Tandy Leather Factory: "Passing" in Mar. 2014
Traveling Through Time | 20 min read | What I learned from "passing" on Tandy in Mar. 2014
Originally published on midstoryventures.com in March 2021.
This is part two in a ten-part series. Before reading this segment in the Traveling Through Time case study series — please read the Introduction post here.
Essentially, I simulated an investment opportunity from many years ago based on Geoff Gannon’s Singular Diligence newsletter. The write-up below is a record of my thought process and a reflection on what happened.
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Simulating the Past: Arriving to a decision
WOULD I HAVE INVESTED 20% OF MY CAPITAL INTO TANDY ON MARCH 31, 2014?
Tandy Leather Factory is a chain of retail and wholesale outlets providing leather crafting goods.
Tandy has 80 retail outlets and 30 wholesale outlets. It generates approx. 65% of its sales from retail and 35% from wholesale. It generates about $80M in sales per year with a 15% profit margin.
Tandy looks cheap.
Most average businesses trade at a 10X EBIT multiple. Tandy trades at 7x EBIT.
Tandy is a category killer. It probably has one of the largest moats in the retail business.
PetSmart, a category killer in the pet food business, didn’t have nearly as wide of a moat, but it was taken private at 12x EBIT. If Tandy was just as durable, it should be valued just as high as PetSmart.
Even if Tandy was bought at 12x EBIT and held for 10 years from today, Tandy should be able to generate its shareholders a 10% return as long as it grew EBIT by 7% and paid out 40% of its earnings.
Tandy has a pathway to hit that growth rate and pay out those dividends.
Tandy has plenty of ways it can grow. The company has publicly stated that it is focused on growing its retail, not wholesale, business. On the retail side, Tandy can grow its store count or grow square footage, increase its prices, or leverage its operating scale.
Tandy is unlikely to grow the number of stores.
This is because there is a lack of real estate or demand. It’s because managers are not available. At Tandy, the managers are the backbone of the business.
Tandy’s model requires very little labor compared to other retail concepts. It only hires two to four associates per store being paid minimum wage or slightly above minimum wage.
The managers are the face of the store, providing years of education for the customer and selecting inventory that is appropriate for the store. Managers are compensated by a $36,000 salary and a bonus (25% of the store’s pre-tax profits). Managers can earn as much as $200,000 by the end of the year.
Most of the people in the business are already working for Tandy. Tandy is the leader in its niche, and like most category killers, has the largest market share. It is also hard to get new managers on board because the stores are located in areas with cheap rent. Since Tandy has such a dominant position, it has been able to afford having run-down stores in low-income, high-crime areas. Tandy is starting to offer managers better-looking stores in safer, higher-income areas, but the availability of managers is still low. It also takes a really long time to train a new manager.
Management aims for a total of 100 - 120 stores in the United States. It has 80, so they could at most build 20 - 40 more retail stores. Historically, the company has been able to open about 2 stores per year. So in 10 years, they could open as many as 20 stores. That’s growth of a little more than 2% per year. It might take some time to mature, but assuming the new stores have similar population sizes in their city, that 2% store growth should translate to 2% sales growth per year.
Tandy could very well increase its square footage.
Because it has been hard to hire new managers and open new locations, management has chosen to relocate stores and their managers into larger buildings in safer neighborhoods. The theory behind this is that by increasing the square footage per store and relocating its stores in a more central location, it should be able to generate incremental sales from new customers.
The traditional retail model uses an average 2,900 sq feet, but it could be as low as 2,000 sq feet. The new model uses about 5,000 sq feet (4,000 square feet to 6,000 sq ft).
The beauty of this strategy is that they can control their destiny. They can overcome the growth constraint. They don’t have to wait on anyone.
However, the quality of this growth is questionable.
Most retail concepts grow by adding new stores for a reason. Retailers are looking to gain new customers. Existing customers can only purchase so much. It is important to be mindful of the percentage share of wallet for any type of product.
Larger stores do not necessarily main new customers. Brick-and-mortar sales are severely constrained by distance. There comes a point where it becomes too inconvenient for a customer to drive X amount of time to get to the retail location. In an ever-increasing world of eCommerce, convenience becomes a greater focus for the customer.
Tandy’s relocation strategy will only be accretive if the 40-50% growth in square footage leads to 40-50% growth in sales. The relocation would need to bring in 15-20 new customers per day over the course of the entire year, assuming the average order value is $50-75.
