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Executives

Kimberly Esterkin

Jason Boling - Chief Financial Officer and Principal Accounting Officer

Henry Stupp - Chief Executive Officer and Director

Analysts

James Fronda - Sidoti & Company, LLC

Pankaj Chandak

Brian Guy Lancaster - Clayton Partners LLC

Cherokee (CHKE) Q2 2014 Earnings Call September 12, 2013 4:30 PM ET

Operator

Greetings and welcome to the Cherokee Inc. Second Quarter 2014 Earnings Conference Call. [Operator Instructions]

It is now my pleasure to introduce your host, Ms. Kimberly Esterkin. Thank you. Ms. Esterkin, you may begin.

Kimberly Esterkin

Thank you. Speaking today will be the company’s Chief Executive Officer, Henry Stupp; and Chief Financial Officer, Jason Boling.

You can also find accompanying slides for today's call on Cherokee's Investor Relations website.

Before I hand the call over to management, please note, that on this call, certain information presented contains forward-looking statements.

Certain statements contained herein may contain forward-looking statements for purposes of the Safe Harbor provided by the Private Securities Litigation Reform Act of 1995. When used, the words anticipates, believes, expects, may, should and similar expressions are intended to identify such forward-looking statements.

Forward-looking statements included in this conference call involve known and unknown risks and uncertainties that may cause actual results, performance or achievements of the company to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements.

A further list and description of these risks and uncertainties and other matters can be found in the company’s Annual Report on Form 10-K/A for the fiscal year of 2013, and in its periodic reports on Forms 10-Q and 8-K.

Given these risks and uncertainties, you should not place undue reliance on forward-looking statements as a prediction of actual results.

The company disclaims any intent or obligation to update any of the forward-looking statements contained herein to reflect future events and developments.

The most directly comparable GAAP financial measures and information reconciling non-GAAP financial measure to the company's financial results prepared in accordance with GAAP are included in the earnings release, which is posted on the company's website at www.cherokeegroup.com.

And with that, I'll hand the call over to Cherokee's Chief Financial Officer, Jason Boling.

Jason Boling

Good afternoon, everyone, and thank you for joining us today on our second quarter fiscal 2014 conference call. I will begin today's call by discussing our financial results for the quarter. I will then turn the call over to Henry Stupp, our Chief Executive Officer, to speak in further detail about our brands, our partners, before we open up the call to your questions.

Turning to the second quarter results. Revenues grew 19% to $7.5 million from $6.3 million in the prior-year period, despite the negative impact attributable to foreign currency reductions.

This growth in revenues is primarily from increased revenues from our namesake brand at Target, Liz Lange, and other Cherokee international licenses, offset by a significant decrease of approximately $670,000 in Cherokee royalty revenues at Zellers Canada due to their early closing during the first quarter of fiscal 2014.

We expect the revenue decreases experienced as a result of the cessation of the Zellers Canada operations will be offset by further expansion of Target Canada, which began in March 2013. And Target Canada will continue to add locations through the remainder of calendar 2013.

The Cherokee brand continues to see strong international growth in local currency retail sales, despite foreign currency devaluations in several of our key markets, including Japan, South Africa and India, which have reduced our revenues by approximately $131,000 during the second quarter and approximately $200,000 year-to-date.

In South America, where there is increased economic development, revenues from Tottus, our exclusive retail partner in Peru, Chile and Colombia, showed outstanding results for the quarter, with retail sales increasing approximately 60% over the second quarter of fiscal 2013. We continue to see positive sales momentum in Asia with both Nishimatsuya and RT-Mart.

Selling, general and administrative expenses for the second quarter were $4.2 million or 57% of sales compared with $3.6 million or 58% of sales in the prior-year period. This increase is related to personnel costs that were provided to enhance our 360-degree approach with our partners, including Tesco, and increased amortization costs relating to the acquisition of Liz Lange and Cherokee uniform brands.

On a GAAP basis, net income for the second quarter was $1.9 million or $0.23 per diluted share, an increase of 19% compared with $1.6 million or $0.19 per diluted share in the prior-year period.

Operating income for the second quarter totaled $3.3 million versus $2.7 million in the same period last year. Operating margins for the quarter improved to 43% from 42% in the prior-year period.

For the quarter ended August 3, 2013, we recorded a tax provision of $1.2 million, which equates to an effective tax rate of 38.4% compared to $1 million or an effective tax rate of 39.1% recorded in the second quarter of last year.

