Description

SUMMARY.  Tandy Leather Factory, Inc. (TLF) is a storefront retailer and wholesale distributor of a range of leather and related products with an enterprise value of $26M ($4.82/Share * 8.9M S/O = $43M Market Cap + $0 Debt - $23M Cash + $5M Required Cash for Ops = $26M EV, rounded), positioned to generate $5M-$9M of free cash flow per year.  TLF investors can expect a quick reward in the coming months, once TLF sorts out its nonmaterial accounting issues and reports Q2 2019 (unreported), Q3 2019 (unreported), and Q4 (holiday quarter in progress).  At that point—likely February 2020—TLF’s LTM earnings ratios will leap off the stock screens.

TLF’s recent poor reported results and accounting mishaps have created an excellent buying opportunity.  2018 produced poor operating results due to a clearance of inventory in international and unprofitable stores and various one-off charges (store closures, legal costs, former CEO severance), such that TLF produced a return on tangible capital employed (ROTCE) of 5%—compared with TLF producing averaging a 17% ROTCE from 2006-2017 and always remaining above 10%.

TLF has not yet released its Q2 2019 (June 30, 2019) and Q3 2019 (September 30, 2019) financials.  In 2019, TLF began rolling out a more modernized accounting system.  During implementation management discovered issues regarding its inventory accounting, forcing the company to need to restate years of financials.  The October 21, 2019 8-K revealed two things, however: (1) the accounting mishaps resulted from CFO incompetence rather than mischief and (2) TLF appears to be performing like it used to—with no debt and the following cash from operations: $3.0M in Q1 2019, $2.6M in Q2 2019, and a “cash increase” of $2.3M in Q3 2019.  Upcoming Q4 2019 is typically TFL’s best earning quarter by far because of the holidays.  One cannot be sure how much of TLF’s Q2 2019 and Q3 2019 cash increases came from a reversion to previous EBIT margins (good) vs one-time improvements in inventory management implemented by the new CEO (good, but not as sustainable).  If the cash increases reflect restored EBIT margins, TLF could be back to the glory days of earning +$10M of EBIT annually (as it did during 2013-2016) and the stock will likely more than double (assuming 10x EV/NOPAT).  More likely, the cash increases during the unreported Q2 and Q3 periods derive from a mix of improved EBIT margins and improved inventory efficiency.  I suspect that improved EBIT margins largely drove the healthy cash generation (e.g., more than 75% responsible) because new CEO Janet Carr had already driven Q1 2019 inventories to $31M—the lowest level since Q1 2015.  In other words, TLF management can only squeeze out so much cash by increasing inventory efficiencies—and they appear to have already squeezed a lot as of Q1 2019—so I believe much of the cash generation came from improved EBIT.

Currently, TLF is unlikely to register on stock screens because it trades at 8.0x EV/EBIT and 27.9x P/E, due to severely depressed LTM performance.  As TLF resolves the accounting mishaps and reports the missing quarters (Q2 2019 and Q3 2019) and coming quarter (Q4 2019), LTM EBIT is likely to rise to greater than $7M (and perhaps greater than $10M) on a $22M EV stock (assuming, say,  $4M of Q4 2019 cash buildup from the current $29M EV)—leading to a 2.0x-3.2x EV/EBIT (if the current $4.82 share price were to persist).  That is far too cheap for a high free cash flow business that has survived Amazonization.

Catalysts include the following:

1. The release of revised financials, including unreported Q2 2019 and Q3 2019;
2. The release of TLF’s Q4 2019 financials showing strong free cash flow, since TLF earns big during the holidays and sells down its inventory;
3. Further cash accumulation, displaying a trajectory whereby TLF’s cash could equal its market cap within a few years;
4. A potential special dividend unloading the excess cash;
5. Share repurchases at attractive prices, unloading the excess cash (although limited liquidity prevents TLF from repurchasing more than 400K-500K shares per year); and
6. A rush to cover by short sellers (2.7% short interest with 10-50 days to cover, depending on volumes).

Regarding TLF’s cash hoard, management will ultimately act in shareholders’ interest.  Jeff Gramm—adjunct Columbia Business School professor and the activist value investor who wrote “Dear Chairman: Boardroom Battles and the Rise of Shareholder Activism”, a Buffett-recommended book about corporate boards and activism—runs a small-cap focused hedge fund named Bandera Partners that holds 32% of TLF stock.  Gramm is the chairman of the board.  TLF investors can rest easy knowing that key decision-makers care deeply about capital allocation.

Gramm and new CEO Janet Carr made insider purchases in March 2019—prior to the accounting mishaps—at $5.51 and $5.70, respectively.

TLF stock is thinly traded, so this opportunity relates to investors investing a few million dollars or less.  I hold it as a 12% position.

I should note that OsoNegro wrote up TLF on April 20, 2017 (then trading at $7.95/share).

TABLE OF CONTENTS

1. Business Overview
2. High Returns on Invested Capital
3. Why is TLF Cheap?
4. Valuation
5. Excess Cash and Jeff Gramm
6. Threats
7. Catalysts

This writeup depicts a special situation brought on by an accounting issue, so the catalysts at the end are essential.  For those intending to hold TLF for more than one year, I include some appendices describing TLF’s origin, competitive advantage, and CEO incentives—all containing information that informed my investment decision.  The appendices are less essential to getting oriented.

• Appendix A: Business History: 1919-1999
• Appendix B: Business History: 2000-2019
• Appendix C: Moat
• Appendix D: CEO Incentives

I. BUSINESS OVERVIEW.  TLF’s business is unique.  TLF sells products for leather hobbyists through 117 storefronts spread across the US and Canada (plus a store in Spain, the last remaining international store).  TLF sells hardly any finished goods.  Instead, TLF sells leather (40%), hand tools (20%), dyes, finishes, and glues (8%), hardware (8%), stamps (5%), do-it-yourself kits (5%), lace (3%), buckles (3%), belts, strips, and straps (3%), and other (5%).  Non-leather sales (60% of sales) produce substantially higher gross margins than leather sales (40% of sales), since leather is both pricier and more commoditized.  Hobbyists then create items for themselves or to give away as gifts—such as belts, wallets, horse saddles, purses, shoes, gun holsters, backpacks, and other items.

