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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549


Form 10-K

(Mark One)
x
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the fiscal year ended December 31, 2004
OR

o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 [NO FEE REQUIRED]
        For the transition period ________ to ________

Commission File Number 1-12368
THE LEATHER FACTORY, INC.
(Exact name of registrant as specified in its charter)

Delaware
75-2543540
(State or other jurisdiction of incorporation or organization)
(I.R.S. Employer Identification Number)

3847 East Loop 820 South
  
Fort Worth, Texas
76119
(Address of principal executive offices)
(Zip Code)

Registrant’s telephone number, including area code: (817) 496-4414

Securities registered pursuant to Section 12(b) of the Act:

 
Title of Each Class
  
Name of Each Exchange on Which Registered
  
         
 
Common Stock, par value $.0024
  
American Stock Exchange
  

Securities registered pursuant to Section 12(g) of the Act:
NONE
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes x   No o
 
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o
 
Indicate by check mark whether registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2).  Yes o   No x
 
The aggregate market value of the common stock held by non-affiliates of the registrant was approximately $16,313,250 at June 30, 2004 (the last business day of its most recently completed second fiscal quarter). At March 15, 2005, there were 10,585,802 shares of the registrant's common stock outstanding.
 
DOCUMENTS INCORPORATED BY REFERENCE
 
Certain portions of the Registrant’s definitive Proxy Statement for the Annual Meeting of Stockholders to be held on May 23, 2005, are incorporated by reference in Part III of this report.
 
 
PART I

ITEM 1. BUSINESS

General

We are a retailer and wholesale distributor of a broad line of leather and related products, including 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 kits. During 2004, our consolidated sales totaled $46.1 million of which approximately 7.9% were export sales. We maintain our principal offices at 3847 East Loop 820 South, Fort Worth, Texas 76119. Our common stock trades on the American Stock Exchange under the symbol "TLF."

Our company was founded in 1980 as Midas Leathercraft Tool Company, a Texas corporation. Midas' original business activity focused on the distribution of certain leathercraft tools. In addition, the founders of Midas entered into a consulting agreement with Brown Group, Inc., a major footwear retailer, as a result of their proposal to develop a multi-location chain of wholesale distribution centers known as "The Leather Factory." In 1985, Midas purchased the assets of The Leather Factory from Brown Shoe Group, which then consisted of six distribution centers.

In 1993, Midas changed its name to "The Leather Factory, Inc.", then reincorporated in the state of Delaware in 1994.

The Development of Our Company in Recent Years

Our expansion of the wholesale chain occurred via the opening of new centers as well as numerous acquisitions of small businesses in strategic geographic locations including the acquisition of our Canadian distributor, The Leather Factory of Canada, Ltd., in 1996. By 2000, we had grown to twenty-seven Leather Factory centers located in the United States and two Leather Factory centers in Canada. In November 2000, we acquired the operating assets of two subsidiaries of Tandycrafts, Inc. to form Tandy Leather Company. In 2002, we began opening retail stores under the "Tandy Leather" name. During that year, Tandy Leather purchased four independent leathercraft retail stores and opened another ten. We also opened our thirtieth Leather Factory center - our third in Canada. In 2003, we opened twelve Tandy Leather retail stores. In 2004, we purchase three independent leathercraft retail stores and opened an additional nine stores in the U.S. We also opened another store in Canada which is operating as a Tandy Leather retail store. In November 2004, we acquired all of the issued and outstanding shares of capital stock of Heritan Ltd and its parent, our primary Canadian competitor, headquartered in Barrie, Ontario. The acquisition resulted in an additional three retail stores in Canada, bringing the total locations in Canada to seven - three Leather Factory centers and four Tandy Leather stores.

At December 31, 2004, we operated thirty wholesale distribution centers operating under the Leather Factory name (27 in the U.S. and 3 in Canada) and forty-two retail stores operating under the Tandy Leather name (38 in the U.S. and 4 in Canada). We also own and operate Roberts, Cushman and Company, Inc., a manufacturer of custom hat trims.

Our growth, measured both by our net sales and net income, occurs as a result of the increase in the number of stores we have and the increase from year to year of the sales in our existing stores. The following tables provide summary information concerning the additions of facilities for our Leather Factory wholesale centers and Tandy Leather retail stores in each of our fiscal years from 1999 to 2004.

2

STORE COUNT
YEARS ENDED DECEMBER 31, 1999 through 2004

 
Leather Factory wholesale centers
Tandy Leather retail stores
Year Ended
Opened
Conversions(1)
Total
Opened (2)
Closed
Total
Balance Fwd
    
22
    
N/A
1999
4
0
26
    
N/A
2000
2
0
28
1*
0
1
2001
2
0
30
0
0
1
2002
1
(1)
30
14
1*
14
2003
0
0
30
12
0
26
2004
0
0
30
16
0
42

(1) Leather Factory wholesale center converted to a Tandy Leather retail store.
(2) Includes conversions of Leather Factory wholesale centers to Tandy Leather retail stores.
(*) The Tandy Leather operation began as a central mail-order fulfillment center in 2000 that we closed in 2002.


No single customer’s purchases represent more than 10% of the Company’s total sales in 2004. Sales to the Company’s five largest customers represented 10.6%, 13.8% and 15.1%, respectively, of consolidated sales in 2004, 2003 and 2002. While management does not believe the loss of one of these customers would have a significant negative impact on our operations, it does believe the loss of several of these customers simultaneously or a substantial reduction in sales generated by them could temporarily affect our operating results.

Our Operating Divisions

We service our customers primarily through the operation of three divisions. We identify those divisions based on management responsibility and customer focus. The Wholesale Leathercraft division (formerly referred to as the Leather Factory segment) consists of thirty Leather Factory distribution centers of which 27 are located in the United States and three are located in Canada. The Retail Leathercraft division (formerly referred to as the Tandy Leather segment) consists of 42 retail stores as of the end of 2004. Both of these divisions sell leather and leathercraft-related products. Roberts, Cushman is our third business segment.

Wholesale Leathercraft

The Wholesale Leathercraft operation distributes its broad product line of leather and leathercraft-related products in the United States and internationally through Leather Factory distribution centers. This segment had net sales of $30.6 million, $30.7 million and $30.3 million for 2004, 2003 and 2002, respectively.

General   We operate Leather Factory wholesale centers in 20 states and three Canadian provinces. The centers range in size from 2,600 square feet to 19,800 square feet, with the average size of a center being approximately 6,000 square feet. The type of premises utilized for Leather Factory locations is generally light industrial office/warehouse space in proximity to a major freeway or with other similar access. This type of location typically offers lower rents compared to other more retail-oriented locations.


3

Business Strategy   The Leather Factory business concept centers around the wholesale distribution of leather and related accessories to retailers, manufacturers, and end users. Our strategy is that a customer can purchase the leather, related accessories and supplies necessary to complete his project from one place. The size and layout of the centers are planned to allow large quantities of product to be displayed in an easily accessible and visually appealing manner. Leather is displayed by the pallet where the customer can see and touch it, assessing first-hand the numerous sizes, styles, and grades offered. The location of the centers is selected based on the location of customers, so that delivery time to customers is minimized. A two-day maximum delivery time for phone, Internet and mail orders is our goal.

Leather Factory centers serve customers through various means including walk-in traffic, phone and mail order. We also employ a distinctive marketing tactic in that we maintain an internally-developed target customer mailing list for use in our aggressive direct mail advertising campaigns. We staff Leather Factory wholesale centers with experienced managers whose compensation is tied to the operating profit of the center they manage. Sales are generated by the selling efforts of the store personnel, our direct mail advertising, our website (www.leatherfactory.com), our participation at trade shows and, on a limited basis, the use of sales representative organizations. The sales representative organizations consist of companies located in specific geographic areas that represent numerous companies in a similar industry. These organizations call on customers and show multiple products from more than one vendor at a time.

Customers   Leather Factory’s customer base consists of individuals, wholesale distributors, tack and saddle shops, institutions (prisons and prisoners, schools, hospitals), western stores, craft stores and craft store chains, other large volume purchasers, manufacturers, and retailers dispersed geographically throughout the world. Wholesale sales constitute the majority of our Leather Factory business, although retail customers may purchase products from Leather Factory centers. Leather Factory sales generally do not reflect significant seasonal patterns.

Our Authorized Sales Center (“ASC”) program was developed to create a presence in geographical areas where we do not have a distribution center. An unrelated person operating an existing business who desires to become an ASC must apply with Leather Factory and upon approval, place a minimum initial order. There are also minimum annual purchase amounts the ASC must adhere to in order to maintain ASC status. In exchange, the benefits to the ASC are free advertising in certain sale flyers, price breaks on many products, advance notice of new products, and priority shipping and handling on all orders. Leather Factory centers service 208 ASC's: 115 located in the U.S., 69 located in Canada, and 24 located outside North America.

Merchandise   Our products are generally organized into thirteen categories. We carry a wide assortment of products including leather, lace, hand tools, kits, and craft supplies. We operate a light manufacturing facility in Fort Worth whose processes generally involve cutting leather into various shapes and patterns using metal dies. The factory produces approximately 20% of our products and also assembles and repackages product as needed. Products manufactured in our factory are distributed through our stores under the TejasTM brand name. We also distribute product under the Tandy LeatherTM and Dr. Jackson'sTM brands. We develop new products through the ideas and referrals of customers and store personnel as well as the tracking of fads and trends of interest in the market. Our personnel walk trade shows and various specialty stores with the purpose of obtaining product ideas that are then developed in-house.

We offer an unconditional satisfaction guarantee to our customers. Simply stated, we will accept product returns for any reason. We believe this liberal policy promotes customer loyalty. We offer credit terms to our non-retail customers, upon receipt of a credit application and approval by our credit manager. Generally, our open accounts are net 30 days.

4
 
During 2004 and 2003, Wholesale Leathercraft division sales by product category were as follows:

Product Category
  
2004
Sales Mix
  
2003
Sales Mix
Belts strips and straps
    
2
%
    
2
%
Books, patterns, videos
    
2
%
    
2
%
Buckles
    
4
%
    
3
%
Conchos^
    
3
%
    
3
%
Craft supplies
    
7
%
    
7
%
Tools and Hardware
    
1
%
    
1
%
Dyes, finishes, glues
    
5
%
    
5
%
Hand tools
    
13
%
    
12
%
Hardware
    
6
%
    
6
%
Kits
    
8
%
    
9
%
Lace
    
12
%
    
15
%
Leather
    
34
%
    
32
%
Stamping tools
    
3
%
    
3
%
     
100
%
    
100
%

^A concho is a metal adornment attached to clothing, belts, saddles, etc., usually made into a pattern of some southwestern or geometric object.

In addition to meeting ordinary operational requirements, our working capital needs are a product of the need to maintain inventory at a level we feel is adequate to fill customer orders as they are received with minimal backorders and the time required to collect our accounts receivable. Because availability of merchandise and prompt delivery time are important competitive factors for us, we maintain higher levels of inventory than our smaller competitors. For additional information regarding our cash, inventory and accounts receivable at the end of 2004 and 2003, see "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations."
 
Suppliers   We currently purchase merchandise and raw materials from approximately 200 vendors dispersed throughout the United States and in more than 20 foreign countries. In 2004, our ten largest vendors accounted for approximately 72% of our inventory purchases.

Because leather is sold internationally, market conditions abroad are likely to affect the price of leather in the United States. Outbreaks of mad cow and hoof-and-mouth disease (or foot-and-mouth disease) in certain parts of the world can influence the price of leather we purchase. As such an occurrence is beyond the control of the Company, we cannot predict when and to what extent we could be affected in the future. Aside from increasing purchases when we anticipate price increases (or possibly delaying purchases if we foresee price declines), we do not attempt to hedge our inventory costs.

Overall, we believe that our relationships with suppliers are strong and do not anticipate any material changes in these supplier relationships in the future. Due to the number of alternative sources of supply, the loss of any of these principal suppliers would not have a material impact on our operations.

Operations   Hours of operations vary by location, but generally range from 8:00 am to 6:00 pm Monday through Friday, and from 9:00 am to 4:00 pm on Saturdays. The distribution centers maintain uniform prices, except where lower prices are necessary to meet local competition.

Competition   Most of our competition comes in the form of small, independently-owned retailers who in most cases are also our customers. We estimate that there are several hundred of these small independent stores in the United States and Canada. We compete on price, availability of merchandise, and delivery time. While there is competition in connection with certain products, to our knowledge there is no direct competition affecting our entire product line. Our size relative to most competitors creates an advantage in our ability to stock a full range of products as well as in volume purchasing.


5

Distribution   The Leather Factory distribution centers receive the majority of their inventory from our central warehouse located in Fort Worth, Texas, although occasionally, merchandise is shipped directly from the vendor. Inventory is shipped to the distribution centers from our central warehouse once a week to meet customer demand without sacrificing inventory turns. Customer orders are filled as received, and we do not have backlogs.

We attempt to maintain the optimum number of items in our product line to minimize out-of-stock situations against carrying costs involved with such an inventory level. We generally maintain higher inventories of certain imported items to ensure a continuous supply. The number of products offered changes every year due to the introduction of new items and the discontinuance of others. We carry approximately 2,750 items in the current lines of leather and leather-related merchandise. All items are offered in both the Leather Factory distribution centers and the Tandy Leather retail stores.

Expansion   Leather Factory's expansion across the United States has been fairly consistent since we purchased the original six distribution centers in 1985. The newest center opened in August 2002, bringing the number of distribution centers to thirty. While we do not believe there is a significant and immediate opportunity for expansion of the Leather Factory distribution system in terms of opening additional locations, we do believe expansion could be achieved by acquiring companies in related areas/markets which offer synergistic aspects based on the local markets and/or the product lines of the businesses.

Retail Leathercraft

Our Retail Leathercraft division consists of a growing chain of retail stores operating under the name, Tandy Leather . Tandy Leather Company, established in 1919 as Hinkley-Tandy Leather Company, is the oldest and best-known supplier of leather and related supplies used in the leathercraft industry. We offer a product line of quality tools, leather, accessories, kits and teaching materials. This segment had net sales of $13.5 million, $9.2 million and $7.4 million for 2004, 2003 and 2002, respectively.

General   The Tandy Leather retail chain currently has 42 stores (as of March 1, 2005) located in 27 states and three Canadian provinces with plans to reach 100 stores as opportunities arise over the next several years. The stores range in size from 1,200 square feet to 3,800 square feet, with the average size of a store being approximately 2,000 square feet. The type of premises utilized for a Tandy Leather store is generally an older strip shopping center located at well-known crossroads, making the store easy to find.
 
Business Strategy   Tandy Leather has long been known for its reputation in the leathercraft industry and its commitment to the furthering of the craft through education and customer development. We are committed to this strategy as evidenced by our re-establishment of the retail store chain throughout the United States following our acquisition of the assets of Tandy Leather in 2000. We continue to broaden our customer base by working with various youth organizations and institutions where people are introduced to leathercraft, as well as hosting classes in the stores.

The retail stores serve walk-in, mail and phone order customers as well as orders generated from its website, www.tandyleather.com. Tandy Leather stores are staffed by knowledgeable sales people whose compensation is based, in part, upon the profitability of their store. Sales by Tandy Leather are driven through the efforts of the store staff, trade shows, and our direct mail and e-mail marketing program.


6

Customers Individual retail customers are our largest customer group, representing more than 70% of Tandy Leather's 2004 sales. Youth groups, summer camps, schools, and a limited number of wholesale customers complete our customer base. Like Leather Factory, Tandy fills orders as they are received, and there is no order backlog. Tandy maintains reasonable amounts of inventory to fill these orders. Tandy Leather’s retail store operations historically generate slightly more sales in the 4th quarter of each year (30-35%) while the other three quarters remain fairly even.

Merchandise Our products are generally organized into thirteen categories. We carry a wide assortment of products including leather, hand tools, kits, dyes & finishes, and stamping tools.

During 2004 and 2003, Retail Leathercraft division sales by product category were as follows:

 
Product Category
  
2004
Sales Mix
  
2003
Sales Mix
Belts strips and straps
    
5
%
    
5
%
Books, patterns, videos
    
3
%
    
3
%
Buckles
    
3
%
    
2
%
Conchos
    
3
%
    
3
%
Craft supplies
    
4
%
    
5
%
Tools and Hardware
    
*
      
1
%
Dyes, finishes, glues
    
7
%
    
7
%
Hand tools
    
18
%
    
16
%
Hardware
    
4
%
    
4
%
Kits
    
13
%
    
15
%
Lace
    
5
%
    
5
%
Leather
    
30
%
    
28
%
Stamping tools
    
5
%
    
6
%
     
100
%
    
100
%
     * less than 1%                
 
As indicated above, the products sold in our Tandy Leather stores are also sold in our Leather Factory wholesale centers. Therefore, the discussion above regarding Leather Factory products, their sources and the working capital requirements for the Wholesale Leathercraft division also apply to the Tandy Leather stores. Sales at Tandy Leather stores are generally cash transactions or through national credit cards. We also sell on open account to selected wholesale customers including schools and other institutions and small retailers. Our terms are generally net 30 days. Like Leather Factory, Tandy Leather has an unconditional return policy.

Operations   Hours of operations vary by location, but generally range from 9:00 am to 6:00 pm Monday through Friday, and from 9:00 am to 4:00 pm on Saturdays. In addition, most of the stores stay open late one night a week for leathercrafting classes taught in the stores. Selling prices are uniform throughout the Tandy Leather store system.