Turning to our balance sheet and related metrics. Total cash and cash equivalents as of August 3, 2013, were $2.8 million, up from $2.4 million at the end of the first quarter.

Cash flow from operations totaled $3.5 million for the quarter versus $3.8 million for the prior-year period due to increases in accounts receivable relating to the revenue from both the Cherokee and Liz Lange brands, partially offset by decreases in payables.

We remain in a strong financial position to meet our cash requirements, which will primarily be for business operations, debt service and paying dividends, as determined by our Board of Directors.

A quarterly dividend payment of approximately $840,000 or $0.10 per share will be paid on or around September 16 to the shareholders of record as of September 2, 2013, and reflects an annualized dividend yield of roughly 3.3%.

Thank you, all, for your time. I will now turn the call over to Henry, to speak in further detail about our partners and brands.

Henry Stupp

Thank you, Jason. We are very pleased to have completed a strong first half of fiscal 2014, with year-to-date royalty revenues increasing 12.5% over the first 6 months of fiscal 2013.

We prudently managed our expenses during the second quarter in areas of product development, travel and selling and marketing.

Looking specifically at the second quarter, the company had a 19% increase in revenues over Q2 of 2013, despite the roughly $670,000 decrease in revenues year-over-year from Zellers Canada's closing and approximately $131,000 decrease due to unfavorable currency exchange rates.

In spite of the less-than-favorable foreign exchange rates, we continue to see international growth during the second quarter, particularly in South America and Asia.

In South America, as Jason mentioned, we saw a 60% retail sales growth at Tottus, our exclusive retailer partner in Peru, Chile and Colombia over the prior year time period due to the strength in our Kids apparel and Cherokee footwear.

In addition, we are truly delighted to report that we recently signed a 6-year extension of our partnership with Tottus and look forward to many future years of success with Tottus as our partner.

We also had a strong first half of the fiscal year in Asia. Retail sales at our exclusive Chinese partner, RT-Mart, increased 27% over the first half of fiscal 2013, where Cherokee-branded products are sold in 227 fixture in-store locations, in addition to our recent expansion on Tmall.com.

And at Nishimatsuya in Japan, despite a nearly 25% reduction in the value of the yen, retail sales of Cherokee-branded products in local currency were up 27% year-to-date. As of last quarter, Nishimatsuya now sells Cherokee baby, children's wear, accessories and bedding in all of its 849 stores throughout Japan. We have seen incredible work with our Japanese partner, particularly in kids' essentials and kids apparel.

With respect to our progress with our exclusive U.S. retail partner, Target, the Cherokee brand at Target, excluding the sales of Cherokee-branded school uniforms, continues to see growth during the second quarter, with retail sales up 23% year-over-year. In fact, Target highlighted on its most recent earnings call that for the apparel category, children's, of which Cherokee is a leading contributor, produced the strongest results. Domestic retail sales of Cherokee-branded products for Target for the second quarter totaled $246 million, an increase of $45 million over the same period last year.

For the 6 months ended August 3, 2013, sales of Cherokee-branded merchandise at Target in the United States increased 14% to $527 million in sales.

Over the past few years, we have presented various new exciting initiatives for the Cherokee brand at Target. And we are, therefore, very excited to announce that beginning with spring 2014, we shall be reintroducing a range of adult Cherokee products in target.com. We shall continue to expand the depth of adult assortments throughout calendar 2014. The Target and Cherokee teams have collaborated very closely on this launch, and we are very excited to see adult product returning to Target.

We believe that the launch of Cherokee adults in target.com is an important stepping stone towards our goal of continuing to expand the Cherokee assortment at Target and is a strong testament to the success of the value proposition associated with the introduction of Cherokee's 360-degree approach to enhancing our retail partnerships.

We're also looking into additional growth opportunities for Cherokee school uniforms at both brick-and-mortar locations, in addition to target.com.

We are proud of the collaborative nature of our relationship with Target, I wish to acknowledge their support and encouragement towards growing our business.

We're also exploring additional category expansion opportunities for our Liz Lange maternity brand, which is sold at Target. And for the second quarter, Target sales of Liz Lange products increased approximately 5% over the prior year. Importantly, as we head into the fall and holiday seasons, we shall see an increase in Liz Lange products assortment on target.com. While Liz Lange is one of America's best-selling maternity brands, there's still much room for growth on target.com, and we look forward to further expansion online as well as in stores.