The data is really blurry on the quality of success in these new locations.
On one hand, total sales are growing much faster than same store sales. Tandy has been able to relocate 10-12 stores per year since 2011 (12-15% of its store base). Assuming relocated stores are not part of the same store sales base, that must mean the new stores are bringing in incremental sales.
On the other hand, it might not be enough. Inventory turnover and PP&E turnover seem to have declined after the company’s growth phase in 2008.
Additionally, relocating to gain new customers inherently means that you are stealing customers from other competitors. While Tandy has dominating brand presence, it is unclear from the report if the Tandy brand causes customers to switch suppliers right away.
The strategy is also less cash flow efficient if it cannot meet those sales demands. The new store requires much more inventory, substantially increasing working capital per store.
The report did not include any free cash flow figures, so it is hard to tell if it is producing more or less cash. But it is something to consider.
Without the one-to-one growth in sales and square footage, the occupancy cost percentage of sales per square foot may dangerously rise. This would also mean that potential sales growth won’t necessarily translate to earrings growth. Earnings growth might only be half of sales growth.
As the company continues to relocate 10-15% of its store base, square footage should be able to grow by 3% per year.
Tandy has substantial control over its ability to increase prices.
Leather is often the most expensive item in the hobby and everyone is always looking for the best price since it is a commodity for the most part.
Where Tandy has pricing power is its non-leather products.
Leather has 30% gross margins whereas their non-leather items have 60-70% gross margins. So Tandy has potential pricing power over 75% of its profits.
The pricing power comes from Tandy’s unique position as a market leader. The company often orders 10x more units per product than its competitors. This means they can manufacture the product at the cheapest prices. This also means that competitors often buy certain items from Tandy.
Tandy could easily increase the prices of 75% of its products by 2-4% every year.
Tandy’s cash flow generation should continue to support shareholder distributions.
Management is extremely candid about their capital allocation process. They spend a lot of time thinking about how to return excess cash flow.
They historically generate about $3M in OCF every year and have a 66% payout ratio.
In the past, they have paid special dividends as an alternative to buybacks. Buybacks are more tax-efficient and provide shareholders a way to keep compounding their capital (without needing to redeploy), but management thinks the stock is too illiquid for successful buybacks.
Regardless, the past financials dictate an ability to generate cash flow. In the future, cash flow may be increasingly tied up because of larger, cash-inefficient stores, but it is hard to tell from a surface-level look. It is clear, however, that management remains committed to returning some excess cash flow, even though they want to some level of excess cash on their balance sheet.
Tandy is arguably safer than other retail concepts.
Tandy is a dominant player in its niche, but at the end of the day, it still abides to the laws of competition in retail and manufacturing.
There are a few givens when evaluating the safety of Tandy’s earnings. Givens are the easy yes’s. They are the things you can rely on with high certainty without needing to look into them further.
First, capital allocation is not aggressively dangerous. They don’t pursue acquisitions or sexy opportunities that other retailers or manufacturers might fall victim to. There is no need to worry about management sabotaging what would be needed for a shareholder to earn 10% returns.
Second, they have pricing power over most of its products. They should be able to increase the prices of its non-leather goods and maintain their gross margins without any substantial fear of customers walking away.
There are areas in which Tandy might have been safe in the past, but questionably safe in the future.
The customer visit has been safer than most concepts, historically.
The customer visit is everything in brick-and-mortar businesses.
Historically, the customer visit was driven by Tandy’s unique ability to offer a wide selection (similar to most category killers) and unique ability to offer customer education from its managers.
The durability of these propositions is important.
I would guess that wide selection is the main reason why people come to Tandy. Similar to Home Depot, these hobbyists start “projects.” Every project is different. And every project requires different materials. Maybe even different tools.
Customer education at Tandy stores seems to be the type of advice you would receive at Home Depot. They point you to the right tools and materials to help you complete your project.
It is clear that the future will not be as easy as its past.
It is easy to imagine a future where YouTube can answer enough questions for new and old hobbyists alike because they can tap into an unlimited library of content where hobbyists explain how to do things, the supplies to get, etc. YouTube won’t answer all questions for the customer because every project is different, but I can see a future in which hobbyists think about going to YouTube for questions before thinking about going to their local store. But most projects are similar. And if you already know how to do it and if you already know what you want, then you might end up watching a few YouTube videos, ordering the items online, and finish your project without ever having to step foot into a Tandy Leather store.
