Tandy Leather Factory Inc Q2 FY2022 Earnings Call

Good morning, everybody. Thank you for joining us for a discussion of Tandy's Q2 financial results. I'm Dan Ross, General Counsel and Corporate Secretary for Tandy, and I will be moderating the discussion today. Our CEO, Janet Carr, will give a brief overview of the quarter, and we will then open it up for questions and discussion. I will not be reading questions or comments directly from the chat this time. With that, let's get started. Today's presentation will include statements other than historical results that constitute forward-looking statements within the meaning of the Securities Act of 1933 and the Securities Exchange Act of 1934, each as amended. These statements reflect our expectations or estimates based on the information we have today, but are not guarantees or predictions of future performance. They involve known and unknown risks, uncertainties, and other factors, many of which are beyond our control, and which may cause actual results to differ materially from the statements contained in this presentation. You are cautioned not to put undue reliance on these forward-looking statements. The company assumes no obligation to update or otherwise revise these forward-looking statements, except as required by law. And with that, I'll turn it over to Janet to begin our presentation. Janet?

Sorry. Yes, sorry. Let me start again. Thanks, everyone, for joining today. Our Q2 sales were down 0.8% over last year. Gross margin rate came in at 57%. Operating loss was $700,000, and adjusted EBITDA adjusting for noncash items such as depreciation and stock-based compensation, as well as interest taxes and one-time expenses related to the restatement was negative $100,000. At this time of year, we're building inventory for our July sale and beginning the bills for holiday, so cash was down to $5.6 million, similar to last year from $10.3 million at the end of Q1. Inventory ended the quarter at $40.1 million, down about $3 million from the second quarter and inventory last year. We paid back our small COVID-related Spanish loan and have the opportunity to buy back 360,000 shares of Tandy stock in April. On a year-to-date basis, sales are down 2.6% versus last year, gross margin, 57.7%, and operating income, $100,000, and adjusted EBITDA, $1.5 million. Our sales trend in Q2 versus last year improved over Q1 compared to last year, down less than 1% versus down 4% in Q1. But the retail environment remains challenging due to inflation, worries about recession, war, public health, and so on. We closed one store in March of this year in San Bruno, California, which had no material impact on our retail sales or channel share. Subsequent to the end of the quarter, we also closed the Oxnard, California store in July. We evaluate a number of factors when determining whether to close existing stores. For example, the four-wall cash flow trend and longer-term projections for the store, the long-term sales trend, the ongoing cost of store operations, the date of the lease expiration, the quality of the store and location, and the size and potential of the trade area, including proximity to other existing stores, among other variables. Our overall channel share remains stable year-over-year. We're seeing similar challenges in our commercial business as demand from their customers is also weak. We expect that the retail environment will remain challenged by the many external forces at play right now. Q2 gross profit dollars came in 6.9% below last year due to lower sales and gross margin rates. Gross margin rate of 57% reflects product and capitalized cost increases that we've been realizing over the last year or so that are just now flowing through the cost of sales due to our FIFO methodology of inventory valuation. We've raised prices on about 30% of our SKUs, but we've only seen a nominal increase in average unit retail as a result of product mix. We saw an operating loss of $700,000 in Q2, and operating income of $100,000 in the first half, both down over the same periods in 2021. These declines are the result of factors we've already discussed, softer sales, lower gross margins, in addition to higher operating costs associated mostly with the tight labor market. Adjusted EBITDA for the quarter is 0 and for the first half, $1.5 million. Just a brief reminder of some of our core strengths that we believe give us the adaptability to weather the current challenging environment. First, leather crafting is a large and growing market. We are the market share leader and the only 100-year-old brand in a very fragmented market. We have strong multichannel distribution — retail, web, and commercial, and we're the only player with over 100 retail stores. We have a capable team with a proven track record of managing through business challenges. Aside from the CFO, we've had no turnover in the executive leadership team that I recruited shortly after I arrived here. We have a long-term plan to get to $100 million in sales and $15 million in operating income, and we have a strong financial position. We have a clear roadmap to $100 million in sales and $15 million in operating income, and we discussed that in some detail in our June call. So I'm just going to touch on a few areas as a reminder, two key areas: one, continued improvements in our core business, including optimizing the fleet, using four-wall cash flow as our key metrics, focusing on teaching and bringing customers into stores and into the category, piloting new formats, continuing to improve the breadth and quality of our product offering, and growing our commercial business, targeting small to medium businesses with a tailored business model. The second area of focus is key growth initiatives where we've made very good progress: youth, art therapy, chain wholesale, and international. Just a word about the key principles that we use to manage the business from a financial perspective: disciplined capital allocation. Our growth initiatives do not require significant capital investments, and we expect to fund them out of cash flows from the business. Two, we expect to maintain a conservative balance sheet and will only consider layering on modest leverage when we are generating higher cash flows from operations. And three, our Board is focused on maximizing long-term shareholder value. We will thoughtfully consider all mechanisms for increasing value, from returning capital via dividends or buybacks to monetizing our real estate to M&A. We'll do so responsibly without impairing the business' long-term prospects, which is our highest priority. And from an operating perspective, we believe we can grow profitable sales to $100 million and operating income to $15 million over the next several years by focusing on continually improving our consumer proposition and leveraging our competitive advantages. We've talked about that in some detail in prior calls. We're building an operating model with talent, systems, and processes that can support the business for many years to come, but that can also remain flexible and nimble, allowing us to both scale and respond to changing market conditions quickly. I think we've proven that in the last few years. Before I close, I'd like to note our CFO. First, I would like to thank Mike Galvan for his excellent contributions here over the last two-plus years with us. He ably steered us through the restatement and catch-up of all of our SEC filings while transitioning to a new ERP system. We could not have done this without Mike, and he will be missed. The CFO at Tandy has had to manage through tremendous obstacles in a very high-performance environment. Given what we've accomplished in the face of these obstacles, it's clear that we've been fortunate to have the right person in the job at the right time. Our SeatonHill Partners team has already proven that they can capably support us through the transition. With the restatement and ERP transition behind us, our next CFO will have the experience and capabilities to help lead us into our next chapter. Now, moving on to questions and discussion. If you wish to ask a question or make a comment, message Daniel Ross directly in the chat, and he will ask you to unmute your line. You can join the chat on the toolbar. When you ask, you'll need to accept the prompt to unmute yourself. Dan, do we have some questions?

