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 contain all adjustments (consisting of normal recurring adjustments) necessary to present fairly its financial position as of September 30, 2005March 31, 2006 and December 31, 2004,2005, and its results of operations and cash flows for the three and/or nine-monththree-month periods ended September 30, 2005March 31, 2006 and 2004.2005. Operating results for the three and nine-month periodsthree-month period ended September 30, 2005March 31, 2006 are not necessarily indicative of the results that may be expected for the year ending December 31, 2005.2006. 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, 2004.2005.

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.

We offer an unconditional satisfaction guarantee to our customers and accept all product returns. Net sales represent gross sales less negotiated price allowances, product returns, and allowances for defective merchandise.  

On January 1, 2006, we adopted SFAS No. 123R eliminates123(R), “Share-Based Payment,” and elected to adopt the usestandard using the modified prospective transition method. Under this transition method, compensation cost associated with stock options recognized in 2006 includes: (1) amortization related to the remaining unvested portion of APB 25 and the intrinsic value methodall share based payments granted prior to, but not vested as of accounting, and requires companies to recognize the cost of employee services received in exchange for awards of equity instruments,December 31, 2005, based on the grant date fair value estimated in accordance with the original pro forma footnote disclosure provisions of those awards,FASB Statement No. 123 and (2) amortization related to all share based payments granted subsequent to December 31, 2005, based on the grant date fair value estimated in accordance with the financial statements. The original effective dateprovisions of SFASFASB Statement No. 123R for us was123(R). Accordingly, stock compensation award expense is recognized over the third quarter of 2005. On April 14, 2005,requisite service period using the Securities and Exchange Commission announced a delay in the required effective date for public companies to the first annual reporting period beginning after June 15, 2005.straight-line attribution method. Previously reported amounts have not been restated.

In November 2004, the FASB issued SFAS No. 151, “Inventory Costs — an amendment of ARB No. 43, Chapter 4”, which clarifies the accounting for abnormal amounts of idle facility expense, freight, handling costs and spoilage. The standard requires that such costs be excluded from the cost of inventory and expensed when incurred. SFAS No. 151 is effective for fiscal periods beginning after June 15, 2005. We do not expect that the adoption of SFAS No. 151 will have a material effect on our consolidated financial statements.

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

We operate 3029 company-owned Leather Factory wholesale distribution centers in 2019 states and three Canadian provinces. The Leather Factory centers are 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. Tandy 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 NovemberMay 1, 2005,2006, we arewere operating 5058 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, 2004.2005.

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, “will,”“could, “could,”“should, “should,”“anticipate, “anticipate,”“believe, “believe,”“budgeted, “budgeted,”“expect, “expect,”“intend, “intend,”“plan, “plan,”“project, “project,”“potential, “potential,”“estimate, “estimate,”“continue, “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, whichincluding those described below, could cause actual results to differ materially from those suggested by the forward-looking statements include the risks and uncertainties identified instatements. Please refer also to our Annual Reportannual report on Form 10-K for fiscal year 2005 for additional information concerning these and other uncertainties that could negatively impact the year ended December 31, 2004, as filed withCompany.

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 threequarters ended March 31, 2006 and nine months ended September 30, 2005 and 2004:2005:

Consolidated net sales for the quarter ended September 30, 2005March 31, 2006 increased $1.2$1.7 million, or 11%13.4%, compared to the same period in 2004.2005. Retail Leathercraft and Wholesale Leathercraft contributed $1.1$1.3 million and $190,000,$474,000, respectively, to the increase, which was partially offset bywhile Other reported a $137,000 decline in sales for our Other segment.decrease of $24,000. Operating income on a consolidated basis for the quarter ended September 30, 2005March 31, 2006 was up 16%30.1% or $123,000$472,000 over the thirdfirst quarter of 2004.2005.

ConsolidatedThe following table shows in comparative form our consolidated net salesincome for the nine months ended September 30, 2005 increased $2.9 million, or 9%, comparedfirst quarters of 2006 and 2005:

While Wholesale Leathercaraft recorded 58.2% of our sales in the quarter, all three segments contributed to the same periodimprovement in 2004. Retail Leathercraft reported a sales increase of $3.4 million. Wholesale Leathercraft’s 2005 sales were down $98,000 from those of a year ago. Our Other segment reported a decline in sales of $341,000. Operating income on aour consolidated basisnet income. Additional information appears below for the nine months ended September 30, 2005 was up 23% or $713,000 over last year.each segment.

SimilarIn our distribution centers, compared to the thirdfirst quarter the wholesale centers haveof 2005, we achieved consistent sales gains in all customer groups except for our Wholesale customer group which was virtually flat. Our Manufacturers and Institution customer groups achieved the first nine months of 2005.largest gains for the quarter at 27% and 19%, respectively, due to aggressive advertising campaigns targeted at both groups. Sales to our RETAIL customer group have decreased somewhat as expected duenational account customers were up slightly for the quarter. We hope to build on the continued expansionpositive trend by providing a mix of the Tandy Leather store chain. Sales to our MANUFACTURER customer group continues to produce solid gains as are our INSTITUTION customers. Our WHOLESALE customer group has not produced as well due to a weak third quarter. As discussed in previous filings, sales to our NATIONAL ACCOUNTS have been disappointing this year although we have begun achieving some positive results with this group as of the third quarter.product that better meets their needs and requirements.