Competition   Our competitors are generally small local craft stores that carry a limited line of leathercraft products. Several national retail chains that are customers of The Leather Factory also carry leathercraft products on a very small scale relative to their overall product line. To our knowledge, our retail store chain is the only one in existence solely specializing in leathercraft.

Distribution   The Tandy Leather stores receive their inventory from the Leather Factory central warehouse located in Fort Worth, Texas. The stores generally restock their inventory once a week with a shipment from the warehouse. Tandy Leather's inventory turns are higher than Leather Factory's because the Leather Factory calculation includes its warehouse inventory whereas Tandy Leather's calculation is based strictly on its stores.


7

Expansion   We intend to expand the Tandy Leather retail store chain to 100 stores throughout the United States at an average rate of approximately twelve stores per year. Fourteen stores were opened in 2002; twelve stores were opened in 2003; sixteen were opened in 2004 (including four in Canada). Seven of the 42 stores opened through 2004 were independent leathercraft stores that we acquired. Separately, these acquisitions are not material. The other thirty-five stores have been de novo stores opened by us.  Management's plans for 2005 are to open 6-8 retail stores in the United States to keep us on pace of averaging twelve new stores per year. Two new stores opened in the first three months of 2005.

Roberts, Cushman

Roberts, Cushman, founded in 1856, produces made-to-order trimmings for the headwear industry. This segment had net sales of $2.0 million, $1.8 million, and $2.0 million for 2004, 2003 and 2002, respectively.

Business Strategy   Roberts, Cushman has long been considered one of the leaders in the field of headwear trimmings. It designs and manufactures exclusive trimmings for all types of hats. Trims are sold to hat manufacturers directly. We do not employ an outside sales force. Instead, customers visit our facilities in New York and, with an on-site designer, incorporate their ideas into a customized product. The customer is provided samples or photographs of each design before they leave the premises. These samples can then be used as a sales tool to obtain hat orders from their customers. This “design-on-site” process is unique in the industry.

Customers   We design and manufacture trims for over 75 of the headwear manufacturers worldwide, supplying customized trims, ribbons, buckle sets, name pins, feathers, and other items. Our success in developing and maintaining long-standing relationships with our customers is due primarily to our ability to deliver quality products in a timely manner. Our backlog of in-house orders from customers as of March 10, 2005 was $150,000, which approximates thirty days of sales. Roberts, Cushman’s sales generally do not reflect significant seasonal patterns.

The working capital requirements of this operation are dictated by the amounts needed to meet current obligations, purchase raw material and allow for collection of accounts receivable. Roberts, Cushman provides sufficient cash flow to satisfy these requirements.

Merchandise   Our hat bands are generally produced from leather, ribbon, or woven fabrics, depending on the style of hat. They are created by cutting leather and/or other materials into strips, and then enhancing the trim by attaching conchos and/or three-piece buckle sets, braiding with other materials, and finishing the end or borders by stitching or by lacing with leather lace. We also supply custom-designed buckles and conchos, feathers for dress hats, and name pins, separate from hat bands. Roberts, Cushman purchases components from over 25 vendors, located predominately in the United States. In 2004, our top 10 vendors (in dollars purchased) represented approximately 50% of its total purchases. Products are sold on terms that generally range from net 30 to net 90 days. Because our products are custom-designed, we do not accept product returns, except in the case of defective merchandise.

Expansion   Cushman has been successful providing a very specific product line directly to headwear manufacturers. Given the current industry conditions, we do not believe there is much potential for expansion, other than to capture additional market share.

8

Additional Information

Compliance With Environmental Laws   Compliance by the Company with federal, state and local environmental protection laws has not had, and is not expected to have, a material effect upon capital expenditures, earnings or the competitive position of the Company.

Employees   As of December 31, 2004, the Company employed 328 people, with 303 on a full-time basis. The Company is not a party to any collective bargaining agreement. Overall, management believes that relations with employees are good.

Intellectual Property   We hold approximately twenty registered trademarks, including federal trade name registrations for "The Leather Factory" and "Tandy Leather Company." The trademarks expire at various times through 2012, but can be renewed indefinitely. We hold approximately 500 copyrights covering over 600 registered works, applicable to various products. These begin expiring in 2062. We also hold patents on several belt buckles and leather-working equipment that expire in 2011. These rights are valuable assets and we defend them as necessary.

International Operations   Information regarding our revenues from the United States and abroad and our long-lived assets are found in Note 12 to our Consolidated Financial Statements, Segment Information.

Our Website and Availability of SEC Reports   We file reports with the Securities and Exchange Commission ("SEC"). These reports include our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and any amendments to these filings. The public may read any of these filings at the SEC's Public Reference Room at 450 Fifth Street, NW, Washington, DC 20549. In addition, the public may obtain information on the operation of the Public Reference Room by calling the SEC at 1/800-SEC-0330. Further, the SEC maintains an Internet site that contains reports, proxy and information statements and other information concerning us. You can connect to this site at http://www.sec.gov.

Our corporate website is located at http://www.leatherfactory.com. We make copies of our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, proxy statements and any amendments filed with or furnished to the SEC available to investors on or through our website free of charge as soon as reasonably practicable after we electronically file them with or furnish them to the SEC. Our SEC filings can be found on the Investor Relations page of our website through the "SEC Filings" link. In addition, certain other corporate governance documents are available on this website through the "Corporate Governance" link.

9


Executive Officers of the Registrant 

The following table sets forth certain information concerning the executive officers of the Company.

 
Name and Age
Position and Business Experience
During Past Five Years
Served as Officer Since
J. Wray Thompson, 73
Chief Executive Officer since June 1993. President from June 1993 to January 2001
1993
     
Ronald C. Morgan, 57
President since January 2001. Chief Operating Officer since June 1993
1993
     
Robin L. Morgan, 54
Vice President of Administration since June 1993
1993
     
Shannon L. Greene, 39
Chief Financial Officer since May 2000. Controller from January 1998 to May 2000
2000

Wray Thompson has served as our Chairman of the Board and Chief Executive Officer since June 1993. He also served as President from June 1993 to January 2001. Mr. Thompson was a co-founder of the company.

Shannon L. Greene has served as our Chief Financial Officer and Treasurer since May 2000. She was appointed to serve on the Board of Directors in January 2001. Ms. Greene is also our chief accounting officer. From September 1997 to May 2000, Ms. Greene served as our controller and assistant controller. Ms. Greene also is a member of the company’s Employees’ Stock Ownership Plan (ESOP) Committee and is a certified public accountant. Her professional affiliations include the American Institute of Certified Public Accountants, the Texas Society of Certified Public Accountants and its Fort Worth chapter, the Fort Worth Association for Financial Professionals, and the National Investor Relations Institute.

Robin L. Morgan has served as our Vice President of Administration and Assistant Secretary since June 1993. Ms. Morgan is responsible for import, banking, and procurement for our import product lines and maintains all inventory costs. She administers our insurance programs and serves as chairman of the Company's ESOP committee. Ms. Morgan is married to Ronald C. Morgan, the Company's President.

Ronald C. Morgan has served as our President since January 2001 and has served as Chief Operating Officer and director since June 1993. Mr. Morgan was also a co-founder of the company. Mr. Morgan is married to Robin L. Morgan, the Company's Vice President.

All officers are elected annually by the Board of Directors to serve for the ensuing year.

Under our 1995 Stock Option Plan, there were no unoptioned shares on January 1, 2004 and 10,000 unoptioned shares at December 31, 2004. Under our 1995 Director Non-qualified Stock Option plan, there were 40,000 unoptioned shares on January 1, 2004 and 34,000 unoptioned shares at December 31, 2004. There were no changes to the exercise prices of the outstanding options under these two plans during 2004.

10

ITEM 2. PROPERTIES

We lease all of our premises and believe that all of our properties are adequately covered by insurance. The properties leased by our Wholesale Leathercraft (Leather Factory centers) and Retail Leathercraft (Tandy Leather stores) divisions are described in Item 1 in the description of each segment. Our Fort Worth location, which includes the Fort Worth Leather Factory distribution center, our central warehouse and manufacturing facility, and the sales, advertising, administrative, and executive offices, consists of 115,000 square feet and leases for $410,000 per year. The lease expires in October 2008. We also lease a 284 square-foot showroom in the Denver Merchandise Mart for $5,688 per year. This lease will expire in October 2005. Roberts, Cushman operates in a 10,200 square foot manufacturing facility that is located in Long Island City, New York and leased for $89,000 per year. This lease will expire in June 2006. The following table summarizes the locations of our leased premises on a state and province basis as of December 31, 2004:

State
Wholesale Leathercraft
(Leather Factory)
Retail Leathercraft
(Tandy Leather)
Arizona
2
1
California
3
2
Colorado
1
2
Connecticut
-
1
Florida
1
1
Georgia
-
1
Idaho
-
1
Illinois
1
1
Indiana
-
1
Iowa
1
-
Kansas
1
-
Kentucky
-
1
Louisiana
1
-
Maryland
-
1
Michigan
1
1
Minnesota
-
1
Missouri
1
2
Montana
1
-
Nebraska
-
1
Nevada
-
2
New Mexico
1
2
New York
-
1
North Carolina
1
-
Ohio
1
1
Oklahoma
0
2
Oregon
1
-
Pennsylvania
1
1
Tennessee
1
2
Texas
5
4
Utah
1
1
Virginia
-
1
Washington
1
2
Wisconsin
-
1

Canadian locations:
    
Alberta
1
1
British Columbia
-
1
Manitoba
1
-
Ontario
1
2


11

ITEM 3. LEGAL PROCEEDINGS

We are involved in litigation in the ordinary course of business but are not currently a party to any material pending legal proceedings.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

There were no matters submitted to a vote of our security holders during the fourth quarter of our fiscal year ended December 31, 2004.

PART II 

ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

Our common stock is traded on the American Stock Exchange using the symbol TLF. The high and low prices for each calendar quarter during the last two fiscal years are as follows:
 
   
2004
  
2003
  
Quarter Ended
  
High
  
Low
  
High
  
Low
  
March 31
  
$
5.99
  
$
4.35
  
$
3.45
  
$
2.80
  
June 30
  
$
5.63
  
$
4.40
  
$
3.42
  
$
2.90
  
September 30
  
$
4.49
  
$
3.24
  
$
4.58
  
$
3.25
  
December 31
  
$
3.82
  
$
2.95
  
$
4.85
  
$
3.97
  
 
There were approximately 540 stockholders of record on March 10, 2005.

There have been no cash dividends declared or paid on the shares of our common stock. Our Board of Directors has historically followed a policy of reinvesting our earnings in the expansion of its business. This policy is subject to change based on future industry and market conditions, as well as other factors.

The following table sets forth information regarding our equity compensation plans (including individual compensation arrangements) that authorize the issuance of shares of our common stock. The information is aggregated in two categories: plans previously approved by our stockholders and plans not approved by our stockholders. The table includes information for officers, directors, employees and non-employees. All information is as of December 31, 2004.

 
Column (a)
Column (b)
Column (c)
 
 
Plan Category
Number of Securities to be issued upon exercise of outstanding options, warrants and rights
 
Weighted-average exercise price of outstanding options, warrants and rights
Number of securities remaining available for future issuance under equity compensation plans (excluding securities reflected in Column (a)
Equity compensation plans approved by stockholders
602,500
$1.63
40,000
       
Equity compensation plans not approved by stockholders
 
150,000
 
3.73
 
-
TOTAL
752,500
$2.05
40,000
 
For additional information, see Note 10 to our Consolidated Financial Statements, Stockholders' Equity.

12
 
ITEM 6. SELECTED FINANCIAL DATA

The selected financial data presented below are derived from and should be read in conjunction with the Company’s Consolidated Financial Statements and related notes. This information should also be read in conjunction with "Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations.” In particular, see the information there relating to the adoption of a new accounting pronouncement in 2002. Data in prior years has not been restated to reflect acquisitions, if any, that occurred in subsequent years.


Income Statement Data
  
Years Ended December 31,
  
   
2004
  
2003
  
2002
  
2001
  
2000
  
Net sales
  
$
46,146,284
  
$
41,712,191
  
$
39,728,615
  
$
37,279,262
  
$
30,095,264
  
Cost of sales
    
20,706,239
    
19,020,292
    
18,393,914
    
17,934,935
    
15,147,547
  
Gross profit
    
25,440,045
    
22,691,899
    
21,334,701
    
19,344,327
    
14,947,717
  
Operating expenses
    
21,181,599
    
18,594,240
    
17,202,927
    
15,442,359
    
11,702,633
  
Operating income
   
4,258,446
    
4,097,659
    
4,131,774
    
3,901,968
    
3,245,084
  
Operating income per share - basic
  
$
0.40
  
$
0.40
  
$
0.41
  
$
0.39
  
$
0.33
  
Operating income per shares - diluted
  
$
0.39
  
$
0.38
  
$
0.38
  
$
0.37
  
$
0.32
  
Other expense
    
44,800
    
125,169
    
311,917
    
533,482
    
653,779
  
Income (loss) before income taxes
    
4,213,646
    
3,972,490
    
3,819,857
    
3,368,486
    
2,591,305
  
Income tax provision (benefit)
    
1,559,605
    
1,232,116
    
1,224,868
    
1,362,053
    
1,049,985
  
Income (loss) before cumulative effect of change in accounting principle
    
2,654,041
    
2,740,374
    
2,594,989
    
2,006,433
    
1,541,320
  
Cumulative effect of change in accounting principle
    
-
    
-
    
(4,008,831
)
  
-
    
-
  
Net income (loss)
  
$
2,654,041
  
$
2,740,374
  
$
(1,413,842
)
$
2,006,433
  
$
1,541,320
  
                                 
Earnings (loss) per share
  
$
0.25
  
$
0.27
  
$
(0.14
)
$
0.20
  
$
0.16
  
                                 
Earnings (loss) per share- assuming dilution
  
$
0.24
  
$
0.25
  
$
(0.13
)
$
0.19
  
$
0.15
  
                                 
Weighted average common shares outstanding for:
                        
Basic EPS
    
10,543,994
    
10,323,549
    
10,063,581
    
9,976,181
    
9,875,606
  
                                 
Diluted EPS
    
10,957,518
    
10,861,305
    
10,761,670
    
10,449,306
    
10,182,803
  
                                 
 
Balance Sheet Data
  
As of December 31,
  
   
2004
  
2003
  
2002
  
2001
  
2000
  
                       
Total assets
  
$
22,167,163
  
$
19,058,406
  
$
19,675,602
  
$
19,548,323
  
$
19,686,079
  
                                 
Notes payable, capital lease obligations and
                               
current maturities of long term debt
   
134,067
    
1,134
    
4,218,968
    
4,527,904
    
5,759,626
  
                                 
Notes payable, capital lease obligations and
                                
long-term debt, net of current maturities
    
750,944
    
1,792,984
    
2,256
    
7,691
    
13,025
  
                                 
Total Stockholders’ Equity
  
$
17,310,233
  
$
14,509,493
  
$
11,170,062
  
$
12,423,671
  
$
10,295,637
  

 
13

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

We intend for the following discussion to provide you with information that will assist you in understanding our financial statements, the changes in certain key items in those financial statements from year to year, and the primary factors that accounted for those changes, as well as how certain accounting principles affect our financial statements. This discussion also provides information about the financial results of the various segments of our business so you may better understand how those segments and their results affect our financial condition and results of operations as a whole. Finally, we have identified and discussed trends known to management that we believe are likely to have a material effect.

This discussion should be read in conjunction with our financial statements as of December 31, 2004 and 2003 and the two years then ended and the notes accompanying those financial statements. You are also urged to consider the information under the caption "Summary of Critical Accounting Policies."

Summary

We are the world's largest specialty retailer and wholesale distributor of leather and leathercraft-related items. Our operations are centered on operating retail stores and warehouse distribution centers. We have built our business by offering our customers quality products in one location at competitive prices. The key to our success is our ability to grow our base business. We grow that business by opening new locations and by increasing sales in our existing locations. We intend to continue to expand both domestically, in the short-term, and internationally, in the long-term.

We operate in three segments. First, Wholesale Leathercraft, consisting of our Leather Factory warehouse distribution centers and our national account group, is the largest source of revenues ($30.6 million in 2004). This division has generally offered steady but modest increases in sales. Sales in 2004 were flat compared to sales in 2003, falling short of our target of annual sales growth of 2% to 4%. The decrease in sales to national accounts in 2004 accounted for the shortfall. Excluding national account sales, the distribution centers produced a sales gain of 4.5% for 2004.

Since acquiring its assets in 2000, we have focused on re-establishing Tandy Leather as the operator of retail leathercraft stores. These retail stores comprise our second segment, Retail Leathercraft. Because of growth here, this segment has experienced the greatest increases in sales ($13.5 million in 2004, up from $9.2 million in 2003). Our business plan calls for opening an average of 12 stores annually as we work toward a goal of 100 stores from 42 stores at the end of 2004.

Our third segment is Roberts, Cushman, a manufacturer of trimmings for headwear. Its operations are not material to us. In 2002, we wrote off the goodwill related to our investment in Roberts, Cushman in connection with an accounting change.

On a consolidated basis, a key indicator of costs, gross margin as a percent of total net sales, increased in 2003 and again in 2004, reflecting a number of factors including more retail sales with higher profit margins. However, opening additional Tandy Leather stores, more dollars spent on employee benefits, and new costs associated with Sarbanes-Oxley compliance in 2004 resulted in a 1.3% increase in operating expenses as a percent of total net sales in 2004. Operating expenses were also up 1.3% as a percentage of total net sales in 2003 when compared with 2002 as a result of opening additional Tandy Leather stores and more dollars spent on advertising.


