**UNITED STATES****SECURITIESAND EXCHANGE COMMISSION**

**Washington, D.C.  20549**

 

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**FORM 10-Q**

 

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

 

**For the quarterly period ended October 3,2004**

 

**OR**

 

**o****TRANSITION REPORT PURSUANTTO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For the transition period             to            **

 

**Commission file number 000-50593**

 

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**CHEROKEE INTERNATIONAL CORPORATION**

(Exact name of Registrant as specified in itscharter)

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

 

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

 

**N/A**

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

 

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

 

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

 

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

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

 

 

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TABLE OF CONTENTS

 
| PART  I-FINANCIAL INFORMATION                                                                                                        | 3      |
|--------------------------------------------------------------------------------------------------------------------------------------|--------|
|                                                                                                                                 |   |
| Item  1. Condensed Consolidated Financial Statements (unaudited):                                                                    | 3      |
|                                                                                                                                 |   |
| Condensed  Consolidated Balance Sheets-September 30, 2004 and December 31,  2003                                           | 3      |
|                                                                                                                                 |   |
| Condensed  Consolidated Statements of Operations-For the Three and Nine Months Ended September 30,  2004 and 2003               | 4      |
|                                                                                                                                 |   |
| Condensed  Consolidated Statements of Comprehensive Operations-For the Three and Nine  Months Ended September 30, 2004 and 2003 | 5      |
|                                                                                                                                 |   |
| Condensed  Consolidated Statements of Cash Flows-For the Nine Months Ended September 30,  2004 and 2003                         | 6      |
|                                                                                                                                 |   |
| Notes  to Condensed Consolidated Financial Statements                                                                                | 7      |
|                                                                                                                                 |   |
| Item  2. Management’s Discussion and Analysis of Financial Condition and Results of  Operations                                 | 13     |
|                                                                                                                                 |   |
| Item  3. Quantitative and Qualitative Disclosures About Market Risk                                                                  | 21     |
|                                                                                                                                 |   |
| Item 4. Controls and  Procedures                                                                                                     | 21     |
|                                                                                                                                 |   |
| PART II-OTHER INFORMATION                                                                                                            | 21     |
|                                                                                                                                 |   |
| Item 1. Legal Proceedings                                                                                                            | 21     |
|                                                                                                                                 |   |
| Item  2. Unregistered Sales of Equity Securities and Use of Proceeds                                                                 | 22     |
|                                                                                                                                 |   |
| Item 6. Exhibits                                                                                                                     | 22     |
|                                                                                                                                 |   |
| Signatures                                                                                                                           | 23     |

 

2

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PART I.  FINANCIALINFORMATION

 

**Item 1.  Condensed Consolidated FinancialStatements.**

 

CHEROKEE INTERNATIONAL CORPORATION ANDSUBSIDIARIES

CONDENSED CONSOLIDATEDBALANCE SHEETS

(In Thousands, Except Share Data)

(Unaudited)

 
| ** **                                                                                                                                                                                       | ** ** | **September 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
|                                                                                                                                                                                             |       |                         |       |                        |       |
| ASSETS                                                                                                                                                                                           |       |                         |       |                        |       |
| CURRENT ASSETS:                                                                                                                                                                                  |       |                         |       |                        |       |
| Cash and cash equivalents                                                                                                                                                                        |       | $                            | 16,415     |                        | $          | 4,887 |   |
| Short-term investments                                                                                                                                                                           |       | 159                          |       | 91                          |       |
| Accounts receivable, net                                                                                                                                                                         |       | 28,344                       |       | 25,579                      |       |
| Inventories, net                                                                                                                                                                                 |       | 27,985                       |       | 24,932                      |       |
| Prepaid expenses and other  current assets                                                                                                                                                       |       | 2,225                        |       | 1,842                       |       |
| Total current assets                                                                                                                                                                             |       | 75,128                       |       | 57,331                      |       |
|                                                                                                                                                                                             |       |                         |       |                        |       |
| Property and equipment,  net                                                                                                                                                                     |       | 13,562                       |       | 12,781                      |       |
| Deposits and other assets                                                                                                                                                                        |       | 832                          |       | 250                         |       |
| Deferred financing costs,  net                                                                                                                                                                   |       | 508                          |       | 536                         |       |
| Goodwill                                                                                                                                                                                         |       | 6,317                        |       | 6,317                       |       |
|                                                                                                                                                                                             |       |                         |       |                        |       |
|                                                                                                                                                                                             |       | $                            | 96,347     |                        | $          | 77,215 |   |
| LIABILITIES AND  STOCKHOLDERS’ EQUITY (DEFICIT)                                                                                                                                             |       |                         |       |                        |       |
| CURRENT LIABILITIES:                                                                                                                                                                             |       |                         |       |                        |       |
| Accounts payable                                                                                                                                                                                 |       | $                            | 12,956     |                        | $          | 12,854 |   |
| Accrued liabilities                                                                                                                                                                              |       | 5,646                        |       | 7,073                       |       |
| Accrued restructuring  costs                                                                                                                                                                     |       | 226                          |       | 1,144                       |       |
| Accrued compensation and  benefits                                                                                                                                                               |       | 7,494                        |       | 7,346                       |       |
| Accrued interest payable                                                                                                                                                                         |       | 1,072                        |       | 746                         |       |
| Revolving lines of credit                                                                                                                                                                        |       | —                       |       | 6,132                       |       |
| Current portion of long-term  debt                                                                                                                                                               |       | —                       |       | 2,562                       |       |
| Current portion of capital  lease obligations                                                                                                                                                    |       | 182                          |       | 848                         |       |
| Total current liabilities                                                                                                                                                                        |       | 27,576                       |       | 38,705                      |       |
|                                                                                                                                                                                             |       |                         |       |                        |       |
| Long-term debt, net of  current portion                                                                                                                                                          |       | 46,630                       |       | 162,893                     |       |
| Other long-term  obligations                                                                                                                                                                     |       | 3,920                        |       | 5,585                       |       |
|                                                                                                                                                                                             |       |                         |       |                        |       |
| COMMITMENTS AND  CONTINGENCIES (Note 10)                                                                                                                                                         |       |                         |       |                        |       |
|                                                                                                                                                                                             |       |                         |       |                        |       |
| STOCKHOLDERS’ EQUITY  (DEFICIT)                                                                                                                                                             |       |                         |       |                        |       |
| Preferred stock:  $0.001 par value; 10,000,000 shares  authorized; none issued and outstanding                                                                                              |       | —                       |       | —                      |       |
| Common stock:  $0.001 par value; 60,000,000 shares  authorized; 19,182,254 and 2,213,754 shares issued and outstanding at September 30,  2004 and December 31, 2003, respectively |       | 19                           |       | 2                           |       |
|                                                                                                                                                                                             |       |                         |       |                        |       |
| Paid-in capital                                                                                                                                                                                  |       | 183,549                      |       | 43,710                      |       |
| Accumulated deficit                                                                                                                                                                              |       | (167,889                     | )          | (176,107                    | )          |
| Accumulated other  comprehensive income                                                                                                                                                          |       | 2,542                        |       | 2,427                       |       |
|                                                                                                                                                                                             |       |                         |       |                        |       |
| Net stockholders’ equity  (deficit)                                                                                                                                                         |       | 18,221                       |       | (129,968                    | )          |
|                                                                                                                                                                                             |       |                         |       |                        |       |
|                                                                                                                                                                                             |       | $                            | 96,347     |                        | $          | 77,215 |   |

 

See notes to condensed consolidated financialstatements.

 

3

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CHEROKEE INTERNATIONAL CORPORATION ANDSUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In Thousands, Except Per Share Amounts)

(Unaudited)

 
| ** **                                   | ** ** | **Three Months Ended**       | ** ** | **Nine Months Ended**        | ** ** |
|----------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **                                   | ** ** | **September 30,  2004** | ** ** | **September 30,  2003** | ** ** | **September 30,  2004** | ** ** | **September 30,  2003** | ** ** |
|                                         |       |                         |       |                         |       |   |   |   |   |
| Net sales                                    |       | $                            | 36,375     |                         | $          | 30,130 |   | $ | 111,829 |   | $ | 78,820 |   |
| Cost of sales                                |       | 26,434                       |       | 20,914                       |       | 77,613 |   | 56,720 |   |
| Gross profit                                 |       | 9,941                        |       | 9,216                        |       | 34,216 |   | 22,100 |   |
| Operating Expenses:                          |       |                         |       |                         |       |   |   |   |   |
| Engineering and  development                 |       | 2,462                        |       | 2,148                        |       | 7,128 |   | 6,410 |   |
| Selling and marketing                        |       | 1,945                        |       | 1,686                        |       | 5,775 |   | 4,489 |   |
| General and administrative                   |       | 2,180                        |       | 1,764                        |       | 6,281 |   | 5,074 |   |
| Restructuring costs                          |       | —                       |       | —                       |       | — |   | 4,474 |   |
| Stock compensation expense                   |       | 227                          |       | 823                          |       | 227 |   | 823 |   |
| Total operating expenses                     |       | 6,814                        |       | 6,421                        |       | 19,411 |   | 21,270 |   |
|                                         |       |                         |       |                         |       |   |   |   |   |
| Operating income                             |       | 3,127                        |       | 2,795                        |       | 14,805 |   | 830 |   |
|                                         |       |                         |       |                         |       |   |   |   |   |
| Interest expense                             |       | (713                         | )          | (4,439                       | )          | (4,509 | ) | (12,687 | ) |
| Other income, net                            |       | 93                           |       | 294                          |       | 40 |   | 848 |   |
| Income (loss) before  income taxes           |       | 2,507                        |       | (1,350                       | )          | 10,336 |   | (11,009 | ) |
| Provision for income taxes                   |       | 818                          |       | 1,054                        |       | 2,118 |   | 1,122 |   |
| Net income  (loss)                           |       | $                            | 1,689      |                         | $          | (2,404 | ) | $ | 8,218 |   | $ | (12,131 | ) |
|                                         |       |                         |       |                         |       |   |   |   |   |
| Net income (loss) per  share:                |       |                         |       |                         |       |   |   |   |   |
| Basic                                        |       | $                            | 0.09       |                         | $          | (1.11 | ) | $ | 0.51 |   | $ | (5.76 | ) |
| Diluted                                      |       | $                            | 0.09       |                         | $          | (1.11 | ) | $ | 0.50 |   | $ | (5.76 | ) |
|                                         |       |                         |       |                         |       |   |   |   |   |
| Weighted average common  shares outstanding: |       |                         |       |                         |       |   |   |   |   |
| Basic                                        |       | 19,182                       |       | 2,167                        |       | 15,970 |   | 2,105 |   |
| Diluted                                      |       | 19,463                       |       | 2,167                        |       | 18,397 |   | 2,105 |   |

 

See notes to condensed consolidated financialstatements.

