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On Espresso And Investing



August 14, 2007 – Comments (16)

Let’s face it; reading SEC filings is often about as riveting and exciting as Ben Stein’s economics lecture in the film Ferris Bueller’s Day Off. Often, however, one’s diligence in reading these filings reveals some pretty important pieces of information -- certainly well worth the cost of the triple espresso and Red Bull chaser it sometimes takes to keep me awake long enough to get through them. 

Case in point:  Cherokee Inc. (NASDAQ:CHKE

Cherokee Inc. licenses such popular apparel brands as Cherokee, Sideout, and several others. While there’s a lot to like about this stock with current a 5-star CAPS rating (as many of my fellow CAPS players’ pitches attest), in doing some research for my CAPS newsletter I came across something in the 10K regarding the CEO’s bonus structure that raised my eyebrows.

“The management agreement also provides that, for each fiscal year after fiscal 2000, if our EBITDA for such fiscal year is no less than $5.0 million, then Mr. Margolis will receive a performance bonus equal to (x) 10% of our EBITDA for such fiscal year in excess of $2.5 million up to $10.0 million, plus (y) 15% of our EBITDA for such fiscal year in excess of $10.0 million.”

My first thought was that this bonus structure seemed to me to be a bit generous, but if it aligns the CEO’s interests with those of the shareholders and motivates performance it’s a good thing, right? Maybe so, but let’s look at the definition of EBITDA and how it applies specifically to Cherokee’s business.

EBITDA = Earnings Before Interest, Taxes, Depreciation and Amortization.

Cherokee acquires trademarks and licenses them to retailers. The cost of these acquisitions is initially recorded on the balance sheet as an asset and charged against income over time as amortization expense (the “A” in EBITDA). The CEO’s bonus, however, is calculated on earnings before amortization expense. This means that the CEO’s bonus calculation completely ignores the acquisition costs of these trademarks.  If you’re still looking for a couple of toothpicks to keep your eyelids propped open, consider this:  what would happen if the company grossly overpaid for a trademark? Since the royalty revenues the trademark would bring in would part of EBITDA, but the cost to acquire that stream of royalty revenues would not be, the shareholders would be taking it on the chin while the CEO would be flush with extra cash.

We’re not done yet though. Things get even stickier since EBITDA also excludes the “I”, interest expense. Not only could the company grossly overpay for a trademark, but if it should also add insult to injury by doing so via debt financing, the interest expense associated with that debt financing would also be ignored in the CEO’s bonus calculation.

I’m not suggesting that Cherokee is a bad company, or a bad investment, or that the CEO has ever acted in a way so as to maximize his bonus at the expense of the shareholders. What I am saying, though, is that with this particular bonus structure lays the potential for a conflict of interest between the CEO and the shareholders. I believe that this potential is something every investor or prospective investor in Cherokee should at least be aware of, and it’s the kind of thing that investors will likely only know about if they make the effort to read the company’s SEC filings.

Are SEC filings boring and tedious at times?  You bet.  My advice, however, is to grab a cup of your stimulant of choice (legal, of course!) and grind through them.  You just might find some important nugget of information that you otherwise could have missed.

Disclosure:  I own no shares in Cherokee Inc.


16 Comments – Post Your Own

#1) On August 15, 2007 at 4:45 PM, ikkyu2 (98.33) wrote:

Nice catch, Russell.  Thanks, as always, for sharing your careful insights.

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#2) On August 16, 2007 at 2:29 AM, m1chaelb (68.82) wrote:

thank you for the info I appreciate it as I am still learning these things

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#3) On August 16, 2007 at 12:12 PM, Colo (50.96) wrote:

Great points - it does pay to read thru the fine print...

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#4) On August 16, 2007 at 2:56 PM, BenBernanke (72.39) wrote:

didnt you retire from caps?

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#5) On August 16, 2007 at 3:20 PM, CMFEldrehad (99.99) wrote:

I kinda, sorta, pseudo, semi-retired for a time.

I'm back, at least for now. :-)

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#6) On August 16, 2007 at 3:31 PM, Zikar (62.97) wrote:

And back on top, as I predicted. Hey, at least I got one right!

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#7) On August 16, 2007 at 4:50 PM, tuffsledding (30.80) wrote:

Way to go, Russell! You've been the Top Fool all along from my point of view...  And please, no more talk of "retirement".



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#8) On August 20, 2007 at 10:29 PM, dstaten (< 20) wrote:

Your postings are very analytical and detailed, thank you.

However, the majority of your picks are shorts on bad companies.  Is this your specialty? 


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#9) On August 21, 2007 at 10:41 AM, dexion10 (27.07) wrote:


 I used to have a 90 CAPS score... I got killed going long the mortgage companies and killed shorting other mortgage companies... I'd avoid this battlefield.

There will be time to pick at the carcasses later... but consider the fact that the the economy really depends on a healthy housing market... unfortunately because alll the builders ARE STILL BUILDING AND ADDING SUPPLY they risk wrecking our economy.


Mortgage debts and severity (loan losses) will be much more extreme if housing values aren't stabilized. The best way to stabilize the market would be to bankrupt almost all of the homebuilders.

Don't expect to see banks bail these guys out.

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#10) On August 23, 2007 at 12:56 AM, 070068 (48.93) wrote:

actually u are not a expect,u just pick more share let u get top one,see beyond one month u will be beat by me.

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#11) On August 23, 2007 at 1:55 PM, allstar31 (99.87) wrote:

I love how dexion is completely crazy and off topic.  Very amusing.


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#12) On August 24, 2007 at 3:56 PM, richmouse (81.25) wrote:

ever try pulling and reading there corporation charters ?

I have there is some useful stock information about management style an direction of mission statement but overall it gives only a directional indication of how the company started and were it headed in the future. Question is this good fool info? 

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#13) On August 30, 2007 at 4:30 PM, Gtrinvestor (97.35) wrote:

Nice write-up on the bonus plan info.

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#14) On September 01, 2007 at 2:37 AM, JohnnyBlago (54.40) wrote:

I was looking at your outperform and underperform picks. I notice you have centex and beazer as outperform. I realize they had come down quite a bit before you made those selections. You were probably expecting a bounce. As a mortgage broker, I can tell there is no bounce. Unless they bring back the no income documentation, 100% financing, on sales prices up to a million dollars, this industry should be dead money for a long time. Many of the financials are not out of this yet either regardless of what the fed does. 

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#15) On October 27, 2007 at 12:29 PM, GoldCanyon (46.80) wrote:

I thought about buying this stock.  Because of the dividend.

I looked at it several times but couldn't get comfortable at any price.  A gut reaction, I guess.  They don't actually MAKE anything.

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#16) On December 16, 2007 at 9:55 PM, dwot (29.50) wrote:

I have come to the conclusion that executive bonuses ought to be on a 5 year performance window and payment ought not be stock options.

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