The Company’s credit agreement, which covers its revolving credit facility and term loans, contains financial covenants that are required to be met each quarter. As of June 30, 2001, the Company was not in compliance with some of these financial covenants. On August 13, 2001, the Company and its lenders entered into an agreement whereby the lenders waived the financial covenant defaults as of June 30, 2001, and the parties agreed to modifications to the terms of the existing credit agreement, subject to various conditions and final documentation. Modifications to the existing credit agreement will include, among other things, (1) the guarantee by some of the Company's unit holders, or their equity members, of $10.5 million of the Company's senior debt principal until specific financial ratios are attained, (2) the Company will be restricted from making cash distributions to its equity members until specific financial ratios are attained, (3) the Company will be permitted to make its interest payment due in November 2002 relating to its $100 million of subordinated notes so long as specific financial ratios are attained, (4) the maximum availability under the revolving line of credit will be reduced until approximately April 30, 2002, and (5) LIBOR and base rate margins will be increased for revolver borrowings and term loans. Until the final documentation of an amendment to the credit agreement is completed, the Company will not have access to additional borrowings under its revolving line of credit. If final documentation of an amendment is not completed by September 14, 2001, the lenders' waiver of the Company's financial covenant defaults will expire and the Company will be subject to remedies provided for in the Company's credit agreement. Management believes final documentation of an amendment to the Company's credit agreement will be completed with respect to the terms outlined above, prior to September 14, 2001, and that the Company has adequate liquidity to meet its anticipated cash needs for the foreseeable future.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
| ITEM 2. | Management's Discussion and Analysis of Financial Condition and Results of Operations. |
OVERVIEW
Cherokee is a leading designer and manufacturer of a broad range of switch mode power supplies for original equipment manufacturers (OEM's) primarily in the telecommunications, networking and high-end workstation industries. The Company produces its products and related components in sophisticated manufacturing facilities located in Tustin and Irvine, California; Wavre, Belgium; Guadalajara, Mexico; and Bombay, India.
The principal elements comprising cost of sales are raw materials, labor and manufacturing overhead. Raw materials account for a majority of cost of sales. Raw materials include magnetic subassemblies, sheet metal, electronic and other components, mechanical parts and electrical wires. Labor costs include employee costs of salaried and hourly employees. Manufacturing overhead includes lease costs, depreciation on property, plant and equipment, utilities, property taxes and repairs and maintenance.
Operating expenses include engineering costs, selling and marketing costs and administrative expenses. Engineering costs primarily include salaries and benefits of engineering personnel, safety approval and quality certification fees, depreciation on equipment and subcontract costs for third party contracting services. Selling and marketing expenses primarily include salaries and benefits to account managers and commissions to independent sales representatives. Administrative expenses primarily include salaries and benefits for certain management and administrative personnel, professional fees and information system costs.
On June 15, 2000, the Company acquired Industrial and Telecommunication Systems and related entities ("ITS") for approximately $55 million, including assumption of debt. The acquisition was accounted for using the purchase method of accounting.
During the first half of 2001, the Company continued to generate the majority of its sales from the communications market segment, particularly the networking and telecommunications sectors. As a result of recent unfavorable economic conditions and reduced capital spending by communication service providers that purchase our customers’ products, the Company’s sales decreased in the first quarter of 2001 compared to the fourth quarter of 2000, and decreased again in the second quarter of 2001 compared to the first quarter of 2001. The Company believes that unstable and unpredictable economic conditions will continue, likely resulting in a further decline in revenues in the third quarter of 2001. If these unfavorable economic conditions persist, the Company’s operating results and financial condition would be adversely affected.
RESULTS OF OPERATIONS
THREE MONTHS ENDED JUNE 30, 2001 COMPARED TO THREE MONTHS ENDED JUNE 30, 2000
NET SALES
Net sales increased by approximately 14.6% or $4.2 million to $32.9 million for the three months ended June 30, 2001 from last year's $28.7 million for the three months ended June 30, 2000.
The higher sales were primarily attributable to the acquisition of ITS, which contributed $14.6 million of sales for the three months ended June 30, 2001, compared to $3.3 million of sales contributed for the period June 15 to June 30, 2000. Sales of our North American operations decreased by approximately 28.0% or $7.1 million compared to the prior year, due to lower customer demand as a result of unfavorable economic conditions and reduced capital spending by communication service providers.
GROSS PROFIT
Gross profit decreased by approximately 11.4% or $1.2 million to $9.0 million for the three months ended June 30, 2001 from $10.2 million for the three months ended June 30, 2000. Gross margin for the quarter decreased to 27.4% from 35.5% in the prior year.
