**SECURITIES
AND EXCHANGE COMMISSION**


Washington,
D.C. 20549








**Form
10-K**





(Mark
One)


x
    ANNUAL
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934


For
      the fiscal year ended December 31, 2004


**OR**





o
    TRANSITION
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934 [NO FEE REQUIRED]


For the
transition period ________ to ________





Commission
File Number 1-12368





**THE
LEATHER FACTORY, INC.**


(Exact
name of registrant as specified in its charter)





Delaware
    75-2543540**(State
      or other jurisdiction of incorporation or
      organization)**
    **(I.R.S.
      Employer Identification Number)**





3847
      East Loop 820 SouthFort
      Worth, Texas
    76119**(Address
      of principal executive offices)**
    **(Zip
      Code)**





**Registrant’s
telephone number, including area code** : (817)
496-4414





**Securities
registered pursuant to Section 12(b) of the Act:**





**Title
      of Each Class**
    
    **Name
      of Each Exchange on Which Registered**Common
      Stock, par value $.0024
    
    American
      Stock Exchange





**Securities
registered pursuant to Section 12(g) of the Act:**


NONE





Indicate
by check mark whether the registrant (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period that the registrant was required
to file such reports), and (2) has been subject to such filing requirements for
the past 90 days.  Yes x   No o





Indicate
by check mark if disclosure of delinquent filers pursuant to Item 405 of
Regulation S-K is not contained herein, and will not be contained, to the best
of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. o





Indicate
by check mark whether registrant is an accelerated filer (as defined in Exchange
Act Rule 12b-2).  Yes o   No
x





The
aggregate market value of the common stock held by non-affiliates of the
registrant was approximately $16,313,250 at June 30, 2004 (the last business day
of its most recently completed second fiscal quarter). At March 15, 2005, there
were 10,585,802 shares of the registrant's common stock
outstanding.





**DOCUMENTS
INCORPORATED BY REFERENCE**





Certain
portions of the Registrant’s definitive Proxy Statement for the Annual Meeting
of Stockholders to be held on May 23, 2005, are incorporated by reference in
Part III of this report.









**PART
I**





**ITEM
1. BUSINESS**





**General**





We are a
retailer and wholesale distributor of a broad line of leather and related
products, including leather, leatherworking tools, buckles and adornments for
belts, leather dyes and finishes, saddle and tack hardware, and do-it-yourself
kits. We also manufacture leather lacing and kits. During 2004, our consolidated
sales totaled $46.1 million of which approximately 7.9% were export sales. We
maintain our principal offices at 3847 East Loop 820 South, Fort Worth, Texas
76119. Our common stock trades on the American Stock Exchange under the symbol
"TLF."





Our
company was founded in 1980 as Midas Leathercraft Tool Company, a Texas
corporation. Midas' original business activity focused on the distribution of
certain leathercraft tools. In addition, the founders of Midas entered into a
consulting agreement with Brown Group, Inc., a major footwear retailer, as a
result of their proposal to develop a multi-location chain of wholesale
distribution centers known as "The Leather Factory." In 1985, Midas purchased
the assets of The Leather Factory from Brown Shoe Group, which then consisted of
six distribution centers.





In 1993,
Midas changed its name to "The Leather Factory, Inc.", then reincorporated in
the state of Delaware in 1994.





**The
Development of Our Company in Recent Years**





Our
expansion of the wholesale chain occurred via the opening of new centers as well
as numerous acquisitions of small businesses in strategic geographic locations
including the acquisition of our Canadian distributor, The Leather Factory of
Canada, Ltd., in 1996. By 2000, we had grown to twenty-seven Leather Factory
centers located in the United States and two Leather Factory centers in Canada.
In November 2000, we acquired the operating assets of two subsidiaries of
Tandycrafts, Inc. to form Tandy Leather Company. In 2002, we began opening
retail stores under the "Tandy Leather" name. During that year, Tandy Leather
purchased four independent leathercraft retail stores and opened another ten. We
also opened our thirtieth Leather Factory center - our third in Canada. In 2003,
we opened twelve Tandy Leather retail stores. In 2004, we purchase three
independent leathercraft retail stores and opened an additional nine stores in
the U.S. We also opened another store in Canada which is operating as a Tandy
Leather retail store. In November 2004, we acquired all of the issued and
outstanding shares of capital stock of Heritan Ltd and its parent, our primary
Canadian competitor, headquartered in Barrie, Ontario. The acquisition resulted
in an additional three retail stores in Canada, bringing the total locations in
Canada to seven - three Leather Factory centers and four Tandy Leather stores.





At
December 31, 2004, we operated thirty wholesale distribution centers operating
under the Leather Factory name (27 in the U.S. and 3 in Canada) and forty-two
retail stores operating under the Tandy Leather name (38 in the U.S. and 4 in
Canada). We also own and operate Roberts, Cushman and Company, Inc., a
manufacturer of custom hat trims.





Our
growth, measured both by our net sales and net income, occurs as a result of the
increase in the number of stores we have and the increase from year to year of
the sales in our existing stores. The following tables provide summary
information concerning the additions of facilities for our Leather Factory
wholesale centers and Tandy Leather retail stores in each of our fiscal years
from 1999 to 2004.





2





**STORE
COUNT**


**YEARS
ENDED DECEMBER 31, 1999 through 2004**





**Leather
      Factory wholesale centers**
    **Tandy
      Leather retail stores**Year
      Ended
    Opened
    Conversions(1)
    Total
    Opened
      (2)
    Closed
    TotalBalance
      Fwd
    
    
    22
    
    
    N/A1999
    4
    0
    26
    
    
    N/A2000
    2
    0
    28
    1*
    0
    12001
    2
    0
    30
    0
    0
    12002
    1
    (1)
    30
    14
    1*
    142003
    0
    0
    30
    12
    0
    262004
    0
    0
    30
    16
    0
    42





(1)
Leather Factory wholesale center converted to a Tandy Leather retail
store.


(2)
Includes conversions of Leather Factory wholesale centers to Tandy Leather
retail stores.


(*) The
Tandy Leather operation began as a central mail-order fulfillment center in 2000
that we closed in 2002.








No single
customer’s purchases represent more than 10% of the Company’s total sales in
2004. Sales to the Company’s five largest customers represented 10.6%, 13.8% and
15.1%, respectively, of consolidated sales in 2004, 2003 and 2002. While
management does not believe the loss of one of these customers would have a
significant negative impact on our operations, it does believe the loss of
several of these customers simultaneously or a substantial reduction in sales
generated by them could temporarily affect our operating results.





**Our
Operating Divisions**





We
service our customers primarily through the operation of three divisions. We
identify those divisions based on management responsibility and customer focus.
The Wholesale Leathercraft division (formerly referred to as the Leather Factory
segment) consists of thirty Leather Factory distribution centers of which 27 are
located in the United States and three are located in Canada. The Retail
Leathercraft division (formerly referred to as the Tandy Leather segment)
consists of 42 retail stores as of the end of 2004. Both of these divisions sell
leather and leathercraft-related products. Roberts, Cushman is our third
business segment.





**Wholesale
Leathercraft**





The
Wholesale Leathercraft operation distributes its broad product line of leather
and leathercraft-related products in the United States and internationally
through Leather Factory distribution centers. This segment had net sales of
$30.6 million, $30.7 million and $30.3 million for 2004, 2003 and 2002,
respectively.





**General** **** We
operate Leather Factory wholesale centers in 20 states and three Canadian
provinces. The centers range in size from 2,600 square feet to 19,800 square
feet, with the average size of a center being approximately 6,000 square feet.
The type of premises utilized for Leather Factory locations is generally light
industrial office/warehouse space in proximity to a major freeway or with other
similar access. This type of location typically offers lower rents compared to
other more retail-oriented locations.








3





**Business
Strategy** **** The
Leather Factory business concept centers around the wholesale distribution of
leather and related accessories to retailers, manufacturers, and end users. Our
strategy is that a customer can purchase the leather, related accessories and
supplies necessary to complete his project from one place. The size and layout
of the centers are planned to allow large quantities of product to be displayed
in an easily accessible and visually appealing manner. Leather is displayed by
the pallet where the customer can see and touch it, assessing first-hand the
numerous sizes, styles, and grades offered. The location of the centers is
selected based on the location of customers, so that delivery time to customers
is minimized. A two-day maximum delivery time for phone, Internet and mail
orders is our goal.





Leather
Factory centers serve customers through various means including walk-in traffic,
phone and mail order. We also employ a distinctive marketing tactic in that we
maintain an internally-developed target customer mailing list for use in our
aggressive direct mail advertising campaigns. We staff Leather Factory wholesale
centers with experienced managers whose compensation is tied to the operating
profit of the center they manage. Sales are generated by the selling efforts of
the store personnel, our direct mail advertising, our website
(www.leatherfactory.com), our participation at trade shows and, on a limited
basis, the use of sales representative organizations. The sales representative
organizations consist of companies located in specific geographic areas that
represent numerous companies in a similar industry. These organizations call on
customers and show multiple products from more than one vendor at a time.





**Customers**  Leather Factory’s customer base consists of individuals, wholesale distributors,
tack and saddle shops, institutions (prisons and prisoners, schools, hospitals),
western stores, craft stores and craft store chains, other large volume
purchasers, manufacturers, and retailers dispersed geographically throughout the
world. Wholesale sales constitute the majority of our Leather Factory business,
although retail customers may purchase products from Leather Factory centers.
Leather Factory sales generally do not reflect significant seasonal patterns.





Our
Authorized Sales Center (“ASC”) program was developed to create a presence in
geographical areas where we do not have a distribution center. An unrelated
person operating an existing business who desires to become an ASC must apply
with Leather Factory and upon approval, place a minimum initial order. There are
also minimum annual purchase amounts the ASC must adhere to in order to maintain
ASC status. In exchange, the benefits to the ASC are free advertising in certain
sale flyers, price breaks on many products, advance notice of new products, and
priority shipping and handling on all orders. Leather Factory centers service
208 ASC's: 115 located in the U.S., 69 located in Canada, and 24 located outside
North America.





**Merchandise** Our products are generally organized into thirteen categories. We carry a wide
assortment of products including leather, lace, hand tools, kits, and craft
supplies. We operate a light manufacturing facility in Fort Worth whose
processes generally involve cutting leather into various shapes and patterns
using metal dies. The factory produces approximately 20% of our products and
also assembles and repackages product as needed. Products manufactured in our
factory are distributed through our stores under the Tejas TM brand
name. We also distribute product under the Tandy Leather TM and Dr.
Jackson's TM brands.
We develop new products through the ideas and referrals of customers and store
personnel as well as the tracking of fads and trends of interest in the market.
Our personnel walk trade shows and various specialty stores with the purpose of
obtaining product ideas that are then developed in-house.





We offer
an unconditional satisfaction guarantee to our customers. Simply stated, we will
accept product returns for any reason. We believe this liberal policy promotes
customer loyalty. We offer credit terms to our non-retail customers, upon
receipt of a credit application and approval by our credit manager. Generally,
our open accounts are net 30 days.





4





During
2004 and 2003, Wholesale Leathercraft division sales by product category were as
follows:





**Product
      Category**
    
    **2004**
      **Sales
      Mix**
    
    **2003**
      **Sales
      Mix**Belts
      strips and straps
    
    
    2
    %
    
    
    2
    %Books,
      patterns, videos
    
    
    2
    %
    
    
    2
    %Buckles
    
    
    4
    %
    
    
    3
    %Conchos^
    
    
    3
    %
    
    
    3
    %Craft
      supplies
    
    
    7
    %
    
    
    7
    %Tools
      and Hardware
    
    
    1
    %
    
    
    1
    %Dyes,
      finishes, glues
    
    
    5
    %
    
    
    5
    %Hand
      tools
    
    
    13
    %
    
    
    12
    %Hardware
    
    
    6
    %
    
    
    6
    %Kits
    
    
    8
    %
    
    
    9
    %Lace
    
    
    12
    %
    
    
    15
    %Leather
    
    
    34
    %
    
    
    32
    %Stamping
      tools
    
    
    3
    %
    
    
    3
    %**100**
    **%**
    
    
    **100**
    **%**





^A concho
is a metal adornment attached to clothing, belts, saddles, etc., usually made
into a pattern of some southwestern or geometric object.





In
addition to meeting ordinary operational requirements, our working capital needs
are a product of the need to maintain inventory at a level we feel is adequate
to fill customer orders as they are received with minimal backorders and the
time required to collect our accounts receivable. Because availability of
merchandise and prompt delivery time are important competitive factors for us,
we maintain higher levels of inventory than our smaller competitors. For
additional information regarding our cash, inventory and accounts receivable at
the end of 2004 and 2003, see "Item 7. Management's Discussion and Analysis of
Financial Condition and Results of Operations."





**Suppliers** **** We
currently purchase merchandise and raw materials from approximately 200 vendors
dispersed throughout the United States and in more than 20 foreign
countries. **** In 2004,
our ten largest vendors accounted for approximately 72% of our inventory
purchases.





Because
leather is sold internationally, market conditions abroad are likely to affect
the price of leather in the United States. Outbreaks of mad cow and
hoof-and-mouth disease (or foot-and-mouth disease) in certain parts of the world
can influence the price of leather we purchase. As such an occurrence is beyond
the control of the Company, we cannot predict when and to what extent we could
be affected in the future. Aside from increasing purchases when we anticipate
price increases (or possibly delaying purchases if we foresee price declines),
we do not attempt to hedge our inventory costs.





Overall,  we
believe that our relationships with suppliers are strong and do not anticipate
any material changes in these supplier relationships in the future. Due to the
number of alternative sources of supply, the loss of any of these principal
suppliers would not have a material impact on our operations.





**Operations**  Hours of operations vary by location, but generally range from 8:00 am to 6:00
pm Monday through Friday, and from 9:00 am to 4:00 pm on Saturdays. The
distribution centers maintain uniform prices, except where lower prices are
necessary to meet local competition.





**Competition** **** Most of our competition comes in the form of small, independently-owned
retailers who in most cases are also our customers. We estimate that there are
several hundred of these small independent stores in the United States and
Canada. We compete on price, availability of merchandise, and delivery time.
While there is competition in connection with certain products, to our knowledge
there is no direct competition affecting our entire product line. Our size
relative to most competitors creates an advantage in our ability to stock a full
range of products as well as in volume purchasing.








5





**Distribution** **** The
Leather Factory distribution centers receive the majority of their inventory
from our central warehouse located in Fort Worth, Texas, although occasionally,
merchandise is shipped directly from the vendor. Inventory is shipped to the
distribution centers from our central warehouse once a week to meet customer
demand without sacrificing inventory turns. Customer orders are filled as
received, and we do not have backlogs.





We
attempt to maintain the optimum number of items in our product line to minimize
out-of-stock situations against carrying costs involved with such an inventory
level. We generally maintain higher inventories of certain imported items to
ensure a continuous supply. The number of products offered changes every year
due to the introduction of new items and the discontinuance of others. We carry approximately
2,750 items in the current lines of leather and leather-related merchandise. All
items are offered in both the Leather Factory distribution centers and the Tandy
Leather retail stores.





**Expansion** Leather Factory's expansion across the United States has been fairly consistent
since we purchased the original six distribution centers in 1985. The newest
center opened in August 2002, bringing the number of distribution centers to
thirty. While we do not believe there is a significant and immediate opportunity
for expansion of the Leather Factory distribution system in terms of opening
additional locations, we do believe expansion could be achieved by acquiring
companies in related areas/markets which offer synergistic aspects based on the
local markets and/or the product lines of the businesses.





**Retail
Leathercraft**





Our
Retail Leathercraft division consists of a growing chain of retail stores
operating under the name, Tandy Leather . Tandy Leather Company, established in
1919 as Hinkley-Tandy Leather Company, is the oldest and best-known supplier of
leather and related supplies used in the leathercraft industry. We offer a
product line of quality tools, leather, accessories, kits and teaching
materials. This segment had net sales of $13.5 million, $9.2 million and $7.4
million for 2004, 2003 and 2002, respectively.





**General** **** The Tandy
Leather retail chain currently has 42 stores (as of March 1, 2005) located in 27
states and three Canadian provinces with plans to reach 100 stores as
opportunities arise over the next several years. The stores range in size from
1,200 square feet to 3,800 square feet, with the average size of a store being
approximately 2,000 square feet. The type of premises utilized for a Tandy
Leather store is generally an older strip shopping center located at well-known
crossroads, making the store easy to find.





**Business
Strategy** **** Tandy
Leather has long been known for its reputation in the leathercraft industry and
its commitment to the furthering of the craft through education and customer
development. We are committed to this strategy as evidenced by our
re-establishment of the retail store chain throughout the United States
following our acquisition of the assets of Tandy Leather in 2000. We continue to
broaden our customer base by working with various youth organizations and
institutions where people are introduced to leathercraft, as well as hosting
classes in the stores.





The
retail stores serve walk-in, mail and phone order customers as well as orders
generated from its website, www.tandyleather.com. Tandy Leather stores are
staffed by knowledgeable sales people whose compensation is based, in part, upon
the profitability of their store. Sales by Tandy Leather are driven through the
efforts of the store staff, trade shows, and our direct mail and e-mail
marketing program.








6





**Customers** **** Individual
retail customers are our largest customer group, representing more than 70% of
Tandy Leather's 2004 sales. Youth groups, summer camps, schools, and a limited
number of wholesale customers complete our customer base. Like Leather Factory,
Tandy fills orders as they are received, and there is no order backlog. Tandy
maintains reasonable amounts of inventory to fill these orders. Tandy Leather’s
retail store operations historically generate slightly more sales in the
4 th quarter
of each year (30-35%) while the other three quarters remain fairly
even.





**Merchandise**  Our
products are generally organized into thirteen categories. We carry a wide
assortment of products including leather, hand tools, kits, dyes & finishes,
and stamping tools.





During
2004 and 2003, Retail Leathercraft division sales by product category were as
follows:





**Product
      Category**
    
    **2004**
      **Sales
      Mix**
    
    **2003**
      **Sales
      Mix**Belts
      strips and straps
    
    
    5
    %
    
    
    5
    %Books,
      patterns, videos
    
    
    3
    %
    
    
    3
    %Buckles
    
    
    3
    %
    
    
    2
    %Conchos
    
    
    3
    %
    
    
    3
    %Craft
      supplies
    
    
    4
    %
    
    
    5
    %Tools
      and Hardware
    
    
    *
    
    
    
    1
    %Dyes,
      finishes, glues
    
    
    7
    %
    
    
    7
    %Hand
      tools
    
    
    18
    %
    
    
    16
    %Hardware
    
    
    4
    %
    
    
    4
    %Kits
    
    
    13
    %
    
    
    15
    %Lace
    
    
    5
    %
    
    
    5
    %Leather
    
    
    30
    %
    
    
    28
    %Stamping
      tools
    
    
    5
    %
    
    
    6
    %**100**
    **%**
    
    
    **100**
    **%***
      less than 1%




As
indicated above, the products sold in our Tandy Leather stores are also sold in
our Leather Factory wholesale centers. Therefore, the discussion above regarding
Leather Factory products, their sources and the working capital requirements for
the Wholesale Leathercraft division also apply to the Tandy Leather stores.
Sales at Tandy Leather stores are generally cash transactions or through
national credit cards. We also sell on open account to selected wholesale
customers including schools and other institutions and small retailers. Our
terms are generally net 30 days. Like Leather Factory, Tandy Leather has an
unconditional return policy.