The relocation also poses a threat to Tandy’s value proposition. As stores are relocated, it will take more time and gas for most customers to get to Tandy’s. The convenience ratio must be considered. Does Tandy’s value work only for customers in a 10 mile radius, or will it also work for customers in a 20 mile radius? On top of the education provided by YouTube and the ease of online shopping, at what point will the store be too far?
Without knowing the hobby in greater detail, it is hard to answer these questions.
The hobby seems to be steady.
The hobby has been around for about 40 years. It was spurred by the hippy boom in the late 60’s and early 70’s. Since then, it has settled down to a quiet pace. Tandy has continued to grow unit volume, so it seems like the market is steady.
The growth of any hobby is dictated by the barrier to entry for newcomers. In games, the barrier to entry is the learning curve. If there are a lot of rules or mechanics to a game, then that provides a natural barrier to entry.
Leather crafting is no different. It is quite expensive even compared to other artistic hobbies. Leather is inherently expensive. It will probably rise in cost.
Tools are also expensive. Tools are the connection between a craftsperson and their craft. Psychologically, it is the vessel for which the craftsperson exacts their craft. Without good tools, it is very difficult for a hobbyist to grow in their skill and more valuable, more challenging projects.
Without seeing the numbers, I could see why leather crafting may be considered a dying hobby. But at the same time, Tandy has been growing. And a niche store cannot grow unless its hobby grows, especially if it already has a large share of the market.
Tandy’s manufacturing business has stood the test of time.
Tandy seems to have the purchasing volume and experience to have been dominant in the past. But purchasing scale is not necessarily the most durable form of competitive advantage.
I would imagine Tandy holds a moat on its hand tools, stamping tools, dyes / finishes / glues, and kits. These items make up 30% of their sales. Since they are non-leather items with high functionality, they are probably generating 70% gross margins.
New entrants are always excited to attack businesses with high gross margins. It is easy to see a future where a new entrant exclusively focuses on producing good hand tools, then expanding its product line. This may threaten Tandy’s cost advantage.
Tandy’s brand as a manufacturer is more durable than cost. The functionality and experience of making the best tools is a proposition that usually sticks in customer’s minds for a long time.
It is hard to tell how much of the company’s success has been attributable to its purchasing power or its brand. But it is extremely important to know.
Tandy is very, very close to the type of investment I would normally make.
It is dominant in its niche. Its competitive position seems safer than most businesses. It has multiple pathways for growth. It seems like management has a predictable, capital allocation strategy. Most importantly, it is trading at a below average price for being an above-average business.
I could see a future where buying this business at a below-average price would be as safe as cash.
But I do not have high conviction in that future because I still have questions around the quality of its relocation strategy, the dynamics of the customer visit, and the nature of its brand power. Therefore, I will be passing up the opportunity to put 20% of my net worth into the business.
Back to the Present: What actually happened
HOW WOULD HAVE IT PLAYED OUT IF I SOLD MY STAKE TODAY?
This is a little hard to assess because there are multiple issues involved.
Tandy hasn’t reported any publicly-audited financials since its first quarter 2019 release.
The company brought on new leadership in 2016, departing with the founder’s son. New leadership found that there were several accounting errors that misstated inventory and, as a result, understated income in the business. The company said that accounting changes were not material.
While they were figuring out their accounting problems and replacing their CFO, they did not meet the requirements of the NASDAQ and found themselves delisted in 2021.
The most important part of this exercise is to evaluate our prior assessment of the company’s performance.
Regardless of the delisting, there were four years of results and management commentary to analyze. That is plenty of information to know directionally whether we were right or wrong.
The company grew the number of stores from 110 to 117.
The company’s sales stagnated from 2015 to 2018. In 2015, it generated $84.2M in sales and in 2018 it generated $83.1M in sales.
Gross margin was fairly steady through the period, but SG&A increased substantially, causing the operating margin to decline from 13% to 6%.
The company’s stagnation/decline was offset with higher cash flow.
Over the four years, Tandy only spent $4M on capital expenditures. With the $4M, they grew their domestic store count from 110 to 117 (opened 9, closed 2).
The company actually bought less inventory per store during this period, since store count grew but ending inventory levels stayed the same.
In the past, the company generated about $3-4M in operating cash flow per year. Over the 2015-2018 period, Tandy generated about $7M in operating cash flow per year.
