Recommendation: Strong Buy

Quarterly Update - Basis for Rating

Once again, in the second quarter of 2002, The Leather Factory (AMEX:TLF) exceeded its prior year results and our earlier estimates by a substantial margin. Total revenues increased 7.4% versus the prior year quarter, while net income rose 27.3%. As a result of continued strong customer demand for its products, and the rapid and successful expansion of its marketing efforts, we have increased our revenue and earnings projections for 2002.

• Arts-and-crafts retailers, including leathercraft retailers, continued to report strong retail sales during the second quarter and into the current third quarter, even though the overall retail industry has continued to be weak.
  
  
• The Company has continued to integrate its Tandy Leather acquisition. To exploit Tandy's strong retail brand equity, during the second quarter, it opened another four outlets in its planned chain of Tandy Leather Stores, and during the first two months of the current third quarter, it opened four more retail stores, bringing its total to ten in the U.S. Additionally, it converted several Canadian locations to become "combination stores," offering both Tandy Leather and The Leather Factory product lines.
  
  
• To reflect the Company's improved financial performance during the first half of 2002 and its continuing operational strengths, we have revised our projections upward for the remainder of the year. We are now estimating that The Leather Factory will generate revenues of $41.1 million and fully diluted earnings per share of $0.27, versus our previous projections of $39.1 million in revenues and fully diluted earnings per share of $0.25, excluding the non-recurring impairment writeoff taken in the first quarter.
  
  
• In spite of the Company's strong performance, its market price remained static, largely as a result of overall market weakness. As a result, the Company's stock still appears to be significantly undervalued.
  

Based on its current fundamentals, we believe that The Leather Factory's shares can currently justify a market price around $5.75 a share -- almost twice its current trading range. If the Company continues to meet our expectations for 2002, it then can certainly support a target price around $6.75 a share.

Company Background

In its 10-K Report, the Company describes itself as a:

Wholesale manufacturer and distributor of a broad product line of leather, leatherworking tools, buckles and other belt supplies, shoe care and repair supplies, leather dyes and finishes, adornments for belts, bags, and garments, saddle and tack hardware, and do-it-yourself leathercraft kits. TLF also carries a product line of small finished leather goods such as cigar cases, wallets and western accessories distributed under the name `Royal Crown Custom Leather.'

On November 30, 2000, The Leather Factory acquired the operating assets of Tandy Leather from Tandycrafts (now in liquidation) for $2.8 million in cash and the assumption of about $500,000 in liabilities.

With its long history of having a retail presence, the Tandy Leather name has much stronger brand equity with consumers than does The Leather Factory. We believe that this name recognition is probably the most powerful asset acquired in this transaction, and the Company is rapidly taking action to exploit this strength, as will be discussed below.

Another subsidiary, Roberts, Cushman & Company, produces and sells a related product line of hat trims (the decorative piece of material that adorns the outside of a hat), which it sells directly to the hat making industry.

Tandy Leather Expansion

During the second quarter the Company continued its effort to rebuild the Tandy Leather chain of retail leathercrafting stores, ending the quarter with a total of six stores in the U.S. and one "combination store" in Canada.

These expansion efforts have accelerated during the third quarter. During July, the Company announced the opening of a new Tandy Leather retail store in Fort Worth, at the same location previously occupied by a successful Tandy Leather store in the original chain. In addition, retail stores opened in Albuquerque, New Mexico, and Las Vegas, Nevada, on August 1, and in Dallas, Texas on Aug. 5.

The Leather Factory has also announced the acceleration of its plans for new retail store openings. Management has stated that, "Given the success of the new stores so far, we're on pace to open a total of 10 to 12 Tandy retail stores in 2002."

The Tandy Leather Company web site, at www.tandyleather.com, currently proclaims that:

Now 10 "Genuine" Tandy Leather Company stores are open and ready to serve you. Each is fully stocked and managed by experienced leathercraft professionals ready to give you outstanding service and leathercrafting advice. Experience convenient shopping in person, by phone, fax or mail. Ask about their leathercraft classes!