**Operations** **** Hours of
operations vary by location, but generally range from 9:00 am to 6:00 pm Monday
through Friday, and from 9:00 am to 4:00 pm on Saturdays. In addition, most of
the stores stay open late one night a week for leathercrafting classes taught in
the stores. Selling prices are uniform throughout the Tandy Leather store
system.





**Competition** **** Our
competitors are generally small local craft stores that carry a limited line of
leathercraft products. Several national retail chains that are customers of The
Leather Factory also carry leathercraft products on a very small scale relative
to their overall product line. To our knowledge, our retail store chain is the
only one in existence solely specializing in leathercraft.





**Distribution** **** The Tandy
Leather stores receive their inventory from the Leather Factory central
warehouse located in Fort Worth, Texas. The stores generally restock their
inventory once a week with a shipment from the warehouse. Tandy Leather's
inventory turns are higher than Leather Factory's because the Leather Factory
calculation includes its warehouse inventory whereas Tandy Leather's calculation
is based strictly on its stores.








7





**Expansion** We intend to expand the Tandy Leather retail store chain to 100 stores
throughout the United States at an average rate of approximately twelve stores
per year. Fourteen stores were opened in 2002; twelve stores were opened in
2003; sixteen were opened in 2004 (including four in Canada). Seven of the 42
stores opened through 2004 were independent leathercraft stores that we
acquired. Separately, these acquisitions are not material. The other thirty-five
stores have been *de
novo* stores
opened by us. ** Management's
plans for 2005 are to open 6-8 retail stores in the United States to keep us on
pace of averaging twelve new stores per year. Two new stores opened in the first
three months of 2005.





**Roberts,
Cushman**





Roberts,
Cushman, founded in 1856, produces made-to-order trimmings for the headwear
industry. This segment had net sales of $2.0 million, $1.8 million, and $2.0
million for 2004, 2003 and 2002, respectively.





**Business
Strategy** Roberts, Cushman has long been considered one of the leaders in the field of
headwear trimmings. It designs and manufactures exclusive trimmings for all
types of hats. Trims are sold to hat manufacturers directly. We do not employ an
outside sales force. Instead, customers visit our facilities in New York and,
with an on-site designer, incorporate their ideas into a customized product. The
customer is provided samples or photographs of each design before they leave the
premises. These samples can then be used as a sales tool to obtain hat orders
from their customers. This “design-on-site” process is unique in the industry.





**Customers** **** We design
and manufacture trims for over 75 of the headwear manufacturers worldwide,
supplying customized trims, ribbons, buckle sets, name pins, feathers, and other
items. Our success in developing and maintaining long-standing relationships
with our customers is due primarily to our ability to deliver quality products
in a timely manner. Our backlog of in-house orders from customers as of March
10, 2005 was $150,000, which approximates thirty days of sales. Roberts,
Cushman’s sales generally do not reflect significant seasonal
patterns.





The
working capital requirements of this operation are dictated by the amounts
needed to meet current obligations, purchase raw material and allow for
collection of accounts receivable. Roberts, Cushman provides sufficient cash
flow to satisfy these requirements.





**Merchandise**  Our hat bands are generally produced from leather, ribbon, or woven fabrics,
depending on the style of hat. They are created by cutting leather and/or other
materials into strips, and then enhancing the trim by attaching conchos and/or
three-piece buckle sets, braiding with other materials, and finishing the end or
borders by stitching or by lacing with leather lace. We also supply
custom-designed buckles and conchos, feathers for dress hats, and name pins,
separate from hat bands. Roberts, Cushman purchases components from over 25
vendors, located predominately in the United States. In 2004, our top 10 vendors
(in dollars purchased) represented approximately 50% of its total purchases.
Products are sold on terms that generally range from net 30 to net 90 days.
Because our products are custom-designed, we do not accept product returns,
except in the case of defective merchandise.





**Expansion** **** Cushman
has been successful providing a very specific product line directly to headwear
manufacturers. Given the current industry conditions, we do not believe there is
much potential for expansion, other than to capture additional market share.





8





**Additional
Information**





**Compliance
With Environmental Laws** **** Compliance
by the Company with federal, state and local environmental protection laws has
not had, and is not expected to have, a material effect upon capital
expenditures, earnings or the competitive position of the Company.





**Employees** **** As of
December 31, 2004, the Company employed 328 people, with 303 on a full-time
basis. The Company is not a party to any collective bargaining agreement.
Overall, management believes that relations with employees are
good.





**Intellectual
Property** We hold approximately twenty registered trademarks, including federal trade name
registrations for "The Leather Factory" and "Tandy Leather Company." The
trademarks expire at various times through 2012, but can be renewed
indefinitely. We hold approximately 500 copyrights covering over 600 registered
works, applicable to various products. These begin expiring in 2062. We also
hold patents on several belt buckles and leather-working equipment that expire
in 2011. These rights are valuable assets and we defend them as
necessary.





**International
Operations** **** Information
regarding our revenues from the United States and abroad and our long-lived
assets are found in Note 12 to our Consolidated Financial Statements, *Segment
Information* .





**Our
Website and Availability of SEC Reports** We file reports with the Securities and Exchange Commission ("SEC"). These
reports include our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q,
Current Reports on Form 8-K and any amendments to these filings. The public may
read any of these filings at the SEC's Public Reference Room at 450 Fifth
Street, NW, Washington, DC 20549. In addition, the public may obtain information
on the operation of the Public Reference Room by calling the SEC at
1/800-SEC-0330. Further, the SEC maintains an Internet site that contains
reports, proxy and information statements and other information concerning us.
You can connect to this site at http://www.sec.gov.





Our
corporate website is located at http://www.leatherfactory.com. We make copies of
our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports
on Form 8-K, proxy statements and any amendments filed with or furnished to the
SEC available to investors on or through our website free of charge as soon as
reasonably practicable after we electronically file them with or furnish them to
the SEC. Our SEC filings can be found on the Investor Relations page of our
website through the "SEC Filings" link. In addition, certain other corporate
governance documents are available on this website through the "Corporate
Governance" link.





9








**Executive
Officers of the Registrant**





The
following table sets forth certain information concerning the executive officers
of the Company.





**Name
      and Age**
    **Position
      and Business Experience**
      **During
      Past Five Years**
    **Served
      as Officer Since**J.
      Wray Thompson, 73
    Chief
      Executive Officer since June 1993. President from June 1993 to January
      2001
    1993Ronald
      C. Morgan, 57
    President
      since January 2001. Chief Operating Officer since June 1993
    1993Robin
      L. Morgan, 54
    Vice
      President of Administration since June 1993
    1993Shannon
      L. Greene, 39
    Chief
      Financial Officer since May 2000. Controller from January 1998 to May 2000
    2000





**Wray
Thompson** has
served as our Chairman of the Board and Chief Executive Officer since June 1993.
He also served as President from June 1993 to January 2001. Mr. Thompson
was a co-founder of the company.





**Shannon
L. Greene** has
served as our Chief Financial Officer and Treasurer since May 2000. She was
appointed to serve on the Board of Directors in January 2001. Ms. Greene is also
our chief accounting officer. From September 1997 to May 2000, Ms. Greene served
as our controller and assistant controller. Ms. Greene also is a member of the
company’s Employees’ Stock Ownership Plan (ESOP) Committee and is a certified
public accountant. Her professional affiliations include the American Institute
of Certified Public Accountants, the Texas Society of Certified Public
Accountants and its Fort Worth chapter, the Fort Worth Association for Financial
Professionals, and the National Investor Relations Institute.





**Robin
L. Morgan** has
served as our Vice President of Administration and Assistant Secretary since
June 1993. Ms. Morgan is responsible for import, banking, and procurement for
our import product lines and maintains all inventory costs. She administers our
insurance programs and serves as chairman of the Company's ESOP committee. Ms.
Morgan is married to Ronald C. Morgan, the Company's President.





**Ronald
C. Morgan** has
served as our President since January 2001 and has served as Chief Operating
Officer and director since June 1993. Mr. Morgan was also a co-founder of
the company. Mr. Morgan is married to Robin L. Morgan, the Company's Vice
President.





All
officers are elected annually by the Board of Directors to serve for the ensuing
year.





Under our
1995 Stock Option Plan, there were no unoptioned shares on January 1, 2004 and
10,000 unoptioned shares at December 31, 2004. Under our 1995 Director
Non-qualified Stock Option plan, there were 40,000 unoptioned shares on January
1, 2004 and 34,000 unoptioned shares at December 31, 2004. There were no changes
to the exercise prices of the outstanding options under these two plans during
2004.





10





**ITEM
2. PROPERTIES**





We lease
all of our premises and believe that all of our properties are adequately
covered by insurance. The properties leased by our Wholesale Leathercraft
(Leather Factory centers) and Retail Leathercraft (Tandy Leather stores)
divisions are described in Item 1 in the description of each segment. Our Fort
Worth location, which includes the Fort Worth Leather Factory distribution
center, our central warehouse and manufacturing facility, and the sales,
advertising, administrative, and executive offices, consists of 115,000 square
feet and leases for $410,000 per year. The lease expires in October 2008. We
also lease a 284 square-foot showroom in the Denver Merchandise Mart for $5,688
per year. This lease will expire in October 2005. Roberts, Cushman operates in a
10,200 square foot manufacturing facility that is located in Long Island City,
New York and leased for $89,000 per year. This lease will expire in June 2006.
The following table summarizes the locations of our leased premises on a state
and province basis as of December 31, 2004:





**State**
    **Wholesale
      Leathercraft**
      **(Leather
      Factory)**
    **Retail
      Leathercraft**
      **(Tandy
      Leather)**Arizona
    2
    1California
    3
    2Colorado
    1
    2Connecticut
    -
    1Florida
    1
    1Georgia
    -
    1Idaho
    -
    1Illinois
    1
    1Indiana
    -
    1Iowa
    1
    -Kansas
    1
    -Kentucky
    -
    1Louisiana
    1
    -Maryland
    -
    1Michigan
    1
    1Minnesota
    -
    1Missouri
    1
    2Montana
    1
    -Nebraska
    -
    1Nevada
    -
    2New
      Mexico
    1
    2New
      York
    -
    1North
      Carolina
    1
    -Ohio
    1
    1Oklahoma
    0
    2Oregon
    1
    -Pennsylvania
    1
    1Tennessee
    1
    2Texas
    5
    4Utah
    1
    1Virginia
    -
    1Washington
    1
    2Wisconsin
    -
    1





**Canadian
      locations:**Alberta
    1
    1British
      Columbia
    -
    1Manitoba
    1
    -Ontario
    1
    2








11





**ITEM
3. LEGAL PROCEEDINGS**





We are
involved in litigation in the ordinary course of business but are not currently
a party to any material pending legal proceedings.





**ITEM
4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS**





There
were no matters submitted to a vote of our security holders during the fourth
quarter of our fiscal year ended December 31, 2004.





**PART
II**





**ITEM
5. MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS**





Our
common stock is traded on the American Stock Exchange using the symbol TLF. The
high and low prices for each calendar quarter during the last two fiscal years
are as follows:




**2004**
    
    **2003****Quarter
      Ended**
    
    **High**
    
    **Low**
    
    **High**
    
    **Low**March
      31
    
    $
    5.99
    
    $
    4.35
    
    $
    3.45
    
    $
    2.80June
      30
    
    $
    5.63
    
    $
    4.40
    
    $
    3.42
    
    $
    2.90September
      30
    
    $
    4.49
    
    $
    3.24
    
    $
    4.58
    
    $
    3.25December
      31
    
    $
    3.82
    
    $
    2.95
    
    $
    4.85
    
    $
    3.97


There
were approximately 540  stockholders
of record on March 10 ,
2005 .





There
have been no cash dividends declared or paid on the shares of our common stock.
Our Board of Directors has historically followed a policy of reinvesting our
earnings in the expansion of its business. This policy is subject to change
based on future industry and market conditions, as well as other
factors.





The
following table sets forth information regarding our equity compensation plans
(including individual compensation arrangements) that authorize the issuance of
shares of our common stock. The information is aggregated in two categories:
plans previously approved by our stockholders and plans not approved by our
stockholders. The table includes information for officers, directors, employees
and non-employees. All information is as of December 31, 2004.


**Column
      (a)**
    **Column
      (b)**
    **Column
      (c)****Plan
      Category**
    **Number
      of Securities to be issued upon exercise of outstanding options, warrants
      and rights**
    **Weighted-average
      exercise price of outstanding options, warrants and
      rights**
    **Number
      of securities remaining available for future issuance under equity
      compensation plans (excluding securities reflected in Column
      (a)**Equity
      compensation plans approved by stockholders
    602,500
    $1.63
    40,000Equity
      compensation plans not approved by stockholders
    150,000
    3.73
    -TOTAL
    752,500
    $2.05
    40,000


For
additional information, see Note 10 to our Consolidated Financial Statements, *Stockholders'
Equity* .







12




**ITEM
6. SELECTED FINANCIAL DATA**





The
selected financial data presented below are derived from and should be read in
conjunction with the Company’s Consolidated Financial Statements and related
notes. This information should also be read in conjunction with "Item 7 -
Management’s Discussion and Analysis of Financial Condition and Results of
Operations.” In particular, see the information there relating to the adoption
of a new accounting pronouncement in 2002. Data in prior years has not been
restated to reflect acquisitions, if any, that occurred in subsequent
years.








**Income
      Statement Data**
    
    Years
      Ended December 31,2004
    
    2003
    
    2002
    
    2001
    
    2000Net
      sales
    
    $
    46,146,284
    
    $
    41,712,191
    
    $
    39,728,615
    
    $
    37,279,262
    
    $
    30,095,264Cost
      of sales
    
    
    20,706,239
    
    
    19,020,292
    
    
    18,393,914
    
    
    17,934,935
    
    
    15,147,547Gross
      profit
    
    
    25,440,045
    
    
    22,691,899
    
    
    21,334,701
    
    
    19,344,327
    
    
    14,947,717Operating
      expenses
    
    
    21,181,599
    
    
    18,594,240
    
    
    17,202,927
    
    
    15,442,359
    
    
    11,702,633Operating
      income
    
    
    4,258,446
    
    
    4,097,659
    
    
    4,131,774
    
    
    3,901,968
    
    
    3,245,084Operating
      income per share - basic
    
    $
    0.40
    
    $
    0.40
    
    $
    0.41
    
    $
    0.39
    
    $
    0.33Operating
      income per shares - diluted
    
    $
    0.39
    
    $
    0.38
    
    $
    0.38
    
    $
    0.37
    
    $
    0.32Other
      expense
    
    
    44,800
    
    
    125,169
    
    
    311,917
    
    
    533,482
    
    
    653,779Income
      (loss) before income taxes
    
    
    4,213,646
    
    
    3,972,490
    
    
    3,819,857
    
    
    3,368,486
    
    
    2,591,305Income
      tax provision (benefit)
    
    
    1,559,605
    
    
    1,232,116
    
    
    1,224,868
    
    
    1,362,053
    
    
    1,049,985Income
      (loss) before cumulative effect of change in accounting
      principle
    
    
    2,654,041
    
    
    2,740,374
    
    
    2,594,989
    
    
    2,006,433
    
    
    1,541,320Cumulative
      effect of change in accounting principle
    
    
    -
    
    
    -
    
    
    (4,008,831
    )
    
    -
    
    
    -Net
      income (loss)
    
    $
    2,654,041
    
    $
    2,740,374
    
    $
    (1,413,842
    )
    $
    2,006,433
    
    $
    1,541,320Earnings
      (loss) per share
    
    $
    0.25
    
    $
    0.27
    
    $
    (0.14
    )
    $
    0.20
    
    $
    0.16Earnings
      (loss) per share-*assuming
      dilution*
    
    $
    0.24
    
    $
    0.25
    
    $
    (0.13
    )
    $
    0.19
    
    $
    0.15Weighted
      average common shares outstanding for:Basic
      EPS
    
    
    10,543,994
    
    
    10,323,549
    
    
    10,063,581
    
    
    9,976,181
    
    
    9,875,606Diluted
      EPS
    
    
    10,957,518
    
    
    10,861,305
    
    
    10,761,670
    
    
    10,449,306
    
    
    10,182,803




**Balance
      Sheet Data**
    
    As
      of December 31,2004
    
    2003
    
    2002
    
    2001
    
    2000Total
      assets
    
    $
    22,167,163
    
    $
    19,058,406
    
    $
    19,675,602
    
    $
    19,548,323
    
    $
    19,686,079Notes
      payable, capital lease obligations andcurrent
      maturities of long term debt
    
    
    134,067
    
    
    1,134
    
    
    4,218,968
    
    
    4,527,904
    
    
    5,759,626Notes
      payable, capital lease obligations andlong-term
      debt, net of current maturities
    
    
    750,944
    
    
    1,792,984
    
    
    2,256
    
    
    7,691
    
    
    13,025Total
      Stockholders’ Equity
    
    $
    17,310,233
    
    $
    14,509,493
    
    $
    11,170,062
    
    $
    12,423,671
    
    $
    10,295,637





13





**ITEM
7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS**





We intend
for the following discussion to provide you with information that will assist
you in understanding our financial statements, the changes in certain key items
in those financial statements from year to year, and the primary factors that
accounted for those changes, as well as how certain 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, 2004 and 2003 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
stores and warehouse distribution centers. 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 three segments. First, Wholesale Leathercraft, consisting of our
Leather Factory warehouse distribution centers and our national account group,
is the largest source of revenues ($30.6 million in 2004). This division has
generally offered steady but modest increases in sales. Sales in 2004 were flat
compared to sales in 2003, falling short of our target of annual sales growth of
2% to 4%. The decrease in sales to national accounts in 2004 accounted for the
shortfall. Excluding national account sales, the distribution centers produced a
sales gain of 4.5% for 2004.





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 ($13.5 million in 2004, up from $9.2
million in 2003). Our business plan calls for opening an average of 12 stores
annually as we work toward a goal of 100 stores from 42 stores at the end of
2004.





Our third
segment is Roberts, Cushman, a manufacturer of trimmings for headwear. Its
operations are not material to us. In 2002, we wrote off the goodwill related to
our investment in Roberts, Cushman in connection with an accounting
change.





On a
consolidated basis, a key indicator of costs, gross margin as a percent of total
net sales, increased in 2003 and again in 2004, reflecting a number of factors
including more retail sales with higher profit margins. However, opening
additional Tandy Leather stores, more dollars spent on employee benefits, and
new costs associated with Sarbanes-Oxley compliance in 2004 resulted in a 1.3%
increase in operating expenses as a percent of total net sales in 2004.
Operating expenses were also up 1.3% as a percentage of total net sales in 2003
when compared with 2002 as a result of opening additional Tandy Leather stores
and more dollars spent on advertising.








