CHKE Cherokee Inc. (MM)

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X.  Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statement presentation.  Cherokee Inc. changed its name to Apex Global Brands Inc. effective June 27, 2019.  These financial statements include the accounts of Apex Global Brands Inc. and its consolidated subsidiaries (the “Company”) and include all adjustments, consisting of normal recurring adjustments, necessary for a fair presentation of the Company’s financial condition and the results of operations for the periods presented.  The condensed consolidated financial statements and notes thereto should be read in conjunction with the audited financial statements and notes thereto for the year ended February 2, 2019 included in the Company’s Annual Report on Form 10-K.  Interim results are not necessarily indicative of results to be expected for the full year.

Liquidity and Going Concern

The accompanying condensed consolidated financial statements have been prepared on the going concern basis of accounting, which assumes the Company will continue to operate as a going concern and which contemplates the realization of assets and the satisfaction of liabilities and commitments in the normal course of business.  Under the Company’s senior secured credit facility, the Company is required to maintain specified levels of Adjusted EBITDA as defined ($9.5 million for the trailing twelve months as of February 1, 2020) and maintain a minimum cash balance of $1.0 million.  The Company’s financial projections currently indicate that the Company will remain in compliance with these covenants for a period of at least one year from the issuance date of these condensed consolidated financial statements.  Actual year-to-date revenues have been lower than the Company’s previous forecasts due to lower than expected royalties reported by the Company’s licensees, which have been negatively impacted by the economic uncertainty surrounding Brexit, global trade wars and increasing tariffs on footwear and apparel, and the weakening of the British pound sterling and euro in relation to the United States dollar.  As a result, management has enacted certain cash savings measures.

Should actual revenues during the upcoming year be lower than management’s current projections by an amount that may potentially result in a violation of the Adjusted EBITDA covenant or the minimum cash balance covenant, or if timing of cash receipts is materially different than management’s expectations, management believes that there are additional cash saving measures that could be implemented during this time period, including reductions in discretionary expenses related to marketing programs, product development and general and administrative expenses  However, if actual future revenues are substantially below current forecasts, such actions may not be adequate to maintain compliance with the Adjusted EBITDA covenant and the minimum cash balance covenant.  Because of this uncertainty, there is substantial doubt about the Company’s ability to continue as a going concern.  In addition to the Company’s management endeavoring to increase its earnings through the cost-saving measures noted above, the Company is in active negotiations for new and amended licenses that would increase its working capital and Adjusted EBITDA.

In June 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2016-13, “Financial Instruments-Credit Losses (“Topic 326”).  For trade receivables, the Company will be required to use a forward-looking expected loss model rather than the incurred loss model for recognizing credit losses which reflects losses that are probable.  This new standard is effective for the Company’s fiscal year ending January 30, 2021 (‘‘Fiscal 2021’’).  The Company is currently evaluating the impact of the adoption of this standard on our condensed consolidated financial statements. Management does not expect the impact of adoption to be material.

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In March 2016, the FASB issued authoritative guidance which modified existing guidance for off-balance sheet treatment of a lessee’s operating leases (“Topic 842”).  The standard requires a lessee to recognize assets and liabilities related to long-term leases that were classified as operating leases under previous guidance.  An asset is recognized related to the right to use the underlying asset, and a liability is recognized related to the obligation to make lease payments over the term of the lease.  These amounts are determined based on the present value of the lease payments over the lease term.  The standard also requires expanded disclosures about leases.  The Company adopted this standard as of the beginning of its fiscal year ending February 1, 2020, electing the transition option that allowed it not to restate the comparative periods in its financial statements in the year of adoption and to carry forward its historical assessment of whether contracts are, or contain, leases, along with its historical assessment of lease classifications and initial direct costs.

The Company’s leases obligations comprise primarily individual leases for office space without multiple components.  The Company determines if an arrangement is or contains a lease at inception by evaluating various factors, including whether a vendor’s right to substitute an identified asset is substantive. Lease classification is determined at the lease commencement date when the leased assets are made available for use.  For the Company’s long-term leases, operating leases obligations are included in other current liabilities and long-term lease liabilities, and right-of-use assets are included in accrued revenue and other assets. The Company does not have any material finance leases.  The operating lease obligations and right-of-use assets recognized on adoption of Topic 842 were $4.7 million and $4.6 million, respectively.  The difference between the total right-of-use assets and total lease liabilities recorded on adoption is primarily due to the derecognition of prepaid rent expenses.

