| CHEROKEE INTERNATIONAL CORP ITEM 1A RISK FACTORS The following risk factors, among others, could cause our financial performance to differ significantly from the goals, plans, objectives, intentions and expectations expressed in this Annual Report on Form 10-K If any of the following risks and uncertainties or other risks and uncertainties not currently known to us or not currently considered to be material actually occurs, our business, financial condition or operating results could be harmed substantially |
| 11 ______________________________________________________________________ Risks Relating to Our Company and Industry We are substantially dependent upon sales to a relatively small group of customers |
| The loss of one or more major customers, or the discontinuation or modification of these customers’ products, could materially and adversely affect the results of our operations |
| Our top ten customers accounted for approximately 53prca of our net sales during 2005 and approximately 58prca of our net sales during 2004 |
| The loss of any of our major customers could have a material adverse effect on our financial condition or results of operations |
| We do not have long-term contracts with our customers, and our customers use alternative power supply providers for some or all of their products |
| We may not be able to maintain our customer relationships, and our customers may reduce the volume or cancel purchase orders, purchase power supplies elsewhere or develop relationships with additional providers of power supplies, any of which could adversely affect our financial condition or results of operations |
| A significant change in the liquidity or financial position of any of these customers could also have a material adverse effect on the collectibility of our accounts receivables, our liquidity and our future operating results |
| Prior to, or at the end of, a product’s life cycle, any of our customers may decide to discontinue or modify any of its products |
| In that event, the customer may no longer have a need for our products or may choose to integrate a competitor’s power supply into the customer’s new or modified product |
| The resulting loss of revenues could also adversely affect our financial condition or results of our operations |
| Failure by our customers or us to keep up with rapid technological change in the electronic equipment industries could result in reduced sales |
| Many of our existing customers are in the electronic equipment industries, especially wireless infrastructure and networking, and produce products that are subject to rapid technological change, obsolescence and large fluctuations in world-wide product demand |
| These industries are characterized by intense competition and end-user demand for increased product performance at lower prices |
| We may not be able to properly assess developments in the electronic equipment industries or identify product groups or customers with the potential for continued and future growth |
| Factors affecting the electronic equipment industries, in general, or any of our major customers or their products, in particular, could have a material adverse effect on our financial condition or results of operations |
| For instance, as a provider of power supplies to OEMs in the electronic equipment industries, our sales are dependent upon the success of the underlying products of which our power supplies are a component |
| If our customers’ products are not well received by, or if demand for their products fail to develop among end-users, our customers may discontinue or modify the product or reduce the production of the product |
| Any of these events could lead to the cancellation or reduction of orders for our power supplies that were previously made or anticipated, which could materially adversely affect our financial condition or results of operation |
| See ‘‘—Cancellations, reductions or delays in customers’ orders or commitments, or an increase in the number of warranty product returns could have a material adverse impact on our financial condition and results of operations’’ for more information |
| The markets for our products are characterized by rapidly changing technologies, increasing customer demands, evolving industry standards, frequent new product introductions and shortening product life cycles |
| Generally, our customers purchase our power supplies for the life cycle of a product, which can range anywhere from two to fifteen years |
| The development of new, technologically advanced products is a complex and uncertain process requiring high levels of innovation and cost, as well as the accurate anticipation of technological and market trends |
| As the life cycle of our customers’ products shorten, we will be required to bid on contracts for replacement or next generation products to replace revenues generated from discontinued products more frequently |
| These bids may not be successful |
| Even if we are successful, we may not be able to successfully develop, introduce or manage the transition of new products |
| 12 ______________________________________________________________________ Any failure or delay in anticipating technological advances or developing and marketing new products that respond to any significant technological change or significant changes in customer demand could have a material adverse effect on our financial condition or results of operations |
| We face significant competition, including from some competitors with greater resources and geographic presence than us |
