Tian Ming Huang

Final Paper 88399 Seminar in Value Investing - Professor 8ruce Greenwald SEARCH: COMPANY CHARACTERISTICS

Business description
Tandy Brands Accessories' (Tandy) designs, manufactures and markets fashion accessories, primarily leather goods, for men, women and children. It distributes its products to all types of retail operations including mass merchants, department stores, golf pro shops, specialty retail stores, military exchange stores and wholesale club outlets using a broad portfolio of owned and licensed brand names including Dockers, Levi's, Jones New York, Perry Ellis Portfolio, Perry Ellis America, Woolrich, Haggar, Amity, Canterbury, Princess Gardner, Accessory Design Group and Rolfs. Its main investment characteristics are as follows.

Market value
As at March 12, 2004, the company's market value was as follows:
3.08 x 6.26 million shares = $81.9 million 11.9 million

Its equity value and market value is small contributing to its obscurity and making it a potential value stock. The stock's obscurity is also reflected by the lack of analyst coverage. A search of InvestextPlus revealed that the last report on the stock was dated March 5, 2000 by Sidoti & Company while Multex provided a report, dated April 12, 2001 by Bear Stearns.

Industry
Tandy is in the relatively unglamorous apparel and fashion accessories industry, enhancing its attractiveness as a value stock.

Shareholders
As of August 18, 2003, the company's ownership struclure" was as follows.
895 25.4 31.4

The significant proportion of officer and institutional stockholding (including holdings by Fidelity, Calpers and Charles Schwab) also enhance the stock as a value investment given the greater possibility of interest alignment between management and stockholders and institutional attention.

1 2

Stock ticker - NASDAQ NM: TBAC Source: moneycentral.msn.com Page 1

Tian Ming Huang
Final Paper 88399 Seminar in Value Investing - Professor Bruce Greenwald

Growth
Over the past five years, Tandy has experienced sales growth of approximately 11.4% per annum and net income growth of approximately 6.9%3.

Total return of stock
The total return of the stock, as calculated by Morningstar.com, is as listed below.
31.2% 26.3% -3.3%

While the 1-year and 3-year return rates indicate that we may have 'missed the boat', the trailing 5-year average return supports Tandy's potential as a viable value investment.

Dividend yield, price earnings ratio and market to book ratio
The stock is therefore relatively cheap, as indicated below.
0.7% 9.78 0.86

Special circumstances
In fiscal 1995, the company adopted the Tandy Brands Accessories, Inc. 1995 Stock Deferral Plan for NonEmployee Directors (Deferral Plan) in order to provide non-employee directors an equity interest in the company, in lieu of their compensation fees, to attract and retain well-qualified individuals to serve as nonemployee directors and to enhance the identity of interests between the non-employee directors and our stockholders. The acceptance by the said Directors of the Plan reflects their confidence in the company's prospects. On October 17, 2000, the Board of Directors also approved a plan to repurchase, from time to time in the open market or through negotiated transactions, shares of the company's common stock. This program is an extension of a $4 million stock repurchase plan initiated on October 20, 1999, and extended on April 26, 2000.

3

Calculated from data in the company's 10-K form and Reuters. Page 2

Tian Ming Huang
Final Paper B8399 Seminar in Value Investing - Professor Bruce Greenwald

VALUATION

Generation of latest twelve month (LTM) financials
The generation of LTM financials (in $ million) for Tandy are as documented below-,
Statement Relevant section of Statement of Cash Flows Add 6 months Subtract 6 weeks ended months ended Ad9 ~21Oa~ths S~6626 weeks~~~1 months ~~~~

Net sales Cost of goods sold

Fiscal year ending 6/2003 Fiscal year

~~imt

6/200f 46.399

1212°qj4.68

12/20Bt.236

Depreciation and amortization Total operating expenses Operating income Interest expense Royalty and other income Earnings from continuing operations Income tax expense Earnings from continuing operations after tax Cumulative effect of accounting change net of income taxes Net income

62.717 15.371

31.323 12.388

2.833 0.101
12.639

1.37 0.031
11.049

4.922 7.717 0.581
7.136

4.295 6.754 0.000
6.754

Fiscal year ending 612002 Net sales sold

Add 6 months weeks ended 1212002

Subtract 6 months ended 1212001

205.769 133.706

126.25 82.236

Asset valuation
Basic valuation. The valuation of Tandy's assets (in $ million), excluding goodwill, as at end-December 2003 is as indicated below. Since the fashion accessories industry, and Tandy's position within it, is expected to be economically sustainable (Tandy has been in business for 70 years), Tandy's net assets would be valued at their reproduction cost.

