Tandy Leather Factory (TLF) – a cheap business with a path to a decent return
Some great resources have been devoted to covering Tandy Leather Factory (disclosure: no position) on places like Microcap Club, as well as various blogs and podcasts. The consensus seems to be that this is a ‘Buffett-like’ business – slow growth, predictable, consistently profitable, slow to change, strong competitive advantage in a niche market – in the microcap space, capable of delivering a decent return moving forward with decent downside protection and an incentivized management team/board capable of closing any valuation gap.
Key Investment Highlights
For a niche retailer, Tandy possesses a pretty dominant competitive positioning, and remains the only place in leather crafting with the large amount of SKUs as well as workshops where people can touch, see, feel and learn about the product
There is a new management team in place, and the board consists of the guy who literally wrote the book on activism, already implementing positive changes, operational and in terms of capital allocation
Tandy is using cheap debt to repurchase shares, will do it again if the price keeps dropping
They also have a history of paying out special dividends, although this can’t be relied on as a source of return (despite the excess cash)
Operating infrastructure changes much better align incentives to grow store base and sales numbers – taking care of their people. Tandy is still committed to growth
Cheap valuation, less than 8x EBIT, 20%+ free cash flow yield (on depressed numbers), with potential for buybacks, future operating income growth and dividends
I don’t have much differentiated insight to contribute, other than some notes on the business turnaround/growth efforts, so I will likely keep this to a simple, higher level overview of the business and opportunity. I’ve posted the resources below.
Tandy Leather Factory is a specialty retailer of leather and leathercraft related items. Tandy is the largest specialty leather retailer of its kind, with 2018 sales of $83mm, and [depressed] operating income in the range of $4.5mm (annualizing Q1 numbers). The business has seen its growth stall in addition to the halting of new store openings since 2015-2016, and is currently attempting to right the ship by investing some of their strong margins into operational improvements to help spur growth.
Tandy operates one segment, their US segment, and sells to two aggregated customer groups, retail (made up of consumers and individuals) and non-retail (made up of re-sellers, distributors and businesses). Retail makes up 62% of Tandy’s business, while non-retail covers the remaining 38%. In terms of leather craft retailing (how’s that for a niche business?), Tandy has about as strong of a competitive advantage as you could find, absolutely dominating the industry due to their size, scale, buying power, and being able to serve as the preferred supplier for their much smaller competitors. The company has an incredibly resilient business model, growing sales through the financial crisis, and maintaining a strong top-line over the last five years despite the on-going retail apocalypse and industry disruption.
So how have they been able to achieve this?
The actual hobby of leather crafting is over 100 years old, dating back to before WWII, and has been slow to change, with one dominant player (Tandy) emerging from this period, and I’d estimate hundreds of single-store mom and pop shops. Tandy has a has a long and interesting history dating back to 1919 (which I’m not going to get into), and now operates 115 stores, of which 114 are in the US, and 1 overseas.
The business of leathercrafting and selling leather (a commodity) doesn’t possess any inherent competitive advantages, and as a retailer this is true for Tandy as well (the business earns low gross margins on raw leather sales), however, a large national presence, a focus on leather goods and accessories (as opposed to leather as an ancillary product) a large number of SKUs, and purchasing advantages provide Tandy with an interesting competitive advantage and market share leadership within their niche. While I haven’t been able to find any good market share data, I’d estimate that Tandy’s share is above 90%, and most likely 10-15x the size of their next largest competitor.
Furthermore, retail disruption risk (aka Amazon) may be limited due to the nature of the business, as customers may prefer to sample the look and feel of leather and leather goods before purchasing, and be guided by a salesperson/customer service associate (similar to buying an instrument or maybe a set of tools).
In addition, Tandy has an incredibly entrenched position within the industry as both a purchaser of leather and leather related products, as well as a supplier for competitors. This is where the existing moat becomes interesting. During due diligence, I was not able to find a competitor who is not also a customer of Tandy’s. Whenever a business is competing with its peers in selling to end customers, but those peers also depend on that business, you’ve got a potentially attractive setup. Tandy’s size, number of SKUs, experience and purchasing power advantages result in a strong moat for the majority of their business (selling leather has no competitive advantages, but leather makes up less than 25% of Tandy’s profits).
