First, the business. Cherokee is strictly a brand licensor. It owns the Cherokee, Sideout, and Carole Little brands (among others), which it licenses to selected retailers. The company does no product design, no production sourcing, and little marketing - this is left to the licensees. Cherokee provides and fosters well-known brands that allow customers to charge more for what is, in effect, store-brand merchandise. This is what's known as a "light" business model, requiring next to no capital investment and few expenses save for paying the handful of employees and maintaining the brand trademarks in various countries. As a result, Cherokee is a phenomenally efficient business, with post-tax returns on capital routinely climbing above 150%.
Cherokee gets paid a percentage of the net sales of licensed products, and most of their deals also have a minimum annual payment clause. The largest deal, by far, is one with Target to sell Cherokee-branded apparel, which has accounted for about 42% of revenue for the last several years. This deal runs through January of 2013. The other large contract is with U.K.-based Tesco, the third-largest global retailer. In fiscal 2011 (roughly calendar 2010), Tesco contributed 27% of sales. The remaining 30% or so are spread out through multiple agreements with retailers both big and small, domestic and international. Examples include a licensing deal for the Carol Little brand to TJX Companies (TJX) and Sideout to volleyball equipment maker Mikasa Sports.
This is a company in a bit of a transition. Cherokee has stagnated badly over the past 5 years, with revenues declining 29% and operating profits down 25% since 2006. In that same period, the dividend has been cut from $3 a share in 2007 down to $0.80 today (a still respectable 4.4% yield). Tesco, in particular, has not been a very good partner, with royalties down almost by half from just 3 years ago, and failing to expand Cherokee's brands into Asia. Predictably, the stock price has followed suit, down to the high teen's today from about $45, 5 years ago.
The wheels started turning last August, when long-time CEO Robert Margolis handed the reins over to licensing veteran Henry Stupp. In January, Margolis also gave up his chairmanship, effectively leaving the company (though he does still have a 7% ownership stake). There was turnover at CFO as well. This should help Cherokee in several ways. For one, the company is in need of some fresh energy to ignite growth. Secondly, Margolis was handsomely paid. His salary was $800k, and Cherokee will end up spending nearly $13 million in severance (through bonuses, severance, and buying back some of his stock) - $10 million of which they had to secure debt for! Stupp's compensation, at $375k, is much more reasonable, and the difference is material to such a small business.
Cherokee's dividend has been its biggest attraction for many years. It once paid out a 8-10% yield, but was never sustainable. The current dividend should be. It represents just 50% of last year's free cash flow, and provides the firm additional cash to pay down the newly minted debt, and also to pursue growth avenues, such as acquiring new brands.
Modeling low single-digit growth going forward, the stock looks to be worth about $22 a share. That is 25% upside from current prices (including the dividend). That makes Cherokee a solid Magic Formula pick. Given the management turnover, downward trend, and revenue concentration between 2 customers, I'd like to see the stock get a bit cheaper before considering it for a Top Buy recommendation, however.
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Steve does not own CHKE.
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