 

4

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CHEROKEE INTERNATIONAL CORPORATION ANDSUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE OPERATIONS

(In Thousands)

(Unaudited)

 
| ** **                                | ** ** | **Three Months Ended**       | ** ** | **Nine Months Ended**        | ** ** |
|-------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **                                | ** ** | **September 30,  2004** | ** ** | **September 30,  2003** | ** ** | **September 30,  2004** | ** ** | **September 30,  2003** | ** ** |
|                                      |       |                         |       |                         |       |   |   |   |   |
| Net income  (loss)                        |       | $                            | 1,689      |                         | $          | (2,404 | ) | $ | 8,218 |   | $ | (12,131 | ) |
| Other  comprehensive income (loss):       |       |                         |       |                         |       |   |   |   |   |
| Foreign  currency translation adjustments |       | 1,141                        |       | (259                         | )     | 115 |   | 1,138 |   |
| Comprehensive  income (loss)              |       | $                            | 2,830      |                         | $          | (2,663 | ) | $ | 8,333 |   | $ | (10,993 | ) |

 

See notes to condensed consolidated financialstatements.

 

5

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CHEROKEE INTERNATIONAL CORPORATION ANDSUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In Thousands)

(Unaudited)

 
| ** **                                                                                          | ** ** | **Nine Months Ended**        | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|------------------------------|------------|
| ** **                                                                                          | ** ** | **September 30,  2004** | ** ** | **September 30,  2003** | ** ** |
|                                                                                                |       |                         |       |   |   |
| CASH FLOWS FROM OPERATING  ACTIVITIES:                                                              |       |                         |       |   |   |
| Net income (loss)                                                                                   |       | $                            | 8,218      |   | $ | (12,131 | ) |
| Adjustments to reconcile  net income (loss) to net cash provided by (used in) operating activities: |       |                         |       |   |   |
| Depreciation and  amortization                                                                      |       | 2,261                        |       | 2,700 |   |
| Stock compensation expense                                                                          |       | 227                          |       | 823 |   |
| Gain on sale of land                                                                                |       | —                       |       | (367 | ) |
| Amortization of deferred  financing costs                                                           |       | 118                          |       | 206 |   |
| Write-off of unamortized  deferred financing costs and debt discount                                |       | 224                          |       | — |   |
| Paid-in-kind interest  converted to debt                                                            |       | —                       |       | 2,541 |   |
| Net change in operating  assets and liabilities:                                                    |       |                         |       |   |   |
| Accounts receivable, net                                                                            |       | (2,810                       | )          | (7,200 | ) |
| Inventories, net                                                                                    |       | (3,078                       | )          | (4,027 | ) |
| Prepaid expenses and other  current assets                                                          |       | (385                         | )          | (15 | ) |
| Deposits and other assets                                                                           |       | (582                         | )          | 314 |   |
| Accounts payable                                                                                    |       | 125                          |       | 2,197 |   |
| Accrued liabilities and  accrued restructuring costs                                                |       | (2,332                       | )          | (209 | ) |
| Accrued compensation and  benefits                                                                  |       | (65)                         |       | 1,183 |   |
| Accrued interest payable                                                                            |       | 327                          |       | (950 | ) |
| Other long-term  obligations                                                                        |       | (1,655                       | )          | 9,756 |   |
| Net cash provided by (used  in) operating activities                                                |       | 593                          |       | (5,179 | ) |
|                                                                                                |       |                         |       |   |   |
| CASH FLOWS FROM INVESTING  ACTIVITIES:                                                              |       |                         |       |   |   |
| Additions to property and  equipment                                                                |       | (3,075                       | )          | (1,281 | ) |
| Net change in short-term  investments                                                               |       | (68                          | )     | 377 |   |
| Proceeds from sale of land                                                                          |       | —                       |       | 516 |   |
| Net cash used in investing  activities                                                              |       | (3,143                       | )          | (388 | ) |
|                                                                                                |       |                         |       |   |   |
| CASH FLOWS FROM FINANCING  ACTIVITIES:                                                              |       |                         |       |   |   |
| Borrowings on revolving  lines of credit                                                            |       | 11,301                       |       | 48,299 |   |
| Payments on revolving  lines of credit                                                              |       | (17,433                      | )          | (45,670 | ) |
| Payments on obligations  under capital leases                                                       |       | (665                         | )          | (998 | ) |
| Payments on long-term debt                                                                          |       | (65,519                      | )          | (2,537 | ) |
| Deferred financing costs                                                                            |       | (249                         | )          | — |   |
| Proceeds from the exercise  of warrants and stock options                                           |       | 16                           |       | — |   |
| Net proceeds from sale of  common stock                                                             |       | 86,470                       |       | — |   |
| Net cash provided by (used  in) financing activities                                                |       | 13,921                       |       | (906 | ) |
|                                                                                                |       |                         |       |   |   |
| Cash effect of exchange  rate changes                                                               |       | 157                          |       | 416 |   |
|                                                                                                |       |                         |       |   |   |
| Net increase (decrease) in  cash and cash equivalents                                               |       | 11,528                       |       | (6,057 | ) |
| Cash and cash equivalents,  beginning of period                                                     |       | 4,887                        |       | 8,504 |   |
|                                                                                                |       |                         |       |   |   |
| Cash and cash equivalents,  end of period                                                           |       | $                            | 16,415     |   | $ | 2,447 |   |
|                                                                                                |       |                         |       |   |   |
| SUPPLEMENTAL INFORMATION                                                                            |       |                         |       |   |   |
| Conversion of senior  convertible notes into common stock                                           |       | $                            | 53,370     |   | $ | — |   |

 

See notes to condensed consolidated financialstatements.

 

6

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CHEROKEE INTERNATIONALCORPORATION AND SUBSIDIARIES

NOTES TOCONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

1.                                       Nature ofOperations

 

Cherokee International Corporation (the “Company”) is a designer andmanufacturer of power supplies for original equipment manufacturers (OEMs). Itsadvanced power supply products are typically custom designed into mid- tohigh-end commercial applications in the computing and storage, wirelessinfrastructure, enterprise networking, medical and industrial markets.

 

*Initial Public Offering*

 

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

 

2.                                       Basis ofPresentation and Summary of Significant Accounting Policies

 

*Basis of Presentation*

 

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

 

Results of operations for the interim nine months ended September 30,2004 and 2003 are not necessarily indicative of the results of operations forthe full fiscal year. The Company’s third quarter represented the 14-weekperiod ended on October 3, 2004 and the 13-week period ended on September 28,2003. For presentation purposes, these fiscal quarters and the nine-monthperiods then ended have been referred to as ending on September 30.

 

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

 

Certain information normally included in footnote disclosures to thefinancial statements has been condensed or omitted in accordance with the rulesand regulations of the Securities and Exchange Commission. Accordingly, thefinancial statements do not include all the information and note disclosuresnormally included in annual consolidated financial statements prepared inaccordance with accounting principles generally accepted in the United Statesof America. These unaudited condensed consolidated financial statements shouldbe read in conjunction with the other disclosures contained herein and with theCompany’s audited consolidated financial statements and notes thereto for theyear ended December 31, 2003, contained in Amendment No. 5 to the Company’sRegistration Statement on Form S-1 (File No. 333-110723) filed on February 18,2004.

 

*Use of Estimates*

 

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

 

*Reclassifications*

 

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

 

7

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*Stock-Based Compensation*

 

As permitted by SFAS No. 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, “Accounting for Stock Issuedto Employees”, and provides the expanded disclosures specified in SFAS No. 123,as amended by SFAS No. 148, “Accounting for Stock-Based Compensation—Transitionand Disclosure”.

