Tandy Leather Factory (TLF) 10-Q2022 Q2 Quarterly report

Tandy Leather Factory, Inc. is one of the world’s largest specialty retailers of leather and leathercraft-related items.  Founded in 1919 in Fort Worth, Texas, and organized in 2005 as a Delaware corporation, the Company introduced leathercrafting to millions of American and later Canadian and other international customers and has built a track record as the trusted source of quality leather, tools, hardware, supplies, kits and teaching materials for leatherworkers everywhere.  Today, our mission remains to build on our legacy of inspiring the timeless art and trade of leatherworking.

What differentiates Tandy from the competition is our high brand awareness and strong brand equity and loyalty, our network of retail stores that provides convenience, a high-touch customer service experience, and a hub for the local leathercrafting community, and our 100-year heritage.  We believe that this combination of qualities is unique to Tandy and gives the brand competitive advantages that are difficult for others to replicate.

We sell our products primarily through company-owned stores, through orders generated from our global websites, and through direct account representatives in our commercial division.  We also manufacture leather lace, cut leather pieces and most of the do-it-yourself kits that are sold in our stores and on our websites.  We also offer production services to our business customers such as cutting (“clicking”), splitting, and some assembly. We maintain our principal offices at 1900 Southeast Loop 820, Fort Worth, Texas 76140.

As of June 30, 2022, the Company operates a total of 105 retail stores.  There are 94 stores in the United States (“U.S,”), ten stores in Canada and one store in Spain.

Tandy Leather has been introducing people to leatherworking for over 100 years.  Our stores have been and continue to be our competitive advantage: where our consumers learn the craft in classes, open table, and from the expertise of our store staff, where they can touch, feel and test the product, and where they can connect and commune with others passionate about leather.  Our website provides inspiration, detailed product descriptions and specifications, educational information and videos, and a convenient place to also purchase product – especially for those who are far from our retail stores, including a growing international customer base.  For many of our retail and web customers, leatherworking evolves from a passion to a trade.  Our commercial division is tailored to the needs of those customers who build businesses around leather.  With dedicated direct account representatives, a direct-from-our-warehouse shipping model, bulk and volume-based competitive pricing, customized product development, and production and pre-production services, we are building long-term, strategic relationships with our largest customers.

Our focus over the last three years has been on three broad strategic initiative areas:

At the time of filing this Form 10-Q, the American and world economies have been acutely affected by a combination of factors arising from both the COVID-19 pandemic and the war resulting from the invasion of Ukraine by Russian military forces. The current impacts of these events include (but are not limited to) levels of inflation that are the highest in the U.S. in more than 40 years, fuel prices at or near record highs, an extremely tight labor market with rising wages and competition to attract qualified workers, supply chain disruption, rising real estate prices and increases in interest rates.  Purchases of non-essential, discretionary products tend to decline in periods of uncertainty regarding future economic prospects, such as the current one, as disposable income declines.  The Company believes that these events have dampened its sales for the first half of 2022.  The future remains uncertain, and continued increased labor, freight, product and other costs as well as weakening customer demand could have a negative impact on the Company’s future financial performance.

A description of our critical accounting policies appears in Item 7 “Management's Discussions and Analysis of Financial Condition and Results of Operations” in our annual report on Form 10-K for the year ended December 31, 2021.

Revenue Recognition.  Our revenue is earned from sales of merchandise and generally occurs via three methods: (1) at the store counter, (2) shipment of product generally via web sales, and (3) sales of product directly to commercial customers.  We recognize revenue when we satisfy the performance obligation of transferring control of product merchandise over to a customer.  At the store counter, our performance obligation is met, and revenue is recognized when a sales transaction occurs with a customer.  When merchandise is shipped to a customer, our performance obligation is met, and revenue is recognized when control passes to the customer. Shipping terms are normally free on board (“FOB”) shipping point and control passes when the merchandise is shipped to the customer.  Sales tax and comparable foreign tax are excluded from net sales, while shipping charged to our customers is included in net sales.  Net sales are based on the amount of consideration that we expect to receive, reduced by estimates for future merchandise returns.

The sales return allowance is based each year on historical customer return behavior and other known factors and reduces net sales and cost of sales, accordingly.  Under our sales returns policy, merchandise may be returned, under most circumstances, up to 60 days after date of purchase.  As merchandise is returned, the company records the sales return against the sales return allowance.