14

We reported consolidated net income for 2004 of $2.7 million. Consolidated net income for 2003 was also $2.7 million. In 2002, we reported a consolidated net loss of $1.4 million due to an accounting change. We have used our cash flow to fund our operations, to fund the opening of new Tandy Leather stores and to reduce our bank debt. In 2004, we reduced our bank debt by $1.3 million, and, at the end of 2004, our stockholders’ equity had increased to $17.3 million from $14.5 million the previous year.

Comparing the December 31, 2004 balance sheet with the prior year’s, we increased our investments in inventory ($12.7 million from $11.1 million) and accounts receivable ($2.0 million from $1.8 million), while total cash increased to $2.6 million from $1.7 million. In addition to cash on hand, we have a $3 million bank line of credit, of which $505,000 was drawn on December 31, 2004.

Net Sales

Net sales for the three years ended December 31, 2004 were as follows:
           
 
Year
Wholesale
Leathercraft
Retail
Leathercraft
 
Cushman
 
Total Company
Total Company Increase
from Prior Year
2004
$30,630,121
$13,515,662
$2,000,501
$46,146,284
10.6%
2003
$30,684,092
$9,216,838
$1,811,261
$41,712,191
5.0%
2002
30,313,478
7,387,874
2,027,263
39,728,615
6.6%

Our net sales grew by 10.6% in 2004 when compared with 2003 and 5.0% in 2003 when compared with 2002. These annual increases resulted primarily from our retail leathercraft expansion program.

Costs and Expenses

In general, our gross profit as a percentage of sales (our gross margin) fluctuates based on the mix of customers we serve, the mix of product we sell, and our ability to source product globally. Our negotiations with suppliers for lower pricing is an on-going process and we have varying degrees of success in those endeavors. Sales to retail customers tend to produce higher gross margins than sales to wholesale customers due to the difference in pricing levels. Therefore, as retail sales increase in the overall sales mix, higher gross margins tend to follow. Finally, there is significant fluctuation in gross margins between the various merchandise categories we offer. As a result, our gross margins can vary depending on the mix of products sold during any given time period.

For 2004, our cost of sales decreased as a percentage of total net sales when compared to 2003, resulting in an overall increase of 0.7% in the Company's gross margin from 54.4% in 2003 to 55.1% in 2004.

Similarly, our total cost of sales as a percentage of our total net sales had decreased for 2003 when compared to 2002 resulting in an overall increase in gross margin of 0.7% from 53.7% for 2002 to 54.4% in 2003. These increases in gross margin were primarily due to increased retail sales over the three years.

Our gross margins for the three years ended December 31, 2004 were as follows:
         
 
Year
Wholesale
Leathercraft
Retail
Leathercraft
 
Cushman
 
Total Company
2004
54.10%
61.98%
30.31%
55.13%
2003
53.23%
62.98%
30.62%
54.40%
2002
53.56%
59.49%
34.64%
53.70%


15

Our operating expenses increased 1.3% as a percentage of total net sales to 45.9% in 2004 when compared with 44.6% in 2003. This increase was primarily due to operating costs associated with the twelve Tandy stores opened in 2004 (an increase of $650,000), bonuses awarded to corporate and operational management ($400,000) the cost of employee health care (an increase of $500,000), an increase in advertising expenses ($200,000), and expenses associated with compliance with Section 404 of the Sarbanes-Oxley Act ($200,000). We believe that our advertising efforts - particularly our direct mail campaigns - generate sales. As we expand into new markets, the number of customers and potential customers increases resulting in an increase in the number of direct mail pieces produced and distributed. While we monitor our advertising costs with great scrutiny, management believes that the trend of increased advertising and marketing costs could continue for at least the near future.

We have completed the initial phase of design and documentation in our efforts to comply with Section 404 of the Sarbanes-Oxley Act with the assistance of outside consultants. While additional and on-going testing of our control processes is necessary, we hope to complete the majority of that work without the need for significant outside assistance. Management is analyzing the status of this project to determine if we will be able to accomplish this work satisfactorily with internal staff. If not, we will incur additional costs in 2005.

For 2003, operating expenses increased 1.3% as a percentage of total net sales to 44.6% in 2003 when compared with 2002. This increase was primarily due to operating costs (rents, utilities, telephones, etc.) associated with the twelve Tandy stores opened in 2003 (an increase of $700,000) as well as an increase in advertising expenses (an increase of $500,000) and investor relation expenses (an increase of $200,000).

Other Expenses (net)

Other expenses (net), which consists primarily of interest expense and currency exchange gain and loss, was $45,000 in 2004 compared to $125,000 in 2003, a decrease of approximately 64%. This decrease is attributable to the interest paid on our outstanding debt.

In 2003, other expenses (net) were $125,000 in 2003 compared to $312,000 in 2002, a decrease of approximately 60%. Our interest expense continues to decrease due to the reduction in our outstanding bank debt. The currency exchange gain and loss, resulting from our Canadian operation, was a gain of $102,000 in 2003 compared to a gain of $10,000 in 2002.

Net Income

During 2004, we earned net income of $2.65 million, a slight decrease from our net income of $2.74 million for 2003. The overall improvement in gross margin and a reduction in interest and other expenses contributed positively to our net income while increased operating expenses and income tax expense in 2004 offset that improvement.

During 2003, we earned net income of $2.74 million, a substantial increase over our net loss of $1.4 million for 2002. (As discussed in previous filings, a new accounting pronouncement required us to record a $4.0 million charge against earnings as a result of the write-off of the goodwill of Roberts, Cushman in 2002, resulting in a net loss. This charge was reported as a cumulative effect of a change in accounting principle. Net income before the change was $2.6 million.) As a result of the increase in our overall gross margin and a reduction in interest and other expenses, our profits in 2003 grew at a rate faster than sales. Partially offsetting gross margin and other expense improvements were increased operating expenses in 2003 as discussed above.


16

Re-categorization of operating divisions

Until the fourth quarter of 2004, we provided division or segment information on a legal entity basis. More specifically, the Leather Factory segment consisted of 27 U.S.-based warehouse distribution centers and 3 Canadian-based warehouse distribution centers which were owned and operated by the legal entity of the same name. The Tandy Leather segment consisted of the expanding U.S.-based retail store chain which was owned and operated by Tandy Leather Company. With the opening of our Calgary store in October 2004, which is owned by The Leather Factory but operated as a Tandy Leather retail store, management has determined that it is more useful to provide segment financial information based upon wholesale and retail operating divisions rather than on a legal entity basis. The acquisition of the three Canadian retail stores of Heritan Ltd in December 2004, which are owned by the Leather Factory but operated as Tandy Leather stores, further strengthened our decision to make a change in the way we report divisional, or segment, information.

If we continued entity reporting, the segments would be as follows:

As of 9/30/04:
As of 12/31/04:
Leather Factory:
Leather Factory:
27 locations in U.S.
27 locations in U.S.
3 locations in Canada
7 locations in Canada**
   
Tandy Leather:
Tandy Leather:
36 retail stores in U.S.
38 retail stores in U.S.
 
**3 warehouse distribution centers and 4 retail stores

Changing reporting to a wholesale and retail division reporting, the segments are as follows:

As of 9/30/04:
As of 12/31/04:
Wholesale:
Wholesale:
27 locations in U.S.
27 locations in U.S.
3 locations in Canada
3 locations in Canada
   
Retail:
Retail:
36 retail stores in U.S.
38 retail stores in U.S.
 
4 retail stores in Canada

As indicated in the tables above, this change in divisional reporting does not affect prior periods for comparison purposes as there were no retail stores in the Leather Factory legal entity until October 2004.
 
Wholesale Leathercraft (formerly referred to as "Leather Factory Segment")
         
 
 
Year
Net Sales
Incr (Decr)
 from Prior Yr
 
Operating
Income
Operating Income
Incr (Decr)
from Prior Year
Operating Income
as a Percentage
of Sales
2004
(0.2)%
$3,031,316
(13.0)%
9.5%
2003
1.2%
$3,462,457
(7.5)%
11.3%
2002
5.6%
$3,742,844
0.6%
12.3%

Wholesale Leathercraft, consisting of 30 warehouse distribution centers, accounted for 66.4% of total Company net sales in 2004, which compares to 73.5% in 2003 and 76.3% in 2002. The decrease in this division's contribution to our total net sales is the result of the growth in Retail Leathercraft and we expect this trend to continue.

The net sales decrease in 2004 resulted from a decrease in national account sales offset by gains to our wholesale and small manufacturing customer groups. Our sales mix by customer group was as follows:

17


Customer Group
  
2004
  
2003
  
2002
  
Retail
    
23%
 
  
23%
 
  
20%
 
Institution
    
7%
 
  
8%
 
  
8%
 
Wholesale
    
47%
 
  
42%
 
  
44%
 
National Accounts
    
16%
 
  
20%
 
  
21%
 
Manufacturers
    
7%
 
  
7%
 
  
7%
 
     
100%
 
  
100%
 
  
100%
 

The 2004 decrease in operating income as a percentage of divisional sales resulted from an increase of 2.04% in operating expenses (as a percentage of sales) compared with 2003, partially offset by an increase in gross margin (as a percentage of sales) of 0.59%. The operating expense increase as a percent of sales in 2004 was higher than 2003 due to bonuses awarded to corporate and operational management ($300,000) for 2004 and the cost of our employee health benefits (an increase of $300,000). In addition, we spent $170,000 with outside consultants on our Sarbanes-Oxley 404 project. Being the largest division, Wholesale Leathercraft bears the majority of the pro rata allocation of corporate expenses.

The 2003 decrease in operating income as a percentage of sales resulted from a 0.33% decrease in gross margin (as a percentage of sales) and an increase of 0.72% in operating expenses (as a percentage of sales) compared with 2002. The gross margin decline was driven primarily by an increase in the quantities of leather sold during the year. Given that leather is our lowest gross margin item, an increase in leather sales, all other factors being equal, will result in a lower overall gross margin. Our freight costs (shipping merchandise from vendors to us) were up in 2003 as well due an increase in the number of air shipments versus ocean shipments. The operating expense increase as a percent of sales in 2003 was higher than 2002. Advertising and marketing costs are a significant expense in our operation as we believe there is a direct correlation between how much we advertise and how much product we sell. Our increase in investor outreach programs in 2003 also contributed to the decline in operating income this year.

Retail Leathercraft (formerly referred to as "Tandy Leather Segment")
         
 
 
Year
Net Sales
Increase
from Prior Yr
 
Operating
Income
Operating Income
Incr (Decr)
from Prior Year
Operating Income
as a Percentage
of Sales
2004
46.6%
$1,210,566
37.3%
8.9%
2003
24.7%
$604,291
62.7%
6.6%
2002
11.8%
$371,372
31.7%
5.0%

Reflecting the growth previously discussed, Retail Leathercraft accounted for 29.3% of our total net sales in 2004, up from 22.1% in 2003 and 18.6% in 2002.

Growth in net sales for Retail Leathercraft division in 2004 and 2003 resulted primarily from our expansion program. Expansion during 2004 and 2003 consisted of the opening of 16 and 12 new stores, respectively.

Our sales mix by customer group was as follows:

Customer Group
  
2004
  
2003
  
2002
  
Retail
    
72%
 
  
72%
 
  
65%
 
Institution
    
6%
 
  
6%
 
  
12%
 
Wholesale
    
21%
 
  
21%
 
  
23%
 
National Accounts
    
0%
 
  
0%
 
  
0%
 
Manufacturers
    
1%
 
  
1%
 
  
0%
 
     
100%
 
  
100%
 
  
100%
 


18

Operating income as a percentage of sales increased to 8.9% for 2004 compared to 6.6% for 2003. Gross margin decreased from 63.0% in 2003 to 61.8% in 2004 due primarily to limitations in increasing selling prices to match cost increases. Selling prices are set at the time the product catalog is produced. As a result, it is difficult to implement price increases to customers until we distribute a new catalog. Historically, we distribute our new catalog at the beginning of each calendar year and did so in January 2004. However, due to the cost increases in metals, fuel, and other items this year and the need to pass on these increases to customers, we accelerated that schedule and distributed our 2005 catalog on November 1, 2004. Operating expenses as a percent of sales in 2004 decreased by 3.61%, from 56.4% for 2003 to 52.8% for 2004 as sales and gross margin grew at a faster pace than that of operating expenses.

Operating income as a percentage of sales increased in 2003 when compared to 2002. Segment gross margin increased from 59.5% in 2002 to 63.0% in 2003 due to increased retail sales and more efficient purchasing of product from vendors. Segment operating expenses as a percent of sales increased by 1.95% in 2003. Expanded advertising initiatives and rent for store space accounted for the operating expense increase, offset partially by a decrease in costs to ship merchandise to customers. The decrease in shipping is a result of the store expansion as more sales occur in the stores as compared to ordering via mail, phone or the Internet.

We intend to continue the expansion of Tandy Leather’s retail store chain in 2005 by opening a total of 6-8 new stores throughout the year. As of March 15, 2005, we have opened two new stores this year: Van Nuys, CA and Phoenix, AZ. We remain committed to a conservative expansion plan for this division that minimizes risks to our profits and maintains financial stability.

Roberts, Cushman
         
 
 
Year
Net Sales
Incr (Decr)
from Prior Yr
 
Operating
Income (Loss)
Operating Income
Incr (Decr)
from Prior Year
Operating Income
as a Percentage
of Sales
2004
10.4%
$34,565
11.8%
1.7%
2003
(10.6)%
$30,911
76.1%
1.7%
2002
3.3%
$17,558
117.6%
0.9%

The Roberts, Cushman operation accounted for 4.3% of our total sales in 2004 compared with 4.4% and 5.1% in 2003 and 2002, respectively.

For 2004, Roberts, Cushman’s sales were up 10.4% while gross profit margins decreased slightly from 30.6% to 30.3%. Operating income increased from $31,000 in 2003 to $35,000 for 2004. Sales grew faster than operating expenses which accounted for the improvement in operating income.

The 2003 decrease in Roberts, Cushman's net sales resulted from the continued slowdown in the headwear industry overall. Several of our customers (hat manufacturers) are on shortened work weeks due to the decline in orders. Segment gross margin as a percentage of sales decreased 4.0% from 2002. However, operating income improved modestly.

Roberts, Cushman's sales and profits are immaterial to our company as a whole, and the segment does not fit our business model for the future. We continue to assess strategic options for this segment.


19
 
Financial Condition
 
At December 31, 2003, our net total assets were $19.1 million. We held $11.1 million of inventory and $1.9 million of property and equipment. Our cash totaled $1.7 million and our receivables were $1.8 million. Current liabilities were $2.5 million, while our long-term debt was $1.8 million. Total stockholders' equity at the end of 2003 had increased to $14.5 million, primarily as a result of the $2.7 million net income recorded in 2003. The increase in cash from 2002 to 2003 was due primarily to the increase in cash sales at Tandy Leather (as opposed to sales on open account), as well as the decrease in cash tied up in inventory owned at the end of 2003 compared to 2002. While we have no required payment schedule prior to maturity on our revolving line of credit, management strives to apply as much available cash as possible to our outstanding debt balance. Generally speaking, the majority of cash on our balance sheet is funds held in depository accounts with various banks awaiting collectibility for transfer either to our operating account or to the line of credit.

At December 31, 2004, we held $2.6 million of cash, $12.7 million of inventory, accounts receivable of $2.0 million, and $1.9 million of property and equipment. Goodwill and other intangibles (net of amortization and depreciation) were $743,000 and $438,000, respectively. We also own a leather artwork collection, most of which was created by Al Stohlman, a legendary leathercrafter, valued on our balance sheet at $250,000. Net total assets were $22.2 million. Current liabilities were $3.8 million (including $134,000 of current maturities of long-term debt), while long-term debt was $751,000. Total stockholders’ equity at the end of 2004 was $17.3 million.

Specific ratios on a consolidated basis at the end of each year ended December 31 were as follows:

   
2004
  
2003
  
2002
Solvency Ratios:
            
Quick Ratio
Cash+Accts Rec/Total Current Liabilities
1.21
  
1.40
  
0.31
Current Ratio
Total Current Assets/Total Current Liabilities
4.79
  
6.16
  
1.94
Current Liabilities to Net Worth
Total Current Liabilities/Net Worth
0.22
  
0.17
  
0.74
Current Liabilities to Inventory
Total Current Liabilities/Inventory
0.30
  
0.23
  
0.66
Total Liabilities to Net Worth
Total Liabilities/Net Worth
0.28
  
0.31
  
0.76
Fixed Assets to Net Worth
Fixed Assets/Net Worth
0.11
  
0.13
  
0.18
             
Efficiency Ratios:
            
Collection Period (Days Outstanding)
Accounts Receivable/Credit Sales x 365
43.57
  
41.45
  
43.54
Inventory Turnover
Sales/Average Inventory
3.87
  
3.51
  
3.65
Assets to Sales
Total Assets/Sales
0.48
  
0.46
  
0.49
Sales to Net Working Capital
Sales/Current Assets - Current Liabilities
3.21
  
3.18
  
5.06
Accounts Payable to Sales
Accounts Payable/Sales
0.04
  
0.04
  
0.04
             
Profitability Ratios:
            
Return on Sales (Profit Margin)
Net Profit After Taxes/Sales
0.06
  
0.07
  
0.07
Return on Assets
Net Profit After Taxes/Total Assets
0.12
  
0.14
  
0.13
Return on Net Worth (Return on Equity)
Net Profit After Taxes/Net Worth
0.15
  
0.19
  
0.23
             

Capital Resources and Liquidity

On November 1, 2004, we entered into a Credit Agreement with Bank One, N.A., which replaced our line of credit with Wells Fargo Bank. The current facility matures in October 2007 and is secured by our accounts receivable and inventory. We opted to reduce the maximum amount that may be borrowed under this line of credit to $3.0 million in order to reduce the fees required on the un-borrowed portion of the line.