 

The table below reconciles net income (loss) as reported and pro formanet income (loss) had compensation cost been determined using the provisions ofSFAS No. 123 for the three and nine months ended September 30, 2004 and2003 (in thousands except per share data):

 
| ** **                                                                                                                        | ** ** | **Three Months Ended**       | ** ** | **Nine Months Ended**        | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **                                                                                                                        | ** ** | **September 30,  2004** | ** ** | **September 30,  2003** | ** ** | **September 30,  2004** | ** ** | **September 30,  2003** | ** ** |
| Net income  (loss), as reported                                                                                                   |       | $                            | 1,689      |                         | $          | (2,404 | ) | $ | 8,218 |   | $ | (12,131 | ) |
| Add: Stock-based  employee compensation included in net income (loss), net of tax                                                 |       | 227                          |       | —                       |       | 227 |   | — |   |
| Deduct: Total  stock-based employee compensation expense determined under the fair value  based method for all awards, net of tax |       | (263                         | )          | (41                          | )          | (587 | ) | (116 | ) |
| Net income  (loss)-pro forma                                                                                                      |       | $                            | 1,653      |                         | $          | (2,445 | ) | $ | 7,858 |   | $ | (12,247 | ) |
|                                                                                                                              |       |                         |       |                         |       |   |   |   |   |
| Net income  (loss) per share, as reported:                                                                                        |       |                         |       |                         |       |   |   |   |   |
| Basic                                                                                                                             |       | $                            | 0.09       |                         | $          | (1.11 | ) | $ | 0.51 |   | $ | (5.76 | ) |
| Diluted                                                                                                                           |       | $                            | 0.09       |                         | $          | (1.11 | ) | $ | 0.50 |   | $ | (5.76 | ) |
| Pro forma  net income (loss) per share:                                                                                           |       |                         |       |                         |       |   |   |   |   |
| Basic                                                                                                                             |       | $                            | 0.09       |                         | $          | (1.13 | ) | $ | 0.49 |   | $ | (5.82 | ) |
| Diluted                                                                                                                           |       | $                            | 0.08       |                         | $          | (1.13 | ) | $ | 0.48 |   | $ | (5.82 | ) |
|                                                                                                                                   |            |                              |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

For the purpose of estimating the compensation cost of the Company’soption grants in accordance with SFAS No. 123, the fair value of each optiongrant is estimated on the date of grant using the Black-Scholes option-pricingmodel, with the following weighted average assumptions used for grants duringthe nine months ended September 30, 2004: expected stock price volatilityof 53%; risk-free interest rate of 3.51%; no dividends; and expected lives offive years.  The assumptions used for thenine months ended September 30, 2003 were: expected stock price volatilityof zero; risk-free interest rate of 2.73%; no dividends; and expected lives offive years.

 

*Translation of Foreign Currency*

 

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

 

*Recent Accounting Pronouncements*

 

In January 2003, the FASB issued FIN 46,“Consolidation of Variable Interest Entities.” In general, a variable interest entity is a corporation, partnership,trust or any other legal structure used for business purposes that either (a)does not have equity investors with voting rights or (b) has equity investorsthat do not provide sufficient financial resources for the entity to supportits activities.  FIN 46 requires avariable interest entity to be consolidated by a company if that company issubject to a majority of the risk of loss from the variable interest entity’sactivities or entitled to receive a majority of the entity’s residual returnsor both.  The consolidation requirementsof FIN 46 apply immediately to variable interest entities created after January 31,2003.  With respect to variable interestentities created before January 31, 2003, in December 2003 the FASBissued FIN 46R which, among other things, revised the implementation date tofirst fiscal years or interim periods ending after March 15, 2004, withthe exception of Special Purpose Entities (“SPE”). The consolidated requirementsapply to all SPE’s in the first fiscal year or interim period ending after December 15,2003. As the Company determined that it did not have any variable interestentities to which these interpretations apply, the Company adopted FIN 46R inthe first quarter of 2004, and such adoption did not have a material impact onits financial statements.

 

8

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*Inventories*

 

Inventories are valued at the lower of average cost or market.Inventory costs include the cost of material, labor and manufacturing overheadand consist of the following, net of reserve for obsolescence (in thousands):

 
| ** **        | ** ** | **September 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|-------------------|------------|------------------------------|------------|-----------------------------|------------|
|              |       |                         |       |                        |       |
| Raw material      |       | $                            | 20,512     |                        | $          | 16,244 |   |
| Work-in-process   |       | 4,657                        |       | 4,662                       |       |
| Finished goods    |       | 2,816                        |       | 4,026                       |       |
|              |       |                         |       |                        |       |
| Inventories,  net |       | $                            | 27,985     |                        | $          | 24,932 |   |

 

As of September 30, 2004 and December 31, 2003, the reservefor inventory obsolescence was $4.0 million and $4.2 million, respectively.

 

3.                                       Income Taxes

 

The Company accounts for income taxes in accordance with SFAS No. 109, “Accountingfor Income Taxes.”  In accordance withSFAS No. 109, deferred tax assets and liabilities are recorded for theestimated future tax effects of temporary differences between the carryingvalue of assets and liabilities for financial reporting and their tax basis,and carryforwards to the extent they are realizable.  A deferred tax provision or benefit resultsfrom the net change in deferred tax assets and liabilities during theperiod.  A deferred tax asset valuationallowance is recorded if it is more likely than not that all or a portion ofthe recorded deferred tax assets will not be realized.  As of December 31, 2003, deferred taxassets include $42.7 million relating to a tax basis step up from a recapitalizationtransaction in 1999 and $12.5 million of net operating loss carryforwards.  The Company has recorded a full valuationallowance against its deferred tax assets.

 

Provision for income taxes of $2.1 millionfor the nine months ended September 30, 2004 was calculated using anestimated effective tax rate for 2004 of 20.5%. Provision for income taxes for the three months ended September 30,2004 included an adjustment to bring the year-to-date effective tax rate from16.6% used for the first six months of 2004 to the 20.5% used for the ninemonth period.  Provision for income taxesfor the three and nine month periods in 2004 primarily reflected estimatedtaxable income in Belgium as the Company no longer has net operating lossesavailable in Belgium in 2004.  Incomegenerated in the United States during 2004 is expected to be fully offset by theutilization of deferred tax assets, resulting in the relatively low effectivetax rate for the year. Provision for income taxes for the three months ended September 30,2003 of $1.1 million primarily reflected an accrual for an estimated taxliability relating to an audit assessment by the India tax authorities forprevious years.

 

4.                                       NetIncome (Loss) Per Share

 

In accordance with SFAS No. 128, “EarningsPer Share,” basic earnings (loss) per share is based upon the weighted averagenumber of common shares outstanding. Diluted earnings (loss) per share is based upon the weighted averagenumber of common and potential shares of common stock for each periodpresented.  Potential common sharesinclude the dilutive effect of stock options and warrants under the treasurystock method and senior convertible notes under the if-converted method.  For purposes of the diluted earnings pershare calculation for the nine months ended September 30, 2004, the seniorconvertible notes are assumed to have been converted at the beginning of theperiod, and as a result, net income has been increased by $1.0 million for thereduction in interest expense related to the senior convertible notes.  The diluted loss per share calculations forthe three and nine months ended September 30, 2003 exclude the dilutiveeffect of stock options and warrants because the impact is anti-dilutive.  Net loss per share for the third quarter 2003as stated under the caption “Management’s Discussion and Analysis of FinancialCondition and Results of Operations—Quarterly Results of Operations” inAmendment No. 5 to the Company’s Registration Statement on Form S-1 (File No.333-110723) filed on February 18, 2004, was subsequently determined to be$1.11 per share, basic and diluted, as shown in the table below rather than$1.06 per share.

 

9

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The following table sets forth thecomputation of basic and diluted net income (loss) per share (in thousands,except per share amounts):

 
| ** **                                                   | ** ** | **Three Months Ended**       | ** ** | **Nine Months Ended**        | ** ** |
|--------------------------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **                                                   | ** ** | **September 30,  2004** | ** ** | **September 30,  2003** | ** ** | **September 30,  2004** | ** ** | **September 30,  2003** | ** ** |
|                                                         |       |                         |       |                         |       |   |   |   |   |
| Net income  (loss)                                           |       | $                            | 1,689      |                         | $          | (2,404 | ) | $ | 8,218 |   | $ | (12,131 | ) |
| Adjustment  for interest expense on senior convertible notes |       | —                       |       | —                       |       | 1,036 |   | — |   |
| Net income  (loss), adjusted                                 |       | $                            | 1,689      |                         | $          | (2,404 | ) | $ | 9,254 |   | $ | (12,131 | ) |
|                                                         |       |                         |       |                         |       |   |   |   |   |
| Shares:                                                      |       |                         |       |                         |       |   |   |   |   |
| Weighted-average  common shares outstanding—basic       |       | 19,182                       |       | 2,167                        |       | 15,970 |   | 2,105 |   |
| Effect of  dilutive securities:                              |       |                         |       |                         |       |   |   |   |   |
| Senior  convertible notes and warrants                       |       | —                       |       | —                       |       | 1,960 |   | — |   |
| Outstanding  stock options                                   |       | 281                          |       | —                       |       | 467 |   | — |   |
| Weighted-average  common shares outstanding—diluted     |       | 19,463                       |       | 2,167                        |       | 18,397 |   | 2,105 |   |
|                                                         |       |                         |       |                         |       |   |   |   |   |
| Net income  (loss) per share:                                |       |                         |       |                         |       |   |   |   |   |
| Basic                                                        |       | $                            | 0.09       |                         | $          | (1.11 | ) | $ | 0.51 |   | $ | (5.76 | ) |
| Diluted                                                      |       | $                            | 0.09       |                         | $          | (1.11 | ) | $ | 0.50 |   | $ | (5.76 | ) |

 

5.                                       DeferredFinancing Costs

 

Net deferred financing costs are comprised of the following as of September 30,2004 and December 31, 2003 (in thousands):

 
| ** **                     | ** ** | **September 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|--------------------------------|------------|------------------------------|------------|-----------------------------|------------|
|                           |       |                         |       |                        |       |
| Deferred financing costs       |       | $                            | 580        |                        | $          | 834 |   |
| Accumulated amortization       |       | (72                          | )          | (298                        | )          |
|                           |       |                         |       |                        |       |
| Deferred financing costs,  net |       | $                            | 508        |                        | $          | 536 |   |

 

The Company amortizes deferred financing costs over the life of therelated debt, which is 4.5 years.  Duringthe nine months ended September 30, 2004, the Company wrote-offunamortized deferred financing costs of $0.2 million and fully amortizeddeferred financing costs of $0.3 million, as a result of the repayment ofoutstanding indebtedness in connection with the initial public offering.