The Company uses estimates of its incremental borrowing rate (IBR) based on the information available at the lease commencement date in determining the present value of lease payments.  In determining the appropriate IBR, the Company considers information including, but not limited to, its credit rating, the lease term, and the currency in which the arrangement is denominated.  For leases which commenced prior to our adoption of Topic 842, we used the estimated IBR on the date of adoption. When the Company has the sole option to either renew or terminate a lease, the present value of the right-of-use asset and lease obligation includes the extension period when it is reasonably certain that the Company will exercise the option. Lease expense is recognized on a straight-line basis over the lease term.

Intangible assets consist of the following:

The Hi-Tec Acquisition during Fiscal 2017 resulted in trademarks valued at $52.4 million that are classified as indefinite lived and not subjected to amortization.  Other indefinite lived trademarks include certain Cherokee brand trademarks that were acquired in historical transactions.  The Company has acquired other trademarks that are being amortized over their estimated useful lives, which average 10.0 years with no residual values.  Amortization of intangible assets was $0.2 million and $0.2 million for the three months ended August 3, 2019 and August 4, 2018, respectively, and $0.4 million and $0.6 million for the six months ended August 3, 2019 and August 4, 2018, respectively.    

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Other current liabilities consist of the following:

The Company incurred restructuring charges in Fiscal 2018 and Fiscal 2017 related to the Hi-Tec Acquisition and its integration into the Company’s ongoing operations (the “Hi-Tec Plan”).  Restructuring charges were also incurred in the fourth quarter of Fiscal 2018 as the Company’s staff was realigned to appropriately support its then current business (the “FY18 Plan”).  Furthermore, during Fiscal 2019, the Company took additional steps designed to improve its organizational efficiencies by eliminating redundant positions and unneeded facilities, and by terminating various consulting and marketing contracts (the “FY19 Plan”).         

Charges and payments against the restructuring plan obligations were as follows:

On August 3, 2018, the Company entered into a senior secured credit facility, which provided a $40.0 term loan, and $13.5 million of subordinated promissory notes (the “Junior Notes”). The credit facility was amended on January 30, 2019 to provide an additional term loan of $5.3 million. The term loans mature in August 2021 and require quarterly principal payments and monthly interest payments based on LIBOR plus a margin.  The additional $5.3 million term loan also requires interest of 3.0% payable in kind with such interest being added to the principal balance of the loan.  The term loans are secured by substantially all the assets of the Company and are guaranteed by the Company’s subsidiaries.  The Junior Notes mature in November 2021, and they are secured by a second priority lien on substantially all of the assets of Company and guaranteed by the Company’s subsidiaries.  Interest is payable monthly on the Junior Notes, but no periodic amortization payments are required.  The Junior Notes are subordinated in rights of payment and priority to the term loans but otherwise have economic terms substantially similar to the term loans.  Excluding the interest payable in kind, the weighted-average interest rate on both the term loans and Junior Notes at August 3, 2019 was 11.3%.

The term loans are subject to a borrowing base and include financial covenants and obligations regarding the operation of the Company’s business that are customary in facilities of this type, including limitations on the payment of dividends.  Financial covenants include the requirement to maintain specified levels of EBITDA, as defined in the agreement, and maintain a specified level of cash on hand. (See Note 1, Liquidity and Going Concern.)  The Company is required to maintain a borrowing base comprising the value of the Company’s trademarks that exceeds the outstanding balance of the term loans.  If the borrowing base is less than the outstanding term loans at any measurement period, then the Company would be required to repay a portion of the term loans to eliminate such shortfall.  Events of default include, among other things, the occurrence of a change of control of the Company, and a default under the term loans agreement would also trigger a default under the Junior Notes agreements.

