Good day, ladies and gentlemen, and welcome to the Q4 2018 Tandy Leather Factory, Inc. Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will be given at that time. [Operator Instructions] As a reminder, this call is being recorded. I’d now like to turn the call over to Tina Castillo, Chief Financial Officer. You may begin. Tina

Thank you, Michelle. Good morning, and welcome to Tandy Leather’s fourth quarter and fiscal year 2018 earnings conference Call. Joining me today is Janet Carr, our CEO. This morning, I’ll start with a discussion of our fourth quarter and fiscal year 2018 results, then I’ll turn the call over to Janet, who will share with you some of the key initiatives currently underway to drive long-term sales growth and improve profitability and cash flow. We will then provide some time to take your questions. Before we get started, our earnings release and related SEC filings are available on our Investor Relations section of our website, and a replay of this webcast will be available later today. Please keep in mind that there may be forward-looking statements on this call. Statements would include words like expect, believe, anticipate, plan, intend, target or words with similar meaning and based – and are based on our beliefs and expectations and are subject to certain risks and uncertainties that may cause actual results to differ materially from our forward-looking statements about those results. These risks are detailed in our various filings with the SEC, such as the most recent Form 10-K and 10-Q as well as in news releases and other communications. We do not undertake to update or revise any forward-looking statements, which speak only as of the time they are made. As you may have seen in our earnings release, looking at fourth quarter results, while our top line had a modest improvement, there were some discrete items that while not unexpected, unfavorably impacted our operating results to net income. Starting with sales, we saw a 1% improvement this quarter over last year’s fourth quarter, led by 1.9% increase in sales to our non-retail customer base, which is the first increase in…

Thanks, Tina. And hello, everyone. In November, I told you that it had been an exciting first five weeks, and now, I’m here to tell you that the excitement has not worn off in the first five months. I continued the Tandy emerging process by spending time in our tool and hardware factories in Taiwan, in our tanneries in Mexico and in our retail stores around the country. I’ve had regular town hall meetings with two-way conversations with all our employees, numerous meetings with all of our store managers as we work through an evolution of our approach to retail. And I’m rebuilding relationships with many former Tandy employees and friends of Tandy. And perhaps most importantly, I’ve been listening intently to our consumers, in qualitative and quantitative consumer research that we’ve conducted, in stores and shows, through social media and through the many direct ways that our customers reach out to me. From this emersion, there’s some insights that I’d like to share with you. Our brand is strong, especially with the hobbyist leather-crafting community. Net promoter scores and brand trust levels are among the highest I’ve ever seen for any brand in any category. We get high marks for the convenience and excellent customer service of our stores and our leather crafting expertise. The Tandy store as the hub of local leather-crafting communities has emerged as an important strength, and the insight of firms are planned to create a compelling and engaging retail environment. And while we do a good job meeting the product needs of our core customers, we have opportunities to broaden our range and improve our overall value equation, especially among the more expert leather crafters. It’s also clear from this emersion that we have significant opportunity to drive growth with our Wholesale or business…

Ladies and gentlemen, please stand-by. Please go ahead.

Thank you, Michelle. Sorry that we got disconnected. I just want to make sure that we were at the right place. Okay, hang on. Sorry, I’m just finding – I’m just finding our place. I think we were talking about investing in product development, merchandising and merchandise planning, understanding and forecasting demand and in-season selling, price and promotion responsiveness and sell-through will allow us to manage and plan buys, receipt flow, and most importantly, inventory. I got cut off at the most important place. I’m sure you were all left hanging, inventory! We know that our inventory levels are too high, and while we’ve made some progress in 2018 compared to 2017, even before the inventory write-off, we need these basic merchandise planning skills to be able to turn our inventory faster without starving the business for growth. Our goal is to improve inventory returns in 2019, and we will have more to share with you as we start to see some results from our efforts. Finally, an update on the how-to? How we organize? How we deliver the proposition to our consumers? How we get the work done? To achieve our goals to drive growth with both retail and commercial customers, we need to invest in building the right foundation to support our new operating model. 2019 will be a year of some significant investments. As we transition from the old to the new, we will have some overlap of costs, some onetime expenses and some learning curve. In the long run, our SG&A run rate will be helped by these 2019 investments in automation, modern systems, most of which are now subscription-based and don’t require huge capital investments or even long-term service contracts, and best practice expertise that many of our new team members have brought to Tandy. We’ve already discussed the organizational changes to the retail and commercial divisions. We now have, for the first time in recent memory, senior leaders in human resources, marketing, technology, distribution and logistics and legal. These are all areas where we’re investing in building basic processes to allow us to make better, faster decisions, to eliminate low-value manual processes and to invest our operating dollars in the most effective, efficient, high ROI activities. We have a number of other initiatives underway, including improvements in systems, reengineering of our warehouse processes to reflect the latest thinking, managing retail with meaningful metrics, improving our people support processes and countless others. We have made – we have most of the right team in place. We have begun the most-important foundation, building initiatives, and we will be rolling out customer-facing improvements throughout the year. With 2019 as a year of investment and transition in both our infrastructure and our customer proposition, we are looking forward to sharing our results with you each quarter. Now there are questions, I’m sure.

