Monday, December 29, 1997

Cherokee, Inc.
(Nasdaq: CHKE)
Phone: 818-908-9868
Price (12/26/97): $14 5/8


In 1994, coming off its second bankruptcy in two years, Cherokee decided to go virtual. Instead of designing and manufacturing its popular Cherokee branded clothes, it would simply license its name to others who would do the dirty work. At the top of its licensee hit list? Dayton Hudson's (NYSE: DH) money engine Target Stores.

Cherokee's near triple in the last year shows that this strategy has paid off. Inventories were cleared out during the first quarter of FY96 (ended August 1995). By the second quarter of FY97, sales and earnings comparisons started looking unbelievably attractive. New deals and stronger-than-expected clothing sales have pushed royalties ever higher, up 90% in the latest quarter. That was good for a tripling of earnings to $0.21 per share.

Sales of Cherokee branded clothes have hit a bulls-eye for Target, beating that company's own expectations by $50 million last year. So that retailer inked a new deal that extends into 2004. On September 30, Zellers Inc., Canada's leading discount department store chain, also licensed the brand through January 2003, guaranteeing Cherokee a minimum of $10 million. Catalog retailer Brylane, whose catalogs include Lane Bryant, King Size, Lerner, and Chadwick's of Boston, has also recently a signed deal that extends through June 2002.

These long-term contracts seem designed to help management raise financing. On November 11, Chair/CEO Robert Margolis said the company had retained Libra Investments (a major stockholder) "to act as its financial advisor in connection with a possible sale or leveraged recapitalization." The stock rose to a high around $15 on the news.


Based in Van Nuys, California, Cherokee had just 12 employees as of May 31. Its main business is licensing the Cherokee name, which is associated with casual, contemporary, moderately priced apparel. Rather than making deals with wholesalers, which is more common, Cherokee has gone directly to retailers.

Licenses are offered on an exclusive or non-exclusive basis in multiple categories. The Zellers pact is an exclusive agreement covering all categories of apparel, fashion accessories, cosmetics, and home and recreational products. The new deal with Target is similar, offering greater exclusivity and broadening the discounter's Cherokee offerings to include men's and boys apparel. Retailers design and manufacture the merchandise, but Cherokee gets final approval.

Cherokee has contracts with other U.S. retailers such as Pamida, Caldor, and Brylane. It has also signed pacts with some Pacific Rim companies, with royalties expected to kick in next fiscal year. To broaden its stable of brands, Cherokee recently bought the trademarks of Sideout Sports, a firm associated with California beach volleyball and known for quality activewear.

Royalties on non-exclusive retail licenses begin at 3% of net sales, but fall with rising sales volume. Under the new Target deal, Cherokee will be paid a minimum of $9 million in the first two years and $10.5 million in each of the ensuing four years.

Target accounted for 68% of revenue during FY98. The latest proxy shows Cherokee shares concentrated in just a few hands, including CEO Margolis (29%), other insiders (10.6%), Value Partners (27.2%), and Cowen & Co. (5.1%).


Income Statement
12-month sales: $9.8 million
12-month income: $7.9 million
12-month EPS: $0.96
Profit Margin: 80.6%
Market Cap: $122.1 million

Balance Sheet
Cash: $9.4 million
Current Assets: $10.3 million
Current Liabilities: $0.2 million
Long-Term Debt: N/A

Price-to-earnings: 15.2
Price-to-sales: 12.5


Until recently, retailers have enjoyed a strong year. But even an investor set on finding undiscovered plays in the clothing biz might have had a hard time uncovering Cherokee. The Peter Lynch method of checking stores to see what's selling might have worked.

The old rising margins screen, though, would have worked well. Quarterly comparisons between the new licensor and the old manufacturer made Cherokee look like it had lost its footing... until the November quarter of 1996. Sales were up 17%, with earnings per share up more than five-fold.


First Call shows no earnings estimates, but a late October profile of Cherokee in The Wall Street Journal's California edition noted that analyst Robert Lushman of Amroc Securities rated the company a "buy," with a 12-month target of $19 a share. That didn't include the Zellers or revised Target agreements.

Based on the company's eye-popping 80% profit margins and the minimum royalty payments from the Zeller and Target deals alone, Cherokee should deliver two years of at least $1.05 per share in earnings followed by three years of at least $1.20. Each additional million in revenue could add another dime per share in earnings. Guesstimating, the forward PE is around 13.

These exclusive licenses will constrain Cherokee from hustling up royalties from new sources in the U.S. and Canada, but downside protection is worth something to an investor, and upside surprises are always possible.

These earnings estimates and price targets, though, must now be revised given the recently announced cash dividend of $5.50 per share payable on or shortly after January 15 to stockholders of record at the close of business January 2. That dividend will be taxable as ordinary income up to the amount of Cherokee's earnings for the new fiscal year ending January 31 (perhaps $1 per share).

The rest of the dividend will qualify as a return of capital, meaning that new investors won't pay any taxes on that portion of the dividend. For long-term holders with a cost basis below, say, $4.50 per share, profits would be taxed as a capital gain.

The company has raised $48 million in cash for the dividend by assigning its rights under the Target deal to a new limited liability corporation, which has pledged the agreement as collateral for the loan. These transactions will allow Cherokee to reward its current shareholders with a fat check while allowing them to maintain ownership of the company.

The result will be a huge decline in reported earnings for the next six years and an imminent fall in the company's market price to adjust for the cash payout. In theory, this transaction should be a non-event for current shareholders, although the new financing obligations will cut into the future stream of income, making Cherokee a bit less attractive in the future, on balance.

The question is how much additional income Cherokee will enjoy from strong sales under current licenses and from potential new deals. In short, how strong are its brands, its partners, and the retailing biz in general? This one should be worth watching, though, just for the education.

-- Louis Corrigan

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