Apparel licensor and marketer Cherokee Inc. (NASDAQ:CHKE) is a highly profitable company with decent growth prospects and a high dividend yield. But before jumping in headfirst, there are a number of potential pitfalls to mull over.
The recent past
The most recent information was released today as Cherokee posted second-quarter earnings. Revenue grew 10.2% to $12.4 million while net income advanced 8% to $4.9 million. That's not huge growth, but a net margin of 40% demonstrates how profitable the company really is.
Management highlighted strong international royalty growth for the quarter, as retailer Tesco is a major customer. U.S. strength was attributed to the Carol Little brand, licensed to TJX Companies (NYSE:TJX), although royalties from Target (NYSE:TGT) fell 3.6%. Target is Cherokee's largest customer.
Other details include some forthcoming payments related to Cherokee's past pursuit of rival licensor Mossimo (NASDAQ:MOSS). After some negotiating, another rival apparel marketer and licensor, Iconix Brands (NASDAQ:ICON), came away with Mossimo. But Iconix still owes Cherokee a "finders fee" of about $33 million, plus an additional $900,000 from a dispute between Cherokee and Mossimo which also included unfriendly litigation. In any case, the matter looks to be settled for the most part, with cash moving Cherokee's way.
Too good to be true?
Cherokee has built a niche, highly profitable stable of apparel, related accessories, and footwear brand license agreements. It also mentions home furnishing and recreational product exposure. The total business boasts operating margins and returns on capital near 70%. And while revenue and earnings growth have only advanced about 8% and 10% annually over the past five years, Cherokee generates almost as much free cash flow as it reports in net income, with a subsequent dividend yield of 6.5%. At times it sounds too good to be true. Is it?
Fellow Fool Tim Beyers recently offered some useful insight regarding his concerns about Cherokee's dividend at this point in time. The company does pay a juicy dividend, but it has only done so for a couple of years now; it's also too hard to tell if it will grow over time or even continue at its current rate, as management may use capital to make acquisitions. Tim is also concerned that Cherokee is paying out annual dividends that exceed its free cash flow. I completely agree with him in preferring a longer history of dividend payments, but I'm taking a more positive spin on the second point: I'd prefer management pay excess cash to investors in the form of cold, hard cash as opposed to holding on to it or repurchasing shares that have more indirect shareholder benefits. The appeal of the business is that it has minimal capital expenditures and maintenance needs, although management is always looking to acquire additional brands and trademarks.
And although dividends paid out last year exceeded free cash flow, due to proceeds from the issuance of stock options, total cash still increased by nearly $1 million. And total cash has grown for at least three years now. It's the cash flow-generating capabilities that draw me to Cherokee.
A risky investment proposition
But overall, Tim has every right to take a cautious stance. Cherokee isn't a very large company, and its royalty payments tend to fluctuate due to a select group of licensees with payments contingent on underlying clothing sales that compete in a crowded retail space with a multitude of brands, such as Gap (NYSE:GPS). As a case in point, recent earnings missed consensus analyst targets, though there are currently only two to three with active coverage. Additionally, Target accounts for close to half of total revenue, causing a considerable amount of customer concentration risk that is also uneven, as judging by this quarter's decrease in royalty payments.
In weighing the investment pros and cons for Cherokee, I believe it is still worth consideration. Sure, it's small and riskier, but it generates prodigious amounts of cash flow that it is paying out to shareholders. At about 17 times earnings, there is some downside risk, but the dividend is high enough to offer offsetting compensation and the company is growing by almost 10% per year. As such, it wouldn't take much to earn 10% or more on your investment each year. My money isn't where my mouth is yet, but I'm seriously mulling it over.
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Fool contributor Ryan Fuhrmann has no financial interest in any company mentioned. Feel free to e-mail him with feedback or to discuss any companies mentioned further. The Fool has an ironclad disclosure policy.