Tandy also increased its Total Debt/EBITDA from 0.30x to 1.20x. However, because the company did not heavily reinvest its cash into capex or inventory, its cash balance grew at a faster rate and finished 2018 with a large net cash balance. Tandy used some of its excess cash to buy back $9M of its shares by 2018.
They also made some key changes over this period.
First, Tandy announced its plan to transition from wholesale/commercial customers to retail customers. Management disclosed, “We believe the decline to this [non-retail] group is due to our pricing, which is perceived to be not as competitive as other suppliers.” Their new operating model is meant to focus on higher-margin retail customers by providing them deeply knowledgeable sales associates. The model is designed to still retain their lower-margin but higher per-customer volume wholesale and business customers but offer them a more streamlined and efficient service.
Second, they disclosed that new stores were cannibalizing same store sales at existing locations.
Third, management emphasized their focus on cash flow management for their domestic stores. They explicitly said, “This is a shift in direction from prior management, who had pursued top-line growth through opening new stores.” As a result, they changed their manager compensation structure so that base pay reflects cost of living and overall performance rating while bonus pay is tied to cash flow indicators such as sales, labor cost, and inventory.
The delisting naturally caused the share price to decline.
When the Singular Diligence Report was published in March 2014, the market cap was about $97.4M. With a current market cap of $37.0M, the stock decayed at a 13% compounded rate over the 7 years.
First: the relocation strategy. The relocation strategy was their primary strategy for growth. I did not believe this was the most reliable strategy for growth, since I believed it would have changed the durability and quality of the business model. This type of strategy-shifting growth was not something that was as reliable as simply repeating the same concept in different locations.
Second: the safety of the customer visit. Tandy’s model offers wide selection and customer education, but it was unclear how important those factors actually were. It was easy to see a future where those value propositions could be satisfied through some other means so that the customer could get a cheaper product with similar quality.
Third: the power of the brand. It was hard to distinguish how much of the company’s success was attributable to its purchasing power (cost advantage) or its brand (customer advantage). Since 40% of the sales were built around a commodity (leather) and 60% of the sales were built around high-gross margin items, I could foresee a future where customers look elsewhere for cheaper products with similar quality/functionality.
There were a few critical parts of the puzzle I could not build conviction around.
First: the relocation strategy. The relocation strategy was their primary strategy for growth. I did not believe this was the most reliable strategy for growth, since I believed it would have changed the durability and quality of the business model. This type of strategy-shifting growth was not something that was as reliable as simply repeating the same concept in different locations.
Second: the safety of the customer visit. Tandy’s model offers wide selection and customer education, but it was unclear how important those factors actually were. It was easy to see a future where those value propositions could be satisfied through some other means so that the customer could get a cheaper product with similar quality.
Third: the power of the brand. It was hard to distinguish how much of the company’s success was attributable to its purchasing power (cost advantage) or its brand (customer advantage). Since 40% of the sales were built around a commodity (leather) and 60% of the sales were built around high-gross margin items, I could foresee a future where customers look elsewhere for cheaper products with similar quality/functionality.
Reflecting for the Future: On getting better
HOW WOULD I HAVE CHANGED MY PROCESS, GIVEN THE RESULTS?
Given the results, I believe I made the correct decision.
Even before the internal accounting investigation and the delisting, the company’s share price was on the decline since March 31, 2014, the day the report was published.
But price is not the basis for saying that I made the correct decision; the deterioration of the business was.
It is also important that you don’t confuse financial health with business health.
Upon further assessment, it’s clear the company’s financial health actually improved by 2018.
Most people will think otherwise because they will point to the decline in operating profit. However, it was clear to me that the cash that ran through the SG&A line was to hire staff in HR, technology, and marketing, to ultimately support the new operating model. While it was an expense on the income statement, this was actually an investment to further their strategy. This was not a big deal to me.
The cash flow management of the business massively contributed to the improvement in its financial health. Somehow, they were able to grow the amount of stores with less cash than I expected.
But sometimes the financial statements do not accurately reflect the business health because there is a lag in timing. I came to the conclusion that I made the right decision when I read the 2018 Annual Report.
There were a few items that made me believe the business was actually less safe than before. And those items were all related to the areas I felt uncertain about.
First: the growth strategy. Earlier in the report, I pointed out that “relocating to gain new customers inherently means that you are stealing customers from other competitors.” If Tandy was the largest competitor in the market, and it wanted to get new customers within the same geographical region, it would have to take customers from other competitors. While the company did not relocate as many stores as I thought, I was correct in getting to the root cause: if you try to expand square footage (through relocation or stores) in the same region, you will either have to take from a competitor or take it from somewhere else. And by adding storefronts in the same region, management essentially set up a strategy to cannibalize their own sales. There’s a reason why the addition of 7 net stores did not grow top-line sales. AUV decreased by 7% from 2015 to 2018.