Leathercraft classes are another important tool for bringing new people into this craft, in addition to the extensive line of leathercrafting kits and workbooks offered as part of both product lines. In addition, classes and demonstrations create additional awareness of tooled leather as a fashion accessory. Reportedly, store managers in the original Tandy Leather chain would also work with art teachers in the schools to encourage student interest in this art form.

The Company has also strengthened its presence in Canada. During the quarter, the Company opened its first "combination store" in Toronto, Ontario so as to test the effectiveness of offering the combined Leather Factory and Tandy Leather Company product lines at one retail location. On July 15, The Leather Factory announced that, going forward, "it will be operating its Canadian stores as combination stores," and that "The existing Leather Factory store in Winnipeg, Manitoba has added Tandy's complete line of merchandise effective July 1." A month later it announced that "it has opened a Leather Factory/Tandy Leather combination store in Edmonton, Alberta, Canada."

Informal discussions with management indicate that they are receiving a lot of positive feedback about these retail locations from their existing customer base via e-mail, letters, and phone calls. Likewise, they indicate that they have not seen any indications that their existing network of independent Authorized Sales Centers is currently feeling threatened by the Tandy Retail expansion. The Company has a strong pool of previously successful store managers from the original Tandy retail system to draw upon to staff future locations.

It appears unlikely that the Company will attempt to "rebrand" all of its Company-owned Distribution Centers, as in many cases they are not sited in strong retail locations. They are normally located in light industrial, office or warehouse spaces that are easily accessible to existing leathercrafters but unlikely to attract new participants. The new Tandy Leather stores are being opened in more accessible locations. However, it appears likely that Distribution Centers that have historically generated strong retail sales will be converted to combination stores as the opportunities present themselves; the Austin, Texas combination store is the result of converting a former Leather Factory distribution center.

Business Environment

According to the Hobby Industry Association's quarterly research, "industry sales continue to be strong as compared to other consumer retail industries" during the second quarter. Although this marketing research study apparently does not break leathercrafting out separately, "When comparing the second quarter of 2002 with the second quarter of 2001, HIA's findings conclude that industry sales grew from year to year in all categories."

This strong retail craft sales trend has continued through August, even though initial reports indicate that the overall retail segment was very weak during the month. Most department store chains reported August same-store sales that were well below expectations, with Wal-Mart and the majority of apparel retailers leading the way south. However, craft stores have provided one of the few bright spots in the industry:

• On September 5, Michaels Stores (NYSE:MIK) reported that "total sales for the month of August increased 12% to $174.1 million from $155.4 million for the same period last year. Same-store sales for the month increased 6%. Year-to-date sales of $1.354 billion for fiscal 2002 increased 16% from $1.166 billion for the same period last year while same-store sales were up 7% year-to-date."
  
  
• Unfortunately A.C. Moore (NASDAQ:ACMR) does not publish any monthly sales data, although sales for the six months ended June 30, 2002, were $168.7 million, an increase of 26% over 2001 first half sales of $133.6 million. Comparable store sales growth for the six months ended June 30, 2002, was 12%.
  
  
• Jo-Ann Stores (NYSE: JAS.A), a leading national fabric and craft retailer, also reported on September 5 that August net sales increased 7.0% to $111.4 million from $104.1 million for the same period last year. August same-store sales increased 8.6%. Year-to-date net sales increased 9.7% to $837.5 million from $763.2 million in the prior year. Year-to-date same-store sales increased 10.3%, versus a same-store sales increase of 4.9% for the same period ending September 1, 2001.

Additional evidence that craft sector sales remain solid is provided by another Hobby Industry Association research study. Conducted during June of this year, it reports that "crafters are spending significant time and money at their favorite craft stores. More than 80% of 1,241 respondents indicated that they shop for crafts at least once or twice per month; 28% shop for crafts once or twice per week. Among respondents, 63% spend more than $20 during a visit to the craft store."

Recent Financial Performance

The Leather Factory again reported strong operating results in the second quarter of 2002, as shown in Table 1. Total revenues increased 7.4% versus the prior year quarter, while net income rose 27.3%. First half revenues gained over 8%, while net income jumped 32%, before including the impact of an accounting principle change that was discussed in depth in our June 27, 2002, Research Report update.