4

Calculated using data from the company's forms 10-K and 10-Q. Page 3

Tian Ming Huang
Final Paper B8399 Seminar in Value Investing - Professor Bruce Greenwald

1.709 57.123 0.000

14.025 (book value) 42.514 (book value + allowances (calculated using 2003
allowances/gross receivables ratio))

57.123 (no adjustment for inventory turnover required given the
small difference between the 1212003 and 1212002 days turnover of 139 and 148 respectively) 6.308 (book value)

I current assets and equipment (original cost) Buildings & leasehold improvements Machinery & equipment assets (excluding goodwill and other intangible assets) Total assets (excluding goodwill and other intangible assets)

6.308 118.261 33.175 9.869
23.306

0.000 1.709 -11.653
0.000

-11.653 0.000

119.970 21.522 (proportion attributed to property and equipment estimated using June 2003 proportions) 9.869 (valued at cost, given low likelihood of depreciation) 11.653 (assumed that equipment has depreciated 50%) 1.353 (book value)

1.353

152.789

-9.944

142.845

Valuation of brands. The value of Tandy's brands and licenses may be estimated in a number of ways. Firstly, assuming that the net brand value per dollar of sales is $0.5, Tandy's brand value at end-2003 is 0.5*226.628 = $113.314 million. The valuation of Tandy's brands may also be inferred from the private market value of Tandy's most recent acquisitions, as indicated below:

n.a.

n.a.

0.239
Data on goodwill is obtained lrom Tandy's lorm 10-K
2

0.500 9.000

0.478 0.232

Data on recentlanticipated sales is obtained lrom HBW Equity Research Report July 19,2001 lor

Frank Spielberg, Bear Stearns Equity Research January 18, 2001 lor Stagg and Tandy conference call on April 18, 2002 for AA&E.

Given Tandy's net sales of $226.6 million in 2003, the value of its brands may be approximated as 226.6*0.337 = $76.364 million, which is approximately 1.4 years worth of selling, general and administrative expenses. To be conservative, this lower figure will be used, instead of the $113 million estimated above, in the subsequent calculations. Net Asset Value. Tandy's net asset/ enterprise value (in $ million) may now be estimated as follows:

Page 4

Tian Ming Huang
Final Paper B8399 Seminar in Value Investing - Professor Bruce Greenwald

Assets (excluding goodwill)

134.123

8.722

142.845 (book value differs from that in basic valuation because net PPE, and not original cost PPE, has been used in this case). 76.364 (reproduction value is as estimated above) 219.209 21.586 (book value)

Goodwill and other intangible assets/ brand value otal assets Liabilities (not including debt)

16.414 150.537 21.586

59.950 68.672 0.000

Net asset value

128.951

197.623

It should be noted that approximately 39% of Tandy's net asset value comprises the value of its brands.

Earnings Power Valuation
Margin history. Tandy's annual operating margin to date is as documented below.