TLF has had two types of business: (1) wholesale and (2) retail.  For the wholesale business, TLF purchases from 150 vendors dispersed throughout the US and 20 different countries (top 10 accounted for 68% of inventory in 2018).  TLF routes the vast majority of purchases through its large Fort Worth, TX facility.  At the facility, TLF manufactures a small range of products (e.g., cutting leather into various shapes and patterns using metal dies, fabrication, assembly, and packaging/repackaging), but most of the ordered inventory remains as is.  Then, on a weekly basis, TLF distributes the inventory to approximately 30 wholesale distribution facilities spread across the US and Canada.  The wholesale stores have averaged approximately 6,000 sq ft in light industrial office/warehouse near a major freeway.  In the stores, TLF displays the leather and leather accessories on pallets, where customers can see and touch them.  The stores are strategically placed throughout the US to enable max 2-day delivery to customers.  A couple of decades ago, retail customers (i.e., individual hobbyists) comprised approximately 25% of wholesale store sales.  In 2016, retail customers comprised 48% of wholesale store sales.  As discussed in Appendix B: Business History 2000-2019, TLF has shifted its customer mix toward higher-margin retail customers, since reviving the Tandy Leather founders’ retail storefront model in 2000.

The retail storefronts are similar, except they average 2,000 sq ft and resemble an arts and crafts store.  Like the wholesale stores, the retail stores receive weekly shipments from the main facility in Fort Worth, TX.  In the early 2000s, when then-President Wray Thompson began first began reviving the small retail storefront concept, retail customers comprised approximately 66% of retail store sales.  In 2016, retail customers comprised 60% of retail store sales.  Like the wholesale stores, the retail stores also ship to customers.

In 2017, TLF stopped segmenting stores as wholesale or retail.  (As described in the Appendix B: Business History: 2000-2019 section, the larger wholesale stores were former The Leather Factory distribution centers, and all the retail stores were opened after the acquisition of Tandy Leather in 2000.)  Management consolidated the reporting because the line between wholesale storefronts and retail storefronts had blurred—as evidenced by the convergence of retail customers to 50%-60% at both the wholesale and retail stores.  For instance, I checked out the Harahan, Louisiana storefront—formerly identified as a distribution center—and it resembled a normal retail store.  So in 2016, TLF reported 27 Wholesale + 84 Retail + 4 International = 115 total stores.  In 2017, TLF reported 115 North America + 4 International = 119 total stores.

A typical store has a store manager (~$40,000/year according to Glassdoor + reported 25% store EBIT bonus) and an assistant (~$21,000/year according to Glassdoor).  In 2018, TLF carried approximately 2,600 different items (leather and leather accessories), and all items were offered in all stores.

TLF enjoys high gross margins (+60%) but low inventory turnover (2.3x in recent years, defined as Net Sales / Average Inventory).  By comparison, a publicly reported comparable like Michaels (MIK) has significantly lower gross margins (40%) but higher inventory turnover (4.5x-5.0x).

TLF’s new CEO, Janet Carr, has substantial retailing experience and appears to be aggressively working to improve the low inventory turnover—hopefully without disappointing customers.  She indicated that 3.0x inventory turnover ought to be an achievable target.  Since her tenure began in Q4 2018, she already appears to have made progress reducing inventory from $41M in Q3 2018 to $31M in Q1 2019 (much of that naturally comes from building up inventories prior to the holiday season, then selling it down during the holiday season—still, it is a healthy reduction from 2018 Q1 inventory of $37M and reflects the lowest figure since Q1 2015).

Finally, TLF has a capital-light business.  In a 2017 presentation, then-CEO Shannon Greene described TLF’s “new store economics” as such:

Opening a new store requires (1) a cheap lease on the outskirts of town (customers are willing to drive, hours in some cases according to Yelp reviews); (2) $75K of store setup costs, and (3) $150K of inventory.  For context, during 2014-2018, the average gross profit per store was $445K.  While it may take a couple of years for a new store to ramp up its revenues to existing store levels, one can get a picture of TLF’s favorable unit economics and return on capital.

II. HIGH RETURNS ON INVESTED CAPITAL.  TLF’s capital-light business model and economies of scale enable it to earn high returns on tangible capital employed (ROTCE).  During 2006-2017, TLF averaged an ROTCE of 17%, never dropping below 11%.  For this measurement,

ROTCE = NOPAT/AVG[TCE]

Where:

NOPAT = EBIT * (1-25.7%)

TCE = [$5M of required cash for operations] + [Inventories] + [Net property and plant] + [Receivables] + [Deferred income taxes assets] +  [Other current assets] + [Operating lease assets] + [Other long-term assets] – [Payables] – [Accrued expenses and liabilities] – [Income taxes payable] – [Current maturities of capital lease obligations] – [Operating lease liabilities] – [Deferred income taxes].  Essentially that equates to $5M cash and the other net tangible assets required to run the business, less the cash financing provided by suppliers (payables), employees (accrued expenses), and the government (deferred taxes).

The NOPAT/AVG[TCE] measurement isolates the underlying quality of the business, comparing TLF’s after-tax earnings (assuming TLF’s post-Tax Act tax rate of 25.7%) to the business needs in terms of capital investment and working capital.  The measurement prevents TLF’s idle excess cash and formerly higher tax rate from interfering with an assessment of the underlying business.

III. WHY IS TLF CHEAP?  During 2017 and 2018, a few optically bad things led to poorer operating results: revenues (and same-store revenues) remained flat; TLF’s operating expenses as percentage of revenues jumped from 50% in 2016 to 55% in 2017; the international expansion initiative flopped, leading to store closures (one-off expenses) and inventory write-downs; and TLF repatriated trapped cash (mostly $CAD, presumably), leading to a 47% effective tax rate in 2018.  Flat revenues—in concert with a relatively flat store count—lines up with expectations for this industry.  TLF’s 2017 10-K attributed the increase in operating expenses from 50% to 55% to the following:

“The $3.4 million increase in operating expenses in 2017 compared to 2016 was primarily due to *$1.3 million in costs related to the seven new stores that have opened / reopened since October 2016, *$1.1 million related to the district manager program that was rolled out in early 2017, $0.2 million for an increase in base salary for our store managers, $0.2 million in increased advertising and marketing related to our national sponsorship of the Pinners program, with the remaining increase related to increases in credit card processing fees, occupancy costs across our store footprint, and home office wages.”

