Description

What the Market Sees: Tandy Leather Factory (TLF) is an unknown, boring, bricks-and-mortar, low-tech retailer operating in the dying industry of leathercraft. Weak sales trends, poor capital allocation, and relative obscurity would lead most investors to say “pass”.    

What I See: TLF is the market leader in an Amazon-resistant niche of specialty retail with a very loyal following from leathercraft hobbyists. Revenue was down (-1.5%) in 2016 but by no means in free-fall, and recent management actions could revive organic growth in 1-2 years. The business model is very profitable, with gross margins >60%, EBIT margins >12.5% and healthy FCF, trading at 6.3x TTM EBIT, 11.6x TTM EPS (10x Ex-Cash).  You have protection to the downside by the fact TLF is overcapitalized with a net cash balance equal to ~12% of the market cap, and mgmt bought back 9% of the shares outstanding over the past 1.5 years. Lastly, a newly board member just bought ~8% of the company in the open market over the past 4 months, and his firm has a very profitable history of selling retail companies to strategic buyers at a premium after he joins their board. Most investors probably don’t even know this company exists as they have only ~300 shareholders of record.

Summary Business Description (Shamelessly lifted from the 2016 10K)

We are the leading specialty leathercraft retailer with a wide product breadth and a long history of leathercraft expertise. Our broad line of leather and related products include leather, leatherworking tools, buckles and adornments for belts, leather dyes and finishes, saddle and tack hardware, and do-it-yourself kits. We also manufacture leather lacing and some of our do-it-yourself kits.

At December 31, 2016, we operated 27 stores located in North America operating under the Leather Factory name and 84 stores located in North America operating under the Tandy Leather name, and four combination wholesale and retail stores operating under the Tandy Leather Factory name in the United Kingdom, Australia and Spain.

Tandy Leather Factory, Inc. and our subsidiaries operate in three operating segments as follows:

Wholesale Leathercraft – 24 US stores and 3 Canadian stores

Retail Leathercraft – 77 US stores and 7 Canadian stores

International Leathercraft – 2 UK stores, 1 Australian store and 1 Spanish store

We intend to expand the Tandy Leather retail store chain from the 84 stores open as of December 31, 2016 to between 120 and 150 stores throughout North America as it makes financial sense.

Recent Financial History

Why Does this Opportunity Exist?

Weak Recent Retail Sales: Retail stocks, particular bricks-and-mortar, are out of favor now and top-line growth at TLF has decelerated for the past few years with new store growth slowing.

Relatively Unknown Stock:  It’s safe to say the stock is not on the radar of most investors. According to the 2016 10-K, TLF had approximately 306 stockholders of record as of March 22, 2017. It has no sell-side analyst coverage, and quarterly earnings calls often have only 0-1 questions asked during the Q&A sessions (mostly from private investors).

Microcap Size: TLF’s market cap of <$75 million and average daily liquidity of <$500K make this investment applicable only for PA’s or micro-cap investors.

Levers for Operating Improvements

The current CEO, Shannon Greene, is relatively new in her tenure (was former CFO) and I believe there is a legitimate sense of urgency to turn things around. (The last CEO, Jon Thompson, resigned in Feb 2016 with no explanation which probably means he was fired.)

If you read past conference calls, there was a general sense they did not have a very good handle on the reasons the business has been slowing down over the past few years. They mostly stuck to vague retail-industry excuses about “cautious discretionary spending from consumer”. What I believe most likely happened, is that reality struck that they are a niche retailer in a low-to-no grow industry of leathercraft, which is likely dominated by hobbyists. To their credit, given the tactile nature of the product, I believe TLF is one of the few retail concepts insulated from Amazon because customers like to come into the store and touch and feel the merchandise. Plus, their stores create an “experience” for consumers with in-house tutorials and a workforce well-versed in leathercraft (they can’t just hire anyone off the street).

In the past, management spoke of trying to find improvements that did not require more money. This is no longer the case. TLF has called 2017 “A Year of Investment” (Source: March 2017 Investor Pres), which to me signals a change in mentality that they finally have to go on offense to reverse their weak performance. TLF has a number of levers which they can pull to increase SSS.

