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 March 31,June 30, 2006 and December 31, 2005, and its results of operations and cash flows for the three-monththree and/or six-month periods ended March 31,June 30, 2006 and 2005. Operating results for the three-month periodthree and six-month periods ended March 31,June 30, 2006 are not necessarily indicative of the results that may be expected for the year ending December 31, 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, 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. 123(R), “Share-Based Payment,” and elected to adopt the standard 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 all share based payments granted prior to, but not vested as of December 31, 2005, based on the grant date fair value estimated in accordance with the original pro forma footnote disclosure provisions of 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 provisions of FASB Statement No. 123(R). Accordingly, stock compensation award expense is recognized over the requisite service period using the straight-line attribution method. Previously reported amounts have not been restated.

We recognized share based compensation expense of approximately $22,000$23,000 and $45,000, respectively, for the quarterthree and six months ended March 31,June 30, 2006, as a component of operating expenses. Had compensation expense for our stock option plans been based upon the projected fair values at the grant dates for awards under those plans in accordance with SFAS No. 123, our pro forma net earnings, basic and diluted earnings per common share for the quarterthree and six months ended March 31,June 30, 2005 would have been as follows:

We operate 29 company-owned Leather Factory wholesale distribution centers in 19 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, tokits. The Leather Factory’s primary customers are retailers manufacturers, and end users.manufacturers. Our Wholesale Leathercraft segment also includes our National Account sales group.

As of August 1, 2006, we operate 62 company-owned Tandy Leather the oldestretail stores in 31 states and best-known supplier of leather and related supplies usedthree Canadian provinces. The Tandy Leather stores are engaged in the leathercraft industry, has been the primary leathercraft resource for decades. Tandy Leather’s products includeretail sales of quality tools, leather, accessories, kits and teaching materials. In 2002, we began expanding Tandy Leather’s industry presenceprimary customers are hobbyists, craftsmen, and other end users. We intend to continue increasing the number of company-owned retail stores by opening retailnew stores or acquiring existing stores. As of May 1, 2006, we were operating 58 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, 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,” “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, including those described below, could cause actual results to differ materially from those suggested by the forward-looking statements. 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 Company.

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 presenttable presents selected financial data of each of our three segments for the quarters ended March 31,June 30, 2006 and 2005:

Consolidated net sales for the quarter ended March 31,June 30, 2006 increased $1.7$1.2 million, or 13.4%9.9%, compared to the same period in 2005. Retail Leathercraft and Wholesale LeathercraftAll three segments contributed $1.3 million and $474,000, respectively, to the increase, while Other reported a decreasewith Retail Leathercraft being the largest contributor of $24,000.$1.1 million. Operating income on a consolidated basis for the quarter ended March 31,June 30, 2006 was up 30.1%28.5% or $472,000$377,000 over the firstsecond quarter of 2005.

The following table shows in comparative form our consolidated net income for the firstsecond quarters of 2006 and 2005:

Our Wholesale Leathercraft operation consists of 29 distribution centers and our National Account group. Net sales increased 1.1%, or $84,000, for the second quarter of 2006 as follows:

The following table presents the combined sales mix by customer categories for the quarters ended March 31,June 30, 2006 and 2005:

In our distribution centers, compared to the firstsecond quarter of 2005, we achieved sales gains in all customer groups except for our Wholesale customer group which was virtually flat.down slightly. Our Manufacturers and Institution customer groupsgroup achieved the largest gainsgain for the quarter at 27% and 19%, respectively,18% due to aggressive advertising campaigns targeted at both groups.an acceleration of purchases by them to avoid increasing prices. Sales to our national accountNational Account customers were up slightlyincreased minimally for the quarter. We hope to build on the positive trend by providing a mix of product that better meets their needs and requirements.

Operating income for Wholesale Leathercraft during the current quarter increased by $350,000$384,000 from the comparative 2005 quarter, an improvement of 29.9%44.6%. Operating expenses as a percentage of sales were 37.2%41.2%, down $80,000$148,000 from the firstsecond quarter of 2005. Bad debtReductions in legal, professional, and returned check expense decreased significantly inbank fees and some employee benefit costs accounted for the first quarter due to aggressive collection efforts. Outside service expense is also down due tomajority of the elimination of temporary staffing.decrease.

Our Retail Leathercraft operation consists of 5661 Tandy Leather retail stores at March 31,June 30, 2006, compared to 4446 stores at March 31,June 30, 2005. Net sales were up approximately 29%27% for the firstsecond quarter of 2006 over the same quarter last year. A store is categorized as "new" ifuntil it wasis operating less than half offor the full comparable period in the prior year.