 

6.                                       Long-TermDebt

 

Long-term debt consists of the following at September 30, 2004 andDecember 31, 2003 (in thousands):

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

 

10

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Presented below is a breakdown of the Company’s long-term debt payableto third parties and affiliates at September 30, 2004 and December 31,2003 (in thousands):

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

 

The senior notes mature on November 1, 2008.  Interest on the senior notes is payable incash on May 1 and November 1 of each year. The senior notes are secured by a second priority lien on substantiallyall of the Company’s domestic assets and by a pledge of 65% of the equity ofcertain of its foreign subsidiaries.  Asof September 30, 2004, the Company was in compliance with all of thecovenants set forth in the principal agreements governing the 5.25% seniornotes.

 

In connection with the Company’s initial public offering, the Companyamended and restated its existing senior revolving credit facility with GeneralElectric Capital Corporation.  Theamended credit facility (the “Credit Facility”) provides for borrowings of upto $20.0 million that are subject to a borrowing base comprised of eligibleaccounts receivable and inventory, which was $15.7 million at September 30,2004.  The Credit Facility matures in August 2008,and 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 addition to paying interest on outstandingprincipal, the Company is required to pay a commitment fee to the lenders underthe amended facility in respect of the average daily balance of unused loancommitments at a rate of 0.5% per annum. The Credit Facility is secured by a first-priority lien, subject topermitted encumbrances, on substantially all of the Company’s domestic assetsand by a pledge of 65% of the equity of certain of the Company’s foreignsubsidiaries.  The Credit Facilitycontains restrictive covenants requiring the Company to, among other things,maintain certain senior leverage ratios. As of September 30, 2004, there were no borrowings outstandingunder the Credit Facility, and the Company was in compliance with all of thecovenants under the Credit Facility.

 

Cherokee Europe maintains a working capital line of credit ofapproximately $3.7 million with a Belgian bank, BBL, which is denominated inEuros, collateralized by a pledge in first and second rank over a specificamount of business assets, requires Cherokee Europe to maintain a certainspecific minimum solvency ratio and is cancellable at any time.  As of September 30, 2004, CherokeeEurope had no outstanding borrowings under the line of credit and was incompliance with all covenants.

 

7.                                       OtherLong-Term Obligations

 

Other long-term obligations consist of the following at September 30,2004 and December 31, 2003 (in thousands):

 

 

| ** **                                                                                     | ** ** | **September 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| Restructuring  costs                                                                           |       | $                            | 1,525      |                        | $          | 1,670 |   |
| Long service  award                                                                            |       | 1,777                        |       | 1,515                       |       |
| Interest  payable related to the 14.5% second lien notes and the 12% senior convertible  notes |       | —                       |       | 2,400                       |       |
| Deferred  compensation                                                                         |       | 618                          |       | —                      |       |
| Other  long-term obligations                                                                   |       | $                            | 3,920      |                        | $          | 5,585 |   |

 

8.                                       CherokeeEurope Restructuring

 

In June 2003, the Company received approval for a restructuringplan (the “European Restructuring”) of its operations in Europe from theWorkers Union and the appropriate governmental authorities in Belgium.  The European Restructuring involved theelimination of 61 operational and administrative positions at the CherokeeEurope facility in Belgium due to unfavorable economic conditions in thatmarket.  All of the terminations werecompleted in 2003.  Pursuant to theEuropean Restructuring, the Company recorded a restructuring charge of $4.5million in operating expenses in the statement of operations during the ninemonths ended September 30, 2003. The European Restructuring costs are comprised entirely of one-timetermination benefits to be paid through 2010. The Company paid $1.1 million during the nine months ended September 30,2004 under the European Restructuring.

 

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

 

| Balance as  of January 1, 2004    |   | $      | 2,814  |   |
|----------------------------------------|--------|--------|--------|--------|
| Payments                               |   | (1,063 | )      |
| Balance as  of September 30, 2004 |   | 1,751  |   |
| Less current  portion                  |   | (226   | )      |
| Due after  one year                    |   | $      | 1,525  |   |

 

9.                                       CustomerConcentration

 

For the quarter ended September 30, 2004, two customers accountedfor 11% and 10%, respectively, of net sales, and for the nine months ended September 30,2004 one customer accounted for 18% of net sales, and no other customeraccounted for 10% or more of net sales in either period.  For the quarter ended September 30,2003, three customers accounted for 23%, 14% and 11%, respectively, of netsales, and for the nine months ended September 30,2003, two customers accounted for 18% and 11%, respectively, of net sales, andno other customer accounted for 10% or more of net sales in either period.  A decision by a major customer to decreasethe amount purchased from the Company or to cease purchasing the Company’sproducts could have a material adverse effect on the Company’s financialposition and results of operations.

 

As of September 30, 2004, two customers accounted for 12% and 11%,respectively, of net accounts receivable, and no other customer accounted for10% or more of net accounts receivable in such period.

 

10.                                 Commitments andContingencies

 

                                                *Guarantees and Indemnities*

 

The Company has agreed to indemnify the former owners of CherokeeEurope for product liability, environmental hazard and employment practiceclaims relating solely to post-acquisition business.  The Company also indemnifies its directorsand officers to the maximum extent permitted under the laws of the State ofDelaware, and various lessors in connection with facility leases for certainclaims arising from such facility or lease. No claims are currently pending against the Company for such indemnifications.The maximum amount of potential future payments under such indemnifications isnot determinable.

 

The Company has not incurred significant amounts related to theseguarantees and indemnifications, and no liability has been recorded in thefinancial statements for guarantees and indemnifications as of September 30,2004.

 

11.           Stock and DeferredCompensation Plans

 

                                                *2002 Employee Stock Option Plan*

 

As of September 30,2004 the Company recorded stock compensation expense of $0.2 million inconnection with the retirement of the Company’s former Chairman.

 

                                                *2004 Employee Stock Purchase Plan*

 

On February 16, 2004, the Company adopted the 2004 Employee StockPurchase Plan (the ‘‘ESPP’’). The ESPP provides that a total of 400,000 sharesof Common Stock are reserved for issuance under the plan, plus an annualincrease to be added on the first day of the Company’s fiscal year (beginning2005) equal to the lesser of (i) 250,000 shares or (ii) 1% of the number ofoutstanding shares on the last day of the immediately preceding fiscal year.The ESPP, which is intended to qualify as an ‘‘employee stock purchase plan’’under Section 423 of the Code, is implemented utilizing six-monthofferings with purchases occurring at six-month intervals, with a new offeringperiod commencing on the first trading day on or after May 15 (beginning in theyear 2005) and November 15 (beginning in the year 2004) and ending on thelast trading day on or before November 14 or May 14, respectively. TheCompany’s Board of Directors oversees the ESPP administration.  Employees are eligible to participate if theyare employed for at least 20 hours per week and more than 5 months in acalendar year by the Company, subject to certain restrictions as defined. TheESPP permits eligible employees to purchase Common Stock through payrolldeductions, which may not exceed 15% of an employee’s compensation. The priceof Common Stock purchased under the ESPP will be 85% of the lower of the fairmarket value of the Common Stock at the beginning of each six-month offeringperiod or on the applicable purchase date. Employees may end theirparticipation in an offering at any time during the offering period, andparticipation ends automatically upon termination of employment. The Company’sBoard of Directors may at any time amend or terminate the ESPP, except that nosuch amendment or termination may adversely affect shares previously grantedunder the ESPP.  As of September 30,2004, no shares have been issued under the ESPP.

 

                                                *2004 Omnibus Stock Incentive Plan*

 

On February 16,2004, the Company adopted the 2004 Omnibus Stock Incentive Plan (the ‘‘2004Plan’’). The 2004 Plan provides that a total of 800,000 shares of the Company’sCommon Stock are reserved for issuance under the 2004 Plan, plus an annual increaseto be added on the first day of the Company’s fiscal year (beginning 2005)equal to the lesser of (i) 450,000 shares or (ii) 2% of the number ofoutstanding shares on the last day of the immediately preceding fiscal year.Any officer, director, employee, consultant or advisor of the Company iseligible to participate in the 2004 Plan. The 2004 Plan provides for the issuance of stock-based incentive awards,including stock options, stock appreciation rights, restricted stock, deferredstock, and performance shares.  As of September 30,2004, no shares have been issued under the 2004 Plan.

 

 

12

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                                                *Deferred Compensation Plans*

 

On February 16, 2004, the Company adopted two executive deferredcompensation plans for the benefit of certain designated employees andnon-employee directors of the Company. The plans allow participating employeesand non-employee directors to make pre-tax deferrals of up to 100% of theirannual base salary and bonuses and retainer fees and meeting fees,respectively. The plans allow the Company to make matching contributions andemployer profit sharing credits at the sole discretion of the Company. Aparticipant’s interest in each matching contribution and employer profitsharing credits, if any, vests in full no later than after 3 years.  As of September 30, 2004, the total ofall participants' deferred balances, including investment activity to date,amounted to $618,000 and is included in other long-term obligations. TheCompany has provided no matching contributions.

