Cherokee Inc.: Weighing Potential Risks and Rewards

| About: Cherokee Inc. (CHKE)

For those who have ever wandered into a Target (NYSE:TGT) to buy new clothes or shoes, encountering the Cherokee (NASDAQ:CHKE) brand is inevitable. What you may not know is that this remarkable little company has only 18 full time employees, less owned property then most small families, and yet collected over 75 million dollars in revenue last year and turned nearly 53% 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, 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 24 million in cash on the balance sheet, and no debt. Free cash flow margin has averaged an outstanding 50% or higher for the last 5 years. The company doesn't horde this cash... it pays out 65% of it, to the tune of a 9% dividend yield. This alone makes Cherokee an attractive investment candidate.

The next thing to examine is management - a crucial component of smallcap success. Robert Margolis is CEO, and has been with the company since it's 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 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 potential deals in China for the Sideout brand and Mexico for the Cherokee brand.

So far Cherokee sounds like a great candidate for investment. But there are some serious risks here. First, nearly 75% of revenue comes from two contracts - with Target in the US (42%) and Tesco (OTCPK:TSCDY) in Europe and Asia (32%). While both agreements run for at least 4 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 (NYSE:NKE), VF Corp. (NYSE:VFC), Gap (NYSE:GPS), Iconix, etc. Iconix (NASDAQ:ICON) has even aped Cherokee's business model, and has used their 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.

The final argument against Cherokee is that the company is deceptively cheap right now. The 17.9% Earnings Yield is an illusion created by a one time, 33 million dollar gain on the termination of a contract with Mossimo last year after they were bought by Iconix. Backing out this revenue, the Earnings Yield is 8.8% - not bad but certainly not noteworthy. Using a 8.8% EY would probably not get CHKE into the Magic Formula screen.

Disclosure: None