| Our failure to adequately compete could have a material adverse effect on our business |
| The design, manufacture and sale of power supplies are highly competitive and characterized by increasing customer demands for product performance, shorter manufacturing cycles and lower prices |
| Our competition includes numerous companies throughout the world, some of which have advantages over us in terms of labor and component costs and technology |
| Our principal competitors are Artesyn Technologies, Astec Power, Delta Electronics, Magnetek, Power One, Tyco International and Vicor |
| Some of our competitors have substantially greater net sales, resources and geographic presence than we do |
| Competition from existing competitors or new market entrants may increase at any time |
| We also face competition from current and prospective customers that may design and manufacture their own power supplies |
| In times of an economic downturn, or when dealing with high-volume orders, price may become a more important competitive factor, forcing us to reduce prices and thereby adversely affecting our financial results |
| Some of our major competitors have also consolidated through merger and acquisition transactions |
| Consolidation among our competitors is likely to create companies with increased market share, customer bases, proprietary technology and marketing expertise, and an expanded sales force |
| These developments may adversely affect our ability to compete |
| Cancellations, reductions or delays in customers’ orders or commitments, or an increase in the number of warranty product returns could have a material adverse impact on our financial condition and results of operations |
| We do not obtain long-term purchase orders or commitments from our customers, and customers may generally cancel, reduce or postpone orders or commitments |
| A variety of conditions, both specific to the individual customer and generally affecting the customer’s industry, may cause customers to cancel, reduce or delay orders or commitments that were previously made or anticipated |
| At any time, a significant portion of our backlog may be subject to cancellation or postponement |
| Substantially our entire dlra47dtta3 million backlog as of December 31, 2005 was subject to cancellation upon the payment by our customers of cancellation fees that vary depending on individual purchase orders |
| For example, in 2001 we experienced cancellations of approximately dlra14dtta0 million as a result of unfavorable economic conditions and reduced capital spending by communication providers that purchased our customers’ end products |
| We also enter into certain warehousing arrangements with some of our customers, whereby we agree to bear the risk and cost of carrying inventory |
| Under these arrangements, we deliver the power supplies ordered by such customers to a third-party location, permit these customers to take delivery of the power supplies within a specified time period after our delivery of the products, and invoice these customers for the products only after they have taken ultimate delivery and title has passed |
| We may not be able to replace cancelled, delayed or reduced orders or commitments in a timely manner or at all and in some instances may need to write-off inventory |
| Significant or numerous cancellations, as well as reductions or delays in orders or commitments, including as a result of delays in or the failure to take delivery of products that are subject to such arrangements, by a customer or group of customers, could materially adversely affect our financial condition or results of operations |
| We also offer our customers a warranty for products that do not function properly within a limited time after delivery |
| We regularly monitor and track warranty product returns and record a provision for the estimated amount of future warranty returns based on historical experience and any notification we receive of pending warranty returns |
| We may not continue to experience the same warranty return rates that we 13 ______________________________________________________________________ have in the past |
| Any significant increase in product failure rates and the resulting warranty credit returns could have a material adverse effect on our operating results for the period or periods in which those warranty returns occur |
| Our international manufacturing operations and our international sales subject us to various risks associated with, among other things, foreign laws, policies, economies and exchange rate fluctuations |
| We have manufacturing operations located in Mexico, Europe, India, and China |
| We may expand our operations into other foreign countries in the future |
| In addition, international sales have been, and are expected to continue to be, an important component of our total sales |
| International sales represented 56prca of our net sales in 2005 and 59prca of our net sales in 2004 |
| Our manufacturing operations and international sales are subject to inherent risks, all of which could have a material adverse effect on our financial condition or results of operations |
| For example, our European Division (Cherokee Europe) has two restructuring plans in place, the first one (the 1999 Europe restructuring) was inherited by us in 2000 when we purchased this division from Panta Electronics, the second (the 2003 Europe restructuring) was implemented in 2003 by us |
| Both of these plans were significantly impacted by local labor laws and union labor negotiations, and required termination benefits |