 

12.                                 Retirement Plans

 

Cherokee Europe maintains a pension plan for certain levels of staffand management that includes a defined benefit feature.  The following represents the amounts relatedto this defined benefit plan for the three and nine months ended September 30,2004 and 2003 (in thousands):

 
| ** **                                  | ** ** | **Three Months Ended**       | ** ** | **Nine Months Ended**        | ** ** |
|---------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| **Components of Net Periodic Benefit Cost** | ** ** | **September 30,  2004** | ** ** | **September 30,  2003** | ** ** | **September 30,  2004** | ** ** | **September 30,  2003** | ** ** |
| Service cost                                |       | $                            | 41         |                         | $          | 28 |   | $ | 118 |   | $ | 84 |   |
| Interest  cost                              |       | 63                           |       | 51                           |       | 182 |   | 155 |   |
| Expected  return on plan assets             |       | (36                          | )          | (41                          | )          | (105 | ) | (121 | ) |
| Net periodic  benefit cost                  |       | $                            | 68         |                         | $          | 38 |   | $ | 195 |   | $ | 118 |   |
|                                             |            |                              |            |                              |            |  |  |  |  |  |  |  |  |  |

 

As of September 30, 2004, $0.1 million of pension plan contributionshave been made.  Cherokee Europepresently anticipates contributing an additional $0.1 million to fund itspension plan in 2004 for a total for the year of $0.2 million.

 

13.                                 Cherokee Europe Fire

 

On January 19, 2004, the Company experienced a fire in part of itsfacility in Belgium, which destroyed certain inventory, property andequipment.  The Company was fully insuredat the replacement value for the destroyed items, subject to a $5,000deductible, and the facility returned to full production the next day.  Within operating expenses for the nine monthsended September 30, 2004, the Company recorded a loss related to thedestroyed inventory, property and equipment. This loss has been fully offset by partial proceeds received andexpected recoveries from the insurance company, which have been recorded inprepaid expenses and other current assets.

 

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

 

OVERVIEW

 

Weare a designer and manufacturer of power supplies for Original EquipmentManufacturers, or OEMs. Our advanced power supply products are typically customdesigned into mid- to high-end commercial applications in the computing andstorage, wireless infrastructure, enterprise networking, medical and industrialmarkets.

 

We generate a significant portion of our sales from OEMs in thecommunications and computing market segment, particularly the telecom wirelessinfrastructure and networking sectors. During 2001, 2002 and the first quarterof 2003, our operating results were negatively affected by unfavorable economicconditions and reduced capital spending by communication service providers thatpurchase our customers’ products. Although we saw improvement in these economicconditions throughout 2003 and during the nine months ended September 30,2004, these improvements may not continue or may not be sustainable. Forexample, we experienced softness in demand from one of our largest customers inthe telecom wireless infrastructure market beginning in the second quarter of2004, which continued into the third quarter. We expect the reduced demand fromthis customer to continue at least through the remainder of 2004. Offsettingthis softness in demand, we recently have experienced increases in revenues fromnew customers and programs. However, new programs typically have highermaterial and labor costs in the early stages of production and, as a result,our material costs as a percentage of sales have increased over prior periodsresulting in lower gross margins. We expect this change in revenue mix, withincreased revenues from new programs, to continue during the fourth quarter of 2004.

 

Weoperate worldwide and have facilities in Orange County, California; Bombay,India; Guadalajara, Mexico; and Wavre, Belgium. We were founded in 1978 inOrange County, California. As we expanded our business and customer base, weopened facilities in Bombay, India in January 1984 and Guadalajara, Mexicoin August 1988. In June 2000, we acquired Cherokee Europe SCA(“Cherokee Europe”), which addeda manufacturing facility in Wavre, Belgium and enabled us to better serve theEuropean market.

 

OnApril 30, 1999, an investor group led by affiliates of Oaktree CapitalManagement, LLC (“Oaktree”) and GFI Energy Ventures, LLC (“GFI”) acquired 60%of our then-outstanding equity.

 

InNovember 2002, we consummated a series of transactions, resulting in therestructuring of our debt and capital structure and the reorganization of ourcompany from a California limited liability company into a Delaware corporation(the “Restructuring Transactions”).  Aspart of the Restructuring Transactions, we amended our then-existing creditfacility and entered into new senior credit facilities providing, in theaggregate, for $15.0 million of term loans (the “Term Loans”) and a revolvingcredit facility of up to $7.6 million (the “Old Revolving Facility”), in eachcase maturing November 30, 2005. As of December 31, 2003, two of theTerm Loans bore interest at an annual rate of 5.49% and the remaining two TermLoans bore interest at an annual rate of 5.91%. Borrowings under the OldRevolving Facility bore interest at an annual rate of 6.75% as of such date. Aspart of the Restructuring Transactions, we also issued approximately $41.0million original principal amount of 14 1/2% pay-in-kind second lien notes due2006 (“Second Lien Notes”), together with warrants to purchase 2,447,813 sharesof our common stock at $0.039 per share. Interest on the Second 

 

13

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Lien Notes was paid in kind from issuance. We also completed anexchange offer with respect to all of our outstanding $100.0 million of 10 1/2%senior subordinated notes due 2009. In exchange for the senior subordinatednotes, we issued (1) $46.6 million of 5 1/4% senior notes due 2008, (“SeniorNotes”) together with warrants to purchase 1,633,714 shares of our common stockat $0.039 per share and (2) $53.4 million of 12% senior convertible notes due2008 (“Senior Convertible Notes”), which were convertible into 6,283,796 sharesof our common stock at approximately $8.49 per share. From issuance, intereston the Senior Notes was paid in cash. Interest on the Senior Convertible Notes was added to the principalamount from the date of issuance. Amounts added to the principal in respect ofinterest payments on the Senior Convertible Notes were not convertible intoshares of our common stock.  Inconnection with our initial public offering described below, we repaid the TermLoans and the Old Revolving Facility, amended and restated our senior creditfacility, repaid the Second Lien Notes in full and repaid $4.4 million inaccrued interest and $12.1 million in interest added to the principal amount ofour Senior Convertible Notes.  Inaddition, all of the outstanding warrants were exercised and the originalprincipal amount of the Senior Convertible Notes was converted into shares ofour Common Stock.

 

Prior to the Restructuring Transactions in November 2002, we wereorganized as a California limited liability company and treated as apartnership for United States federal income tax purposes. As a result of beingreorganized into a Delaware corporation, Cherokee became subject to UnitedStates federal income taxation.

 

We completed our initial public offering of 6,600,000 shares of ourcommon stock on February 25, 2004. The net proceeds from the offering were $86.5 million.  We used approximately $73.2 million of thenet proceeds to repay outstanding indebtedness, including the Term Loans, theOld Revolving Facility, the Second Lien Notes, related interest on theseobligations, as well as accrued interest and interest added to the principalamount of our Senior Convertible Notes. In connection with the offering, we issued 6,283,796 shares of ourcommon stock upon conversion of the original principal amount of ouroutstanding Senior Convertible Notes, and issued 4,071,114 shares of commonstock upon exercise of all outstanding warrants.

 

In addition, in connection with the offering,we amended and restated our existing senior revolving credit facility withGeneral Electric Capital Corporation. The amended facility (the “Credit Facility”) provides for borrowings ofup to $20.0 million that are subject to a borrowing base comprised of eligibleaccounts receivable and inventory, which was $15.7 million at September 30,2004.  Please refer to “Liquidity andCapital Resources” below for additional information regarding our outstandingindebtedness.

 

On January 19, 2004 we experienced afire in part of our facility in Belgium, which destroyed some inventory,property and equipment.  We were fullyinsured at the replacement value for the destroyed items, subject to a $5,000deductible, and the facility returned to full production the next day.  See further discussion in Note 13 to theaccompanying financial statements.

 

BASIS OF REPORTING

 

*Net Sales*

 

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

 

*Cost of Sales*

 

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

 

*Operating Expenses*

 

Operating expenses include engineering costs, selling and marketingcosts and general and administrative expenses. Engineering costs primarily include salaries and benefits of engineeringpersonnel, safety approval and quality certification fees, depreciation onequipment and subcontract costs for third-party contracting services.  Selling and marketing expenses primarilyinclude salaries and benefits to account managers and commissions toindependent sales representatives. Administrative expenses primarily include salaries and benefits forcertain management and administrative personnel, professional fees andinformation system costs.  Operatingexpenses also include the direct expense and allocation of costs attributableto these departments for lease costs, depreciation on property, plant andequipment, utilities, property taxes and repairs and maintenance.

 

CRITICAL ACCOUNTING POLICIES

 

We prepare our consolidated financialstatements in conformity with accounting principles generally accepted in theUnited States of America.  As such, weare required to make certain estimates, judgments and assumptions that webelieve are reasonable based upon the information currently available.  These estimates and assumptions affect thereported amounts of assets and liabilities at the date of the financialstatements and the reported amounts of revenues and expenses during the periodspresented.  Any future 

 

14

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changes to these estimates andassumptions could have a material effect on our reported amounts of revenue,expenses, assets and liabilities.  Thesignificant accounting policies that we believe are the most critical to aid infully understanding and evaluating our reported financial results include thefollowing:

 

*Revenue Recognition*

 

We recognize revenue from product sales atthe time of shipment and passage of title. We also offer our customers the right to return products that do notfunction properly within a limited time after delivery.  We monitor and track product returns andrecord a provision for warranty based on historical experience, which has beeninsignificant to our financial condition and results of operations.  Any significant increase in product failurerates could have a material adverse effect on our operating results for theperiod or periods in which those returns materialize.