The decrease in gross profit was primarily due to significantly lower gross profit contributed by the North American operations which was attributable to the lower sales. This was partially offset by gross profit contributed by ITS of $3.1 million for the three months ended June 30, 2001 compared to $0.8 million for the period June 15 to June 30, 2000. The decrease in gross margin compared to the prior year was primarily due to the inclusion in 2001 of the ITS operations, which had a lower gross margin than the North American operations. In addition, the gross margin for the North American operations decreased primarily as a result of a change in product mix.
OPERATING EXPENSES
Operating expenses for the three months ended June 30, 2001 increased by approximately 59.3% or $2.1 million to $5.8 million from $3.6 million for the three months ended June 30, 2000. As a percentage of sales, operating expenses increased to 17.6% from 12.6% in the second quarter of the prior year.
The increase in operating expenses, as expressed in dollars as well as a percentage of net sales, was primarily attributable to the inclusion in 2001 of the ITS operations and amortization of goodwill and other related intangibles associated with the ITS acquisition. Partially offsetting the increase in dollars relating to the ITS operations was a decrease in operating expenses for the North American operations.
OPERATING INCOME
Operating income decreased by approximately 50.5% or $3.3 million to $3.2 million for the three months ended June 30, 2001 from $6.5 million for the three months ended June 30, 2000. Operating margin decreased to 9.9% for the second quarter from 22.8% in the prior year.
The decrease in operating income was primarily attributable to a decrease in the operating income of the North American operations which decreased in the second quarter primarily due to the lower sales and decreased gross margin. Operating income contributed by ITS in the second quarter was offset by amortization of goodwill and other related intangibles associated with the ITS acquisition. The decrease in operating margin was primarily attributable to the decrease in gross margin combined with higher operating expenses as a percentage of sales discussed above.
INTEREST EXPENSE
Interest expense for the three months ended June 30, 2001 was $4.2 million compared to $4.1 million for the three months ended June 30, 2000. The effect of increased debt during the three months ended June 30, 2001 compared to the prior year's quarter was offset by lower interest rates on the Company's revolver borrowings and term loans in the current year compared to the prior year.
NET INCOME (LOSS)
As a result of the items discussed above, the Company recorded a net loss of $(0.9) million for the three months ended June 30, 2001 compared to net income of $2.5 million for the three months ended June 30, 2000.
SIX MONTHS ENDED JUNE 30, 2001 COMPARED TO SIX MONTHS ENDED JUNE 30, 2000
NET SALES
Net sales increased by approximately 33.6% or $18.2 million to $72.3 million for the six months ended June 30, 2001 from last year's $54.1 million for the six months ended June 30, 2000.
The higher sales were primarily attributable to the acquisition of ITS, which contributed $28.5 million of sales for the six months ended June 30, 2001, compared to $3.3 million of sales contributed for the period June 15 to June 30, 2000. Sales of our North American operations decreased by approximately 13.8% or $7.0 million compared to the prior year, due to lower customer demand as a result of unfavorable economic conditions and reduced capital spending by communication service providers.
GROSS PROFIT
Gross profit increased by approximately 11.2% or $2.1 million to $21.1 million for the six months ended June 30, 2001 from $19.0 million for the six months ended June 30, 2000. Gross margin for the six months ended June 30, 2001 decreased to 29.2% from 35.1% in the prior year.
The increase in gross profit was primarily due to the gross profit contributed by ITS, partially offset by a decrease in gross profit contributed by the North American operations resulting primarily from lower sales. The decrease in gross margin compared to the prior year was primarily due to the inclusion in 2001 of the ITS operations, which had a lower gross margin than the North American operations. In addition, the gross margin for the North American operations decreased primarily as a result of a change in product mix.
OPERATING EXPENSES
Operating expenses for the six months ended June 30, 2001 increased by approximately 94.4% or $6.0 million to $12.4 million from $6.4 million for the six months ended June 30, 2000. As a percentage of sales, operating expenses increased to 17.2% from 11.8% in the prior year.
The increase in operating expenses, as expressed in dollars as well as a percentage of net sales, was primarily attributable to the inclusion in 2001 of the ITS operations and amortization of goodwill and other related intangibles associated with the ITS acquisition. Partially offsetting the increase in dollars relating to the ITS operations was a decrease in operating expenses for the North American operations.
OPERATING INCOME
Operating income decreased by approximately 31.2% or $3.9 million to $8.6 million for the six months ended June 30, 2001 from $12.6 million for the six months ended June 30, 2000. Operating margin decreased to 12.0% for the current year's period from 23.2% in the prior year.
The decrease in operating income was primarily attributable to a decrease in the operating income of the North American operations resulting primarily from lower sales and decreased gross margin. Operating income contributed by ITS in the current year's period was offset by amortization of goodwill and other related intangibles associated with the ITS acquisition. The decrease in operating margin was primarily attributable to the decrease in gross margin combined with higher operating expenses as a percentage of sales discussed above.
