These financial statements include the accounts of Tandy Leather Factory, Inc. and its subsidiaries.  Unless the context indicates otherwise, references to “we”, “us”, and “our” refer to the consolidated operations of Tandy Leather Factory, Inc. and its subsidiaries.  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, 2010March 31, 2011 and December 31, 2009,2010, and its results of operations and cash flows for the three and/or nine-monththree-month periods ended September 30, 2010March 31, 2011 and 2009, respectively.2010.  Operating results for the three and nine-month periodsthree-month period ended S eptember 30, 2010March 31, 2011 are not necessarily indicative of the results that may be expected for the fiscal year ending December 31, 2010.2011.  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, 2009.2010.

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.

A two-step process is used to test for goodwill impairment.  The first phase screens for impairment, while the second phase (if necessary) measures the impairment.  We have elected to perform the annual analysis during the fourth calendar quarter of each year.  As of December 31, 2009,2010, management determined that the present value of the discounted estimated future cash flows of the stores associated with the goodwill is sufficient to support their respective goodwill balances.  No indicators of impairment were identified during the first nine monthsquarter of 2010.2011.

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.

The net effect of converting stock options and warrants to purchase 10,00090,600 and 128,700136,700 shares of common stock at exercise prices less than the average market prices has been included in the computations of diluted EPS for the quarter ended September 30,March 31, 2011 and 2010, and 2009, respectively.

In May 2010, our Board of Directors authorized a $0.75 per share special one-time cash dividend that was paid to shareholders of record at the close of business on June 3, 2010. We released the funds used to pay for the special one-time cash dividend on July 1, 2010 and the dividend, totaling $7.7 million, was paid to shareholders on July 5, 2010. Our Board will determine future cash dividends after giving consideration to our then existing levels of profit and cash flow, capital requirements, current and forecasted liquidity, as well as financial and other business conditions existing at the time.  We did not make any dividend payments during 2009.

Geographic sales information is based on the location of the customer.  No single foreign country, except for Canada, accounted for any material amount of our consolidated net sales for the three or nine-monththree-month periods ended September 30, 2010 or 2009.March 31, 2011 and 2010.  We do not have any significant long-lived assets outside of the United States.

On October 15, 2010, we announced the closing of Mid-Continent Leather Sales, a wholesale store located in Coweta, Oklahoma, due to its unsatisfactory sales and earnings performance.  In the fourth quarter, we anticipate incurring the followingAll related one-time expenses associated with the store closing which will be includedhave been expensed in 2010 as part of operating expenses:expenses.  The store closing did not result in an impairment of goodwill.

Our Wholesale Leathercraft segment operates 29 company-owned wholesale stores in 19 states and three Canadian provinces.  These 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, to retailers, manufacturers, and end users.  Our Wholesale Leathercraft segment also includes our National Account sales group, whose only customers are only national craft chains.

Our Retail Leathercraft segment operates company-owned Tandy Leather Company retail stores in 35 states and six Canadian provinces.  Tandy Leather, the oldest and one of the best-known suppliersuppliers of leather and related supplies used in the leathercraft industry, has been thea 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, 2010,2011, we were operating 76 Tandy Leather retail stores located throughout the United States and Canada.

Our International Leathercraft segment operates one company-owned store in Northampton, United Kingdom.  The store, which opened in February 2008, operates as a combination retail and wholesale store.  In 2011, we intend to open a new store in Australia and one to two stores in Spain.  While the opening dates have not been determined yet, we are estimating the Australia store to open in the third quarter and the Spain store(s) to open in the fourth quarter.

A description of our critical accounting policies appears in Item 7 “Management's Discussions and Analysis of Financial Condition and Results of Operations” in our Annual Report on Form 10-K for the fiscal year ended December 31, 2009.2010.

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 “f uture”“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 Report on Form 10-K for fiscal year ended December 31, 20092010 for additional information concerning these and other uncertainties that could negatively impact the Company.

Various oils usedOur performance is subject to manufacture certain leatherworldwide economic conditions and leathercraftstheir impact on levels of consumer spending that affect not only the ultimate consumer, but also small businesses and other retailers.  The United States and global economies have suffered from a prolonged recession for the past several years and a result consumer spending has remained depressed, and may be subject to further deterioration for the foreseeable future.   Specialty retail, and retail in general, are derivedheavily influenced by general economic cycles.  Purchases of non-essential products tend to decline in periods of recession or uncertainty regarding future economic prospects, as disposable income declines.  During periods of economic uncertainty, we may not be able to maintain or increase our sales to existing customers, make sales to new customers, open and operate new stores, maintain sales levels at our existing stores, maintain or increase our international operations on a profitable basis, or maintain our earnings from petroleumoperations as a percentage of net sales.  As a result, our operating results may be adversely and natural gas.  Also,materially affected by continued downward trends or uncertainly in the carriers who transportUnited States or global economies.