 

*Accounts Receivable*

 

We perform ongoing credit evaluations of ourcustomers and adjust credit limits based upon payment history, the customer’scurrent credit worthiness and various other factors, as determined by ourreview of their current credit information. We continuously monitor collections and payments from our customers andmaintain a provision for estimated credit losses based upon our historicalexperience, and any specific customer collection issues that we haveidentified.  While credit losses havehistorically been within our expectations and the provisions established, wemay not continue to experience the same credit loss rates that we have in thepast.  A significant portion of ouraccounts receivable are concentrated in a small number of customers.  A significant change in the liquidity orfinancial position of any one of these customers could have a material adverseeffect on the collectibility of our accounts receivable, our liquidity and ourfuture operating results.

 

*Inventories*

 

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

 

*Deferred Taxes*

 

We recognize deferred tax assets andliabilities based on the differences between the financial statement carryingvalues and the tax bases of assets and liabilities.  We regularly review our deferred tax assetsfor recoverability and establish a valuation allowance based on historicaltaxable income, projected future taxable income, and the expected timing of thereversals of existing temporary differences. If our future taxable income is significantly higher than expectedand/or we are able to utilize our tax credits, we may be required to reverseall or a significant part of our valuation allowance against such deferred taxassets which could substantially reduce our effective tax rate for suchperiod.  Therefore, any significantchanges in statutory tax rates or the amount of our valuation allowance couldhave a material effect on the value of our deferred tax assets and liabilities,and our reported financial results.

 

*Goodwill and LongLived Assets*

 

We review the recoverability of the carryingvalue of goodwill on an annual basis or more frequently when an event occurs orcircumstances change to indicate that an impairment of goodwill has possiblyoccurred.  The determination of whetherany potential impairment of goodwill exists is based upon a comparison of thefair value of the reporting unit to the accounting value of its net assets.

 

We also review the recoverability of thecarrying value of long-lived assets whenever events or changes in circumstancesindicate that the carrying amount of an asset may not be recoverable.  Recoverability of these assets is determined basedupon the forecasted undiscounted future net cash flows from the operations towhich the assets relate, utilizing our best estimates, appropriate assumptionsand projections at the time.  Theseprojected future cash flows may vary significantly over time as a result ofincreased competition, changes in technology, fluctuations in demand,consolidation of our customers and reductions in average selling prices.  If the carrying value is determined not to berecoverable from future operating cash flows, the asset would be deemedimpaired and an 

 

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impairment loss would berecognized to the extent the carrying value exceeded the estimated fair marketvalue of the asset.

 

RESULTS OF OPERATIONS

 

THREE MONTHS ENDED SEPTEMBER 30, 2004 COMPARED TO THREE MONTHSENDED SEPTEMBER 30, 2003

 

NET SALES

 

Net sales increased by approximately 20.7%, or $6.2 million, to $36.4million for the three months ended September 30, 2004 from $30.1 millionfor the three months ended September 30, 2003.

 

Our net sales increase for the third quarter of 2004was primarily attributable to increased sales volume to a broad base ofcustomers in the datacom, telecom and industrial end markets, including severalnew customers that have engaged Cherokee in recent quarters.    Also contributing to the third quartersales increase was a favorable foreign currency exchange rate effect of $0.9million due to a stronger Euro in the third quarter of 2004 compared to thethird quarter of 2003.  These increaseswere partially offset by a $3.6 million decrease in sales to one of our largestcustomers, which is in the telecom wireless infrastructure market, compared tothe prior year period.

 

GROSS PROFIT

 

Gross profit increased by approximately 7.9%, or $0.7 million, to $9.9million for the three months ended September 30, 2004 from $9.2 millionfor the three months ended September 30, 2003. Gross margin for the threemonths ended September 30, 2004 decreased to 27.3% from 30.6% in the prioryear period.

 

The$0.7 million increase in gross profit was attributable to the higher saleslevel, partially offset by the decrease in gross margin.  The decrease in gross margin was primarilyattributable to an increase in direct material costs as a percentage of sales,which resulted from a different revenue mix during the third quarter of2004.  This mix included programs withhigher material content than the prior year period, as well as increasedrevenues from new programs, which typically have higher material and laborcosts in the early stages of production.

 

OPERATING EXPENSES

 

Operating expenses for the three months ended September 30, 2004increased by approximately 6.1%, or $0.4 million, to $6.8 million from $6.4million for the three months ended September 30, 2003.  As a percentage of net sales, operatingexpenses decreased to 18.7% from 21.3% in the prior year period.

 

Theincrease in operating expenses was due to increases in selling and marketing,engineering and development, and general and administrative expenses of $0.3million, $0.3 million and $0.4 million, respectively, primarily to support thehigher sales volume and related business activities compared to a year ago, andincreased payroll related costs, professional fees and public company expenses.  Of these increases, approximately $0.2million was attributable to a stronger Euro versus the third quarter of2003.  These increases were partiallyoffset by a decrease in stock compensation expense of $0.6 million compared tothe same period in 2003.

 

OPERATING INCOME

 

As a result of the factors discussed above, operating income increased$0.3 million to $3.1 million for the three months ended September 30,2004, from $2.8 million for the three months ended September 30,2003.  Operating margin decreased to 8.6%from 9.3% in the prior year period.

 

INTEREST EXPENSE

 

Interest expense for the three months ended September 30, 2004 was$0.7 million compared to $4.4 million for the three months ended September 30,2003.  The decrease in interest expensewas due to the repayment of debt and conversion to equity of our seniorconvertible notes in connection with our initial public offering.

 

INCOME TAXES

 

Provision for income taxes for the threemonths ended September 30, 2004 was $0.8 million compared to $1.1 millionfor the three months ended September 30, 2003.

 

Provision for incometaxes of $0.8 million for the three months ended September 30, 2004 wascalculated using an estimated effective tax rate for 2004 of 20.5%, andincludes an adjustment to bring the effective tax rate from 16.6% used for thefirst six months of 2004 to the 20.5% used for the nine month period.  The rate increase from 2003 was due largelyto shifts in the geographical mix of income for the year and reflects estimatedtaxable income in Belgium as the Company no longer has net operating lossesavailable in Belgium in 2004.  Incomegenerated in the United States during 2004 is expected to be fully offset by theutilization of deferred tax assets, resulting in the relatively low effectivetax rate for the year.  See furtherdiscussion of the income tax provision and net operating loss carryforwards inNote 3 to the accompanying financial statements.  Theprovision for income taxes for the three months ended September 30, 2003 of$1.1 million was primarily due to an accrual for an estimated tax liabilityrelating to an audit assessment by the India tax authorities for previousyears.

 

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NET INCOME (LOSS)

 

As a result of the factors discussed above, we recorded net income of$1.7 million for the three months ended September 30, 2004, compared to anet loss of $2.4 million for the three months ended September 30, 2003.

 

NINE MONTHS ENDED SEPTEMBER 30, 2004 COMPARED TO NINE MONTHS ENDEDSEPTEMBER 30, 2003

 

NET SALES

 

Net sales increased by approximately 41.9%, or $33.0 million, to $111.8million for the nine months ended September 30, 2004 from $78.8 millionfor the nine months ended September 30, 2003.

 

Our net sales increase was primarily attributable to increased sales volumeto a broad base of customers in the datacom, telecom and industrial endmarkets, including several new customers that have engagedCherokee in recent quarters.  One of ourlargest customers, which is in the telecom wireless infrastructure market,accounted for approximately $4.5 million of the sales increase over the prioryear period, although sales from this customer declined in the third quarter of2004 compared to the prior year’s third quarter.  Also contributing to the overall salesincrease was a favorable foreign currency exchange rate effect of $3.6 milliondue to a stronger Euro in the nine months ended September 30, 2004 versusthe comparable period in 2003.

 

GROSS PROFIT

 

Gross profit increased by approximately 54.8%, or $12.1 million, to$34.2 million for the nine months ended September 30, 2004 from $22.1million for the nine months ended September 30, 2003. Gross margin for thenine months ended September 30, 2004 increased to 30.6% from 28.0% in theprior year period.

 

Ofthe $12.1 million increase in gross profit, $9.2 million was attributable tothe higher sales level and the remaining $2.9 million was attributable to theincreased gross margin.  Substantiallyall of the increase in gross margin was due to lower direct labor and overheadcosts as a percentage of sales.  For thenine months ended September 30, 2004, direct labor and factory overhead atCherokee Europe improved significantly as a percentage of sales, reflectingincreased efficiencies due to higher production volumes, as well as a lowermanufacturing cost structure resulting from the restructuring plan implementedin June 2003, as described below. These decreases in direct labor and overhead costs as a percentage ofsales were partially offset by an increase in material costs as a percentage ofsales, which resulted from a different revenue mix primarily during the thirdquarter of 2004.  This mix includedprograms with higher material content than the prior year period, as well asincreased revenues from new programs, which typically have higher material andlabor costs in the early stages of production.

 

OPERATING EXPENSES

 

Operating expenses for the nine months ended September 30,2004, decreased by approximately 8.7%, or $1.9 million, to $19.4 million from$21.3 million for the nine months ended September 30, 2003.  As a percentage of sales, operating expensesdecreased to 17.4% from 27.0% in the prior year period.