According to the company, they think it is not unreasonable to assume they can get SSS to grow in-line with GDP (~1% - 3%), with additional growth from opening at least 3-4 new stores per year. I will outline here a few of the operational changes that have been made in the last 6 months that could lead to a stronger 2018 and beyond.

New Store Openings to Accelerate: Recent SSS trends have been weak (zero to low-single digit declines) with few new store openings the past two years (0 in 2015 and 2 in 2016) with a current base of 84. Going forward they are committing to doing at least 3-4 new stores/year.

“A Year of Investment” & District Restructuring: Read the latest earnings report, and you can see the company is doing more to promote the leathercraft hobby to a wider audience. TLF is adding headcount to increase their social media presence and stepping up their hobby/trade show game. They recently restructured their network of regional managers to allow them to better manage the business. Before, RM’s had the difficult task of managing/visiting 20-25 stores in their region. Now their workload will be reduced to overseeing 6-10 stores. According to the company “Under the old footprint, our regional managers were busy putting out fires,” With a smaller footprint they can give more care to driving foot traffic at individual stores. (Note – Workers bonuses are compensated based on individual store performance).

Increasing store hours: Upon careful reading of the 10K, stores are only open 6 days of the week (closed Sundays); 9am – 6pm M-F and 9am – 4pm on Saturdays. I believe it is low-hanging fruit to starting opening the stores on Sundays. I do not have a strong view yet as to quantify this upside. Of course, there would be some cannibalization of Mon – Sat sales. However, it seems like common sense that a store for hobbyists, particularly for those that need to see and feel the product in person, would be better to do on weekends. The company has NOT mentioned longer retail hours publicly, but when speaking the company, it was readily clear that they are very seriously considering adding retail hours. To keep payroll costs down, they would most likely shave some early hours off other days, and shift them to Sunday. (E.g. If they open at 10 am instead of 9am M-F, that would give them at least 5 hours to add to Sunday)

To be clear here, I am NOT suggesting this is going to morph into a high-growth retail concept. I believe these 2016-2017 changes are intended to juice growth back to the low-to-mid single digit range. Showing signs of any organic growth would help the “story” for when I ultimately believe the company will eventually be sold.

Potential Catalysts for Stock Re-Rating

*Potential* for Activism by Newest Board Member: Less than 1 year ago (June 2016), James C. Pappas was invited to join the TLF Board of Directors as an Outside Director. Pappas is the leader of JCP Investment Management, a Houston-based fund with a solid track record of shareholder activism with regards to U.S. retail/restaurant companies. Since joining, he has amassed an approx. 8% position in the stock, immediately making him the 2nd largest shareholder. What gets even more interesting, is that the largest shareholder is Bandera Partners, another value/activist hedge fund who has been in the name for number of years and has a ~31% position. (Fun fact – TLF’s Institutional Ownership of ~67% is the largest for any public company under $100M market cap).

Large Insider Purchases at Current Prices: What initially drew me to TLF was when I noticed Mr. Pappas building a ~8% position in the stock, through a series of 8 open market purchases between December 2016 and April 2017. While there a million reasons why an insider might sell a stock, there is typically only one reason to buy; they think it is undervalued. (Note to reader – TLF has no requirement that Directors hold stock; this was totally voluntary). His weighted average purchase price was ~$7.41, which is very close to today’s prices.

There’s a saying that goes, “History doesn’t repeat itself, but it does rhyme.” If you spend some time researching JCP’s recent track record, they have a pattern of pushing for changes at retail/restaurant companies that eventually culminate with a sale of the company. There are hints of this in Mr. Pappas’s corporate bio on the TLF website. A few excerpts:

“He served on the board of directors of The Pantry, Inc., the largest independently operating convenience store chains in the U.S. from March 2014 until it was acquired in February 2015.” (11 months until company sold)

“Pappas also served on the board of directors, including Chairman of the Board, of Morgan's Foods from February 2012 until it was acquired in May 2014.” (2 years, 3 months until company sold)

Here are a few other investments by JCP not mentioned in the TLF bio:

Casella Waste (Sep-2015): JCP acquired a 5.7% stake in CWST, and published an open letter to the Board of Directors highlighting concerns with the company’s underperformance and poor corporate governance and asking for new Directors. I won’t get into all the back-and-forth here, but by Nov-2015 (2 months later), JCP announced just days in advance of CWST’s annual meeting that it was withdrawing its competing slate of directors. "We are gratified to have served as the catalyst for these positive first steps in the right direction and are inclined to give the new board a chance to deliver on its promises to shareholders,” James Pappas said at the time.  Now in fairness, Casella claimed that the strategic changes they made were underway before JCP ever got involved. Regardless of who is right here – CWST ended up massively outpacing the market. The stock has gone from $6.44 - $14.15, so +120% (Sept 10, 2015 – Apr 18, 2017), vs. +20% for the S&P 500.