On November 3, 2003, we entered into a Credit and Security Agreement with Wells Fargo Bank, N.A., which replaced a line of credit with another bank affiliated with Wells Fargo. The Wells Fargo current facility would have matured in November 2005 and was secured by all assets of the Company.


20

We are currently in compliance with all covenants and conditions contained in the Bank One Credit Agreement and have no reason to believe that we will not continue to operate in compliance with the provisions of these financing arrangements. The principal terms and conditions of the Credit Agreement are described in further detail in Note 4 to the Consolidated Financial Statements, Notes Payable and Long-Term Debt. 

We borrow and repay funds under revolving credit terms as needed. Principal balances at the end of each quarter are shown below:

4th Qtr. ‘03
1st Qtr. ‘04
2nd Qtr. ‘04
3rd Qtr. ‘04
4th Qtr. ‘04
(Wells Fargo)
(Wells Fargo)
(Wells Fargo)
(Wells Fargo)
(Bank One)
$1,792,984
$1,267,984
$1,100,000
$1,013,565
$505,154

Total bank indebtedness at the end of 2003 and 2004 are shown below:

   
December 31,
  
   
2003
  
2004
  
   
Principal
  
Accrued Interest
  
Principal
  
Accrued Interest
  
Revolving Line
 
$
1,792,984
  
$
6,374
  
$
505,154
  
$
6,219
  

Reflecting the reduction of bank indebtedness during the period, our financing activities for 2004, 2003 and 2002 had net cash requirements (deficits) of $1.2 million, $1.3 million and $214,000, respectively.

The primary source of liquidity and capital resources during 2004 was cash flow provided by operating activities. Cash flow from operations for 2004 was $2.9 million, the largest portion generated from net income. Cash flow from operations in 2003 was $3.3 million, generated from net income and the reduction of inventory. Cash flow from operations in 2002 was $1.4 million.

Consolidated accounts receivable increased to $2.0 million at December 31, 2004 compared to $1.8 million at December 31, 2003. Average days to collect accounts slowed slightly from 41.46 days in 2003 to 43.57 days in 2004 on a consolidated basis.

Inventory increased from $11.1 million at the end of 2003 to $12.7 million at December 31, 2004. We expect our inventory to slowly trend upward as we continue our expansion of the Tandy Leather store chain. However, we are pleased with our investment in inventory at the end of 2004 as it was within 3% of our internal targets of optimum inventory levels. We attempt to manage our inventory levels to avoid tying up excessive capital.

Consolidated inventory turned 3.87 times during 2004, a slight improvement from the 3.51 times turned in 2003. We compute our inventory turnover rates as sales divided by average inventory.

By operating division, inventory turns are as follows:

Segment
2004
2003
2002
Wholesale Leathercraft
3.11
2.97
3.20
Retail Leathercraft
8.88
8.69
8.10
Roberts, Cushman
4.12
3.71
4.12
       
Wholesale Leathercraft distribution centers only
8.69
8.26
7.96


21

Retail Leathercraft inventory turns are significantly higher than that of the Wholesale Leathercraft because its inventory consists only of the inventory at the stores. The Tandy Leather stores have no warehouse (backstock) inventory to include in the turnover computation as the stores get their product from the Leather Factory central warehouse. Leather Factory's turns are expected to be slower because the central warehouse inventory supports the stores and distribution centers.

Accounts payable increased to $1.9 million at the end of 2004 compared to $1.6 million at the end of 2003 due primarily to the increase in inventory purchases.

As discussed above, the largest use of operating cash in 2004 was for debt reduction and inventory purchases. Capital expenditures totaled $370,000 and $360,000 for the years ended December 31, 2004 and 2003, respectively. The 2004 capital expenditures consisted of fixtures and equipment for the new Tandy Leather retail stores ($155,000), the remodel of the accounting offices located at our corporate complex ($77,000), and miscellaneous computer and other equipment ($124,000). Capital expenditures in 2003 occurred primarily due to the expansion of the Tandy Leather store chain and the construction of the Stohlman Leather Museum and Gallery located at our Fort Worth corporate complex. Also in 2004, we made expenditures of $557,000 to purchase our primary Canadian competitor as well as three U.S.-based independent leathercraft stores for conversion to Tandy Leather stores. Since we intend to continue opening or acquiring new Tandy Leather stores, expenditures related to this expansion should continue into 2005.  

We believe that cash flow from operations will be adequate to fund our operations in 2005, while also funding expansion and debt reduction. At this time, management knows of no trends or demands, commitments events or uncertainties that will or are likely to materially affect our liquidity, capital resources or results of operations. In addition, we anticipate that this cash flow will enable us to meet the contractual obligations and commercial commitments. However, if cash flows should decrease or uses of cash increase, we may defer debt reduction or increase our borrowings on our line of credit as needed. We believe that, if desired, our present financial condition would permit us to increase the maximum amount that could be borrowed from lenders. Further, we could defer expansion plans if required by unanticipated drops in cash flow. In particular, because of the relatively small investment required by each new Tandy Leather store, we have flexibility in when we make most expansion expenditures.

Off-Balance Sheet Arrangements

We have not had any off-balance sheet arrangements during 2004, 2003 and 2002, and we do not currently have any such arrangements.

Contractual Obligations

The following table summarizes by years our contractual obligations and commercial commitments as of December 31, 2004 (not including related interest expense):

   
Payments Due by Periods
  
 
Contractual Obligations
  
 
Total
  
Less than
1 Year
  
1 - 3
Years
  
4 -5 Years
  
After 5 Years
  
Long-Term Debt(1)
  
$
505,154
    
--
  
$
505,154
    
--
    
--
  
Capital Lease Obligations
    
379,857
  
$
134,067
    
134,067
  
$
111,723
    
--
  
Operating Leases(2)
    
6,237,775
    
2,107,214
    
3,933,668
  
$
196,893
    
--
  
Total Contractual Obligations
  
$
7,122,786
  
$
2,241,281
  
$
4,572,889
  
$
308,616
  
$
--
  
____________________
(1) Our loan from Bank One matures in October 2007. The loan's maturity can be accelerated in the event of a material adverse change or upon other occurrences described in the related credit agreement.
(2) These are our leased facilities.


22

In addition to the information shown in the table above, estimated annual interest to be paid on our line of credit with Bank One would be approximately $30,000 per year, assuming an average interest rate of 5.00% and there was no repayment of principal until maturity. Management expects to continue repaying principal as our cash flow allows and as a result, would expect the interest to be paid to be lower than the $30,000 estimate. The interest rate on the capital lease is 0%. Any imputed interest over the term of the lease would be insignificant.

Summary of Critical Accounting Policies

Management strives to report the financial results of the Company in a clear and understandable manner, although in some cases accounting and disclosure rules are complex and require us to use technical terminology. We follow generally accepted accounting principles in the U.S. in preparing our consolidated financial statements. These principles require us to make certain estimates and apply judgments that affect our financial position and results of operations. Management continually reviews its accounting policies, how they are applied and how they are reported and disclosed in our financial statements. Following is a summary of our more significant accounting policies and how they are applied in preparation of the financial statements.

Basis of Consolidation. We report our financial information on a consolidated basis. Therefore, unless there is an indication to the contrary, financial information is provided for the parent company, The Leather Factory, Inc., and its subsidiaries as a whole. Transactions between the parent company and any subsidiaries are eliminated for this purpose. We own all of the capital stock of our subsidiaries, and we do not have any subsidiaries that are not consolidated. None of our subsidiaries are “off balance sheet.”

Revenue Recognition. We recognize revenue for retail (over the counter) sales as transactions occur and other sales upon shipment of our products provided that there are no significant post-delivery obligations to the customer and collection is reasonably assured, which generally occurs upon shipment. Net sales represent gross sales less negotiated price allowances, product returns, and allowances for defective merchandise.

Allowance for Accounts Receivable. We reduce accounts receivable by an allowance for amounts that may become uncollectible in the future. This allowance is an estimate based primarily on our evaluation of the customer's financial condition, past collection history, and the aging of the account. If the financial condition of any of our customers deteriorates, resulting in an impairment or inability to make payments, additional allowances may be required.

Inventory. Inventory is stated at the lower of cost or market and is accounted for on the “first in, first out” method. This means that sales of inventory treat the oldest item of identical inventory as being the first sold. In addition, we periodically reduce the value of our inventory for slow-moving or obsolete inventory. This reduction is based on management's review of items on hand compared to their estimated future demand. If actual future demand is less favorable than those projected by management, additional write-downs may be necessary. Goods shipped to us are recorded as inventory owned by us when the risk of loss shifts to us from the supplier.

Goodwill. We have indicated previously that a change in the accounting rules necessitated a change in 2002 in how we report goodwill on our balance sheet. As a result, we incurred an impairment write-down in 2002 of our investment in Roberts, Cushman in the amount of $4.0 million. The remaining goodwill on our balance sheet is analyzed by management periodically to determine the appropriateness of its carry value. As of December 31, 2004, management determined that the present value of the discounted estimated future cash flows of the stores associated with the goodwill is sufficient to support their respective goodwill balances. If actual results of these stores differ significantly from management's projections, such difference could affect the present value calculation in the future resulting in an impairment of all or part of the goodwill currently carried on our balance sheet.


23

Forward-Looking Statements

“Item 1. Business” and “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” of this report contain forward-looking statements of management. In general, these are predictions or suggestions of future events and statements or expectations of future occurrences. There are certain important risks that could cause results to differ materially from those anticipated by some of the forward-looking statements. Some, but not all, of the important risks which could cause actual results to differ materially from those suggested by the forward-looking statements include, among other things:

·  
We might fail to realize the anticipated benefits of the opening of Tandy Leather retail stores or we might be unable to obtain sufficient new locations on acceptable terms to meet our growth plans. Also, other retail initiatives might not be successful.

·  
Political considerations here and abroad could disrupt our sources of supplies from abroad or affect the prices we pay for goods.

·  
Continued involvement by the United States in war and other military operations in the Middle East and other areas abroad could disrupt international trade and affect the Company's inventory sources.

·  
The recent slump in the economy in the United States, as well as abroad, may cause our sales to decrease or not to increase or adversely affect the prices charged for our products. Also, hostilities, terrorism or other events could worsen this condition.
 
·  
As a result of the on-going threat of terrorist attacks on the United States, consumer buying habits could change and decrease our sales.
 
·  
Livestock diseases such as mad cow could reduce the availability of hides and leathers or increase their cost. Also, the prices of hides and leathers fluctuate in normal times, and these fluctuations can affect the Company.
 
·  
If, for whatever reason, the costs of our raw materials and inventory increase, we may not be able to pass those costs on to our customers, particularly if the economy has not recovered from its downturn.
 
·  
Other factors could cause either fluctuations in buying patterns or possible negative trends in the craft and western retail markets. In addition, our customers may change their preferences to products other than ours, or they may not accept new products as we introduce them.
 
·  
Tax or interest rates might increase. In particular, interest rates are likely to increase at some point from their present low levels. These increases will increase our costs of borrowing funds as needed in our business.

·  
Any change in the commercial banking environment may affect us and our ability to borrow capital as needed.

·  
Other uncertainties, which are difficult to predict and many of which are beyond the control of the Company, may occur as well.


24

The Company does not intend to update forward-looking statements.


ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We face exposure to financial market risks, including adverse movement in foreign current exchange rates and changes in interest rates. These exposures may change over time and could have a material impact on our financial results. We do not use or invest in market risk sensitive instruments to hedge any of these risks or for any other purpose.

Foreign Currency Exchange Rate Risk

Our primary foreign currency exposure is related to our subsidiary in Canada. The Leather Factory of Canada, Ltd. has local currency (Canadian dollar) revenue and local currency operating expenses. Changes in the currency exchange rate impact the U.S. dollar amount of revenue and expenses. See Note 12 to the Consolidated Financial Statements, Segment Information, for financial information concerning our foreign activities.  

Interest Rate Risk

We are subject to market risk associated with interest rate movements on outstanding debt. Our borrowings under the credit agreement with Bank One accrue interest at a rate that changes with fluctuations in the prime rate. Based on our level of debt at March 1, 2005, an increase of one percent in the prime rate would result in additional interest expense of approximately $5,000 during a twelve-month period.



25
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
 
The Leather Factory, Inc.
Consolidated Balance Sheets
December 31, 2004 and 2003
 
   
December 31,
2004
  
December 31,
2003
  
ASSETS
          
CURRENT ASSETS:
              
Cash
  
$
2,560,202
  
$
1,728,344
  
Accounts receivable-trade, net of allowance for doubtful accounts
              
of $85,000 and $31,000 in 2004 and 2003, respectively
    
2,032,289
    
1,828,738
  
Inventory
    
12,749,709
    
11,079,893
  
Prepaid income taxes
    
-
    
206,023
  
Deferred income taxes
    
199,308
    
134,312
  
Other current assets
    
629,723
    
702,236
  
Total current assets
    
18,171,231
    
15,679,546
  
               
PROPERTY AND EQUIPMENT, at cost
    
6,005,526
    
5,574,992
  
Less accumulated depreciation and amortization
    
(4,100,961
)
  
(3,669,099
)
     
1,904,565
    
1,905,893
  
               
GOODWILL, net of accumulated amortization of $758,000 and
             
$758,000 in 2004 and 2003, respectively
    
742,860
    
704,235
  
OTHER INTANGIBLES, net of accumulated amortization of
             
$185,000 and $164,000 in 2004 and 2003, respectively
    
437,758
    
432,549
  
OTHER assets
    
910,749
    
336,183
  
   
$
22,167,163
  
$
19,058,406
  
               
LIABILITIES AND STOCKHOLDERS' EQUITY
              
CURRENT LIABILITIES:
              
Accounts payable-trade
  
$
1,954,146
  
$
1,545,079
  
Accrued expenses and other liabilities
    
1,682,003
    
1,000,427
  
Income taxes payable
    
22,764
    
-
  
Current maturities of capital lease obligation
    
134,067
    
1,134
  
Total current liabilities
    
3,792,980
    
2,546,640
  
               
DEFERRED INCOME TAXES
    
313,006
    
209,289
  
               
LONG-TERM DEBT, net of current maturities
    
505,154
    
1,792,984
  
CAPITAL LEASE OBLIGATION, net of current maturities
    
245,790
    
-
  
COMMITMENTS AND CONTINGENCIES
    
-
    
-
  
               
STOCKHOLDERS' EQUITY:
              
Preferred stock, $0.10 par value; 20,000,000 shares
             
authorized, none issued or outstanding
    
-
    
-
  
Common stock, $0.0024 par value; 25,000,000 shares
              
authorized, 10,560,661 and 10,487,961 shares issued at 2004 and 2003,
              
10,554,711 and 10,487,961 outstanding at 2004 and 2003, respectively
    
25,345
    
25,171
  
Paid-in capital
    
4,796,999
    
4,673,158
  
Retained earnings
    
12,458,760
    
9,804,719
  
Treasury stock
    
(25,487
)
  
-
  
Less: Notes receivable-secured by common stock
    
-
    
(20,000
)
Accumulated other comprehensive income
   
54,616
    
26,445
  
Total stockholders' equity
    
17,310,233
    
14,509,493
  
   
$
22,167,163
  
$
19,058,406
  
 
The accompanying notes are an integral part of these financial statements.
 
26

The Leather Factory, Inc.
Consolidated Statements of Income
For the Years Ended December 31, 2004, 2003 and 2002

   
2004
  
2003
  
2002
  
               
NET SALES
  
$
46,146,284
  
$
41,712,191
  
$
39,728,615
  
COST OF SALES
    
20,706,239
    
19,020,292
    
18,393,914
  
Gross Profit
    
25,440,045
    
22,691,899
    
21,334,701
  
                     
OPERATING EXPENSES
    
21,181,599
    
18,594,240
    
17,202,927
  
INCOME FROM OPERATIONS
    
4,258,446
    
4,097,659
    
4,131,774
  
                     
OTHER (INCOME) EXPENSE:
                    
Interest expense
    
53,400
    
206,942
    
246,878
  
Other, net
    
(8,600
)
  
(81,773
)
  
65,039
  
Total other expense
    
44,800
    
125,169
    
311,917
  
                     
INCOME BEFORE INCOME TAXES AND CUMULATIVE EFFECT
OF CHANGE IN ACCOUNTING PRINCIPLE
    
4,213,646
    
3,972,490
    
3,819,857
  
                     
PROVISION FOR INCOME TAXES
    
1,559,605
    
1,232,116
    
1,224,868
  
                     
NET INCOME BEFORE CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE
    
2,654,041
    
2,740,374
    
2,594,989
  
                     
CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE, NET OF INCOME TAXES
    
-
    
-
    
(4,008,831
)
                     
NET INCOME (LOSS)
  
$
2,654,041
  
$
2,740,374
  
$
(1,413,842
)
                     
                     
NET INCOME (LOSS) PER COMMON SHARE - BASIC:
                    
INCOME BEFORE CUMULATIVE EFFECT OF CHANGE IN ACCTG PRINCIPLE
  
$
0.25
  
$
0.27
  
$
0.26
  
CUMULATIVE EFFECT OF CHANGE IN ACCTG PRINCIPLE, NET OF TAX
    
-
    
-
    
(0.40
)
   
$
0.25
  
$
0.27
  
$
(0.14
)
                     
NET INCOME (LOSS) PER COMMON SHARE - DILUTED:
                    
INCOME BEFORE CUMULATIVE EFFECT OF CHANGE IN ACCTG PRINCIPLE
  
$
0.24
  
$
0.25
  
$
0.24
  
CUMULATIVE EFFECT OF CHANGE IN ACCTG PRINCIPLE, NET OF TAX
    
-
    
-
    
(0.37
)
   
$
0.24
  
$
0.25
  
$
(0.13
)
                     
Weighted Average Number of Shares Outstanding:
                    
Basic
    
10,543,994
    
10,323,549
    
10,063,581
  
Diluted
    
10,957,518
    
10,861,305
    
10,761,670
  
 
The accompanying notes are an integral part of these financial statements.

