Cherokee Inc. CHKE
April 30, 2001 - 12:40pm EST by
kevin328
2001 2002
Price: 8.75 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 0 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

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Description

Cherokee has an interesting and unique business model. The company, once a manufacturer of Cherokee brand apparel, has found a niche as a licensor of this brand and others to large retailers. No longer do they design, manufacture, market, and sell apparel, but instead they simply license an array of brands and let retailers and wholesalers do the leg work. This way, the retailers utilize their economies of scale to produce the branded apparel cheaply, and CHKE enjoys high margins and eliminates inventory risk.

Currently, the majority of revenues come from the U.S., through royalty payments primarily from Target and Mervyn’s, but the company is working to diversify the business. An agreement signed with the Carrefour Group of France in late 2000 should start contributing international revenues in late 2001. Carrefour is the second largest retailer in the world. Also, CHKE acted as an agent in brokering a licensing deal between Mossimo and Target, from which CHKE is to receive 15% of all royalty payments as a finder’s fee.

Additionally, the company seeks to represent other brands, such as it did with Mossimo, in soliciting similar licensing arrangements. Chairman and CEO Robert Margolis is a well-connected person in this industry, and (from what I can tell) deserves the credit for making CHKE’s relationship-based business succeed. He’s been with CHKE for 20 years, and owns over 20% of the company.

The valuation of this stock is compelling. Trading at less than 7X trailing earnings, and with a 38% net margin, there are gobs of free cash coming in. ($1.34 in FY2001*) EBITDA in FY 2001 was approx. 2.40 per share. And there is negligible CapEx required by this business. The EV to trailing EBITDA is 5, and the $30 million of debt is continually being paid down. And now consider the 14% revenue growth, which resulted in 34% net income growth, and CHKE is just plain cheap. (37% EPS growth after buy-backs) Management expects this growth to continue at least for the next 1-2 years, as Target further increases sales and the new Carrefour agreement begins to kick in revenues. And surely there are more deals in the pipeline.

The company purchased the Sideout brand in 1997, which has proved a successful plug-and-play for this business. Management has indicated they are always on the lookout for other reasonably-priced purchases, and with such high cash flow, such an acquisition shouldn’t be difficult. Currently most FCF is used to repurchase shares and pay down debt.

The bottom line is CHKE has found a creative (and very profitable) way to add value in the mass retailing and wholesaling industry. Their costs are fairly fixed, (largely compensation for the 14 employees) and nearly all new royalty revenue and licensing agreements should drop right to the bottom line. (During FY 2001 pre-tax margins increased by 11%, to 63%)

*FY2001 ended 2/3/01

Catalyst

1. Sheer value.
2. Continued growth from current licensing agreements.
3. Increasing contributions from new international licensees.
4. Expanding margins. (relatively fixed costs)
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    Description

    Cherokee has an interesting and unique business model. The company, once a manufacturer of Cherokee brand apparel, has found a niche as a licensor of this brand and others to large retailers. No longer do they design, manufacture, market, and sell apparel, but instead they simply license an array of brands and let retailers and wholesalers do the leg work. This way, the retailers utilize their economies of scale to produce the branded apparel cheaply, and CHKE enjoys high margins and eliminates inventory risk.

    Currently, the majority of revenues come from the U.S., through royalty payments primarily from Target and Mervyn’s, but the company is working to diversify the business. An agreement signed with the Carrefour Group of France in late 2000 should start contributing international revenues in late 2001. Carrefour is the second largest retailer in the world. Also, CHKE acted as an agent in brokering a licensing deal between Mossimo and Target, from which CHKE is to receive 15% of all royalty payments as a finder’s fee.

    Additionally, the company seeks to represent other brands, such as it did with Mossimo, in soliciting similar licensing arrangements. Chairman and CEO Robert Margolis is a well-connected person in this industry, and (from what I can tell) deserves the credit for making CHKE’s relationship-based business succeed. He’s been with CHKE for 20 years, and owns over 20% of the company.

    The valuation of this stock is compelling. Trading at less than 7X trailing earnings, and with a 38% net margin, there are gobs of free cash coming in. ($1.34 in FY2001*) EBITDA in FY 2001 was approx. 2.40 per share. And there is negligible CapEx required by this business. The EV to trailing EBITDA is 5, and the $30 million of debt is continually being paid down. And now consider the 14% revenue growth, which resulted in 34% net income growth, and CHKE is just plain cheap. (37% EPS growth after buy-backs) Management expects this growth to continue at least for the next 1-2 years, as Target further increases sales and the new Carrefour agreement begins to kick in revenues. And surely there are more deals in the pipeline.

    The company purchased the Sideout brand in 1997, which has proved a successful plug-and-play for this business. Management has indicated they are always on the lookout for other reasonably-priced purchases, and with such high cash flow, such an acquisition shouldn’t be difficult. Currently most FCF is used to repurchase shares and pay down debt.

    The bottom line is CHKE has found a creative (and very profitable) way to add value in the mass retailing and wholesaling industry. Their costs are fairly fixed, (largely compensation for the 14 employees) and nearly all new royalty revenue and licensing agreements should drop right to the bottom line. (During FY 2001 pre-tax margins increased by 11%, to 63%)

    *FY2001 ended 2/3/01

    Catalyst

    1. Sheer value.
    2. Continued growth from current licensing agreements.
    3. Increasing contributions from new international licensees.
    4. Expanding margins. (relatively fixed costs)

    Messages


    SubjectMargolis
    Entry04/30/2001 02:18 PM
    Membertom208
    Margolis is CHKE. He works 3 days a week and plays a lot of golf-- good thing he's well-connected in the industry. I'd worry that he might start to slack off (!), but his compensation agreement minimizes this risk, I guess.