15.4 6.9%

13.4
6.5%

10.8 5.5%

8.2%

18.5 10.4%

13.0 9.7"10

8.4 8.2%

1.4 1.6%

It should be noted that Tandy's operating margin for the year ending December 2003 of 7.2% is in line with its historical profit margin. Given the lack of seasonality in its sales5, no adjustment to the EBIT for the year ending December 2003 is therefore required. Depreciation adjustment. Adjustments are required, however, for depreciation and amortization in order to determine the actual amount of reinvestment the company needs to make in order to restore a firm's assets at the end of the year to their level at the start of the year. This is illustrated below.
Depreciation and amortization Actual capital investment Growth investment 4.167 2.904

~~~~

~m
0.069 0.645
2.26

AveragePPEISalesin past twoyears ending612003and 612002 Growthcapex
Maintenance capex Excess ceerecianor

Earnings power value. Tandy's earnings power may be estimated as follows:

5

See "Management Discussion and Analysis" in Tandy's form 10-K for fiscal 2003. Page 5

Tian Ming Huang
Final Paper B8399 Seminar in Value Investing - Professor Bruce Greenwald

0.078 (average annual royalty income over the past three years)

7.820 (assuming that approximately 13.7% of SG&A expenses funded growth, given the company's average net sales growth of 13.7% over the past past 8 years) adjustment for selling, general and administrative expenses due to employee severance costs EBIT adjusted Less Taxes EBIT after tax Add excess depreciation after tax Adjusted EBIT after tax

0.387 (9/10*$0.43 million assuming that employee severance occurs once a decade) 24.72 9.614 (effective tax rate is 38.9% as stated in the annual report) 15.101 1.53 (as calculated above)

16.628

The adjustment for selling, general and administrative expenses to support growth undertaken above should correct Tandy's earnings power for the costs of implementing a new distribution software systems. The calculation of the company's weighted average cost of capital (WACC) is, in turn, illustrated below:
Calculation of WACC Assumptions: - The company has a capital structure of 50% debt and 50% equity, given that it has room for increased debt given its current D/C of only 24.9% - The cost of equity is a lowish 10%, given the company's beta of only 0.48 (source: Yahoo! Finance) and mature business. - The cost of debt is approximately 8%, higher than the 5.6% stated in the annual report due to the higher debt assumed.

WAGG:
0.5*10%+0.5*8%*(1-0.389)
= 7.44%

Given the earnings power and WACC, Tandy's earnings power value = 16.628/7.44% + excess cash = 223.49 + (14.025 -1.5%*226.628)
= 223.49 + 10.63 = $234.12 million.

REVIEW

The excess of earnings power value ($234.12 million) over net asset value ($197.62 million), as calculated above, of $36.5 million may reflect either Tandy's enjoyment of sustainable barriers to entry/competitive advantages, superior management or simply inaccurate assumptions, and hence valuations, given the small magnitude of the excess.

6

As stated in page 36 of Tandy's form 10-K for fiscal 2003. Page 6

Tian Ming Huang
Final Paper B8399 Seminar in Value Investing - Professor Bruce Greenwald

Strategic analysis
Industry map. The fashion accessories industry is highly fragmented with few publicly traded pure-play companies. Tandy's main competitors therefore include pure-play fashion accessories makers such as Humphreys Accessories LLC (Humphreys), Swank, Inc. (Swank), Coach, Inc. (Coach) and Dooney and Bourke, Inc. as well as non-pure play companies which have a stake in the industry such as Fossil, Inc. (Fossil), Kenneth Cole Productions (KCP), Nine West Group (NW), and The Timberland Company (Timberland). Of these companies, only Fossil, Swank, Coach, KCP and Timberland are publicly traded. They will therefore be the focus of analysis given the difficulty in obtaining financial information for the other companies. Wilsons the Leather Experts, which designs and markets, rather than manufacture, leather accessories is also included in the analysis as a proxy for the leather accessories industry. Do barriers/competitive advantages exist? The table below indicates the return on equity for Tandy and its main competitors.

estimated gross margin for categor! 45.0% -1.8% 42.7% -9.5% 17.1% 29.4% 8.3% 45.0% -117.2% 42.0% 4.3% 11.6% 26.0% 8.1% 45.0% -43.8% 35.5% 26.7% 28.4% 31.6% 6.1% 45.0% 7.4% 18.6% 28.9% 25.0% 41.4% 13.0% 45.0% 12.6% 8.6% 21.3% 24.5% 24.6% 17.2% 45.0% 20.1% 11.7% 18.7% 23.3% 24.90% 15.6%

of data: Reuters Investor and respective 10-K forms of companies. 2SG Cowen report on Fossil, Inc., January 9, 2004.

The table above indicates that pure-play accessories manufacturers (Tandy, Swank and even Coach) have not experienced above cost of capital ROEs for sustained periods. In this regard, the excellent performance of Fossil, Timberland and KCP may be inferred to have arisen from their other business segments though it is difficult to be conclusive given that the 1O-K forms of these companies report segment data on the basis of distribution channels and geographic markets rather than products. In terms of market share, the fashion accessories industry remains highly fragmented, as stated above. While Tandy was, in 1999, the market leader in men's belts and personal goods and women's personal goods with 18%, 10% and 9% respectively of the market, its market leadership may be tenuous as illustrated by the decision of Jones Apparel Group to terminate the handbag portion of its existinq licensing agreement with Tandy in 1999. Given the above, it may be inferred that barriers to entry/competitive advantages are lacking in the fashion accessories industry, as they are for Tandy.

