprimarily from changes in foreign currency exchange rates and short-terminterest rates. We did not have any derivative financial instruments at March 31, 2006.

We had no variable rate debt outstanding at March 31,2006. However, any debt we incur under the Credit Facility and Cherokee Europeline of credit with BBL will bear interest at a variable rate. We cannotpredict market fluctuations in interest rates and their impact on any variablerate debt we may incur in the future, nor can there be any assurance that fixedrate long-term debt will be available to us at favorable rates, if at all.

The functional currencyfor our European operations is the Euro. We are, therefore, subject to acertain degree of market risk associated with changes in foreign currencyexchange rates. This risk is mitigated by the fact that our revenues andexpenses are generally both transacted in Euros, thereby 

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reducingthe risk of foreign currency fluctuation on our European operations. The effectof foreign currency exchange rate fluctuations on our operating results as ofand for the quarter ended March 31, 2006, was not material. Historically,we have not actively engaged in exchange rate-hedging activities.

**Item 4.**                Controls andProcedures

*Disclosure Controlsand Procedures*

Our management, with theparticipation of our President and Chief Executive Officer, and our ExecutiveVice President of Finance, Chief Financial Officer and Secretary, has evaluatedthe effectiveness of our disclosure controls and procedures (as such term isdefined in Rules 13a-15(e) and 15d-15(e) under theSecurities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the endof the period covered by this report. Based on such evaluation, our Presidentand Chief Executive Officer, and our Executive Vice President of Finance, ChiefFinancial Officer and Secretary have concluded that, as of the end of suchperiod, our disclosure controls and procedures were effective.

*Changes in InternalControl Over Financial Reporting*

In late March 2006, the Company learned thatemployees of its Indian subsidiary manufacturing operations had made certainunauthorized payments that may have been in violation of the Foreign CorruptPractices Act and local laws. The facility in India is used for the solepurpose of manufacturing products for other Company locations and, as such,does not generate revenue or issue invoices to external customers. Itmanufactures approximately 6% (by volume) of the products offered by theCompany.

The subject payments, in the aggregate, amount toapproximately $40,000 in 2004 and 2005, and less than $10,000 in 2006. TheCompany retained outside counsel who conducted an internal investigation intothese payments. The Company has notified the Department of Justice and theSecurities and Exchange Commission of this matter, and will cooperate fullywith any investigations that may be conducted by such regulatory agencies. TheCompany believes that this matter will not have a material impact on itsconsolidated financial statements.  Inthe interim, the Company has directed that no such payments be made withoutprior approval of U.S. management and is enhancing its existing policies andprocedures to ensure compliance with applicable laws.

Except as noted above, there have not been any changesin our internal control over financial reporting (as such term is defined in Rules 13a-15(f) and15d-15(f) under the Exchange Act) during our March 31, 2006quarter-end that have materially affected, or are reasonably likely tomaterially affect, our internal control over financial reporting.

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**PART II   OTHERINFORMATION**

**Item 1.**   LegalProceedings

On March 15, 2006, we concluded an arbitrationproceeding with our former Chairman of the Board, over the disputed amount dueto him under his 2003 Stock Option Plan Agreement, at the time of his resignationas Chairman of the Board in July 2004. The arbitrator issued an award infavor of him. Pursuant to an agreement with an unrelated third-party, we willbe reimbursed for the amounts awarded against us, including fees and legalexpenses, in the proceeding. Therefore, no expenses in connection with thisproceeding have been incurred or accrued by the Company.

In late March 2006, the Company learned thatemployees of its Indian subsidiary manufacturing operations had made certainunauthorized payments that may have been in violation of the Foreign CorruptPractices Act and local laws. The facility in India is used for the solepurpose of manufacturing products for other Company locations and, as such,does not generate revenue or issue invoices to external customers. Itmanufactures approximately 6% (by volume) of the products offered by theCompany.

The subject payments, in the aggregate, amount toapproximately $40,000 in 2004 and 2005, and less than $10,000 in 2006. TheCompany retained outside counsel who conducted an internal investigation intothese payments. The Company has notified the Department of Justice and theSecurities and Exchange Commission of this matter, and will cooperate fullywith any investigations that may be conducted by such regulatory agencies. TheCompany believes that this matter will not have a material impact on itsconsolidated financial statements.

During the quarter ended March 31,2006, we were not a party to any material legal proceedings. We areoccasionally a party to lawsuits relating to routine matters incidental to ourbusiness. As with all litigation, we can provide no assurance as to the outcomeof any particular lawsuit, and we note that litigation inherently involvessignificant costs.

**Item 1A.**   RiskFactors

There have been no material changes to the Company’srisk factors from those disclosed in the Company’s 2005 Annual Report on Form 10-K.

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**Item 6.   Exhibits**

**EXHIBIT INDEX**

Exhibits have heretoforebeen filed with the SEC and are incorporated herein by reference. Managementcontracts or compensatory plans or arrangements are marked with an asterisk.