14





We
reported consolidated net income for 2004 of $2.7 million. Consolidated net
income for 2003 was also $2.7 million. In 2002, we reported a consolidated net
loss of $1.4 million due to an accounting change. We have used our cash flow to
fund our operations, to fund the opening of new Tandy Leather stores and to
reduce our bank debt. In 2004, we reduced our bank debt by $1.3 million, and, at
the end of 2004, our stockholders’ equity had increased to $17.3 million from
$14.5 million the previous year.





Comparing
the December 31, 2004 balance sheet with the prior year’s, we increased our
investments in inventory ($12.7 million from $11.1 million) and accounts
receivable ($2.0 million from $1.8 million), while total cash increased to $2.6
million from $1.7 million. In addition to cash on hand, we have a $3 million
bank line of credit, of which $505,000 was drawn on December 31,
2004.





**Net
Sales**





Net sales
for the three years ended December 31, 2004 were as follows:


Year
    Wholesale
      Leathercraft
    Retail
      Leathercraft
    Cushman
    Total
      Company
    Total
      Company Increase
      from
      Prior Year**2004**
    **$30,630,121**
    **$13,515,662**
    **$2,000,501**
    **$46,146,284**
    **10.6%**2003
    $30,684,092
    $9,216,838
    $1,811,261
    $41,712,191
    5.0%2002
    30,313,478
    7,387,874
    2,027,263
    39,728,615
    6.6%





Our net
sales grew by 10.6% in 2004 when compared with 2003 and 5.0% in 2003 when
compared with 2002. These annual increases resulted primarily from our retail
leathercraft expansion program.





**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 product we sell, and our
ability to source product globally. Our negotiations with suppliers for lower
pricing is 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 2004,
our cost of sales decreased as a percentage of total net sales when compared to
2003, resulting in an overall increase of 0.7% in the Company's gross margin
from 54.4% in 2003 to 55.1% in 2004.





Similarly,
our total cost of sales as a percentage of our total net sales had decreased for
2003 when compared to 2002 resulting in an overall increase in gross margin of
0.7% from 53.7% for 2002 to 54.4% in 2003. These increases in gross margin were
primarily due to increased retail sales over the three years.





Our gross
margins for the three years ended December 31, 2004 were as follows:


Year
    Wholesale
      Leathercraft
    Retail
      Leathercraft
    Cushman
    Total
      Company**2004**
    **54.10%**
    **61.98%**
    **30.31%**
    **55.13%**2003
    53.23%
    62.98%
    30.62%
    54.40%2002
    53.56%
    59.49%
    34.64%
    53.70%








15





Our
operating expenses increased 1.3% as a percentage of total net sales to 45.9% in
2004 when compared with 44.6% in 2003. This increase was primarily due to
operating costs associated with the twelve Tandy stores opened in 2004 (an
increase of $650,000), bonuses awarded to corporate and operational management
($400,000) the cost of employee health care (an increase of $500,000), an
increase in advertising expenses ($200,000), and expenses associated with
compliance with Section 404 of the Sarbanes-Oxley Act ($200,000). We believe
that our advertising efforts - particularly our direct mail campaigns - generate
sales. As we expand into new markets, the number of customers and potential
customers increases resulting in an increase in the number of direct mail pieces
produced and distributed. While we monitor our advertising costs with great
scrutiny, management believes that the trend of increased advertising and
marketing costs could continue for at least the near future.





We have
completed the initial phase of design and documentation in our efforts to comply
with Section 404 of the Sarbanes-Oxley Act with the assistance of outside
consultants. While additional and on-going testing of our control processes is
necessary, we hope to complete the majority of that work without the need for
significant outside assistance. Management is analyzing the status of this
project to determine if we will be able to accomplish this work satisfactorily
with internal staff. If not, we will incur additional costs in 2005.





For 2003,
operating expenses increased 1.3% as a percentage of total net sales to 44.6% in
2003 when compared with 2002. This increase was primarily due to operating costs
(rents, utilities, telephones, etc.) associated with the twelve Tandy stores
opened in 2003 (an increase of $700,000) as well as an increase in advertising
expenses (an increase of $500,000) and investor relation expenses (an increase
of $200,000).





**Other
Expenses (net)**





Other
expenses (net), which consists primarily of interest expense and currency
exchange gain and loss, was $45,000 in 2004 compared to $125,000 in 2003, a
decrease of approximately 64%. This decrease is attributable to the interest
paid on our outstanding debt.





In 2003,
other expenses (net) were $125,000 in 2003 compared to $312,000 in 2002, a
decrease of approximately 60%. Our interest expense continues to decrease due to
the reduction in our outstanding bank debt. The currency exchange gain and loss,
resulting from our Canadian operation, was a gain of $102,000 in 2003 compared
to a gain of $10,000 in 2002.





**Net
Income**





During
2004, we earned net income of $2.65 million, a slight decrease from our net
income of $2.74 million for 2003. The overall improvement in gross margin and a
reduction in interest and other expenses contributed positively to our net
income while increased operating expenses and income tax expense in 2004 offset
that improvement.





During
2003, we earned net income of $2.74 million, a substantial increase over our net
loss of $1.4 million for 2002. (As discussed in previous filings, a new
accounting pronouncement required us to record a $4.0 million charge against
earnings as a result of the write-off of the goodwill of Roberts, Cushman in
2002, resulting in a net loss. This charge was reported as a cumulative effect
of a change in accounting principle. Net income before the change was $2.6
million.) As a result of the increase in our overall gross margin and a
reduction in interest and other expenses, our profits in 2003 grew at a rate
faster than sales. Partially offsetting gross margin and other expense
improvements were increased operating expenses in 2003 as discussed above.








16





**Re-categorization
of operating divisions**





Until the
fourth quarter of 2004, we provided division or segment information on a legal
entity basis. More specifically, the Leather Factory segment consisted of 27
U.S.-based warehouse distribution centers and 3 Canadian-based warehouse
distribution centers which were owned and operated by the legal entity of the
same name. The Tandy Leather segment consisted of the expanding U.S.-based
retail store chain which was owned and operated by Tandy Leather Company. With
the opening of our Calgary store in October 2004, which is owned by The Leather
Factory but operated as a Tandy Leather retail store, management has determined
that it is more useful to provide segment financial information based upon
wholesale and retail operating divisions rather than on a legal entity basis.
The acquisition of the three Canadian retail stores of Heritan Ltd in December
2004, which are owned by the Leather Factory but operated as Tandy Leather
stores, further strengthened our decision to make a change in the way we report
divisional, or segment, information.





If we
continued entity reporting, the segments would be as follows:





As
      of 9/30/04:
    As
      of 12/31/04:**Leather
      Factory:**
    **Leather
      Factory:**27
      locations in U.S.
    27
      locations in U.S.3
      locations in Canada
    7
      locations in Canada****Tandy
      Leather:**
    **Tandy
      Leather:**36
      retail stores in U.S.
    38
      retail stores in U.S.





**3
warehouse distribution centers and 4 retail stores





Changing
reporting to a wholesale and retail division reporting, the segments are as
follows:





As
      of 9/30/04:
    As
      of 12/31/04:**Wholesale:**
    **Wholesale:**27
      locations in U.S.
    27
      locations in U.S.3
      locations in Canada
    3
      locations in Canada**Retail:**
    **Retail:**36
      retail stores in U.S.
    38
      retail stores in U.S.4
      retail stores in Canada





As
indicated in the tables above, this change in divisional reporting does not
affect prior periods for comparison purposes as there were no retail stores in
the Leather Factory legal entity until October 2004.





**Wholesale
Leathercraft (formerly referred to as "Leather Factory
Segment")**


Year
    Net
      Sales
      Incr
      (Decr)
      from
      Prior Yr
    Operating
      Income
    Operating
      Income
      Incr
      (Decr)
      from
      Prior Year
    Operating
      Income
      as
      a Percentage
      of
      Sales**2004**
    **(0.2)%**
    **$3,031,316**
    **(13.0)%**
    **9.5%**2003
    1.2%
    $3,462,457
    (7.5)%
    11.3%2002
    5.6%
    $3,742,844
    0.6%
    12.3%





Wholesale
Leathercraft, consisting of 30 warehouse distribution centers, accounted for
66.4% of total Company net sales in 2004, which compares to 73.5% in 2003 and
76.3% in 2002. 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.





The net
sales decrease in 2004 resulted from a decrease in national account sales offset
by gains to our wholesale and small manufacturing customer groups. Our sales mix
by customer group was as follows:





17








**Customer
      Group**
    
    **2004**
    
    **2003**
    
    **2002**Retail
    
    
    23%
    
    
    23%
    
    
    20%Institution
    
    
    7%
    
    
    8%
    
    
    8%Wholesale
    
    
    47%
    
    
    42%
    
    
    44%National
      Accounts
    
    
    16%
    
    
    20%
    
    
    21%Manufacturers
    
    
    7%
    
    
    7%
    
    
    7%100%
    
    
    100%
    
    
    100%





The 2004
decrease in operating income as a percentage of divisional sales resulted from
an increase of 2.04% in operating expenses (as a percentage of sales) compared
with 2003, partially offset by an increase in gross margin (as a percentage of
sales) of 0.59%. The operating expense increase as a percent of sales in 2004
was higher than 2003 due to bonuses awarded to corporate and operational
management ($300,000) for 2004 and the cost of our employee health benefits (an
increase of $300,000). In addition, we spent $170,000 with outside consultants
on our Sarbanes-Oxley 404 project. Being the largest division, Wholesale
Leathercraft bears the majority of the pro rata allocation of corporate
expenses.





The 2003
decrease in operating income as a percentage of sales resulted from a 0.33%
decrease in gross margin (as a percentage of sales) and an increase of 0.72% in
operating expenses (as a percentage of sales) compared with 2002. The gross
margin decline was driven primarily by an increase in the quantities of leather
sold during the year. Given that leather is our lowest gross margin item, an
increase in leather sales, all other factors being equal, will result in a lower
overall gross margin. Our freight costs (shipping merchandise from vendors to
us) were up in 2003 as well due an increase in the number of air shipments
versus ocean shipments. The operating expense increase as a percent of sales in
2003 was higher than 2002. Advertising and marketing costs are a significant
expense in our operation as we believe there is a direct correlation between how
much we advertise and how much product we sell. Our increase in investor
outreach programs in 2003 also contributed to the decline in operating income
this year.





**Retail
Leathercraft (formerly referred to as "Tandy Leather
Segment")**


Year
    Net
      Sales
      Increase
      from
      Prior Yr
    Operating
      Income
    Operating
      Income
      Incr
      (Decr)
      from
      Prior Year
    Operating
      Income
      as
      a Percentage
      of
      Sales**2004**
    **46.6%**
    **$1,210,566**
    **37.3%**
    **8.9%**2003
    24.7%
    $604,291
    62.7%
    6.6%2002
    11.8%
    $371,372
    31.7%
    5.0%





Reflecting
the growth previously discussed, Retail Leathercraft accounted for 29.3% of our
total net sales in 2004, up from 22.1% in 2003 and 18.6% in 2002.





Growth in
net sales for Retail Leathercraft division in 2004 and 2003 resulted primarily
from our expansion program. Expansion during 2004 and 2003 consisted of the
opening of 16 and 12 new stores, respectively.





Our sales
mix by customer group was as follows:





**Customer
      Group**
    
    **2004**
    
    **2003**
    
    **2002**Retail
    
    
    72%
    
    
    72%
    
    
    65%Institution
    
    
    6%
    
    
    6%
    
    
    12%Wholesale
    
    
    21%
    
    
    21%
    
    
    23%National
      Accounts
    
    
    0%
    
    
    0%
    
    
    0%Manufacturers
    
    
    1%
    
    
    1%
    
    
    0%100%
    
    
    100%
    
    
    100%








18





Operating
income as a percentage of sales increased to 8.9% for 2004 compared to 6.6% for
2003. Gross margin decreased from 63.0% in 2003 to 61.8% in 2004 due primarily
to limitations in increasing selling prices to match cost increases. Selling
prices are set at the time the product catalog is produced. As a result, it is
difficult to implement price increases to customers until we distribute a new
catalog. Historically, we distribute our new catalog at the beginning of each
calendar year and did so in January 2004. However, due to the cost increases in
metals, fuel, and other items this year and the need to pass on these increases
to customers, we accelerated that schedule and distributed our 2005 catalog on
November 1, 2004. Operating expenses as a percent of sales in 2004 decreased by
3.61%, from 56.4% for 2003 to 52.8% for 2004 as sales and gross margin grew at a
faster pace than that of operating expenses.





Operating
income as a percentage of sales increased in 2003 when compared to 2002. Segment
gross margin increased from 59.5% in 2002 to 63.0% in 2003 due to increased
retail sales and more efficient purchasing of product from vendors. Segment
operating expenses as a percent of sales increased by 1.95% in 2003. Expanded
advertising initiatives and rent for store space accounted for the operating
expense increase, offset partially by a decrease in costs to ship merchandise to
customers. The decrease in shipping is a result of the store expansion as more
sales occur in the stores as compared to ordering via mail, phone or the
Internet.





We intend
to continue the expansion of Tandy Leather’s retail store chain in 2005 by
opening a total of 6-8 new stores throughout the year. As of March 15, 2005, we
have opened two new stores this year: Van Nuys, CA and Phoenix, AZ. We remain
committed to a conservative expansion plan for this division that minimizes
risks to our profits and maintains financial stability.





**Roberts,
Cushman**


Year
    Net
      Sales
      Incr
      (Decr)
      from
      Prior Yr
    Operating
      Income
      (Loss)
    Operating
      Income
      Incr
      (Decr)
      from
      Prior Year
    Operating
      Income
      as
      a Percentage
      of
      Sales**2004**
    **10.4%**
    **$34,565**
    **11.8%**
    **1.7%**2003
    (10.6)%
    $30,911
    76.1%
    1.7%2002
    3.3%
    $17,558
    117.6%
    0.9%





The
Roberts, Cushman operation accounted for 4.3% of our total sales in 2004
compared with 4.4% and 5.1% in 2003 and 2002, respectively.





For 2004,
Roberts, Cushman’s sales were up 10.4% while gross profit margins decreased
slightly from 30.6% to 30.3%. Operating income increased from $31,000 in 2003 to
$35,000 for 2004. Sales grew faster than operating expenses which accounted for
the improvement in operating income.





The 2003
decrease in Roberts, Cushman's net sales resulted from the continued slowdown in
the headwear industry overall. Several of our customers (hat manufacturers) are
on shortened work weeks due to the decline in orders. Segment gross margin as a
percentage of sales decreased 4.0% from 2002. However, operating income improved
modestly.





Roberts,
Cushman's sales and profits are immaterial to our company as a whole, and the
segment does not fit our business model for the future. We continue to assess
strategic options for this segment.








19




**Financial
Condition**




At
December 31, 2003, our net total assets were $19.1 million. We held $11.1
million of inventory and $1.9 million of property and equipment. Our cash
totaled $1.7 million and our receivables were $1.8 million. Current liabilities
were $2.5 million, while our long-term debt was $1.8 million. Total
stockholders' equity at the end of 2003 had increased to $14.5 million,
primarily as a result of the $2.7 million net income recorded in 2003. The
increase in cash from 2002 to 2003 was due primarily to the increase in cash
sales at Tandy Leather (as opposed to sales on open account), as well as the
decrease in cash tied up in inventory owned at the end of 2003 compared to 2002.
While we have no required payment schedule prior to maturity on our revolving
line of credit, management strives to apply as much available cash as possible
to our outstanding debt balance. Generally speaking, the majority of cash on our
balance sheet is funds held in depository accounts with various banks awaiting
collectibility for transfer either to our operating account or to the line of
credit.





At
December 31, 2004, we held $2.6 million of cash, $12.7 million of inventory,
accounts receivable of $2.0 million, and $1.9 million of property and equipment.
Goodwill and other intangibles (net of amortization and depreciation) were
$743,000 and $438,000, respectively. We also own a leather artwork collection,
most of which was created by Al Stohlman, a legendary leathercrafter, valued on
our balance sheet at $250,000. Net total assets were $22.2 million. Current
liabilities were $3.8 million (including $134,000 of current maturities of
long-term debt), while long-term debt was $751,000. Total stockholders’ equity
at the end of 2004 was $17.3 million.





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





**2004**
    
    **2003**
    
    **2002****Solvency
      Ratios:**Quick
      Ratio
    Cash+Accts
      Rec/Total Current Liabilities
    1.21
    
    1.40
    
    0.31Current
      Ratio
    Total
      Current Assets/Total Current Liabilities
    4.79
    
    6.16
    
    1.94Current
      Liabilities to Net Worth
    Total
      Current Liabilities/Net Worth
    0.22
    
    0.17
    
    0.74Current
      Liabilities to Inventory
    Total
      Current Liabilities/Inventory
    0.30
    
    0.23
    
    0.66Total
      Liabilities to Net Worth
    Total
      Liabilities/Net Worth
    0.28
    
    0.31
    
    0.76Fixed
      Assets to Net Worth
    Fixed
      Assets/Net Worth
    0.11
    
    0.13
    
    0.18**Efficiency
      Ratios:**Collection
      Period (Days Outstanding)
    Accounts
      Receivable/Credit Sales x 365
    43.57
    
    41.45
    
    43.54Inventory
      Turnover
    Sales/Average
      Inventory
    3.87
    
    3.51
    
    3.65Assets
      to Sales
    Total
      Assets/Sales
    0.48
    
    0.46
    
    0.49Sales
      to Net Working Capital
    Sales/Current
      Assets - Current Liabilities
    3.21
    
    3.18
    
    5.06Accounts
      Payable to Sales
    Accounts
      Payable/Sales
    0.04
    
    0.04
    
    0.04**Profitability
      Ratios:**Return
      on Sales (Profit Margin)
    Net
      Profit After Taxes/Sales
    0.06
    
    0.07
    
    0.07Return
      on Assets
    Net
      Profit After Taxes/Total Assets
    0.12
    
    0.14
    
    0.13Return
      on Net Worth(Return on Equity)
    Net
      Profit After Taxes/Net Worth
    0.15
    
    0.19
    
    0.23





**Capital
Resources and Liquidity**





On
November 1, 2004, we entered into a Credit Agreement with Bank One, N.A., which
replaced our line of credit with Wells Fargo Bank. The current facility matures
in October 2007 and is secured by our accounts receivable and inventory. We
opted to reduce the maximum amount that may be borrowed under this line of
credit to $3.0 million in order to reduce the fees required on the un-borrowed
portion of the line.





On
November 3, 2003, we entered into a Credit and Security Agreement with Wells
Fargo Bank, N.A., which replaced a line of credit with another bank affiliated
with Wells Fargo. The Wells Fargo current facility would have matured in
November 2005 and was secured by all assets of the Company.