Yes, we do. Thanks, Janet. Our first question comes from Eric Speron.

Janet, can you hear me?

Yes.

So Janet, in the press release, you talked about managing costs and conserving cash, and you mentioned protecting the runway of the business. My question is, while we want to become leaner where possible, can we also be more aggressive? Are there ways to increase the agility of the business and actually achieve more with less? Of course, cost management will be a focus, but do you see options for variabilizing the compensation structure? Or could we consider having more player-coaches? Are there opportunities for us to strengthen operations at headquarters? Because it appears we are already quite lean. That's my question regarding costs.

Yes. I think we're pretty lean. I know that when you were here, and we spent some time walking through our facility, you don't see a lot of suits walking around. Everybody does everything. It's a good thought, though, and we need to continually look at this. I appreciate the input. We are variabilizing our compensation where we can. So, very good thought, and I think we need to continue to push on it, but I think there's nothing that's really obvious right at this moment.

Our next question will come from Eddie Reily.

Janet, just on cost reduction measures. I was wondering about the strategic fit for the Spain store, it looks like they're experiencing a little bit more top-line pressure than the U.S. and Canada. Just want to know how that kind of fits in with the portfolio going forward?

Yes, it's a great question. Spain has been and is still quite cash flow positive. It also represents the model of how we want to tackle international with mostly a wholesale approach. Our same store sells a lot to resellers, small retailers, and small businesses all throughout Europe. So it does serve a strategic purpose, and they definitely pay their way. So we're using that as a jumping-off point to grow our international business without huge capital investments, and it's important in that way.

