In the opinion of management, the accompanying consolidated financial statements for Tandy Leather Factory, Inc. (formerly known as The Leather Factory, Inc.) and its consolidated subsidiaries (“TLF” or the “Company”) contain all adjustments (consisting of normal recurring adjustments) necessary to present fairly its financial position as of JuneSeptember 30, 2005 and December 31, 2004, and its results of operations and cash flows for the three and/or six-monthnine-month periods ended JuneSeptember 30, 2005 and 2004. Operating results for the three and six-monthnine-month periods ended JuneSeptember 30, 2005 are not necessarily indicative of the results that may be expected for the year ending December 31, 2005. These consolidated financial statements should be read in conjunction with the audited consolidated financial statements and accompanying notes included in our Annual Report on Form 10-K for the year ended December 31, 2004.

The preparation of financial statements in accordance with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.

The CompanyWe recorded amortization expense of $19,645$29,218 during the first sixnine months of 2005 compared to $28,046$42,318 during the first halfnine months of 2004. The Company hasWe have no intangible assets not subject to amortization under SFAS 142. Based on the current amount of intangible assets subject to amortization, the estimated amortization expense for each of the succeeding 5 years is as follows:

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

The Company accountsWe account for stock options granted to itsour directors and employees using the intrinsic value method prescribed by APB No. 25 which requires compensation expense be recognized for stock options when the quoted market price of the Company’sour common stock on the date of grant exceeds the option’s exercise price. No compensation cost has been reflected in net income for the granting of director and employee stock options as all options granted had an exercise price equal to the quoted market price of the Company’sour common stock on the date the options were granted.

Had compensation cost for the Company’sour stock options been determined consistent with the SFAS 123 fair value approach, the Company’sour net income and net income per common share for the three and sixnine months ended JuneSeptember 30, 2005 and 2004, on a pro forma basis, would have been as follows:

The fair values of stock options granted were estimated on the dates of grant using the Black-Scholes option pricing model with the following weighted average assumptions: risk-free interest rate of 4.0%4.25% and 3.125% for 2005 and 2004, respectively; dividend yields of 0% for both periods; volatility factors of .366 for 2005 and .302 for 2004; and an expected life of the valued options of 5 years.

The following table sets forth the computation of basic and diluted earnings per share (“EPS”):

Geographic sales information is based on the location of the customer. No single foreign country’s net sales were material to the Company'sour consolidated net sales for the three and sixnine month periods ended JuneSeptember 30, 2005 and 2004. The Company doesWe do not have any significant long-lived assets outside of the United States.

We operate 30 company-owned Leather Factory wholesale distribution centers in 20 states and three Canadian provinces. Our business conceptThe Leather Factory centers aroundare engaged in the wholesale distribution of leather and related items, including leatherworking tools, buckles and belt adornments, leather dyes and finishes, saddle and tack hardware, and do-it-yourself kits, to retailers, manufacturers, and end users. Our Wholesale Leathercraft segment also includes our National Account sales group.

Tandy Leather, the oldest and best-known supplier of leather and related supplies used in the leathercraft industry, has been the primary leathercraft resource for decades. ProductsTandy Leather’s products include quality tools, leather, accessories, kits and teaching materials. In 2002, we began expanding Tandy Leather’s industry presence by opening retail stores. As of AugustNovember 1, 2005, we have opened 46are operating 50 Tandy Leather retail stores located throughout the United States and Canada.

Our “Other” segment consists of Roberts, Cushman and Co., a wholly-owned subsidiary that custom designs and manufactures decorative hat trims for headwear manufacturers.

A description of our critical accounting policies appears in "Item 2. Management's Discussions and Analysis of Financial Condition and Results of Operations" in our Annual Report on Form 10-K for the year ended December 31, 2004.

Certain statements contained in this report and other materials we file with the Securities and Exchange Commission, as well as information included in oral statements or other written statements made or to be made by us, other than statements of historical fact, are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Forward-looking statements generally are accompanied by words such as “may,”“will,”“could,”“should,”“anticipate,”“believe,”“budgeted,”“expect,”“intend,”“plan,”“project,”“potential,”“estimate,”“continue,” or “future” variations thereof or other similar statements. 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 assume no obligation to update or otherwise revise our forward-looking statements even if experience or future changes make it clear that any projected results, express or implied, will not be realized.

