CHKE Cherokee Inc. (MM)

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSI S OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

As used in this discussion and analysis, “Cherokee Global Brands”, the “Company”, “we”, “us” and “our” refer to Cherokee Inc. and its consolidated subsidiaries, unless the context indicates or requires otherwise.  Additionally, “Fiscal 2020” refers to our fiscal year ending February 1, 2020 and “Fiscal 2019” refers to our fiscal year ended February 2, 2019.  The following discussion and analysis should be read together with the unaudited condensed consolidated financial statements and the related notes included in this report.  The information contained in this quarterly report on Form 10‑Q is not a complete description of our business or the risks associated with an investment in our securities.  For additional context with which to understand our financial condition and results of operations, refer to management’s discussion and analysis of financial condition and results of operations (“MD&A”) contained in our Annual Report on Form 10‑K, for the fiscal year ended February 2, 2019, which was filed with the Securities and Exchange Commission (“SEC”) on April 23, 2019, as well as the consolidated financial statements and notes contained therein (collectively, our “Annual Report”).  In preparing this MD&A, we presume that readers have access to and have read the MD&A in our Annual Report pursuant to Instruction 2 to paragraph (b) of Item 303 of Regulation S‑K.  The section entitled “Risk Factors” set forth in Item 1A of our Annual Report and similar disclosures in our other SEC filings discuss some of the important risk factors that may affect our business, results of operations and financial condition.  

In addition to historical information, this discussion and analysis contains “forward‑looking statements” within the meaning of the Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended.  Forward-looking statements are statements other than historical facts that relate to future events or circumstances or our future performance.  The words “anticipates”, “believes”, “estimates”, “plans”, “expects”, “objectives”, “goals”, “aims”, “hopes”, “may”, “might”, “will”, “likely”, “should” and similar words or expressions are intended to identify forward‑looking statements, but the absence of these words does not mean that a statement is not forward-looking.  Forward‑looking statements in this discussion and analysis include statements about, among other things, our future financial and operating performance, our future liquidity and capital resources, our business and growth strategies and anticipated trends in our business and our industry.  Forward-looking statements are based on our current views, expectations and assumptions and involve known and unknown risks, uncertainties and other factors that may cause actual results, performance, achievements or stock prices to be materially different from any future results, performance, achievements or stock prices expressed or implied by the forward‑looking statements.  Such risks, uncertainties and other factors include, among others, those described in Item 1A, “Risk Factors” in this report and in our Annual Report.  In addition, we operate in a competitive and rapidly evolving industry in which new risks emerge from time to time, and it is not possible for us to predict all of the risks we may face, nor can we assess the impact of all factors on our business or the extent to which any factor or combination of factors could cause actual results to differ from our expectations.  As a result of these and other potential risks and uncertainties, forward-looking statements should not be relied on or viewed as predictions of future events because some or all of them may turn out to be wrong.  Forward-looking statements speak only as of the date they are made and, except as required by law, we undertake no obligation to update any of the forward‑looking statements we make in this discussion and analysis to reflect future events or developments or changes in our expectations or for any other reason.

Overview

Cherokee Global Brands is a global marketer and manager of a portfolio of fashion and lifestyle brands that we own, brands that we create, and brands that we elevate for others.  Company-owned brands, which are licensed in multiple consumer product categories and retail channels around the world, include Cherokee, Hi-Tec, Magnum, 50 Peaks, Interceptor, Hawk Signature, Tony Hawk, Liz Lange, Completely Me by Liz Lange, Everyday California, Carole Little, Sideout and others.  As part of our business strategy, we also regularly evaluate other brands and trademarks for acquisition into our portfolio.  We believe the strength of our brand portfolio and platform of design, product development and marketing capabilities has made us one of the leading global licensors of style-focused lifestyle brands for apparel, footwear, accessories and home products.

We have licensing relationships with recognizable retail partners in their global locations to provide them with the rights to design, manufacture and sell products bearing our brands.  We refer to this strategy as our “Direct to Retail” or “DTR” licensing model.  We also have license agreements with manufacturers and distributors for the manufacture and sale of products bearing our brands, which we refer to as “wholesale” licensing. In addition, we have relationships with other retailers that sell products we have developed and designed.  As a brand marketer and manager, we do not directly

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sell product ourselves.  Rather, we earn royalties when our licensees sell licensed products bearing the trademarks that we own or that we have designed and developed.

For certain of our key legacy brands, including Cherokee, Hawk Signature and Tony Hawk and Liz Lange, we are shifting our strategy for U.S. sales from DTR licensing to wholesale licensing. In addition, we are primarily pursuing a wholesale licensing strategy for global sales of our recently acquired Hi-Tec, Magnum, Interceptor and 50 Peaks brands.  We believe these arrangements signal a significant shift in our business strategy, from our historical focus on DTR licensing for all of our brands to a substantially greater focus on wholesale licensing for many of our key brands. Although we believe these new wholesale licensing arrangements may help to diversify our sources of revenue and licensee or other partner relationships, and may provide additional avenues to obtain brand recognition and grow our Company, this shift in our strategy also exposes us to a number of risks, and it has had a negative effect on our results of operations as we transition to our new licensees.