Okay. Got you. And just wondering if you could maybe unpack the differences in revenue between Canada and the U.S. I'm wondering if the overall sales decline is more a factor of the macro environment or trends in leather crafting overall?

I think coming out of last year, where we had strong trends and then the slowdown that we saw in Q1, all of our arrows are pointing in a really positive direction in terms of Tandy and our customers and what we've been doing in the broader category. So we believe we have no reason to believe it's anything beyond the macro environment.

Okay. Got you. And if you could just maybe go into why Canadian revenue was up versus U.S.? If you have any color there, you'd like to provide us.

I don't think we have a great deal of insight into why Canada has been up, except that it was down a lot more in 2020. In 2021, they took a lot longer to recover from the pandemic. So I think that they're having a little bit of an easier comparison.

Okay. Our next question comes from Shai Dardashti who has not unmuted and sent me the question by text, so I'll just read it. Shai asks how does the company perceive the opportunity to unlock shareholder value from the company's real estate holdings?

Yes. Great question, Shai. We have a very valuable real estate holding here in Fort Worth. And at this point, we are maintaining it. We're considering ways to potentially unlock some value from it. But one thing that we are being very cautious about is leveraging up, and we want to maintain sort of the risk profile that we have today, and we don't feel like extracting the monetizing the value of our real estate today is the right long-term strategic decision for the business. At some point in the future, we would definitely consider that. And we are on an ongoing basis. Regularly, the Board is considering all of the assets that we have and how we can best monetize them. But if you're asking a specific question, should we sell our property or should we leverage it up? The answer for us right now is no, that does not feel like the right decision from a risk perspective for us.

The next question is another one I received through the chat directly from Josh Womack, who's asking whether the Board has discussed an extension of the share repurchase plan, which he said he thinks may have expired on July 31. So I can just answer that. Josh, you are correct that the plan that we had in place did expire on July 31. And the Board has recently approved a renewal of that plan with the same $5 million value of shares that we can repurchase, and the new plan will extend until the end of August 2024. We announced that in the 10-Q that we recently filed, but certainly I don't blame you for not seeing it, but the Board has renewed the plan. Our next question will come from Tim Heitman. If you can unmute yourself, Tim?

There. Can you hear me? A couple of questions on commercial. Maybe give us a little more perspective on the types of customers you guys consider commercial? I know that you've kind of changed using the store base in terms of shipping direct now out of the warehouse, maybe changing the focus and maybe describe the sales force and how they might operate to grow that business. And then maybe an example of the success or opportunity in that space because that should still be a pretty growing business in the long run?

Absolutely. Our commercial business is defined by sales of over $5,000 and above $20,000 per year. Customers spending over $5,000 primarily receive services from our stores with preferential pricing and are mostly businesses. Those served by our commercial group, which has direct account representatives reaching out to customers, do not need to visit the store; instead, products are shipped directly from our warehouse to their business locations, along with preferential pricing. Examples of such customers include bag makers, shoemakers, and various holster and knife sheath manufacturers. We also cater to the upholstery and jewelry sectors. For instance, we work with a customer who provides upholstery for a large fast-food chain. They have been sourcing leather from us to cover barstools, previously done at their factory where workers cut the leather by hand. We showed them a more efficient method by creating a dye and template to utilize our large commercial clickers for cutting those pieces. The customer has expressed great appreciation, as we not only reduced their labor and overall costs, but they have now become loyal Tandy customers, purchasing all their leather from us — an outcome that might not have been realized without our service. This is the kind of initiative we aim to pursue going forward.

Just maybe one other quick follow-up unrelated. Are you guys looking to try to get another line of credit now that your financials are all current?

Yes. Great question. And yes, we are in active discussions with a number of financial institutions, and we expect to have something in place, working capital line of credit in the coming months.

At this point, I don't have anyone in the queue who wants to read their own questions. I do have two more in the chat. Dave McCann, do you want to read your question? You can unmute. Okay, he doesn't have a mic. I'll read this one to Janet. He asks if she can discuss any recent sales trends in July and August, especially since gas prices have somewhat decreased. Also, what inflationary trends are being observed in cowhide costs? Sorry, I don't have a mic on my end.

