In the opinion of management, the accompanying consolidated financial statements for Tandy 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, 2006March 31, 2007 and December 31, 2005,2006, and its results of operations and cash flows for the three- and/or nine-monththree-month periods ended September 30, 2006March 31, 2007 and 2005.2006. Operating results for the three and nine-month periodsthree-month period ended September 30, 2006March 31, 2007 are not necessarily indicative of the results that may be expected for the year ending December 31, 2006.2007. 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, 2005.2006.

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.

During the ninethree months ended September 30,March 31, 2007 and 2006, the stock option activity under our stock option plans was as follows:

Other information pertaining to option activity during the ninethree month periods ended September 30,March 31, 2007 and 2006 and 2005 are as follows:

The following table sets forth the computation of basic and diluted earnings per share (“EPS”) for the three and nine months ended September 30, 2006March 31, 2007 and 2005:2006:

We operate 29Our Wholesale Leathercraft segment operates 30 company-owned Leather Factory wholesale distribution centersstores in 1920 states and three Canadian provinces. The Leather Factory centersThese stores 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. The Leather Factory’s primary customers arekits, to retailers, manufacturers, and manufacturers.end users. Our Wholesale Leathercraft segment also includes our National Account sales group.

Currently, we operate 62 company-owned Tandy Leather, retail stores in 31 statesthe oldest and three Canadian provinces. The Tandy Leather stores are engagedbest-known supplier of leather and related supplies used in the retail sales ofleathercraft 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 primary customers are hobbyists, craftsmen, and other end users. We intend to continue increasing the numberindustry presence by opening retail stores. As of company-ownedMay 1, 2007, we were operating 67 Tandy Leather retail stores by opening new stores or acquiring existing 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 2.7. 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, 2005.2006.

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 20052006 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 table presentstables present selected financial data of each of our three segments for the quarters ended September 30, 2006March 31, 2007 and 2005:2006. Certain prior year amounts have been reclassified to conform to the current year presentation.

Consolidated net sales for the quarter ended September 30, 2006March 31, 2007 increased $782,000,$94,000, or 6.6%0.65%, compared to the same period in 2005.2006. Retail Leathercraft was responsible forcontributed $713,000 to the increase, while Wholesale Leathercraft and Other reported decreases of $924,000, offset somewhat by Wholesale Leathercraft’s sales decline of $144,000.$280,000 and $339,070. Operating income on a consolidated basis for the quarter ended September 30, 2006March 31, 2007 was up 40.7%down 4.3% or $366,000 over$87,000 from the thirdfirst quarter of 2005.2006.

The following table shows in comparative form our consolidated net income for the thirdfirst quarters of 20062007 and 2005:2006:

Our Wholesale Leathercraft operation consists of 29 distribution centers30 wholesale stores and our National Account group. Net sales decreased 2.0%, or $144,000, for the third quarter of 2006 as follows:

In our distribution centers,wholesale stores, compared to the thirdfirst quarter of 2005, we achieved modest2006, the customer sales gainsmix was somewhat different than our historical pattern. A normal sales mix in the wholesale stores is 20-25% retail and 75-80% wholesale (all other customer groups). As the sales mix table above indicates, our Retail and Manufacturerretail sales were significantly higher than that of normal levels, the cause of which was weaker sales, specifically leather sales, to our other customer groups. The overall declinemajority of leather sold in sales occurredthe Leather Factory stores is sold to our wholesale and manufacturer customers. Due to some pricing pressure in the market, our Wholesale customer groupprices were not as competitive and as a result, our customers purchased leather from other suppliers. As a result, sales to these customer groups were down overall. We believe that we are seeing early signs of weak marketing initiatives duringthat trend reversing and expect to regain our market share in this area as other suppliers are adjusting their selling prices to levels matching that of the quarter.overall market. Sales to our National Accountnational account customers decreased 3%were up 2% for the quarter.quarter compared to the same quarter last year.

Operating income for Wholesale Leathercraft during the current quarter increaseddecreased by $258,000$173,000 from the comparative 20052006 quarter, an improvementa decline of 39.6%11.4%. Operating expenses as a percentage of sales were 41.3%42.0%, down $508,000up $305,000 from the thirdfirst quarter of 2005. Reductions in legal, professional,2006. In an effort to improve sales, advertising and bank fees, contributions,marketing expenses increased $155,000 due to additional mailings as well as new marketing initiatives. Temporary staffing expenses were up $66,000 and some employee benefit costs accounted for the majority of the decrease.benefits, specifically employee medical programs, increased $62,000.

Our Retail Leathercraft operation consists of 6265 Tandy Leather retail stores at September 30, 2006,March 31, 2007, compared to 4856 stores at September 30, 2005.March 31, 2006. Net sales were up approximately 22%13% for the thirdfirst quarter of 20062007 over the same quarter last year. A store is categorized as "new" until it is operating for the full comparable period in the prior year.