| When we acquired Cherokee Europe in 2000 we inherited approximately dlra2dtta2 million liability obligation to be paid through 2010 |
| When we implemented the 2003 Europe restructuring we recorded a dlra4dtta5 million expense to be paid through 2016 |
| See ‘‘Management’s Discussion and Analysis of Financial Condition and Results of Operations—Results of Operations |
| ’’ Other risks affecting our international operations include: · differences or unexpected changes in regulatory requirements; · political and economic instability; · terrorism and civil unrest; · work stoppages or strikes; · interruptions in transportation; · restrictions on the export or import of technology; · difficulties in staffing and managing international operations; · variations in tariffs, quotas, taxes and other market barriers; · longer payment cycles; · problems in collecting accounts receivables; · changes in economic conditions in the international markets in which our products are sold; and · greater fluctuations in sales to customers in developing countries |
| Although we transact business primarily in US dollars, a portion of our sales and expenses, including labor costs, are denominated in the Mexican peso, the Indian rupee, the Euro and other European currencies |
| For 2005 and 2004, net sales in Europe accounted for 41prca and 42prca of our net sales, respectively |
| Fluctuations in the value of the US dollar relative to the Euro impacted our revenue, cost of goods sold and operating margins for these periods and resulted in foreign currency translation gains and losses |
| Foreign currency translation gains or losses recorded in other comprehensive income, a component of equity, in 2005 and 2004 were a loss of dlra2dtta6 million and a gain of dlra1dtta6 million, respectively |
| Historically, we have not actively engaged in substantial exchange rate hedging activities and do not intend to do so in the future |
| 14 ______________________________________________________________________ An interruption in delivery of component supplies could lead to supply shortages or a significant increase in our cost of materials |
| We are dependent on our suppliers for timely shipments of components, including components manufactured by us in our India facilities |
| We typically use a primary source of supply for each component used in our products |
| Changing suppliers or establishing alternate primary sources of supply, if needed, could take a significant period of time, which in turn could result in supply shortages and increased prices |
| In some cases, we source components from only one manufacturer |
| Substantially all of our revenues are derived from the sale of products that include components that we source from only one manufacturer |
| In addition, many of our suppliers are located outside of the United States, and timely delivery from these suppliers may not occur due to interruptions in transportation, import-export controls, tariffs, quotas, taxes and other market barriers, and political and economic stability in the country in which the components used in our products are produced or the surrounding region |
| An interruption in supply could have a material adverse affect on our operations |
| Any shortages of particular components could increase product delivery times and costs associated with manufacturing, thereby reducing gross margins |
| Additionally, these shortages could cause a substantial loss of business due to shipment delays |
| Any significant shortages or price increases of components could have a material adverse effect on our financial condition or results of operations |
| Our quarterly sales may fluctuate while our expenditures remain relatively fixed, potentially resulting in lower gross margins and volatility in our stock price |
| Our quarterly results of operations have fluctuated in the past and may continue to fluctuate in the future |
| For example, sales to one of our largest customers in the first quarter of 2005 were dlra5dtta1 million, and decreased 67prca to dlra1dtta7 million in the second quarter of 2005 driven by fluctuations in demand from that customer |
| Fluctuations in customer needs, cancellations, reductions and delays in orders and commitments may cause our quarterly results to fluctuate |
| See ‘‘—Cancellations, reductions or delays in customers’ orders or commitments or an increase in the number of warranty product returns could have a material adverse impact on our financial condition and results of operations |
| ’’ Variations in volume production orders and in the mix of products sold by us have also significantly affected sales and gross profit |
| Sales are generally impacted by a combination of these items and may also be affected by other factors |
| These factors include: · the receipt and shipment of large orders or reductions in these orders (including the impact of any customer warehousing arrangements); raw material availability and pricing; · product and price competition; and · the length of sales cycles |
| In addition, a substantial portion of our sales in a given quarter may depend on obtaining orders for products to be manufactured and shipped in the same quarter in which those orders are received |
| As a result of this and other factors described above, sales for future quarters are difficult to predict and our financial condition or results of operations in a given quarter may be below our expectations and our gross margins may decrease |
| Our expense levels are relatively fixed and are based, in part, on expectations of future revenues |