The following tables present selected financial data of each of our three segments for the quarters ended September 30, 2010March 31, 2011 and 2009.2010.

Consolidated net sales for the quarter ended September 30, 2010March 31, 2011 increased 977,000$1.3 million, or 8%8.8%, compared to the same period in 2009.2010.  All three segments contributedachieved sales gains, ranging from 2% to the sales increase.32%.  Operating income on a consolidated basis for the quarter ended September 30, 2010March 31, 2011 was up 25%24.5%, or $212,000 over$376,000, from the thirdfirst quarter of 2009.2010.

The following table shows in comparative form our consolidated net income for the thirdfirst quarters of 20102011 and 2009:2010:

Our Wholesale Leathercraft operation consists of 29 wholesale stores and our National Account sales group.  The National Account sales group’s customers consist of only national craft chains.  The following table presents the combined sales mix by customer categories for the quarters ended September 30, 2010March 31, 2011 and 2009:2010:

The increase in sales and gross profit margins and sales growing faster than expenses.  Operatingdollars contributed to the improvement in operating income.  However, the largest contributor to the operating improvement was the reduction in operating expenses, as a percentage of sales were 53%down $220,000, or 7%, up $125,000 from the third quarter of 2009.  Comparedcompared to last year’s third quarter,first quarter.  Decreases in advertising expenses ($143,000), bad debt expense ($97,000), and employee compensationbenefits ($137,000), offset somewhat by increases in legal and benefits increased $146,000, legal & professional fees increased $32,000,($99,000) and travel expenses increased $44,000. These increases were partially offset with decreases in suppliesoutside services ($48,000)26,000), advertising and marketing costs ($44,000), and miscellaneous administrative expenses ($20,000).accounted for the overall expense reduction.

Our Retail Leathercraft operation consists of 76 Tandy Leather retail stores at September 30, 2010, compared to 75 stores at September 30, 2009.March 31, 2011 and 2010.  Net sales were up 12%increased 13.6% for the thirdfirst quarter of 20102011 over the same quarter last year.  A store is categorized as "new"“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, 2011 and 2010 and 2009 for our Retail Leathercraft operation:

Sales to our Retail and Wholesaleeach customer groups ingroup increased slightly over the thirdfirst quarter of 2010, increased compared towith the third quarterexception of 2009, while sales to our Institution and Manufacturerinstitution customer group declined.    These sales trends are consistent throughout the company – that is, our retail business appears to be holding fairly steady while our wholesale business has declined.  We believe the struggling U.S. economy is the primary reason for these sales trends.  That is, the retail customer is slowly gaining confidence in their ability to spend discretionary dollars.  The wholesale customer, however, appears to be questioning his ability to keep his doors open until the economy has recovered.  As a result, he is extremely cautious in his purchases.  The retail stores av eraged approximately $31,000 in sales per store per month for the third quarter of 2010.

SalesConsisting of one store located in the UK, this division’s sales totaled $415,000$509,000 for the thirdfirst quarter of 2011, compared to $384,000 in the first quarter of 2010, compared to $342,000 in the third quarteran improvement of 2009, an increase of 21%32%. Gross profit margin felldecreased 3 percentage points from 67.2% in last year’s thirdthe first quarter to 58.9% in the current quarter.  The decline isof 2010 due primarily to the fluctuationimpact of the currency conversion rate on the selling prices in inventory valueour UK store.  We determine UK selling prices taking into consideration the currency conversion between the U.S. dollar and the BritishGreat Britain pound.  Even so, the store generates higher profit margins than that of a comparable U.S. store as it sells a heavier mix of higher margin tools and supplies and less lower margin leather.  Operating expenses totaled $197,000, an increase of $20,000 over$215,000 in the thirdfirst quarter of 2009.  The2011, up from $172,000 in the first quarter of 2010.  Employee compensation is this segment’s largest expense, contributors were employee compensation,followed by advertising and marketing expenses, shipping costs to customers, and rent.

We paid $67,000$62,000 in interest expense in the third quarter of 2010 on our bank debt which is related to our building purchase,in the first quarter of 2011, compared to $69,000 in interest expense$66,000 in the third quarter last year.  We earned $10,000 in interest income during the thirdfirst quarter of 2010, a $32,000 decrease over last year’s third quarter interest income earned of $42,000, due2010.  Due to the reduction in cash on hand compared to last year, we recorded $8,000 in interest income on our cash.cash balances during the quarter compared to $35,000 a year ago.  We recorded $6,000an expense of $72,000 for currency fluctuations in income during the thirdfirst quarter of 2010 related to currency fluctuations from our Canadian and UK operations.2011.  Comparatively, in the thirdfirst quarter of 2009,2010, we recorded an expense of $115,000$92,000 for currency fluctuations.