We record a gift card liability for the unfulfilled performance obligation on the date we issue a gift card to a customer.  We record revenue and reduce the gift card liability as the customer redeems the gift card.  In addition, for gift card breakage, we recognize a proportionate amount for the expected unredeemed gift cards over the expected customer redemption period, which is one year.

Inventory.  Inventory is stated at the lower of cost (first-in, first-out) or net realizable value.  Finished goods held for sale includes the cost of merchandise purchases, the costs to bring the merchandise to our Texas distribution center, warehousing and handling expenditures, and distributing and delivering merchandise to our stores.  These costs include depreciation of long-lived assets utilized in acquiring, warehousing and distributing inventory.  Manufacturing inventory including raw materials and work-in-process is valued on a first-in, first-out basis using full absorption accounting which includes material, labor, and other applicable manufacturing overhead.  Carrying values of inventory are analyzed and, to the extent that the cost of inventory exceeds the net realizable value, provisions are made to reduce the carrying amount of the inventory.

We regularly review all inventory items to determine if there are (i) damaged goods (e.g., for leather, excessive scars or damage from ultra-violet (“UV”) light), (ii) items that need to be removed from our product line (e.g., slow-moving items, inability of a supplier to provide items of acceptable quality or quantity, and to maintain freshness in the product line) and (iii) pricing actions that need to be taken to adequately value our inventory at the lower of cost or net realizable value.

Since the determination of net realizable value of inventory involves both estimation and judgement with regard to market values and reasonable costs to sell, differences in these estimates could result in ultimate valuations that differ from the recorded asset.

The majority of inventory purchases and commitments are made in U.S. dollars in order to limit the Company’s exposure to foreign currency fluctuations.  Goods shipped to us are recorded as inventory owned by us when the risk of loss shifts to us from the supplier.  Inventory is physically counted twice annually in the Texas distribution center.  At the store level, inventory is physically counted each quarter.  Inventory is then adjusted in our accounting system to reflect actual count results.

Leases.  We lease certain real estate for our retail store locations and warehouse equipment for our Texas distribution center, both under long-term lease agreements.  Starting in 2019, with the adoption of Accounting Standards Update (“ASU”) 2016-02, Leases (Topic 842), once we have determined an arrangement is a lease, at inception we recognize a lease asset and lease liability at commencement date based on the present value of the lease payments over the lease term.

For our operating leases, the present value of our lease payments may include: (1) rental payments adjusted for inflation or market rates, and (2) lease terms with options to renew the lease when it is reasonably certain we will exercise such an option. The exercise of lease renewal options is generally at our discretion. Payments based on a change in an index or market rate are not considered in the determination of lease payments for purposes of measuring the related lease liability. We discount lease payments using our incremental borrowing rate based on information available as of the measurement date.

We recognize rent expense related to our operating leases on a straight-line basis over the lease term.

For finance leases, our right-of-use assets are amortized on a straight-line basis over the earlier of the useful life of the right-of-use asset or the end of the lease term with rent expense recorded to operating expenses.  We adjust the lease liability to reflect lease payments made during the period and interest incurred on the lease liability using the effective interest method. The incurred interest expense is recorded in interest expense on the Condensed Consolidated Statements of Comprehensive Income (Loss).

The depreciable life of related leasehold improvements is based on the shorter of the useful life or the lease term.  We also perform interim reviews of our lease assets for impairment when evidence exists that the carrying value of an asset group, including a lease asset, may not be recoverable.

None of our lease agreements contain contingent rental payments, material residual value guarantees or material restrictive covenants.  We have no sublease agreements and no lease agreements in which we are named as a lessor.

Stock-based Compensation.  The Company’s stock-based compensation relates primarily to restricted stock unit (“RSU”) awards.  Accounting guidance requires measurement and recognition of compensation expense at an amount equal to the grant date fair value.  Compensation expense is recognized for service-based stock awards on a straight-line basis or ratably over the requisite service period, based on the closing price of the Company’s stock on the date of grant.  The service-based awards typically vest ratably over the requisite service period, provided that the participant is employed on the vesting date.  The total compensation expense is reduced by actual forfeitures as they occur over the requisite service period of the awards.  Performance-based RSUs vest, if at all, upon the Company satisfying certain performance targets.  The Company records compensation expense for awards with a performance condition when it is probable that the condition will be achieved.  If the Company determines it is not probable a performance condition will be achieved, no compensation expense is recognized.  If the Company changes its assessment in a subsequent period and concludes it is probable a performance condition will be achieved, the Company will recognize compensation expense ratably between the period of the change in assessment through the expected date of satisfying the performance condition for vesting.  If the Company subsequently assesses that it is no longer probable that a performance condition will be achieved, the accumulated expense that has been previously recognized will be reversed. The compensation expense ultimately recognized, if any, related to performance-based awards will equal the grant date fair value based on the number of shares for which the performance condition has been satisfied.  We issue shares from authorized shares upon the lapsing of vesting restrictions on RSUs.  We do not use cash to settle equity instruments issued under stock-based compensation awards.