The following tables present selected financial data of each of our three segments for the three and sixnine months ended JuneSeptember 30, 2005 and 2004:

We achieved increases in gross profit margins and operating income, with both growing faster than sales for the quarter. Operating income for Wholesale Leathercraft increased $216,000,$52,000, or 33%8.6%, for the secondthird quarter compared to 2004. Gross profit margins improved to 54.8%56.5% for the secondthird quarter of 2005 compared to 53.6%54.6% for the secondthird quarter of 2004. The improvement in gross profit margins resulted in a 5.6%6.1% increase in gross profit dollars, or $225,000.$236,000. Operating expenses increased $9,000,$184,000, or 0.3%5.6%, in the secondthird quarter of 2005. We were able to hold the cost of employee health benefits steadyAdvertising and marketing expense was up $201,000 for the quarter, as well as bad debt expense ($61,000) and contributions ($44,000). We achieved small reductions in most of ourprofessional fees ($100,000), telephone expenses ($20,000), and minimal amounts in various other expense categories.

Net sales for the sixnine months ended JuneSeptember 30, 2005 decreased almost 2%0.4% from the same period in 2004 as follows:

Operating income for Wholesale Leathercraft increased $312,000$363,000 for the sixnine months ended JuneSeptember 30, 2005 compared to 2004, a increase of 18%16%. Gross profit margins improved from 53.9%54.1% at JuneSeptember 30, 2004 to 55%55.5% at JuneSeptember 30, 2004.2005. Operating expenses are down $291,000$106,000 for the first sixnine months of 2005. We have trimmed many general expenses, including payrolllegal/professional fees ($125,000), contract labor ($8,000)16,000), travel and entertainment ($15,000)32,000), repairs and maintenance ($18,000)25,000), telephone ($27,000), and bank feesutilities ($5,000)34,000), compared to the same period for 2004.

Our Retail Leathercraft segment consists of forty-sixforty-eight Tandy Leather retail stores as of JuneSeptember 30, 2005, up from thirty-twothirty-six stores a year ago. Net sales were up approximately 38%37% for the secondthird quarter of 2005 over the same quarter last year.

Sales in the current quarter showed strong growth. The "same stores" continue to post solid gains. Average sales per month for stores that have been open for at least six months as of JuneSeptember 30, 2005 is $33,000, which continues to beat our internal expectations of $30,000 per month per store.was $32,000.

The following table presents Tandy Leather’s sales mix by customer categories for the quarters ended JuneSeptember 30, 2005 and 2004:

Second quarter operating income for our Retail Leathercraft segment increased $224,000$242,000 or 117%44% over operating income in last year's secondthird quarter. Gross profit margins improved slightlydecreased from 62.2%63.3% to 62.4%61.3% for the quarter andwhile operating margin improved from 6.4%5.5% to 10.1%5.8%. Operating expenses increased $481,000$565,000 or 29%32% for the quarter. Expenses associated with the stores opened since June ofSeptember 2004, such as personnel, rents, and utilities, accounted for the majority of the additional expenses in the quarter.

Net sales for the first sixnine months of 20042005 were up approximately 36%37% over the same period last year. New stores are defined as those that were operated less than half of the comparable period in the prior year. Specifically, stores that opened in late March 2003May 2004 or later are classified as new stores in the following table:

Operating income for the sixnine months ended JuneSeptember 30, 2005 increased $309,000$383,000 or 63%56% over operating income in last year's comparable period. Gross profit margins improvedfell slightly from 61.5%62.1% to 62.2%61.9%. Operating expenses were 52.7%53.6% of sales in the first sixnine months of 2005 compared to 53.5%54.9% in the same period last year.

Net sales decreased $141,000$137,000 for the secondthird quarter of 2005 compared to the secondthird quarter of 2004, although operating income improved $28,000.2004. Gross profit margins improveddeclined from 27.4%31.2% to 34%28.6%. Operating income decreased $15,000. Operating expenses decreased $38,000$36,000 for the quarter, the majority of which came from reductions in personnel expenses.

Net sales decreased $204,000$341,000 for the first halfnine months of 2005 over the first halfsame period of 2004 and operating income decreased $31,000.$46,000. Gross profit margin is down for the year at 28.7% compared to 33.2%32.6% a year ago. Operating expenses decreased $78,000$114,000 during the first sixnine months of 2005 primarily due to continued cutbacks in administrative expenses.

As a result of the elimination of our bank debt in March 2005, we paid no interest in the secondthird quarter of 2005, compared to $12,000$27,000 in the secondthird quarter of 2004. We also recorded $13,000$66,000 in income during the quarter for currency fluctuations from our Canadian operation. Comparatively, in the secondthird quarter of 2004, we recorded a $12,000an $11,000 expense for currency fluctuations.