TLF’s 2018 10-K attributes elevated operating costs to the following:

“The $1.9 million increase in operating expenses in 2018 compared to 2017 was primarily due to *$0.6 million of higher costs related to five new stores that have opened since April 2017; $0.8 million of higher labor costs related to increasing pay for our store associates and extending our store operating hours (opening later in the evenings and Sunday openings); *$0.2 million of one-time costs related to store closures; *$0.3 million of impairment charges for underperforming stores; *$0.9 million of one-time costs related to our change in management (of which $0.6 million related to separation payments to our former CEO and president and $0.3 million related to legal and advisory costs). These increases were offset by $0.9 million reduction in print and postage costs.”

TLF’s 2018 gross margins suffered as well, as incoming CEO Janet Carr worked to push out damaged, slow-moving, and excess inventory—leading to a write-down.  Exclusive of the write-down, TLF would have achieved a 62.6% gross margin instead of 60.9% in 2018.

One-off costs drove TLF’s recent gross margins lower and operating costs as a percentage of revenue higher—thereby driving EBIT margins lower.  Based on the cash increases that occurred during Q2 2019 and Q3 2019 (based on the October 21, 2019 8-K), I expect that this trend has largely reverted.  In the block quotes above, I starred (*) the cost increases that I expect to have decreased.  In the past, TLF has not repeatedly produced one-time costs—a habit of less scrupulous company managements.

Then, in August 2019, the accounting mishaps caused TLF’s stock to plunge.  Based on my extensive reading of TLF’s business history and 10-Ks describing TLF’s method of inventory accounting, I strongly suspected that TLF’s accounting issues resulted from CFO incompetence rather than mischief and began buying.  A close reading of TLF’s October 21, 2019 8-K confirms this, and the stock rebounded a bit but remains substantially undervalued.

Also, because TLF is a microcap (sub $50M market cap), it receives no analyst coverage and only a subset of investors will find researching it worthwhile.

IV. VALUATION.  In my view, the most appropriate way to value TLF is EV/NOPAT—assuming a normalized effective tax rate of 25.7%—where:

EV = Market Cap + Debt – Cash + Required Cash

Current EV = $43M + $0 – $23M + $5M = $26M (rounded)

NOPAT = EBIT * (1-25.7%)

LTM NOPAT = $3.2 * (1-25.7%) = $2.4M

Thus EV/NOPAT = $26M/$2.4M = 10.8x, based on the depressed LTM NOPAT.  EV/NOPAT provides a reasonable measure of TLF’s value because it controls for TLF’s capital structure and cash hoard, while also providing a sense of its after-tax earning power.  (EV/EBIT is a good measure as well—and I refer to it in this writeup—but it doesn’t account for taxes.)  P/E, for instance, is a misleading value measure because TLF has loads of distributable cash earning little interest.

In today’s low-interest environment, we might conservatively expect a specialty retailer to trade at approximately 10x free cash flow.  By comparison, Capital IQ forward EV/EBIT estimates (a pretax measure that produces lower multiples than post-tax measures) for the Michaels peers are the following: Michaels (MIK, 8.6x—with a lot of debt); Williams-Sonoma (WSM, 13.6x); Bed Bath & Beyond (BBBY, 13.1x); DICK’S Sporting Goods (DKS, 17.2x); Tractor Supply Company (TSCO, 17.7x); Ulta Beauty (ULTA, 17.0x); Lowe’s (LOW, 15.5x); The Home Depot (HD, 16.1x); National Vision Holdings (EYE, 29.5x); and The Container Store Group (TCS, 16.3x).  If TLF can hold steady (1) revenues at $84M, (2) gross margins at 62.6% (exclusive of recent inventory write-downs), and (3) operating expenses / revenues at 54.6% (exclusive of recent store closure costs, impairments for underperforming stores, and CEO severance), then TLF will achieve an EBIT margin of 8% and EBIT of $6.7M.  Applying TLF’s 25.7% tax rate renders NOPAT of $5.0M.  (This is a base case, of course.  I expect that TLF management has surpassed this “hold steady” scenario based on the $2.6M Q2 2019 and $2.3M Q3 2019 cash increases.)

Applying a 10x EV/NOPAT multiple produces an EV of $50M.  Then add $23M of excess cash ($23M from the October 8-K, less $5M of cash required for operations, plus $5M cash generated from operations over the next six months—or perhaps even Q4 alone) to get a market cap of $72M ($7.93/share)—a 65% increase over the current market cap of $43M.  But is the $23M of cash truly worth $23M to an investor, as I have treated it there?  It depends on (1) what the investor expects management and the board to do with the cash and (2) the tax status of the investor.  One might haircut the cash, say, 25% to account for (1) and (2)—leading to a $67M market cap ($7.31/share) expectation and 52% upside.  Employing the same math, if TLF is back to earning a 12% EBIT margin—a possibility supported by both (a) the Q2 2019 and Q3 2019 cash increases and (b) the fact that TLF’s EBIT margin never dipped below 12% during 2011-2016—TLF’s market cap would double to $90M ($9.93/share).

I present the conservative case below: 55% operating expenses / revenues (leading to 8% EBIT margins), 75% valuation of cash, 10x EV/NOPAT market valuation.  The figure below contains a lot of relevant historical financial information too.  This case produces a 52% return within the first year (Y1E).

Conservative Case (54.6% operating expenses / revenues)

The improved case results in a quick doubling of TLF’s stock price: 51% operating expenses / revenues (leading to 12% EBIT margins), 75% valuation of cash, 10x EV/NOPAT market valuation.  This case produces a 95% return in the first year (Y1E).

