We intend for the following discussion to provide you with information that will assist you in understanding our financial statements, the changes in key items in those financial statements from year to year and the primary factors that accounted for those changes, as well as how particular accounting principles affect our financial statements. This discussion also provides information about the financial results of the various segments of our business so you may better understand how those segments and their results affect our financial condition and results of operations as a whole. Finally, we have identified and discussed trends known to management that we believe are likely to have a material effect.

This discussion should be read in conjunction with our financial statements as of December 31, 2008 and 2007 and the two years then ended and the notes accompanying those financial statements. You are also urged to consider the information under the caption "Summary of Critical Accounting Policies."

Summary

We are the world's largest specialty retailer and wholesale distributor of leather and leathercraft-related items. Our operations are centered on operating retail and wholesale stores. We have built our business by offering our customers quality products in one location at competitive prices. The key to our success is our ability to grow our base business. We grow that business by opening new locations and by increasing sales in our existing locations. We intend to continue to expand both domestically, in the short-term, and internationally, in the long-term.

We operate in four segments. First, Wholesale Leathercraft, consisting of our Leather Factory stores and our national account group, is the largest source of our revenues ($26.4 million in 2008). This division has generally offered steady but modest increases in sales. Sales in 2008 declined 10.6%. The wholesale stores' sales declined 10% compared to 2007 and national account sales were down 12%. Much of the sales decline at the stores is attributed to an overall weakness in consumer spending, which results in fewer purchases of our products by small businesses. The decline in national account sales is related to weaker consumer spending as well as the expected decline in sales to one customer who stopped purchasing from us in the first quarter of 2008.

Since acquiring its assets in 2000, we have focused on re-establishing Tandy Leather as the operator of retail leathercraft stores. These retail stores comprise our second segment, Retail Leathercraft. Because of growth here, this segment has experienced the greatest increases in sales ($25.2 million in 2008, up from $24.6 million in 2007). Our business plan calls for opening an average of 10-12 stores annually as we work toward a goal of 100+ stores from 73 stores at the end of 2008. We have slowed down our new store openings in recent years due to the general economic conditions in the U.S. We plan to open 4 new stores in 2009, one of which was opened in the first quarter.

Our third segment is International Leathercraft, which consists of stores located outside of North America. Currently, we have one retail/wholesale combination store located in the United Kingdom, which was opened in February 2008. It is our intention to add more stores to this segment once we have a large enough customer base to support additional stores.

We refer to our fourth segment as "Other". It consists of Roberts, Cushman, a supplier of trimmings for headwear. Its operations are not material to us.

On a consolidated basis, a key indicator of costs, gross margin as a percent of total net sales, held steady in 2007 and increased in 2008. Operating expenses as a percent of total net sales in 2008 increased 2.0% from 2007. Operating expenses increased 4.6% as a percentage of total net sales in 2007 when compared with 2006. The increase in operating expenses in 2007 was due to our delayed response to cut expenses on weaker than expected sales, particularly in the second and third quarters. We were much more successful in our control of operating expenses in 2008, given the continued weak sales environment.

We reported consolidated net income for 2008 of $2.6 million. Consolidated net income for 2007 and 2006 was $3.1 million and $4.8 million, respectively. We have used our cash flow to fund our operations, to fund the opening of new Tandy Leather stores, to purchase necessary property and equipment and make acquisitions of small competitors in the retail and wholesale market. In 2007, we incurred $4.0 million in bank debt to purchase a 191,000 square foot building to house our corporate headquarters and central support units. We moved into that facility in the first quarter of 2008. At the end of 2009, our stockholders' equity had increased to $31.3 million from $29.8 million the previous year.

Comparing the December 31, 2008 balance sheet with the prior year's balance sheet, we reduced our investment in inventory from $17.5 million to $16.0 million, while total cash (including certificates of deposit and other short-term investments) increased from $6.8 million from $10.8 million.

Net Sales

Net sales for the three years ended December 31, 2008 were as follows:

         Wholesale      Retail    International                          Incr (Decr) from
 Year   Leathercraft Leathercraft Leathercraft    Other    Total Company    Prior Year
 2008    $26,423,858  $25,231,145      $836,535   $745,556   $53,237,094      (3.8)%
 2007    $29,555,978  $24,663,750             - $1,097,274   $55,317,002       0.2%
 2006    $31,068,188  $22,520,461             - $1,610,372   $55,199,021       8.8%

Our net sales fell by 3.8% in 2008 when compared with 2007 and grew by 0.2% in 2007 when compared with 2006. The 2008 sales decline resulted primarily from our Wholesale Leathercraft segment, offset somewhat by an increase in Retail Leathercraft sales and the sales from our new International Leathecraft segment, although sales at our retail stores have slowed down somewhat due to an overall slowdown in consumer spending in 2007 and 2008. The reduction in sales in our wholesale stores is also the result of the overall economic slowdown in the U.S.