[Operator Instructions] Our first question comes from Kelly Cardwell of Central Square Management. Your line is open.

Hi, guys. How are you doing?

Hi, Kelly.

I’m glad that you came back on to talk about inventory because that is absolutely something I wanted to hear a little bit more about it, if you wouldn’t mind. I mean, just in the current quarter, the reduction in inventory, obviously, generated a lot of cash and it seems like there’s a pretty good – despite some of the investments happening, there is also a good cash story that’s emerging here. And probably more of the focus on it, given that, I’ve heard inventory a couple of times in this call. So can you give us a sense without putting a day on it, but just a sense for, should we expect in order of magnitude, the reductions the amount of inventory you’ll be able to pull out to continue in the future? Or is there some turns number in mind? Like, I know you guys used to be over three times back several years ago. Is that achievable? And then, I guess, the second part of the question would be something we are pulling cash out. Could you help us understand prioritizes for the use of that cash?

Sure. So I’ll start with, yes, inventory is a huge area of focus for us. Janet has been able to come in and bring all kinds of wonderful retail best practices to us, and one of them that we need to do some more work around is our inventory and our merchandise planning and that’s an area that we are looking to add some talent. And we believe there’s a huge opportunity here to improve our turnover. As you know, in the past, we have built up inventory over the quarter. December 31 is generally our lowest amount. And as we work through our new buyer got each fall, as we work through new product launches, as we build up for our holiday, we typically invested $5 million to $7 million by September 30. And we don’t anticipate doing that in 2019. So our goal is to improve our inventory turn. We are investing and looking to add talent in that, and we’ll be able to share more with you next quarter on where we think our inventory levels maybe.

I think, to add on to that, Kelly, we’ve got a lot of work to do to really do the bottoms up on what’s the right receipt flow, what is the right investment in product, and then how do we manage that inventory level down. And it’s not – as you could imagine, it’s not trivial. But we are building those capabilities. We’re not prepared to share specific numbers and targets with you, but without even trying, we’ve done, as you pointed out, a really good job of releasing a fair amount of that. I think some real basic things around keeping it nice and clean in terms of discontinued, slow movers, aged inventory that we haven’t done a great job of in the past. And we are going to be absolutely vigilant about that. And that will help a lot. But there is this whole period of, we got to get it cleaned up, we got to get some capabilities in place and then we can do a better job of forecasting and looking forward in managing that receipt flow. And yes, at some point, Tina is going to shoot me daggers here, but at some point, we should be turning at three. Is that going to happen in 2019? I’d be shocked. No, I’m going to say no. But it’s a reasonable goal. It’s very a reasonable goal for us for the future. So that’s what I will say.

Yes. You also, Kelly, had a question about cash and some of the initiatives there. Yes, that was a great highlight was that we ended the year with $24.1 million in cash, and we did make the decision to pay down that debt and bring the cash back from overseas. And we’re working to maximize the yields on our cash levels. But at this time, we’re holding on to that cash because we want to invest in the business in 2019.

What type of investments are contemplated in addition to – obviously, the operating expense type of investments, I think, we understand, but are there also capital investments that you’re considering?

We are currently not planning on opening any new stores. Our CapEx has been anywhere from $1.1 million to $2 million over the last three or four years. We’ve opened two to five stores each year. We’ve also done multiple relocations of stores, and so we’re kind of on a pause right now as we look at the whole retail experience, and so our CapEx will be down from some of the last couple of years.