Okay. From a sales trend perspective, July and August have been similar to what we saw in Q2. We are continuing to adapt. We are trying a lot of different things. And so when we talk again at the end of Q3, we'll be able to report back to you on our insights coming out of some of that experimentation, but we're not just sitting on our hands saying, 'The same old thing we were doing is not working now.' We're trying a lot of different things. But what we're not necessarily seeing is consumers responding in the environment in a completely different way. The second part of the question, sorry, was on the cost of leather. Yes, we have seen, especially over the last 12 months or so, significant increases in the cost of raw material and in leather. Our tanneries are still struggling with obtaining raw material. That's actually one of the biggest challenges that they’ve had, as well as the cost of labor, as many of these markets have continued to struggle with COVID and have simply been short of labor. So we, again, sourced from many tanneries and we've been moving and juggling and doing everything possible to continue to keep those costs as low as possible. Where the costs are really going up, as you all know, is shipping; the costs of containers coming from overseas have, I think the word is quintupled. They are now more than five times the cost before COVID. So that is representing a challenge for us, and all of that has to flow through product costs.

Okay. A follow-up question from Eddie Reily.

Just another one for me, sorry. I was wondering if you guys are planning on taking any pricing action to maybe offset the cost of freight, maybe for the 70% additional SKUs?

Yes. We did. We are taking pricing action where we can, Eddie. And it's selective. We're doing it on the products where we're seeing the most significant increases. We're also keeping our eye on competition because our customers do. So in some places where we have to maintain competitive pricing, we're doing that. And where we can follow, we do that as well. So it's not necessarily a one-for-one situation. This product has gone up 10%, so we'll raise our price by 10%, right? We're looking at our entire portfolio of products and making those judgments where we think the customer is going to be less price sensitive. We're doing that, where we know that they benchmark off of key items, we're making sure that we're staying competitive with those. So it will continue to happen. It's also something we can address through product mix. Our machine sales, for example, have been very strong, and that has been helpful. And the other area where we can have an impact is in promotion. So we can take some regular retail prices up. We can do some promotion, and in the end, the mix may result in a higher average unit retail.

The next question is from Eric Bradley, who also doesn't have a microphone, so ask me to read it. He asks, are there any additional updates on any plans to uplift to NASDAQ?

Yes. Do you want to answer that, Dan?

Sure. Eric, we have submitted everything now for relisting on NASDAQ. We are waiting for their approval. The application has taken longer because coming out of our restatement, NASDAQ asked us to file another quarter's 10-Q timely to show we can do it before they consider the application, and we just did that this week on Monday. And so at this point, hopefully, they will be in the final part of the review process. Eric Speron, I'm going to unmute you in just a moment for a follow-up.

Just on gross profit, you mentioned mix and to Eddie's question about price. The way I read that section of the Q was that this gross profit, these percentages we're seeing are a big function of FIFO, but it is in fact how you're dealing with the business today. It wasn't totally clear to me. Did it also mean to imply that the outlook for gross profit is going to be mired further? Or did it mean to imply that you guys are managing as best you can and that the gross profit percentage probably is going to stay in the high 50s? I just don't know if I grasped how you were...

Yes. If you think about where we were back in 2018, the model was sort of what I would call extreme high-low. We had very, very high regular retail prices, and then we promoted it frequently and deeply. The problem with that model is that our competitors do not use that approach. Our consumers perceived us as charging them excessively. So we shifted to this sort of modified EDLP strategy, Everyday Low Price Strategy. So on all of the key consumables, right, the essentials of the leather crafting business, the items that people really focus on, we had to bring those to be competitive every day. And we don't promote for the most part; we don't promote those items. So key wedged leather, for example, key hardware, key liquids, and dyes that people use every day. You want to be able to just come in and buy those when you need them, not wait to stock up on sales. That was kind of strategically what we did. We gave up some gross margin to do that. That was an investment to rebuild credibility in the market, take back market share that was dwindling away with our customers. And I expect that where the gross margin is today is about where it's probably going to remain. There will continue to be mix that comes to play, but this was roughly the impact of our movement to an EDLP strategy.