Costs and Expenses

In general, our gross profit as a percentage of sales (our gross margin) fluctuates based on the mix of customers we serve, the mix of products we sell and our ability to source products globally. Our negotiations with suppliers for lower pricing are an on-going process, and we have varying degrees of success in those endeavors. Sales to retail customers tend to produce higher gross margins than sales to wholesale customers due to the difference in pricing levels. Therefore, as retail sales increase in the overall sales mix, higher gross margins tend to follow. Finally, there is significant fluctuation in gross margins between the various merchandise categories we offer. As a result, our gross margins can vary depending on the mix of products sold during any given time period.

For 2008, our cost of sales decreased as a percentage of total net sales when compared to 2007, resulting in an increase in consolidated gross profit margin from 57.3% to 58.9%. Our total cost of sales as a percentage of our total net sales held steady from 2006 to 2007, resulting in a consolidated gross profit margin at 57.3% in both years. Increases in gross margin are primarily due to increased retail sales from year to year.

Our gross margins for the three years ended December 31, 2008 were as follows:

          Wholesale      Retail    International
  Year   Leathercraft Leathercraft Leathercraft   Other   Total Company
  2008      56.5%        61.6%         68.4%      44.1%       58.9%
  2007      55.7%        59.7%           -        44.8%       57.3%
  2006      56.1%        60.8%           -        32.1%       57.3%

Our operating expenses increased 2.0% as a percentage of total net sales to 51.1% in 2008 when compared with 49.1% in 2007. This increase indicates that our operating expenses grew faster than our sales during this period. However, 2008 operating expenses were only $38,000 higher than those of 2007. Significant expense fluctuations in 2008 compared to 2007 are as follows:

                   Expense                    2008 amount  Incr (decr) over 2007
 Employee compensation & benefits            $14.0 million            $(160,000)
 Rent & utilities                              4.1 million               323,000
 Depreciation and amortization                     985,000               350,000
 Advertising                                   3.0 million             (400,000)
 Freight out - shipping product to customers   1.5 million             (140,000)
 Property taxes                                    260,000               135,000
 Outside services                                  260,000             (240,000)

Our operating expenses increased 4.6% as a percentage of total net sales to 49.1% in 2007 when compared with 44.5% in 2006. Significant expense fluctuations in 2007 compared to 2006 are as follows:

                   Expense               2007 amount  Incr (decr) over 2006
       Employee compensation & benefits $14.1 million              $800,000
       Rent & utilities                   3.8 million               300,000
       Depreciation and amortization          635,000               240,000
       Advertising                        3.4 million               400,000
       Legal & professional fees              650,000               350,000

Other Income/Expense (net)

Other Income/Expense consists primarily of currency exchange fluctuations, interest income and interest expense. In 2008, we had other expense (net) of $67,000 compared to other income (net) of $317,000 in 2007. We received $230,000 for surface damage and additional access related to the oil and gas lease associated with a portion of the land surrounding our corporate facility. We earned $141,000 in interest income on our cash and paid $332,000 in interest expense on our bank debt. We had a currency exchange loss of $114,000 in 2008 compared to income of $9,000 in 2007.

In 2007, we had other income (net) of $317,000 compared to other income (net) of $98,000 in 2006. We received rental income of $150,000 from our new building as we leased the building to the sellers for 90 days after purchase. We also received $100,000 as a signing bonus on an oil and gas lease we signed related to a portion of the land we purchased. We earned $140,000 in interest income on our cash and paid $122,000 in interest expense on our bank debt. We had a currency exchange gain of $9,000 in 2007 compared to $52,000 in 2006.

Net Income

During 2008, we earned net income of $2.6 million, a 16% decline over our net income of $3.1 million earned during 2007. The decline in net income was the result of the decrease in gross profit and the decrease in other income, partially offset by the reduction in income tax expense.

During 2007, we earned net income of $3.1 million, a 35% decline from our net income of $4.8 million earned during 2006. The decline in net income was the result of the increase in operating expenses at a higher rate than that of our sales, partially offset by the reduction in income tax expense.