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Outstanding borrowings under the term loans were $44.5 million at August 3, 2019 with associated unamortized debt issuance costs of $2.5 million.  Outstanding Junior Notes were $13.5 million at August 3, 2019 with associated unamortized debt issuance costs of $0.5 million.

The Company indemnifies certain customers against liability arising from third‑party claims of intellectual property rights infringement related to the Company’s trademarks.  These indemnities appear in the licensing agreements with the Company’s customers, are not limited in amount or duration and generally survive the expiration of the contracts.  The Company is unable to determine a range of estimated losses that it could incur related to such indemnities since the amount of any potential liabilities cannot be determined until an infringement claim has been made.

The Company is involved from time to time in various claims and other matters incidental to the Company’s business, the resolution of which is not presently expected to have a material adverse effect on the Company’s financial position, results of operations or liquidity.  Estimated reserves for contingent liabilities, including threatened or pending litigation, are recorded as liabilities in the financial statements when the outcome of these matters is deemed probable and the liability is reasonably estimable.

The Company has non-cancelable operating lease agreements with various expiration dates through December 31, 2026 for office space and equipment.  Certain lease agreements include options to renew, which are not reasonably certain to be exercised and therefore are not factored into our determination of the present value of lease obligations.

Operating lease costs are included as a component of selling, general and administrative expense and were $0.1 million and $0.3 million, excluding variable lease costs and sublease income, for the three and six months ended August 3, 2019, respectively.  Cash paid for operating lease obligations is consistent with operating lease costs for the period.  Total lease expense recognized prior to our adoption of Topic 842 was $0.2 million and $0.4 million for the three and six months ended August 4, 2018, respectively.

As of August 3, 2019, the weighted-average remaining lease term is 6.4 years, and the weighted-average IBR is 8.8%.  The right-of-use assets as of August 3, 2019 was $4.3 million.  Future minimum commitments under non-cancelable operating leases as of August 3, 2019 are as follows:

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Future minimum lease payments as of February 2, 2019 were as follows:

Revenues by geographic area based upon the licensees’ country of domicile comprise the following:

Long‑lived assets located in the United States and outside the United States amount to $0.2 million and $0.3 million, respectively, at August 3, 2019 and $0.2 million and $0.4 million, respectively, at February 2, 2019.

Deferred revenue totaled $2.5 million and $2.2 million at August 3, 2019 and February 2, 2019, respectively.  Revenue recognized in the three and six months ended August 3, 2019 that was previously included in deferred revenue was $0.7 million and $1.4 million, respectively.  Revenue recognized in the three and six months ended August 4, 2018 that was previously included in deferred revenue was $0.9 million and $1.8 million.  

Two licensees accounted for approximately 21% of accounts receivable at August 3, 2019, and two licensees accounted for approximately 25% and two licensees for approximately 26% of revenues for three and six months ended August 3, 2019, respectively.  Two licensees accounted for approximately 29% of accounts receivable at February 2, 2019, and three licensees accounted for approximately 45% and two licensees for approximately 20% of revenues for three and six months ended August 4, 2018, respectively.

Basic earnings (loss) per share (“EPS”) is computed by dividing the net (loss) income attributable to common stockholders by the weighted-average number of common shares outstanding during the period, while diluted EPS additionally includes the dilutive effect of outstanding stock options and warrants as if such securities had been exercised at the beginning of the period.  The computation of diluted common shares outstanding excludes outstanding stock options and warrants that are anti‑dilutive.  

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Each reporting period, the Company evaluates the realizability of its deferred tax assets.  As of August 3, 2019, the Company continued to maintain a full valuation allowance against its deferred tax assets in the United States and the foreign subsidiaries acquired in the Hi-Tec Acquisition.  These valuation allowances will be maintained until there is sufficient positive evidence to conclude that it is more likely than not that these deferred tax assets will be realized.   

As of August 3, 2019, the reserve for uncertain tax positions resulting from unrecognized tax benefits related to the Company’s Hi-Tec subsidiaries was $3.3 million.  There was no change in the three months ended August 3, 2019 and  a decrease of $0.1 million in the six months ended August 3, 2019, in the Company’s liability for uncertain tax positions.      

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