Description

Cherokee Inc. (CHKE) is a licensor of various brands (Cherokee, Tony Hawk, Liz Lange, Everyday California, Hi-Tec) covering various product categories (Kids and Adult Apparel, Footwear, etc.) to retailers and wholesalers partners across the globe.

The valuation is cheap today, in the midst of a tough retail environment and the integration of a large acquisition and the continued transition away from their largest and longest running licensing agreement. At about 7.5x to 10x depressed-EPS, I think Cherokee offers value in a very overvalued market.

The unique business model is that Cherokee carries no inventory, but supports their retailer and wholesale licensees with an in-house design team and fully developed marketing programs. They refer to this as their 360o platform.

Cherokee’s stock (and operations) has had a very tough 18 months. With its stock recently falling below $8, the stock has effectively round-tripped to levels last seen five years ago. It was in the upper-$20s as recently as mid-2015.

As I wrote back in 2015 on VIC, the problems for the stock started with their loss (a difficult and somewhat voluntary decision?) of their biggest and 20+ year exclusive licensing relationship with Target in the US.

Almost 18 months later, the Target/Cherokee relationship is now officially over. The replacement of this deal has rightfully been the primary focus of investors.

Frankly, the replacement revenue for the Target deal was not what I thought it would be back in 2015. Instead of establishing a new, exclusive US direct-to-retailer arrangement (think, a Wal-Mart), Cherokee opted to sign licensing deals with nearly a dozen non-exclusive, multi-product category wholesalers.

The revenue ramp up of these deals has now just started and it appears that it will likely take 18-24 months to replace the old Target deal’s licensing revenue for the Cherokee brand in the US.

However, it’s important to note that Cherokee’s US licensing revenue per dollar of retail sales is now in the range of around 4% vs. the Target licensing deal of closer to 1.5%. In this way, the old Target deal needed about $1.1 billion of retail sales to produce the former $15 million of annual revenues for the Cherokee brand in the US.

As I mentioned two years ago, the new wholesaler licensing deals will only need about $400 million of collective retail sales to produce the same $15 million in revenue. In addition, where Target underutilized the various produce categories for the Cherokee brand (choosing almost exclusively to sell kids’ apparel), the new wholesaler licensing arrangements run the gamut of categories, from apparel to footwear to swimwear to intimate apparel to school lunch bags, etc.

In the end, the Target “revenue replacement cliff” - which seems large right now - is not necessarily as difficult to leap as currently believed. If successful, the Cherokee branded business in the US will be better positioned with greater diversification (larger number of retail doors, much wider product categories and better access to online sales via Amazon.)

Cherokee responded to the now-upon-us FY 2018 (ends Jan 31, 2019) Target revenue cliff in typical fashion; they bought more revenue with their very recent Hi-Tec acquisition.

While this action can be a source of critique from investors - and frankly, the possibility of dumb acquisitions was a primary critique leveled back in my 2015 writeup - its validity certainly depends on the price they’ve paid for that new revenue and if an acquisition moves them toward their strategic plan of diversification and a better ability to attain synergistic benefits utilizing their global pipeline of retailer/wholesaler relationships.

In terms of price, I think the Hi-Tec acquisition’s metrics look favorable enough and its size does move the ball strategically down the field (much greater brand diversification, widens their global footprint, deepens their ties to new retailers in the US - Walmart, and provides them access to a lower tax jurisdiction.)

For about $60 million - funded by selling a little over 4 million common shares at $9.50 per share and through (net) borrowing of about $30 million via Cerberus - they expect to earn in FY 2018 (FY ends Jan ‘18) about $19 million in total Hi-Tec licensing revenues and produce about $7 million in adjusted-EBITDA.

These Hi-Tec projections do not bake in any new licensing deals, nor do they include any integration costs, thus the word, adjusted. [By the way, it is said over and over by the CFO that they want to abandon reporting any adjusted GAAP figures in due time. We shall see. As integration and legal costs slow down, I do believe they'll report on a straight GAAP basis soon again.]

In addition, the deal’s projections do not factor in any opportunities to widen Hi-Tec’s brand licensing throughout their network of existing retail / wholesale licensees.

Nor do the projections incorporate any opportunity to possibly consolidate or rationalize any duplicative design and marketing personnel costs within Hi-Tec’s offices based in the Netherlands (which will provide Cherokee with certain tax benefits, lowering their tax rate to the mid-20% range.)

Valuation and Guidance:

The FY 2018 consolidated financial picture is for about $50 million in revenues and about $20 million in adjusted EBITDA (again, excluding certain integration and legal costs related to the Hi-Tec acquisition.)

To bring this down to an earnings figure, as a pure licensor their capex is very limited. Their interest cost on a $30 million debt level will be around $2 million to $2.5 million. And, with their latest guidance incorporating the tax benefits of the Hi-Tec transaction, their effective tax rate is about 25% or about $4 million.

Very roughly and without baking in much replacement of the US licensing revenues from the expired Target deal in FY 2018, Cherokee can still easily earn about $1 per share on their 13 million shares outstanding. I think this is a low range in terms of earnings power. This puts their valuation at currently 7.5x to 10x earnings.

It is my belief - and I grant you, I might be a sucker for their low-overhead, Dairy Queen-like licensing model - that the troubles experienced by the loss of the Target deal marked the low point for Cherokee and the $0.80 to $1 per share earnings power we now see is the nadir.

With international licensing growth already happening, with the large Hi-Tec acquisition and with the expected replacement of the US licensing revenue of the namesake Cherokee brand, being able to earn substantially more than $1 should be viewed by investors as the expectation over the next 2 years. With that, I'd also expect the stock to trade at a considerably higher earnings multiple, as it once did.

As difficult as it has been to involved with Cherokee’s stock over the years - believe me - today I feel strongly that it's quite cheap in a wildly silly stock market.

Catalyst

A ramp up of both the multiple licensing deals for the Cherokee brand in the US - replacing the Target deal - and the integration and diversification benefits of the new Hi-Tec acquisition announced in December 2016. This requires patience and the valuation will likely be forgiving.