Right. Well, so I guess that’s kind of where my thought was is that it sounds like this is actually a year that you’re bringing a lot of cash in. So I understand – definitely, investment in the business is a great idea, but if it’s not investing with CapEx, and presumably – like, I understand, on the operating side, like, you signaled pretty clearly that there will be some restructuring kind of frictional costs, but are there other things that I’m not thinking through on working capital or elsewhere?

That’s it. That’s it, investing in the business. There’s going to be some higher operating expenses that we think will benefit in 2020. And part of what we’re talking about in terms of systems, a lot of it is subscription-based. So we’re not going to invest in some – $3 million ERP systems. We’re not going to have a lot of CapEx with regards to that technology. So no, it’s going to be in OpEx primarily.

So it’s – correct me if I’m wrong, but it seems like you’ll have – even with all the investments you want to make, you’ll probably have a pretty decent chunk of free cash flow coming in the door, right? Just from savings with inventory and elsewhere in reductions and CapEx, et cetera.

At this point, we are not going to give any guidance.

Let me put it this way. Let’s say, we have the happy outcome where we are having nice free cash flow generation, how are you thinking about prioritizes other than, like, generically, I understand investing in the business, but it – either can you talk more specifically about some of those investments and/or maybe talk about things like you bought back stock, obviously, in the fourth quarter significantly at pretty good prices. Is that something that’s still on the table? And just kind of what are the puts and takes? I just want to understand how you guys are thinking about capital allocation?

Yes. And so our stock buyback program is still in place. So far through 2019, we purchased over $300,000 back, and our capital allocation is really we’re investing in the business, looking at 2019 as a year of investment and transition, and we will be giving quarterly updates. But for right now, our plan was, let’s pay down this debt. We still have our stock buyback program in place. And we’ll just keep providing updates as the quarter progresses. I mean, there’s really not this – at this point, we are looking at the business, we’ve got Janet on board, we’re looking at our retail and commercial new operating model and investing in those areas, we’ll pause and see how that’s working, make adjustments. And really, 2019 is going to be a year of just investing and monitoring and evaluating how these are working out.

Right. And I think we want to get a sense of what our run rate cash flow will be looking like. I mean, as we’ve been talking about, we’re all pretty focused on cash – free cash flow as an important metric for us. And we got a lot of change going on right now. So I think, we want to get through this. And then we have a better visibility into the future as to what this looks like. And then I think we can start counting our chickens and say, okay, now that we can see this business on a run rate basis is going to be delivering x amount of free cash flow every year, now we need to start thinking about how we want to in that. And I – we don’t have a better answer than that right now.

Okay. That’s great. Looking forward to monitoring the progress. Thank you.

Thanks, Kelly.

[Operator Instructions] Our next question comes from Michael Kusher [ph]. Your line is open.

Yes, I have three questions. And the first question is on page one of the press release, there are a number of special type items starting with the $1.4 million write-down of inventory. Could you tell us what the tax rate would be on these items? I presume they’re all pretax. Would the 28% tax rate to kind of normalize these expenses be the right number? So that would be my first question. Another question is, why were the cash taxes paid in the year 2018 so much higher than 2017 when the GAAP earnings were down significantly? And then my final question has to do with your International operations. I’m not sure how you can make a go of it with only three stores. It seems like it’s not worth messing around with. You have only three international stores and it seems like if you took some cash back from these stores, they’re going to be even less profitable in the future. So those are my three questions. Thank you.

Sure Michael. So the first question you had about the special items. For the most part, yes, a 25% effective tax rate would be appropriate. We were able to – or we plan to take that $1.4 million write- down of inventory as tax deduction for 2018. The rest of the items, there may be some temporary timing differences. For example, the payout of the severance payments related to management. That’s a cash item. And so some of that will be taken in 2019. As far as your question about why our cash tax is so much higher in 2018 versus 2017, some of that is transition tax related. So the new tax act that was passed in December 2017, we had transition taxes that we had to pay. We also have a new, what we call, guilty tax, our global income tax for our foreign locations, primarily Canada, we had to pay higher taxes for. So we do have a prepaid tax number at the end of the year. So we did pay a little bit more in income taxes than we should have, and so what’s showing is that we do have a refund available. And so a lot of that is just timing.