Income Taxes.  Income taxes are estimated for each jurisdiction in which we operate.  This involves assessing current tax exposure together with temporary differences resulting from differing treatment of items for tax and financial statement accounting purposes.  Any resulting deferred tax assets are evaluated for recoverability based on estimated future taxable income.  To the extent it is more-likely-than-not that all or a portion of a deferred tax asset will not be realized, a valuation allowance is recorded.  Our evaluation regarding whether a valuation allowance is required or should be adjusted also considers, among other things, the nature, frequency, and severity of recent losses, forecasts of future profitability and the duration of statutory carryforward periods.  Deferred tax assets and liabilities are measured using the enacted tax rates in effect in the years when those temporary differences are expected to reverse.  The effect on deferred taxes from a change in tax rate is recognized through continuing operations in the period that includes the enactment date of the change.  Changes in tax laws and rates could affect recorded deferred tax assets and liabilities in the future.  A tax benefit from an uncertain tax position may be recognized when it is more-likely-than-not that the position will be sustained upon examination, including resolutions of any related appeals or litigation processes, based on the technical merits.  Income tax positions must meet a more-likely-than-not recognition threshold to be recognized.  We recognize tax liabilities for uncertain tax positions and adjust these liabilities when our judgement changes as a result of the evaluation of new information not previously available.  Due to the complexity of some of these uncertainties, the ultimate resolution may result in a payment that is materially different from the current estimate of the tax liabilities.  These differences will be reflected as increases or decreases to income tax expense and the effective tax rate in the period in which new information becomes available.  We recognize interest and/or penalties related to all tax positions in income tax expense. To the extent that accrued interest and penalties do not ultimately become payable, amounts accrued will be reduced and reflected as a reduction of the overall income tax provision in the period that such determination is made.  We may be subject to periodic audits by the Internal Revenue Service and other taxing authorities.  These audits may challenge certain of our tax positions, such as the timing and amount of deductions and allocation of taxable income to the various jurisdictions.

The following table presents selected financial data:

Consolidated net sales for the quarter ended June 30, 2022 decreased $0.2 million, or 0.8%, compared to the corresponding prior year period.  We believe the decrease in sales was due to continued weaker consumer demand as a result of inflation and ongoing uncertainty related to global political, economic and public health concerns.

Our store footprint consisted of 105 and 106 stores at June 30, 2022 and June 30, 2021, respectively.

Since January 1, 2022, we closed one store in San Bruno, CA in March 2022.  We did not open any new stores for the first half of 2022.  We evaluate a number of factors when determining whether to close existing stores, for example: the 4-wall cash flow trend and longer-term projection for the store, the long-term sales trend, ongoing cost of store operations, date of lease expiration, quality of the store and location, and the size and potential of the trade area including proximity to other existing stores, among other variables.  We use similar factors to determine whether to open new stores.

Gross profit decreased by $0.8 million, or 6.9%, compared to the same period in 2021, and our gross margin percentage for the quarter ended June 30, 2022 decreased to 57.0% compared to 60.8% in the corresponding prior year period.   The lower gross margin rate was due to a combination of factors, including product and customer mix shifts and higher costs for product, warehouse handling and freight that we began to see as early as 2021, but are now flowing through cost of sales. Due to our use of the FIFO method of valuation of inventory and our relatively low inventory turns, increases in product-related costs, including product itself, warehouse handling costs, and freight will not flow through to cost of sales immediately; there will be a lag in the impact of these increased costs on our gross margin.

Operating expenses increased $0.7 million or 6.4% compared to the corresponding prior year period, mostly as a result of increases in recurring payroll related costs for stores and corporate of $0.5 million, driven largely by wage increases for retail, travel and conference expense of $0.2 million primarily related to our store manager conference in April 2022, service related expenses in the areas of product logistics, tax services, internet and software costs of $0.3 million, digital marketing expense of $0.1 million and other expenses of $0.2 million, partially offset by decreases in performance based compensation of $0.5 million and restatement related costs of $0.1 million.  Adjusted operating expenses, which excludes the non-routine items related to the restatement, increased $0.8 million or 8.2% for the reasons noted above.  Adjusted operating expenses excluding non-routine items as shown above is a non-GAAP measure, included here to provide additional information regarding the Company’s financial performance on a recurring basis.  Non-routine items are primarily legal and accounting costs associated with the restatement.