INTEREST EXPENSE
Interest expense for the six months ended June 30, 2001 was $8.5 million compared to $8.0 million for the six months ended June 30, 2000. This increase was primarily due to the additional debt incurred in June 2000 in connection with the ITS acquisition.
NET INCOME
As a result of the items discussed above, net income decreased to approximately breakeven for the six months ended June 30, 2001 from $4.7 million for the six months ended June 30, 2000.
LIQUIDITY AND CAPITAL RESOURCES
CASH FLOWS
SIX MONTHS ENDED JUNE 30, 2001 COMPARED TO SIX MONTHS ENDED JUNE 30, 2000
Net cash provided by operating activities was $8.5 million for the six months ended June 30, 2001 compared to $3.9 million for the six months ended June 30, 2000. Cash provided by operating activities for 2001 reflects net income of approximately zero, depreciation and amortization of $3.4 million and decreases of $9.7 million in accounts receivable and $6.7 million in inventory, partially offset by decreases of $9.2 million in accounts payable and $1.7 million in accrued compensation and benefits. Cash provided by operating activities for 2000 reflects net income of $4.7 million, depreciation and amortization of $1.5 million, and a $1.5 million increase in accrued liabilities, partially offset by an increase of $3.1 million in accounts receivable.
Net cash used in investing activities for the six months ended June 30, 2000 primarily consists of $51.4 million for the purchase of ITS, net of acquired cash.
Net cash used in financing activities of $2.1 million for the six months ended June 30, 2001 primarily reflects $2.9 million of payments on long-term debt and an equity distribution of $2.1 million, partially offset by a $3.3 million net increase in revolving credit borrowings. Net cash provided by financing activities of $41.1 million for the six months ended June 30, 2000 primarily reflects proceeds from bank borrowings aggregating $13.0 million and $34.3 million from the sale of units, which were used to finance the purchase of ITS.
LIQUIDITY
Historically, the Company has financed its operations with cash from operations supplemented by borrowings from credit facilities. The Company's current and future liquidity needs primarily arise from debt service on indebtedness, working capital requirements, capital expenditures and distributions to pay taxes.
The Company's historical capital expenditures have substantially resulted from investments in equipment to increase manufacturing capacity and improve manufacturing efficiencies. For fiscal 2001, the Company expects capital expenditures to be approximately $2 million to $3 million.
As of June 30, 2001, the Company's borrowings consisted of $100 million of senior subordinated notes and $66.0 million of borrowings under its various credit facilities, including $15.1 million drawn under its $25 million domestic revolving credit facility. The Company is not subject to any amortization requirements under the subordinated notes prior to maturity in 2009, but it is required to make scheduled repayments under certain term loans.
The Company’s credit agreement, which covers its revolving credit facility and term loans, contains financial covenants that are required to be met each quarter. As of June 30, 2001, the Company was not in compliance with some of these financial covenants. On August 13, 2001, the Company and its lenders entered into an agreement whereby the lenders waived the financial covenant defaults as of June 30, 2001, and the parties agreed to modifications to the terms of the existing credit agreement, subject to various conditions and final documentation. Modifications to the existing credit agreement will include, among other things, (1) the guarantee by some of the Company's unit holders, or their equity members, of $10.5 million of the Company's senior debt principal until specific financial ratios are attained, (2) the Company will be restricted from making cash distributions to its equity members until specific financial ratios are attained, (3) the Company will be permitted to make its interest payment due in November 2002 relating to its $100 million of subordinated notes so long as specific financial ratios are attained, (4) the maximum availability under the revolving line of credit will be reduced until approximately April 30, 2002, and (5) LIBOR and base rate margins will be increased for revolver borrowings and term loans. Until the final documentation of an amendment to the credit agreement is completed, the Company will not have access to additional borrowings under its revolving line of credit. If final documentation of an amendment is not completed by September 14, 2001, the lenders' waiver of the Company's financial covenant defaults will expire and the Company will be subject to remedies provided for in the Company's credit agreement. Management believes final documentation of an amendment to the Company's credit agreement will be completed with respect to the terms outlined above, prior to September 14, 2001, and that the Company has adequate liquidity to meet its anticipated cash needs for the foreseeable future.
NEW ACCOUNTING PRONOUNCEMENTS
Statement of Financial Accounting Standards (SFAS) No. 133, ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES, is effective for all fiscal years beginning after June 15, 2000. SFAS 133, as amended, establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities. Under SFAS 133, certain contracts that were not formerly considered derivatives may now meet the definition of a derivative and all derivatives are to be reported on the balance sheet at fair market value. The Company adopted SFAS 133 effective January 1, 2001. The adoption of SFAS 133 did not have a significant impact on the financial position, results of operations, or cash flows of the Company.