Improved Case (51.0% operating expenses / revenues)

I believe investors can expect that most or all of that, say, 42% to 100% upside to occur quickly—perhaps in the next few months.  TLF has not yet reported Q2 2019 and Q3 2019, but those quarters are in the bag and produced cash increases of $2.6M and $2.3M, respectively.  TLF performs best during Q4 because of holiday shopping.  The Q4s from 2014-2018 averaged $6.0M of free cash flow (cash from operations, less capex).  (I expect a lower Q4 2019 figure because the new management appears more adept at inventory management, and much of that $6.0M figure came from selling down the inventory during the holidays, but suffice it to say that Q4 is good to TLF.)  Once TLF clears up the accounting mishaps and reports Q4 2019, TLF’s LTM earnings—by all measures—will leap off the stock screens.  Thus TLF investors today can expect a quick reward.  NASDAQ accepted TLF’s plan to regain compliance, granting TLF an extension until February 17, 2020 to file its Q2 2019 and Q3 2019 10-Qs.  So February 2020 is the likely launch date for the stock.

TLF’s price relative to book value provides another valuation lens.  TLF’s high ROTCE (see High Returns on Invested Capital section) signals that if the business is stable and run by capable management, then it should trade for substantially more than its net tangible book value (TLF has only $1M of intangibles).  Historically that has been the case.  From 2006-2016, TLF traded at an average of approximately 1.7x P/B.  The lowest and highest average P/B years were 2009 and 2014, when TLF traded at an average of 0.9x and 2.0x, respectively.  At the current share price, TLF trades for 0.67x P/B.  67% of book value is a substantial discount to the fair value of a company that has a board genuinely aligned with shareholders (Jeff Gramm’s fund owns 32%), a new CEO with 25 years of retailing experience, and a business that has generated 17% ROTCE historically.

Finally, Benjamin Graham die-hards can find comfort in TLF’s balance sheet.  As a reminder, TLF has not yet released financials beyond Q1 2019.  However, the October 21, 2019 8-K indicated a Q3 2019 cash level of $22.6M with no debt.  Thus we can construct what the latest balance sheet might look like by combining the Q1 2019 balance sheet with the October 21, 2019 8-K information.  In the following balance sheet, everything except the cash (Q3 2019) and equity (residual) come from the Q1 2019 10-Q. 

The strong balance sheet compares well with a market cap of $43M, providing ample downside protection.  If we give the cash its full value of $23M, discount the inventories by 66% to $10M, and value the net plant and equipment at $15M, we have substantial protection against our purchase price from TLF’s liquidatable assets themselves: $23M + $10M + $15M = $48M.  The $15M estimated value for net plant and equipment reflects TLF’s main facility in Fort Worth, TX—the only facility that TLF owns rather than leases.  TLF’s Fort Worth, TX HQ was assessed at $15M in 2018.  Also, the Bank of Texas gave TLF a $15M line of credit (for repurchasing shares), secured by the Fort Worth facility.

Insiders bought at higher prices.  CEO Janet Carr made open market purchases on March 13, 2019 for 8,800 TLF shares at $5.70.  Similarly, on March 11, 2019 Board Chairman Jeff Gramm made open market purchases for 1,329 TLF shares at $5.51.

V. EXCESS CASH AND JEFF GRAMM.  Microcap excess cash is often trapped under the management.  This ought not to be a long-term issue with Jeff Gramm as TLF’s Chairman of the Board.  Gramm’s Buffett-recommended book, “Dear Chairman”—which hails activist investors wresting power from unaligned managements—begins with a detailed recounting of Benjamin Graham’s proxy fight against Northern Pipeline management to return Northern Pipeline’s hidden bond portfolio to investors.  Gramm’s Bandera Partners LLC owns 32% of TLF’s stock, and his mind is in the right place.  I spoke with Mr. Gramm briefly, but he indicated he should not discuss TLF until the accounting issues are straightened out.

The other top holders are focused investors as well.  The top four largest shareholders are focused investment funds: Bandera Partners LLC (32.0%), JCP Investment Management LLC (9.6%), Central Square Management LLC (6.6%), Beddow Capital Management, Inc. (5.8%)—totaling 54.1%.

VI. THREATS

1. 10b-5 litigation costs;
2. Restatement costs;
3. Amazonization; and
4. Disease

(1) 10b-5 litigation costs.  TLF will likely have to pay off “wronged” shareholders who bought based on the misstated financials.  Shareholders who bought TLF stock during the “class period” (March 7, 2018 through August 15, 2019) can claim damages.  US securities law permits such shareholders to organize as a class behind a lead plaintiff and sue the company.  Google “tandy leather class action” to see some of the law firms trying to organize the class.  Each law firm wants to round up enough as many shareholders as possible—and hopefully the lead plaintiff.  I learned a bit about this by calling some of these firms, claiming to have bought during the class period. 

I spoke with two 10b-5 economic damages experts—one at the top of the field with decades of experience—and they indicated that TLF’s 10b-5 litigation costs should not exceed $1M-$2M, tops.  TLF and the lead counsel will likely settle.  Small caps have faced more 10b-5 litigation in recent years, as law firms have targeted smaller companies for settlements.  For some back-of-the-envelope math, if we take every single share traded from March 7, 2018 through August 15, 2019 (3.5M shares) and measure the difference between the closing price (e.g., $6.00/share) and likely claim price ($4.50/share), multiplied by Cornerstone Research’s median settlement of as a percentage of “Simplified Tier I Damages” for similarly small cases (14%), we can ballpark TLF’s exposure at less than $1M.

[Purchase cost] – [Post-disclosure cost] = [Max exposure] * [Median settlement %] = [Expected exposure]

May 1, 2019 example:

(9,169 shares * $5.85/share) – (9,169 shares * $4.50/share) = $12,378 * 14% = $1,733

March 7, 2018 through August 15, 2019

(3,521,970 shares * $6.43/share weighted average) – (3,521,970 shares * $4.50/share) = $6,782,113 * 14% = $949,496

According to the 10b-5 experts, the worst-case scenario is if both sides play hardball.  For TLF, it’s a single game; for the lead counsel, it’s a repeated game.  If TLF is stubborn, the lead counsel may feel the need to make an example of TLF to intimidate future targets.  The lead counsel may even incur a loss and drawn-out legal process to make its point (these firms usually earn a 30% contingency fee).  The 10b-5 experts dismissed this as a remote possibility, but I still wanted to flag it for readers.