We derive revenues primarily from licensing our trademarks to retailers, manufacturers and distributors all over the world, and we are continually pursuing relationships with new retailers, manufacturers and distributors in order to expand the reach of our existing brands into new geographic and customer markets and new types of stores and other selling mediums. As of May 4, 2019, we had 43 continuing license agreements in approximately 80 countries. These arrangements include relationships with Walmart, Soriana, Comercial Mexicana, TJ Maxx, Tottus, Pick N Pay, Nishimatsuya, Big 5, Academy, JD Sports, Black’s and Lidl. As of May 4, 2019, we had contractual rights to receive over $56.4 million of minimum royalty revenues over the next nine years, excluding any revenues that may be guaranteed in connection with contract renewals.

The terms of our royalty arrangements vary for each of our licensees.  We receive quarterly royalty statements and periodic sales and purchasing information from our licensees.  However, our licensees are generally not required to provide, and typically do not provide, information that would enable us to determine the specific reasons for period‑to‑period fluctuations in sales or purchases.  As a result, we do not typically have sufficient information to determine the effects on our operations of changes in price, volume or mix of products sold.

Revenues in United States and Canada no longer include revenues from our Flip Flop Shops franchise business, which we sold in June 2018.  Flip Flop Shops royalties contributed 5% of total revenue for the three months ended May 5, 2018. Our revenues in the Middle East, India and Africa include revenues from our Cherokee licensee in South Africa that expired at the end of Fiscal 2019 and has yet to be replaced.  Our royalty revenues in Asia grew as a result of our new product development and design services agreement with a major retailer in the People’s Republic of China.  We are providing our product design and development expertise for a brand that they own, which we believe will efficiently enhance their retail operations.

Sales of products by certain of our licensees that operate in Europe are being negatively affected by the economic uncertainty surrounding Brexit. We believe this had a negative effect on these licensees’ businesses during the three months ended May 4, 2019 and a corresponding negative impact on our royalty revenues for that same period. This

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trend may continue into future quarters.   Furthermore, the United States has indicated its intent to increase tariff rates on apparel and footwear.  We believe our licensees who use manufacturing facilities in countries subject to increasing tariffs are taking proactive steps to offset the potential impact of higher tariffs , including moving production to countries not subject to higher tariffs and negotiating lower costs with ex isting suppliers.  Nonetheless, if enacted, these higher tariffs may result in higher prices and a corresponding slow-down in retail sales of products bearing our trademarks, which in turn could result in lower royalty revenues.

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Three Months Ended May 4, 2019 Compared to Three Months Ended May 5, 2018

The decrease in royalty revenues in the three months ended May 4, 2019 compared to the three months ended May 5, 2018 was primarily due to the expiration of our Cherokee license in South Africa at the end of Fiscal 2019 and the sale of our Flip Flop Shops franchise business in June 2018.  These decreases were partially offset by revenues from our new design services agreement with a retailer in China.

Selling, general and administrative expenses decreased 12% to $3.9 million in the three months ended May 4, 2019 from $4.4 million in the three months ended May 5, 2018.  These expenses include payroll, employee benefits, marketing, sales, legal, rent, information systems and other administrative costs that are part of our ongoing operations.  The decrease in selling, general and administrative expenses for the three-month period was primarily due to reduced spending for payroll that resulted from our restructuring plan that we implemented during the three months ended August 4, 2018 to improve our organizational efficiencies.

Stock-based compensation in the three months ended May 4, 2019 was $0.2 million compared to $0.3 million in the three months ended May 5, 2018, and comprises charges related to stock options and restricted stock grants.  We incurred $0.1 million of costs during the three months ended May 4, 2019 for legal and other costs related to business acquisitions and restructuring.

We own various trademarks that are considered to have indefinite lives, while others are being amortized over their estimated useful lives.  We also have furniture, fixtures and other equipment that is being amortized over their useful lives.  Depreciation and amortization decreased in the three months ended May 4, 2019 compared to the three ended May 5, 2018 primarily due to the disposition of our Flip Flop Shops franchise business.

Interest expense was $2.2 million in the three months ended May 4, 2019 compared to $1.7 million in the three months ended May 5, 2018. This increase was primarily due to our increased debt level, along with higher non-cash interest charges related to our new term loans.

The provision for income taxes was $0.6 million in the three months ended May 4, 2019 compared to a $0.8 million in the three months ended May 5, 2018.  Even though we generated an operating loss in both of these periods, we

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reported tax expense because no tax benefits were recognized for tax losses in the United States and certain foreign jurisdictions due to previously established valuation allowances .   

Our net loss was $2.3 million in the three months ended May 4, 2019 compared to a net loss of $2.7 million in the three months ended May 5, 2018. Our Adjusted EBITDA increased 14% to $1.2 million in the three months ended May 4, 2019 from $1.0 million in the three months ended May 5, 2018.

Liquidity and Capital Resources

We generally finance our working capital needs and capital investments with operating cash flows, term loans, subordinated promissory notes and lines of credit. In December 2016, we entered into a $50.0 million credit facility that was used to partially fund the Hi-Tec Acquisition. On August 3, 2018, we replaced that credit facility with a $40.0 million term loan and $13.5 million of subordinated promissory notes, and on January 30, 2019, we entered into an incremental $5.3 million term loan.