 

The decrease in operating expenses of $1.9 million was primarily due toCherokee Europe restructuring costs of $4.5 million recorded in June 2003(described below) and a decrease in stock compensation expense of $0.6 million,partially offset by increases in engineering and development, selling andmarketing, and general and administrative expenses of $0.7 million, $1.3million and $1.2 million, respectively, primarily to support the significantlyhigher sales volume and related business activities compared to a yearago.  Of these increases, approximately$0.8 million was attributable to a stronger Euro versus the nine months ended September 30,2003, $0.4 million was attributable to higher sales commissions, $0.3 millionwas attributable to professional fees and public company expenses, and theremaining increase resulted primarily from increased payroll and related costs.

 

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RESTRUCTURING COSTS

 

During 2003, we implemented a restructuring plan involving theelimination of a number of operational and administrative positions at the CherokeeEurope facility in Belgium due to unfavorable economic conditions in thatmarket.  Pursuant to the Cherokee Europerestructuring plan, we recorded a charge for restructuring costs of $4.5million for the nine months ended September 30, 2003.  The restructuring costs were comprisedentirely of one-time termination benefits to be paid through 2010.

 

The following is a breakdown of the Cherokee Europe restructuringaccrual for the period January 1, 2003 through September 30, 2004 (inthousands):

 

| Balance as of January 1, 2003    |   | $      | — |   |
|---------------------------------------|--------|--------|--------|--------|
| Restructuring costs recognized        |   | 4,474  |   |
| Payments                              |   | (1,660 | )      |
| Balance as of December 31, 2003  |   | 2,814  |   |
| Payments                              |   | (1,063 | )      |
| Balance as of September 30, 2004 |   | $      | 1,751  |   |

 

OPERATING INCOME

 

As a result of the factors discussed above, operating income increasedto $14.8 million for the nine months ended September 30, 2004 compared to$0.8 million for the nine months ended September 30, 2003.  Operating margin increased to 13.2% from 1.1%in the prior year period.  The operating incomefor the nine months ended September 30, 2003 included the effect of theCherokee Europe restructuring costs of $4.5 million.

 

INTEREST EXPENSE

 

Interest expense for the nine months ended September 30, 2004 was$4.5 million compared to $12.7 million for the nine months ended September 30,2003.  The decrease in interest expensewas due to the repayment of debt and conversion to equity of our seniorconvertible notes in connection with our initial public offering.

 

OTHER INCOME, NET

 

Other income, net for the nine months ended September 30, 2004 was$0.04 million compared to $0.8 million for the nine months ended September 30,2003.  The amount for the ninemonths ended September 30, 2003 included a gain on the sale of land of$0.4 million and foreign currency exchange gains of $0.4 million.

 

INCOME TAXES

 

Provision for incomestaxes for the nine months ended September 30, 2004 was $2.1 millioncompared to $1.1 million for the nine months ended September 30, 2003.

 

Provision for incometaxes of $2.1 million for the nine months ended September 30, 2004 wascalculated using an estimated effective tax rate for 2004 of 20.5%.  The increase in both the provision for incometaxes and effective tax rate from 2003 was due largely to shifts in thegeographical mix of income for 2004 and reflects estimated taxable income inBelgium as the Company no longer has net operating losses available in Belgium in2004.  Income generated in the UnitedStates during 2004 is expected to be fully offset by the utilization of deferredtax assets, resulting in the relatively low effective tax rate for theyear.  See further discussion of theincome tax provision and net operating loss carryforwards in Note 3 to theaccompanying financial statements. Provision for income taxes for the nine months ended September 30,2003 of $1.1 million was primarily due to an accrual for an estimated taxliability relating to an audit assessment by the India tax authorities forprevious years.

 

NET INCOME (LOSS)

 

As a result of the factors discussed above, we recorded net income of$8.2 million for the nine months ended September 30, 2004, compared to anet loss of $12.1 million for the nine months ended September 30, 2003.

 

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LIQUIDITY AND CAPITAL RESOURCES

 

CASH FLOWS

 

NINE MONTHS ENDED SEPTEMBER 30, 2004 COMPARED TO NINE MONTHS ENDEDSEPTEMBER 30, 2003

 

Net cash provided by operating activities was $0.6 million for the ninemonths ended September 30, 2004, compared to net cash used in operatingactivities of $5.2 million for the nine months ended September 30,2003.  Net cash provided by operatingactivities for the nine months ended September 30, 2004 reflected thepositive effect of $8.2 million in net income and $2.3 million of depreciationand amortization.  These amounts werepartially offset by a $2.8 million increase in accounts receivable and a $3.1million increase in inventories due to increased sales and businessactivity, and an increase in deposits and other assets of $0.6 milliondue primarily to assets related to our deferred compensation plan, a decreasein accrued liabilities and accrued restructuring costs of $2.3 million due mainly to payments for restructuringcosts and professional fees, and a decrease in other long-termobligations of $1.7 million due to the payment of accrued paid-in-kind interestwith a portion of the net proceeds from the initial public offering.  Cash used in operating activities for thenine months ended September 30, 2003 reflected a net loss of approximately$12.1 million, increases of $7.2 million in receivables and $4.0 million ininventories, partially offset by non-cash charges for depreciation andamortization of $2.7 million, paid-in-kind interest of $2.5 million, and thepositive impact of a $9.8 million increase in other long-term obligations, a$2.2 million increase in accounts payable and a $1.2 million increase inaccrued compensation and benefits.

 

Net cash used in investing activities of $3.1 million for the ninemonths ended September 30, 2004 primarily reflected additions to propertyand equipment.  Net cash used ininvesting activities of $0.4 million for the nine months ended September 30,2003 reflects additions to property and equipment, partially offset by proceedsfrom a sale of land of $0.5 million and a decrease in short-term investments of$0.4 million.

 

Net cash provided by financing activities of $13.9 million for the ninemonths ended September 30, 2004 reflected the net proceeds from ourinitial public offering of $86.5 million, partially offset by payments onlong-term debt of $65.5 million and net payments under the old revolving linesof credit of $6.1 million.  Net cash used in financing activities of $0.9million for the nine months ended September 30, 2003 reflected payments onlong-term debt and capital lease obligations totaling $3.5 million, partiallyoffset by net borrowings under the old revolving lines of credit of $2.6million.

 

LIQUIDITY

 

We completed our initial public offering of 6,600,000 shares of ourcommon stock on February 25, 2004. The net proceeds from the offering were $86.5 million. We usedapproximately $73.2 million of the net proceeds to repay outstandingindebtedness, including the Term Loans, the Old Revolving Facility, the SecondLien Notes, related interest on these obligations, as well as accrued interestand interest added to the principal amount of our Senior ConvertibleNotes.  The remainder of the net proceedsis held in high-grade commercial paper with an original maturity of threemonths or less, and is included in our cash and cash equivalents increase of$11.5 million for the nine months ended September 30, 2004.

 

As of September 30, 2004, we had cash and cash equivalents of$16.4 million, working capital of $47.6 million and no borrowings under the CreditFacility.  Historically, we have financedour operations with cash from operations supplemented by borrowings from creditfacilities and debt issuances.  Ourcurrent and future liquidity needs primarily arise from working capitalrequirements and capital expenditures. Our historical capital expenditures have primarily resulted frominvestments in equipment to increase manufacturing capacity and to improvemanufacturing efficiencies. For 2004, we expect capital expenditures to beapproximately $3 million to $4 million, which will relate primarily toinvestments in manufacturing equipment, and we have spent $3.1 million duringthe first nine months of 2004.

 

As of September 30, 2004, our borrowings consisted ofapproximately $46.6 million of Senior Notes bearing interest at 5.25% annually,and no borrowings under the Credit Facility. We are required to make scheduled interest payments to holders of theSenior Notes.

 

We have operating lease obligations relating to our facilities inTustin and Irvine, California, and Bombay, India.  We have capital lease obligations formanufacturing equipment, which will be paid in 2004.

 

We have purchase commitments primarily with vendors and suppliers forthe purchase of inventory, property and equipment, and other goods and servicesas part of the normal course of business.  These commitments are generally evidenced by purchase orders that may ormay not include cancellation provisions. Based on current expectations, we do not believe that any cancellationpenalties we incur under these obligations would have a material adverse effecton our financial condition and results of operations.

 

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The maturities of our long-term debt, including capital leases, andfuture payments under our operating leases as of September 30, 2004 are asfollows (in millions):

 
| **Contractual obligation** | ** ** | **October to  December 31,  2004** | ** ** | **2005** | ** ** | **2006** | ** ** | **2007** | ** ** | **2008** | ** ** | **Thereafter** | ** ** | **Total** | ** ** |
|----------------------------|------------|----------------------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------------|------------|-----------|------------|
| Senior Notes               |       | $                                            | —     |     | $          | —   |       | $        | —     |     | $          | —         |       | $         | 46.6       |   | $ | — |   | $ | 46.6 |   |
| Capital leases             |       | 0.2                                          |       | —   |       | —   |       | —   |       | —   |       | —         |       | 0.2       |       |
| Operating leases           |       | .4                                           |       | 1.4      |       | 1.5      |       | 1.5      |       | 1.5      |       | 0.6            |       | 6.9       |       |
| Purchase order commitments |       | 14.2                                         |       | 7.1      |       | —   |       | —   |       | —   |       | —         |       | 21.3      |       |
| Total                      |       | $                                            | 14.8       |     | $          | 8.5      |       | $        | 1.5        |     | $          | 1.5            |       | $         | 48.1       |   | $ | 0.6 |   | $ | 75.0 |   |

 

The Senior Notes mature on November 1, 2008.  Interest on the Senior Notes is payable incash on May 1 and November 1 of each year. The Senior Notes are secured by a second priority lien on substantiallyall of our domestic assets and by a pledge of 65% of the equity of certain ofour foreign subsidiaries.