Wholesale Leathercraft
The increases in net sales, operating income, operating income increases (or
decreases) and operating income as a percentage of sales from our Wholesale
Leathercraft stores for the three years ended December 31, 2008 were as follows:

  Year    Net Sales  Operating   Operating    Operating
         Incr (Decr)   Income      Income    Income as a
          from Prior             Incr (Decr)  Percentage
             Yr                  from Prior    of Sales
                                    Year
  2008     (10.6)%   $1,842,526   (34.8)%        6.9%
  2007     (3.7)%    $2,826,710   (41.3)%        9.6%
  2006     (0.1)%    $4,814,240    29.4%        15.5%

Wholesale Leathercraft, consisting of our 30 wholesale stores and our national account group, accounted for 49.6% of our consolidated net sales in 2008, which compares to 53.4% in 2007 and 56.2% in 2006. The decrease in this division's contribution to our total net sales is the result of the growth in Retail Leathercraft and we expect this trend to continue.

Sales in the wholesale stores decreased 10.4% in 2008 compared to sales in 2007 while the sales decline in our national account group was 12.2%. By customer group, we had sales declines in all groups. The most significant decreases were in our wholesale and manufacturer groups. The customers of these groups are small businesses and have been significantly affected by the weakness in our economy. Our sales mix by customer group in the Wholesale Leathercraft division was as follows:

Customer Group    2008 2007 2006
Retail             26%  23%  25%
Institution         8%   8%   7%
Wholesale          41%  42%  39%
National Accounts  17%  15%  19%
Manufacturers       8%  12%  10%
                  100% 100% 100%

The 2008 decrease in operating income as a percentage of divisional sales resulted from a decrease of 9.2% in gross margin (as a percentage of sales) compared with 2007, offset partially by a decrease of 3.9% in operating expenses as a percent of sales. Significant operating expense decreases occurred in employee compensation and benefits ($670,000), outside services ($235,000) and freight out ($200,000). These decreases were partially offset by increases in depreciation expense ($400,000) and property taxes ($230,000), both due to the purchase of our corporate facility.

The 2007 increase in operating income as a percentage of divisional sales resulted from a decrease of 0.6% in gross margin (as a percentage of sales) compared with 2006, and an increase of 6.6% in operating expenses as a percent of sales. Significant operating expense increases occurred in employee compensation and benefits ($500,000), depreciation expense ($200,000), legal and professional fees ($300,000) and advertising costs ($200,000). These increases were partially offset by decreases in various insurance expenses ($100,000) and general supplies ($75,000).

Retail Leathercraft

The increases in net sales, operating income, operating income increases (or
decreases) and operating income as a percentage of sales from our Retail
Leathercraft stores for the three years ended December 31, 2008 were as follows:

  Year    Net Sales  Operating    Operating    Operating
          Increase     Income      Income     Income as a
         from Prior              Incr (Decr)   Percentage
             Yr                  from Prior     of Sales
                                    Year
  2008      2.3%     $2,188,282     41.7%         8.7%
  2007      9.5%     $1,544,320    (33.2)%        6.3%
  2006      25.0%    $2,310,073     30.7%        10.3%

Reflecting the growth previously discussed, Retail Leathercraft accounted for 47.4% of our total net sales in 2008, up from 44.6% in 2007 and 40.8% in 2006.

Growth in net sales for Retail Leathercraft division in 2008 and 2007 resulted primarily from our expansion program. Expansion during 2008 and 2007 consisted of the opening of 1 and 10 new stores, respectively.

Our sales mix by customer group in the Retail Leathercraft division was as follows:

Customer Group    2008 2007 2006
Retail             65%  63%  65%
Institution         9%   8%   8%
Wholesale          25%  27%  26%
National Accounts   0%   0%   0%
Manufacturers       1%   2%   1%

Operating income as a percentage of sales increased to 8.7% for 2008 compared to 6.3% for 2007. Gross margin improved to 61.6% in 2008 from 59.7% in 2007. Operating expenses as a percent of sales in 2008 decreased by 0.6%, from 53.5% for 2007 to 52.9% for 2008 as operating expenses grew at a slower pace than that of sales and gross margin.

Operating income as a percentage of sales decreased to 6.3% for 2007 compared to 10.3% for 2006. Gross margin fell to 59.7% in 2007 from 60.8% in 2006. Operating expenses as a percent of sales in 2007 decreased by 3.0%, from 50.5% for 2006 to 53.5% for 2007 as operating expenses grew at a faster pace than that of sales and gross margin.