CST Brands (Dec-2015): JCP acquired a stake in CST Brands, and published an open letter arguing that the risks to achieving the company’s 2020 plan was outweighed by the value of selling to a strategic buyer. On Aug 22, 2016 it was announced CST Brands was sold to Alimentation Couche-Tard Inc. CST stock went from $38.86 - $47.45, so +22% (Dec 22, 2015 – Aug 22, 2016), vs. +7% for the S&P.

Fiesta Restaurant Group (Sep-2016): JCP revealed a 6.2% stake in FRG, and said it believed “significant operational and strategic opportunities are available to the issuer to enhance stockholder value,” This saga is still ongoing, but as of April 12th (6 days ago), JCP sent another letter saying they raised their stake to 8.7%, and are trying to change the Board. (We will see how this goes, but I think you get the idea by this point…)

I believe the fact pattern here strongly implies that: A) the newest Director and 2nd largest shareholder believes the company to be undervalued, and B) TLF could be a takeover target at some point in the next few years. Said another way – there are limited options for these value/activist funds to exit their concentrated positions in such a microcap and illiquid stock, further raising the probability that the company will need to be sold outright at some point.

Other Potential Catalysts (Timing Unkown)

Return to SSS Growth: A return to organic growth would be a natural catalyst I expect to happen first. As sales increase, off of a larger store base, operating leverage would be high for a bricks-and-mortar retailer with gross margins > 60%.

Foreign Cash Repatriation/Tax Holiday: According to IR, ~50% of TLF’s $16.9M cash balance ($8M) is held overseas and thus not readily for usage in the U.S. In the event Washington passes legislation allowing companies to repatriate their cash in a tax-efficient manner, this cash could be used for growth initiatives or (mostly likely) returned to shareholders through either a special dividend or share repurchases. To put things in context, back in 2004 Congress enacted a tax holiday allowing repatriation of foreign profits at roughly ~5% tax rate. Assuming a potential tax range of 5% - 10%, that would free $7.6M - $8M ($0.82 - $0.86 per share) or 10%- 11% of the current market cap.

Valuation: As mentioned above, today the company is trading at 11.6x TTM EPS (10x Ex-Cash), and 6.3x TTM EBIT. Given the increase in investment for 2017, guidance for 2017 is for Sales of $84M - $85M, and an EPS of $0.56 - $0.58 (assuming a flat share-count). That gets you to an implied forward multiple of 13.7x – 14.2x ’17 EPS (12x - 12.4x Ex-Cash). For 2017, EBIT margins will take a hit, declining from 12.4% last year to ~10% next year. If the company can get some organic growth, using not-heroic assumptions, I can see them doing $90M+ in sales, and getting to an EPS range of $0.70 - $0.80. Using today’s forward multiples of 13.5x – 14.5x EPS, that gives you a valuation range of $9.45 - $11.60. Add in excess cash of $0.82/share (after repatriation tax) that gives you $10.27 – $12.42, for a potential upside of 29% - 56%. I’ll let you come up with your own assumptions for a take-out scenario, but the LBO math here is very, very easy to see how it could be a very profitable take-private or acquisition.

Downside Risks

Given the operating leverage of a bricks-and-mortar business with high-fixed costs, I would be concerned if SSS declines were to accelerate. That would cause me to change my mind. However, as mentioned above, the Company has been shown to be willing to put their money where their mouth is, as they have been strong buyers of their own stock at $7 and below; levels only (-12%) lower than today. Conversely, should the situation deteriorate I think that would only hasten the sale of the company, which I believe to be inevitable at some point. When I spoke with the company, even they had to admit that they did not have a good reason to be public.

Catalyst

I see the potential catalysts as: 1) Improvement in organic growth, 2) Potential activist play by newest board member, 3) Tax reform, 4)Take-private or sale to strategic