Operating income for Wholesale Leathercraft during the current quarter increased $363,000 forby $350,000 from the nine months ended September 30,comparative 2005 compared to 2004, a increasequarter, an improvement of 16%29.9%. Gross profit margins improved from 54.1% at September 30, 2004 to 55.5% at September 30, 2005. Operating expenses areas a percentage of sales were 37.2%, down $106,000 for$80,000 from the first nine monthsquarter of 2005. We have trimmed many general expenses, including legal/professional fees ($16,000), travelBad debt and entertainment ($32,000), repairs and maintenance ($25,000), telephone and utilities ($34,000), comparedreturned check expense decreased significantly in the first quarter due to aggressive collection efforts. Outside service expense is also down due to the same period for 2004.elimination of temporary staffing.

Our Retail Leathercraft segmentoperation consists of forty-eight56 Tandy Leather retail stores as of September 30, 2005, up from thirty-sixat March 31, 2006, compared to 44 stores a year ago.at March 31, 2005. Net sales were up approximately 37%29% for the thirdfirst quarter of 20052006 over the same quarter last year.

Operating income forincreased $109,000 from the nine months ended September 30,comparative 2005 increased $383,000 or 56% overquarter, although operating income as a percentage of sales decreased from 9.0% in last year's comparable period. Gross profit marginsthe first quarter of 2005 to 8.6% in the first quarter of 2006. Our gross margin fell slightly from 62.1% to 61.9%.60.3% due to the increase in sales to wholesale customers. Operating expenses were 53.6%as a percentage of sales decreased from 53.1% to 51.4%. We gained some operating leverage in our labor and freight costs. In addition, we achieved significant reductions in our bad debt expense compared to the first nine monthsquarter of 2005 compared to 54.9% in the same period last year.2005.

Net salesSales decreased $137,000$23,000 or 4.7% for the thirdfirst quarter of 2005 compared to the third quarter of 2004.2006. Gross profit margins declined from 31.2% to 28.6%. Operatingand operating income decreased $15,000.increased $5,000 and $13,000, respectively. Operating expenses decreased $36,000 for the quarter, the majority of which came from reductions in personnel expenses.

As a result of the elimination of our bank debt in March 2005, weWe paid no interest in the thirdfirst quarter of 2005, compared to $27,000 in the third quarter of 2004.2006 as our bank debt has been zero since March 2005. We also recorded $66,000$17,000 in income during the quarter for currency fluctuations from our Canadian operation. Comparatively, in the thirdfirst quarter of 2004, we recorded an $11,000a $26,000 expense for currency fluctuations.

On our consolidated balance sheet, total assets increased from $22.1$25.7 million at year-end 20042005 to $26.8$27.9 million at September 30, 2005.March 31, 2006. Our cash and accounts receivable and inventory accounted for the majority of the increase. Total stockholders’ equity increased from $17.3$21.2 million at December 31, 20042005 to $20$22.6 million at September 30, 2005, mostMarch 31, 2006. Most of which isthe increase was attributable to our earnings in the first nine monthsquarter of thethis year. Our current ratio fell from 4.795.3 at December 31, 20042005 to 3.544.8 at September 30, 2005 as a result ofMarch 31, 2006 due to the increase in inventory and the payables associated with the inventory at the end of the quarter.accounts payable.

Our investment in inventory increaseddecreased by $4.8 million$625,000 at March 31, 2006 from year-end 2004 to September 30, 2005. Inventory in transit at September 30, 2005 was $1.5 million. Inventory turnover decreased to an annualized rate of 3.233.75 times during the first nine monthsquarter of 2005,2006, from 3.753.93 times for the first nine monthsquarter of 2004.2005. Inventory turnover was 3.873.57 times for all of 2004.2005. 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 thirdfirst quarter, our total inventory on hand exceededwas within 1% of our internal targets for optimal inventory 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.levels.

Our investment in accounts receivable was $2.4$3.0 million at September 30, 2005,March 31, 2006, up $375,000$806,000 from $2.0$2.2 million at year-end 2004.2005. This is a result of an increase in credit sales during the third quarter of 2005ended March 31, 2006 as compared to that of the last quarter ended December 31, 2005 of 2004$500,000 and a slightan increase in the average days outstanding on our accounts. The average days to collect accounts for the first nine monthsquarter of 2006 was 52 days, virtually unchanged from the first quarter of 2005 slowed slightly from the fourth quarter of 2004 from 45 days to 4651.8 days.

Accounts payable increased $1.3$1.0 million from the end of 2004 to $2.3 million at the end of the thirdfirst quarter, due primarily to the intentional slowdown of 2005 as a result of the increase in inventory on hand at September 30, 2005.payments to vendors. Accrued expenses and other liabilities increased $1.4 million.decreased $655,000. The increase is due tobonuses accrued at the accrual recordedend of December 2004 were paid in March 2005, which accounted for inventory en route to us as of September 30, 2005 in the amount of $1.5 million.decrease.

During the first nine monthsquarter of 2005,2006, cash flow usedprovided by operating activities was $3,000.$1.7 million. The net income generated for the year and the increase in accounts payment and accrued expensesquarter accounted for the majority of the cash flow, offset by increases in accounts receivable and inventory.other current assets. Cash flow used in investing activities totaled $357,000, $168,000$112,000, the majority of which pertains to the purchasewas computer equipment 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 $197,000.store fixtures. Cash flow usedprovided by financing activities was $431,000,totaled $4,000, consisting of payments on our revolving credit facility and capital lease obligation totaling $605,000, partiallyof $34,000, offset by proceeds from employee stock option exercises by employees totaling $174,000.

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 millionfunds and our revolving credit facility with JPMorgan Chase Bank, which we could borrow from if necessary.is based upon the level of our accounts receivable and inventory. At March 31, 2006, the available and unused portion of the credit facility was $3.0 million.

For disclosures about market risk affecting the Company,us, 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, 2004.2005. We believe that our exposure to market risks has not changed significantly since December 31, 2004.2005.

At the end of the thirdfirst quarter of 2005,2006, 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 September 30, 2005,March 31, 2006, 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.