And let me take the question on International. You’re right, Michael. If you were to do this all over again, you wouldn’t likely put one store in a bunch of different countries all around the world. Difficult to manage. And difficult to be strategic. And yes, here we are. And as we said earlier, we’re really focused on cash flow. So to the extent that these stores actually are delivering, we’re doing what we can to maintain them to the extent that they’re not. So we did close Australia earlier with management problems with difficulty managing 17-hour time zone change, et cetera, and not providing the free cash flow that we were expecting. So we will be making those selective decisions on a store-by-store basis. I have to agree with you that this is not the way I would like to approach international growth. But on the other hand, I’m also not going to close a store that’s delivering value for shareholders. So that’s how we’ve been making those decisions incrementally.

Okay. Thank you.

Thank you.

Our next question comes from Jeff Bailey [ph]. Your line is open.

Good morning. Can you hear me?

Yes.

Yes.

Wonderful, wonderful. Thank you very much for all the detailed information and the fulsome description on the plan going forward. I guess, my first question is, it’s a little bit broad. So, Tandy spent a decent amount of time deemphasizing the Wholesale segment in the market, and now you’ve devised a plan to go back and address that market. So I’m wondering what has changed? How are you – I mean, you’ve described in great detail what the opportunities are. But I guess, how big is that market? Is it growing? And how will Tandy differentiate its products through that channel?

Yes. It’s a good question. It’s difficult to know how big it is. Because this is not – this is a lot of small to medium manufacturers. You’re not going to be able to go buy a report from McKinsey or someone that sizes that market. So what – how do we know that it’s worth going after? Well, at a minimum, this is where our competition has been taking share from us over the last, however, many years. So we know from being able to talk to a lot of these customers that they’re still out there in the market. And they’re now buying from others. So at a minimum, we should be able to go get that share back and then some. We also have dabbled in the past with some larger national accounts. And I think those also are an opportunity. How big can they be? They can be large. They can be quite large. I don’t know what that is. But with a relatively small investment, we have been serving this market not particularly well, out of our retail stores, asking our store managers to go try to drum up some wholesale business, right?

So, with a relatively small investment in a few people and that’s about it, and a car and a phone. We can actually go after this business and start to understand how big it can be. It’s not like a retail store, where you have to spend a bunch of capital and sign a long lease and hire a bunch of people in order to test the market. This isn’t really easy way and a low-cost way where if it turns out it’s not worth it, it’s not costing us very much and it’s pretty easy to move on to do something else. So the attraction of it, to be honest, is that this is a place where you could potentially drive big sales growth, right? I can’t tell you how big it is, in total, but I know that it’s a lot easier to go recruit one $50,000 a year customer than it is to go recruit a whole bunch of $100-a-year retail customers. And the potential for being able to grow that sales is in $50,000-a-year chunks, right? So when you start to think about it that way, this becomes kind of a no-brainer, at least to go after to build – to go build after it. And I think the challenge that I have is I don’t feel like we created the right model to go after it, right? We – by trying to do this through retail, we’ve really suboptimized and have not provided the right proposition for these customers. And to your other question, why – how would we differentiate? Yes, a lot of what these customers buy is undifferentiated. It’s relatively commoditized. But we are the biggest in the industry. So, there isn’t a reason why somebody else should be able to provide that kind of product at better pricing than we can. So, our goal is to be competitive. And there’s not a reason why we can’t be competitive. We’re competing with guys who are a fraction of our size. So I think that the service that we can offer, our expertise, our size and our ability to source lots of product from lots of different places at way better volumes, and therefore, way better cost than what our competitors can do, all of those things give us huge advantages. I just don’t think we’ve done a good job of leveraging those advantages in the past.

Thank you. And I appreciate you saying that way, because I think a lot of managers they tend to overemphasize the brand strength. And from what I understand you’re saying is that to a great degree, it is a price game for a lot of the products. Obviously, the product scope is very wide. So thank you for...

It’s price – I’m sorry to go on about this, but it’s not just price, it’s price, it’s consistency, it’s quality, it’s service. And commercial customers are looking for that to be efficient, right? They don’t care if you have a beautiful logo. They want what they want. They want it to be consistent, they want it to be the quality that they’re paying for. And they want it at good pricing. And understanding that, that’s what those customers want, that’s where we need to build the team and the model that can deliver on that. And that’s what we’re trying to do.