In June 2001, the Financial Accounting Standards Board ("FASB") issued two new pronouncements: SFAS No. 141, "Business Combinations", and SFAS No. 142, "Goodwill and Other Intangible Assets". SFAS 141 prohibits the use of the pooling-of-interest method for business combinations initiated after June 30, 2001 and also applies to all business combinations accounted for by the purchase method that are completed after June 30, 2001. There are also transition provisions that apply to business combinations completed before July 1, 2001, that were accounted for by the purchase method. SFAS 142 is effective for fiscal years beginning after December 15, 2001 to all goodwill and other intangible assets recognized in an entity's statement of financial position at that date, regardless of when those assets were intially recognized. The Company is currently evaluating the provisions of SFAS 141 and SFAS 142 and has not adopted such provisions in its June 30, 2001 financial statements.
FORWARD-LOOKING STATEMENTS
Statements in this report containing the words "believes," "anticipates,", "expects," and words of similar meaning, and any other statements which may be construed as a prediction of future performance or events, constitute "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements involve known and unknown risks, uncertainties, and other factors that may cause the actual results, performance, or achievements of the Company, or industry results, to be materially different from any future results, performance, or achievements expressed or implied by such forward-looking statements. Such factors include, among others, (1) restrictions imposed by the Company's substantial leverage and restrictive covenants in its debt agreements, (2) reductions in sales to any of the Company's significant customers or in customer capacity generally, (3) changes in the Company's sales mix to lower margin products, (4) increased competition, (5) disruptions of the Company's established supply channels, and (6) the additional risk factors identified in the Company's Annual Report on Form 10-K dated December 31, 2000 and those described from time to time in the Company's other filings with the SEC, press releases and other communications. The Company disclaims any obligations to update any such factors or to announce publicly the result of any revisions to any of the forward-looking statements contained or incorporated by reference herein to reflect future events or developments.
| ITEM 3. | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK |
Market risks relating to our operations result primarily from changes in short-term interest rates. The Company did not have any derivative financial instruments at June 30, 2001.
The Company's exposure to market risk for changes in interest rates relates primarily to its current domestic credit facility. In accordance with the credit facility, the Company enters into variable rate debt obligations to support general corporate purposes, including capital expenditures and working capital needs. The Company continuously evaluates its level of variable rate debt with respect to total debt and other factors, including assessment of the current and future economic environment.
The Company had approximately $66 million in variable rate debt outstanding at June 30, 2001. Based upon these variable rate debt levels, a hypothetical 10% adverse change in interest rates would increase interest expense by approximately $0.5 million on an annual basis, and likewise decrease our earnings and cash flows. The Company cannot predict market fluctuations in interest rates and their impact on its variable rate debt, nor can there be any assurance that fixed rate long-term debt will be available to the Company at favorable rates, if at all. Consequently, future results may differ materially from the estimated adverse changes discussed above.
As a result of the ITS acquisition in June 2000, the Company has European operations and is, therefore, subject to a certain degree of market risk associated with changes in foreign currency exchange rates. The Company has not actively engaged in exchange rate hedging activities.
The Company is subject to disputes and potential claims by third parties that are incidental to the conduct of its business. The Company does not believe that the outcome of any such matters, pending at June 30, 2001 will have a material adverse effect on its financial condition or results of operations.
| ITEM 6. | EXHIBITS AND REPORTS ON FORM 8-K | |
| (a) | EXHIBITS: |
| | |
| 3.1* | Second Amended and Restated Operating Agreement of Cherokee International, LLC, dated as of April 30, 1999. |
| | |
| 3.2* | Amendment No. 1 to the Second Amended and Restated Operating Agreement of Cherokee International, LLC, dated as of |
| June 28, 1999. |
| | |
| 3.3* | Amendment No. 2 to the Second Amended and Restated Operating Agreement of Cherokee International, LLC, dated as of |
| June 28, 1999. |
| | |
| 3.4** | Amendment No. 3 to the Second Amended and Restated Operating Agreement of Cherokee International, LLC, dated as of |
| June 12, 2000. |
| | |
| 3.5** | Amendment No. 4 to the Second Amended and Restated Operating Agreement of Cherokee International, LLC, dated as of |
| June 14, 2000. |
| | |
| (b) | REPORTS ON FORM 8-K |
| | | |
The Company did not file any reports on Form 8-K during the 13-week period ended July 1, 2001.
*Incorporated by reference to designated exhibit to the Company's Registration Statement on Form S-4 (File No. 333-82713).
** Incorporated by reference to designated exhibit to the Company's Quarterly Report on Form 10-Q, dated July 2, 2000.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
| | | Cherokee International, LLC |
| | | |
| Date: August 15, 2001 | | /s/ R. Van Ness Holland, Jr. |
| | |
|
| | | R. Van Ness Holland, Jr. |
| | | Chief Financial Officer |