Cash Flows

We used $2.9 million of cash in our operating activities in the three months ended May 4, 2019, compared to $1.2 million used in the three months ended May 5, 2018.  This $1.7 million increase in cash used in operations resulted primarily from collecting less cash from our licensees during the three months ended May 4, 2019 compared to the three months ended May 5, 2018 when we collected cash from our sales and distribution business that was sold to International Brands Group during the fourth quarter of Fiscal 2018.  This decrease in cash collections was partially offset by using less cash to fund our restructuring obligations.

Our investing activities were minimal in the three months ended May 4, 2019. We generated $1.8 million of cash from investing activities in the three months ended May 5, 2018 primarily as a result of selling our sales and distribution operations of Hi-Tec to International Brands Group in the fourth quarter of Fiscal 2018.

Our financing activities provided $0.3 million of cash in the three months ended May 4, 2019 compared to using $0.4 million of cash in the three months ended May 5, 2018.  We made principal payments of $0.3 million in the three months ended May 4, 2019, but this was more than offset by $0.6 million of cash received from the exercise of stock warrants.

Credit Facilities

On August 3, 2018, we replaced our previous credit facility with a combination of a senior secured credit facility, which provided a $40.0 million term loan, and $13.5 million of subordinated promissory notes. On January 30, 2019, the credit facility was amended to provide an additional $5.3 million term loan. The term loans mature in August 2021 and require quarterly principal payments and monthly interest payments based on LIBOR plus a margin. The additional $5.3 million term loan also requires interest of 3.0% payable in kind with such interest being added to the principal balance of the loan.  The term loans are secured by substantially all of our assets and are guaranteed by our subsidiaries. The $13.5 million of subordinated promissory notes mature in November 2021, and they are secured by a second priority lien on substantially all of our assets and guaranteed by our subsidiaries. Interest is payable monthly on the subordinated promissory notes, but no periodic amortization payments are required. The subordinated promissory notes are subordinated in rights of payment and priority to the term loan but otherwise have economic terms substantially similar to the term loan. Excluding the interest payable in kind, the weighted-average interest rate on both the term loans and subordinated promissory notes at May 4, 2019 was 11.3%. Outstanding borrowings under the senior secured credit facility were $44.8 million at May 4, 2019, and outstanding subordinated promissory notes were $13.5 million.

The term loans are subject to a borrowing base and include financial covenants and obligations regarding the operation of our business that are customary in facilities of this type, including limitations on the payment of dividends.  Financial covenants include the requirement to maintain specified levels of Adjusted EBITDA, as defined in the credit agreement (approximately $9.5 million for the trailing twelve months as of February 1, 2020), and maintain a minimum cash balance of $1.0 million. We are required to maintain a borrowing base comprising the value of our trademarks that

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exceeds the outstanding balance of the term loan. If the borrowing base is less than the outstanding term loan at any measurement period, then we would be required to repay a portion of the term loan to eliminate such shortfall.

Our financial projections currently indicate that we will remain in compliance with the Adjusted EBITDA and minimum cash balance covenants for a period of at least one year from the date of this report. However, there is an inherent risk that we may not achieve our projections and that our licensees may report lower than expected royalties, or the timing of cash receipts may not be in line with our projections. Should any of these scenarios occur, there is a risk that we may violate the Adjusted EBITDA covenant or the minimum cash balance covenant.

If actual revenues during the upcoming year are lower than our projections by an amount that may potentially result in a violation of the Adjusted EBITDA covenant or the minimum cash balance covenant, or if timing of cash receipts is materially different than our expectations, we believe that there are various cash saving measures that could be quickly implemented during this time period, including reductions in discretionary expenses related to marketing programs, product development, and general and administrative expenses, including reducing personnel and personnel related costs if necessary.  Such actions could potentially harm the business if large reductions in spending become necessary.  We believe that the cash savings from actions already enacted and additional savings from further measures that could be taken, if necessary would allow us to maintain compliance with the Adjusted EBITDA covenant and the minimum cash balance covenant.  If we do not comply with the terms of the credit agreement in the future, including if we experience a change of control, it would be an event of default, and, subject to certain cure periods, the lender would have the right to require immediate repayment of the term loan, and/or exercise any other rights or remedies it may have, including foreclosing on our assets that serve as collateral.  Furthermore, a default under our term loan agreement would also trigger a default under our subordinated promissory note agreements.

In connection with the refinancing on August 3, 2018, we issued warrants to purchase shares of our common stock to our term loan lenders and to certain holders of our subordinated promissory notes. In the three months ended May 4, 2019, 1,245,000 stock warrant shares were exercised and converted into our common stock for a cash exercise price of $0.6 million.

Critical Accounting Policies and Estimates

This MD&A is based upon our condensed consolidated financial statements, which are included in this report.  The preparation of these condensed financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities.  Refer to our Annual Report on Form 10-K for a discussion of our critical accounting policies and recent accounting pronouncements.