27

The Leather Factory, Inc.
Consolidated Statements of Cash Flows
For the Years Ended December 31, 2004, 2003 and 2002

   
2004
  
2003
  
2002
  
CASH FLOWS FROM OPERATING ACTIVITIES:
              
Net income (loss)
  
$
2,654,041
  
$
2,740,374
  
$
(1,413,842
)
Adjustments to reconcile net income (loss) to net cash
                   
Provided by operating activities -
                    
Depreciation and amortization
    
452,653
    
529,262
    
491,312
  
Loss on disposal of assets
    
(2,000
)
  
(9,103
)
  
-
  
Amortization of deferred financing costs
    
-
    
-
    
37,038
  
Deferred income taxes
    
38,721
    
47,991
    
(30,184
)
Other
    
20,123
    
47,235
    
(2,502
)
Cumulative effect of change in accounting principle
    
-
    
-
    
4,008,831
  
Net changes in assets and liabilities, net of effect of
                    
business acquisitions:
                    
Accounts receivable-trade, net
    
(112,738
)
  
109,960
    
359,255
  
Inventory
    
(1,303,762
)
  
1,615,451
    
(3,463,866
)
Income taxes
    
228,787
    
(150,379
)
  
16,124
  
Other current assets
    
(102,163
)
  
(30,119
)
  
(192,726
)
Accounts payable-trade
    
406,357
    
(49,830
)
  
291,311
  
Accrued expenses and other liabilities
    
658,692
    
(1,502,904
)
  
1,332,179
  
Total adjustments
    
284,670
    
607,564
    
2,846,772
  
Net cash provided by operating activities
    
2,938,711
    
3,347,938
    
1,432,930
  
                     
CASH FLOWS FROM INVESTING ACTIVITIES:
                    
Purchase of property and equipment
    
(369,559
)
  
(360,202
)
  
(1,073,515
)
Payments in connection with businesses acquired
    
(556,794
)
  
-
    
(435,747
)
Proceeds from sale of assets
    
2,000
    
6,217
    
-
  
Decrease (increase) in other assets
    
10,280
    
(27,970
)
  
(14,754
)
Other intangible costs
    
-
    
-
    
(1,625
)
Net cash used in investing activities
    
(914,073
)
  
(381,955
)
  
(1,525,641
)
                     
CASH FLOWS FROM FINANCING ACTIVITIES:
                    
Net decrease in revolving credit loans
    
(1,287,830
)
  
(2,420,550
)
  
(286,889
)
Payments on notes payable and long-term debt
    
(23,478
)
  
(6,556
)
  
(27,483
)
Decrease (increase) in cash restricted for payment on revolver
    
-
    
553,839
    
(62,110
)
Payments received on notes secured by common stock
    
20,000
    
24,003
    
27,936
  
Repurchase of common stock (treasury stock)
    
(25,487
)
  
-
    
-
  
Proceeds from issuance of common stock and warrants
    
124,015
    
510,068
    
133,774
  
Net cash used in financing activities
    
(1,192,780
)
  
(1,339,196
)
  
(214,772
)
                     
NET INCREASE (DECREASE) IN CASH
    
831,858
    
1,626,787
    
(307,483
)
                     
CASH, beginning of period
    
1,728,344
    
101,557
    
409,040
  
                     
CASH, end of period
  
$
2,560,202
  
$
1,728,344
  
$
101,557
  
                     
                     
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
                    
Interest paid during the period
  
$
59,773
  
$
216,275
  
$
213,791
  
Income tax paid during the period, net of (refunds)
    
1,197,347
    
1,138,799
    
1,254,679
  
                     
NON-CASH INVESTING ACTIVITIES:
                    
Equipment acquired under capital lease financing arrangements
  
$
402,201
    
-
    
-
  
 
The accompanying notes are an integral part of these financial statements.

28
 
The Leather Factory, Inc.
Consolidated Statements of Stockholders' Equity
For the Years Ended December 31, 2004, 2003 and 2002

   
 
 
Number of Shares
  
 
 
Par Value
  
 
 
Paid-in Capital
  
 
 
Treasury
Stock
  
 
 
Retained Earnings
  
Notes receivable
secured by common stock
  
Accumulated Other Cumulative Income (Loss)
  
 
 
 
Total
  
 
 
Comprehensive
Income (Loss)
  
BALANCE, December 31, 2001
    
9,991,161
  
$
23,979
  
$
4,030,808
    
-
  
$
8,478,187
  
$
(71,939
)
$
(37,064
)
$
12,423,671
        
                                                         
Payments on notes receivable secured by common stock
    
-
    
-
    
-
    
-
    
-
    
27,936
    
-
    
27,936
        
Shares issued - stock options exercised
    
158,800
    
381
    
133,393
    
-
    
-
    
-
    
-
    
133,774
        
Net loss
   
-
    
-
    
-
    
-
    
(1,413,842
)
  
-
    
-
    
(1,413,842
)
  
(1,413,842
)
Translation adjustment
    
-
    
-
    
-
    
-
    
-
    
-
    
(1,477
)
  
(1,477
)
  
(1,477
)
BALANCE, December 31, 2002
    
10,149,961
  
$
24,360
  
$
4,163,901
    
-
  
$
7,064,345
  
$
(44,003
)
$
(38,541
)
$
11,170,062
        
                                                         
Comprehensive income for the year ended December 31, 2002            
                          
$
(1,415,319
)
                                                         
Payments on notes receivable secured by common stock
    
-
    
-
          
-
    
-
    
24,003
    
-
    
24,003
        
Shares issued - stock options and warrants exercised
    
338,000
    
811
    
442,016
    
-
    
-
    
-
    
-
    
442,827
        
Warrants to acquire 100,000 shares of common stock issued
    
-
    
-
    
67,241
    
-
    
-
    
-
    
-
    
67,241
        
Net income
    
-
    
-
    
-
    
-
    
2,740,374
    
-
    
-
    
2,740,374
  
$
2,740,374
  
Translation adjustment
    
-
    
-
    
-
    
-
    
-
    
-
    
64,986
    
64,986
    
64,986
  
BALANCE, December 31, 2003
    
10,487,961
  
$
25,171
  
$
4,673,158
    
-
  
$
9,804,719
  
$
(20,000
)
$
26,445
  
$
14,509,493
        
                                                         
Comprehensive income for the year ended December 31, 2003            
                          
$
2,805,360
  
                                                         
Payments on notes receivable secured by common stock
    
-
    
-
    
-
    
-
    
-
    
20,000
    
-
    
20,000
        
Shares issued - stock options and warrants exercised
    
72,700
    
174
    
74,896
    
-
    
-
    
-
    
-
    
75,070
        
Warrants to acquire 50,000 shares of common stock issued
    
-
    
-
    
48,945
    
-
    
-
    
-
    
-
    
48,945
        
Purchase of treasury stock
    
-
    
-
    
-
    
(25,487
)
  
-
    
-
    
-
    
(25,487
)
      
Net income
    
-
    
-
    
-
    
-
    
2,654,041
    
-
    
-
    
2,654,041
  
$
2,654,041
  
Translation adjustment
    
-
    
-
    
-
    
-
    
-
    
-
    
28,171
    
28,171
    
28,171
  
BALANCE, December 31, 2004
    
10,560,661
  
$
25,345
  
$
4,771,512
  
$
(25,487
)
$
12,458,760
    
-
 
$
54,616
  
$
17,310,233
        
                                                         
Comprehensive income for the year ended December 31, 2004            
                          
$
2,682,212
  

The accompanying notes are an integral part of these financial statements.
 
29
 
THE LEATHER FACTORY, INC.
NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS
 
DECEMBER 31, 2004, 2003, and 2002

 
1. SIGNIFICANT ACCOUNTING POLICIES
 
·  
Business

Our primary line of business is the sale of leather, leather crafts and related supplies. We sell our products via company-owned stores throughout the United States and Canada. Numerous customers including retailers, wholesalers, assemblers, distributors and other manufacturers are geographically disbursed throughout the world. The Company also has light manufacturing facilities in Texas and New York.
 
·  
Management estimates and reporting

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and reported amounts of revenues and expenses during the periods presented. Actual results could differ from those estimates. Significant assets and liabilities with reported amounts based on estimates include trade accounts receivables and deferred income taxes.

·  
Principles of consolidation

The consolidated financial statements include the accounts of The Leather Factory, Inc. and its wholly owned subsidiaries, The Leather Factory, L.P. (a Texas limited partnership) and its corporate partners, Tandy Leather Company, L.P. (a Texas limited partnership) and its corporate partners, Roberts, Cushman & Company, Inc. (a New York corporation), and The Leather Factory of Canada, Ltd. (a Canadian corporation). All intercompany accounts and transactions have been eliminated in consolidation.

·  
Foreign currency translation

Foreign currency translation adjustments arise from activities of the Company’s Canadian operations. Results of operations are translated into U.S. dollars using the average exchange rates during the period, while assets and liabilities are translated using period-end exchange rates. Foreign currency translation adjustments of assets and liabilities are recorded in stockholders’ equity.

·  
Revenue recognition

The Company's sales generally occur via two methods: (1) at the store counter, and (2) shipment by common carrier. Sales at the counter are recorded and title passes as transactions occur. Otherwise, sales are recorded and title passes when the merchandise is shipped to the customer. Shipping terms are normally FOB shipping point.

The Company offers an unconditional satisfaction guarantee to all customers and accepts all product returns. Net sales represent gross sales less negotiated price allowances, product returns, and allowances for defective merchandise.

·  
Discounts

The Company maintains four price levels on a consistent basis: retail, wholesale, business, and distributor. Gross sales are reported after deduction of discounts. The Company does not pay slotting fees or make other payments to resellers. Several customers require the Company to participate in their cooperative advertising programs. These programs are a negotiated percentage of their purchases and are accounted for as a reduction of sales.

·  
Expense categories

Cost of goods sold include inbound freight and duty charges from vendors to the Company's central warehouse, freight and handling charges to move merchandise from the central warehouse to the Company's stores, and manufacturing overhead, as appropriate.


30

Operating expenses include all selling, general and administrative costs including wages and related employee expenses (payroll taxes, health benefits, ESOP contributions, etc.), advertising, outbound freight charges (to ship merchandise to customers), rent, and utilities.

·  
Property and equipment, net of accumulated depreciation and amortization

Property and equipment are stated at cost. Depreciation is computed using the straight-line method over the estimated useful lives of the assets, which are five to ten years for equipment, five to seven years for furniture and fixtures, and five years for vehicles. Leasehold improvements are amortized over the lesser of the life of the lease or the useful life of the asset. Repairs and maintenance costs are expensed as incurred.

·  
Inventory

Inventory is valued at the lower of first-in, first-out cost or market. In addition, the value of inventory is periodically reduced for slow-moving or obsolete inventory based on management's review of items on hand compared to their estimated future demand.

·  
Impairment of long-lived assets

The Company adopted SFAS No. 144, Accounting for the Impairment or Disposal of Long-lived Assets, effective January 1, 2002. The statement supersedes SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of, and the accounting and reporting provisions of Accounting Principles Board (APB) Opinion No. 30, Reporting the Results of Operations for a Disposal of a Segment of a Business. The adoption of SFAS No. 144 did not affect the financial condition or results of operations of the Company.

·  
Earnings per share

Basic earnings per share are computed based on the weighted average number of common shares outstanding during the period. Diluted earnings per share includes, to the extent inclusion of such shares would be dilutive to earnings per share, the effect of outstanding options and warrants, computed using the treasury stock method. Unearned shares, if any, held by the Employees' Stock Ownership Plan (ESOP) are deemed not to be outstanding for earnings per shares calculations.

BASIC
  
2004
  
2003
  
2002
  
Net income (loss)
  
$
2,654,041
  
$
2,740,374
  
$
(1,413,842
)
                     
Weighted average common shares outstanding
    
10,543,994
    
10,323,549
    
10,063,581
  
                     
Earnings per share - basic
  
$
0.25
  
$
0.27
  
$
(0.14
)
                     
                     
DILUTED
                    
Net income (loss)
  
$
2,654,041
  
$
2,740,374
  
$
(1,413,842
)
                     
Weighted average common shares outstanding
    
10,543,994
    
10,323,549
    
10,063,581
  
Effect of assumed exercise of stock options and warrants
    
413,524
    
537,756
    
698,089
  
Weighted average common shares outstanding, assuming dilution
    
10,957,518
    
10,861,305
    
10,761,670
  
                     
Earnings per share - diluted
 
$
0.24
  
$
0.25
  
$
(0.13
)
                     
Outstanding options and warrants excluded as anti-dilutive
    
136,000
    
60,000
    
-
  

For additional disclosures regarding the employee stock options and the warrants, see Note 9. The net effect of converting stock options and warrants to purchase 752,500 and 792,700 shares of common stock at option prices less than the average market prices has been included in the computations of diluted EPS for the years ended December 31, 2004 and 2003, respectively.

·  
Goodwill and other intangibles

Statement of Financial Accounting Standards ("SFAS") No. 142, "Goodwill and Other Intangible Assets," prescribes a two-phase process for impairment testing of goodwill, which is performed once annually, absent indicators of impairment. The first phase screens for impairment, while the second phase (if necessary) measures the impairment. As a result of SFAS 142, an impairment write-down occurred in the first quarter of 2002 of the investment in subsidiary, Roberts, Cushman & Company, Inc., in the amount of $4.0 million. Goodwill remaining on the balance sheet is analyzed by management periodically to determine the appropriateness of its carrying value. Management has elected to perform the annual analysis during the fourth calendar quarter of each year. As of December 31, 2004, management determined that the present value of the discounted estimated future cash flows of the stores associated with the goodwill is sufficient to support their respective goodwill balances.

31


Under SFAS 142, goodwill impairment is deemed to exist if the net book value of a reporting unit exceeds its estimated fair value. The Company’s reporting units are generally the same as the operating segments identified in Note 11 - Segment Information. The new methodology in SFAS 142 differs from the Company’s prior policy, which was permitted under earlier accounting standards, of using undiscounted cash flows of the acquired asset to determine if goodwill is recoverable.

A summary of changes in the Company’s goodwill for the years ended December 31, 2004 and 2003 is as follows:

   
Leather
Factory
  
Tandy
Leather
  
Balance, December 31, 2002
  
$
333,655
  
$
352,829
  
Acquisitions and adjustments
    
17,751
    
-
  
Impairments
    
-
    
-
  
Balance, December 31, 2003
    
351,406
    
352,829
  
Acquisitions and adjustments
    
8,048
    
30,577
  
Impairments
    
-
    
-
  
Balance, December 31, 2004
  
$
359,454
  
$
383,406
  

As of December 31, 2004 and 2003, the Company’s intangible assets and related accumulated amortization consisted of the following:

   
As of December 31, 2004
  
   
 
Gross
  
Accumulated Amortization
  
 
Net
  
Trademarks, Copyrights
  
$
544,369
  
$
174,611
  
$
369,758
  
Non-Compete Agreements
    
78,000
    
10,000
    
68,000
  
   
$
622,369
  
$
184,611
  
$
437,758
  

   
As of December 31, 2003
  
   
 
Gross
  
Accumulated Amortization
  
 
Net
  
Trademarks, Copyrights
  
$
544,369
  
$
138,320
  
$
406,049
  
Non-Compete Agreements
    
52,000
    
25,500
    
26,500
  
   
$
596,369
  
$
163,820
  
$
432,549
  

Excluding goodwill, the Company has no intangible assets not subject to amortization under SFAS 142. Amortization of intangible assets of $33,782 in 2004, $52,215 in 2003, and $48,283 in 2002 was recorded in operating expenses. Based on the current amount of intangible assets subject to amortization, the estimated amortization expense for each of the succeeding 5 years are as follows:

   
Leather
Factory
  
Tandy
Leather
  
 
Total
  
2005
  
$
5,954
  
$
32,837
  
$
38,791
  
2006
    
5,954
    
32,837
    
38,291
  
2007
    
5,954
    
31,837
    
37,791
  
2008
    
5.954
    
30,337
    
36,291
  
2009
    
5,954
    
30,337
    
36,291
  

During 2004, the Company acquired the following intangible assets:
       
Amortization Period
  
Non-Compete Agreements
  
$
26,000
    
3 - 5 years
  
               

·  
Fair value of financial Instruments

The principal financial instruments held consist of accounts receivable, accounts payable, notes payable and long-term debt. The carrying value of accounts receivable and accounts payable approximate their fair value due to the relatively short-term nature of the accounts. The interest rates on the Company’s notes payable and long-term debt fluctuate with changes in the prime rate and are the rates currently available to the Company; therefore, the carrying amount of those instruments approximates their fair value.
 