(2) Restatement costs.  Costs related to restating TLF’s financials pose another threat to TLF’s cash.  However, given the benign nature of TLF’s misstatements and a look at similar situations, I estimate approximately $1M of audit cleanup costs.

A reader of the October 21, 2019 8-K can tell that the CFO struggled with how to properly account for inventory, messing things up in one quarter then trying to correct them in the next.  While TLF will need to restate years of financials, sales and cash balances are unaffected—and the net impact on inventories is less than $500K (on +$30M of inventories).  Still, the auditor will have to conduct a thorough review of the inventory accounting, thereby restating gross margins, net income, etc.  I spoke with some audit experts, and none expected the cost to run over $1M.  One thought that since TLF’s uses a smaller audit firm (not Big Four) tackling a singular issue (inventories), the costs would likely run a few hundred thousand dollars.  Another investor cited the case of Ecology and Environment Inc. (EEI), a similarly sized company that improperly accounted for an investment, costing shareholders $0.9M.

(3) Amazonization.  I fear that specialty may be next on the Amazon chopping block.  What does TLF offer to customers?  First, it gets them interested in leathercrafting.  Next, it stocks its stores with a wide selection of inventory to see, feel, and purchase.  The relationship formed by getting the customers interested is powerful; but I fear that if customers find a way to access the equivalent of TLF’s large inventory online—coupled with credible reviews from other leathercrafters—Amazon could lure away TLF’s customers with better pricing.  As Bezos famously said, “Your margin is my opportunity.”

The counterargument runs that if this is a major threat, wouldn’t it have happened already?  Amazon has decimated retail for well over a decade.  Yet TLF’s gross margin has only improved over the past decade, mainly due to a shift toward higher-margin retail customers—36% of sales in 2005 vs 58% of sales in 2018.  During the same 14-year period, TLF’s gross margin steadily improved from 57% to 63% (in 2018, TLF’s gross margin was 61%, but excluding write-downs, it would have been 63%).

A respected leathercrafting YouTuber’s (238K subscribers) suggested starter kit provides insight into Tandy’s strong position in the market.  In a video titled, “Top 25 Recommended Leatherwork Tools” with 400K views, leathercrafter Ian Atkinson suggests 25 leathercrafting tools, and a bit more than half are TLF products.  Given that TLF is not the low-cost producer of a number of the products (e.g., cutting mat, thread snippers, turbo lighter, cobbler’s hammer, etc.), >50% share for TLF is an encouraging.  For the list of 25 items, see the following webpage: https://www.ianatkinson.net/leather/toolset.htm.

(4) Disease.  Also, outbreaks of mad cow and hoof-and-mouth disease (or foot-and-mouth disease) in certain parts of the world can influence the price of leather used in TLF’s products.  Since leathercrafting is a hobby, customers may shift away from leathercrafting should the price of leather rise disproportionately.  TLF experienced this situation during the early part of 2001 and believe we managed our leather costs satisfactorily so as not to significantly affect its customers or our profits.  TLF said they accomplished this by anticipating price increases and making additional purchases before the anticipated increases could take effect.

APPENDICES

APPENDIX A: BUSINESS HISTORY: 1919-1999.  If you find business genealogy interesting, TLF won’t disappoint.  If not, feel free to skip this Appendix A: Business History: 1919-1999 section.  Just note that getting store managers to think like owners is core to TLF’s DNA.  Store managers reportedly earn 25% of store EBIT—which is reminiscent of Les Schwab’s “Pride in Performance”, a Munger favorite for illustrating how to drive business success with incentives.

Tandy began in 1919 as the Hinkley-Tandy Leather Company in Fort Worth, TX—where the company is based today.  Back then, the company focused on selling leather for shoe repair.  In 1942, during WWII, the US government bought shipments of leather from Hinkley-Tandy to be used as therapy in hospitals.  Patients, many of them war-wounded, cut their own hides, drew their own patterns, did their own tooling, and turned out slippers, belts, and billfolds.  Tandy founder Dave Tandy envisioned creating a hobbyist leathercrafting market by teaching the art to the public with kits and full instructions.  When Dave Tandy’s son Charles (WWII veteran and HBS graduate) returned home, they opened the first leathercrafting store in 1950 (Hinkley departed), and the business as it is today was borne.

The leathercrafting retail stores generated substantial cash flow.  By 1961, Tandy Leather was operating 125 stores in 105 cities across the US and Canada.  Then, the newly named Tandy Corporation used the strong operating cash flow from the leathercrafting stores to purchase a controlling stake in Radio Shack out of near-bankruptcy in 1962 for a reported $300,000.  Tandy closed RadioShack's unprofitable mail-order business, ended credit purchases, and eliminated many top management positions—meanwhile keeping the salespeople, merchandisers, and advertisers.  Tandy reduced RadioShack’s number of items carried from 40,000 to 2,500, seeking to "identify the 20% that represents 80% of the sales."  Tandy also replaced the large RadioShacks with many "little holes in the wall"—large numbers of rented locations that were easier to close and re-open elsewhere if one location didn't work out.  Most notably, to encourage store managers to think like owners, Tandy required managers to have ownership stakes in their stores—much like how Tandy today reportedly pays a store manager 25% of the store’s EBIT.  RadioShack grew from 9 stores when Tandy purchased it in 1962 to over 7,000 company-owned stores and 1,000 franchises in the 1990s.

Tandy Corporation also became a major player in the nascent personal computer industry, alongside Commodore and IBM—an interesting bit of history that I’ll leave the reader to pursue if interested.  In 1975, Tandy separated into three distinct publicly traded companies, isolating the leathercrafting business of today.

Charles Tandy, the founder of the leathercrafting store model, died in 1978.  Following his death, the history gets a bit complicated, but essentially the company began a gradual shift away from the storefront retailing business in favor of a pure mail-order catalog.  Top executives forced out then-Tandy President Wray Thompson.