So Tandy’s long operating history and purchasing power has led to higher than normal gross margins for a retailer (consistently in the 58-62% range), and the combination of high gross margins and low capital investment has allowed Tandy to earn pre-tax returns on capital of 30% for long periods of time, while funding store expansion and operations with internally generated cash flow. In addition, Tandy’s balance sheet is very strong, with no debt and a large net cash position.
So what do we have here? Tandy is a statistically cheap turnaround story that appears likely to revert to the mean following declining operating performance and a large drop in the share price. Given the strong balance sheet and ample downside protection in the form of cash, current assets and the likely value of the company’s building, I’d put liquidation value somewhere around $4-5 per share.
In addition, we have a smart, experienced, incentivized management team that thinks long term, and is implementing operating changes designed to continue to grow the business and increase sales and operating income.
Although growth expectations have to be tempered moving forward, I’d argue that Tandy is an above average business, currently trading at around 7.5x [what I’d view as a depressed] TTM EBIT, which appears to be a below average price (and has routinely traded at less than 7x in the past).
But in order for the current price to be considered undervalued, you’d have to believe in the turnaround story taking place involving the new management team and improving operations. Although sales and organic growth have been flat over the past few years – while the business has remained profitable – it appears as though these issues can be tied to operational and store level issues as opposed to a decline in the demand for leather goods and services.
In other words, Tandy doesn’t appear to be a value trap (statistically cheap business in a declining industry), but rather a statistically cheap business with ample downside protection and a potential path to a decent return. Still, questions remain about the effectiveness of the turnaround.
Tandy currently trades below book value, which I’d estimate is around $6.50/share, with around $4.0/share in net current assets (my estimate after discounting inventory by 2/3rds), including 32% of their market cap in cash. For the trailing twelve months, Tandy generated somewhere in the neighborhood of $8mm in free cash flow (deceiving given sale of inventory was a large source, and TTM numbers include past quarters with higher FCF), giving investors a 23% current free cash flow yield. In addition, TTM EBIT numbers came in over $4mm (capex totals $1.2 – $1.9mm per year), so you’re still getting a 12-13% operating earnings yield at most likely trough earnings (if you believe the industry is not in secular decline) with very accretive buybacks potentially taking place in the future. I’d argue that Tandy is a $35mm EV business capable of earning $4-5mm per year as a baseline in operating income.
So if we use my estimate of net current asset value of $4.0/share as potential downside, investors are looking at a potential 33% downside from today’s price. But, if you believe that the turnaround is real, management will continue to opportunistically repurchase shares, Tandy will maintain their competitive position, and operating income will start to return to long term averages, there is potential for significant upside.
So….is the turnaround real?
In 2018, the board implemented a management change in an effort to return the business to organic growth and improved operating income. A number of changes were implemented, including:
Developing new operating model
Reducing store management structure
Closing international stores
Rebuilding business processes leads to increased headcount, HR, legal, tech and marketing
The creation of a separate team that will operate as a wholesale sales and service organization
These new initiatives obviously had the effect of increasing expenses and reducing operating income – which is where the stock took a hit – but I believe the past few years can provide some sort of normalized EBIT number, and a chunk of non-recurring costs through the end of 2018 through 1H 2019 should add at least another $1mm or so (being conservative) to operating income by 2020.
Without getting too in depth, the new initiatives were implemented to spark a hire in new store managers (key to Tandy’s growth plans), improve how the company measures success (stores are being managed for cash flow), and work through unfavorable inventory issues (both at unprofitable stores and moving old/unwanted SKUs).
I believe the entire operating model and growth plans (including new store openings) revolve around the hiring of store managers, key to driving new locations and store level EBIT. Tandy has run into some serious issues on the recruiting front in the past few years based on a low base salary offering for managers and the expectation that new hires move to a location of Tandy’s choice upon being hired.
In the past, Tandy’s compensation approach for store managers has been $36,000 base salary + 25% of store EBIT. Sales associates who are not managers earn $10/hour. This arrangement has proved tough for some managers, as well as for the recruitment of new managers given that when Tandy hires a new store manager, they expect them to move, which has historically been a deal killer for most potential employees. Think about it, how incentivized would you be to move to a location in the US of your employer’s choosing, for a $36,000 base salary?