20





We are
currently in compliance with all covenants and conditions contained in the Bank
One 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 4 to the Consolidated Financial Statements, *Notes
Payable and Long-Term Debt.*





We borrow
and repay funds under revolving credit terms as needed. Principal balances at
the end of each quarter are shown below:





**4****th****Qtr. ‘03**
    **1****st****Qtr. ‘04**
    **2****nd****Qtr. ‘04**
    **3****rd****Qtr. ‘04**
    **4****th****Qtr. ‘04****(Wells
      Fargo)**
    **(Wells
      Fargo)**
    **(Wells
      Fargo)**
    **(Wells
      Fargo)**
    **(Bank
      One)**$1,792,984
    $1,267,984
    $1,100,000
    $1,013,565
    $505,154





Total
bank indebtedness at the end of 2003 and 2004 are shown below:





**December
      31,****2003**
    
    **2004****Principal**
    
    **Accrued
      Interest**
    
    **Principal**
    
    **Accrued
      Interest**Revolving
      Line
    
    $
    1,792,984
    
    $
    6,374
    
    $
    505,154
    
    $
    6,219





Reflecting
the reduction of bank indebtedness during the period, our financing activities
for 2004, 2003 and 2002 had net cash requirements (deficits) of $1.2 million,
$1.3 million and $214,000, respectively.





The
primary source of liquidity and capital resources during 2004 was cash flow
provided by operating activities. Cash flow from operations for 2004 was $2.9
million, the largest portion generated from net income. Cash flow from
operations in 2003 was $3.3 million, generated from net income and the reduction
of inventory. Cash flow from operations in 2002 was $1.4 million.





Consolidated
accounts receivable increased to $2.0 million at December 31, 2004 compared to
$1.8 million at December 31, 2003. Average days to collect accounts slowed
slightly from 41.46 days in 2003 to 43.57 days in 2004 on a consolidated basis.





Inventory
increased from $11.1 million at the end of 2003 to $12.7 million at December 31,
2004. We expect our inventory to slowly trend upward as we continue our
expansion of the Tandy Leather store chain. However, we are pleased with our
investment in inventory at the end of 2004 as it was within 3% of our internal
targets of optimum inventory levels. We attempt to manage our inventory levels
to avoid tying up excessive capital.





Consolidated
inventory turned 3.87 times during 2004, a slight improvement from the 3.51
times turned in 2003. We compute our inventory turnover rates as sales divided
by average inventory.





By
operating division, inventory turns are as follows:





**Segment**
    **2004**
    **2003**
    **2002**Wholesale
      Leathercraft
    3.11
    2.97
    3.20Retail
      Leathercraft
    8.88
    8.69
    8.10Roberts,
      Cushman
    4.12
    3.71
    4.12Wholesale
      Leathercraft distribution centers only
    8.69
    8.26
    7.96








21





Retail
Leathercraft inventory turns are significantly higher than that of the Wholesale
Leathercraft because its inventory consists only of the inventory at the stores.
The Tandy Leather stores have no warehouse (backstock) inventory to include in
the turnover computation as the stores get their product from the Leather
Factory central warehouse. Leather Factory's turns are expected to be slower
because the central warehouse inventory supports the stores and distribution
centers.





Accounts
payable increased to $1.9 million at the end of 2004 compared to $1.6 million at
the end of 2003 due primarily to the increase in inventory
purchases.





As
discussed above, the largest use of operating cash in 2004 was for debt
reduction and inventory purchases. Capital expenditures totaled $370,000 and
$360,000 for the years ended December 31, 2004 and 2003, respectively. The 2004
capital expenditures consisted of fixtures and equipment for the new Tandy
Leather retail stores ($155,000), the remodel of the accounting offices located
at our corporate complex ($77,000), and miscellaneous computer and other
equipment ($124,000). Capital expenditures in 2003 occurred primarily due to the
expansion of the Tandy Leather store chain and the construction of the Stohlman
Leather Museum and Gallery located at our Fort Worth corporate complex. Also in
2004, we made expenditures of $557,000 to purchase our primary Canadian
competitor as well as three U.S.-based independent leathercraft stores for
conversion to Tandy Leather stores. Since we intend to continue opening or
acquiring new Tandy Leather stores, expenditures related to this expansion
should continue into 2005.





We
believe that cash flow from operations will be adequate to fund our operations
in 2005, while also funding expansion and debt reduction. At this time,
management knows 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.
However, if cash flows should decrease or uses of cash increase, we may defer
debt reduction or increase our borrowings on our line of credit as needed. We
believe that, if desired, our present financial condition would permit us to
increase the maximum amount that could be borrowed from lenders. Further, we
could defer expansion plans if required by unanticipated drops in cash flow. In
particular, because of the relatively small investment required by each new
Tandy Leather store, we have flexibility in when we make most expansion
expenditures.





**Off-Balance
Sheet Arrangements**





We have
not had any off-balance sheet arrangements during 2004, 2003 and 2002, and we do
not currently have any such arrangements.





**Contractual
Obligations**





The
following table summarizes by years our contractual obligations and commercial
commitments as of December 31, 2004 (not including related interest
expense):





**Payments
      Due by Periods****Contractual
      Obligations**
    
    **Total**
    
    **Less
      than**
      **1
      Year**
    
    **1
      - 3**
      **Years**
    
    **4
      -5 Years**
    
    **After
      5 Years****Long-Term
      Debt(1)**
    
    $
    505,154
    
    
    --
    
    $
    505,154
    
    
    --
    
    
    --**Capital
      Lease Obligations**
    
    
    379,857
    
    $
    134,067
    
    
    134,067
    
    $
    111,723
    
    
    --**Operating
      Leases(2)**
    
    
    6,237,775
    
    
    2,107,214
    
    
    3,933,668
    
    $
    196,893
    
    
    --**Total
      Contractual Obligations**
    
    $
    7,122,786
    
    $
    2,241,281
    
    $
    4,572,889
    
    $
    308,616
    
    $
    --


____________________


(1) Our
loan from Bank One matures in October 2007. The loan's maturity can be
accelerated in the event of a material adverse change or upon other occurrences
described in the related credit agreement.


(2) These
are our leased facilities.








22





In
addition to the information shown in the table above, estimated annual interest
to be paid on our line of credit with Bank One would be approximately $30,000
per year, assuming an average interest rate of 5.00% and there was no repayment
of principal until maturity. Management expects to continue repaying principal
as our cash flow allows and as a result, would expect the interest to be paid to
be lower than the $30,000 estimate. The interest rate on the capital lease is
0%. Any imputed interest over the term of the lease would be
insignificant.





**Summary
of Critical Accounting Policies**





Management
strives to report the financial results of the Company in a clear and
understandable manner, although in some cases accounting and disclosure rules
are complex and require us to use technical terminology. We follow generally
accepted accounting principles in the U.S. in preparing our consolidated
financial statements. These principles require us to make certain estimates and
apply judgments that affect our financial position and results of operations.
Management continually reviews its accounting policies, how they are applied and
how they are reported and disclosed in our financial statements. Following is a
summary of our more significant accounting policies and how they are applied in
preparation of the financial statements.





**Basis
of Consolidation.** We
report our financial information on a consolidated basis. Therefore, unless
there is an indication to the contrary, financial information is provided for
the parent company, The Leather Factory, Inc., and its subsidiaries as a whole.
Transactions between the parent company and any subsidiaries are eliminated for
this purpose. We own all of the capital stock of our subsidiaries, and we do not
have any subsidiaries that are not consolidated. None of our subsidiaries are
“off balance sheet.”





**Revenue
Recognition.** We
recognize revenue for retail (over the counter) sales as transactions occur and
other sales upon shipment of our products provided that there are no significant
post-delivery obligations to the customer and collection is reasonably assured,
which generally occurs upon shipment. Net sales represent gross sales less
negotiated price allowances, product returns, and allowances for defective
merchandise.





**Allowance
for Accounts Receivable.** We
reduce accounts receivable by an allowance for amounts that may become
uncollectible in the future. This allowance is an estimate based primarily on
our evaluation of the customer's financial condition, past collection history,
and the aging of the account. If the financial condition of any of our customers
deteriorates, resulting in an impairment or inability to make payments,
additional allowances may be required.





**Inventory.** Inventory is stated at the lower of cost or market and is accounted for on the
“first in, first out” method. This means that sales of inventory treat the
oldest item of identical inventory as being the first sold. In addition, we
periodically reduce the value of our inventory for slow-moving or obsolete
inventory. This reduction is based on management's review of items on hand
compared to their estimated future demand. If actual future demand is less
favorable than those projected by management, additional write-downs may be
necessary. Goods shipped to us are recorded as inventory owned by us when the
risk of loss shifts to us from the supplier.





**Goodwill.** We have
indicated previously that a change in the accounting rules necessitated a change
in 2002 in how we report goodwill on our balance sheet. As a result, we incurred
an impairment write-down in 2002 of our investment in Roberts, Cushman in the
amount of $4.0 million. The remaining goodwill on our balance sheet is analyzed
by management periodically to determine the appropriateness of its carry value.
As of December 31, 2004, 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. If actual
results of these stores differ significantly from management's projections, such
difference could affect the present value calculation in the future resulting in
an impairment of all or part of the goodwill currently carried on our balance
sheet.








23





**Forward-Looking
Statements**





“Item 1.
Business” and “Item 7. Management’s Discussion and Analysis of Financial
Condition and Results of Operations” of this report contain forward-looking
statements of management. In general, these are predictions or suggestions of
future events and statements or expectations of future occurrences. 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 which could cause actual results to differ materially from those
suggested by the forward-looking statements include, among other
things:





·
    We
      might fail to realize the anticipated benefits of the opening of Tandy
      Leather retail stores or we might be unable to obtain sufficient new
      locations on acceptable terms to meet our growth plans. Also, other retail
      initiatives might not be successful.





·
    Political
      considerations here and abroad could disrupt our sources of supplies from
      abroad or affect the prices we pay for
goods.





·
    Continued
      involvement by the United States in war and other military operations in
      the Middle East and other areas abroad could disrupt international trade
      and affect the Company's inventory sources.





·
    The
      recent slump in the economy in the United States, as well as abroad, may
      cause our sales to decrease or not to increase or adversely affect the
      prices charged for our products. Also, hostilities, terrorism or other
      events could worsen this condition.




·
    As
      a result of the on-going threat of terrorist attacks on the United States,
      consumer buying habits could change and decrease our
  sales.




·
    Livestock
      diseases such as mad cow could reduce the availability of hides and
      leathers or increase their cost. Also, the prices of hides and leathers
      fluctuate in normal times, and these fluctuations can affect the
      Company.




·
    If,
      for whatever reason, the costs of our raw materials and inventory
      increase, we may not be able to pass those costs on to our customers,
      particularly if the economy has not recovered from its
      downturn.




·
    Other
      factors could cause either fluctuations in buying patterns or possible
      negative trends in the craft and western retail markets. In addition, our
      customers may change their preferences to products other than ours, or
      they may not accept new products as we introduce them.




·
    Tax
      or interest rates might increase. In particular, interest rates are likely
      to increase at some point from their present low levels. These increases
      will increase our costs of borrowing funds as needed in our
      business.





·
    Any
      change in the commercial banking environment may affect us and our ability
      to borrow capital as needed.





·
    Other
      uncertainties, which are difficult to predict and many of which are beyond
      the control of the Company, may occur as
well.








24





The
Company does not intend to update forward-looking statements .








**ITEM
7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
RISK**





We face
exposure to financial market risks, including adverse movement in foreign
current exchange rates and changes in interest rates. These exposures may change
over time and could have a material impact on our financial results. We do not
use or invest in market risk sensitive instruments to hedge any of these risks
or for any other purpose.





**Foreign
Currency Exchange Rate Risk**





Our
primary foreign currency exposure is related to our subsidiary in Canada. The
Leather Factory of Canada, Ltd. has local currency (Canadian dollar) revenue and
local currency operating expenses. Changes in the currency exchange rate impact
the U.S. dollar amount of revenue and expenses. See Note 12 to the Consolidated
Financial Statements, *Segment Information* , for
financial information concerning our foreign activities.





**Interest
Rate Risk**





We are
subject to market risk associated with interest rate movements on outstanding
debt. Our borrowings under the credit agreement with Bank One accrue interest at
a rate that changes with fluctuations in the prime rate. Based on our level of
debt at March 1, 2005, an increase of one percent in the prime rate would result
in additional interest expense of approximately $5,000 during a twelve-month
period.













25


**ITEM
8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA**




**The
Leather Factory, Inc.**


**Consolidated
Balance Sheets**


**December
31, 2004 and 2003**




**December
      31,**
      **2004**
    
    **December
      31,**
      **2003****ASSETS**CURRENT
      ASSETS:Cash
    
    $
    2,560,202
    
    $
    1,728,344Accounts
      receivable-trade, net of allowance for doubtful accountsof
      $85,000 and $31,000 in 2004 and 2003, respectively
    
    
    2,032,289
    
    
    1,828,738Inventory
    
    
    12,749,709
    
    
    11,079,893Prepaid
      income taxes
    
    
    -
    
    
    206,023Deferred
      income taxes
    
    
    199,308
    
    
    134,312Other
      current assets
    
    
    629,723
    
    
    702,236Total
      current assets
    
    
    18,171,231
    
    
    15,679,546PROPERTY
      AND EQUIPMENT, at cost
    
    
    6,005,526
    
    
    5,574,992Less
      accumulated depreciation and amortization
    
    
    (4,100,961
    )
    
    (3,669,099
    )1,904,565
    
    
    1,905,893GOODWILL,
      net of accumulated amortization of $758,000 and$758,000
      in 2004 and 2003, respectively
    
    
    742,860
    
    
    704,235OTHER
      INTANGIBLES, net of accumulated amortization of$185,000
      and $164,000 in 2004 and 2003, respectively
    
    
    437,758
    
    
    432,549OTHER
      assets
    
    
    910,749
    
    
    336,183**$**
    **22,167,163**
    
    **$**
    **19,058,406****LIABILITIES
      AND STOCKHOLDERS' EQUITY**CURRENT
      LIABILITIES:Accounts
      payable-trade
    
    $
    1,954,146
    
    $
    1,545,079Accrued
      expenses and other liabilities
    
    
    1,682,003
    
    
    1,000,427Income
      taxes payable
    
    
    22,764
    
    
    -Current
      maturities of capital lease obligation
    
    
    134,067
    
    
    1,134Total
      current liabilities
    
    
    3,792,980
    
    
    2,546,640DEFERRED
      INCOME TAXES
    
    
    313,006
    
    
    209,289LONG-TERM
      DEBT, net of current maturities
    
    
    505,154
    
    
    1,792,984CAPITAL
      LEASE OBLIGATION, net of current maturities
    
    
    245,790
    
    
    -COMMITMENTS
      AND CONTINGENCIES
    
    
    -
    
    
    -STOCKHOLDERS'
      EQUITY:Preferred
      stock, $0.10 par value; 20,000,000 sharesauthorized,
      none issued or outstanding
    
    
    -
    
    
    -Common
      stock, $0.0024 par value; 25,000,000 sharesauthorized,
      10,560,661 and 10,487,961 shares issued at 2004 and 2003,10,554,711
      and 10,487,961 outstanding at 2004 and 2003, respectively
    
    
    25,345
    
    
    25,171Paid-in
      capital
    
    
    4,796,999
    
    
    4,673,158Retained
      earnings
    
    
    12,458,760
    
    
    9,804,719Treasury
      stock
    
    
    (25,487
    )
    
    -Less:
      Notes receivable-secured by common stock
    
    
    -
    
    
    (20,000
    )Accumulated
      other comprehensive income
    
    
    54,616
    
    
    26,445Total
      stockholders' equity
    
    
    17,310,233
    
    
    14,509,493**$**
    **22,167,163**
    
    **$**
    **19,058,406**




The
accompanying notes are an integral part of these financial
statements.




26





**The
Leather Factory, Inc.**


**Consolidated
Statements of Income**


**For
the Years Ended December 31, 2004, 2003 and 2002**


**2004**
    
    **2003**
    
    **2002**NET
      SALES
    
    $
    46,146,284
    
    $
    41,712,191
    
    $
    39,728,615COST
      OF SALES
    
    
    20,706,239
    
    
    19,020,292
    
    
    18,393,914Gross
      Profit
    
    
    25,440,045
    
    
    22,691,899
    
    
    21,334,701OPERATING
      EXPENSES
    
    
    21,181,599
    
    
    18,594,240
    
    
    17,202,927INCOME
      FROM OPERATIONS
    
    
    4,258,446
    
    
    4,097,659
    
    
    4,131,774OTHER
      (INCOME) EXPENSE:Interest
      expense
    
    
    53,400
    
    
    206,942
    
    
    246,878Other,
      net
    
    
    (8,600
    )
    
    (81,773
    )
    
    65,039Total
      other expense
    
    
    44,800
    
    
    125,169
    
    
    311,917INCOME
      BEFORE INCOME TAXES AND CUMULATIVE EFFECT
      OF
      CHANGE IN ACCOUNTING PRINCIPLE
    
    
    4,213,646
    
    
    3,972,490
    
    
    3,819,857PROVISION
      FOR INCOME TAXES
    
    
    1,559,605
    
    
    1,232,116
    
    
    1,224,868NET
      INCOME BEFORE CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING
      PRINCIPLE
    
    
    2,654,041
    
    
    2,740,374
    
    
    2,594,989CUMULATIVE
      EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE, NET OF INCOME
    TAXES
    
    
    -
    
    
    -
    
    
    (4,008,831
    )NET
      INCOME (LOSS)
    
    $
    2,654,041
    
    $
    2,740,374
    
    $
    (1,413,842
    )NET
      INCOME (LOSS) PER COMMON SHARE - BASIC:INCOME
      BEFORE CUMULATIVE EFFECT OF CHANGE IN ACCTG PRINCIPLE
    
    $
    0.25
    
    $
    0.27
    
    $
    0.26CUMULATIVE
      EFFECT OF CHANGE IN ACCTG PRINCIPLE, NET OF TAX
    
    
    -
    
    
    -
    
    
    (0.40
    )$
    0.25
    
    $
    0.27
    
    $
    (0.14
    )NET
      INCOME (LOSS) PER COMMON SHARE - DILUTED:INCOME
      BEFORE CUMULATIVE EFFECT OF CHANGE IN ACCTG PRINCIPLE
    
    $
    0.24
    
    $
    0.25
    
    $
    0.24CUMULATIVE
      EFFECT OF CHANGE IN ACCTG PRINCIPLE, NET OF TAX
    
    
    -
    
    
    -
    
    
    (0.37
    )$
    0.24
    
    $
    0.25
    
    $
    (0.13
    )Weighted
      Average Number of Shares Outstanding:Basic
    
    
    10,543,994
    
    
    10,323,549
    
    
    10,063,581Diluted
    
    
    10,957,518
    
    
    10,861,305
    
    
    10,761,670


The
accompanying notes are an integral part of these financial
statements.