An overall gross margin increase of almost 1% led to strong gross profit gains of 9.2% versus the prior year quarter. However, this gain was more than offset by increased operating expenses which grew from 40.6% to 42.0% of revenue. As a result, income from operations gained only 2.9% versus the prior year quarter.

On the other hand, the Company's operating cash flows have remained quite strong over the last year, allowing the Company to reduce its reliance on its revolving line of credit. This, in turn, has allowed the Company to reduce its interest expenses substantially, by almost 62% in the latest quarter versus last year. In combination, these forces led to a 27% quarterly improvement in net income, as shown by Table 1.

Table 1. Summary of Financial Performance

Once again, these results exceeded our most recent projections, as published in our last quarterly update. Revenues came in almost 4% ahead of our projections, while net income was 24% higher than we had initially forecast.

During the second quarter of 2002, each individual component of the Company's business contributed to its successes:

• The Leather Factory, the Company's "core business," was the primary source of its revenue gains, having generated a 9.7% increase in revenue versus the same quarter last year, while a small increase in its gross margins led to a 10.4% increase in gross profits. All customer categories contributed to this gain, with the exception of "Institutional," where sales fell as the result of tightened prison security. However, operating expenses increased almost 16% due to increased personnal costs and advertising expenses, which in turn led to a slight decline in operating income.
  
  
• Tandy Leather saw an unexpectedly small revenue increase during the quarter, in spite of having opened a total of six retail stores as of June 30.

  However, it appears that this weakness was not due to "cannibalization," but is the result of a sharp fall-off in sales to institutions, of which childrens summer camps are a major component, which reportedly saw a $300,000 shortfall. Although the Company's 10-Q for the quarter states that "The six retail stores opened so far this year added $517,400 in sales while the central distribution center's sales decreased by $490,600 for the quarter," management has subsequently indicated that only about $100,000 of the retail store gain is the result of "a policy decision to distribute orders received by the central distribution center to the Tandy retail stores."
  
  Tandy's gross margin jumped three percentage points, from 56.2% last year to 59.5% in the latest quarter. Increases in operating expenses resulting from recent retail store openings. As a result, Tandy Leather's operating income jumped almost 33% to $98,000 for the quarter.

• Roberts, Cushman & Company generated an almost 110% increase in operating profits in the quarter, as the result of a significant reduction in its operating expenses; late in 2001 the Company took steps to reduce Cushman's personnel costs. This subsidiary's revenues and gross margins were comparable with the prior year's quarter, maintaining the halt in business erosion that began in the first quarter.
  

The Leather Factory's balance sheet continued to strengthen during the second quarter. As the result of continued strong operating cash flows, the Company's working capital rose to $7.4 million at June 30, from $5.8 million at the end of December 2001. However, much of this gain came as an increase in inventories, to return them to seasonally normal levels and provide additional inventory for new Tandy Leather retail store openings.

Financial Projections

To reflect the Company's improved financial performance during the first half of 2002, we have revised our projections upward for the remainder of the year. Results from our in-depth Earnings Model can be found on Page 8. We are now estimating that The Leather Factory will generate revenues of $41.1 million and fully diluted earnings per share of $0.27, versus our previous projections of $39.1 million in revenues and fully diluted earnings per share of $0.25, excluding the non-recurring impairment writeoff taken in the first quarter.

Table 2. Summary of Financial Projections

While all parts of The Leather Factory's business contributed to this estimated increase, this is primarily driven by the initial strength of the new Tandy Leather retail stores and their projected impact on revenues and net income during the remaineder of the year. Although the month-by-month revenue gains from new store openings prior to June 30, 2002, have not yet had a noticable impact on reported revenues, we expect their impact to become more visible in the third and fourth quarters. Of the six stores open on June 30, half of them had been open for only a month. However, they can all be expected to contribute revenues and net income during the entire second half, and they should be joined by at least another four retail stores in the fourth quarter.