32
 
·  
Deferred taxes
 
Deferred income taxes result from temporary differences in the bases of our assets and liabilities reported for book and tax purposes.

·  
Stock options

We periodically grant stock options for a fixed number of shares to employees and non-employee directors with an exercise price equal to the fair market value of the shares at the date of grant. We account for stock option grants to employees and directors using the intrinsic value method. Under the intrinsic value method, compensation associated with stock awards to employees and directors is determined as the difference, if any, between the current fair value of the underlying common stock on the date compensation is measured and the price the employee or director must pay to exercise the award. The measurement date for employee awards is generally the date of grant.

At December 31, 2004, we had two stock-based compensation plans, which are described more fully in Note 9. No stock-based compensation cost is reflected in net income in 2004 and 2003, as all options granted under those plans had an exercise price equal to the market value of the underlying common stock on the date of grant. The following table illustrates the effect on net income and earnings per share if we had applied the fair value recognition provisions of FASB Statement No. 123, Accounting for Stock-Based Compensation, to stock-based compensation.

   
Years Ended December 31,
  
   
2004
  
2003
  
2002
  
Net income (loss), as reported
  
$
2,654,041
  
$
2,740,374
  
$
(1,413,842
)
Plus: Stock -based employee compensation expense included in reported net income, net of tax
    
-
    
-
    
-
  
Less: Total stock-based compensation expense determined under fair value based method for all awards, net of related tax effects
    
117,443
    
98,186
    
103,619
  
Pro forma net income (loss)
    
2,536,598
    
2,642,188
  
$
(1,517,461
)
                     
Earnings (loss) per share:
                    
Basic - as reported
  
$
0.25
  
$
0.27
  
$
(0.14
)
Basic - pro forma
  
$
0.24
  
$
0.26
  
$
(0.15
)
                     
Diluted - as reported
  
$
0.24
  
$
0.25
  
$
(0.13
)
Diluted - pro forma
  
$
0.23
  
$
0.24
  
$
(0.14
)

The fair value of options at the date of grant was estimated using the Black-Scholes option pricing model with the following weighted-average assumptions:

   
2004
  
2003
  
2002
  
Volatility
    
36.4
%
  
69.6
%
  
73.6
%
Expected option life
    
3-5
    
5
    
5
  
Interest rate (risk free)
    
3.375
%
  
3.25
%
  
3.00
%
Dividends
    
None
    
None
    
None
  

The effect on 2004, 2003 and 2002 pro forma net income (loss) and earnings (loss) per share of the estimated fair value of stock options and shares are not necessarily representative of the effects on the results of operations in the future. In addition, the estimates made utilize a pricing model developed for traded options with relatively short lives; our option grants typically have a life of up to ten years and are not transferable. Therefore, the actual fair value of a stock option grant may be different from our estimates. We believe that our estimates incorporate all relevant information and represent a reasonable approximation in light of the difficulties involved in valuing non-traded stock options.

In December 2004, SFAS No. 123 (revised 2004), "Share-Based Payment" (SFAS 123R) was issued. SFAS 123R replaces SFAS No. 123 and supercedes APB Opinion No. 25. The Company is required to adopt SFAS 123R beginning July 1, 2005. SFAS 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on their fair values. The pro forma disclosures previously permitted under SFAS no longer will be an alternative to financial statement recognition. Sec Note 12 - Recent Accounting Pronouncements for additional information.

33


·  
Comprehensive income

Comprehensive income represents all changes in stockholders’ equity, exclusive of transactions with stockholders. The accumulated balance of foreign currency translation adjustments is presented in the consolidated financial statements as “accumulated other comprehensive income or loss”.

·  
Shipping and handling costs

All shipping and handling costs incurred by the Company are included in operating expenses on the statements of income. These costs totaled approximately $1,360,000, $1,206,000 and $1,284,000 for the years ended December 31, 2004, 2003 and 2002, respectively.

·  
Advertising

With the exception of catalog costs, advertising costs are expense as incurred. Catalog costs are capitalized and expensed over the estimated useful life of the particular catalog in question, which is typically twelve to eighteen months. Such capitalized costs are included in other current assets and totaled $217,000 and $102,304 at December 31, 2004 and 2003, respectively. Total advertising expense was $2,571,124 in 2004; $2,399,879 in 2002; and $2,265,659 in 2002.

The Company agrees to list the names and addresses of the Authorized Sales Centers (ASCs) in certain mailing pieces produced. The inclusion of these names and addresses are at the Company's sole discretion. The production and distribution of direct mailings is the primary method of advertising used by the Company and normally consists of 50 to 75 unique mailing pieces annually. Normally, the ASCs are included in six to eight of those pieces. The Company believes that the inclusion of these ASC locations in the flyers has no impact on the financial statements of the Company.

·  
Cash flow presentation

For purposes of the statement of cash flows, the Company considers all highly liquid investments with initial maturities of three months or less from the date of purchase to be cash equivalents.

2. VALUATION AND QUALIFYING ACCOUNTS

·  
Allowance for uncollectible accounts

We maintain allowances for bad debts based on factors such as the composition of accounts receivable, the age of the accounts, historical bad debt experience, and management's evaluation of the financial condition and past collection history of each customer. Accounts are written off as they are deemed uncollectible based on a periodic review of accounts. Our allowance for doubtful accounts was $85,132 and $31,469, respectively, at December 31, 2004 and 2003. The reduction in 2003 was due to improvements in trade accounts receivable and collections of accounts for which reserves had been provided. The 2004 reserve balance returned to a more normal level based on our general evaluation of the collectibility of our accounts. The following is a roll forward of the allowance for doubtful accounts:
 
   
 
Balance at beginning of year
  
 
Reserve "purchased" during year
  
Additions (reductions) charged to costs and expenses
  
 
Foreign exchange gain/loss
  
 
 
Write-offs
  
 
Balance at end of year
  
Year ended December 31, 2004
  
$
31,469
    
9,785
    
104,587
    
4,980
    
(65,688
)
$
85,133
  
Year ended December 31, 2003
  
$
77,657
    
-
    
87,175
    
967
    
(134,330
)
$
31,469
  
Year ended December 31, 2002
  
$
190,890
    
-
    
(30,197
)
  
24
    
(83,060
)
$
77,657
  

·  
Sales returns and defective merchandise

Product returns are generally recorded directly against sales as those returns occur. Historically, the amount of returns is immaterial and as a result, no reserve is recorded in the financial statements.

·  
Slow-moving and obsolete inventory

The majority of inventory items maintained by the Company have no restrictive shelf life. Management reviews all inventory items annually to determine what items should be eliminated from the product line. Items are selected for several reasons: (1) the item is slow-moving; (2) the supplier is unable to provide an acceptable quality or quantity; or (3) to maintain a freshness in the product line. Once an item has been selected to discontinue, we devalue the cost of the item by 25% of its original value each quarter until its value has been reduced to zero. Reductions in inventory for slow-moving and obsolete inventory are recorded directly against inventory.

34


3.  
BALANCE SHEET COMPONENTS

   
December 31,
  
   
2004
  
2003
  
INVENTORY
              
Finished goods held for sale
  
$
11,571,869
  
$
9,902,140
  
Raw materials and work in process
    
1,177,840
    
1,177,753
  
TOTAL
  
$
12,749,709
  
$
11,079,893
  
               
PROPERTY AND EQUIPMENT
              
Leasehold improvements
  
$
1,181,828
  
$
1,100,785
  
Equipment
    
3,837,654
    
3,572,506
  
Furniture and fixtures
    
939,976
    
843,851
  
Vehicles
    
46,068
    
57,850
  
     
6,005,526
    
5,574,992
  
Less: accumulated depreciation
    
(4,100,961
)
  
(3,669,099
)
TOTAL
  
$
1,904,565
  
$
1,905,893
  
 
Depreciation expense was $444,878, $477,047, and $443,029 for the years ended December 31, 2004, 2003 and 2002, respectively.
 
    December 31, 
   
2004
  
2003
  
OTHER CURRENT ASSETS
          
Accounts receivable - employees
  
$
40,401
  
$
23,375
  
Accounts receivable - other
    
70,814
    
24,691
  
Prepaid expenses
    
436,011
    
495,334
  
Payments on merchandise not rec'd
    
82,497
    
158,836
  
TOTAL
  
$
629,723
  
$
702,236
  
               
OTHER ASSETS
              
Security deposits - utilities, locations, etc.
  
$
75,903
  
$
73,193
  
Leather art collection
    
250,000
    
250,000
  
Other
    
-
    
12,990
  
Computer software not implemented yet
    
584,846
    
-
  
TOTAL
  
$
910,749
  
$
336,183
  
               
ACCR EXPS AND OTHER LIABILITIES
    
       
Accrued bonuses
  
$
768,937
  
$
527,880
  
Accrued payroll
    
212,298
    
220,055
  
Accrued ESOP contribution
    
140,000
    
-
  
Sales and payroll taxes payable
    
208,896
    
154,948
  
Other
    
351,872
    
97,544
  
TOTAL
  
$
1,682,003
  
$
1,000,427
  

4. NOTES PAYABLE AND LONG-TERM DEBT

On November 1, 2004, the Company entered into a Credit Agreement with Bank One, N.A. ("Bank One"), pursuant to which Bank One agreed to provide a revolving credit facility of up to $3,000,000. The revolver bears interest at prime less ..5% or LIBOR plus 1.35% and matures on October 6, 2007. Proceeds of the closing of the Credit Facility were used to pay all amounts due and owing by the Company pursuant to the Credit and Security Agreement by and between the Company and Wells Fargo Bank, N.A. ("WFB"). At closing, the Company's revolving line of credit with WFB in the principal amount of $975,000 was satisfied in its entirety.

On November 3, 2003, the Company entered into a Credit and Security Agreement with Wells Fargo Bank Texas, N.A. ("WFB-TX"), pursuant to which WFB-TX agreed to provide a revolving credit facility of up to $6,000,000. The revolver bears interest at prime less .5% and matures on November 3, 2005. Proceeds of the closing of the Credit Facility were used to pay all amounts due and owing by the Company pursuant to the Credit and Security Agreement, as amended, by and between the Company and Wells Fargo Bank Minnesota, N.A. ("WFB-MN"). At closing, the Company's revolving line of credit with WFB-MN in the principal amount of $2,054,549 was satisfied in its entirety.


35

On November 26, 2003, the Company entered into the First Amendment to the Credit and Security Agreement ("Amendment 1") with WFB-TX. There, WFB-TX approved the Company's request for a reduction in the maximum loan amount to $5,000,000, a reduction of $1,000,000. Also, Amendment 1 modified the original restriction regarding the repurchase of treasury stock to allow for treasury stock repurchases under $150,000.

At December 31, 2004 and 2003, the amounts outstanding under the above agreements consisted of the following:

   
2004
  
2003
 
Credit Agreement with Bank One - collateralized by inventory and accounts receivable; payable as follows:
              
               
Line of Credit Note dated October 6, 2004 in the maximum principal amount of $3,000,000 with revolving features as more fully described below - interest due quarterly at prime less .5% (4.75% at 12/31/2004) or LIBOR plus 1.35%; matures October 6, 2007
  
$
505,154
    
-
  
               
Credit and Security Agreement with WFB-TX - collateralized by all of the assets of the Company; payable as follows:
              
               
Revolving Note, as amended, dated November 3, 2003 in the maximum principal amount of $5,000,000 with revolving features as more fully described below - interest due monthly at prime less .5% (3.5% at December 31, 2003); matures November 3, 2005
    
-
  
$
1,792,984
  
     
505,154
    
1,792,984
  
Less - Current maturities
   
-
    
-
  
   
$
505,154
  
$
1,792,984
  

The terms of the Credit Facility contain various covenants which, among other things, require the Company to meet a specific debt service coverage ratio and limit capital expenditures. Other covenants prohibit the Company from incurring indebtedness except as permitted by the terms of the Credit Facility, from entering into any new business or making material changes in any of the Company’s business objectives, purposes or operations. The facility places an affirmative duty on the Company to disclose any covenant violation to the lender.

Scheduled maturities of the Company's notes payable and long-term debt are as follows:
 
2005
  
$
-
  
2006
    
-
  
2007
    
505,154
  
2008
    
-
  
   
$
505,154
  

5. CAPITAL LEASE OBLIGATIONS

The Company leases certain licensed software under a capital lease agreement. The asset subject to the agreement totaling $402,201 is included in other assets as of December 31, 2004. The asset will be reclassified into property and equipment once the conversion and implementation process is completed.

The Company leases certain warehouse equipment under a capital lease agreement. Assets subject to the agreement totaling $18,651 and related accumulated depreciation of $6,262 are included in property and equipment as of December 31, 2003.

At December 31, 2004 and 2003, the amounts outstanding under capital lease obligations consisted of the following:

   
2004
  
2003
 
Capital Lease secured by certain licensed software - total monthly principal payments of $11,172, no interest, maturing October 2007
  
$
379,857
    
-
  
Capital Lease secured by equipment - total monthly principal and interest payments of $572 at approximately 12% interest; maturing February 2004
    
-
    
1,134
  
     
379,857
    
1,134
  
Less - Current maturities
   
134,067
    
1,134
  
   
$
245,790
  
$
-
  


36

6. EMPLOYEE BENEFIT PLAN

The Company has an Employee Stock Ownership Plan (the "Plan") for employees with at least one year of service (as defined by the Plan) and who have reached their 21st birthday. Under the Plan, the Company makes annual cash or stock contributions to a trust for the benefit of eligible employees. As of December 31, 2004, 213 employees and former employees were participants in or beneficiaries of the ESOP. The trust invests in shares of the Company's common stock. The amount of the Company's annual contribution is discretionary. Benefits under the Plan are 100% vested after three years of service and are payable upon death, disability or retirement. Vested benefits are payable upon termination of employment.

The Company applies Statement of Position 93-6 (SOP 93-6), "Employers’ Accounting for Employee Stock Ownership Plans," of the Accounting Standards Division of the American Institute of CPAs. During 2004, 2003, and 2002, respectively, the Company contributed $250,000; $221,400; and $345,312 in cash as current year contributions to the plan and recognized compensation expense related to these payments.

The following table summarizes the number of shares held by the Plan and the market value as of December 31, 2004, 2003, and 2002:

   
Number of Shares
  
Market Value
  
   
2004
  
2003
  
2002
  
2004
  
2003
  
2002
  
Allocated
    
948,147
    
981,540
    
956,320
  
$
3,365,922
  
$
4,750,654
  
$
3,232,362
  
Unearned
    
-
    
-
    
-
    
-
    
-
    
-
  
Total
    
948,147
    
981,540
    
956,320
  
$
3,365,922
  
$
4,750,654
  
$
3,232,362
  

The Company currently offers no postretirement or postemployment benefits to its employees.

7. INCOME TAXES

The provision for income taxes consists of the following:

       
2004
  
2003
  
2002
  
Current provision:
    
Federal
  
$
1,380,951
  
$
1,144,763
  
$
1,078,146
  
 
    
State
    
139,933
    
40,267
    
51,556
  
           
1,520,884
    
1,185,030
    
1,129,702
  
Deferred provision (benefit):
    
Federal
    
33,483
    
46,850
    
82,014
  
 
    
State
    
5,238
    
236
    
13,152
  
           
38,721
    
47,086
    
95,166
  
         
$
1,559,605
  
$
1,232,116
  
$
1,224,868
  

Income (loss) before income taxes is earned in the following tax jurisdictions:

   
2004
  
2003
  
2002
  
United States
  
$
4,078,434
  
$
3,744,550
  
$
3,794,256
  
Canada
    
135,213
    
227,940
    
25,601
  
   
$
4,213,647
  
$
3,972,490
  
$
3,819,857
  

The income tax effects of temporary differences that give rise to significant portions of deferred income tax assets and liabilities are as follows:
 

   
2004
  
2003
  
Deferred income tax assets:
              
Allowance for doubtful accounts
  
$
26,546
  
$
9,782
  
Capitalized inventory costs
    
115,022
    
103,605
  
Warrants
    
42,989
    
-
  
Accrued expenses, reserves, and other
    
57,740
    
20,925
  
Total deferred income tax assets
    
242,297
    
134,312
  
               
Deferred income tax liabilities:
              
Property and equipment depreciation
    
249,892
    
204,482
  
Goodwill and other intangible assets amortization
    
106,103
    
4,807
  
Total deferred income tax liabilities
    
355,995
    
209,289
  
               
Net deferred tax asset (liability)
    
($113,698
)
  
($ 74,977
)

 
37

The net deferred tax liability is classified on the balance sheets as follows:

   
2004
  
2003
  
Current deferred tax assets
  
$
199,308
  
$
134,312
  
Long-term deferred tax liabilities
    
(313,006
)
  
(209,289
)
Net deferred tax asset (liability)
  
$
(113,698
)
$
( 74,977
)

The effective tax rate differs from the statutory rate as follows:
 
   
2004
  
2003
  
2002
  
Statutory rate
    
34%
 
  
34%
 
  
34%
 
State and local taxes
    
4%
 
  
1%
 
  
1%
 
Non-deductible goodwill amortization
    
0%
 
  
0%
 
  
0%
 
Other
    
(1%
)
  
(4%
)
  
(3%
)
Effective rate
    
37%
 
  
31%
 
  
32%
 

8. COMMITMENTS AND CONTINGENCIES

Operating Leases

The Company's primary office facility and warehouse are leased under a five-year lease agreement that expires in March 2008. Rental agreements for the stores and warehouse distribution units expire on dates ranging from March 2005 to January 2010. The Company's lease agreement for the manufacturing facility in Long Island City, New York, expires on June 30, 2006.

