Sunday, July 7, 2019

Tandy Leather Factory, Inc. (TLF)

Here is a write-up I posted on MicroCapClub last month for those that may be interested in the micro-cap space. But first, please read the relevant disclosure below.

Disclosure: I am the portfolio manager at Sorfis Investments, LLC ("Sorfis") and the separate accounts that Sorfis manages own shares in Tandy Leather Factory, Inc. We may in the future buy or sell shares and are under no obligation to update our activities. This is not a recommendation to buy or sell a security. Please do your own research before making an investment decision.


Tandy Leather Factory, Inc. (TLF)

Ticker: TLF
Price: $5.45
Shares outstanding: 8,934,024
Market cap: $48.7 million
Cash: $17.7 million
Debt: $0
Enterprise value: $31 million

Tandy Leather Factory is a specialty retailer of leather and leathercraft related items. Leather is ~40% of sales, hand tools ~20% of sales, and then there are a bunch of items that make up a single-digit percent of sales (dyes, finishes, glues, hardware, kits, stamping tools, etc.). They are basically a one-stop shop, and by far the largest player in this niche.

They categorize their customers into 2 types: Retail (~62% of sales) and Non-Retail (~38% of sales). Retail customers are individuals that come into their stores and are the end-user. Non-Retail customers are small businesses, youth organizations (Boy Scouts, 4-H, etc.), hospitals, military, distributors, re-sellers, and other similar, non-individual customers.

At the end of Q1, the company operated 117 stores, which are mostly in low-rent, strip mall type of locations. With the closure of the last U.K. store which was planned for this month, there will be 116 stores, with 115 in North America and 1 in Spain. A few more underperforming stores are also expected to be closed as leases expire in the near future.

In Q4 of last year, the company made both a management and strategy change. I think the previous management, which were long-time company veterans, did a good job over the years, but as is often the case, especially in the micro-cap world, put too much emphasis on top-line growth over economically profitable growth. And when cash flow slowed a bit, they started trying new things, such as starting a district manager program, continuing to operate the international stores (which lacked scale) that were unprofitable, as well as some other things which may have been reasonable experiments, but ended up being bad returns on investment (conference sponsorships, opening on Sundays, etc.). More expectations were also put on store managers to get out and try and sell non-retail/commercial business, which took them away from running their stores and providing great customer service to the retail customer base. 

The new CEO (Janet Carr) is focusing more on cash flow. So unprofitable stores will be closed when leases are up. The district manager program has been scrapped in favor zone managers, where 12 district managers have been replaced by 8 zone managers, reporting to 1 retail head manager instead of 2 regional managers. The store managers will also get to spend more time in their stores, as well as new incentives (pay based on cost of living, can now earn overtime, and incentive pay now based on sales, inventory turn, and labor costs instead of just store profit—so that more is in their control). The factory in Fort Worth, which produced about 10% of company product, has been reduced from about 25 employees down to 6, as some of the product it produced can be sourced from cheaper from elsewhere. 

But there is also money being spent on other things in 2019. They’ve hired a few people to focus solely on reaching out to commercial customers. This is potentially an area for growth, as we don’t really know how big this niche market is, but there is now a select, lower overhead group operating out of company headquarters focused on it, instead of having a lot of reliance on store managers to also perform much of those duties. They’ve also hired some other people in Fort Worth to professionalize other departments (marketing, merchandising, human resources, logistics), and are investing in technology that is long overdue to be updated (accounting and POS systems). 

I think there is a lot of uncertainly about how some of these changes may pan out, but I think there’s little downside buying at these levels. Tangible book value is around $6.30 per share the way I calculate it, which should be pretty close to liquidation value given that the inventory does not go bad quickly, and the inventory that was bad (e.g. faded leather that is hard to sell) or slow moving was written down when the new management team came in at the end of 2018 to provide a clean slate.

And while there is investment and some changes happening in 2019, I think—unless they really make some bad capital allocation decisions—the underlying earning power in 2018 should be the minimum level of earning power going forward. Given that I really do think the inventory write-down here can be counted as a one-off expense, and if we add that plus the portion of the previous management severance expensed during 2018, then the after-tax income at a normalized ~25% tax rate going forward would have been around $4.2 million last year. So besides buying it below tangible book value, we’re also getting about an 8.6% after-tax earnings yield (even without backing out excess cash), which I think is likely to grow in the years ahead.

Helping to protect the capital allocation going forward, we also have two former MicroCap Leadership Summit speakers on the board in Jeff Gramm and Brent Beshore. Jeff’s firm, Bandera, owns around 32% of the company. And another board member that runs an investment firm owns a little under 10% of the company.

While it’s often hard to know what actually causes a stock’s price to drop, and it could be coincidence, there is some probability that worries over the tariffs have caused concern among one or more investors with enough shares to move the price. As part of her immersion process into Tandy, Janet Carr mentioned visiting the company’s tanneries in Mexico during the company’s earnings call in March. And then in the week after President Trump’s tweet about the tariffs on Mexico, volume increased in the stock and many shares traded down just slightly above and below the $5 per share range. It may be a coincidence, but I thought it was worth noting, though the company actually gets a little less than 5% of its leather from Mexico (the sources are diversified, but South American countries seem to be the biggest source). And of the $17 million in imports last year, about $2 million were from China (Taiwan was the biggest at around $5 million).

Janet Carr also received restricted shares for joining the company and will receive some extra shares if operating income exceeds $12 million for 2 years in a row and $14 million in one year, which, given the company made $12 million in 2014 and had operating margins in the 12.4-14.4% range from 2012 to 2016, this is a reachable goal—which should certainly make buyers at today’s valuation happy if it is achieved.

Over the next few years, given the company still has a great competitive position and many of the inefficiencies of the past are in the process of being addressed, I think getting somewhere back in the 10-15% operating margin range is likely achievable, and probably within the next 2 or 3 years. So if we assume no growth and the closure of a few more stores, we’d be around $80 million of revenue which, at a 25% tax rate, gets us somewhere in the $6 million to $9 million range of after-tax income, which would give us a very good earnings yield on today’s sub-$50 million market cap, even before backing out excess cash. The company has also paid out a few special dividends in the past, and has been buying back stock. 

What would that cash flow be worth? It’s hard to predict multiples, and I prefer to mostly focus on my downside and earnings yield as a base return. But multiples of small, private businesses with $5 million+ in EBITDA that have a good competitive position, aren’t necessarily growth businesses, but also aren’t too capital intensive tend to sell for 6-8x EBITDA. So assuming a 12.5% operating margin on $80 million of sales, we get $10 million in operating earnings plus about $1.8 million in Depreciation and Amortization, so $11.8 in EBITDA. This would give us a valuation range of $70.8 million to $94.4 million. Assuming 9 million shares outstanding (i.e. buybacks roughly offset extra restricted shares), and $1 per share in excess cash (probably too low), we’d get a valuation somewhere in the $8.85 to $11.50 per share range. 

So in summary, there is uncertainty with how some of the changes will play out, but many of the operational things may be “unrecognized simplicities” that a fresh set of eyes can fix fairly quickly and return the business and operating margins back to where they were a few years ago. If margins get back there, I actually expect it to be with slightly lower gross margins, as the company focuses more on gross margin dollars instead of the percentage, but gains efficiency on the operating costs. All in all, I think it is a potential low downside investment with a reasonable path to doubling over the next 2 or 3 years.

Disclosure: Long