Page 7

Tian Ming Huang
Final Paper B8399 Seminar in Value Investing - Professor Bruce Greenwald

Source of competitive advantage. On a more micro basis, Tandy is not protected by government licenses nor does it experience cost advantages (no special know-how and access to cheap resources relative to its competitors). While the company has 70 years of experience in the business, its expertise in designs is not specific to the company. Its competitors, such as Humphreys, which has operated for 85 years and which also serves multiple retail channels, also possess design expertise. In any case, competitors would easily be able to copy the company's accessories designs. Stark illustrations of the ease with which accessories designs may be copied is provided by the abundance of knock-offs of some of the most famous branded accessories in the world, such as Louis Vuitton and Prada, in New York City's Chinatown. Additionally, Tandy's much vaunted retail distribution system is not company-specific. Competitors such as Humphreys also serve multiple retail channels, supplying its Levi's, Dockers, Columbia, Bill Adler Studio, Reward, etc. labels to more than 2,000 customers, including nine of the ten leading U.S. apparel retailers, in 2000. Tandy also does not enjoy captive customer demand (low 'habit' purchases, search costs and switching costs). While large retail chains have tended, over recent years, to consolidate their supply sources, relying on resources with proven expertise in design, delivery and quality control (example: Tandy has been a supplier to Walmart, which accounted for 38% of its net sales in fiscal 2003, for 74 years), demand from these sources should not be assumed as given. The amendment of Tandy's Jones licensing agreement as mentioned above is a case in point.

Growth valuation
With regard to the value of growth, this would be insignificant for LC given that growth is only valuable within a franchise, which LC does not possess. This is supported by the calculations below.

Using the Growth Value Matrix', the present value of Tandy's cash flow's with growth/EPV is near 1 indicating a lack of growth value.

Franchise income calculation
7

See Table 7.11 in Value Investing by Greenwald, et. al. Page 8

Tian Ming Huang
Final Paper B8399 Seminar in Value Investing - Professor Bruce Greenwald

Tandy's lack of franchise value is also supported by franchise income calculations below.
7.44% 197.6 234.1 petitive free entry earnings = %*197.6 = ranchise earnings = 16.628 - 14.70 =

14.70 1.92

The company's 1.35% pricing/ cost advantage is not significant.

Bottomline
Margin of safety. Given that Tandy does not have franchise value, it may be inferred that its asset value and earnings power value are equivalent and that any excess in earnings power value over asset value is the result of superior non-sustainable management quality (as reflected by three factors: management's success in adding value to the company through seven of nine acquisitions it has made since 19928; recognition by the retail community - JC Penney, Target and Wal-mart - of Tandy's product and service in the form of several "vendor of the year" awards in a number of accessories classiticafions''; and the excess of Tandy's growth over the industry's recent growth rates of 3-5% in recent years's). The company's intrinsic enterprise value therefore ranges from $197.6 - $234.1 million l.e. approximately $215.9 million. The company's equity value may then be determined as follows:
Enterprise value ($ million) Less debt ($ million)
215.9 30.0

Given Tandy's enterprise market value of $111.9 million and equity value of $81.9 million or $13.08 per share as at March 12, 2004, it is arguable that Tandy is a viable value stock for joint-based purchase, providing an enterprise margin of safety of approximately 48% and equity margin of safety of approximately 56%.
See Tandy's 10-K forms and "Tandy Brands Accessories Investment Research", Principal Financial Securities, Inc., September 12,1997. 9 See Tandy's 10-K form for the year ended June 30, 2003. 10 Company estimate in Tandy's form 10-K. Page 9

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Tian Ming Huang
Final Paper B8399 Seminar in Value Investing - Professor Bruce Greenwald