 

The Credit Facility provides for borrowings of up to $20.0 million thatare subject to a borrowing base comprised of eligible accounts receivable andinventory, which was $15.7 million at September 30, 2004.  We plan to use funds available under theamended facility to finance our working capital as needed.  The amended facility matures in August 2008,and bears interest, at our option, at a rate per annum equal to LIBOR plus 2.5%or the agent bank’s base rate plus 1.0%. In addition to paying interest on outstanding principal, we are requiredto pay a commitment fee to the lenders under the amended facility in respect ofthe average daily balance of unused loan commitments at a rate of 0.5% perannum.  The Credit Facility is our seniorobligation and ranks equal in right of payment with our existing and futurepermitted senior debt, and senior in right of payment to our future permittedsubordinated debt.  The Credit Facilityis secured by a first-priority lien, subject to permitted encumbrances, onsubstantially all of our domestic assets and by a pledge of 65% of the equityof certain of our foreign subsidiaries. The Credit Facility contains covenants that restrict our business operations,including covenants limiting our ability to make investments, enter intomergers or acquisitions, dispose of assets, incur additional debt, grant liens,enter into transactions with affiliates, redeem or repurchase our capitalstock, repay other debt and pay dividends, and contains a financial ratio testbased on senior leverage.  The amendedfacility contains customary events of defaults, including defaults in thepayment of principal or interest, defaults in the compliance with the covenantscontained in the documents evidencing the Credit Facility, cross defaults toother material debt and bankruptcy or other insolvency events.

 

As of September 30, 2004, we were in compliance with all of thefinancial covenants set forth in the principal agreements governing our debt.

 

Based on our current expectations, we believe that our existing cashand cash equivalents, working capital and available borrowing capacity at September 30,2004 will be sufficient to meet our anticipated cash requirements for the nexttwelve months, including operating requirements, contractual obligations,planned capital expenditures and debt service.

 

RECENT ACCOUNTING PRONOUNCEMENTS

 

In January 2003, the FASB issued FIN 46, “Consolidation ofVariable Interest Entities.”  In general,a variable interest entity is a corporation, partnership, trust or any otherlegal structure used for business purposes that either (a) does not have equityinvestors with voting rights or (b) has equity investors that do not providesufficient financial resources for the entity to support its activities.  FIN 46 requires a variable interest entity tobe consolidated by a company if that company is subject to a majority of the riskof loss from the variable interest entity's activities or entitled to receive amajority of the entity’s residual returns or both.  The consolidation requirements of FIN 46apply immediately to variable interest entities created after January 31,2003.  With respect to variable interestentities created before January 31, 2003, in December 2003 the FASBissued FIN 46R, which among other things, revised the implementation date tofirst fiscal years or interim periods ending after March 15, 2004, withthe exception of Special Purpose Entities (“SPE”). The consolidatedrequirements apply to all SPE’s in the first fiscal year or interim periodending after December 15, 2003. As we determined that we did not have any variableinterest entities to which these interpretations apply, we adopted FIN 46R inthe first quarter of 2004, and such adoption did not have a material impact on ourfinancial statements.

 

FORWARD-LOOKING STATEMENTS

 

Statements in this report containing the words “believes,” “anticipates,”“estimates,” “expects,” and similar expressions, or the negative of such wordsor expressions, and any other statements which may be construed as a predictionof future performance or events, constitute “forward-looking statements” withinthe meaning of the Private Securities Litigation Reform Act of 1995.  These forward-looking statements are basedupon our current expectations and projections about future events.  Such forward-looking statements involve knownand unknown risks, uncertainties, and other factors that may cause our actualresults, performance, or achievements, or industry results, to be materiallydifferent from any future results, performance, or achievements expressed or 

 

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implied by such forward-lookingstatements.  Such factors include, amongothers, (1) changes in general economic and business conditions, domesticallyand internationally, (2) reductions in sales to, or the loss of, any of oursignificant customers or in customer capacity generally, (3) changes in oursales mix to lower margin products, (4) increased competition in our industry,(5) disruptions of our established supply channels, (6) our level of debt andrestrictions imposed by our debt agreements, and (7) the additional riskfactors identified in our filings with the Securities and Exchange Commission,including our Registration Statement on Form S-1 (File No. 333-110723).  Except as required by law, we undertake noobligation to update any forward-looking statements even though our situationmay change in the future.

 

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

 

Market risk relating to our operations result primarily from changes inforeign currency exchange rates and short-term interest rates.  We did not have any derivative financialinstruments at September 30, 2004.

 

We had no variable rate debt outstanding at September 30,2004.  However, any debt we incur underthe Credit Facility will bear interest at a variable rate.  We cannot predict market fluctuations ininterest rates and their impact on any variable rate debt we may incur in thefuture, nor can there be any assurance that fixed rate long-term debt will beavailable to us at favorable rates, if at all.

 

The functional currency for our European operations is the Euro.  We are, therefore, subject to a certaindegree of market risk associated with changes in foreign currency exchangerates.  This risk is mitigated by thefact that our revenues and expenses are generally both recorded in Euros,thereby reducing the risk of foreign currency translations on our European operations.  The effect of foreign currency exchange ratefluctuations on our operating results as of and for the nine months ended September 30,2004, was not material.  Historically, wehave not actively engaged in exchange rate hedging activities.

 

**Item 4.****                                   Controlsand Procedures.**

 

a)              *Disclosure Controls andProcedures*

 

Our management, with the participation of our Chief Executive Officerand Chief Financial Officer, has evaluated the effectiveness of our disclosurecontrols and procedures (as such term is defined in Rules 13a-15(e) and15d-15(e) under the Securities Exchange Act of 1934, as amended (the “ExchangeAct”)) as of the end of the period covered by this report.  Based on such evaluation, our Chief ExecutiveOfficer and Chief Financial Officer have concluded that, as of the end of such period,our disclosure controls and procedures are effective in recording, processing,summarizing and reporting, on a timely basis, information required to bedisclosed by us in the reports that we file or submit under the Exchange Act.

 

b)             *Internal Control OverFinancial Reporting*

 

There have not been anychanges in our internal control over financial reporting (as such term isdefined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during thefiscal quarter to which this report relates that have materially affected, orare reasonably likely to materially affect, our internal control over financialreporting.

 

PART II.                OTHER INFORMATION

 

**Item 1.****                                   LegalProceedings.**

 

During the nine months ended September 30, 2004, we were not aparty to any material legal proceedings. We are occasionally a party to lawsuits relating to routine mattersincidental to our business.  As with alllitigation, we can provide no assurance as to the outcome of any particularlawsuit, and we note that litigation inherently involves significant costs.

 

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**Item 2.****                                   UnregisteredSales of Equity Securities and Use of Proceeds.**

 

On February 25, 2004, we closed the sale of 6,600,000 shares ofour Common Stock at a price of $14.50 per share in a firm commitmentunderwritten initial public offering. The offering was effected pursuant to a Registration Statement on FormS-1 (File No. 333-110723), which the Securities and Exchange Commission declaredeffective on February 19, 2004.

 

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

 

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

 

2.                                       approximately$2.5 million was paid by us in connection with offering fees and expenses;

 

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

 

4.                                       approximately$5.3 million has been used as of September 30, 2004, for general corporatepurposes; and

 

5.                                       approximately$8.0 million has been retained by us for general corporate purposes and is heldin high-grade commercial paper with an original maturity of three months orless.

 

**Item 6.****                                   Exhibits.**

 

EXHIBIT INDEX

 
| **Exhibit No.** | ** ** | **Description**                                                                                                                                   |
|-----------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1             |       | Restated Certificate of Incorporation of  Cherokee International Corporation (1)                                                                  |
| 3.2             |       | Amended and Restated By-Laws of Cherokee  International Corporation (1)                                                                           |
| 4.1             |       | Specimen of Stock Certificate (2)                                                                                                                 |
| 31.1            |       | Certification of Chief Executive Officer  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                                          |
| 31.2            |       | Certification of Chief Financial Officer  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                                          |
| 32.1            |       | Certification of CEO and CFO Pursuant to 18  U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002 |
|            |       |                                                                                                                                              |
|                 |
| (1)             |       | Previously filed with the Registration  Statement on Form S-8 filed by the Registrant on March 16, 2004.                                     |
| (2)             |       | Previously filed with Amendment No. 4 to  the Registration Statement on Form S-1 filed by the Registrant on February 17,  2004.              |
|            |       |                                                                                                                                              |

 

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**SIGNATURES**

 

Pursuant to the requirements of the Securities Exchange Act of 1934,the Registrant has duly caused this report to be signed on its behalf by theundersigned thereunto duly authorized.

 
| Dated:   November 16, 2004 |                               |                                          |
|--------------------------------------|------------------------------------|-----------------------------------------------|
|                                 |                               |                                          |
|                                 | CHEROKEE INTERNATIONAL CORPORATION |
|                                 |                               |                                          |
|                                 |                               |                                          |
|                                 | By:                                | /s/ Jeffrey M. Frank                          |   |
|                                 |                               | Jeffrey M. Frank                              |
|                                 |                               | President and Chief Executive Officer         |
|                                 |                               |                                          |
|                                 |                               |                                          |
|                                 | By:                                | /s/ Van Holland                               |   |
|                                 |                               | Van Holland                                   |
|                                 |                               | Chief Financial Officer                       |
|                                 |                               | (Principal Financial and Accounting  Officer) |
|                                      |                                    |                                               |  |  |

 

 

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