We intend to continue the expansion of Tandy Leather's retail store chain in 2009 by opening approximately 4 new stores, one of which was opened in the first quarter. We remain committed to a conservative expansion plan for this division that minimizes risks to our profits and maintains financial stability. In the current economic environment in the U.S., it is possible that we will change our plans for store openings in 2009 if we determine that the U.S. retail sector can not support additional store openings at that time.

International Leathercraft

International Leathercraft consists of all stores located outside of North America. Currently, that represents one retail/wholesale combination store located in the United Kingdom. International Leathercraft accounted for 1.6% of our total sales in 2008. Operating income was $54,000 in 2008. We expect this segment to become a larger part of our total operations as time progresses.

Other

Roberts, Cushman accounted for 1.4% of our total sales in 2008 compared with 2.0% and 2.9% in 2007 and 2006, respectively. Operating income was $94,000 in 2008 compared to operating income of $140,000 in 2007 and an operating loss of $57,000 in 2006. Roberts, Cushman's sales and profits are immaterial to us as a whole.

At December 31, 2008, we held $10.8 million of cash and certificates of deposit, $16.0 million of inventory, accounts receivable of $1.2 million, and $10.3 million of property and equipment. Goodwill and other intangibles (net of amortization and depreciation) were $966,000 and $355,000, respectively. Net total assets were $40.9 million. Current liabilities were $5.1 million (including $468,000 of current maturities of long-term debt), while long-term debt was $4.0 million. Total stockholders' equity at the end of 2008 was $31.2 million.

At December 31, 2007, we held $6.8 million of cash, $17.5 million of inventory, accounts receivable of $2.5 million, and $7.0 million of property and equipment. Goodwill and other intangibles (net of amortization and depreciation) were $990,000 and $384,000, respectively. Net total assets were $37.6 million. Current liabilities were $3.8 million (including $135,000 of current maturities of long-term debt), while long-term debt was $3.9 million. Total stockholders' equity at the end of 2007 was $29.8 million.

Specific ratios on a consolidated basis at the end of each year ended December 31 were as follows:

                                                         2008  2007  2006
          Solvency Ratios:
          Quick Ratio              Cash+Accts Rec/Total   2.37  2.48  1.74
                                   Current Liabilities
                                   Total Current
          Current Ratio            Assets/Total Current   5.72  7.47  5.19
                                   Liabilities
          Current Liabilities to   Total Current          0.16  0.13  0.20
          Net Worth                Liabilities/Net Worth
          Current Liabilities to   Total Current          0.32  0.22  0.31
          Inventory                Liabilities/Inventory
          Total Liabilities to Net Total Liabilities/Net  0.31  0.26  0.21
          Worth                    Worth
          Fixed Assets to Net      Fixed Assets/Net       0.33  0.23  0.07
          Worth                    Worth

          Efficiency Ratios:
          Collection Period (Days  Accounts
          Outstanding)             Receivable/Credit     54.89 63.42 53.43
                                   Sales x 365
          Inventory Turnover       Sales/Average          3.18  3.19  3.36
                                   Inventory
          Assets to Sales          Total Assets/Sales     0.77  0.68  0.58
          Sales to Net Working     Sales/Current Assets   2.22  2.27  2.45
          Capital                  - Current Liabilities
          Accounts Payable to      Accounts               0.02  0.03  0.03
          Sales                    Payable/Sales

          Profitability Ratios:
          Return on Sales (Profit  Net Profit After       0.05  0.06  0.09
          Margin)                  Taxes/Sales
          Return on Assets         Net Profit After       0.06  0.08  0.15
                                   Taxes/Total Assets
          Return on Net Worth      Net Profit After       0.08  0.10  0.18
          (Return on Equity)       Taxes/Net Worth

Capital Resources and Liquidity

On July 31, 2007, we entered into a Credit Agreement and Line of Credit Note with JPMorgan Chase Bank, N.A., pursuant to which the bank agreed to provide us with a credit facility of up to $5,500,000 to facilitate our purchase and remodel of real estate consisting of a 195,000 square foot building situated on 30 acres of land located at 1900 SE Loop 820 in Fort Worth, Texas. Proceeds in the amount of $4,050,000 were used to fund the initial purchase of the property. On April 30, 2008, that amount was rolled into a ten-year term note, and we began making monthly debt service payments in May 2008.

We are currently in compliance with all covenants and conditions contained in the JPMorgan Chase Credit Agreement and have no reason to believe that we will not continue to operate in compliance with the provisions of these financing arrangements. The principal terms and conditions of the Credit Agreement are described in further detail in Note 6 to the Consolidated Financial Statements, Notes Payable and Long-Term Debt.