Here’s a former Tandy CEO during a 2013 interview:
“Really the only reason we haven’t grown nationally has been we really had a hard time trying to hire managers…if we could hire more people we would probably open more stores. We would love to open six a year if we could but right now it’s been pretty slow. So it remains to be seen whether or not we can get enough managers.”
I believe the above remains true today, which gives me pause about initiating a position, as I have no particular insight into whether the new operating changes will help drive new store manager hires. Compensation changes have been positive, with pay now based on cost of living, a new incentive structure in place, and the ability to earn overtime. But the relocation aspect still worries me, as this has prevented 99% of new hires from joining the company. A quick look on Glassdoor also reveals how fond people are of Tandy’s requirement that store managers relocate.
Although there is ample downside protection, my biggest issue with initiating a position here, even though I like plenty of the pieces in place, is how investors will end up seeing a return if no new stores (or very few) are opened moving forward?
Of note, at one point, Tandy had 350 stores in the US! By the mid-90s they had closed most of those, and before 2000 they had closed them all! Previous management made a bet on mail order as the future – which turned out to be incorrect – and severely damaged the business to the point where two former employees were able to purchase Tandy Leather for a fraction of the value of the brand name. But that’s neither here nor there.
Building back up the store base through 2015, Tandy had 80 stores in the US a few years ago, with plans to reach 100-120 in the US. Well, here we are today with 115 stores, including a few that have been closed. So has the business reached saturation in the US? In addition, back in 2015, Tandy targeted international expansion as well, fixating on a handful of countries they believed could support $5mm in sales. Given the recent activity of late, contribution of international to total revenues, and increased investment in US operations, I think its safe to say that management has ditched the international expansion plans (there is currently one profitable international store, down from three last year).
That leaves Tandy with two options for growth outside of new store openings. Increasing existing store square footage and relocating existing stores to better markets.
I’m less clear on how effective the above two avenues will be, – which is giving me pause on the name in general – but the key to continued sales growth as well as new potential store openings lies in the company’s store managers.
Even though I believe Tandy can eventually return to low single digit growth and continued free cash flow generation, this is a tough business to value as I’m finding it difficult to normalize declining operating metrics. I think we’d be throwing darts at the wall in trying to come up with a fair earnings or FCF multiple, so looking at this thing from a current earnings or FCF yield standpoint (aka what are we getting now?) with potential operating improvements on the horizon and the opportunity for significant buybacks would be the best approach.
Quick Note on Management and the Board
New CEO Janet Carr currently owns under 10,000 shares, but could end up owning over half a million shares of stock (via restricted stock units vesting), and has interesting incentives in place including 92,000 additional restricted stock units to be awarded if operating income exceeds $12mm two years in a row, or $14mm during one year.
In addition, as mentioned above, Brent Beshore is on the board, in addition to Jeff Gramm, who also owns 32% of the company. I’m tempted enough to get on board with this aspect of the thesis alone, as both investors are long-term thinkers who have a detailed understanding of businesses and incentive structures.
Tandy lacks specific comps for help in valuing the business, but the long operating history and steady profitability can be relied upon for a back of the napkin valuation. Unless we start to see the effectiveness of operational improvements and the return to core business growth, it’s possible that Tandy’s days of trading at a low to mid-teens like multiple of operating income are probably over. Mature businesses with little to no growth and no reinvestment runways don’t deserve high multiples, nor should Tandy with its small size and illiquidity.
The above average competitive positioning and business resiliency does need to be taken into account, and assuming Tandy can double operating income (consistently around $10-12mm from 2012-2016) within the next 2-3 years to $7-8mm, an 11-12x multiple doesn’t seem egregious, and would get us to a share price range of $9-11, a 50-80% return from today’s prices. Again, this doesn’t take into account the optionality of buybacks or any special dividends, and investors are well-protected given the balance sheet and nearly $4/share in downside protection in cash, inventory, and the company’s headquarters.
I’m going to dig in some more, but so far, I like the opportunity and the price.
Demand for products
Tariffs and other issues raising raw material prices
Never returns to growth
Secular decline / dying brand / dying industry
Competition and wage pressure drives up costs