    SubjectCorrection and Margolis
    Entry04/30/2001 09:28 PM
    Memberkevin328
    Tom- I agree that Margolis makes this company work. I mistakenly wrote that Margolis himself owns 20% of the company-- This is not true, but his compensation plan is tied directly to EBITDA.
    Perhaps he enjoys a golfing lifestyle, but the business is relatively hands-off. Target already owns exclusive rights in the US for the flagship Cherokee brand, and Carrefour is set to grow the brand around the world. And remember, design, manufacturing, and marketing responsibilities lie with the retailer/wholesaler, so CHKE only does occasional quality-control and lets the royalties roll in.
    Margolis has inked favorable terms thus far in CHKE's deals, and based on his compensation plan and 20 year history with the company, I'm confident he'll get the job done going forward.

    SubjectSheer Value
    Entry04/30/2001 09:35 PM
    Memberround291

    SubjectSheer Value
    Entry04/30/2001 09:47 PM
    Memberround291
    I apologize, but I frankly don't see the "sheer value" here. A business based on licensing poorly supported brand names isn't all that attractive from my vantage point. One wonders what Margolis is being compensated for in the form of these agreements. One things for sure though...a dollar earned in the form of capital gains is more valuable than a dollar of ordinary income.

    There's little liquidity in the issue. Performance is erratic. There is no strategy for growth...and he doesn't need my money.

    Subjectround291
    Entry04/30/2001 10:25 PM
    Memberkevin328
    We can argue all day about Margolis' bonus. It may not be ideal, but I don't see that as the main issue here. I think your description of "poorly supported brand names" is a bit off the mark. The value to Target or any other mass retailer of the Cherokee brand is not that it is glamorous and attracts customers, or draws them away from other stores, but it gives customers a recognizable name every time they come in the store. People who buy their clothes at Target aren't the same shoppers who must choose between Gap, Abercrobie, or AEOS.
    Licensing the brand from CHKE is a cheap and efficient alternative to the start-up costs of creating a new brand.
    Also, just because CHKE isn't directly involved in the manufacture or marketing side of the brand doesn't mean that this is poorly done. The quality of the merchandise and the in-store display of the merchandise are the most important "support" factors for brands in this lower level of the retail market, and judging by Target's sales growth, they are hardly doing a poor job.
    As for eratic performance, I assume you mean in the stock price. The underlying business has been steadily picking up steam for several years, with improving margins, cash flows, and profits. And to the true value investor, business perfomance is the important issue.
    The bottom line is this is a fundamentally sound business that should pay for itself in free cashflow within the next 4 years. And that is what Margolis is being compensated for.

    SubjectGood Points
    Entry05/01/2001 08:07 PM
    Memberround291
    I admit to being slightly off on my "erratic performance" comments as the company seems to have strung together a couple years of growth.

    How big is the market for licensing a names (which doesn't seem to receive much media support and likely has marginal customer recognition)to retailers? How sustainable is this business model?

    SubjectMarket Size and Sustainability
    Entry05/01/2001 09:45 PM
    Memberkevin328
    Cherokee has no direct competitors, meaning they are the only ones out there with a retail/wholesale-direct licensing strategy. So it is impossible to pin down the market size. (Mossimo copied CHKE's model in Feb. 2001, with direct help from CHKE. This was due to impending bankruptcy)

    But think of it this way: In the US last year, mass retailers (Target, KMart, Wal-Mart, etc) did 10's of billions of dollars of retail apparel sales in a hotly competitive environment. (1.87B of Cherokee products) As retailers continue to work to keep margins up and prices down, more mid-sized, mid-market brands (such as Mossimo) will fail, and CHKE's licensing model will be an attractive escape. Target has been praised in the press for its ability to keep up with current fashion trends and still offer bargain prices. (there's been no mention of CHKE in connection to this, but one must wonder if this is Target's economies of scale at work...) It is a big win for retailers, and it seems to be the direction the industry is heading.

    And CHKE, along with Margolis, is at the center of this. They've already capitalized on Mossimo's transition (though possible bankruptcy for Mossimo still stands in the way) and are well positioned to cash in on others-- whether it be through assisting other brands, or through an acquisition of a struggling brand. (Remember, the Sideout acquisition has already proved to be a plug-and-play success)

    I hope this helps illuminate the industry and business model. And of course, the 10-k is a great place to hear it from management's mouth too.

    SubjectSpell-C
    Entry08/17/2001 08:26 AM
    Memberjay347
    Hi,
    I've been looking at CHKE, and have a few questions.

    The 10Q states: "While all royalties paid under the Amended Target Agreement appear in our consolidated financial statements, since the issuance of the Secured Notes, most of such royalties have been, and most, if not all of such royalties received until the maturity of the Secured Notes, will be distributed to the holders of the Secured Notes."

    What is the significance of the sale of the brand to Spell-C? And what is the significance of the zero coupon notes issued? It seems to me that the special dividend paid in 12/97 of $5.50 represented the bulk of expected earnings from the Target agreement as monitized by the zero-coupon notes. Therefore a current shareholder is really not reaping the benefit of the target agreement. Does anyone concur?

    Jay



    Subjectare you a seller at these leve
    Entry01/24/2002 10:22 PM
    Membernorth481
    are you a seller at these levels?

    SubjectForbes Article
    Entry06/02/2002 08:38 AM
    Memberlil305
    For anyone interested in this company, there is a good article in the June 10, 2002 issue of Forbes.
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