On our consolidated balance sheet, total assets decreased from $43.3remained steady at $40.6 million at year-end 2009 to $40.1 million at September 30, 2010.  The decrease in cash and short-term investments (which consists of certificates of deposit), offset by an increase in inventory and other current assets, accounted for the increase.  The decrease in cash and short-term investments was primarily the result of the special, one-time dividend of $7.7 million that was paid in July 2010.  The increase in other current assets consisted of $1.3 million in merchandise paid in advance of shipping by the vendor and $250,000 for a three-year license renewal of our point-of-sale software.March 31, 2011.  Total stockholders’ equity decreasedincreased from $33.3$29.8 million at December 31, 20092010 to $28.5$31.0 million at September 30, 2010.  The d ecrease was alsoMarch 31, 2011, the increase being attributable to earnings in the dividend, partially offset by our 2010 earnings.first quarter of this year.  Our current ratio dropped to 3.8 at September 30, 2010increased from 5.64.2 at December 31, 20092010 to 5.3 at March 31, 2011 due primarily to the reductiona decrease in cash held as a result of the $7.7 million dividend paid.

Trade accounts receivable was $1.4 million at September 30, 2010,March 31, 2011, up $240,000$180,000 from $1.2 million at year-end 2009.2010.  The average days to collect accounts for the first three quartersquarter of 20102011 were 4648 days, up slightly from 44 days for the first three quartersquarter of 2009.2010 of 46 days.  We have tightenedare monitoring our credit policy givencustomer accounts very closely in order to minimize the risk of uncollectible accounts in the current economic environment and are closely monitoring our customers with open accounts to ensure collectability of the accounts.environment.

Accounts payable increased $1.4 million to $2.6$2.0 million at the end of the SeptemberMarch 31, 2011 compared to $1.2 million at year-end 2010, primarily due to the increase ofin inventory purchases during the first quarter in the third quarter.response to our sales increase.  Accrued expenses decreased $2,186,000 from December 31, 2010 to March 31, 2011 due to the semi-annual payment of manager bonuses and other liabilities increased $839,000, the majority of which is the increasea reduction in inventory in transit to us at September 30, 2010 compared to December 31, 2009.year-end 2010.

During the first three quartersquarter of 2010,2011, cash flow used inby operating activities was $766,000.$496,000.  The reduction in accrued liabilities of $2.2 million and increase in inventory and other current assets of $614,000, offset partially by net income of $1.2 million and the increase in accounts payable of $777,000, accounted for the majority of the operating cash used.  Cashused in the first quarter.  Accrued liabilities decreased from December 31, 2010 to March 31, 2011 due to the payment of manager bonuses in the first quarter and the reduction in inventory in transit.  The increase in other current assets is due to an increase in prepaid insurance, inventory, and pre-opening store expenses.

By comparison, during the first quarter of 2010, cash flow provided by operating activities was $224,000.  Net income of $948,000, offset by the increase in other current assets of $707,000 accounted for the majority of the operating cash provided.  Prepaid insurance, postage and inventory accounted for the increase in other current assets.

Cash flow used in investing activities totaled $2.4$142,000 in the first quarter of 2011, consisting primarily of new purchase of store fixtures and computer equipment.  In the first quarter of 2010, cash used in investing activities totaled $2.1 million, consisting primarily of $3.3 million in net certificate of deposit purchases, offset somewhat by the sale or maturities partially offset by $963,000 in fixed asset purchases.  of the same.

Cash flow used by financing activities totaled $7.7 million, which is$51,000 in the dividend paid.first quarter of 2011, consisting of debt repayments.  In the first quarter of 2010, cash flow used by financial activities totaled $59,000, consisting of debt repayments of $51,000 and the purchase of treasury stock of $8,000.

We expect to fund our operating and liquidity needs as well as our current expansion of Tandy Leather's retail store chaingrowth from a combination of current cash balances and internally generated funds.

For disclosures about market risk affecting us, see Item 7A "Quantitative“Quantitative and Qualitative Disclosures About Market Risk"Risk” in our Annual Report on Form 10-K for fiscal year ended December 31, 2009.  Our2010.  We believe that our exposure to market risks has not changed significantly since December 31, 2009.2010.

Our management team, under the supervision and with the participation of our principal executive officer and our principal financial officers,officer, evaluated the effectiveness of the design and operation of our disclosure controls and procedures as such term is defined under Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934, as amended, as of the last day of the fiscal period covered by this report, September 30, 2010.March 31, 2011. The term disclosure controls and procedures means our controls and other procedures that are designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission’s rules and forms. Disclos ureDisclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Securities Exchange Act of 1934, as amended, is accumulated and communicated to management, including our principal executive and principal financial officer, or persons performing similar functions, as appropriate to allow timely decisions regarding required disclosure. Based on this evaluation, our principal executive officer and our principal financial officer concluded that, as of September 30, 2010,March 31, 2011, our disclosure controls and procedures were effective at a reasonable assurance level.

There have been no changes in our internal control over financial reporting during the fiscal quarter ended September 30, 2010March 31, 2011 that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.