| If revenue levels are below expectations, the market price of our common stock could fall substantially, and our financial condition or results of operations could be materially adversely affected |
| 15 ______________________________________________________________________ Our ability to successfully implement our business strategy is dependent on our ability to retain and attract key personnel |
| Our ability to successfully implement our business strategy depends to a significant degree on the efforts of Jeffrey M Frank, President, Chief Executive Officer, and Director, Linster W Fox, Executive Vice President of Finance, Chief Financial Officer and Secretary, and Mukesh Patel, Executive Vice President, Global Operations, along with other members of our senior management team |
| We have no employment retention agreements with our key management executives and do not maintain key person life insurance for any of our executive officers |
| We believe that the loss of service of any of these executives could have a material adverse effect on our business |
| In addition, we depend on highly skilled engineers and other personnel with technical skills that are in high demand and are difficult to replace |
| As a result, our ability to maintain and enhance product and manufacturing technologies and to manage any future growth also depends on our success in attracting and retaining personnel with highly technical skills |
| The competition for these qualified technical personnel may be intense if the relatively limited number of qualified and available power engineers continues |
| We may not be able to attract and retain qualified technical personnel |
| Changes in government regulations or product certification could result in delays in shipment or loss of sales |
| Our operations are subject to general laws, regulations and government policies in the United States and abroad |
| Additionally, our product standards are certified by agencies in various countries, including, among others, the United States, Canada, Germany and the United Kingdom |
| Changes in these laws, regulations, policies or certification standards could negatively affect the demand for our products, result in the need to modify our existing products, increase time-to-production or affect the development of new products, each of which may involve substantial costs, or loss of or delayed sales and could have a material adverse effect on our financial condition or results of operations |
| Environmental compliance could require significant expenditures and failure to so comply could result in fines or revocation of licenses or permits, any of which could materially and adversely affect our financial condition or results of operations |
| We are subject to federal, state and local environmental laws and regulations (in both the United States and abroad) that govern the handling, transportation and discharge of materials into the environment, including into the air, water and soil |
| Environmental laws could become even more stringent in the future, imposing greater compliance costs and increasing risks and penalties associated with their violation or the contamination of the environment |
| Should there be an environmental accident or violation related to our operations, our financial condition or results of operations may be adversely affected |
| We could be held liable for significant penalties and damages under environmental laws and could also be subject to a revocation of licenses or permits, which could materially and adversely affect our financial condition or results of operations |
| Two recent EEC directives that are having an effect on the entire electronics industry are as follows: (1) Restriction of Hazardous Substances in Electrical and Electronic Equipment, more commonly known as RoHS This directive bans the use of certain elements that are commonly found in components used to manufacture electrical and electronic assemblies |
| This directive will become effective on July 1, 2006 |
| To comply with the RoHS directive, it will be necessary to purchase more compliant materials |
| There is a potential for having to dispose of non-compliant materials in the future, which could adversely affect the financial performance of the company |
| There is also a risk for fines associated with non-compliance to the RoHS directive |
| 16 ______________________________________________________________________ (2) Waste Electrical and Electronic Equipment, also known as WEEE This directive requires manufacturers and importers to properly recycle or dispose of this equipment at the end of its useful life |
| This directive became effective August 13, 2005 |
| We believe we have limited exposure to the WEEE directive because our products are usually installed into another user’s system, but this interpretation could change in the future |
| If so, there could be significant risk from fines and costs associated with non-compliance to the existing laws and regulations in the European Union |
| Our operations are vulnerable to interruption by fire, earthquake, power loss, telecommunications failure and other events beyond our control |
| Our operations are vulnerable to interruption by earthquakes, fires, electrical blackouts, power losses, telecommunications failures and other events beyond our control |
| Our executive offices and key manufacturing and engineering facilities are located in Southern California |