27





**The
Leather Factory, Inc.**


**Consolidated
Statements of Cash Flows**


**For
the Years Ended December 31, 2004, 2003 and 2002**





**2004**
    
    **2003**
    
    **2002**CASH
      FLOWS FROM OPERATING ACTIVITIES:Net
      income (loss)
    
    $
    2,654,041
    
    $
    2,740,374
    
    $
    (1,413,842
    )Adjustments
      to reconcile net income (loss) to net cashProvided
      by operating activities -Depreciation
      and amortization
    
    
    452,653
    
    
    529,262
    
    
    491,312Loss
      on disposal of assets
    
    
    (2,000
    )
    
    (9,103
    )
    
    -Amortization
      of deferred financing costs
    
    
    -
    
    
    -
    
    
    37,038Deferred
      income taxes
    
    
    38,721
    
    
    47,991
    
    
    (30,184
    )Other
    
    
    20,123
    
    
    47,235
    
    
    (2,502
    )Cumulative
      effect of change in accounting principle
    
    
    -
    
    
    -
    
    
    4,008,831Net
      changes in assets and liabilities, net of effect ofbusiness
      acquisitions:Accounts
      receivable-trade, net
    
    
    (112,738
    )
    
    109,960
    
    
    359,255Inventory
    
    
    (1,303,762
    )
    
    1,615,451
    
    
    (3,463,866
    )Income
      taxes
    
    
    228,787
    
    
    (150,379
    )
    
    16,124Other
      current assets
    
    
    (102,163
    )
    
    (30,119
    )
    
    (192,726
    )Accounts
      payable-trade
    
    
    406,357
    
    
    (49,830
    )
    
    291,311Accrued
      expenses and other liabilities
    
    
    658,692
    
    
    (1,502,904
    )
    
    1,332,179Total
      adjustments
    
    
    284,670
    
    
    607,564
    
    
    2,846,772**Net
      cash provided by operating activities**
    
    
    **2,938,711**
    
    
    **3,347,938**
    
    
    **1,432,930**CASH
      FLOWS FROM INVESTING ACTIVITIES:Purchase
      of property and equipment
    
    
    (369,559
    )
    
    (360,202
    )
    
    (1,073,515
    )Payments
      in connection with businesses acquired
    
    
    (556,794
    )
    
    -
    
    
    (435,747
    )Proceeds
      from sale of assets
    
    
    2,000
    
    
    6,217
    
    
    -Decrease
      (increase) in other assets
    
    
    10,280
    
    
    (27,970
    )
    
    (14,754
    )Other
      intangible costs
    
    
    -
    
    
    -
    
    
    (1,625
    )**Net
      cash used in investing activities**
    
    
    **(914,073**
    **)**
    
    **(381,955**
    **)**
    
    **(1,525,641**
    **)**CASH
      FLOWS FROM FINANCING ACTIVITIES:Net
      decrease in revolving credit loans
    
    
    (1,287,830
    )
    
    (2,420,550
    )
    
    (286,889
    )Payments
      on notes payable and long-term debt
    
    
    (23,478
    )
    
    (6,556
    )
    
    (27,483
    )Decrease
      (increase) in cash restricted for payment on revolver
    
    
    -
    
    
    553,839
    
    
    (62,110
    )Payments
      received on notes secured by common stock
    
    
    20,000
    
    
    24,003
    
    
    27,936Repurchase
      of common stock (treasury stock)
    
    
    (25,487
    )
    
    -
    
    
    -Proceeds
      from issuance of common stock and warrants
    
    
    124,015
    
    
    510,068
    
    
    133,774**Net
      cash used in financing activities**
    
    
    **(1,192,780**
    **)**
    
    **(1,339,196**
    **)**
    
    **(214,772**
    **)**NET
      INCREASE (DECREASE) IN CASH
    
    
    831,858
    
    
    1,626,787
    
    
    (307,483
    )CASH,
      beginning of period
    
    
    1,728,344
    
    
    101,557
    
    
    409,040CASH,
      end of period
    
    $
    2,560,202
    
    $
    1,728,344
    
    $
    101,557SUPPLEMENTAL
      DISCLOSURES OF CASH FLOW INFORMATION:Interest
      paid during the period
    
    $
    59,773
    
    $
    216,275
    
    $
    213,791Income
      tax paid during the period, net of (refunds)
    
    
    1,197,347
    
    
    1,138,799
    
    
    1,254,679NON-CASH
      INVESTING ACTIVITIES:Equipment
      acquired under capital lease financing arrangements
    
    $
    402,201
    
    
    -
    
    
    -




The
accompanying notes are an integral part of these financial
statements.







28


**The
Leather Factory, Inc.**


**Consolidated
Statements of Stockholders' Equity**


**For
the Years Ended December 31, 2004, 2003 and 2002**


**Number
      of Shares**
    
    **Par
      Value**
    
    **Paid-in
      Capital**
    
    **Treasury**
      **Stock**
    
    **Retained
      Earnings**
    
    **Notes
      receivable**
      **secured
      by common stock**
    
    **Accumulated
      Other Cumulative Income (Loss)**
    
    **Total**
    
    **Comprehensive**
      **Income
      (Loss)**BALANCE,
      December 31, 2001
    
    
    9,991,161
    
    $
    23,979
    
    $
    4,030,808
    
    
    -
    
    $
    8,478,187
    
    $
    (71,939
    )
    $
    (37,064
    )
    $
    12,423,671Payments
      on notes receivable secured by common stock
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    27,936
    
    
    -
    
    
    27,936Shares
      issued - stock options exercised
    
    
    158,800
    
    
    381
    
    
    133,393
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    133,774Net
      loss
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    (1,413,842
    )
    
    -
    
    
    -
    
    
    (1,413,842
    )
    
    (1,413,842
    )Translation
      adjustment
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    (1,477
    )
    
    (1,477
    )
    
    (1,477
    )BALANCE,
      December 31, 2002
    
    
    10,149,961
    
    $
    24,360
    
    $
    4,163,901
    
    
    -
    
    $
    7,064,345
    
    $
    (44,003
    )
    $
    (38,541
    )
    $
    11,170,062Comprehensive
      income for the year ended December 31, 2002
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    (1,415,319
    )Payments
      on notes receivable secured by common stock
    
    
    -
    
    
    -
    
    
    
    
    
    -
    
    
    -
    
    
    24,003
    
    
    -
    
    
    24,003Shares
      issued - stock options and warrants exercised
    
    
    338,000
    
    
    811
    
    
    442,016
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    442,827Warrants
      to acquire 100,000 shares of common stock issued
    
    
    -
    
    
    -
    
    
    67,241
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    67,241Net
      income
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    2,740,374
    
    
    -
    
    
    -
    
    
    2,740,374
    
    $
    2,740,374Translation
      adjustment
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    64,986
    
    
    64,986
    
    
    64,986BALANCE,
      December 31, 2003
    
    
    10,487,961
    
    $
    25,171
    
    $
    4,673,158
    
    
    -
    
    $
    9,804,719
    
    $
    (20,000
    )
    $
    26,445
    
    $
    14,509,493Comprehensive
      income for the year ended December 31, 2003
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    2,805,360Payments
      on notes receivable secured by common stock
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    20,000
    
    
    -
    
    
    20,000Shares
      issued - stock options and warrants exercised
    
    
    72,700
    
    
    174
    
    
    74,896
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    75,070Warrants
      to acquire 50,000 shares of common stock issued
    
    
    -
    
    
    -
    
    
    48,945
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    48,945Purchase
      of treasury stock
    
    
    -
    
    
    -
    
    
    -
    
    
    (25,487
    )
    
    -
    
    
    -
    
    
    -
    
    
    (25,487
    )Net
      income
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    2,654,041
    
    
    -
    
    
    -
    
    
    2,654,041
    
    $
    2,654,041Translation
      adjustment
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    28,171
    
    
    28,171
    
    
    28,171BALANCE,
      December 31, 2004
    
    
    10,560,661
    
    $
    25,345
    
    $
    4,771,512
    
    $
    (25,487
    )
    $
    12,458,760
    
    
    -
    
    $
    54,616
    
    $
    17,310,233Comprehensive
      income for the year ended December 31, 2004
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    2,682,212
 The
accompanying notes are an integral part of these financial
statements.




29




**THE
LEATHER FACTORY, INC.**


**NOTES
TO CONSOLIDATED**


**FINANCIAL
STATEMENTS**


****


**DECEMBER
31, 2004, 2003, and 2002**





**1.**  **SIGNIFICANT
ACCOUNTING POLICIES**


****


***·***
    ***Business***





Our
primary line of business is the sale of leather, leather crafts and related
supplies. We sell our products via company-owned stores throughout the United
States and Canada. Numerous customers including retailers, wholesalers,
assemblers, distributors and other manufacturers are geographically disbursed
throughout the world. The Company also has light manufacturing facilities in
Texas and New York.


**


*·*
    *Management
      estimates and reporting*





The
preparation of financial statements in conformity with accounting principles
generally accepted in the United States of America requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and reported amounts of revenues and expenses during
the periods presented. Actual results could differ from those estimates.
Significant assets and liabilities with reported amounts based on estimates
include trade accounts receivables and deferred income taxes.





*·*
    *Principles
      of consolidation*





The
consolidated financial statements include the accounts of The Leather Factory,
Inc. and its wholly owned subsidiaries, The Leather Factory, L.P. (a Texas
limited partnership) and its corporate partners, Tandy Leather Company, L.P. (a
Texas limited partnership) and its corporate partners, Roberts, Cushman &
Company, Inc. (a New York corporation), and The Leather Factory of Canada, Ltd.
(a Canadian corporation). All intercompany accounts and transactions have been
eliminated in consolidation.





*·*
    *Foreign
      currency translation*





Foreign
currency translation adjustments arise from activities of the Company’s Canadian
operations. Results of operations are translated into U.S. dollars using the
average exchange rates during the period, while assets and liabilities are
translated using period-end exchange rates. Foreign currency translation
adjustments of assets and liabilities are recorded in stockholders’
equity.





*·*
    *Revenue
      recognition*





The
Company's sales generally occur via two methods: (1) at the store counter, and
(2) shipment by common carrier. Sales at the counter are recorded and title
passes as transactions occur. Otherwise, sales are recorded and title passes
when the merchandise is shipped to the customer. Shipping terms are normally FOB
shipping point.





The
Company offers an unconditional satisfaction guarantee to all customers and
accepts all product returns. Net sales represent gross sales less negotiated
price allowances, product returns, and allowances for defective
merchandise.





*·*
    *Discounts*





The
Company maintains four price levels on a consistent basis: retail, wholesale,
business, and distributor. Gross sales are reported after deduction of
discounts. The Company does not pay slotting fees or make other payments to
resellers. Several customers require the Company to participate in their
cooperative advertising programs. These programs are a negotiated percentage of
their purchases and are accounted for as a reduction of sales.





*·*
    *Expense
      categories*





Cost of
goods sold include inbound freight and duty charges from vendors to the
Company's central warehouse, freight and handling charges to move merchandise
from the central warehouse to the Company's stores, and manufacturing overhead,
as appropriate.








30





Operating
expenses include all selling, general and administrative costs including wages
and related employee expenses (payroll taxes, health benefits, ESOP
contributions, etc.), advertising, outbound freight charges (to ship merchandise
to customers), rent, and utilities.





*·*
    *Property
      and equipment, net of accumulated depreciation and amortization*





Property
and equipment are stated at cost. Depreciation is computed using the
straight-line method over the estimated useful lives of the assets, which are
five to ten years for equipment, five to seven years for furniture and fixtures,
and five years for vehicles. Leasehold improvements are amortized over the
lesser of the life of the lease or the useful life of the asset. Repairs and
maintenance costs are expensed as incurred.





*·*
    *Inventory*





Inventory
is valued at the lower of first-in, first-out cost or market. In addition, the
value of inventory is periodically reduced for slow-moving or obsolete inventory
based on management's review of items on hand compared to their estimated future
demand.





*·*
    *Impairment
      of long-lived assets*





The
Company adopted SFAS No. 144, *Accounting
for the Impairment or Disposal of Long-lived Assets* ,
effective January 1, 2002. The statement supersedes SFAS No. 121 *,
Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to
be Disposed of,* and the
accounting and reporting provisions of Accounting Principles Board (APB) Opinion
No. 30, *Reporting
the Results of Operations for a Disposal of a Segment of a
Business* . The
adoption of SFAS No. 144 did not affect the financial condition or results of
operations of the Company.





*·*
    *Earnings
      per share*





Basic
earnings per share are computed based on the weighted average number of common
shares outstanding during the period. Diluted earnings per share includes, to
the extent inclusion of such shares would be dilutive to earnings per share, the
effect of outstanding options and warrants, computed using the treasury stock
method. Unearned shares, if any, held by the Employees' Stock Ownership Plan
(ESOP) are deemed not to be outstanding for earnings per shares
calculations.





***BASIC***
    
    **2004**
    
    **2003**
    
    **2002**Net
      income (loss)
    
    $
    2,654,041
    
    $
    2,740,374
    
    $
    (1,413,842
    )Weighted
      average common shares outstanding
    
    
    10,543,994
    
    
    10,323,549
    
    
    10,063,581**Earnings
      per share - basic**
    
    **$**
    **0.25**
    
    **$**
    **0.27**
    
    **$**
    **(0.14**
    **)*****DILUTED***Net
      income (loss)
    
    $
    2,654,041
    
    $
    2,740,374
    
    $
    (1,413,842
    )Weighted
      average common shares outstanding
    
    
    10,543,994
    
    
    10,323,549
    
    
    10,063,581Effect
      of assumed exercise of stock options and warrants
    
    
    413,524
    
    
    537,756
    
    
    698,089Weighted
      average common shares outstanding,assuming
      dilution
    
    
    10,957,518
    
    
    10,861,305
    
    
    10,761,670**Earnings
      per share - diluted**
    
    **$**
    **0.24**
    
    **$**
    **0.25**
    
    **$**
    **(0.13**
    **)**Outstanding
      options and warrants excluded as anti-dilutive
    
    
    136,000
    
    
    60,000
    
    
    -





For
additional disclosures regarding the employee stock options and the warrants,
see Note 9. The net effect of converting stock options and warrants to purchase
752,500 and 792,700 shares of common stock at option prices less than the
average market prices has been included in the computations of diluted EPS for
the years ended December 31, 2004 and 2003, respectively.





***·***
    ***Goodwill
      and other intangibles***





Statement
of Financial Accounting Standards ("SFAS") No. 142, "Goodwill and Other
Intangible Assets," prescribes a two-phase process for impairment testing of
goodwill, which is performed once annually, absent indicators of impairment. The
first phase screens for impairment, while the second phase (if necessary)
measures the impairment. As a
result of SFAS 142, an impairment write-down occurred in the first quarter of
2002 of the investment in subsidiary, Roberts, Cushman & Company, Inc., in
the amount of $4.0 million. Goodwill remaining on the balance sheet is analyzed
by management periodically to determine the appropriateness of its carrying
value. Management has elected to perform the annual analysis during the fourth calendar quarter of
each year. As of
December 31, 2004, 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.





31








Under
SFAS 142, goodwill impairment is deemed to exist if the net book value of a
reporting unit exceeds its estimated fair value. The Company’s reporting units
are generally the same as the operating segments identified in Note 11 - Segment
Information. The new methodology in SFAS 142 differs from the Company’s prior
policy, which was permitted under earlier accounting standards, of using
undiscounted cash flows of the acquired asset to determine if goodwill is
recoverable.





A
summary of changes in the Company’s goodwill for the years ended December 31,
2004 and 2003 is as follows:





**Leather**
      **Factory**
    
    **Tandy**
      **Leather**Balance,
      December 31, 2002
    
    $
    333,655
    
    $
    352,829Acquisitions
      and adjustments
    
    
    17,751
    
    
    -Impairments
    
    
    -
    
    
    -Balance,
      December 31, 2003
    
    
    351,406
    
    
    352,829Acquisitions
      and adjustments
    
    
    8,048
    
    
    30,577Impairments
    
    
    -
    
    
    -Balance,
      December 31, 2004
    
    $
    359,454
    
    $
    383,406





As
of December 31, 2004 and 2003, the Company’s intangible assets and related
accumulated amortization consisted of the following:





**As
      of December 31, 2004****Gross**
    
    **Accumulated****Amortization**
    
    **Net**Trademarks,
      Copyrights
    
    $
    544,369
    
    $
    174,611
    
    $
    369,758Non-Compete
      Agreements
    
    
    78,000
    
    
    10,000
    
    
    68,000$
    622,369
    
    $
    184,611
    
    $
    437,758





**As
      of December 31, 2003****Gross**
    
    **Accumulated****Amortization**
    
    **Net**Trademarks,
      Copyrights
    
    $
    544,369
    
    $
    138,320
    
    $
    406,049Non-Compete
      Agreements
    
    
    52,000
    
    
    25,500
    
    
    26,500$
    596,369
    
    $
    163,820
    
    $
    432,549





Excluding
goodwill, the Company has no intangible assets not subject to amortization under
SFAS 142. Amortization of intangible assets of $33,782 in 2004, $52,215 in 2003,
and $48,283 in 2002 was recorded in operating expenses. Based on the current
amount of intangible assets subject to amortization, the estimated amortization
expense for each of the succeeding 5 years are as follows:





**Leather**
      **Factory**
    
    **Tandy**
      **Leather**
    
    **Total**2005
    
    $
    5,954
    
    $
    32,837
    
    $
    38,7912006
    
    
    5,954
    
    
    32,837
    
    
    38,2912007
    
    
    5,954
    
    
    31,837
    
    
    37,7912008
    
    
    5.954
    
    
    30,337
    
    
    36,2912009
    
    
    5,954
    
    
    30,337
    
    
    36,291





During
2004, the Company acquired the following intangible assets:





**Amortization
      Period**Non-Compete
      Agreements
    
    $
    26,000
    
    
    3
      - 5 years





***·***
    ***Fair
      value of financial
Instruments***





The
principal financial instruments held consist of accounts receivable, accounts
payable, notes payable and long-term debt. The carrying value of accounts
receivable and accounts payable approximate their fair value due to the
relatively short-term nature of the accounts. The interest rates on the
Company’s notes payable and long-term debt fluctuate with changes in the prime
rate and are the rates currently available to the Company; therefore, the
carrying amount of those instruments approximates their fair value.




32




***·***
    ***Deferred
      taxes***




Deferred
income taxes result from temporary differences in the bases of our assets and
liabilities reported for book and tax purposes.





***·***
    ***Stock
      options***





We
periodically grant stock options for a fixed number of shares to employees and
non-employee directors with an exercise price equal to the fair market value of
the shares at the date of grant. We account for stock option grants to employees
and directors using the intrinsic value method. Under the intrinsic value
method, compensation associated with stock awards to employees and directors is
determined as the difference, if any, between the current fair value of the
underlying common stock on the date compensation is measured and the price the
employee or director must pay to exercise the award. The measurement date for
employee awards is generally the date of grant.





At
December 31, 2004, we had two stock-based compensation plans, which are
described more fully in Note 9. No stock-based compensation cost is reflected in
net income in 2004 and 2003, as all options granted under those plans had an
exercise price equal to the market value of the underlying common stock on the
date of grant. The following table illustrates the effect on net income and
earnings per share if we had applied the fair value recognition provisions of
FASB Statement No. 123, *Accounting
for Stock-Based Compensation* , to
stock-based compensation.