Our effective tax rate for the three months ended June 30, 2022 was (23.2%) compared to 22.5% for the same period in 2021.  Our effective tax rate differs from the federal statutory rate primarily due to U.S. state income tax expense, expenses that are nondeductible for tax purposes, the change in our valuation allowance associated with our deferred tax assets, and differences in tax rates in foreign jurisdictions.

The following table presents selected financial data:

Consolidated net sales for the six months ended June 30, 2022 decreased $1.1 million, or 2.6%, compared to the same period in 2021.  We believe the decrease in sales was due to continued weaker consumer demand as a result of inflation and ongoing uncertainty related to global political, economic and public health concerns, coupled with comparison to prior year COVID-era stimulus payments that fueled sales.

Since January 1, 2022, we closed one store in San Bruno, CA in March 2022.  We did not open any new stores for the first half of 2022.  We evaluate a number of factors when determining whether to close existing stores, for example: the 4-wall cash flow trend and longer-term projection for the store, the long-term sales trend, ongoing cost of store operations, date of lease expiration, quality of the store and location, and the size and potential of the trade area including proximity to other existing stores, among other variables.  We use similar factors to determine whether to open new stores.

Gross profit decreased by $1.0 million, or 4.4%, compared to the same period in 2021, and our gross margin percentage for the six months ended June 30, 2022 decreased to 57.7% compared to 58.7% in the corresponding prior year period.  The lower gross margin rate was due to a combination of factors, including product and customer mix shifts and higher costs for product, warehouse handling and freight that we began to see as early as 2021, but are now flowing through cost of sales. Due to our use of the FIFO method of valuation of inventory and our relatively low inventory turns, increases in product-related costs, including product itself, warehouse handling costs, and freight will not flow through to cost of sales immediately; there will be a lag in the impact of these increased costs on our gross margin.

Operating expenses increased $0.6 million or 2.6% compared to the corresponding prior year period, mostly as a result of increases in recurring payroll related costs for stores and corporate of $1.1 million, driven largely by wage increases for retail, stock compensation expense of $0.2 million, travel and conference expense of $0.3 million primarily related to our store manager conference in April 2022, service related expenses in the areas of product logistics, tax services, internet and software costs of $0.3 million, depreciation expense of $0.1 million, supplies and office expenses of $0.1 million and other expenses of $0.2 million, partially offset by decreases in performance based compensation of $0.9 million and restatement related costs of $0.8 million.  Adjusted operating expenses, which excludes the non-routine items related to the restatement, increased $1.3 million, or 6.5%, for the reasons noted above.  Adjusted operating expenses excluding non-routine items as shown above is a non-GAAP measure, included here to provide additional information regarding the Company’s financial performance on a recurring basis.  Non-routine items are primarily legal and accounting costs associated with the restatement.

Our effective tax rate for the six months ended June 30, 2022 was 26.3% compared to 22.8% for the same period in 2021.  Our effective tax rate differs from the federal statutory rate primarily due to U.S. state income tax expense, expenses that are nondeductible for tax purposes, the change in our valuation allowance associated with our deferred tax assets, and differences in tax rates in foreign jurisdictions.

We require cash principally for day-to-day operations, to purchase inventory and to finance capital investments.  We expect to fund our operating and liquidity needs primarily from a combination of current cash balances and cash generated from operating activities.  Any excess cash will be invested as determined by our Board of Directors in accordance with its approved investment policy.  Our cash balances as of June 30, 2022 totaled $5.6 million. 

During the second quarter of 2020, the Company borrowed $0.4 million from Banco Santander S.A. under the Institute of Official Credit Guarantee for Small and Medium-sized Enterprises in order to facilitate the continuation of employment and to attenuate the economic effects of the COVID-19 virus.  This loan was provided for by the Spanish government as part of a COVID-19 relief program.  During the second quarter of 2022, we repaid this loan in full.

On August 9, 2020, the Board of Directors approved a new program to repurchase up to $5.0 million of its common stock between August 9, 2020 and July 31, 2022, subject to the completion of our financial restatement and the filing of all delinquent filings with the SEC.  The Company's previous share repurchase program expired in August 2020.

