Why Tandy Leather is inexpensive with a large margin of safety
Tandy Leather Factory Inc. (TLF, Financial) compounded intrinsic value for years, posting a decade of positive free cash flow and net income. Consistent positive financial results contrast with a falling price-enterprise value, making it an intriguing value pick.
Tandy's tangible book value increased 131% from a 2010 year-end balance of $2.78 per share to its most recent balance of $6.42 per share. Tandy's book value was driven higher by a $39.76 million increase in retained earnings from the December 2010 balance of $26.43 million to the most recent report in March of $66.19 million. Further, $34.95 million in free cash flow was generated between December 2010 and March 2019.
During this value-creating period from 2010 to the end of the first quarter, the enterprise value per share decreased 26.8%. Enterprise value per share was $4.48 for the period ending December 2010 compared to the first-quarter balance of $3.28 per share. The market price per share dropped 4.62% from $4.72 at year-end 2010 to Friday's closing price of $4.50.
Tandy Leather is an Amazon (AMZN)-resistant storefront retailer. The customers want to touch, smell and feel its products, and it offers in-store classes and hands-on help from a skilled staff. Ten years of increasing book value and positive high free cash flow margins are the real measures of its resistance to Amazon.
Its CEO since 2018, Janet Carr, has delivered tangible improvements and updates to investors about rational strategic initiatives to drive long-term earnings growth in her short tenure. More about her below in the first-quarter earnings call commentary.
Management owns 42.20% of the company's shares outstanding. Board member and value investors Jeff Gramm of Bandera Partners has 2,859,338 shares or 32% at an average price of $8.44. Board member James Pappas of JCP Investments has 860,998 shares or 9.64% shares outstanding at an average purchase price of $7.70.
Tandy Leather Factory is an illiquid (286 shareholders) micro cap and a specialty physical store retailer in the dying niche of leather crafting. Conversely, I see a consistently profitable, ignored and oversold opportunity, driven by a new CEO with a board of strategic capital allocators. Tandy sells leather, leather crafts and related supplies in 42 states, seven Canadian provinces and 115 North American stores. Spain is the only remaining location outside North America.
The low valuation alone would be sufficient due diligence to invest in Tandy. However, the prospects are enhanced with the new CEO Janet Carr, as discussed below.
First quarter 2019 conference call commentary.
Carr developed two different business models for commercial and retail customers. The infrastructure, processes, personal talent and system resources are built. The strategy, "The How-To," focuses on making it all happen while maximizing economic returns. This strategic process will re-establish brand credentials, develop a compelling leather crafting retail experience and offer improved deals to entice business customers.
Pricing is a customer concern due to its lack of transparency. But "Everyday Honest Prices" were phased in during the prior two months. This policy simplifies previously complex and confusing price tiers. Now, pricing is transparent to customers and prices are more competitive for every customer.
A commercial division was introduced with competitive pricing based on comparative wholesale competitors. Further, a reseller license agreement helps support brand and price integrity. The new pricing program launched with a complete marketing campaign, including in-store, direct mail, digital, social and personal outreach to their largest customers. The longer-term expectation is increased sales, gross margin dollars and brand image. The goal is to increase total customer spending and entice old customers back.
The second significant initiative is targeting the largest commercial customers. These customers need products not carried in retail stores but that can be quickly sourced -- a consistent supply is required with multiple shipping options. Larger customers moved from a retail store relationship to a commercial account representative. Further, a dedicated operations manager controls leather choice, order management and selling support. Management reports positive customer feedback.
Management is appraising the cash flow performance of stores as a critical metric in developing their store fleet. Bonus targets are set for inventory turns. However, exploiting inventory opportunities requires merchandise planning capabilities. Currently, these tools are unavailable.
Unfortunately, the factory workforce was reduced by 75% because they were not justified at current business levels -- management is evaluating lower-cost outsourced options. A senior leader is now overseeing the merchandising and commercial functions.
Financial commentary from the first quarter 2019 earnings call provides additional color for current and future value
Strategic progress realized during first quarter 2019 included rightsizing the store fleet. Three underperforming stores closed, though sales year-over-year improved 2.40% with the launch of a new sewing machine, adding $500,000 in new sales. The higher clearance and promotional activities improved revenue. However, revenue performance was also improved by liquidated inventory during the Australia store closing.
Gross profits declined, and operating income fell 34% as strategic progress continues. The new operating model may continue to negatively affect results for 2019. The promotional events during the recent quarter with its unfavorable customer-product mix and higher freight costs produced a $400,000 decline in gross profit. There were additional one-time expenses of $155,000 related to closing three underperforming stores, $100,000 related to eliminating corporate positions and a $156,000 for non-cash share-based compensation. As mentioned in the prior earnings call, 2019 will be a year of significant investment, and these investments are needed for long-term income growth.
During the first quarter, debt was fully repaid, forcing an interest expense reduction of $33,000 compared to the prior quarter. The steady, healthy cash flow from operations continues. Cash flow for the quarter was $3 million, driven primarily by the $3.3 million reductions in inventory. This reduction in inventory resulted from three store closures this quarter and efforts to clear out damaged and excess inventory. Outstanding debt of $9 million was paid, and the company repurchased $714,000 of outstanding shares. These actions brought cash to a strong balance of $17.68 million.
Below are additional decision-making data in two tables.
Risk: There is some danger that sales stagnate as the leather crafting niche continues to shrink. Also, there could be difficulty finding skilled labor and higher associated payroll costs, coupled with the increasing cost of maintaining a retail storefront. Future competition and inventory expansion could come from existing hobby and craft stores.
Opportunity: Shareholder-friendly, value-enhancing corporate action such as going private or a sale if profitable growth or market fails to fairly value. Time is on the side of Carr because the company has a strong balance sheet and cash flow. Financial strength will facilitate the full implementation of its corporate strategy. Additionally, it can afford a special dividend, continued share buybacks and the continued slow compounding of intrinsic value. Absolute, relative and historical valuation is deeply discounted and will not go unnoticed forever. You can't ask for a better shareholder-friendly board and CEO in terms of optimal capital allocation decisions.
In conclusion, Tandy Leather Factory offers a large margin of safety and is deeply discounted in this overpriced market. Price alone would be compelling enough. But the investable opportunity is enhanced with the addition of Carr. Additionally, investors can wait for market recognition, mean reversion or longer-term favorable corporate action.
Disclosure: Long Tandy Leather Factory
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