Interest expense in the first sixnine months of 2005 was $3,000, down from $26,000$52,000 in the first halfnine months of 2004, due to the reduction of our debt. We also recorded $9,100 in gain from the sale of assets.

On our consolidated balance sheet, total assets increased from $22.1 million at year-end 2004 to $25.5$26.8 million at JuneSeptember 30, 2005. Our accounts receivable and inventory accounted for the majority of the increase. Total stockholders’ equity increased from $17.3 million at December 31, 2004 to $19.3$20 million at JuneSeptember 30, 2005. Most2005, most of the increase was fromwhich is attributable to our earnings in the first halfnine months of thisthe year. Our current ratio fell from 4.79 at December 31, 2004 to 3.703.54 at JuneSeptember 30, 2005 as a result of the increase in inventory-in-transitinventory and the payables associated with the inventory at the end of the quarter.

Our investment in inventory increased by $2.2$4.8 million from year-end 2004 to JuneSeptember 30, 2005. Inventory in transit at JuneSeptember 30, 2005 was $2.0$1.5 million. Inventory turnover decreased to an annualized rate of 3.593.23 times during the first sixnine months of 2005, from 3.983.75 times for the first halfnine months of 2004. Inventory turnover was 3.87 times for all of 2004. We compute our inventory turns as sales divided by average inventory. Inventory management is a significant factor in our financial position and, as we continue our expansion of the Tandy Leather store chain, we expect our inventory to slowly increase. We strive to maintain the optimal amount of inventory throughout the system in order to fill customer orders timely without tying up too much working capital. At the end of the secondthird quarter, our total inventory on hand was within 5% ofexceeded our internal targets for optimal inventory levels.levels by approximately 15%. However, we expect our inventory to decrease through the fourth quarter to a more reasonable level by the end of the year.

Our investment in accounts receivable was $2.5$2.4 million at JuneSeptember 30, 2005, up $489,000$375,000 from $2.0 million at year-end 2004. This is a result of an increase in credit sales during the first halfthird quarter of 2005 as compared to that of the last halfquarter of 2004 and a slight increase in the average days outstanding on our accounts. The average days to collect accounts for the first halfnine months of 2005 slowed slightly from the fourth quarter of 2004 from 4345 days to 46 days.

Accounts payable remained virtually unchangedincreased $1.3 million from the end of 2004 to the end of the secondthird quarter of 2005 increasing $56,000.as a result of the increase in inventory on hand at September 30, 2005. Accrued expenses and other liabilities increased $1.7$1.4 million. The increase is due to the accrual recorded for inventory enrouteen route to us as of JuneSeptember 30, 2005 in the amount of $2.0 million, partially offset by a reduction in accrued payroll and bonuses and various other expense accruals. The bonuses accrued at the end of December 2004 were paid in March 2005.$1.5 million.

During the first halfnine months of 2005, cash flow providedused by operating activities was $924,000.$3,000. The net income generated for the year and the increase in accounts payment and accrued expenses accounted for the majority of the cash flow, partially offset by increases in accounts receivable and inventory. Cash flow used in investing activities totaled $213,000, $139,000$357,000, $168,000 of which pertains to the purchase and additional development of a new computer system. Once the system is usable for point-of-sale and inventory management, we intend to reclassify the cost to property and equipment. Equipment purchased to date in 2005 totaled $83,000.$197,000. Cash flow used by financing activities was $456,000,$431,000, consisting of payments on our revolving credit facility and capital lease obligation totaling $572,000,$605,000, partially offset by proceeds from stock option exercises by employees totaling $116,000.$174,000.

As of JuneSeptember 30, 2005, we had no bank debt.

We expect to fund our operating and liquidity needs as well as our current expansion of Tandy Leather's retail store chain from a combination of current cash balances and internally generated funds. We also have a $3.0 million revolving credit facility with JPMorgan Chase Bank, which we could borrow from if necessary.

For disclosures about market risk affecting the Company, see Item 7A "Quantitative and Qualitative Disclosures About Market Risk" in our Annual Report on Form 10-K for our fiscal year ended December 31, 2004. We believe that our exposure to market risks has not changed significantly since December 31, 2004.

At the end of the secondthird quarter of 2005, 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 and Exchange Act of 1934, as amended. Based upon this evaluation and notwithstanding the limitations contained in the final paragraph of this Item 4, they concluded that, as of JuneSeptember 30, 2005, 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 period 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.

Pursuant to the requirements of the Securities and Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.