Second: the customer visit. It was clear that the wide selection and customer education was not of highest importance to a significant portion of their customer group. Wholesale/commercial customers were eager to find less expensive products, and this makes up 30%+ of total sales. The company shifted its focus on retail customers, but I believe however manufacturers, wholesale, and industrial customers trend, retail customers will eventually follow 5-10 years from now. While Tandy is perfectly suited for the retail customer, the retail customer will most likely have more options to choose from in the future, since wholesalers / commercial players will attack those high gross margins products.
Third: the brand power. I believe the brand is still valuable. There are no signs of its brand presence deteriorating. However, it is clear the power of the brand is not as strong as it used to be, since 30%+ of their customers are looking to move away from Tandy and consider other routes.
For these reasons, I believe I made the correct decision to not invest in the business.
If the company did not have the accounting problems, which was a major issue that caused delisting, would the company have been a good bet?
I do not believe so. It is hard to imagine that, in 2021, the unit economics are better now than they were in the past. The unit economics are being diluted from management’s self-sabotaging strategy of new stores in the same geographic region. And they are being diluted by customers that are looking for more competitive prices with similar quality or better convenience.
The business might currently be better on a free cash flow basis today, but the report initially valued the company as a snowball (earnings basis), not as a waterfall (free cash flow basis). It would have not made sense to value the company on a free cash flow basis in 2014, so that logic would not justify that it was a good bet.
Even though I made the correct decision, I believe there are areas where I could improve my investment process.
I probably spent 15-20 hours on this case study compared to the 10-15 spent on Movado.
Almost all of these extra hours were spent on really thinking about the business. Thinking looks like writing, re-writing thoughts; writing responses to question prompts that I ask myself; recording voice memos to “unload my thoughts.” These were all very helpful in getting a clear understanding of the key parts of the business.
I spent much more time thinking about durability compared to my case study on Movado. This was crucial in coming to the correct decision.
But I wasn’t as efficient as possible, which was the goal I made for myself last December.
Why couldn’t I come to a faster decision?
I thought about this question for the past two days. It ate at me.
It was only after a conversation with another investor that I realized that there are three types of “bets.”
There are logical bets.
There are no-brainer bets.
And there are high conviction bets.
Logical bets are the ones that “make sense” if presented by other investors. It is an investment thesis that might very well work out, but one where you have no conviction at all. It would be one where you would be on an emotional rollercoaster and frenzy anytime you see new information about the company.
No-brainer bets are a step up from logical bets. They are a much higher step up. No-brainers are only possible if you have prior knowledge about the industry. You already know what customers want and how their behavior changes when prices change, quality changes, competitors change, etc. You see an investment thesis and say: “There is no way I should lose money, given my prior knowledge in this.”
High-conviction bets are not necessarily related to no-brainer bets. No-brainer bets assume prior knowledge. High-conviction bets don’t. You can arrive at a high-conviction bet after months or years of studying a certain business or industry. The key characteristic of a high-conviction bet is that you can ride it out without needing any piece of information 2-3 years from now. You have absolute knowledge and conviction that, throughout the long-term holding period, management will do X, competitors will do Y, customers will do Z. It is a transcendent level of investing. It often looks like an investor putting 50%+ of their capital into one bet.
There is a reason why doing these case studies are very difficult. Each issue is the Singular Diligence team’s best investment idea in that month. It is vetted by some of the best investment minds.
As a result, you end up with very compelling, logical bets.
The reason it takes time for me to work through each case study is not because I cannot develop a framework for analyzing the opportunity. Through these case studies and my own personal investment portfolio, I have built a solid foundation for quickly framing each company.
The reason why it takes so long is because I lack the industry familiarity, product knowledge, and customer understanding to take an action with that framework.
When that happens, I have to spend some time looking at the fundamentals in more detail. That is what takes up most of the time.
The biggest takeaway for me from this case study is this: find a way to quickly get familiar with an industry’s fundamentals. That way, I can be more efficient in recognizing no-brainer opportunities.
If you want to read write-ups similar to Geoff Gannon’s Singular Diligence newsletter, please visit focusedcompounding.com where Geoff and Andrew currently publish their content.