| Exhibit No. | ** ** | **Description** | ** ** |
|------------------|------------|-----------------|------------|
|             | 3.1        |            |       | Restated Certificate of  Incorporation of Cherokee International Corporation.(1) |   |
|             | 3.2        |            |       | Amended and Restated  By-Laws of Cherokee International Corporation.(1) |   |
|             | 4.1        |            |       | Specimen certificate for  shares of common stock, par value $0.001 per share.(4) |   |
|             | 4.2        |            |       | Indenture, dated as of  November 27, 2002, between Cherokee International Corporation, as  issuer, and U.S. Bank, N.A., as trustee, relating to the 5.25% Senior Notes  due 2008.(2) |   |
|             | 4.3        |            |       | Form of 5.25%  Senior Notes due 2008.(2) |   |
|             | *10.1      |            |       | Cherokee International  Corporation 2004 Omnibus Stock Incentive Plan.(3) |   |
|             | *10.2      |            |       | Form of 2004 Stock  Option Agreement.(3) |   |
|             | *10.3      |            |       | Form of Officer and  Director Indemnification Agreement.(4) |   |
|             | *10.4      |            |       | Executive Deferred  Compensation Plan (and related schedule).(3) |   |
|             | 10.5       |            |       | 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 named therein.(5) |   |
|             | 10.6       |            |       | Amended and Restated  Revolving Note, dated as of February 25, 2004, issued by Cherokee International  Corporation.(5) |   |
|             | 10.7       |            |       | Amended and Restated  Security Agreement, dated as of February 25, 2004, by and between  Cherokee International Corporation and the Agent.(5) |   |
|             | 10.8       |            |       | Registration  Rights Agreement, dated as of February 25, 2004, by and among Cherokee  International Corporation and the Securityholders party thereto.(6) |   |
|             | 10.9       |            |       | Security  Agreement, dated as of November 27, 2002, between Cherokee International  Corporation and U.S. Bank, N.A., as agent (relating to the 5.25% Senior Note  Indenture).(2) |   |
|             | 10.10      |            |       | Trademark  Security Agreement, dated as of November 27, 2002, between Cherokee  International Corporation and U.S. Bank, N.A., as agent (relating to the  5.25% Senior Note Indenture).(2) |   |
|             | 10.11      |            |       | Pledge Agreement,  dated as of November 27, 2002, between Cherokee International  Corporation and U.S. Bank, N.A., as agent (relating to the 5.25% Senior Note  Indenture).(2) |   |
|             | 10.12      |            |       | Pledge Agreement,  dated as of November 27, 2002, between Cherokee Netherlands I B.V. and  U.S. Bank, N.A., as agent (relating to the 5.25% Senior Note Indenture).(2) |   |
|             | *10.13     |            |       | Cherokee  International Corporation 2002 Stock Option Plan.(2) |   |
|             | *10.14     |            |       | Form of 2002  Stock Option Agreement.(2) |   |
|             | *10.15     |            |       | Severance  Agreement, dated as of March 31, 2005, between Cherokee International  Corporation and Jeffrey M. Frank.(7) |   |
|             | 10.16      |            |       | Lease Agreement,  dated as of April 30, 1999, by and between Ganpat I. Patel and Manju G.  Patel, Trustees of the Patel Family Trust dated July 17, 1987, as to an  undivided two-thirds interest, and Kenneth O. King and Arlene King, husband  and wife as joint tenants, as to an undivided one-third interest, as tenants  in common, and Cherokee International Corporation.(2) |   |
|             | *10.17     |            |       | 2005 Cash  Incentive Compensation program for executive officers and other employees  dated as of March 14, 2005.(8) |   |
|             | *10.18     |            |       | Severance  Agreement, dated as of June 16, 2005, between Cherokee International  Corporation and Mukesh Patel.(9) |   |

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| Exhibit No. | ** ** | **Description** | ** ** |
|------------------|------------|-----------------|------------|
|             | *10.19     |            |       | Letter Agreement,  dated as of October 14, 2005, between Cherokee International Corporation  and Linster W. Fox.(10) |   |
|             | *10.20     |            |       | Severance  Agreement, dated as of October 14, 2005, between Cherokee International  Corporation and Linster W. Fox.(10) |   |
|             | *10.21     |            |       | 2006 Cash  Incentive Compensation program for executive officers and other employees  dated as of January 06, 2006.(11) |   |
|             | 31.1       |            |       | Certification of  President, Chief Executive Officer, and Director pursuant to Section 302  of the Sarbanes-Oxley Act of 2002. |   |
|             | 31.2       |            |       | Certification of  Executive Vice President of Finance, Chief Financial Officer and Secretary  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |   |
|             | 32.1       |            |       | Certification of CEO and  CFO Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002. |   |

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

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

(3)          Incorporated byreference from Amendment No. 2 to the Registration Statement on Form S-1(File No. 333-110723), filed by the Registrant on February 4,2004.

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

(5)          Incorporated byreference from the Quarterly Report on Form 10-Q, filed by theRegistrant on May 12, 2004.

(6)          Incorporated byreference from the Quarterly Report on Form 10-Q, filed by theRegistrant on August 9, 2004.

(7)          Previously filed as anexhibit to our Form 10-K on April 1, 2005.

(8)          Previously filed as anexhibit to our Form 8-K on March 21, 2005.

(9)          Previously filed as anexhibit to our Form 8-K on June 16, 2005.

(10)   Previously filed as an exhibitto our Form 8-K on October 31, 2005.

(11)   Previously filed as an exhibitto our Form 8-K on February 08, 2006.

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**SIGNATURES**

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned, thereuntoduly authorized.

CHEROKEE INTERNATIONAL CORPORATION

| Date: May 17, 2006  | By:    | /s/ JEFFREY M.  FRANK                                                        |
|--------------------------|--------|------------------------------------------------------------------------------|
|                     |   | Jeffrey M. Frank                                                             |
|                     |   | President, Chief Executive Officer, and Director                             |
| Date: May 17,  2006 | By:    | /s/ LINSTER W. FOX                                                           |
|                     |   | Linster W. Fox                                                               |
|                     |   | Executive Vice President of Finance, Chief Financial  Officer, and Secretary |

 

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