On April 11, 2022, we entered into an agreement with two institutional shareholders of the Company, to repurchase 359,500 shares of our common stock, par value $0.0024 in a private transaction. The purchase price was $5.00 per share for a total of $1.8 million. The closing of the repurchases took place on April 22, 2022, and these shares were subsequently cancelled. Prior to the repurchase, the shares represented approximately 4.2% of our outstanding common stock.

On December 8, 2021, we entered into an agreement with an institutional shareholder of the Company, to repurchase 212,690 shares of our common stock, par value $0.0024 in a private transaction. The purchase price was $5.00 per share for a total of $1.1 million. The closing of the repurchase took place on December 16, 2021, and these shares were subsequently cancelled. Prior to the repurchase, the shares represented approximately 2.4% of our outstanding common stock.

On January 28, 2021, we entered into an agreement with an institutional shareholder of the Company, to repurchase 500,000 shares of our common stock, par value $0.0024 in a private transaction separate from our share repurchase program. The purchase price was $3.35 per share for a total of $1.7 million. The closing of the repurchase took place on February 1, 2021, and these shares were subsequently cancelled. Prior to the repurchase, the shares represented approximately 5.5% of our outstanding common stock.

For the six months ended June 30, 2022, cash from operations used $1.8 million driven by a net investment in inventory of $2.1 million, a reduction in lease liabilities of $1.7 million, income tax payments mostly related to the 2021 tax year of $0.9 million and net prepaid expenses of $0.6 million, partially offset by net income of $0.1 million, non-cash expenses of $2.8 million, including depreciation, amortization, and stock-based compensation, a net increase of $0.4 million in accounts payable and accrued expenses, a net decrease of $0.2 million in accounts receivable and other changes in operating assets and liabilities.  We invested $0.5 million in capital expenditures primarily related to system implementations.  Cash used in financing activities was primarily due to the purchase of 359,500 shares of our common stock for $5.00 per share, or $1.8 million, from two institutional shareholders of the Company in a private transaction.  We also paid off our loan with Banco Santander S.A. in Spain for $0.4 million during the second quarter.  The activities above, in addition to the effect of exchange rate changes, resulted in a net decrease in cash of $4.6 million.

For the six months ended June 30, 2021, cash from operations used $2.8 million driven by the net buildup of inventory of $4.8 million, a reduction in lease liabilities of $1.7 million, and a net decrease of $1.0 million in accounts payable and accrued expenses, partially offset by net income of $1.3 million, non-cash expenses of $2.6 million, including depreciation, amortization, and stock-based compensation, a federal income tax refund of $1.0 million related to the 2019 tax year, and other changes in operating assets and liabilities. We invested $0.2 million in capital expenditures primarily related to system implementations. Cash used in financing activities was primarily due to the purchase of 500,000 shares of our common stock for $3.35 per share, or $1.7 million, from an institutional shareholder of the Company in a private transaction. The activities above, in addition to the effect of exchange rate changes, resulted in a net decrease in cash of $4.6 million.

As part of the filing of this Form 10-Q for the period ended June 30, 2022, our management, with the participation of our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), evaluated the effectiveness of the design and operation of our disclosure controls and procedures as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”).  As a result of this evaluation, our CEO and CFO concluded that our disclosure controls and procedures were not effective due to the material weaknesses described below.

Our management, including our CEO and CFO, is responsible for establishing and maintaining adequate internal control over our financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act. Management’s establishing and maintaining adequate internal control over financial reporting is based upon the criteria established in Internal Control-Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (the “COSO Framework”). A system of internal control over financial reporting should be designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with GAAP.

An effective internal control system, no matter how well designed, has inherent limitations, including the possibility of human error, the circumvention or overriding of controls, or fraud, and therefore can provide only reasonable assurance with respect to reliable financial reporting. Because of its inherent limitations, our internal control over financial reporting may not prevent or detect all misstatements.

A material weakness is defined as a deficiency, or combination of deficiencies in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of our annual or interim financial statements will not be prevented or detected on a timely basis. Based on this definition, our management, with the participation of our CEO and CFO, evaluated the effectiveness and design of our internal control over financial reporting against the COSO Framework and concluded that our internal control over financial reporting was not effective as of June 30, 2022 due to material weaknesses arising from flaws in our control environment, risk oversight measures, control activities, information processing and communication and our monitoring systems, each of which is described in more detail below.