And part of this for your can do was all that the leather was the item that drove traffic. So how do you integrate leather sale with the Wholesale? And do you integrate leather sales with the Wholesale channel? And is there an advantage there, where there could be some higher gross margins with more differentiated products?

Absolutely, we know that the commercial customer buy the higher percentage of leather than the retail customer does from our current business. And we have an expectation that leather is going to be the most important driver for these customers. It is, as you well know, an organic product. It is not – every piece is unique and different makes it – it’s not like selling rivets, right? Where a rivet is a rivet and you might have different qualities, but it’s – they’re supercommoditized. So leather is going to be critically important, and that’s like not just about price, right? It’s about price, consistency, quality, making sure of the grade that they want is exactly what they’re getting. So we think that we have the capability to do this and there’s going to be a lot of learning for sure that goes on, but yes, leather is going to be a critically important part of this.

And obviously, all through the landscape retailers are being disintermediated. I have a two-part question. What are you seeing as far as commoditization of the products from overseas? And then secondly, if the current administration in D.C. pulls out of the Universal Postal Union, which gives overseas sellers below-market rates for shipping, will you see that accruing advantage to Tandy?

Yes, overseas sellers and cheap commodity knockoffs is a problem. And we have a number of initiatives underway to start to address that, most of which we’re not really prepared to talk about today in any detail, except to say we need to address it. And again, I think that our relative size in the market allows us to be a lot more aggressive about addressing those folks than we have in the past. I’m not familiar with the second part of your question and what’s going on there, and so I’m not qualified to answer that, with regard to what it could mean for overseas sellers. Sorry, I don’t understand that one.

Yes, retail buyers that are willing to order through eBay and to a smaller extent, Amazon, if they want to await a month for the product, they can often get goods at 50% or75% of the price that they’re available domestically, because the Universal Postal Union provides discounted shipping rates from foreign countries.

Okay. I don’t know that we’re seeing a lot of that in our categories. The kinds of things that people are looking to buy, that is so plentifully available to be shipped from the U.S. on sites like eBay and Amazon from all kinds of resellers, and I see that as the biggest challenge to begin with and frankly, if we can provide great value and we can be in more of these places and more prominently in more of these places, we should be on the first page of Amazon, for example. Today, we’re not. We – I think that we’re going to have a much better position. So I’m kind of less worried about what the others will do and what they’re doing. I’m more worried about how do we create the right proposition for Tandy, because I think if we can get our proposition right, the other competition, to some extent, falls away. People want to buy from Tandy, and we are ubiquitous, and we need to be more ubiquitous online than we are today, and we need to create – we need to compete better sort of on the merits, the products, the price, the value, the service proposition.

And the board of directors as they currently stand, do you think you have all the talent and skills and abilities you need? Or do you plan on adding to the board of directors at all in the coming months?

I think the board is very happy with its composition right now. We have a really great cross-section of experience, capability, talent, points of view. It is a very active board in the sense that they are very engaged in the business and where we’re going in our strategy. And I think, we could probably pull them, but I think that they’re pretty happy with their composition right now. I mean, I don’t think there’s anybody – any change that is planned in the near future.

And then last question. I heard what you said in response to Kelly’s question, but I just want to ask it more clearly and just be certain. The company bought back $300,000 worth of stock in 2019 so far, and like I said, I understand. So are you saying that there will be no more buybacks in the immediate future for 2019?

No. We’re saying that we have a current plan in place, and we reevaluate that at each of our different board meetings. So there currently is a plan that is through August 2019.

Right. Okay, thank you. That’s all I have.

Okay, great. Thank you.

There are no further questions. I’d like to turn the call back over to Janet Carr for any closing remarks.

Well, thanks, everyone. As they said it’s been a very exciting five months. We’re all superenergized here to do the things we need to do. I think we all have a pretty good view of what the future holds for us, at least for 2019 and in the near years. And we’re very much looking forward to sharing with you how things are going at our next call. Thank you.

Ladies and gentlemen, thank you for participating in today’s conference. This does conclude the program, and you may all disconnect. Everyone, have a great day.