**Years
      Ended December 31,****2004**
    
    **2003**
    
    **2002**Net
      income (loss), as reported
    
    $
    2,654,041
    
    $
    2,740,374
    
    $
    (1,413,842
    )Plus:
      Stock -based employee compensation expense included in reported net
      income, net of tax
    
    
    -
    
    
    -
    
    
    -Less:
      Total stock-based compensation expense determined under fair value based
      method for all awards, net of related tax effects
    
    
    117,443
    
    
    98,186
    
    
    103,619Pro
      forma net income (loss)
    
    
    2,536,598
    
    
    2,642,188
    
    $
    (1,517,461
    )Earnings
      (loss) per share:Basic
      - as reported
    
    $
    0.25
    
    $
    0.27
    
    $
    (0.14
    )Basic
      - pro forma
    
    $
    0.24
    
    $
    0.26
    
    $
    (0.15
    )Diluted
      - as reported
    
    $
    0.24
    
    $
    0.25
    
    $
    (0.13
    )Diluted
      - pro forma
    
    $
    0.23
    
    $
    0.24
    
    $
    (0.14
    )





The fair
value of options at the date of grant was estimated using the Black-Scholes
option pricing model with the following weighted-average
assumptions:





**2004**
    
    **2003**
    
    **2002**Volatility
    
    
    36.4
    %
    
    69.6
    %
    
    73.6
    %Expected
      option life
    
    
    3-5
    
    
    5
    
    
    5Interest
      rate (risk free)
    
    
    3.375
    %
    
    3.25
    %
    
    3.00
    %Dividends
    
    
    None
    
    
    None
    
    
    None





The
effect on 2004, 2003 and 2002 pro forma net income (loss) and earnings (loss)
per share of the estimated fair value of stock options and shares are not
necessarily representative of the effects on the results of operations in the
future. In addition, the estimates made utilize a pricing model developed for
traded options with relatively short lives; our option grants typically have a
life of up to ten years and are not transferable. Therefore, the actual fair
value of a stock option grant may be different from our estimates. We believe
that our estimates incorporate all relevant information and represent a
reasonable approximation in light of the difficulties involved in valuing
non-traded stock options.





In
December 2004, SFAS No. 123 (revised 2004), "Share-Based Payment" (SFAS 123R)
was issued. SFAS 123R replaces SFAS No. 123 and supercedes APB Opinion No. 25.
The Company is required to adopt SFAS 123R beginning July 1, 2005. SFAS 123R
requires all share-based payments to employees, including grants of employee
stock options, to be recognized in the financial statements based on their fair
values. The pro forma disclosures previously permitted under SFAS no longer will
be an alternative to financial statement recognition. Sec Note 12 - Recent
Accounting Pronouncements for additional information.





33








*·*
    ***Comprehensive
      income***





Comprehensive
income represents all changes in stockholders’ equity, exclusive of transactions
with stockholders. The accumulated balance of foreign currency translation
adjustments is presented in the consolidated financial statements as
“accumulated other comprehensive income or loss”.





***·***
    ***Shipping
      and handling costs***





All
shipping and handling costs incurred by the Company are included in operating
expenses on the statements of income. These costs totaled approximately
$1,360,000, $1,206,000 and $1,284,000 for the years ended December 31, 2004,
2003 and 2002, respectively.





***·***
    ***Advertising***





With the
exception of catalog costs, advertising costs are expense as incurred. Catalog
costs are capitalized and expensed over the estimated useful life of the
particular catalog in question, which is typically twelve to eighteen months.
Such capitalized costs are included in other current assets and totaled $217,000
and $102,304 at December 31, 2004 and 2003, respectively. Total advertising
expense was $2,571,124 in 2004; $2,399,879 in 2002; and $2,265,659 in
2002.





The
Company agrees to list the names and addresses of the Authorized Sales Centers
(ASCs) in certain mailing pieces produced. The inclusion of these names and
addresses are at the Company's sole discretion. The production and distribution
of direct mailings is the primary method of advertising used by the Company and
normally consists of 50 to 75 unique mailing pieces annually. Normally, the ASCs
are included in six to eight of those pieces. The Company believes that the
inclusion of these ASC locations in the flyers has no impact on the financial
statements of the Company.





***·***
    ***Cash
      flow presentation***





For
purposes of the statement of cash flows, the Company considers all highly liquid
investments with initial maturities of three months or less from the date of
purchase to be cash equivalents.





**2.
VALUATION AND QUALIFYING ACCOUNTS**





·
    Allowance
      for uncollectible accounts





We
maintain allowances for bad debts based on factors such as the composition of
accounts receivable, the age of the accounts, historical bad debt experience,
and management's evaluation of the financial condition and past collection
history of each customer. Accounts are written off as they are deemed
uncollectible based on a periodic review of accounts. Our allowance for doubtful
accounts was $85,132 and $31,469, respectively, at December 31, 2004 and 2003.
The reduction in 2003 was due to improvements in trade accounts receivable and
collections of accounts for which reserves had been provided. The 2004 reserve
balance returned to a more normal level based on our general evaluation of the
collectibility of our accounts. The following is a roll forward of the allowance
for doubtful accounts:





**Balance
      at beginning of year**
    
    **Reserve
      "purchased" during year**
    
    **Additions
      (reductions) charged to costs and expenses**
    
    **Foreign
      exchange gain/loss**
    
    **Write-offs**
    
    **Balance
      at end of year**Year
      ended December 31, 2004
    
    $
    31,469
    
    
    9,785
    
    
    104,587
    
    
    4,980
    
    
    (65,688
    )
    $
    85,133Year
      ended December 31, 2003
    
    $
    77,657
    
    
    -
    
    
    87,175
    
    
    967
    
    
    (134,330
    )
    $
    31,469Year
      ended December 31, 2002
    
    $
    190,890
    
    
    -
    
    
    (30,197
    )
    
    24
    
    
    (83,060
    )
    $
    77,657





·
    Sales
      returns and defective merchandise





Product
returns are generally recorded directly against sales as those returns occur.
Historically, the amount of returns is immaterial and as a result, no reserve is
recorded in the financial statements.





·
    Slow-moving
      and obsolete inventory





The
majority of inventory items maintained by the Company have no restrictive shelf
life. Management reviews all inventory items annually to determine what items
should be eliminated from the product line. Items are selected for several
reasons: (1) the item is slow-moving; (2) the supplier is unable to provide an
acceptable quality or quantity; or (3) to maintain a freshness in the product
line. Once an item has been selected to discontinue, we devalue the cost of the
item by 25% of its original value each quarter until its value has been reduced
to zero. Reductions in inventory for slow-moving and obsolete inventory are
recorded directly against inventory.





34








**3.**
    **BALANCE
      SHEET COMPONENTS**


**December
      31,****2004**
    
    **2003**INVENTORYFinished
      goods held for sale
    
    $
    11,571,869
    
    $
    9,902,140Raw
      materials and work in process
    
    
    1,177,840
    
    
    1,177,753TOTAL
    
    $
    12,749,709
    
    $
    11,079,893PROPERTY
      AND EQUIPMENTLeasehold
      improvements
    
    $
    1,181,828
    
    $
    1,100,785Equipment
    
    
    3,837,654
    
    
    3,572,506Furniture
      and fixtures
    
    
    939,976
    
    
    843,851Vehicles
    
    
    46,068
    
    
    57,8506,005,526
    
    
    5,574,992Less:
      accumulated depreciation
    
    
    (4,100,961
    )
    
    (3,669,099
    )TOTAL
    
    $
    1,904,565
    
    $
    1,905,893


Depreciation
expense was $444,878, $477,047, and $443,029 for the years ended December 31,
2004, 2003 and 2002, respectively.





**December
    31,****2004**
    
    **2003**OTHER
      CURRENT ASSETSAccounts
      receivable - employees
    
    $
    40,401
    
    $
    23,375Accounts
      receivable - other
    
    
    70,814
    
    
    24,691Prepaid
      expenses
    
    
    436,011
    
    
    495,334Payments
      on merchandise not rec'd
    
    
    82,497
    
    
    158,836TOTAL
    
    $
    629,723
    
    $
    702,236OTHER
      ASSETSSecurity
      deposits - utilities, locations, etc.
    
    $
    75,903
    
    $
    73,193Leather
      art collection
    
    
    250,000
    
    
    250,000Other
    
    
    -
    
    
    12,990Computer
      software not implemented yet
    
    
    584,846
    
    
    -TOTAL
    
    $
    910,749
    
    $
    336,183ACCR
      EXPS AND OTHER LIABILITIESAccrued
      bonuses
    
    $
    768,937
    
    $
    527,880Accrued
      payroll
    
    
    212,298
    
    
    220,055Accrued
      ESOP contribution
    
    
    140,000
    
    
    -Sales
      and payroll taxes payable
    
    
    208,896
    
    
    154,948Other
    
    
    351,872
    
    
    97,544TOTAL
    
    $
    1,682,003
    
    $
    1,000,427





**4.
NOTES PAYABLE AND LONG-TERM DEBT**





On
November 1, 2004, the Company entered into a Credit Agreement with Bank One,
N.A. ("Bank One"), pursuant to which Bank One agreed to provide a revolving
credit facility of up to $3,000,000. The revolver bears interest at prime less
..5% or LIBOR plus 1.35% and matures on October 6, 2007. Proceeds of the closing
of the Credit Facility were used to pay all amounts due and owing by the Company
pursuant to the Credit and Security Agreement by and between the Company and
Wells Fargo Bank, N.A. ("WFB"). At closing, the Company's revolving line of
credit with WFB in the principal amount of $975,000 was satisfied in its
entirety.





On
November 3, 2003, the Company entered into a Credit and Security Agreement with
Wells Fargo Bank Texas, N.A. ("WFB-TX"), pursuant to which WFB-TX agreed to
provide a revolving credit facility of up to $6,000,000. The revolver bears
interest at prime less .5% and matures on November 3, 2005. Proceeds of the
closing of the Credit Facility were used to pay all amounts due and owing by the
Company pursuant to the Credit and Security Agreement, as amended, by and
between the Company and Wells Fargo Bank Minnesota, N.A. ("WFB-MN"). At closing,
the Company's revolving line of credit with WFB-MN in the principal amount of
$2,054,549 was satisfied in its entirety.








35





On
November 26, 2003, the Company entered into the First Amendment to the Credit
and Security Agreement ("Amendment 1") with WFB-TX. There, WFB-TX approved the
Company's request for a reduction in the maximum loan amount to $5,000,000, a
reduction of $1,000,000. Also, Amendment 1 modified the original restriction
regarding the repurchase of treasury stock to allow for treasury stock
repurchases under $150,000.





At
December 31, 2004 and 2003, the amounts outstanding under the above agreements
consisted of the following:





**2004**
    
    **2003**Credit
      Agreement with Bank One - collateralized by inventory and accounts
      receivable; payable as follows:Line
      of Credit Note dated October 6, 2004 in the maximum principal amount of
      $3,000,000 with revolving features as more fully described below -
      interest due quarterly at prime less .5% (4.75% at 12/31/2004) or LIBOR
      plus 1.35%; matures October 6, 2007
    
    $
    505,154
    
    
    -Credit
      and Security Agreement with WFB-TX - collateralized by all of the assets
      of the Company; payable as follows:Revolving
      Note, as amended, dated November 3, 2003 in the maximum principal amount
      of $5,000,000 with revolving features as more fully described below -
      interest due monthly at prime less .5% (3.5% at December 31, 2003);
      matures November 3, 2005
    
    
    -
    
    $
    1,792,984505,154
    
    
    1,792,984Less
      - Current maturities
    
    
    -
    
    
    -$
    505,154
    
    $
    1,792,984





The terms
of the Credit Facility contain various covenants which, among other things,
require the Company to meet a specific debt service coverage ratio and limit
capital expenditures. Other covenants prohibit the Company from incurring
indebtedness except as permitted by the terms of the Credit Facility, from
entering into any new business or making material changes in any of the
Company’s business objectives, purposes or operations. The facility places an
affirmative duty on the Company to disclose any covenant violation to the
lender.





Scheduled
maturities of the Company's notes payable and long-term debt are as
follows:





2005
    
    $
    -2006
    
    
    -2007
    
    
    505,1542008
    
    
    -$
    505,154





**5.
CAPITAL LEASE OBLIGATIONS**





The
Company leases certain licensed software under a capital lease agreement. The
asset subject to the agreement totaling $402,201 is included in other assets as
of December 31, 2004. The asset will be reclassified into property and equipment
once the conversion and implementation process is completed.





The
Company leases certain warehouse equipment under a capital lease agreement.
Assets subject to the agreement totaling $18,651 and related accumulated
depreciation of $6,262 are included in property and equipment as of December 31,
2003.





At
December 31, 2004 and 2003, the amounts outstanding under capital lease
obligations consisted of the following:





**2004**
    
    **2003**Capital
      Lease secured by certain licensed software - total monthly principal
      payments of $11,172, no interest, maturing October 2007
    
    $
    379,857
    
    
    -Capital
      Lease secured by equipment - total monthly principal and interest payments
      of $572 at approximately 12% interest; maturing February
    2004
    
    
    -
    
    
    1,134379,857
    
    
    1,134Less
      - Current maturities
    
    
    134,067
    
    
    1,134$
    245,790
    
    $
    -








36





**6.
EMPLOYEE BENEFIT PLAN**





The
Company has an Employee Stock Ownership Plan (the "Plan") for employees with at
least one year of service (as defined by the Plan) and who have reached their
21st birthday. Under the Plan, the Company makes annual cash or stock
contributions to a trust for the benefit of eligible employees. As of December
31, 2004, 213 employees and former employees were participants in or
beneficiaries of the ESOP. The trust invests in shares of the Company's common
stock. The amount of the Company's annual contribution is discretionary.
Benefits under the Plan are 100% vested after three years of service and are
payable upon death, disability or retirement. Vested benefits are payable upon
termination of employment.





The
Company applies Statement of Position 93-6 (SOP 93-6), "Employers’ Accounting
for Employee Stock Ownership Plans," of the Accounting Standards Division of the
American Institute of CPAs. During 2004, 2003, and 2002, respectively, the
Company contributed $250,000; $221,400; and $345,312 in cash as current year
contributions to the plan and recognized compensation expense related to these
payments.





The
following table summarizes the number of shares held by the Plan and the market
value as of December 31, 2004, 2003, and 2002:





**Number
      of Shares**
    
    **Market
      Value****2004**
    
    **2003**
    
    **2002**
    
    **2004**
    
    **2003**
    
    **2002**Allocated
    
    
    948,147
    
    
    981,540
    
    
    956,320
    
    $
    3,365,922
    
    $
    4,750,654
    
    $
    3,232,362Unearned
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    -Total
    
    
    948,147
    
    
    981,540
    
    
    956,320
    
    $
    3,365,922
    
    $
    4,750,654
    
    $
    3,232,362





The
Company currently offers no postretirement or postemployment benefits to its
employees.





**7.
INCOME TAXES**





The
provision for income taxes consists of the following:





**2004**
    
    **2003**
    
    **2002**Current
      provision:
    
    
    Federal
    
    $
    1,380,951
    
    $
    1,144,763
    
    $
    1,078,146State
    
    
    139,933
    
    
    40,267
    
    
    51,5561,520,884
    
    
    1,185,030
    
    
    1,129,702Deferred
      provision (benefit):
    
    
    Federal
    
    
    33,483
    
    
    46,850
    
    
    82,014State
    
    
    5,238
    
    
    236
    
    
    13,15238,721
    
    
    47,086
    
    
    95,166$
    1,559,605
    
    $
    1,232,116
    
    $
    1,224,868





Income
(loss) before income taxes is earned in the following tax
jurisdictions:





**2004**
    
    **2003**
    
    **2002**United
      States
    
    $
    4,078,434
    
    $
    3,744,550
    
    $
    3,794,256Canada
    
    
    135,213
    
    
    227,940
    
    
    25,601$
    4,213,647
    
    $
    3,972,490
    
    $
    3,819,857





The
income tax effects of temporary differences that give rise to significant
portions of deferred income tax assets and liabilities are as
follows:





**2004**
    
    **2003**Deferred
      income tax assets:Allowance
      for doubtful accounts
    
    $
    26,546
    
    $
    9,782Capitalized
      inventory costs
    
    
    115,022
    
    
    103,605Warrants
    
    
    42,989
    
    
    -Accrued
      expenses, reserves, and other
    
    
    57,740
    
    
    20,925Total
      deferred income tax assets
    
    
    242,297
    
    
    134,312Deferred
      income tax liabilities:Property
      and equipment depreciation
    
    
    249,892
    
    
    204,482Goodwill
      and other intangible assets amortization
    
    
    106,103
    
    
    4,807Total
      deferred income tax liabilities
    
    
    355,995
    
    
    209,289Net
      deferred tax asset (liability)
    
    
    ($113,698
    )
    
    ($
      74,977
    )


37





The net
deferred tax liability is classified on the balance sheets as
follows:





**2004**
    
    **2003**Current
      deferred tax assets
    
    $
    199,308
    
    $
    134,312Long-term
      deferred tax liabilities
    
    
    (313,006
    )
    
    (209,289
    )Net
      deferred tax asset (liability)
    
    $
    (113,698
    )
    $
    (
      74,977
    )





The
effective tax rate differs from the statutory rate as follows:





**2004**
    
    **2003**
    
    **2002**Statutory
      rate
    
    
    34%
    
    
    34%
    
    
    34%State
      and local taxes
    
    
    4%
    
    
    1%
    
    
    1%Non-deductible
      goodwill amortization
    
    
    0%
    
    
    0%
    
    
    0%Other
    
    
    (1%
    )
    
    (4%
    )
    
    (3%
    )Effective
      rate
    
    
    37%
    
    
    31%
    
    
    32%





**8.
COMMITMENTS AND CONTINGENCIES**





**Operating
Leases**





The
Company's primary office facility and warehouse are leased under a five-year
lease agreement that expires in March 2008. Rental agreements for the stores and
warehouse distribution units expire on dates ranging from March 2005 to January
2010. The Company's lease agreement for the manufacturing facility in Long
Island City, New York, expires on June 30, 2006.





Rent
expense on all operating leases for the years ended December 31, 2004, 2003, and
2002, was $1,994,030, $1,814,457, and $1,465,577, respectively.





Future
minimum lease payments under noncancelable operating leases at December 31, 2004
were as follows:





Year
      ending December 31:2005
    
    $
    2,107,2142006
    
    
    1,804,6862007
    
    
    1,422,2002008
    
    
    706,7822009
      and thereafter
    
    
    196,893Total
      minimum lease payments
    
    $
    6,237,775





**Litigation**





The
Company is involved in various litigation that arise in the ordinary course of
its business and operations. There are no such matters pending that the Company
expects to have a material impact on its financial position and results of
operations.





**9.
SIGNIFICANT BUSINESS CONCENTRATIONS AND RISK**





Major
Customers





The
Company’s revenues are derived from a diverse group of customers primarily
involved in the sale of leather crafts. While no single customer accounts for
more than 10% of the Company’s consolidated revenues in 2004, 2003 and 2002,
sales to the Company’s five largest customers represented 10.6%, 13.8% and
15.1%, respectively, of consolidated revenues in those years. While management
does not believe the loss of one of these customers would have a significant
negative impact on the Company’s operations, it does believe the loss of several
of these customers simultaneously or a substantial reduction in sales generated
by them could temporarily affect the Company’s operating results.