| Because the Southern California area is located in an earthquake-sensitive area, we are particularly susceptible to the risk of damage to, or total destruction of, our facilities in Southern California and the surrounding transportation infrastructure, which could affect our ability to make and transport our products |
| Furthermore, the State of California experienced deficiencies in its power supply in 2002, which resulted in occasional rolling blackouts and caused us two-to-four hour power supply interruptions over the course of a few days |
| In addition, California continues to face periodic shortages in its power supply |
| If rolling blackouts or other disruptions in power occur, our business and operations would be disrupted, and our business would be adversely affected |
| In January 2004, we experienced a fire in part of our facility in Belgium, Europe, which destroyed certain inventory, property and equipment |
| Our business interruption insurance may not be sufficient to compensate us for losses that may occur and would not compensate us for the loss of consumer goodwill due to disruption of service |
| Third parties may sue us for alleged infringement of their proprietary rights |
| We have received, from time to time, notices of alleged infringement and/or invitations to take licenses from third parties asserting that they have patents (or other intellectual property rights) that are relevant to our present or contemplated business operations |
| There is no guarantee that we will be able to avoid incurring litigation costs related to such assertions |
| Intellectual property claims could be successfully asserted against us, preventing us from using certain of our technologies, or forcing us to modify our technology or to pay license fees for use of that technology |
| Such additional engineering expenses or licensing costs could have an adverse effect on the results of our operations |
| In addition, we could incur substantial expenses in defending against these claims, whether or not we ultimately prevail against these claims |
| Provisions of the agreements governing our debt will restrict our business operations |
| At December 31, 2005, we had dlra46dtta6 million of 5dtta25prca senior notes outstanding, and we had in place a dlra20dtta0 million senior revolving credit facility (with no amounts outstanding) that is subject to a borrowing base comprised of eligible accounts receivable and inventory |
| Our outstanding indebtedness, including our 5dtta25prca senior notes and any debt incurred pursuant to the senior revolving credit facility, is secured by substantially all of our assets |
| Cherokee Europe maintains a working capital line of credit of approximately dlra4dtta1 million with a Belgian bank, BBL, which is denominated in Euros, is collateralized by a pledge in first and second rank over a specific amount of business assets, which requires Cherokee Europe to maintain a certain specific minimum solvency ratio and is cancelable at any time |
| As of December 31, 2005, Cherokee Europe had no outstanding borrowings under the line of credit |
| The agreements governing our debt contain a number of covenants that restrict our business operations, including covenants limiting our ability to make investments, enter into mergers or acquisitions, dispose of assets, incur additional debt, grant liens, enter into transactions with affiliates, redeem or repurchase our capital stock, repay other debt and pay dividends |
| As of December 31, 2005, we were in compliance with our covenants set forth in the agreements |
| Our ability to comply with covenants under agreements governing our debt may be affected by events that are beyond our control, including prevailing economic, financial and industry conditions |
| Our failure to comply with the covenants or restrictions contained in agreements governing our debt could result in an event of default under these agreements, which could result in our debt, together with accrued and unpaid interest, being declared immediately due and payable |
| Credit risks could materially and adversely affect our operations and financial condition |
| Negative or declining economic conditions can increase our exposure to our customers’ credit risk obligations to us |
| In particular, sales to larger customers are sometimes made through contract manufacturers that do not have the same resources as those customers |
| Additionally, if one of our major customers experienced financial difficulties, losses could be in excess of our current allowance |
| At December 31, 2005 and 2004, one of our customers accounted for approximately 10dtta3prca of our total net receivables and another one of our customers accounted for 13dtta1prca , respectively |
| For the periods ended December 31, 2005 and 2004, our accounts receivable write-offs amounted to less than 1prca of our net accounts receivable balance |
| In the event our customers or those contract manufacturers experience financial difficulties and fail to meet their financial obligations to us, or if our recorded bad debt provisions with respect to receivables obligations do not accurately reflect future customer payment levels, we could incur additional write-offs of receivables that are in excess of our provisions, which could have a material adverse effect on our operations and financial condition |
| In addition, we depend on the continuing willingness of our suppliers to extend credit to us to finance our inventory purchases |
| If suppliers become concerned about our ability to generate cash and service our debt, they may delay shipments to us or require payment in advance |