Rent expense on all operating leases for the years ended December 31, 2004, 2003, and 2002, was $1,994,030, $1,814,457, and $1,465,577, respectively.

Future minimum lease payments under noncancelable operating leases at December 31, 2004 were as follows:

Year ending December 31:
      
2005
  
$
2,107,214
  
2006
    
1,804,686
  
2007
    
1,422,200
  
2008
    
706,782
  
2009 and thereafter
    
196,893
  
Total minimum lease payments
  
$
6,237,775
  

Litigation

The Company is involved in various litigation that arise in the ordinary course of its business and operations. There are no such matters pending that the Company expects to have a material impact on its financial position and results of operations.

9. SIGNIFICANT BUSINESS CONCENTRATIONS AND RISK

Major Customers

The Company’s revenues are derived from a diverse group of customers primarily involved in the sale of leather crafts. While no single customer accounts for more than 10% of the Company’s consolidated revenues in 2004, 2003 and 2002, sales to the Company’s five largest customers represented 10.6%, 13.8% and 15.1%, respectively, of consolidated revenues in those years. While management does not believe the loss of one of these customers would have a significant negative impact on the Company’s operations, it does believe the loss of several of these customers simultaneously or a substantial reduction in sales generated by them could temporarily affect the Company’s operating results.

Major Vendors

The Company purchases a significant portion of its inventory through one supplier. Due to the number of alternative sources of supply, loss of this supplier would not have an adverse impact on the Company’s operations.


38
Credit Risk

Due to the large number of customers comprising the Company’s customer base, concentrations of credit risk with respect to customer receivables are limited. At December 31, 2004 and 2003, 16.3% and 20.6%, respectively, of the Company’s consolidated accounts receivable were due from three nationally recognized retail chains. The Company does not generally require collateral for accounts receivable, but performs periodic credit evaluations of its customers and believes the allowance for doubtful accounts is adequate. It is management’s opinion that if any one or a group of customer receivable balances should be deemed uncollectible, it would not have a material adverse effect on the Company’s results of operations and financial condition.

10. STOCKHOLDERS' EQUITY

(a)  
Stock Option Plans

·  
1995 Stock Option Plan

In connection with its 1995 Stock Option Plan for officers and key management employees, the Company has outstanding options to purchase its common stock. The plan provides for the granting of either qualified incentive stock options or non-qualified options at the discretion of the Compensation Committee of the Board of Directors. Options are granted at the fair market value of the underlying common stock at the date of grant and vest over a five-year period. The Company has reserved 1,000,000 shares of common stock for issuance under this plan.

·  
1995 Director Non-Qualified Stock Option Plan

In connection with its 1995 Director Non-qualified Stock Option Plan for non-employee directors, the Company has outstanding options to purchase its common stock. The plan provides for the granting of non-qualified options at the discretion of the Compensation Committee of the Board of Directors. Options are granted at the fair market value of the underlying common stock at the date of grant and vest after six months. The Company has reserved 100,000 shares of common stock for issuance under this plan.

·  
Stock Option Summary

All options expire ten years from the date of grant and are exercisable at any time after vesting. Of the combined 1,100,000 shares available for issuance under the two plans, at December 31, 2004, 2003 and 2002, there were 40,000; 40,000; and 106,000; respectively, in un-optioned shares available for future grants.

A summary of stock option transactions for the years ended December 31, 2004, 2003, and 2002, is as follows:

   
2004
  
2003
  
2002
  
       
Weighted
      
Weighted
      
Weighted
  
       
Average
      
Average
      
Average
  
   
Option
  
Exercise
  
Option
  
Exercise
  
Option
  
Exercise
  
   
Shares
  
Price
  
Shares
  
Price
  
Shares
  
Price
  
Outstanding at January 1
    
675,200
  
$
1.540
    
747,200
  
$
1.196
    
846,000
  
$
1.128
  
Granted
    
18,000
    
3.598
    
68,000
    
4.200
    
10,000
    
2.720
  
Forfeited or expired
    
(18,000
)
  
1.350
    
(2,000
)
  
2.720
    
-
    
-
  
Exchanged
   
-
    
-
    
-
    
-
    
-
    
-
  
Exercised
    
(72,700
)
  
1.053
    
(138,000
)
  
0.972
    
(108,800
)
  
0.810
  
Outstanding at December 31
    
602,500
  
$
1.630
    
675,200
  
$
1.540
    
747,200
  
$
1.196
  
Exercisable at end of year
    
354,500
  
$
1.320
    
308,200
  
$
1.158
    
325,200
  
$
1.017
  
Weighted-average fair value of
                                     
options granted during year
  
$
1.20
        
$
2.31
        
$
1.54
        

The following table summarizes outstanding options into groups based upon exercise price ranges at December 31, 2004:

   
Options Outstanding
 
Options Exercisable
 
       
Weighted
  
Weighted
      
Weighted
  
Weighted
  
       
Average
  
Average
      
Average
  
Average
  
   
Option
 
Exercise
  
Maturity
  
Option
 
Exercise
  
Maturity
  
Exercise Price Range
  
Shares
 
Price
  
(Years)
  
Shares
 
Price
  
(Years)
  
$0.75 or Less
    
14,000
  
$
0.661
    
3.16
    
14,000
  
$
0.661
    
3.16
  
$0.76 to $1.125
    
128,500
  
$
0.865
    
2.75
    
118,500
  
$
0.859
    
2.50
  
$1.126 to $1.69
    
370,000
  
$
1.350
    
6.40
    
198,000
  
$
1.350
    
6.40
  
$1.70 to $2.55
    
2,000
  
$
1.900
    
6.74
    
2,000
  
$
1.900
    
6.74
  
$2.56 to $3.84
    
12,000
  
$
3.270
    
9.31
    
2,000
  
$
2.720
    
7.74
  
$3.85-$4.24
    
76,000
  
$
4.165
    
8.83
    
20,000
  
$
4.104
    
8.73
  
     
602,500
  
$
1.630
    
5.91
    
354,500
  
$
1.320
    
5.11
  
 
39
 
(b)  
Warrants

Warrants to acquire up to 100,000 shares of common stock at $3.10 per share were issued in conjunction with a consulting agreement to an unrelated entity in February 2003. The warrants may be exercised at anytime until expiration on February 12, 2008.

Warrants to acquire up to 50,000 shares of common stock at $5.00 per share were issued in conjunction with a consulting agreement to an unrelated entity in February 2004. The warrants may be exercised at anytime until expiration on February 24, 2009.

A summary of warrant transactions for the years ended December 31, 2004, 2003, and 2002, is as follows:

   
2004
  
2003
  
2002
  
       
Weighted
      
Weighted
      
Weighted
  
       
Average
      
Average
      
Average
  
   
Option
  
Exercise
  
Option
  
Exercise
  
Option
  
Exercise
  
   
Shares
  
Price
  
Shares
  
Price
  
Shares
  
Price
  
Outstanding at January 1
    
100,000
    
3.1000
    
200,000
    
.4375
    
300,000
    
.4727
  
Granted
    
50,000
    
5.0000
    
100,000
    
3.1000
    
-
        
Forfeited or expired
    
-
    
-
    
-
    
-
    
(50,000
)
  
.5430
  
Exchanged
   
-
    
-
    
-
    
-
    
-
        
Exercised
    
-
    
-
    
(200,000
)
  
.4375
    
(50,000
)
  
.5430
  
Outstanding at December 31
    
150,000
    
3.7333
    
100,000
    
3.1000
    
200,000
    
.4375
  
Exercisable at end of year
    
150,000
    
3.7333
    
100,000
    
3.1000
    
200,000
    
.4375
  
Weighted-average fair value of
                                     
warrants granted during year
  
$
0.98
        
$
0.67
          
N/A
        

The following table summarizes outstanding warrants into groups based upon exercise price ranges at December 31, 2004:
 
   
Warrants Outstanding
 
Warrants Exercisable
 
       
Weighted
  
Weighted
      
Weighted
  
Weighted
  
       
Average
  
Average
      
Average
  
Average
  
       
Exercise
  
Maturity
  
 
  
Exercise
  
Maturity
  
Exercise Price Range
  
Warrant
  
Price
  
(Years)
  
Warrant
 
Price
  
(Years)
  
$3.00 or Less
    
-
    
-
    
-
    
-
    
-
    
-
  
                                       
More than $3.00 and
                                      
Less Than $5.00
    
100,000
  
$
3.1000
    
3.12
    
100,000
  
$
3.1000
    
3.12
  
                                       
$5.00 or More
    
50,000
  
$
5.0000
    
4.15
    
50,000
  
$
5.0000
    
4.15
  
     
150,000
  
$
3.7333
    
3.46
    
150,000
  
$
3.7333
    
3.46
  
 
(c)  
Notes Receivable Secured by Common Stock

During 1996, the Company purchased certain notes from a financial institution that are collateralized by the Company’s common stock. These notes relate to shares issued under the Company’s 1993 Non-Qualified Incentive Stock Option Plan. These notes, as renewed in 2000, were due from certain members of management and had maturity dates of December 31, 2004. All notes were paid in full as of December 31, 2004.

11. BUSINESS ACQUISITIONS

During 2002, the company acquired certain assets of the following entities for a total purchase price of $435,747:

Entity
Location
Date of acquisition
Oklahoma Leather Supply
Oklahoma City, Oklahoma
January 2002
Heritage Leather
Boise, Idaho
March 2002
The Leather Shop
Memphis, Tennessee
October 2002
Copper Saguaro
Tempe, Arizona
November 2002

All of the acquired entities were formerly operated as independent retail leathercraft stores. The assets purchased in these acquisitions consisted primarily of inventory, store furniture and fixtures, and equipment. Goodwill recognized in these transactions amounted to $158,878, and is reported in the Tandy Leather Company segment. The Company also entered into non-compete agreements with the former owners totaling $52,000 for periods ranging from three to five years.

40
 
During 2004, the Company acquired certain assets of the following entities for a total purchase price of $156,452:

Entity
Location
Date of acquisition
Robyn's LLC
Syracuse, NY
January 2004
Hawkins Handcrafted Leathers
St. Louis, MO
February 2004
Santa Fe Hides & Trappings
Santa Fe, NM
July 2004

All of the acquired entities were formerly operated as independent retail leathercraft stores. The assets purchased in these acquisitions consisted primarily of inventory, store furniture and fixtures, and equipment. Goodwill recognized in these transactions amounted to $30,577, and is reported in the Tandy Leather Company segment. The Company also entered into non-compete agreements with the former owners totaling $26,000 for periods ranging from one to five years.

On November 30, 2004, the Company acquired all of the issued and outstanding shares of capital stock of 1124055 Ontario Inc., a Canadian corporation, and its wholly-owned subsidiary, Heritan Ltd. The total purchase price was approximately $400,000 which was funded with cash generated from operations.

12. SEGMENT INFORMATION

The Company identifies its segments based on the activities of three distinct operations: Wholesale Leathercraft, which consists of a chain of warehouse distribution units located in the United States and Canada operating as The Leather Factory; Retail Leathercraft, which consists of a chain of retail stores located in the United States and Canada operating as Tandy Leather Company; and Roberts, Cushman & Company, which manufactures decorative hat trims sold directly to hat manufactures and distributors.

The Company’s reportable operating segments have been determined as separately identifiable business units. The Company measures segment earnings as operating earnings, defined as income before interest and income taxes.

   
Wholesale
Leathercraft
  
Retail
Leathercraft
  
Roberts,
Cushman & Co
  
 
Total
  
For the year ended December 31, 2004
                          
Net Sales
  
$
30,630,122
  
$
13,515,662
  
$
2,000,500
  
$
46,146,284
  
Gross Profit
    
16,485,052
    
8,348,616
    
606,377
    
25,440,045
  
Operating earnings
   
2,817,940
    
1,385,565
    
54,941
    
4,258,446
  
Interest expense
    
53,400
    
-
    
-
    
53,400
  
Other, net
    
(6,748
)
  
(1,852
)
  
-
    
(8,600
)
Income before income taxes
    
2,771,288
    
1,387,417
    
54,941
    
4,213,646
  
Depreciation and amortization
    
362,173
    
81,750
    
8,730
    
452,653
  
Fixed asset additions
    
197,853
    
155,328
    
16,378
    
369,559
  
Total assets
  
$
17,991,403
  
$
3,372,812
  
$
802,918
  
$
22,167,163
  
                           
For the year ended December 31, 2003
                          
Net Sales
  
$
30,684,092
  
$
9,216,838
  
$
1,811,261
  
$
41,712,191
  
Gross Profit
    
16,332,776
    
5,804,504
    
554,619
    
22,691,899
  
Operating earnings
   
3,462,457
    
604,291
    
30,911
    
4,097,659
  
Interest expense
    
206,942
    
-
    
-
    
206,942
  
Other, net
    
(81,838
)
  
65
    
-
    
(81,773
)
Income before income taxes
    
3,337,354
    
604,225
    
30,911
    
3,972,490
  
Depreciation and amortization
    
443,623
    
75,854
    
9,785
    
529,262
  
Fixed asset additions
    
214,256
    
137,115
    
8,831
    
360,202
  
Total assets
  
$
15,409,084
  
$
2,908,429
  
$
740,893
  
$
19,058,406
  
                           
For the year ended December 31, 2002
                          
Net Sales
  
$
30,313,478
  
$
7,387,874
  
$
2,027,263
  
$
39,728,615
  
Gross Profit
    
16,237,143
    
4,395,384
    
702,175
    
21,334,701
  
Operating earnings (loss)
    
3,742,844
    
371,372
    
17,558
    
4,131,774
  
Interest expense
    
(246,316
)
  
(562
)
  
-
    
(246,878
)
Other, net
    
(64,071
)
  
(968
)
  
-
    
(65,039
)
Income (loss) before income taxes
    
3,432,457
    
369,842
    
17,558
    
3,819,857
  
Depreciation and amortization
    
367,218
    
111,013
    
13,081
    
491,312
  
Fixed asset additions
    
888,491
    
180,522
    
4,502
    
1,073,515
  
Total assets
  
$
16,205,347
  
$
2,562,737
  
$
907,518
  
$
19,675,602
  

41
Net sales for geographic areas was as follows:
   
2004
  
2003
  
2002
  
United States
  
$
42,485,339
  
$
38,934,923
  
$
37,510,567
  
Canada
    
2,112,601
    
1,611,093
    
1,077,120
  
All other countries
    
1,548,344
    
1,166,175
    
1,140,928
  
   
$
46,146,284
  
$
41,712,191
  
$
39,728,615
  

Geographic sales information is based on the location of the customer. Net sales from no single foreign country was material to the Company’s consolidated net sales for the years ended December 31, 2004, 2003, and 2002. The Company does not have any significant long-lived assets outside of the United States.

13. RECENT ACCOUNTING PRONOUNCEMENTS

In April 2002, the FASB issued Statement of Financial Accounting Standards No. 145, Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections. This statement provides guidance on the classification of gains and losses from the extinguishment of debt and on the accounting for certain specified lease transactions. The adoption of this statement did not have a material impact on the Company's current financial position and results of operations.

 
In July 2002, the FASB issued Statement of Financial Accounting Standards No. 146, Accounting for Costs Associated with Exit or Disposal Activities (SFAS No. 146). SFAS 146 nullifies FASB Emerging Issues Task Force (EITF) Issue No. 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)". It requires that a liability be recognized for those costs only when the liability is incurred, that is, when it meets the definition of a liability in the FASB's conceptual framework. SFAS No. 146 also establishes fair value as the objective for initial measurement of liabilities related to exit or disposal activities. SFAS 146 is effective for exit or disposal activities initiated after December 31, 2002. The adoption of this statement did not have a material impact on the Company's financial position and results of operations.
 

In January 2003, the FASB issued FIN 46, Consolidation of Variable Interest Entities, an Interpretation of Accounting Research Bulletin No. 51. FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 is effective immediately for all new variable interest entities created or acquired prior to February 1, 2003, the provision of FIN must be applied for the first interim or annual period beginning after June 15, 2003. The adoption of FIN 46 did not have a material effect on its financial position or results of operations.

In December 2004, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 123R, "Share-Based Payment." SFAS No. 123R is a revision of SFAS No. 123, "Accounting for Stock Based Compensation," and supercedes APB Opinion No. 25. Among other items, SFAS No. 123R eliminates the use of APB 25 and the intrinsic value method of accounting, and requires companies to recognize the cost of employee services received in exchange for awards of equity instruments, based on the grant date fair value of those awards, in the financial statements. The effective date of SFAS No. 123R for the Company is the third quarter of 2005. SFAS no. 123R permits companies to adopt its requirements using either a "modified prospective" method, or a "modified retrospective" method. Under the "modified prospective" method, compensation cost is recognized in the financial statements beginning with the effective date, based on the requirements of SFAS No. 123R for all share-based payments granted after that date, and based on the requirements of SFAS No. 123 for all unvested awards granted prior to the effective date of SFAS No. 123R. Under the "modified retrospective" method, the requirements are the same as under the "modified prospective" method, but also permits entities to restate financial statements of previous periods, either for all prior periods presented or to the beginning of the fiscal year in which the statement is adopted, based on previously pro forma disclosure made in accordance with SFAS No. 123. The Company has not yet determined which of the methods it will use upon adoption.

