Monday, July 9, 2007

Cherokee's Drop Only Temporary

Cherokee is a company that markets and licenses its brands for apparel, footwear and accessories in the world. They also consult and provide services for companies or anyone looking to add brands for their own line of products. Some of their major brands include Cherokee (which is their best seller), Carole Little and Sideout. The reason they license and not produce on their own is because their mid-priced brands are better suited for larger retailers with economies of scale.

There is an opportunity in this stock because it recently missed analyst earnings expectations and the stock price dropped 25%. A big chunk of the earnings drop can be attributed to a revenue drop of 9% compared to the same quarter of last year, most of the revenue drop can be blamed on the sale of the Mossimo agreement last year, which cut the royalty stream, and the drop in sales of Cherokee products in Target stores.

Industry


The clothing industry is very competitive, although most of the competitors do not have the same business model Cherokee has. Trends can change quickly and it is up to Cherokee’s management and the retailers that they have agreements with to make sure they stay on top of the trends. And it is up to Cherokee’s management, to make sure that the retailers they have agreements with promote their products in their stores. The Cherokee brand, which is mid-priced apparel, competes with the big clothing firms such as Levi Strauss & Co., The Gap, Old Navy and VF Corp. The Sideout brand, which is in the active wear business, competes with companies like Nike and Quiksilver. In the international arena, they also compete with the countries’ local companies.

Company

Cherokee has been around for over 30 years. Their revenues heavily rely on their top two clients, Target in the United States and Tesco in Europe and Asia. Not including the one-time Mossimo gain, the two retailers combined for over 70% of Cherokee’s revenue in fiscal 2007. They run a very lean operation with only 18 employees.

After the price recent drop, there were two significant insider purchases, the CFO Russell Riopelle and a director named Jess Ravich purchased over $600k worth of stock combined. Their track record on purchasing Cherokee shares is good, with an average return of 27% for Ravich and 21% for Riopelle for the following 6 months after a purchase according to www.form4oracle.com. On a side note, insiders own over 16% of the company.

Revenue has been steadily growing over the past 5 years but growth has been slowing, not taking into account the one-time gain. On average, revenue growth has been a little over 7% a year over the same period.

Valuation

CHKE is trading at a trailing price/earnings ratio of 9.81, although that is a little misleading due to the one-time again, and a forward price/earnings ratio of 16.8. They have a very solid balance sheet with no debt and over $22 million in cash. There was rise in Accounts Receivable of over 63% compared to the same period of last year, this is even with revenue dropping. They have a dividend yield of 8% at current prices. Their Cash Flow is very strong, cash flow from operations has been higher than their net income for each of the past 3 years. Return on Equity has ranged from 52.1% to 96.3% over the past 4 years. CHKE was in the top 25 Magic Formula stocks with a market cap of over $100m as of 7/8/2007.

Technicals

CHKE is currently trading below its 3 major moving averages with all of them besides the 200DMA trending down. It just found support at a previous support level of $36 a share. The stock was in a very healthy uptrend before the earnings miss, the long-term trend is neutral, the medium-term trend is down and the short-term trend is up. Volume increased significantly on the way down. The stock mostly never moves quickly so I doubt the stock will run away from here, but if it breaks overhead resistance at $38 a share, this will probably be the last time you see $36 in the near future.



Conclusion

The major obstacles this company is facing is its drop in royalty revenues from Target and the need for new revenue streams. Target is Cherokee’s biggest client and the drop in revenue from Target has not been made up by the gains in Cherokee’s other contracts, but Target is expected to open new stores and that should increase Cherokee’s cut from them. Cherokee’s other biggest client, Tesco, has been growing at a healthy clip and just got Cherokee’s permission to be the sole Cherokee label distributor in new markets in Asia and Eastern Europe.

Although Cherokee will not be a high flier growing its revenue at 15% a year, it would be valid to assume they will continue to grow at their previous growth rate of 7% a year. They have a great business model and their 8% dividend is excellent. Management also actively searches for new brands to acquire. Target’s store expansion and Tesco’s territory expansion should help Cherokee get back to their growing ways.

Disclosure:
I don’t have a position in CHKE.

3 comments:

Anonymous said...

Nice analysis dude, I think with the 8% dividend, this stock will not go much lower. On the contrary, it could go up by 15% within a year if there is positive news

Alex Shadunsky said...

Thanks, I agree, I will be watching closely. It seems like it was an overreaction by the market, Cherokee seems to have a handle on things.

Thanks for stopping by and good luck investing!

Anonymous said...

I am a bit troubled by the $8m bonus the CEO got in 2007, looks excessive compensation.