Wray Thompson and Ron Morgan still believed in the storefront concept and in the 1980s planted an important seed for the TLF that exists today.  In 1980, the two consulted on a similar venture, The Leather Factory.  Then in 1985, their investment partnership bought out The Leather Factory.  The Leather factory introduced a wholesale club in 1986 and relocated the headquarters to Fort Worth, TX in 1989.  The Leather Factory was productive, publicly listing its stock in 1993 via a reverse merger.  However, The Leather Factory stuck to dominating the wholesale business because Tandy dominated the retail business.  As Wray Thompson put it, “Tandy had 100% of the craft market share… We focused on tools and hardware and never did pure retail.”  Retail sales comprised less than 10% of The Leather Factory’s sales.

APPENDIX B: BUSINESS HISTORY: 2000-2019.  In 2000, The Leather Factory purchased Tandy Leather Company for $3.35M ($2.85M cash + $0.50M debt).  Under post-Charles Tandy leadership—after booting Wray Thompson—Tandy had struggled, gradually closing all its stores in favor of the online and mail-order business.  So, in effect, The Leather Factory purchased the assets, website, customer lists, and Tandy Leather brand.  Wray Thompson commented that when he left Tandy, “It was bringing in $45 million a year in sales.  When I bought them, they were doing $7 million.”  Wray Thompson and the new management named the combined company Tandy Leather Factory (TLF):

“Tandy Leather Company, founded by Charles Tandy and his father, was the first U.S. company dedicated to leathercraft.  As such, we believe that Tandy’s name recognition is the best in the industry.  On the other hand, The Leather Factory has provided over twenty years of stability and predictability that enabled us to purchase Tandy Leather Company several years ago.  In order to accurately reflect the long-term stability of The Leather Factory while at the same time promote the name recognition of Tandy Leather Company, it makes sense to change our corporate name to Tandy Leather Factory, Inc.”

In 2000, the combined TLF had 28 distribution centers in the US and Canada from The Leather Factory and a mail-order/internet business based in Fort Worth, TX from Tandy Leather (no retail stores).  TLF had carefully spread its distribution centers throughout the US and Canada, facilitating fast delivery of leathercrafting goods to over 60,000 customers—including wholesalers, institutions, individuals, distributors, retailers, assemblers, and other manufacturers throughout the world.  The distribution centers, typically utilizing light-industrial warehouse/office space in low-rent areas, also offered in-store “one-stop shopping” for leather and leathercraft materials.  The main Fort Worth, TX facility manufactured suede, garment fringe, leathercraft, and craft-related kits in addition to purchasing products from other manufacturers and distributors in 22 countries.  These facilities continued to operate as they did under The Leather Factory prior to the Tandy Leather acquisition, and TLF has maintained 27-30 of these to today.

In 2000, TLF had no retail stores and Wray Thompson wrote to shareholders, “Our goal is to return [Tandy Leather] to its premier status again.  Will there be Tandy Leather stores again?  It’s too soon to tell…”  TLF then began an aggressive reintroduction of Charles Tandy’s old retail concept.  By 2007, TLF had 72 (opening 14 in 2002, 12 in 2003, 16 in 2004, 8 in 2005, 12 in 2006, and 10 in 2007).  Management used operating profits to expand.  As Wray Thompson put it in 2001, “As we continue the expansion of the Tandy stores, we are committed to two things: (1) we will not sacrifice earnings for the sake of revenue growth and (2) we don’t want to incur additional debt to open stores.”

TLF’s operating business was affected by the financial crisis, with EBIT dropping from $7.1M in 2006 to $4.3M in 2007 and $4.0M in 2008, before rebounding to $7.7M in 2011.  Business performance peaked in 2014, with TLF earning $12M of EBIT on $83M of revenues (14% EBIT margin) across 113 stores ($106K EBIT per store).  Same-store sales increases were 3% and 4% in 2013 and 2014, respectively.  During 2014, the market valued TLF at an average of 8.0x EV/EBIT and 2.0x P/B.

TLF continued to expand to 115 North American stores and 4 International stores (UK (2), Spain, and Australia)—meeting the goal set by management in the early 2000s of 110-120 North American stores.

As discussed in the Why is TLF Cheap? section, reported performance lagged in 2017 and 2018.  TLF produced EBIT of $7M and $4M in 2017 and 2018, respectively—coupled with elevated taxes for repatriating trapped cash (mostly $CAD).  Then the accounting scandal in 2019 plunged the stock price to the point that trades today.

APPENDIX C: MOAT.  At its essence, TLF’s competitive advantage comes from its (1) revered brand, (2) supplier relationships and bulk purchasing power, (3) economies of scale in inventory and distribution, and (4) the retail customer base TLF has developed over decades.

Tandy is the top brand in leathercrafting.  Tandy’s role in leathercrafting history and lore oozes out of the early 2000s annual reports, referencing leathercrafting legends like Al Stohlman who had been a part of Tandy before his death in 1998.  In 2002, then-CFO Shannon Greene noted, “The Leather Factory has bought several independent leather stores, and as soon as the signs outside hanged to ‘Tandy’, sales skyrocketed.”  Leathercrafters know and trust the Tandy name.

TLF benefits from its relationships with 150 suppliers across the globe and its bulk purchasing power as the elephant in the niche North American leathercrafting industry.  TLF has written in its 10-K that it “believes it has a competitive advantage on price in most product lines because it purchases in bulk and has an international network of suppliers that can provide quality merchandise at lower costs.  Most of the Company's competitors do not have the multiple sources of supply and cannot purchase sufficient quantities to compete along a broad range of products. In fact, some of the Company’s competitors are also customers, relying on the Company as a supplier.”  Competitor reliance on TLF as a supplier strongly signals TLF’s purchasing strength.