42
 
The Company currently utilizes the Black-Scholes option pricing model to measure the fair value of stock options granted to employees. While SFAS No. 123R permits entities to continue to use such a model, it also permits the use of a "lattice" model. The Company expects to continue using the Black-Scholes option pricing model upon adoption of SFAS No. 123R to measure the fair value of stock options. The adoption of this statement will have the effect of reducing net income and income per share as compared to what would be reported under the current requirements. These future amounts cannot be precisely estimated because they depend on, among other things, the number of options issued in the future, and accordingly, the Company has not determined the impact of adoption of this statement on its results of operations.

SFAS No. 123R also requires that the benefits associated with the tax deductions in excess of recognized compensation cost be reported as a financing cash flow, rather than as an operating cash flow as required under current literature. This requirement will reduce net operating cash flows and increase net financial cash flows in periods after the effective date. These future amounts cannot be estimated, because they depend on, among other things, when employees exercise stock options.

14. QUARTERLY FINANCIAL DATA (UNAUDITED)

   
First
 
Second
 
Third
 
Fourth
 
2004
  
Quarter
 
Quarter
 
Quarter
 
Quarter
 
Net sales
  
$
12,180,877
  
$
10,959,813
  
$
10,580,074
  
$
12,425,520
  
Gross profit
    
6,724,913
    
5,981,059
    
5,939,433
    
6,794,640
  
Net income
   
970,966
    
516,213
    
427,385
    
739,477
  
Net income per common share:
                          
Basic
   
0.09
    
0.05
    
0.04
    
0.07
  
Diluted
    
0.09
    
0.05
    
0.04
    
0.07
  
Weighted average number of common shares outstanding:
                          
Basic
    
10,506,995
    
10,553,243
    
10,560,661
    
10,554,776
  
Diluted
    
11,011,122
    
11,006,638
    
10,931,940
    
10,888,883
  

   
First
 
Second
 
Third
 
Fourth
 
2003
  
Quarter
 
Quarter
 
Quarter
 
Quarter
 
Net sales
  
$
10,560,085
  
$
10,460,675
  
$
10,119,070
  
$
10,572,361
  
Gross profit
    
5,645,504
    
5,721,054
    
5,589,812
    
5,735,528
  
Net income
   
774,518
    
778,704
    
601,680
    
585,472
  
Net income per common share:
                          
Basic
   
0.08
    
0.08
    
0.06
    
0.06
  
Diluted
    
0.07
    
0.07
    
0.06
    
0.05
  
Weighted average number of common shares outstanding:
                          
Basic
    
10,177,433
    
10,234,054
    
10,394,374
    
10,484,184
  
Diluted
    
10,793,464
    
10,805,019
    
10,902,794
    
10,941,853
  


43

 

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM


The Board of Directors and Stockholders
The Leather Factory, Inc. and Subsidiaries

We have audited the accompanying consolidated balance sheets of The Leather Factory, Inc. and Subsidiaries as of December 31, 2004 and 2003, and the related consolidated statements of income, stockholders' equity, and cash flows for each of the two years then ended in the period ended December 31, 2004. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audit in accordance with the standards of the Public Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of the Company as of December 31, 2004 and 2003, and the consolidated results of its operations and its cash flows for each of the two years in the period ended December 31, 2004, in conformity with accounting principles generally accepted in the United States of America.


Weaver & Tidwell LLP


Fort Worth, Texas
February 11, 2005

4318

 
44
 
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM


The Board of Directors
The Leather Factory, Inc.

We have audited the accompanying consolidated statements of operations, stockholders' equity, and cash flows of The Leather Factory, Inc. for the year ended December 31, 2002. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audit in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated results of operations and cash flows of The Leather Factory, Inc. for the year ended December 31, 2002, in conformity with accounting principles generally accepted in the United States of America.


Hein + Associates LLP


Dallas, Texas
February 6, 2003


45
 
ITEM 9. CHANGE IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

None

ITEM 9A. CONTROLS AND PROCEDURES

At the end of 2004, our President, Chief Executive Officer and Chief Financial Officer evaluated the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Rule 13a-15(b) under the Securities Exchange Act of 1934, as amended. Based upon this evaluation, they concluded that, subject to the limitations described below, our disclosure controls and procedures offer reasonable assurance that the information required to be disclosed by us in the reports we file under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the rules and forms adopted by the Securities and Exchange Commission.

During the period covered by this report, there has been no change in our internal controls over financial reporting that materially affected, or is reasonably likely to materially affect, these controls.

Limitations on the Effectiveness of Controls. Our management, including the President, Chief Executive Officer and Chief Financial Officer, does not expect that our disclosure controls and procedures will prevent all error and all fraud. A well conceived and operated control system is based in part upon certain assumptions about the likelihood of future events and can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs.

ITEM 9B. OTHER INFORMATION

None


PART III

Certain information required by Part III is omitted from this annual report as we will file a proxy statement for our 2005 Annual Meeting of Stockholders, pursuant to Regulation 14A of the Securities Exchange Act of 1934, as amended, not later than 120 days after the end of our fiscal year covered by this Report, and certain information included in that proxy statement is incorporated herein by reference.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

The information required by this item is contained under the heading "Executive Officers of the Registrant" in Part I of this Annual Report on Form 10-K, and the remainder is contained in our proxy statement for our 2005 Annual Meeting of Stockholders under the heading "Election of Directors," and is incorporated herein by reference. Information relating to certain filings on Forms 3, 4 and 5 will be contained in our 2005 proxy statement under the heading "Section 16(a) Beneficial Ownership Reporting Compliance," and is incorporated herein by reference. Information required by this item pursuant to Items 401(h), 401(i) and 401(j) of Regulation S-K relating to an audit committee financial expert, the identification of the audit committee of our board of directors and procedures of security holders to recommend nominees to our board of directors will be contained in our 2005 proxy statement under the heading "Corporate Governance" and is incorporated herein by reference.

46
 
We have adopted a written code of ethics that applies to our employees, including our principal executive officer, principal financial officer, principal accounting officer, controller, or persons performing similar functions.  It is available on our website (http://www.leatherfactory.com).

ITEM 11. EXECUTIVE COMPENSATION

The information required by this item is contained in our proxy statement for our 2005 Annual Meeting of Stockholders under the heading "Executive Compensation,” which is incorporated herein by reference.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS

The information required by this item is contained in our proxy statement for our 2005 Annual Meeting of Stockholders under the heading "Security Ownership of Certain Beneficial Owners and Management," which is incorporated herein by reference.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

The information required by this item is contained in our proxy statement for our 2005 Annual Meeting of Stockholders under the heading "Certain Transactions and Related Transactions” and is incorporated herein by reference.
 
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES

The information required by this item is contained in our proxy statement for our 2005 Annual Meeting of Stockholders under the heading "Independent Auditors Fees and Other Matters" and is incorporated herein by reference.

PART IV

ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K

(a)           The following are filed as part of this Annual Report on Form 10-K:

1.
Financial Statements

The following consolidated financial statements are included in Item 8:

·  
Consolidated Balance Sheets at December 31, 2004 and 2003
·  
Consolidated Statements of Income for the years ended December 31, 2004, 2003 and 2002
·  
Consolidated Statements of Cash Flows for the years ended December 31, 2004, 2003 and 2002
·  
Consolidated Statements of Stockholders' Equity for the years ended December 31, 2004, 2003 and 2002

2.
Financial Statement Schedules

47
 
All financial statement schedules are omitted because the required information is not present or not present in sufficient amounts to require submission of the schedule or because the information is reflected in the consolidated financial statements or notes thereto.

3.
Exhibits

The exhibits listed in the Exhibit Index immediately preceding such exhibits are filed as part of this Annual Report on Form 10-K.

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Annual Report on Form 10-K to be signed on its behalf by the undersigned, thereunto duly authorized.

 
THE LEATHER FACTORY, INC.
     
 
By:
 /s/ Wray Thompson
   
Wray Thompson
   
Chairman of the Board and Chief Executive Officer
     
 
By:
 /s/ Shannon L. Greene
   
Shannon L. Greene
   
Chief Financial Officer, Chief Accounting Officer and Treasurer
Dated: March 30, 2005

In accordance with the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Company and in the capacities and on the dates indicated.

Signature
Title
Date
/s/ Wray Thompson
  Chairman of the Board, Chief Executive Officer and Director
March 30, 2005
Wray Thompson
    
     
/s/ Shannon L. Greene
  Chief Financial Officer, Chief Accounting Officer, Treasurer and Director
March 30, 2005
Shannon L. Greene
    
     
/s/ T. Field Lange
  Director
March 30, 2005
T. Field Lange
    
     
/s/ Joseph R. Mannes
  Director
March 30, 2005
Joseph R. Mannes
    
     
/s/ H.W. Markwardt
  Director
March 30, 2005
H.W. Markwardt
    
     
/s/ Michael A. Markwardt
  Director
March 30, 2005
Michael A. Markwardt
    
     
/s/ Ronald C. Morgan
  President and Director
March 30, 2005
Ronald C. Morgan
    
     
/s/ Robin L. Morgan
  Vice President and Assistant Secretary
March 30, 2005
Robin L. Morgan
    
     
/s/ Michael A. Nery
  Director
March 30, 2005
Michael A. Nery
    
     
/s/ William M. Warren
  Secretary
March 30, 2005
William M. Warren
    
 
48
 
THE LEATHER FACTORY, INC. AND SUBSIDIARIES
EXHIBIT INDEX
Exhibit
Number
 
 Description 
3.1
Certificate of Incorporation of The Leather Factory, Inc., filed as Exhibit 3.1 to the Registration Statement on Form SB-2 of The Leather Factory, Inc. (Commission File No. 33-81132) filed with the Securities and Exchange Commission on July 5, 1994, and incorporated by reference herein.
   
3.2
Bylaws of The Leather Factory, Inc., filed as Exhibit 3.2 to the Registration Statement on Form SB-2 of The Leather Factory, Inc. (Commission File No. 33-81132) filed with the Securities and Exchange Commission on July 5, 1994 and incorporated by reference herein.
   
4.1
Financial Advisor's Warrant Agreement, dated February 12, 2003, between The Leather Factory, Inc. and Westminster Securities Corporation filed as Exhibit 4.1 to Form 10-Q filed by The Leather Factory, Inc. with the Securities and Exchange Commission on May 14, 2003 and incorporated by reference herein.
 
   
4.2
Capital Markets Services Engagement Agreement, dated February 12, 2003, between The Leather Factory, Inc. and Westminster Securities Corporation filed as Exhibit 4.2 to Form 10-Q filed by The Leather Factory, Inc. with the Securities and Exchange Commission on May 14, 2003 and incorporated by reference herein.
   
4.3
Financial Advisor's Warrant Agreement, dated February 24, 2004, between The Leather Factory, Inc. and Westminster Securities Corporation filed as Exhibit 4.1 to Form 10-Q field by The Leather Factory, Inc. with the Securities and Exchange Commission on May 14, 2004 and incorporated by reference herein.
   
4.4
Capital Markets Services Engagement Agreement, dated February 24, 2004, between The Leather Factory, Inc. and Westminster Securities Corporation filed as Exhibit 4.2 to Form 10-Q field by The Leather Factory, Inc. with the Securities and Exchange Commission on May 14, 2004 and incorporated by reference herein.
   
10.1
Credit Agreement, dated as of November 3, 2003, made by and among The Leather Factory, Inc., a Delaware corporation; Roberts, Cushman & Company, Inc., a New York corporation; Hi-Line Leather & Manufacturing Company, a California corporation, The Leather Factory of Nevada Investments, Inc., a Nevada corporation, The Leather Factory, Inc., a Nevada corporation; The Leather Factory, L.P., a Texas limited partnership; The Leather Factory, Inc., an Arizona corporation; Tandy Leather Company Investments, Inc., a Nevada corporation; Tandy Leather Company, Inc., a Nevada corporation; Tandy Leather Company, L.P., a Texas limited partnership; and Wells Fargo Bank Texas, National Association filed as Exhibit 10.1 to the Current Report on Form 8-K of The Leather Factory, Inc. (Commission File No. 1-12368) filed with the Securities and Exchange Commission on November 7, 2003 and incorporated by reference herein.
 
 
49
 
10.2
Revolving Line of Credit Note, dated November 3, 2003, in the principal amount of up to $6,000,000.00 given by The Leather Factory, Inc., a Delaware corporation; Roberts, Cushman & Company, Inc., a New York corporation; Hi-Line Leather & Manufacturing Company, a California corporation, The Leather Factory of Nevada Investments, Inc., a Nevada corporation, The Leather Factory, Inc., a Nevada corporation; The Leather Factory, L.P., a Texas limited partnership; The Leather Factory, Inc., an Arizona corporation; Tandy Leather Company Investments, Inc., a Nevada corporation; Tandy Leather Company, Inc., a Nevada corporation; Tandy Leather Company, L.P., a Texas limited partnership, as borrowers, payable to the order of Wells Fargo Bank Texas, National Association, filed as Exhibit 10.2 to the Current Report on Form 8-K of The Leather Factory, Inc. (Commission File No. 1-12368) filed with the Securities and Exchange Commission on November 7, 2003 and incorporated by reference herein.
   
10.3
First Amendment to Credit Agreement, dated as of November 26, 2003, made by and among The Leather Factory, Inc., a Delaware corporation; Roberts, Cushman & Company, Inc., a New York corporation; Hi-Line Leather & Manufacturing Company, a California corporation, The Leather Factory of Nevada Investments, Inc., a Nevada corporation, The Leather Factory, Inc., a Nevada corporation; The Leather Factory, L.P., a Texas limited partnership; The Leather Factory, Inc., an Arizona corporation; Tandy Leather Company Investments, Inc., a Nevada corporation; Tandy Leather Company, Inc., a Nevada corporation; Tandy Leather Company, L.P., a Texas limited partnership; and Wells Fargo Bank, National Association, successor by merger to Wells Fargo Bank Texas, National Association, filed as Exhibit 10.3 to Annual Report on Form 10-K of The Leather Factory, Inc. (Commission File No. 1-12368) filed with the Securities and Exchange Commission on March 29, 2004 and incorporated by reference herein.
   
10.4
First Modification to Promissory Note, dated as of November 26, 2003, made by and among The Leather Factory, Inc., a Delaware corporation; Roberts, Cushman & Company, Inc., a New York corporation; Hi-Line Leather & Manufacturing Company, a California corporation, The Leather Factory of Nevada Investments, Inc., a Nevada corporation, The Leather Factory, Inc., a Nevada corporation; The Leather Factory, L.P., a Texas limited partnership; The Leather Factory, Inc., an Arizona corporation; Tandy Leather Company Investments, Inc., a Nevada corporation; Tandy Leather Company, Inc., a Nevada corporation; Tandy Leather Company, L.P., a Texas limited partnership; and Wells Fargo Bank, National Association, successor by merger to Wells Fargo Bank Texas, National Association, filed as Exhibit 10.4 to Annual Report on Form 10-K of The Leather Factory, Inc. (Commission File No. 1-12368) filed with the Securities and Exchange Commission on March 29, 2004 and incorporated by reference herein.
   
10.5
Credit Agreement, dated as of October 6, 2004, made by The Leather Factory, Inc., a Delaware corporation, and Bank One, National Association, filed as Exhibit 10.1 to the Current Report on Form 8-K of The Leather Factory, Inc. (Commission File No. 1-12368) filed with the Securities and Exchange Commission on November 5, 2004 and incorporated by reference herein.
   
10.6
Line of Credit Note, dated October 6, 2004, in the principal amount of up to $3,000,000 given by The Leather Factory, Inc., a Delaware corporation as borrower, payable to the order of Bank One, National Association, filed as Exhibit 10.2 to the Current Report on Form 8-K of The Leather Factory, Inc. (Commission File No. 1-12368) filed with the Securities and Exchange Commission on November 5, 2004 and incorporate by reference herein.
   
 
 
50
 
14.1
Code of Business Conduct and Ethics of The Leather Factory, Inc., adopted by the Board of Directors on February 26, 2004, filed as Exhibit 14.1 to Annual Report on Form 10-K of The Leather Factory, Inc. (Commission File No. 1-12368) filed with the Securities and Exchange Commission on March 29, 2004 and incorporated by reference herein.
   
21.1
Subsidiaries of the Company filed as Exhibit 21.1 to the Annual Report on Form 10-K of The Leather Factory, Inc. for the year ended December 31, 2002 filed with the Securities and Exchange commission on March 28, 2003, and incorporated by reference herein.
   
*23.1
Consent of Hein + Associates LLP dated March 28, 2005
   
*23.2
Consent of Weaver & Tidwell LLP dated March 28, 2005
   
*31.1
13a-14(a) Certification by Wray Thompson, Chairman of the Board and Chief Executive Officer
   
*31.2
13a-14(a) Certification by Shannon Greene, Chief Financial Officer and Treasurer
   
*32.1
Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
   
______________
  
*Filed herewith.
  
 
51