Our projections for the 2003 year are quite preliminary, and reflect the overall very conservative stance that we have taken in developing these estimates, in the face of the current economic uncertainty.

Analysis of Current Market Valuation

There are several ways to develop a market price justification for The Leather Factory's stock based on the financial projections summarized in Table 2. One of these is to look at the intrinsic value of the stock itself, in light of one of several economic perspectives. Although J.M. Dutton also uses peer comparisons as a valuation tool, the lack of immediately comparable publicly held peers prevents us from using this approach.

Possibly one of the most commonly used and widely accepted equity valuation tools is the "Intrinsic Value" method that was initially described by Dr. Benjamin Graham in his book, The Intelligent Investor. This takes into account both the stock's projected earnings and its projected rate of growth. Its results are shown in the top half of Table 3.

Table 3. Economic Value per Share

Another economic valuation method is the Net Present Value of Projected Cash Flows which projects the current value of the cash flows that a company is expected to generate in future years. The valuation projection given by the Net Present Value method tends to be the more conservative of the two, as shown at the bottom of Table 3.

Based on the financial projections summarized in Table 2, we believe that TLF can justify a market price of $5.75 a share. If the Company continues to meet our expectations for 2002, it can then support a target price of at least $6.75 a share. Our initial projections for 2003 support a per-share valuation in excess of $8.00.

The accompanying chart compares the stock's actual market price against the economic value of a share of stock itself.

This chart shows TLF's price range for each month since October 1999 as a series of "candlesticks", showing the opening, closing and trading range during the month.

The blue line on the chart gives the modeled price at which this stock would have traded had the market priced TLF at its "Economic Value," assuming a 20% projected growth rate.

The red arrow on the right-hand side of the chart shows the extent to which this stock is currently undervalued, supporting our Strong Buy rating.

Click to view Income Model for 2002 and 2003.

Analyst:
Robert M. Davis
Mr. Davis has 15 years of experience as the Chief Financial Officer of two different NASDAQ companies, and for the last five years has been the editor of the highly regarded Napeague Letter, and is currently co-editor of The Securities Sleuth. Forbes Magazine has named both of these E-zines to its 'Best of the Web' list. From 1987 to 1995, he was the Chief Financial Officer of Total Research Corporation (NASDAQ:TOTL), a marketing research and consulting firm in Princeton, NJ. Prior to this he was the was the Corporate Controller for Waverly Press Inc. (NASDAQ:WAVR), a medical and scientific printing and publishing company, and then co-founder, CFO and divisional general manager of a privately-held company in the transportation services industry. He received a BA degree from Rutgers University and an MBA from the Harvard Business School. Mr. Davis is applying for membership in the Philadelphia Society of Security Analysts, and the AIMR

Contact:
The Leather Factory, Inc., 3847 East Loop 820 South, Ft. Worth, Texas 76119 (817) 496-4414. Shannon Greene, Chief Financial Officer. www.leatherfactory.com

J.M.Dutton & Associates, LLC. John M. Dutton, President and Supervisory Analyst, 1129 Manning Drive, Suite 310, El Dorado Hills, CA 95762 Phone (916) 941-4985, Fax (978) 418-6422 Email: [email protected] Web site: www.JMDutton.com

Information, opinions or recommendations contained in this research report are submitted solely for advisory and information purposes. The information used and statements of fact made have been obtained from sources considered reliable but we neither guarantee nor represent the completeness or accuracy. Such information and the opinions expressed are subject to change without notice. This research note is not intended as an offering or a solicitation of an offer to buy or sell the securities mentioned or discussed. Neither the Firm, its principals, nor the assigned analysts own or trade shares of any company covered. The Firm does not accept any equity compensation. Anyone may enroll a company for research coverage, which costs US $25,000 prepaid for one-year. Reports are performed on behalf of the public, and are not a service to any company. The analysts are responsible only to the public, and are paid in advance to eliminate pecuniary interests and insure independence. Please read full disclosure and other reports and notes on the Company at www.JMDutton.com.

© Copyright, 2002, by J.M. Dutton & Associates, LLC.