September 14, 2015 - 3:43pm EST by
2015 2016
Price: 13.92 EPS 1.15 0
Shares Out. (in M): 9 P/E 12 0
Market Cap (in $M): 122 P/FCF 12 0
Net Debt (in $M): 12 EBIT 15 0
TEV ($): 134 TEV/EBIT 8.5 0

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Cherokee Inc. is a direct-to-retail licensor of various brands, namely Cherokee, Tony Hawk and Liz Lange. The big news, driving the stock down about 50% from its recent highs, is Target has just opted to not renew its 20 year relationship with the Cherokee brand. This is a big opportunity for Cherokee and for investors.

Cherokee’s been written up a couple of times over the years on VIC. It is a small cap with a market cap of about $125 million and annual free cash flow of about $10 million. I believe it will grow consistently over the next few years with incremental margins growing considerably as a result of their unique, very low capital intensive licensing business model.

Only a few short months ago, as a result of the progress they’ve made in securing new retailer licensing agreements in both the UK/Ireland and Canada (two perennial trouble spots over the past few years), the company had a market cap of about $250 million.


With a successful transition of the Cherokee brand from its out-dated, under-utilized licensing agreement with Target in the US to a much more lucrative agreement with either one national scale retailer or even licensing agreements with a bevy of retailers licensing specific product categories (kids/baby apparel, adult apparel, shoes, households products, etc.), Cherokee Inc.’s royalty revenue could easily exceed the $15 million they now receive from Target.

Under the current Target agreement, the royalty rate works out to about 1.5% of total retail sales. According Cherokee’s CFO, the going rate with their other licensing deals is around 4% of retail sales. In addition, Target only used the baby/kids apparel category and let all other product categories sit on the shelf. Under the deal, struck largely in 1993, Target had the exclusive rights to all product categories in the US. And, Target had the right to auto-renew in two year increments, regardless of Cherokee’s view that they could earn greater licensing revenue rates under a more modern-day deal. They were simply stuck with Target (and with the volume they did, they just lived with it.)

I believe Target has done Cherokee a favor by opting to not renew the deal.

The stock has taken a dive - down 40% on Friday and today - and I think it’s way, way overdone. This reaction is likely driven by the forced disclosures pressured by Cherokee’s auditors that Target’s non-renewal triggered an event of default in their loan agreement with JP Morgan.

While JP Morgan and Cherokee struck a forbearance agreement until October 12th - a deal agreed upon with three hours of the non-renewal by Target, according the Cherokee’s CFO - investors obviously are concerned that 40%+ of Cherokee’s revenue is facing this cliff on January 31, 2017.

I believe the debt issue is a non-issue.

Currently, Cherokee has $10 million in cash and owes about $21 million. Target must pay $11.3 million annually to Cherokee as a minimum guaranteed amount under their license. So, by default, regardless of the retail sales generated at Target for the Cherokee brand, over the next six quarters, Target must send a minimum of $17 million to Cherokee and probably more based on actual retail sales. Add in the other $30 million in “other than Target US” revenues over this six quarter period, revenue will total at least $47 million - conservatively figured. SG&A costs are about $27 million and taxes are about 35%.

Net of taxes, over the next year and a half - to the end of Target’s agreement - Cherokee will bring in about $12 million in free cash flow. Adding this to the $10 million in cash on hand, Cherokee could basically pay off the $21 million owed to JP Morgan and be debt free on January 31, 2017.

Therefore, JP Morgan isn’t going to do anything other than sign new covenants and possibly extract slightly higher interest - because they can. I expect by October 12, there will be no language containing the phrase “event of default” in Cherokee’s filings.

With the knowledge that the Target deal was suboptimal for Cherokee and with the confidence that Cherokee will replace the Target licensing revenue - likely within about six months to ensure a somewhat seamless transition to a new retailer to start January 31, 2017 - it’s quite unbelievable to me that investors have bailed on the stock to this degree.

I believe Cherokee’s management has proven they can successfully transitions licensees with their move to Sears Canada after Target abandoned Canada earlier this year and with their deal with Argos in the UK/Ireland after Tesco couldn’t get things straightened out.

I won’t speculate on which retailer Cherokee will license with in the US. It may turn out to be a combination of retailers across the various product categories available for the Cherokee brand. What I can say is, under the reasonable assumption of a 3% to 4% royalty rate vs. the 1.5% rate under the Target deal, Cherokee doesn’t need to approach the $1.1 billion in retail sales (kids only) they achieved with Target in the US. Given that adult apparel exceeds kids apparel as a product category, I expect Cherokee will be more profitable after this transition.

And, I further believe clarity around this transition will become apparent in the dead of winter 2016. With that, Cherokee’s stock will likely get back to at least $25 per share, if not higher. As the results come in over transition period, and with the other growth opportunities that are already in place with Argos, the Tony Hawk brand with Sports Authority and with their Point Cove deal in India, Cherokee is poised to earn enough to justify a much higher stock price for the longer-term investor.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.


New licensing deal(s) struck for the US to replace Target.

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