Major
Vendors





The
Company purchases a significant portion of its inventory through one supplier.
Due to the number of alternative sources of supply, loss of this supplier would
not have an adverse impact on the Company’s operations.








38


Credit
Risk





Due to
the large number of customers comprising the Company’s customer base,
concentrations of credit risk with respect to customer receivables are limited.
At December 31, 2004 and 2003, 16.3% and 20.6%, respectively, of the Company’s
consolidated accounts receivable were due from three nationally recognized
retail chains. The Company does not generally require collateral for accounts
receivable, but performs periodic credit evaluations of its customers and
believes the allowance for doubtful accounts is adequate. It is management’s
opinion that if any one or a group of customer receivable balances should be
deemed uncollectible, it would not have a material adverse effect on the
Company’s results of operations and financial condition.





**10.
STOCKHOLDERS' EQUITY**





**(a)**
    **Stock
      Option Plans**





*·*
    *1995
      Stock Option Plan*





In
connection with its 1995 Stock Option Plan for officers and key management
employees, the Company has outstanding options to purchase its common stock. The
plan provides for the granting of either qualified incentive stock options or
non-qualified options at the discretion of the Compensation Committee of the
Board of Directors. Options are granted at the fair market value of the
underlying common stock at the date of grant and vest over a five-year period.
The Company has reserved 1,000,000 shares of common stock for issuance under
this plan.





·
    *1995
      Director Non-Qualified Stock Option
Plan*





In
connection with its 1995 Director Non-qualified Stock Option Plan for
non-employee directors, the Company has outstanding options to purchase its
common stock. The plan provides for the granting of non-qualified options at the
discretion of the Compensation Committee of the Board of Directors. Options are
granted at the fair market value of the underlying common stock at the date of
grant and vest after six months. The Company has reserved 100,000 shares of
common stock for issuance under this plan.





*·*
    *Stock
      Option Summary*





All
options expire ten years from the date of grant and are exercisable at any time
after vesting. Of the combined 1,100,000 shares available for issuance under the
two plans, at December 31, 2004, 2003 and 2002, there were 40,000; 40,000; and
106,000; respectively, in un-optioned shares available for future
grants.





A summary
of stock option transactions for the years ended December 31, 2004, 2003, and
2002, is as follows:





**2004**
    
    **2003**
    
    **2002****Weighted**
    
    
    
    **Weighted**
    
    
    
    **Weighted****Average**
    
    
    
    **Average**
    
    
    
    **Average****Option**
    
    **Exercise**
    
    **Option**
    
    **Exercise**
    
    **Option**
    
    **Exercise****Shares**
    
    **Price**
    
    **Shares**
    
    **Price**
    
    **Shares**
    
    **Price**Outstanding
      at January 1
    
    
    675,200
    
    $
    1.540
    
    
    747,200
    
    $
    1.196
    
    
    846,000
    
    $
    1.128Granted
    
    
    18,000
    
    
    3.598
    
    
    68,000
    
    
    4.200
    
    
    10,000
    
    
    2.720Forfeited
      or expired
    
    
    (18,000
    )
    
    1.350
    
    
    (2,000
    )
    
    2.720
    
    
    -
    
    
    -Exchanged
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    -Exercised
    
    
    (72,700
    )
    
    1.053
    
    
    (138,000
    )
    
    0.972
    
    
    (108,800
    )
    
    0.810Outstanding
      at December 31
    
    
    602,500
    
    $
    1.630
    
    
    675,200
    
    $
    1.540
    
    
    747,200
    
    $
    1.196Exercisable
      at end of year
    
    
    354,500
    
    $
    1.320
    
    
    308,200
    
    $
    1.158
    
    
    325,200
    
    $
    1.017Weighted-average
      fair value ofoptions
      granted during year
    
    $
    1.20
    
    
    
    
    $
    2.31
    
    
    
    
    $
    1.54





The
following table summarizes outstanding options into groups based upon exercise
price ranges at December 31, 2004:





**Options
      Outstanding**
    
    **Options
      Exercisable****Weighted**
    
    **Weighted**
    
    
    
    **Weighted**
    
    **Weighted****Average**
    
    **Average**
    
    
    
    **Average**
    
    **Average****Option**
    
    **Exercise**
    
    **Maturity**
    
    **Option**
    
    **Exercise**
    
    **Maturity**Exercise
      Price Range
    
    **Shares**
    
    **Price**
    
    **(Years)**
    
    **Shares**
    
    **Price**
    
    **(Years)**$0.75
      or Less
    
    
    14,000
    
    $
    0.661
    
    
    3.16
    
    
    14,000
    
    $
    0.661
    
    
    3.16$0.76
      to $1.125
    
    
    128,500
    
    $
    0.865
    
    
    2.75
    
    
    118,500
    
    $
    0.859
    
    
    2.50$1.126
      to $1.69
    
    
    370,000
    
    $
    1.350
    
    
    6.40
    
    
    198,000
    
    $
    1.350
    
    
    6.40$1.70
      to $2.55
    
    
    2,000
    
    $
    1.900
    
    
    6.74
    
    
    2,000
    
    $
    1.900
    
    
    6.74$2.56
      to $3.84
    
    
    12,000
    
    $
    3.270
    
    
    9.31
    
    
    2,000
    
    $
    2.720
    
    
    7.74$3.85-$4.24
    
    
    76,000
    
    $
    4.165
    
    
    8.83
    
    
    20,000
    
    $
    4.104
    
    
    8.73602,500
    
    $
    1.630
    
    
    5.91
    
    
    354,500
    
    $
    1.320
    
    
    5.11




39




**(b)**
    **Warrants**





Warrants
to acquire up to 100,000 shares of common stock at $3.10 per share were issued
in conjunction with a consulting agreement to an unrelated entity in February
2003. The warrants may be exercised at anytime until expiration on February 12,
2008.





Warrants
to acquire up to 50,000 shares of common stock at $5.00 per share were issued in
conjunction with a consulting agreement to an unrelated entity in February 2004.
The warrants may be exercised at anytime until expiration on February 24, 2009.





A summary
of warrant transactions for the years ended December 31, 2004, 2003, and 2002,
is as follows:





**2004**
    
    **2003**
    
    **2002****Weighted**
    
    
    
    **Weighted**
    
    
    
    **Weighted****Average**
    
    
    
    **Average**
    
    
    
    **Average****Option**
    
    **Exercise**
    
    **Option**
    
    **Exercise**
    
    **Option**
    
    **Exercise****Shares**
    
    **Price**
    
    **Shares**
    
    **Price**
    
    **Shares**
    
    **Price**Outstanding
      at January 1
    
    
    100,000
    
    
    3.1000
    
    
    200,000
    
    
    .4375
    
    
    300,000
    
    
    .4727Granted
    
    
    50,000
    
    
    5.0000
    
    
    100,000
    
    
    3.1000
    
    
    -Forfeited
      or expired
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    (50,000
    )
    
    .5430Exchanged
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    -Exercised
    
    
    -
    
    
    -
    
    
    (200,000
    )
    
    .4375
    
    
    (50,000
    )
    
    .5430Outstanding
      at December 31
    
    
    150,000
    
    
    3.7333
    
    
    100,000
    
    
    3.1000
    
    
    200,000
    
    
    .4375Exercisable
      at end of year
    
    
    150,000
    
    
    3.7333
    
    
    100,000
    
    
    3.1000
    
    
    200,000
    
    
    .4375Weighted-average
      fair value ofwarrants
      granted during year
    
    $
    0.98
    
    
    
    
    $
    0.67
    
    
    
    
    
    N/A





The
following table summarizes outstanding warrants into groups based upon exercise
price ranges at December 31, 2004:





**Warrants
      Outstanding**
    
    **Warrants
      Exercisable****Weighted**
    
    **Weighted**
    
    
    
    **Weighted**
    
    **Weighted****Average**
    
    **Average**
    
    
    
    **Average**
    
    **Average****Exercise**
    
    **Maturity**
    
    ****
    
    **Exercise**
    
    **Maturity**Exercise
      Price Range
    
    **Warrant**
    
    **Price**
    
    **(Years)**
    
    **Warrant**
    
    **Price**
    
    **(Years)**$3.00
      or Less
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    -
    
    
    -More
      than $3.00 andLess
      Than $5.00
    
    
    100,000
    
    $
    3.1000
    
    
    3.12
    
    
    100,000
    
    $
    3.1000
    
    
    3.12$5.00
      or More
    
    
    50,000
    
    $
    5.0000
    
    
    4.15
    
    
    50,000
    
    $
    5.0000
    
    
    4.15150,000
    
    $
    3.7333
    
    
    3.46
    
    
    150,000
    
    $
    3.7333
    
    
    3.46


**(c)**
    **Notes
      Receivable Secured by Common Stock**





During
1996, the Company purchased certain notes from a financial institution that are
collateralized by the Company’s common stock. These notes relate to shares
issued under the Company’s 1993 Non-Qualified Incentive Stock Option Plan. These
notes, as renewed in 2000, were due from certain members of management and had
maturity dates of December 31, 2004. All notes were paid in full as of December
31, 2004.





**11.
BUSINESS ACQUISITIONS**





During
2002, the company acquired certain assets of the following entities for a total
purchase price of $435,747:





**Entity**
    **Location**
    **Date
      of acquisition**Oklahoma
      Leather Supply
    Oklahoma
      City, Oklahoma
    January
      2002Heritage
      Leather
    Boise,
      Idaho
    March
      2002The
      Leather Shop
    Memphis,
      Tennessee
    October
      2002Copper
      Saguaro
    Tempe,
      Arizona
    November
      2002





All of
the acquired entities were formerly operated as independent retail leathercraft
stores. The assets purchased in these acquisitions consisted primarily of
inventory, store furniture and fixtures, and equipment. Goodwill recognized in
these transactions amounted to $158,878, and is reported in the Tandy Leather
Company segment. The Company also entered into non-compete agreements with the
former owners totaling $52,000 for periods ranging from three to five
years.





40





During
2004, the Company acquired certain assets of the following entities for a total
purchase price of $156,452:





**Entity**
    **Location**
    **Date
      of acquisition**Robyn's
      LLC
    Syracuse,
      NY
    January
      2004Hawkins
      Handcrafted Leathers
    St.
      Louis, MO
    February
      2004Santa
      Fe Hides & Trappings
    Santa
      Fe, NM
    July
      2004





All of
the acquired entities were formerly operated as independent retail leathercraft
stores. The assets purchased in these acquisitions consisted primarily of
inventory, store furniture and fixtures, and equipment. Goodwill recognized in
these transactions amounted to $30,577, and is reported in the Tandy Leather
Company segment. The Company also entered into non-compete agreements with the
former owners totaling $26,000 for periods ranging from one to five
years.





On
November 30, 2004, the Company acquired all of the issued and outstanding shares
of capital stock of 1124055 Ontario Inc., a Canadian corporation, and its
wholly-owned subsidiary, Heritan Ltd. The total purchase price was approximately
$400,000 which was funded with cash generated from operations.





**12.
SEGMENT INFORMATION**





The
Company identifies its segments based on the activities of three distinct
operations: **Wholesale
Leathercraf** t, which
consists of a chain of warehouse distribution units located in the United States
and Canada operating as The Leather Factory; **Retail
Leathercraf** t, which
consists of a chain of retail stores located in the United States and Canada
operating as Tandy Leather Company; and **Roberts,
Cushman & Company** , which
manufactures decorative hat trims sold directly to hat manufactures and
distributors.





The
Company’s reportable operating segments have been determined as separately
identifiable business units. The Company measures segment earnings as operating
earnings, defined as income before interest and income taxes.





**Wholesale**
      **Leathercraft**
    
    **Retail**
      **Leathercraft**
    
    **Roberts,**
      **Cushman
      & Co**
    
    **Total**For
      the year ended December 31, 2004Net
      Sales
    
    $
    30,630,122
    
    $
    13,515,662
    
    $
    2,000,500
    
    $
    46,146,284Gross
      Profit
    
    
    16,485,052
    
    
    8,348,616
    
    
    606,377
    
    
    25,440,045Operating
      earnings
    
    
    2,817,940
    
    
    1,385,565
    
    
    54,941
    
    
    4,258,446Interest
      expense
    
    
    53,400
    
    
    -
    
    
    -
    
    
    53,400Other,
      net
    
    
    (6,748
    )
    
    (1,852
    )
    
    -
    
    
    (8,600
    )Income
      before income taxes
    
    
    2,771,288
    
    
    1,387,417
    
    
    54,941
    
    
    4,213,646Depreciation
      and amortization
    
    
    362,173
    
    
    81,750
    
    
    8,730
    
    
    452,653Fixed
      asset additions
    
    
    197,853
    
    
    155,328
    
    
    16,378
    
    
    369,559Total
      assets
    
    $
    17,991,403
    
    $
    3,372,812
    
    $
    802,918
    
    $
    22,167,163For
      the year ended December 31, 2003Net
      Sales
    
    $
    30,684,092
    
    $
    9,216,838
    
    $
    1,811,261
    
    $
    41,712,191Gross
      Profit
    
    
    16,332,776
    
    
    5,804,504
    
    
    554,619
    
    
    22,691,899Operating
      earnings
    
    
    3,462,457
    
    
    604,291
    
    
    30,911
    
    
    4,097,659Interest
      expense
    
    
    206,942
    
    
    -
    
    
    -
    
    
    206,942Other,
      net
    
    
    (81,838
    )
    
    65
    
    
    -
    
    
    (81,773
    )Income
      before income taxes
    
    
    3,337,354
    
    
    604,225
    
    
    30,911
    
    
    3,972,490Depreciation
      and amortization
    
    
    443,623
    
    
    75,854
    
    
    9,785
    
    
    529,262Fixed
      asset additions
    
    
    214,256
    
    
    137,115
    
    
    8,831
    
    
    360,202Total
      assets
    
    $
    15,409,084
    
    $
    2,908,429
    
    $
    740,893
    
    $
    19,058,406For
      the year ended December 31, 2002Net
      Sales
    
    $
    30,313,478
    
    $
    7,387,874
    
    $
    2,027,263
    
    $
    39,728,615Gross
      Profit
    
    
    16,237,143
    
    
    4,395,384
    
    
    702,175
    
    
    21,334,701Operating
      earnings (loss)
    
    
    3,742,844
    
    
    371,372
    
    
    17,558
    
    
    4,131,774Interest
      expense
    
    
    (246,316
    )
    
    (562
    )
    
    -
    
    
    (246,878
    )Other,
      net
    
    
    (64,071
    )
    
    (968
    )
    
    -
    
    
    (65,039
    )Income
      (loss) before income taxes
    
    
    3,432,457
    
    
    369,842
    
    
    17,558
    
    
    3,819,857Depreciation
      and amortization
    
    
    367,218
    
    
    111,013
    
    
    13,081
    
    
    491,312Fixed
      asset additions
    
    
    888,491
    
    
    180,522
    
    
    4,502
    
    
    1,073,515Total
      assets
    
    $
    16,205,347
    
    $
    2,562,737
    
    $
    907,518
    
    $
    19,675,602





41


Net sales
for geographic areas was as follows:


**2004**
    
    **2003**
    
    **2002**United
      States
    
    $
    42,485,339
    
    $
    38,934,923
    
    $
    37,510,567Canada
    
    
    2,112,601
    
    
    1,611,093
    
    
    1,077,120All
      other countries
    
    
    1,548,344
    
    
    1,166,175
    
    
    1,140,928$
    46,146,284
    
    $
    41,712,191
    
    $
    39,728,615





Geographic
sales information is based on the location of the customer. Net sales from no
single foreign country was material to the Company’s consolidated net sales for
the years ended December 31, 2004, 2003, and 2002. The Company does not have any
significant long-lived assets outside of the United States.





**13.
RECENT ACCOUNTING PRONOUNCEMENTS**





In April
2002, the FASB issued Statement of Financial Accounting Standards No. 145, *Rescission
of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and
Technical Corrections* . This
statement provides guidance on the classification of gains and losses from the
extinguishment of debt and on the accounting for certain specified lease
transactions. The adoption of this statement did not have a material impact on
the Company's current financial position and results of operations.







In
July 2002, the FASB issued Statement of Financial Accounting Standards No. 146, *Accounting
for Costs Associated with Exit or Disposal Activities* (SFAS
No. 146). SFAS 146 nullifies FASB Emerging Issues Task Force (EITF) Issue No.
94-3, "Liability Recognition for Certain Employee Termination Benefits and Other
Costs to Exit an Activity (including Certain Costs Incurred in a
Restructuring)". It requires that a liability be recognized for those costs only
when the liability is incurred, that is, when it meets the definition of a
liability in the FASB's conceptual framework. SFAS No. 146 also establishes fair
value as the objective for initial measurement of liabilities related to exit or
disposal activities. SFAS 146 is effective for exit or disposal activities
initiated after December 31, 2002. The adoption of this statement did not have a
material impact on the Company's financial position and results of
operations.







In
January 2003, the FASB issued FIN 46, Consolidation of Variable Interest
Entities, an Interpretation of Accounting Research Bulletin No. 51. FIN 46
requires certain variable interest entities to be consolidated by the primary
beneficiary of the entity if the equity investors in the entity do not have the
characteristics of a controlling financial interest or do not have sufficient
equity at risk for the entity to finance its activities without additional
subordinated financial support from other parties. FIN 46 is effective
immediately for all new variable interest entities created or acquired prior to
February 1, 2003, the provision of FIN must be applied for the first interim or
annual period beginning after June 15, 2003. The adoption of FIN 46 did not have
a material effect on its financial position or results of operations.





In
December 2004, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 123R, "Share-Based
Payment." SFAS No. 123R is a revision of SFAS No. 123, "Accounting for Stock
Based Compensation," and supercedes APB Opinion No. 25. Among other items, SFAS
No. 123R eliminates the use of APB 25 and the intrinsic value method of
accounting, and requires companies to recognize the cost of employee services
received in exchange for awards of equity instruments, based on the grant date
fair value of those awards, in the financial statements. The effective date of
SFAS No. 123R for the Company is the third quarter of 2005. SFAS no. 123R
permits companies to adopt its requirements using either a "modified
prospective" method, or a "modified retrospective" method. Under the "modified
prospective" method, compensation cost is recognized in the financial statements
beginning with the effective date, based on the requirements of SFAS No. 123R
for all share-based payments granted after that date, and based on the
requirements of SFAS No. 123 for all unvested awards granted prior to the
effective date of SFAS No. 123R. Under the "modified retrospective" method, the
requirements are the same as under the "modified prospective" method, but also
permits entities to restate financial statements of previous periods, either for
all prior periods presented or to the beginning of the fiscal year in which the
statement is adopted, based on previously pro forma disclosure made in
accordance with SFAS No. 123. The Company has not yet determined which of the
methods it will use upon adoption.





42





The
Company currently utilizes the Black-Scholes option pricing model to measure the
fair value of stock options granted to employees. While SFAS No. 123R permits
entities to continue to use such a model, it also permits the use of a "lattice"
model. The Company expects to continue using the Black-Scholes option pricing
model upon adoption of SFAS No. 123R to measure the fair value of stock options.
The adoption of this statement will have the effect of reducing net income and
income per share as compared to what would be reported under the current
requirements. These future amounts cannot be precisely estimated because they
depend on, among other things, the number of options issued in the future, and
accordingly, the Company has not determined the impact of adoption of this
statement on its results of operations.