Our next question is from Tim Heitman.

Another question on inventory. Last year, you guys made the decision to kind of buy ahead of the surge to ensure that you had inventory, and that turned out to be a great decision relative to a bunch of other retailers and their results. Could you give us maybe a sense of two parts? One, how much 'extra inventory' you might be carrying, plus since there's inflation, there's a difference between average cost of unit in your inventory versus just kind of gross inventory? So is $40 million kind of peak inventory levels going forward regardless of sales? Or do you think you're carrying a few extra million dollars that working capitalized, you could convert back to cash maybe in the 6 to 9 months?

So it's a hard question to answer, Tim. There are many, many, many considerations to keep in mind, not the least of which is FIFO, which I know way too much about at this stage. What I will say is we do have inventory that we'll sell through as we have transitioned some of our key product categories to new vendors. We have many weeks on hand that we stocked up on with our old vendors to make sure that we have enough for the transition. In addition to increasing costs, one of the challenges with vendors is actually how long it’s taking them to get products to us. Some of it is delays in shipment, but a lot of it is they’re just not delivering. We have purchase orders we've written a year ago that still we haven't received. So we did have to stock up in some of these product categories where we were switching to new vendors, not knowing how long it was going to be before the new vendor was providing us with their products. So I think there's a little bit in there, but that inventory level is going to increase as we broaden the product offering and as we increase our overall sales as well. So I'm not — I'm feeling, and this is not analytically derived, that about where we are this year is about where we need to be. We did pull back some as our sales have come in softer in Q1 and Q2 in our product purchasing, but not enough that it would be material.

Janet, Jeff, for those of you who don't know, our Chairman got a question that I think he's going to read.

Sure. Yes. Jeff Gramm, I'm a Director of Tandy. I got a question for clarification on the real estate question. And I just want to be clear that it's not just conservatism and it's not all about whether to leverage or not. It's also we're very in tune with how valuable the property is. We know that after taxes, it's probably worth a third or more of the value of the whole public market value here. A part of our hesitation to do something like a sale-leaseback is that we don't really see ourselves in this property long-term. But we don't want to limit our flexibility by entering into something like a sale-leaseback now. We've looked at options like, well, subdividing or trying to monetize pieces of the property that we're not actively using. It just doesn't seem like a good long-term value proposition. We think the property is a lot more valuable if we keep it intact. Our view is that we want to create the maximum long-term value from this property, and we know that that's there. So this is not just like a conservatism issue that we're not immediately monetizing or leveraging the property. It's also we just think in terms of the operations of the business, we're not at the right juncture to create maximum value from it.

Thank you, Jeff. Any other questions, Dan?

I have just one more from the chat, which says I think you were working on upgrading the quality of the products. Has that been accomplished? Is most of the old inventory gone?

Yes, we were, and we continue to do that. Most of the old inventory is not gone. We are still working our way through that depending on the product category. Hardware was probably the biggest product category. So we are working our way through. We have new vendors in place. We still have a number of other product categories that we're working on. So it's kind of a work in progress, but we've made tremendous steps forward, and we're getting feedback from our customers every day.

Again, any plans to do further write-downs on the inventory?

No. We should — it's part of kind of the regular housekeeping of the business. Leather is an organic product; it is a perishable product, especially veg-tanned leather, which is very sensitive to UV damage. So we are instituting more rigorous storage guidelines around leather, but some of it just has to get thrown out — it's an organic product. So some of it has to get thrown out every period. But that's minimal, and we're really keeping up on that. So there should be no write-down.

Okay. That's all the questions I have in the queue at this point.

Alright. Well, we're here, and you can reach out to us. Either Dan or I or Jeff, and we're happy to have any other — answer any other questions or have any conversation. If this format works for you all, we're looking to do this at the end of Q3 as well. And going forward, we continue to evolve it. But thank you again for participating. Bye.

Bye, everyone.