Catalysts. In essence, the lynchpin or 'idea' underlying the success of Tandy equity as a value investment is the current trend toward mass merchandizing and the increasing 'shift to value' among consumers". As the public has become increasingly aware of the quality, service and convenience of mass-merchandising super-stores, many traditional companies, which competed on quality, prestige and service have become increasing marginalized given their inability to compete with the mass merchandisers on price, due to the cost-savings inherent in the mass-market business model. Evidence of this trend include the general sustained prosperity of mass merchandisers such as Wal-Mart and Target (5-year average ROE of 21.6% and 19.6% respectively12)compared to the slow growth13 and relatively poorer performance of higher-end department stores as reflected by Federated Departmental storesi- 5-year average ROE of only 11.8%. Additionally, McKinsey has found that the number of consumers who shop weekly in the mass-market stores has risen from 25% to 50% from 1996 to 2004. Given the above, possible catalysts for the realization of value of a long Tandy stock holding include, in the short-term, a growing appreciation by the market of the trend toward mass merchandizing AND Tandy's significant participation in this sector through its leadership in fashion accessories for mass merchants (for instance, Wal-mart and Target presently account for approximately 51% ofTandy's net sales). In the longerterm, the acquisition of the company by a large discount retailer (example: Wal-mart15, Target, etc.), which desires upstream integration, or another apparel/accessories manufacturer (example: Fossil, Timberland etc.) that wishes to establish or enhance its presence in mass merchandizing could result in significant realization of value for the Tandy equity investor.

RISK MANAGEMENT

What am I buying? Why am I buying?
Tandy exhibits several characteristics that mitigate the risks of investing in its stock. Besides the 48-56% margin of safety described above, it should also be noted that Tandy equity provides a 22% safety margin even if the value of intangible brand assets are not taken into account. The company is also stable, with a history of steady earnings (as shown by its margin history above) and is not vulnerable to sudden changes in

11 Which, according to a report published in the McKinsey Quarterly 2004 No.1, actually had its origins "in the 1970s and 80s, when Japanese automakers and consumer electronics manufacturers thrived by selling cheaper and initially inferior products that eventually became more reliable than those of the competition-and remained cheaper." 12 Source: Reuters.com at http://yahoo.investor.reuters.com 13 Stated by Walter Levy, founder and chairman of W. K. Levy Associates, Inc., retail-marketing consultants at a Retailing Leadership lecture in Columbia Business School on February 18th, 2004. 14 Federated operates higher-end department stores including Macy's and Bloomingdale's. 15 Though Wal-mart has traditionally not acquired its suppliers, the possibility, nonetheless, remains.

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Tian Ming Huang
Final Paper B8399 Seminar in Value Investing - Professor Bruce Greenwald

technology or taste, given the 'staple diet' nature of its leather belt and accessories products. Additionally, the acceptance of the Deferral Plan by non-employee Directors and institution of a stock repurchase program by the Board of Directors in October 2000, as described above, indicates insider optimism with regard to the company's prospects. Recently, institutional funds with a value bias such as Franklin MicroCap Value A and Perritt Micro Cap Opportunities have also increased their ownership in the company". In addition, other value-oriented funds such as Dimensional U.S. Small Cap Value and Legg Mason U.S. Small Cap Value, which focus on long-term capital appreciation, have equity holdings in Tandy.

Appropriate level of investment
Nevertheless, any long position in the stock should be subjected to a position limit of not more than 5% of a fund. The reasons for this are as follows. Firstly, since management is already doing a good job deriving value in a fragmented industry (as discussed above), ownership of the business is not likely to be value enhancing as it is unlikely that the investor/new owner could perform better in managing the company. A limited position would also facilitate diversification of the fund against any unanticipated developments, such as company impairment resulting from management depredation, given management's stated intention to grow through acquisitions and the possibility of value-destroying acquisitions, industry impairment (example: shift in tastes toward higher-end accessories) and economic deterioration. In addition, a limited position would limit exposure to the thinly traded nature of Tandy's stock. With an average daily trading volume of only 13000 shares", the stock is relatively illiquid, making it difficult to accumulate and more importantly, to liquidate positions should the catalysts stated above fail to materialize. This is perhaps the biggest risk of investing in Tandy equity. In summary, Tandy represents a viable value investment, but it is one in which the investor should not overindulge and which requires careful tracking.
POSTSCRIPT

This investment proposal, and the recommendation to take a long position in Tandy stock, was initiated on March 12,2004, when the stock was trading at $13.08 per share. The price per share at end-day April 12, 2004 was $13.30. Had the long position been taken, the investor would have enjoyed a capital gain of $0.22 per share (notwithstanding transactions costs, etc.) or approximately 1.7% over one month. The stock seems to be moving in the right direction.

16
17

See "Funds Buying" tab for TBAC in Morningstar.com. Source: cnnmoney at http://money.cnn.com/news/companies/research/research.html?pg=sn&symb=

TBAC. Page 11