Turning back to our International business, particularly Canada. During the second quarter of fiscal 2014, the early closing of the remainder of Zellers stores resulted in decrease of $33 million in retail sales and a corresponding reduction of approximately $670,000 in royalty revenue to Cherokee from the prior-year quarter.

Despite this decrease in Zellers income, Cherokee brand is seeing strong early progress with Target Canada. Cherokee's success at Target Canada is not surprising, given Cherokee's position in one of Canada's top-selling children's brands. Target Canada stores have experienced strong initial traffic with the mix of sales in home and apparel higher than expected. In addition, Target locations are continually being added throughout Canada.

During the second quarter, Target added 44 Canadian stores, bringing their total store count to 68, with the goal of operating 124 Canadian stores by year end. We are very excited to be partnering with Target on the Canadian expansion and remain enthused by Cherokee's productivity per store.

Speaking of growth. Our relationship with Tesco has also seen progress since our relaunch at 279 Tesco stores throughout the United Kingdom and Central Europe, as well as on tesco.com last quarter.

As I mentioned in previous earnings calls, the Tesco relaunch is a major brand reintroduction, as Cherokee's presence in Tesco stores had been severely diminished for quite some time. Nevertheless, despite a still challenging economic environment, sales of Cherokee-branded products for the second quarter at Tesco resulted in a 47% revenue increase on a year-over-year basis. As expected, it takes several deliveries to refine our assortments, and we are pleased to be seeing upward sales progress as each new delivery hits the stores.

We're also earning high marks from consumers for the quality of our products and we have positioned Cherokee as a premium brand at Tesco and are seeing high sales per-square-foot at Tesco stores due to the premium pricing of the brand.

While we know it takes time to revitalize a relationship, we're off to a solid start. We'd like to thank Tesco and all of its customers for the growing support of the Cherokee brand.

Now continuing on to discuss Cherokee's progress in the Middle East. Last quarter, Cherokee brand launched 48 stores throughout the United Arab Emirates, Saudi Arabia and Kuwait, as part of our exclusive partnership with the Landmark Group's Max stores.

While still in its early stages, we're happy to report that our second quarter of our partnership with Max is seeing success in each of the launched markets.

And even more recently in August, Cherokee Boys, Girls and Babies products launched in Indonesia for the first time at 11 custom-fitted locations within MAPs, SOGO and Seibu Department stores. The debut Cherokee collection was designed in California included a wide assortment of casual everyday lifestyle apparel, ranging from woven shorts, pants and denim, to sweats, jackets and dresses.

Our partnership with MAP represents an extension to department store category, an excellent opportunity to bring Cherokee brand to a wider consumer base. We will keep you posted on our progress with both Max and MAP stores over the coming quarters.

Our success in over the past 6 months have positioned Cherokee Group for continued growth throughout the remainder of fiscal 2014 and beyond. And we look forward to continuing to share our story on next quarter's earnings call.

I'd like to thank our entire team for the commitment to the company. And with that, operator, we will now open up the call to questions.

Question-and-Answer Session

Operator

[Operator Instructions]

Our first question is from James Fronda of Sidoti & Company.

James Fronda - Sidoti & Company, LLC

The Japan partner that you talked about, the Cherokee baby accessories and bedding, did you say that benefited this quarter, or will that help going forward?

Henry Stupp

Sorry, say again, on Japan...?

James Fronda - Sidoti & Company, LLC

You said the baby accessories and bedding, did that benefit you in this past quarter? Or will that help you going forward?

Henry Stupp

It was introduced during the quarter, so not a huge contributing factor overall. So overall, they're just seeing great comp growth despite the currency devaluation. As we go into the back half of the year, we'll see a greater presence in those categories in those stores and some additional new categories that are being developed as well.

James Fronda - Sidoti & Company, LLC

Okay. And what is Tesco now as a percent of total sales?

Henry Stupp

Oh, we'll get that to you.

Jason Boling

Roughly 4%.

James Fronda - Sidoti & Company, LLC

Okay. And is that all of the stores that you're in there?

Henry Stupp

We're in 278 locations right now. There's room to grow in terms of the store count, significant room to grow. Historically, getting back 6, 7 years ago, when we were in over 500 locations. So as we refine the assortment and continue to identify which are the breakaway categories, breakaway items, we'll be able to hopefully expand our store count, primarily in the CE where we have very little presence right now.

Operator

The next question is from Pankaj Chandak of B. Riley & Co.