TLF benefits from economies of scale in its inventory and distribution.  Most of TLF’s competition consists of small, independently-owned businesses—some of which are also TLF wholesale customers.  TLF also competes with some national chains, for which leathercrafting represents a small share of their overall product line.  Thus TLF has no direct competition affecting its entire product line.  Having such scale helps TLF to identify consumer leathercrafting trends to inform purchasing.  By shipping much of the globally sourced inventory to Fort Worth, TX, then distributing the inventory, TLF can ensure proper supply of a broad inventory at each of its stores at a reasonable cost.  This, among other reasons, helps explain why TLF’s international ambitions faltered.  Management has described how a single store in Australia doesn’t benefit from the economies of scale in inventory and distribution like an incremental US store does.  Ultimately, TLF’s economies of scale provide a competitive edge in balancing (a) having enough inventory to minimize out-of-stock situations and (b) the high cash carrying costs associated with high inventory levels.

Most importantly, TLF has created many of its loyal high-margin individual retail customers, one-by-one over decades.  Founder Dave Tandy once noted, “During my younger days, leather tooling was a secret.  It was a closed industry, with the secrets of tooling passed from father to son and jealously guarded.  But now, anyone can learn to tool leather.  We teach them ourselves.  I even write the instruction booklets.”  TLF has maintained this ethos, selling leathercrafting kits and creating customers with in-store classes.  TLF sources customers via schools, hospitals, youth-related groups and camps (e.g., boy scouts), prisoner programs, and other institutions.  As Dave Tandy once put it, “This is primarily a business of education.  We must teach people leathercrafts, thereby making them interested in doing it.”  The upshot to painstakingly creating customers is that they tend to be sticky.

APPENDIX D: CEO INCENTIVES.  TLF hired a new CEO, Janet Carr, in October 2018 and offered her an interesting compensation plan.  TLF pays Carr only $113K in salary but granted her the opportunity to earn 644K restricted stock units.  460K vest over 5 years for serving as CEO.  92k vest if TLF’s operating income exceeds $12M for 2 consecutive years.  Another 92k vest if TLF’s operating income exceeds $14M in a single year.

The size and structure surprise me.  The 460K for being CEO for 5 years equates to 5% of the company (currently 8.9M shares outstanding)—a large share.  At the current stock price, her compensation before incentives (“base compensation”) equates to around $600K/year ($113K + 92K*$5.15 = $587K).  If this writeup pans out, her base compensation approaches $1M/year (e.g., $113K + 92K*$9.00 = $941K).  She then can earn an additional 184K of stock (“incentive compensation”) by meeting the stated operating earnings hurdles.

The board wisely aligned Carr with shareholders by making her salary small and stock ownership large.  Perhaps I am overthinking this, but I fear that (1) the base compensation of $600K/year dwarfs the incentive compensation and (2) the incentive structure may not necessarily provide the right incentives.  The incentive awards comprise only 29% of her potential total award (184K/644K).  But perhaps more importantly, the incentive itself may encourage reckless expansion.  Faced with (a) loads of excess cash and (b) an operating earnings incentive hurdle, the natural temptation is to use the cash to quickly open new stores and boost operating earnings.  Carr has done the opposite so far, indicating on the Q1 2019 call that TLF does not plan to open any new stores in 2019.  In fact, Carr reduced the store count from 120 in Q3 2018 (just before she came on board) to 117 in Q1 2019 and forecasted the closure of additional low-to-negative cash flow stores.  Still, I may have preferred an incentive such as the ROTCE discussed earlier, to acknowledge TLF’s excess cash while also measuring Carr’s performance on a return metric.

Any concerns over the CEO incentive structure do not threaten the overall thesis.  The structure still heavily incentivizes Carr to boost TLF’s stock price.  I applaud her measures so far as CEO: rationalizing inventories (clearly an area of expertise), reducing factory workforce by 75% (not afraid to make tough decisions), shifting wholesale sales from the stores to a capital-light team in “startup mode” (a sensible asymmetric bet), simplifying pricing (all items used to have three price tags for different tiers of customers), and closing stores that lack a path to profitability.  The Q2 2019 and Q3 2019 cash increases reflect her skill.  Still, I wanted to flag for readers the potential flaws of TLF’s CEO incentive compensation structure.

Catalyst

1. The release of revised financials, including unreported Q2 2019 and Q3 2019;
2. The release of TLF’s Q4 2019 financials showing strong free cash flow, since TLF earns big during the holidays and sells down its inventory;
3. Further cash accumulation displaying a trajectory whereby TLF’s cash could equal its market cap within a few years;
4. A potential special dividend unloading the excess cash;
5. Share repurchases at attractive prices, unloading the excess cash (although limited liquidity prevents TLF from repurchasing more than 400K-500K shares per year); and
6. A rush to cover by short sellers (2.7% short interest with 10-50 days to cover, depending on volumes).

(i) RELEASE OF REVISED FINANCIALS.  The October 21, 2019 8-K regarding the forthcoming accounting restatements revealed two important things: (1) TLF’s accounting mishaps are not a big deal (incompetence not mischief); (2) TLF’s performance during the two unreported quarters (Q2 2019 and Q3 2019) appears quite good.

A reader of the 8-K can tell that the CFO struggled with how to properly account for inventory (see Threats section), and the current state of TLF and the economics of TLF remain unaffected.

The other nugget from the October 21, 8-K was updated cash balances that reflected good performance during Q2 2019 and Q3 2019.  TLF’s Q1 2019 cash balance was $17.7M (Q1 2019 10-Q).  The 8-K indicated a Q2 2019 cash balance of $20.3M and a Q3 2019 cash balance of $22.6M.  Those balances reflect increases of $2.6M in Q2 and $2.3M in Q3.  The 8-K also indicated that debt remains at $0.  TLF has not reported Q2 and Q3, so we cannot see the financial statements behind the increase in cash.  Just as in a jigsaw puzzle one might infer from a tree trunk to fill in branches above, we can use the piecemeal information—coupled with our understanding of the nature of TLF’s business—to fill in the blanks.

TLF has two main determinants of free cash flow: (1) net income and (2) change in inventories.  (On net TLF has closed a few underperforming stores recently, and I would expect depreciation to exceed capex by a few hundred thousand dollars per year if TLF does not grow its store count.)  The best-case scenario would be if the healthy Q2 and Q3 cash increases are coming from good earnings performance rather than reductions in inventory—since there is a limit to how much TLF can improve its inventory efficiency.  The Q1 2019 financials revealed the lowest inventory levels since Q1 2015, so I expect most of the Q2 2019 and Q3 2019 cash increases came from good earnings performance.

