Description

Cherokee [CHKE] is an underfollowed, high margin, brand licensing company which is undergoing a serious turnaround. Legacy management decisions have masked the company’s ability to generate cash and achieve high operating leverage. New management has a real plan to grow the company with owner’s returns in mind and they have supported this with significant stock purchases. Given the current margins, growth profile and leverage to the bottom line this company is trading at over a 50% discount to Intrinsic Value.

Company Description:

Cherokee Inc. markets, manages, and licenses lifestyle brands for apparel, footwear, home, and accessories worldwide. The company owns various trademarks, including Cherokee, Sideout, Sideout Sport, Carole Little, Saint Tropez-West, Chorus Line, All That Jazz, Liz Lange Maternity, and Completely Me.  They take no inventory or other risk associated with purchasing relationships with manufacturers.  Retailers simply license their brands and pay them a royalty.

Turnaround:

The story is primarily one of new management and a significant turnaround being masked by a major customer declining.

In late 2010, Henry Stupp joined CHKE and purchased $1.5mm of stock (with his own after tax cash just like the rest of us) at $18.30 a share.  At the same time the newly appointed Chairman bought 900k worth of stock.

The company had been managed by its founder and CEO, Robert Margolis, to optimize cash flow at the expense of alienating customers and under-investing in the brands they owned.  Think of a real-estate company under-investing in routine maintenance CAPX, sweating the assets to increase near term cash flow.

The under-investment caused Target (their biggest customer) to experiment with other brands and drop SKU’s, reducing royalties over the previous years.  Also, their second biggest customer, Tesco was essentially fazing them out. Royalties that peaked at 12mm were quickly falling and today represent about 800k a year.

Upon Henry’s arrival, and Margolis’s departure, that operating model changed and Henry began to invest in the business. He hired Sally Mueller (23 year brand executive at TGT) and Jamie Curtis (formerly at TGT and Coach).  Target’s sales of Cherokee branded items are up 42% over the past two years and the relationship is materially improved.  Unfortunately the improvement could not compensate for Tesco’s collapse.

It took an increase in operating expenses to get the new team in place and implement the support services needed to retain and grow with its’ licensees/customers.  This had the effect of increasing overhead while overall revenue was falling.  Higher G&A and falling sales is usually something you like to see in a short idea and I’m sure it disappointed numerous shareholders.  We thought it was the right investment and needed to be done.  Clearly the Target numbers have shown it is working.

Also, during this time the dividend was cut from .38 cents a quarter to .10, another move that could be considered a negative development.

As this all transpired they generated roughly $2 a share in free cash flow over the last two years and are now poised to grow revenue and earnings for the first time since 2007.

For such a simple business there have been a lot of complicated puts and takes over the past couple years but the core of the thesis is that Target has recovered and should grow modestly from here while Tesco recovers materially and the growth in the rest of the world “Other” continues.

Business Segments and Growth Opportunities:

Target – largest customer and CHKE is essentially a house brand in the US for them.  Materially improved relationship and sales over the past two years, proving that the heightened level of engagement is paying off.

Tesco – relationship was DEAD, new approach was proposed and now fully supported by Tesco. Former champion of the brand promoted to Head of Apparel at Tesco corporate.  Rolling out new floor set in 280 stores in Feb/Mar 2013.

Zellers/Target Canada –Zellers is closing all stores by March 2013.  About $2mm in trailing royalties.  Target opening 125 stores next year in Canada.  Many of them at former Zellers locations.  Ultimate goal is 250 stores. Target Canada will sell CHKE assortment.  Transition may cause a bit of a headwind next year so modeling 50% of Zellers royalties.

Other (China, Russia, Japan etc.) – Growing at 30% plus, Zellers is lumped into other when they report but you can back it out to get a sense of the growth here and there is good potential from further SKU’s and store openings at their partner companies.

Acquisitions/Liz Lange –Smart acquisitions could provide a lot of growth we have not modeled.  Liz Lange was the first deal for the new team and it is a great start.  Licensed to Target for the last 10 years, LL is a maternity brand.  Bought the company for less than 7x EBITA and financed it with 4.5% debt. Price was $14mm with about $1mm of that coming in an earn-out.  Seller is a private equity firm that bought it for $60mm. The acquisition should contribute .10 to .12 cents a share next year just on their existing business.  CHKE has gotten LL into Target Canada and is looking to place the brand with other retail partners globally.  If they can find solid deals at good prices where they can leverage their global network and keep the economics of that expansion for the shareholders of CHKE rather than using that growth to justify paying too high prices, this area will be a big benefit to shareholders.  We consider it a free call option and have not modeled any additional deals.

Valuation

CHKE is undervalued based on a wide range of metrics, but if we just concentrate on the next fiscal year’s earnings, the valuation is extremely compelling. Key assumptions for next fiscal year are:

1. Roll out of Tesco expected to contribute $2mm conservatively, 280 stores launch in March 2013 and we don’t think CHKE will get back to $12mm in royalties but a modest ramp to $4mm in the next two years is conservative.
2. Other category (ex-Zellers) growing in the 25%+ range (recently in the 30%+)
3. Conservatively modeling Zellers/Target at $1mm which is down 50% due to transition
4. Liz Lange generating $2.4mm in revenue, = only 87% of what they need to hit their earn-out so probably conservative.  Also, does not include anything for Canada launch which is announced. Or anything for additional global partners.
5. G&A Modestly increases from 3.4mm quarterly run rate ending up roughly flat y/y
6. No additional brand acquisitions or new deals with current brands

The company currently trades at 14.7x our EPS estimate for Fiscal 2013 which ends in one month (January 2013). However, given these assumptions, an 18x EPS multiple is more appropriate and consistent with companies generating 50% operating margins, 20%+ growth and 3% dividend yields.

After factoring in the dividends, we think the potential total return could be close to 60% at the end of January 2014. Free cash grows 20% next year to $1.29 per share.  With Tesco continuing to ramp and Target Canada becoming a full contributor we see at least 15% growth in the subsequent year bringing EPS to $1.30 in Fiscal 2015.

Even if we assume the company still trades at the 14.7x EPS multiple, that results in a $20.25 share price in 2015.  Over two years that is a 20% IRR on pure price appreciation, not to mention the 3% dividend yield while you wait.

 Additional Upside to our Model:

• Additional solid brand acquisitions
• Tesco takes off more than modeled
• Corporate tax rates decrease causing a direct earnings increase considering CHKE is a full tax payer.
• France/Germany retailers sign up
• New international deals
• Multiple expansion, company growing at 15-20% likely to have a higher multiple if people believe it is sustainable.
• Inflation hedge, as prices go up so do our royalties

Risks:

• Target customer concentration. 
• Global retail slow down.
• They do a bad deal and destroy shareholder value. 
• CFO is weak and does not represent the company well.  Not a lot for him to do but collect royalty checks and pay bills but if they are going to do more deals, they should upgrade this part of the team.

Catalyst