Pankaj Chandak

This is Pankaj Chandak for Jeff Van Sinderen. For quarter-to-date, could you give us some color about the Kids business in Target, how is that going? And maybe around Back-To-School, how was the trend? And also -- I think you already touched on the adult merchandises -- adult merchandising, bringing it back at Target. Maybe some more color on that, how do you see that playing out over a year or so?

Henry Stupp

Well, as we mentioned, in the first quarter, Target had a particularly soft spring in general. We were up only a couple of percent at the end of the Q -- at the end of the first quarter. And then we had a great second quarter, approximately 30% growth on comp over the prior year, leaving us for the half up a little over 14%. We're obviously very pleased with the performance in the Cherokee brand as we finish the half and going into the second half where -- we remain quite optimistic about our overall Cherokee business. And that's -- those numbers are excluding Cherokee school uniforms, which on a year-over-year basis, Cherokee school uniforms saw an increase of approximately -- let me just look at my number, 25%, as we headed into Back-To-School this year over last year. With respect to the Adult business, the various steps that we've taken internally at Cherokee to develop product, identify great resources that we can bring to all of our licensees is something that we presented to Target, dating back almost 10 months ago. And it was through all of those efforts and initiatives that we put into place that they've decided to reintroduce the adult apparel program in target.com, with the launch at the beginning of next calendar year. And throughout the year, we expect the product assortment for both men's and women's to grow. And remember, of course, we are always and have always been available in children's wear on target.com. And Target's -- most importantly, Target has made a concerted effort to grow their dotcom business substantially in the future. So we're very pleased about having the opportunity to sell the adult apparel on target.com and grow our general business there.

Pankaj Chandak

That helps. And when do you see the adult merchandising being brought into the physical stores?

Henry Stupp

We don't know that yet. That's completely up to Target. We'll let Target make that announcement when they are ready.

Pankaj Chandak

Okay. On the Canada Target launch, I think you talked about you'll be in all of the stores by end of the year. Can you help us sort of understand the productivity of the stores once you enter that? How does that mature?

Henry Stupp

Well, they are only providing us with limited retail analytics at this stage. So we get our quarterly sales reports from Canada as opposed to the U.S. where we're able to monitor on an item and subclass basis on a weekly report. So based on productivity in Canada, we're seeing some good early signs. It's a little difficult to read the productivity per store when they're opening up stores in the middle of a quarter, and we only get quarterly results. So for example, they had 40-odd stores at the beginning of Q2, and then halfway through the Q, they opened up another 20-odd stores, bringing us to the store count of 68. So when we go back and measure the volumes per store, it's a bit of an average number that we have to deploy. And then we compare that against the kind of revenue per door we were doing with Zellers. And at this stage, the guess is, it's comparable. And we'll know more and we'll present more information on future earnings calls as the online systems become more in sync with our needs.

Pankaj Chandak

I appreciate that. And on Tesco, I think you mentioned you're at 277 stores right now. And historically, you were in 500 stores. So outside of the unit growth rate, is there an opportunity to sort of expand the category exposure at Tesco?

Henry Stupp

Yes, there is. We don't want to run into every single category opportunity we have without first getting the assortments right in the categories we're in. So right now, we're in men's and ladies' big boys and big girls categories. We are seeing great results in ladies. So we want to make sure that we continue to really expand on that. That's a very important category and a barometer for the future of the Cherokee business. And after that, we can certainly expand more into little boys and little girls and eventually newborn, infant, toddler, footwear, home. So there's no shortage of categories but we have continue to refine what we're doing with the categories that are in place. They have given us a big opportunity and we want to make sure that we're really executing well.

Pankaj Chandak

That helps. And then last question for me, are you guys ready to talk about sort of the general outlook for sort of holiday 2013, how you're sort of setting up?

Henry Stupp

Well so far, the results that we're seeing with all of our partners is very encouraging. We know that there's concern in general terms about softening at retail. But we're fortunate in that our partnerships are with blue-chip retailers around the world. I said it in earlier calls and I'll say it again, at the time where there is some softening at retail, we are with what I believe the best possible partners around the world, and particularly here at home with Target. We've had a great second quarter. We had a tough comp to beat and we beat it. And we're encouraged by the results. We're encouraged by the consumers' reaction to our product assortment. I think Target has outdone themselves all year in bringing great products to consumers. Consumers are responding to it. And I think we're just very fortunate to have them as one of our 10 core licensees.