The following table presents sales mix by customer categories for the quarters ended September 30,March 31, 2007 and 2006 and 2005 for our Retail Leathercraft operation:

Operating income increased $120,000$58,000 from the comparative 20052006 quarter, andalthough operating income as a percentage of sales increaseddecreased slightly from 5.8%9.0% in the thirdfirst quarter of 20052006 to 7.1%8.9% in the thirdfirst quarter of 2006.2007. Our gross margin fellincreased minimally from 61.3%60.3% to 60.4%60.5%. Operating expenses as a percentage of sales decreasedincreased from 55.5%51.4% to 53.4%51.6%. We expect our operating leverageAdvertising and marketing expenses increased $60,000 in response to improveweaker than expected sales during the quarter. Personnel costs, rent and utilities associated with the new stores accounted for the remainder$200,000 of the year as the stores openedincrease in 2006 overcome the expenses of opening.operating expenses. Employee health benefits also increased by $12,000.

Sales increased $3,000decreased $339,000 or 0.9%52% for the thirdfirst quarter of 2006.2007. Gross profit margins improved by $37,000, while operatingfrom 26.7% to 43.3%. Operating income increased $28,000. Operating expenses decreased by $12,000.

We paid no interest in the first nine monthsquarter of 20062007 as we have noour bank debt.debt has been zero since March 2005. We recorded $56,000$47,000 in interest income during the periodquarter as earned on our cash balances. We recorded $8,000 in income for currency fluctuations from our Canadian operation.in the first quarter of 2007. Comparatively, in the first nine monthsquarter of 2005,2006, we recorded $17,000 in income of $53,000 for currency fluctuations.

On our consolidated balance sheet, total assets increased from $25.7$31.9 million at year-end 20052006 to $30.1$33.5 million at September 30, 2006. Our cash and inventoryMarch 31, 2007. Inventory accounted for the majority of the increase. Total stockholders’ equity increased from $21.2$26.3 million at December 31, 20052006 to $24.9$27.7 million at September 30, 2006.March 31, 2007. Most of the increase was attributable to earnings in the first halfquarter of this year. Our current ratio fell slightlyheld steady at 5.2 from 5.3 at December 31, 20052006 to 5.2 at September 30, 2006 due to the increase in accounts payable.March 31, 2007.

Our investment in inventory increased by $1.5$1.2 million at September 30, 2006March 31, 2007 from year-end 2005.2006. The increase is attributable to weaker than expected sales. We expected to sell more product during the quarter but did not achieve the results we expected. We will be adjusting our inventory purchases during the next few months in order to get our investment in inventory to more reasonable levels. Inventory turnover increased slightlydecreased to an annualized rate of 3.283.59 times during the first nine monthsquarter of 2006,2007, from 3.233.75 times for the first nine monthsquarter of 2005.2006. Inventory turnover was 3.573.36 times for all of 2005.2006. We compute our inventory turns as sales divided by average inventory. At the end of September 2006,the first quarter, our total inventory on hand exceededwas 10% over our internal targets for optimal inventory levels by approximately 12%. However, we expectdue to the weak sales during the quarter. We will be adjusting our purchases during the next few quarters to get our inventory to decrease throughout he fourth quarter to a more reasonable level by the end of the year.accepted levels.

Our investment inTrade accounts receivable was $2.4$2.9 million at September 30, 2006,March 31, 2007, up $249,000$295,000 from $2.2$2.6 million at year-end 2005.2006. This is a result of thean increase in days to collect accounts forcredit sales during the periodquarter ended September 30, 2006March 31, 2007 as compared to that of the quarter ended December 31, 2005.2006. The average days to collect accounts for the first nine monthsquarter of 2006 was 47.52007 were 57.5 days, a slight increaseup from the first nine monthsquarter of 20052006 of 46.852 days. Average daysWe are tightening our credit policy and analyzing our customers with open accounts to collectensure collectibility of the accounts for 2005 was 44.2 days.and will make adjustments as needed.

Accounts payable increased $1.9 million$775,000 to $3.1$2.5 million at the end of September 2006,the first quarter, due primarily to the intentional increaseincreases in inventory purchases during the quarter.purchases. Accrued expenses and other liabilities decreased $831,000.$939,000. The inventorybonuses accrued at the end of December 2006 were paid in transit to us at September 30, 2006 compared to December 31, 2005, and a reduction in accrued employee benefitsMarch 2007, which accounted for the majority of the decrease.

During the first nine monthsquarter of 2006,2007, cash flow provided by operating activities was $2.1 million.$150,000. The net income generated for the quarter accounted for the majority of the cash flow, offset somewhat by thean increase in inventory and accounts payable.a decrease in accrued expenses. Cash flow used in investing activities totaled $371,000,$906,000, consisting of $200,000 in fixed asset purchases and $650,000 for the majorityacquisition of which was computer equipmentMid-Continent Leather Sales, Inc., a wholesale distributor of leather and store fixtures.leathercraft supplies located in Coweta, OK. Cash flow provided by financing activities totaled $6,000,$17,000, consisting of payments on our capital lease of $100,000,$34,000, offset by proceeds from employee stock option exercises totaling $106,000.$51,000.

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

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, 2005.2006. We believe that our exposure to market risks has not changed significantly since December 31, 2005.2006.

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.