(ii) Q4 FREE CASH FLOW (HOLIDAYS).  Q4 is TLF’s best quarter.  During 2014-2017 (ignoring 2018 since it was an ugly transition year with substantial write-downs), TLF averaged net sales of $19.6M for Q1-Q3 (each quarter) vs $24.3M for Q4—24% higher in Q4 during the period.  Q4 gross margins suffer slightly because TLF discounts (63.2% Q1-Q3 gross margins vs 60.7% Q4 gross margins during 2014-2017).  Q4 operating expenses only increase slightly to accommodate the massive Q4 sales, causing operating income to increase substantially (71% higher in Q4 than the Q1-Q3 average during 2014-2017).

That’s not even the best part: Q4 inventory reductions generate even more cash.  TLF’s business centers on carrying substantial inventory (recall that TLF turns over its inventory less than 3x per year).  To prepare for the holiday season, TLF typically builds up inventory during Q2 and Q3 (hurting cash flow).  Then TLF sells down its inventory in Q4, bringing in a mountain of cash.  During 2014-2017, Q1-Q3 average EBIT and Net Cash from Operations were $2.1M and ($0.4M), respectively—but $3.6M and $5.9M for Q4, respectively.  The forthcoming Q4 boost to cash (in addition to what we have already seen from Q2 and Q3) will flow to TLF’s balance sheet, making the valuation even more compelling.

(iii) CASH ACCUMULATION.  At this rate, TLF produces enough cash flow that within 4-5 years TLF’s cash could equal its market cap, at the prevailing stock price.  This is even truer if the stock price dives.

(iv) POTENTIAL SPECIAL DIVIDEND.  TLF could soon pay out a massive special dividend.  In 2010, TLF paid a $7.7M special dividend (otherwise TLF would have ended the year with $13.3M of cash); in 2012, TLF paid a $2.5M special dividend (otherwise TLF would have ended the year with $10.2M of cash); and in 2014, TLF paid a $2.5M special dividend (otherwise TLF would have ended the year with $13.2M of cash).  There is ample precedent for special dividends.

It is possible, however, that Board Chairman Jeff Gramm (whose fund controls 32% of shares) is reluctant to pay a special dividend, as I suspect most of his investors are tax-sensitive (like myself).  My understanding is that special dividends are typically taxed as ordinary income.  Please correct me if I’m mistaken.

Still, TLF could potentially pay out an $18M dividend—just over $2.00/share on a $5.15 stock—and still be fair-to-slightly-undervalued.  After paying such a dividend, TLF would have $5M cash remaining—the figure that the former CEO indicated was the requisite amount to comfortably run the business (probably overly conservative but still useful context for this thought exercise).  Then if the business is to earn, say, $5M of earnings going forward (equivalent to an 8% EBIT margin and 25.7% tax rate at the current revenue run rate of $84M—a very conservative normalized EBIT margin when compared with TLF’s 12% average EBIT margin during the 2010-2017 period), a 10x P/E multiple on the $5M of earnings would place the market cap at $50M—above the $46M today.  In other words, TLF can spare to pay out 40% of its market cap via a special dividend, achieve weak EBIT margins relative to history (8% vs 12% during 2010-2017), and still be undervalued.

At these price levels, we can rest assured that Gramm and the board would like to spend as much cash as possible repurchasing shares.

(v) SHARE REPURCHASES.  TLF has demonstrated an appetite for share repurchases at around $7.00/share and below.  Weighted average share repurchase prices are $7.01, $7.06, and $6.79 in 2015, 2016, and 2018, respectively.   In 2017, TLF did not repurchase shares because “the market price was higher than what we were willing to pay for it” (Q4 2017 earnings call)—with the stock rarely falling below $7.50/share.

Relatively low liquidity prevents TLF from being able to repurchase much more than around 500k shares per year (compared with 9.0M diluted shares outstanding).  Since the bottom fell out of the stock during the second half of 2018, management has been aggressively repurchasing 100k-125k shares per quarter; however, I would imagine they had to stop repurchasing shares once they identified the accounting issues.  I suspect the SEC frowns on companies that announce accounting issues then buy out shareholders at depressed prices.

Still, reducing the share count by 5-6% per year—particularly at such depressed prices—is an excellent use of cash and could help serve as a catalyst.

(vi) SHORT INTEREST.  Pressure on short sellers may drive TLF’s stock price higher.  TLF short interest grew dramatically following the disclosure of the accounting issues.

Short interest:

• 5/31/2019: 4,008 Short Interest (0.0%) | 11,357 Daily Volume (1 Day to Cover)
• 6/14/2019: 143,910 Short Interest (1.6%) | 25,963 Daily Volume (6 Days to Cover)
• 8/15/2019: 148,949 Short Interest (1.7%) | 8,908 Daily Volume (17 Days to Cover)
• 9/13/2019: 70,901 Short Interest (0.8%) | 15,222 Daily Volume (5 Days to Cover)
• 9/30/2019: 138,722 Short Interest (1.6%) | 23,429 Daily Volume (6 Days to Cover)
• 11/15/2019: 243,638 Short Interest (2.7%) | 5,411 Daily Volume (45 Days to Cover)

Source: NASDAQ

I believe the shorts are making a mistake shorting TLF based on the accounting issues, but apparently it’s a popular position.  TLF’s accounting issues resulted from incompetence rather than mischief and will not result in material restatements of prior earnings.  TLF management has already indicated that the revenue and cash balance figures are accurate and provided encouraging Q2 2019 and Q3 2019 cash balances (indicating strong earnings).  As discussed in the Valuation section, TLF’s liquidatable balance sheet alone justifies the current market cap.  When the Q2 2019 (unreported), Q3 2019 (unreported), and Q4 2019 (holidays) earnings come in, the LTM EBIT will likely be in the $7M-$10M range (pushing the EV/EBIT to less than 3.6x at current prices), and the shorts will need to cover.  With 10-50 days to cover, depending on trading volumes, the rush to cover could quickly drive TLF’s share price substantially higher.