Despite Risks, Cherokee Has the Right Business Model

For those who have ever wandered into a Target (TGT) to buy new clothes or shoes, encountering the Cherokee (CHKE) brand is inevitable. What you may not know is that this remarkable little company has only a handful of full time employees, less owned property then most small families, and yet collected over 36 million dollars in revenue last year and turned 44% of those revenues in free cash for its stockholders! Clearly this is one exceptional business - and according to the Magic Formula it's now on sale. Sounds like a great buy, right? Let's dig a little deeper.

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 no marketing - this is left to the licensees. In effect, Cherokee replaces private label brands for these licensees. This is what's known as a "light" business model, requiring next to no capital investment and little expenses save for paying the few employees and maintaining the brand trademarks in various countries. Every dollar invested into capital spending returns several hundred percent in earnings (return on tangible capital).

There's no problem with Cherokee's financial health either. There is almost 14 million in cash on the balance sheet, and no debt. Free cash flow margin has averaged 42% or higher over the last 5 years. The company doesn't hoard this cash, it pays out nearly all of free cash as dividends. Cherokee currently sports a dividend yield over 10%. The dividend alone makes it an attractive investment candidate.

The next thing to examine is management - a crucial component of small cap success. Robert Margolis is CEO, and has been with the company since its founding in 1981. He owns a healthy 12% of the shares, which aligns him with shareholder interests. However, there are some governance issues. Margolis has final say over any additions or subtractions to the Board of Directors. His base pay cannot be cut. The proxy goes so far as to say that his employment agreement must compensate him for any "inconvenience". Clearly, corporate governance could be better, but management isn't a major concern here.

Cherokee has some avenues for growth, as well. The company's deal with UK retailer Tesco (TSCDY.PK) has been advantageous, as Tesco has moved the brand into Eastern Europe, Asia (including China), and parts of Africa. The company also has a deal with Zellers in Canada and deals in China for the Sideout brand and Mexico for the Cherokee brand.

Some risks

So far Cherokee sounds like a great candidate for a Magic Formula portfolio. But there are some serious risks here. First, nearly 85% of revenue comes from two contracts - with Target in the US (42%) and Tesco in Europe and Asia (42%). While both agreements run for at least 3 more years, the retailer has the option of cancellation at the end of each year. It would be disastrous for the company to lose either deal. Replacing the geographic diversity that Tesco provides would be especially difficult.

The second risk is simply competition. Cherokee's brands compete against almost limitless competition - Nike (NKE), VF Corp (VFC), Gap (GPS), Iconix (ICON), etc. Iconix has even aped Cherokee's business model, and has used its greater financial resources to acquire some well known down-market brands like Mossimo and Starter. Competition like this limits Cherokee's ability to acquire new brands when opportunities present themselves. The Cherokee brand also has no durable competitive advantage, as down market products are separated by price, which Cherokee has no control over. If Target or Tesco decides they can make more money selling up market brands, Cherokee products could see less shelf space or be phased out.

MagicDiligence is a fan of the Cherokee business model, its financial health, and its beefy dividend. I would not argue too strongly against including it in a MFI portfolio. However, we're looking for the best companies with durable advantages (less risk), serious growth drivers (more upside), and a truly cheap price (because we're tightwads). Cherokee doesn't quite make the cut as a Top Buy.

Disclosure: Steve owns no position in any stocks discussed in this article.

Comments

[YoYoMama:]

The divy yield is juicy - 10% +. It's on my watch list for a pullback.

May 27 10:07 AM

[Dabqs:]

Steve,
I also considered the concentration of revenues at Target and Tesco a risk for Cherokee, Inc.. As I thought about it, and then spoke with management to understand the business better, I have come to the conclusion that the risk is far less than I had worried about, given that, for example, the agreement with Target precludes the company from establishing a similar agreement with WalMart (brands sold exclusively through Target), however, the agreement with Target and Tesco-- should they not be renewed, allow for Cherokee to immediately establish a new agreement with any other retailer, including, obviously, retailers which compete directly with Target and Tesco. Now, imagine that you are Target, and you have had the Cherokee brands in your stores for years and years, and your customers have come to expect that these brands will be available when they shop your stores. Should these brands not be available due to an end of the Cherokee/Target relationship, how quickly do you think WalMart or another direct competitor to Target would be to establish a new agreement with Cherokee to offer the Cherokee brands which Target's customers have come to expect?

When it comes to something as personal as clothing/apparel, shoppers become very loyal to brands. Should Target end the relationship with Cherokee, Target would likely lose a substantial amount of sales which would follow the brands to a major competitor. And in the ultra competitive retail business, taking such a risk is very unlikely, and would amount to a poor business decision.

In addition, buying Cherokee stock on a pullback where, for example, the dividend yield would be approximately 15% per annum, provides one heck of a cushion--as at 15% per annum, the entire purchase price of the stock is returned to the investor in just under 5 years.

Dabqs

May 27 02:03 PM