Reflecting the borrowing and reduction of bank indebtedness during the periods, our financing activities for 2008, 2007 and 2006 provided (required) net cash of $1.1 million, $4.0 million, and $69,000, respectively.

Our primary source of liquidity and capital resources during 2008 was cash flow provided by operating activities. Cash flow from operations for 2008 and 2007 was $7.8 million and $2.5 million, respectively, the largest portion being generated from net income. This net income was partially offset by the decrease in accrued expenses in 2007 and the decrease of accounts receivable and inventory in 2008. Cash flow from operations in 2006 was $3.9 million.

Consolidated accounts receivable decreased significantly to $1.2 million at December 31, 2008 compared to $2.5 million at December 31, 2007. Average days to collect accounts improved from 63.4 days in 2007 to 54.9 days in 2008 on a consolidated basis. As evidenced by the significant reduction in our accounts receivable at the end of 2008, we have tightened our credit policy and are aggressively monitoring our customer accounts to ensure collectibility. We believe the trend in our collections is the result of the overall slowdown in the U.S. economy. Many of our customers with open accounts are very small businesses, and they tend to feel the effects of an economic slowdown more severely than larger businesses.

Inventory decreased from $17.5 million at the end of 2007 to $16.0 million at December 31, 2008. We expect our inventory to slowly trend upward as we continue our expansion of the Tandy Leather store chain. In 2009, we expect minimal increases in our inventory due to the expected weaknesses in our sales and the limited number of retail stores we plan to open. We attempt to manage our inventory levels to avoid tying up excessive capital while maintaining sufficient inventory in order to service our current customer demand as well as plan for our expected store growth and expansion. We believe our investment in inventory at the end of 2008 was at a very reasonable level given our expansion plans as it was in line with our internal targets of optimum inventory levels.

Consolidated inventory turned 3.18 times during 2008, virtually the same as in 2007 at 3.19 times. We compute our inventory turnover rates as sales divided by average inventory.

By operating division, inventory turns are as follows:

                             Segment               2008  2007  2006
                Wholesale Leathercraft             2.14  2.37  2.40
                Retail Leathercraft                6.05  5.87  6.99
                International Leathercraft         4.61   n/a  n/a
                Roberts, Cushman                   17.75 25.88 7.15

Wholesale Leathercraft stores only 7.14 6.87 7.48

Retail Leathercraft inventory turns are significantly higher than that of Wholesale Leathercraft because its inventory consists only of the inventory at the stores. The retail stores have no warehouse (backstock) inventory to include in the turnover computation as the stores get their product from the central warehouse. Wholesale Leathercraft's turns are expected to be slower because the central warehouse inventory is part of this division and its inventory is held as the backstock for all of the stores.

Accounts payable decreased slightly to $1.1 million at the end of 2008 compared to $1.5 million at the end of 2007.

As discussed above, the largest use of operating cash in 2008 was in the reduction of accounts payable. Cash paid for capital expenditures totaled $2.8 million and $1.7 million for the years ended December 31, 2008 and 2007, respectively. Total capital expenditures (both cash and non-cash) totaled $3.6 million and $5.8 million for the years ended December 31, 2008 and 2007, respectively. In 2007, the primary capital expenditure was the purchase of the land and building to house our corporate offices and central support departments for $4.5 million. Other capital expenditures were factory machines and dies ($110,000); fixtures and equipment for the new Tandy Leather retail stores ($105,000), various store fixtures and computer equipment at existing stores ($85,000), computer system upgrade for advertising department ($100,000), computer equipment for future stores ($125,000); and miscellaneous computer and other office equipment ($250,000). In 2008, the primary capital expenditure was the remodel and retrofit of the building for $3.2 million. Other capital expenditures were factory machines and dies ($55,000) and computer equipment ($415,000). Although we intend to continue opening or acquiring new Tandy Leather retail stores and therefore expenditures related to this expansion should continue into 2009, we do expect our 2009 capital expenditures to be substantially less than that of 2008 as the expenditures related to our building have been completed.

We believe that cash flow from operations will be adequate to fund our operations in 2009, while also funding our limited expansion plans. At this time, we know of no trends or demands, commitments events or uncertainties that will or are likely to materially affect our liquidity, capital resources or results of operations. In addition, we anticipate that this cash flow will enable us to meet the contractual obligations and commercial commitments. We could defer expansion plans if required by unanticipated drops in cash flow. In . . .