SFAS No.
123R also requires that the benefits associated with the tax deductions in
excess of recognized compensation cost be reported as a financing cash flow,
rather than as an operating cash flow as required under current literature. This
requirement will reduce net operating cash flows and increase net financial cash
flows in periods after the effective date. These future amounts cannot be
estimated, because they depend on, among other things, when employees exercise
stock options.





**14.
QUARTERLY FINANCIAL DATA (UNAUDITED)**





First
    
    Second
    
    Third
    
    Fourth**2004**
    
    Quarter
    
    Quarter
    
    Quarter
    
    QuarterNet
      sales
    
    $
    12,180,877
    
    $
    10,959,813
    
    $
    10,580,074
    
    $
    12,425,520Gross
      profit
    
    
    6,724,913
    
    
    5,981,059
    
    
    5,939,433
    
    
    6,794,640Net
      income
    
    
    970,966
    
    
    516,213
    
    
    427,385
    
    
    739,477Net
      income per common share:Basic
    
    
    0.09
    
    
    0.05
    
    
    0.04
    
    
    0.07Diluted
    
    
    0.09
    
    
    0.05
    
    
    0.04
    
    
    0.07Weighted
      average number of common shares outstanding:Basic
    
    
    10,506,995
    
    
    10,553,243
    
    
    10,560,661
    
    
    10,554,776Diluted
    
    
    11,011,122
    
    
    11,006,638
    
    
    10,931,940
    
    
    10,888,883





First
    
    Second
    
    Third
    
    Fourth**2003**
    
    Quarter
    
    Quarter
    
    Quarter
    
    QuarterNet
      sales
    
    $
    10,560,085
    
    $
    10,460,675
    
    $
    10,119,070
    
    $
    10,572,361Gross
      profit
    
    
    5,645,504
    
    
    5,721,054
    
    
    5,589,812
    
    
    5,735,528Net
      income
    
    
    774,518
    
    
    778,704
    
    
    601,680
    
    
    585,472Net
      income per common share:Basic
    
    
    0.08
    
    
    0.08
    
    
    0.06
    
    
    0.06Diluted
    
    
    0.07
    
    
    0.07
    
    
    0.06
    
    
    0.05Weighted
      average number of common shares outstanding:Basic
    
    
    10,177,433
    
    
    10,234,054
    
    
    10,394,374
    
    
    10,484,184Diluted
    
    
    10,793,464
    
    
    10,805,019
    
    
    10,902,794
    
    
    10,941,853








43










**REPORT
OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**








The Board
of Directors and Stockholders


The
Leather Factory, Inc. and Subsidiaries





We have
audited the accompanying consolidated balance sheets of The Leather Factory,
Inc. and Subsidiaries as of December 31, 2004 and 2003, and the related
consolidated statements of income, stockholders' equity, and cash flows for each
of the two years then ended in the period ended December 31, 2004. These
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.





We
conducted our audit in accordance with the standards of the Public Accounting
Oversight Board (United States). Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.





In our
opinion, the consolidated financial statements referred to above present fairly,
in all material respects, the consolidated financial position of the Company as
of December 31, 2004 and 2003, and the consolidated results of its operations
and its cash flows for each of the two years in the period ended December 31,
2004, in conformity with accounting principles generally accepted in the United
States of America.








Weaver
& Tidwell LLP








Fort
Worth, Texas


February
11, 2005





4318







44
 
 ****
 **REPORT
OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**








The Board
of Directors


The
Leather Factory, Inc.





We have
audited the accompanying consolidated statements of operations, stockholders'
equity, and cash flows of The Leather Factory, Inc. for the year ended December
31, 2002. These financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial
statements based on our audits.





We
conducted our audit in accordance with auditing standards generally accepted in
the United States of America. Those standards require that we plan and perform
the audits to obtain reasonable assurance about whether the financial statements
are free of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements. An
audit also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audit provides a reasonable basis
for our opinion.





In our
opinion, the consolidated financial statements referred to above present fairly,
in all material respects, the consolidated results of operations and cash flows
of The Leather Factory, Inc. for the year ended December 31, 2002, in conformity
with accounting principles generally accepted in the United States of America.








Hein +
Associates LLP








Dallas,
Texas


February
6, 2003








45




**ITEM
9. CHANGE IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
DISCLOSURE**





None





**ITEM
9A. CONTROLS AND PROCEDURES**





At the
end of 2004, our President, Chief Executive Officer and Chief Financial Officer
evaluated the effectiveness of the design and operation of our disclosure
controls and procedures pursuant to Rule 13a-15(b) under the Securities Exchange
Act of 1934, as amended. Based upon this evaluation, they concluded that,
subject to the limitations described below, our disclosure controls and
procedures offer reasonable assurance that the information required to be
disclosed by us in the reports we file under the Exchange Act is recorded,
processed, summarized, and reported within the time periods specified in the
rules and forms adopted by the Securities and Exchange Commission.





During
the period covered by this report, there has been no change in our internal
controls over financial reporting that materially affected, or is reasonably
likely to materially affect, these controls.





*Limitations
on the Effectiveness of Controls.* Our
management, including the President, Chief Executive Officer and Chief Financial
Officer, does not expect that our disclosure controls and procedures will
prevent all error and all fraud. A well conceived and operated control system is
based in part upon certain assumptions about the likelihood of future events and
can provide only reasonable, not absolute, assurance that the objectives of the
control system are met. Further, the design of a control system must reflect the
fact that there are resource constraints, and the benefits of controls must be
considered relative to their costs.





**ITEM
9B. OTHER INFORMATION**





None








**PART
III**





Certain
information required by Part III is omitted from this annual report as we will
file a proxy statement for our 2005 Annual Meeting of Stockholders, pursuant to
Regulation 14A of the Securities Exchange Act of 1934, as amended, not later
than 120 days after the end of our fiscal year covered by this Report, and
certain information included in that proxy statement is incorporated herein by
reference.





**ITEM
10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT**





The
information required by this item is contained under the heading "Executive
Officers of the Registrant" in Part I of this Annual Report on Form 10-K, and
the remainder is contained in our proxy statement for our 2005 Annual Meeting of
Stockholders under the heading "Election of Directors," and is incorporated
herein by reference. Information relating to certain filings on Forms 3, 4 and 5
will be contained in our 2005 proxy statement under the heading "Section 16(a)
Beneficial Ownership Reporting Compliance," and is incorporated herein by
reference. Information required by this item pursuant to Items 401(h), 401(i)
and 401(j) of Regulation S-K relating to an audit committee financial expert,
the identification of the audit committee of our board of directors and
procedures of security holders to recommend nominees to our board of directors
will be contained in our 2005 proxy statement under the heading "Corporate
Governance" and is incorporated herein by reference.





46





We
have adopted a written code of ethics that applies to our employees, including
our principal executive officer, principal financial officer, principal
accounting officer, controller, or persons performing similar functions. 
It is available on our website (http://www.leatherfactory.com).





**ITEM
11. EXECUTIVE COMPENSATION**





The
information required by this item is contained in our proxy statement for our
2005 Annual Meeting of Stockholders under the heading "Executive Compensation,”
which is incorporated herein by reference.





**ITEM
12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED
STOCKHOLDER MATTERS**





The
information required by this item is contained in our proxy statement for our
2005 Annual Meeting of Stockholders under the heading "Security Ownership of
Certain Beneficial Owners and Management," which is incorporated herein by
reference.





**ITEM
13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS**





The
information required by this item is contained in our proxy statement for our
2005 Annual Meeting of Stockholders under the heading "Certain Transactions and
Related Transactions” and is incorporated herein by reference.





**ITEM
14. PRINCIPAL ACCOUNTANT FEES AND SERVICES**





The
information required by this item is contained in our proxy statement for our
2005 Annual Meeting of Stockholders under the heading "Independent Auditors Fees
and Other Matters" and is incorporated herein by reference.





**PART
IV**





**ITEM
15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM
8-K**





(a) The
following are filed as part of this Annual Report on Form 10-K:





*1.*
    *Financial
      Statements*





The
following consolidated financial statements are included in Item 8:





·
    Consolidated
      Balance Sheets at December 31, 2004 and
2003


·
    Consolidated
      Statements of Income for the years ended December 31, 2004, 2003 and
      2002


·
    Consolidated
      Statements of Cash Flows for the years ended December 31, 2004, 2003 and
      2002


·
    Consolidated
      Statements of Stockholders' Equity for the years ended December 31, 2004,
      2003 and 2002





*2.*
    *Financial
      Statement Schedules*





47





All
financial statement schedules are omitted because the required information is
not present or not present in sufficient amounts to require submission of the
schedule or because the information is reflected in the consolidated financial
statements or notes thereto.





*3.*
    *Exhibits*





The
exhibits listed in the Exhibit Index immediately preceding such exhibits are
filed as part of this Annual Report on Form 10-K.





**SIGNATURES**





Pursuant
to the requirements of Section 13 or 15(d) of the Securities Exchange Act of
1934, the Registrant has duly caused this Annual Report on Form 10-K to be
signed on its behalf by the undersigned, thereunto duly authorized.





**THE
      LEATHER FACTORY, INC.**By:
    /s/
      Wray Thompson**Wray
      Thompson****Chairman
      of the Board and Chief Executive Officer**By:
    /s/
      Shannon L. Greene**Shannon
      L. Greene****Chief
      Financial Officer, Chief Accounting Officer and
      Treasurer**


Dated:
March 30, 2005





In
accordance with the Securities Exchange Act of 1934, this Report has been signed
below by the following persons on behalf of the Company and in the capacities
and on the dates indicated.





**Signature**
    **Title**
    **Date**/s/
      Wray Thompson
    Chairman of the Board, Chief Executive Officer and
Director
    March
      30, 2005**Wray
      Thompson**/s/
      Shannon L. Greene
    Chief Financial Officer, Chief Accounting Officer, Treasurer and
      Director
    March
      30, 2005**Shannon
      L. Greene**/s/
      T. Field Lange
    Director
    March
      30, 2005**T.
      Field Lange**/s/
      Joseph R. Mannes
    Director
    March
      30, 2005**Joseph
      R. Mannes**/s/
      H.W. Markwardt
    Director
    March
      30, 2005**H.W.
      Markwardt**/s/
      Michael A. Markwardt
    Director
    March
      30, 2005**Michael
      A. Markwardt**/s/
      Ronald C. Morgan
    President and Director
    March
      30, 2005**Ronald
      C. Morgan**/s/
      Robin L. Morgan
    Vice President and Assistant Secretary
    March
      30, 2005**Robin
      L. Morgan**/s/
      Michael A. Nery
    Director
    March
      30, 2005**Michael
      A. Nery**/s/
      William M. Warren
    Secretary
    March
      30, 2005**William
      M. Warren**




48


**THE
      LEATHER FACTORY, INC. AND SUBSIDIARIES**
      **EXHIBIT
      INDEX****Exhibit**
      **Number**
    ****
      ******Description**3.1
    Certificate
      of Incorporation of The Leather Factory, Inc., filed as Exhibit 3.1 to the
      Registration Statement on Form SB-2 of The Leather Factory, Inc.
      (Commission File No. 33-81132) filed with the Securities and Exchange
      Commission on July 5, 1994, and incorporated by reference
      herein.3.2
    Bylaws
      of The Leather Factory, Inc., filed as Exhibit 3.2 to the Registration
      Statement on Form SB-2 of The Leather Factory, Inc. (Commission File No.
      33-81132) filed with the Securities and Exchange Commission on July 5,
      1994 and incorporated by reference herein.4.1
    Financial
      Advisor's Warrant Agreement, dated February 12, 2003, between The Leather
      Factory, Inc. and Westminster Securities Corporation filed as Exhibit 4.1
      to Form 10-Q filed by The Leather Factory, Inc. with the Securities and
      Exchange Commission on May 14, 2003 and incorporated by reference
      herein.4.2
    Capital
      Markets Services Engagement Agreement, dated February 12, 2003, between
      The Leather Factory, Inc. and Westminster Securities Corporation filed as
      Exhibit 4.2 to Form 10-Q filed by The Leather Factory, Inc. with the
      Securities and Exchange Commission on May 14, 2003 and incorporated by
      reference herein.4.3
    Financial
      Advisor's Warrant Agreement, dated February 24, 2004, between The Leather
      Factory, Inc. and Westminster Securities Corporation filed as Exhibit 4.1
      to Form 10-Q field by The Leather Factory, Inc. with the Securities and
      Exchange Commission on May 14, 2004 and incorporated by reference
      herein.4.4
    Capital
      Markets Services Engagement Agreement, dated February 24, 2004, between
      The Leather Factory, Inc. and Westminster Securities Corporation filed as
      Exhibit 4.2 to Form 10-Q field by The Leather Factory, Inc. with the
      Securities and Exchange Commission on May 14, 2004 and incorporated by
      reference herein.10.1
    Credit
      Agreement, dated as of November 3, 2003, made by and among The Leather
      Factory, Inc., a Delaware corporation; Roberts, Cushman & Company,
      Inc., a New York corporation; Hi-Line Leather & Manufacturing Company,
      a California corporation, The Leather Factory of Nevada Investments, Inc.,
      a Nevada corporation, The Leather Factory, Inc., a Nevada corporation; The
      Leather Factory, L.P., a Texas limited partnership; The Leather Factory,
      Inc., an Arizona corporation; Tandy Leather Company Investments, Inc., a
      Nevada corporation; Tandy Leather Company, Inc., a Nevada corporation;
      Tandy Leather Company, L.P., a Texas limited partnership; andWells
      Fargo Bank Texas, National Association filed as Exhibit 10.1 to the
      Current Report on Form 8-K of The Leather Factory, Inc. (Commission File
      No. 1-12368) filed with the Securities and Exchange Commission on November
      7, 2003 and incorporated by reference
herein.
   49
 10.2
    Revolving
      Line of Credit Note, dated November 3, 2003, in the principal amount of up
      to $6,000,000.00 given by The Leather Factory, Inc., a Delaware
      corporation; Roberts, Cushman & Company, Inc., a New York corporation;
      Hi-Line Leather & Manufacturing Company, a California corporation, The
      Leather Factory of Nevada Investments, Inc., a Nevada corporation, The
      Leather Factory, Inc., a Nevada corporation; The Leather Factory, L.P., a
      Texas limited partnership; The Leather Factory, Inc., an Arizona
      corporation; Tandy Leather Company Investments, Inc., a Nevada
      corporation; Tandy Leather Company, Inc., a Nevada corporation; Tandy
      Leather Company, L.P., a Texas limited partnership, as borrowers, payable
      to the order of Wells Fargo Bank Texas, National Association, filed as
      Exhibit 10.2 to the Current Report on Form 8-K of The Leather Factory,
      Inc. (Commission File No. 1-12368) filed with the Securities and Exchange
      Commission on November 7, 2003 and incorporated by reference
      herein.10.3
    First
      Amendment to Credit Agreement, dated as of November 26, 2003, made by and
      among The Leather Factory, Inc., a Delaware corporation; Roberts, Cushman
      & Company, Inc., a New York corporation; Hi-Line Leather &
      Manufacturing Company, a California corporation, The Leather Factory of
      Nevada Investments, Inc., a Nevada corporation, The Leather Factory, Inc.,
      a Nevada corporation; The Leather Factory, L.P., a Texas limited
      partnership; The Leather Factory, Inc., an Arizona corporation; Tandy
      Leather Company Investments, Inc., a Nevada corporation; Tandy Leather
      Company, Inc., a Nevada corporation; Tandy Leather Company, L.P., a Texas
      limited partnership; andWells
      Fargo Bank, National Association, successor by merger to Wells Fargo Bank
      Texas, National Association, filed as Exhibit 10.3 to Annual Report on
      Form 10-K of The Leather Factory, Inc. (Commission File No. 1-12368) filed
      with the Securities and Exchange Commission on March 29, 2004 and
      incorporated by reference herein.10.4
    First
      Modification to Promissory Note, dated as of November 26, 2003, made by
      and among The Leather Factory, Inc., a Delaware corporation; Roberts,
      Cushman & Company, Inc., a New York corporation; Hi-Line Leather &
      Manufacturing Company, a California corporation, The Leather Factory of
      Nevada Investments, Inc., a Nevada corporation, The Leather Factory, Inc.,
      a Nevada corporation; The Leather Factory, L.P., a Texas limited
      partnership; The Leather Factory, Inc., an Arizona corporation; Tandy
      Leather Company Investments, Inc., a Nevada corporation; Tandy Leather
      Company, Inc., a Nevada corporation; Tandy Leather Company, L.P., a Texas
      limited partnership; andWells
      Fargo Bank, National Association, successor by merger to Wells Fargo Bank
      Texas, National Association, filed as Exhibit 10.4 to Annual Report on
      Form 10-K of The Leather Factory, Inc. (Commission File No. 1-12368) filed
      with the Securities and Exchange Commission on March 29, 2004 and
      incorporated by reference herein.10.5
    Credit
      Agreement, dated as of October 6, 2004, made by The Leather Factory, Inc.,
      a Delaware corporation, and Bank One, National Association, filed as
      Exhibit 10.1 to the Current Report on Form 8-K of The Leather Factory,
      Inc. (Commission File No. 1-12368) filed with the Securities and Exchange
      Commission on November 5, 2004 and incorporated by reference
      herein.10.6
    Line
      of Credit Note, dated October 6, 2004, in the principal amount of up to
      $3,000,000 given by The Leather Factory, Inc., a Delaware corporation as
      borrower, payable to the order of Bank One, National Association, filed as
      Exhibit 10.2 to the Current Report on Form 8-K of The Leather Factory,
      Inc. (Commission File No. 1-12368) filed with the Securities and Exchange
      Commission on November 5, 2004 and incorporate by reference
      herein.
   50
  14.1
    Code
      of Business Conduct and Ethics of The Leather Factory, Inc., adopted by
      the Board of Directors on February 26, 2004, filed as Exhibit 14.1 to
      Annual Report on Form 10-K of The Leather Factory, Inc. (Commission File
      No. 1-12368) filed with the Securities and Exchange Commission on March
      29, 2004 and incorporated by reference herein.21.1
    Subsidiaries
      of the Company filed as Exhibit 21.1 to the Annual Report on Form 10-K of
      The Leather Factory, Inc. for the year ended December 31, 2002 filed with
      the Securities and Exchange commission on March 28, 2003, and incorporated
      by reference herein.*23.1
    Consent
      of Hein + Associates LLP dated March 28, 2005*23.2
    Consent
      of Weaver & Tidwell LLP dated March 28, 2005*31.1
    13a-14(a)
      Certification by Wray Thompson, Chairman of the Board and Chief Executive
      Officer*31.2
    13a-14(a)
      Certification by Shannon Greene, Chief Financial Officer and
      Treasurer*32.1
    Certification
      Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of
      the Sarbanes-Oxley Act of 2002______________*Filed
      herewith.




51