The following table presents sales mix by customer categories for the quarters ended March 31,June 30, 2006 and 2005 for our Retail Leathercraft operation:

Operating income increased $109,000$50,000 from the comparative 2005 quarter, although operating income as a percentage of sales decreased from 9.0%10.1% in the firstsecond quarter of 2005 to 8.6%8.9% in the firstsecond quarter of 2006. Our gross margin fell from 62.1%62.4% to 60.3%61.5% due to the increase in sales to wholesale customers.leather sold at the retail stores. Operating expenses as a percentage of sales decreasedincreased slightly from 53.1%52.2% to 51.4%52.6%. We gainedexpected to give up some operating leverage in our labor and freight costs. In addition, we achieved significant reductions in our bad debt expense comparedthis quarter due to the costs associated with the opening of new stores in the first half of the year. We anticipate improving our operating leverage in the last half of the year, particularly in the fourth quarter, as these new stores gain sales momentum to overcome the expenses of 2005.opening.

Sales decreased $23,000increased $26,000 or 4.7%6.1% for the firstsecond quarter of 2006. Gross profit margins and operating income increased $5,000 and $13,000,each decreased $57,000, respectively. Operating expenses decreased $7,000 due toheld steady in the re-alignmentsecond quarters of personnel.2006 and 2005.

We paid no interest in the firstsecond quarter of 2006 as ourwe have no bank debt has been zero since March 2005.debt. We recorded $17,000$32,000 in income during the quarter for currency fluctuations from our Canadian operation. Comparatively, in the firstsecond quarter of 2004,2005, we recorded a $26,000 expenseincome of $13,000 for currency fluctuations.

On our consolidated balance sheet, total assets increased from $25.7 million at year-end 2005 to $27.9$30 million at March 31,June 30, 2006. Our cash and accounts receivableinventory accounted for the majority of the increase. Total stockholders’ equity increased from $21.2 million at December 31, 2005 to $22.6$23.9 million at March 31,June 30, 2006. Most of the increase was attributable to earnings in the first quarterhalf of this year. Our current ratio fell from 5.3 at December 31, 2005 to 4.84.4 at March 31,June 30, 2006 due to the increase in accounts payable.

Our investment in inventory decreasedincreased by $625,000$1.2 million at March 31,June 30, 2006 from year-end 2005. Inventory turnover decreased to an annualized rate of 3.753.41 times during the first quarterhalf of 2006, from 3.933.59 times for the first quarterhalf of 2005. Inventory turnover was 3.57 times for all of 2005. We compute our inventory turns as sales divided by average inventory. At the end of the first quarter,June 2006, our total inventory on hand was withinapproximately 1% ofbelow our internal targets for optimal inventory levels.

Our investment in accounts receivable was $3.0$2.7 million at March 31,June 30, 2006, up $806,000$555,000 from $2.2 million at year-end 2005. This is a result of an increase in credit sales during the quartersix months ended March 31,June 30, 2006 as compared to that of the quarter ended December 31, 2005 of $500,000 and an increase in the average days outstanding on our accounts.$500,000. The average days to collect accounts for the first quarterhalf of 2006 was 5248.4 days, virtually unchangeda slight increase from the first quarterhalf of 2005 of 51.846.6 days.

Accounts payable increased $1.0$1.1 million to $2.3$2.4 million at the end of the first quarter,June 2006, due primarily to the intentional slowdown of payments to vendors. Accrued expenses and other liabilities decreased $655,000.increased $702,000. The bonuses accruedinventory in transit to us at the end ofJune 30, 2006 compared to December 2004 were paid in March31, 2005 which accounted for the decrease.increase.

During the first quarterhalf of 2006, cash flow provided by operating activities was $1.7$2.5 million. The net income generated for the quarter accounted for the majority of the cash flow, offset by increaseswith the increase in inventory and accounts receivable and other current assets.payable offsetting each other. Cash flow used in investing activities totaled $112,000,$252,000, the majority of which was computer equipment and store fixtures. Cash flow provided by financing activities totaled $4,000,$5,000, consisting of payments on our capital lease of $34,000,$67,000, offset by proceeds from employee stock option exercises totaling $38,000.$72,000.

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, internally generated funds and our revolving credit facility with JPMorgan Chase Bank, which is based upon the level of our accounts receivable and inventory. At March 31,June 30, 2006, the available and unused portion of the credit facility was $3.0 million.

For disclosures about market risk affecting us, see Item 7A "Quantitative and Qualitative Disclosures About Market Risk" in our Annual Report on Form 10-K for fiscal year ended December 31, 2005. We believe that our exposure to market risks has not changed significantly since December 31, 2005.