Operator

[Operator Instructions] And the next question is from Brian Lancaster of Clayton Partners.

Brian Guy Lancaster - Clayton Partners LLC

Can you update us a little bit on what you're seeing as far as potential deals and whether you have anything in the pipeline?

Henry Stupp

Yes, we have. In terms of -- we have 3 platforms for growth in the company that we've identified. The first one being organic growth with our existing partners through the introduction of new categories. And we're starting to expand our category assortment. So, for example, earlier this year, we expanded into newborn, infant, toddlers and baby at Target. We've seen great results there. We've also dramatically expanded our Footwear business with Target. We've also, as I just mentioned earlier, expanded the category assortments in Japan. And we're doing the same thing with the majority of our partners. In fact, our team right now is in Mexico, meeting with Comercial Mexicana. They have their annual expo. And Cherokee probably have 60% of the floor space there. We saw some photographs, and we're delighted by what we're seeing. And they actually -- the Mexican partner has actually led all of our partners in terms of category introductions.

Our second major platform for growth is new markets. And last quarter, we introduced ourselves in United Arab Emirates, Saudi Arabia and shortly thereafter, in Indonesia. We have several players that we're hopefully going to be finalizing in the near future in Asia, where we're seeing a lot of interest. And we hope to make those announcements shortly. We also dealing with additional partners in several other countries in Europe, where we're not currently selling our product, particularly in Germany, Italy, France and then on the Eastern European side where we're negotiating in both the Ukraine and in the Baltics. And lastly, our third platform for growth is in new brands. And we've got an active pipeline that the board and our team are actively reviewing. And we hope to make several announcements in coming quarters.

Brian Guy Lancaster - Clayton Partners LLC

What's the sweet spot for sort of new brand acquisitions? I mean, is there a specific size that you think is ideal for the company? Or could you do sort of a broad range of deals?

Henry Stupp

We're looking for baseline annual revenues, between $2.5 million to $3.5 million, $5 million as a baseline of any sort of acquisition.

Brian Guy Lancaster - Clayton Partners LLC

$2.5 million to $5 million of royalty revenue annually?

Henry Stupp

Correct. Correct. And the board has agreed to some pretty strict metrics in terms of how we're going to pursue our acquisition process. In terms of the management team here, our view is to be prudent and strategic and not necessarily opportunistic, in terms of identifying distressed brands and trying to resuscitate them. We'd rather identify brands that are still showing a great growth opportunity, getting early before our peer group has identified them, make sure that we could bring them into our global platform. So we would rather choose the brands that we're going to go after than the brands coming to us because they're in various stages of decline.

Brian Guy Lancaster - Clayton Partners LLC

Great, that's helpful. On Target Canada, can you talk a little more about how you expect to see things develop up there? I mean, do you still expect productivity to be higher than Zellers, when they're sort of all laid out the way they expect to be and when they get their inventories right? Or do you have any incremental read, given the way things have launched?

Henry Stupp

It's very difficult because every time they open up a new tranche of stores, the sales are off-the-charts because of that hole bump factor of Target entering Canada. So when we look at the first month of sales there, they're just so off-the-charts that we can't -- you can't normalize it. If I look at it on a per-store basis in that first month and I compare it to against Zellers, it's obviously a multiple of what Zellers is doing on a per-location basis. So we have to let it settle in for a few months so we can get a good rate. We're encouraged by what we're seeing. We love the product. We are one of Canada's top-selling children's brands from the past decade through Zellers. So we expect to have more and more growth, as Target opens up more and more stores.

Brian Guy Lancaster - Clayton Partners LLC

And do you know or can you say why they -- why you don't get sort of the granular data from them on Canada? It seems like you guys could be really helpful to them in your categories, given your history with Zellers.

Henry Stupp

No. Look, they're running new systems up there. It's not the same online system that they're running in the United States. I think that they're still working through -- David Marlow said they've got some improvements that they need in their systems, particularly in getting goods from the warehouse to the store. We're still short at the store level of goods that are sitting in the warehouse. So I think they're -- I think it's a matter of time. Target has always supplied their partners with detailed analytics. I think that they're just not at that stage yet and they're still opening up stores. So it'll just take a little bit longer, we hope.

Operator

[Operator Instructions] We have no further questions in queue at this time. Ladies and gentlemen, this does conclude today's teleconference. You may disconnect your lines at this time and thank you for your participation.

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