Sanderson Design Group - $SDG.L – A License to Kill (Mediocrity)

SDG are a UK fabric and wallpaper designer and manufacturer who own a number of historical British brands.

Sanderson Design Group have come to my attention over the last few weeks following reading a write up from Adrian Ford on Substack which I highly recommend. I am going to try summarise my personal thoughts on the company and why it interests me. As per usual, I am an idiot on the internet and my personal thoughts should not be taken as investment advice.

Intro

For many years SDG could be described as a subpar business generating below average returns to average returns on a cyclical basis. Their core business is the manufacture of wallpaper and fabrics which mostly serves the UK domestic market, not very exciting. They manufacture and sell wallpaper and fabrics under several brand names including Sanderson which has existed since 1860. Before the current CEO arrived, SDG were in a difficult situation with their strategy. The management team at the time were attempting to combine all their brand IP rather than pursue brand individualism. This was evidently a bad strategy and limited the company’s ability to market its product lines effectively, confusing customers. This write up will discuss the current state of the group, how its manufacturing segment is more attractive than at first glance and how the group’s success overall can be achieved over the long term by continuing to sign contracts for its vast IP library to be licensed out to some of the worlds biggest retailers. If you want a focused write on up the licencing segment (the most attractive part of the company), I would once again direct your towards Adrian’s work.

Business History and Concerns

As mentioned, Sanderson, the namesake of Sanderson Design Group, have existed since 1860. However SDG own a number of other brands that market themselves at different customer price points and tastes. As well as Sanderson these include Zoffany, Morris & Co, Clarke & Clarke, Harlequin and Scion. You don’t have to be an interior design expert to know this is a good portfolio of companies to be able to draw on for designs and allows the company to pivot with consumer trends, tapping into both more modern designs and traditional ones such as traditional botanical designs which are experiencing a growth in popularity. I would advise you to check out the various websites of each brand which showcase a wide range of furnishings which appeal to different tastes in the luxury market. As the consumer market in the UK continues to trend towards more individualism and colours from the very plain designs of the last 20 years, SDG seems well placed to continue being a market leader thanks to their extensive IP and brand history. As well as manufacturing for their own brands, SDG also manufacture wallpaper and fabrics for their competitors in the UK market. They own 2 separate manufacturers.

-          The Anstey Wallpaper Company which has existed for over 100 years and supplied their wallpaper designs to the Royal Family.

-          Standfast & Barracks who manufacture their fabric designs and have been in existence for over 90 years and was also visited and approved by a member of the Royal Family.

The other segment of the business is its licencing business which involves SDG selling their design IP to be used by brands for their own products, think lamps, cushions and bedsheets. This has performed very well since being started in 2019 and has steadily grown its brand and geographic mix. America will continue to be the biggest driver of growth for this area.

So what issues have SDG historically faced? Well, their core business of manufacturing is cyclical. Home furnishing spending is linked to house prices and the economy as a whole. When consumer demand weakens, the group suffer. Despite being a more high-end focussed company, they are not immune to these swings in demand. To illustrate the cyclicality of the industry, take a look at the ROIC chart for one of its competitors, Colefax. The reason I am using Colefax’s as an example of industry trends is they have had a more stable operating history and do not have the manufacturing and licencing segments that SDG have which impact their ROIC numbers, providing a more isolated illustration of the cycle of the industry. If you bring up the chart you will see they experience 1-2 year periods of depressed returns balanced out by increased returns on their money for 1-2 year periods. My focus is understanding if the current management at SDG can flatten this curve going forward as well as keep it on an uptrend. A large part of doing this will be the licencing revenue (we will expand on this later) which goes to straight to the bottom line, pulling their returns upwards. UK demand may not always mimic that of international markets and having the ability to diversify your income across geographies will be key to more consistent ROIC numbers. What I want to avoid is this great source of licencing revenue hiding poor performance from the manufacturing segment. Since the new management took over in 2019, there has been a focus on making sure the 2 manufacturing plants are run as efficiently as possible. It is worth noting that Colefax are a customer of SDG, as are many of their competitors.

SDG’s involvement in manufacturing does mean that they take on the stock risk of their products themselves unlike Colefax who outsource their manufacturing and therefore can be more flexible. They are also exposed to the price inflation of raw materials and if I’m honest I don’t think these risks are worth it for what SDG get in return. The long history of both plants and their respective royal connections clearly are a major factor in SDG being reluctant to cut them loose. I do understand that in the luxury segment, storytelling is a big part of the offering and their ownership of these two historic manufacturing plants are part of the brands storytelling, but SDG clearly need to do a better job at cost control and making the business worth their time. My concern is that it will take up too much of management time when they should be focusing on international expansion, particularly through licencing.

If SDG can demonstrate clear measures to control costs and also use their strategic advantage of manufacturing for their competitors effectively, this may be a different story. It must be said that the industry clearly has gone through a hard 5 years. Back in 2018 the group had not yet begun licencing out its designs and was a pure manufacturing play. They still managed to do 18% ROIC, 17p in EPS and nearly 8.5% OMs. The company are not particularly aggressive in pricing with their competitors and therefore do not use this advantage at present but clearly this is hard to do during a weak sales environment. A question must be asked if your competitors are completely fine with allowing you to produce their products. You are either not charging them enough or providing them a lot of value while taking on a lot of risk. In SDG’s case it seems like it is a bit of both. In an ideal world, I would like to see SDG both significantly more efficient in their own manufacturing and more aggressive with pricing for their competitors. I would like to do some digging with management on the economics of their competitors outsourcing production to them and if there is scope for price raises. This will be a key part of my thesis on the manufacturing side. A lack of ability to cost save or upcharge competition for production will mean these factories continue to be an unimpressive factor of an impressive brand.

Management

Lisa Montague took over the company as CEO in 2019. She gave an interview in late 2023 with the Business of Home Podcast which I highly recommend listening to. In the interview she explained her background with the LVMH group and how she views Sanderson as its CEO. She is certainly an interesting choice to lead the company with a slightly different background to the Home Furnishings sector. She worked at Mulberry for 9 years during a turnaround period and most recently to her current role, worked as CEO of the LVMH owned Loewe group, the oldest fashion house in the group’s portfolio. Lisa speaks very positively of her time there and stresses the amount she learned from being within such a behemoth of an organisation with such high operating standards as well as being able to work alongside the Arnolt family. As a shareholder, I think this is certainly an interesting selling point to be able to invest in a company guided by someone who is a disciple of the LVMH school of management at such a small market cap. Lisa also highlighted in the interview the benefits of working in a much slower paced environment of Home Design, which does not have the pressure of meeting season to season deadlines for its products. She feels SDG allow their designers and team to get things absolutely perfect before release, which is a luxury (no pun intended) that the fashion brands on her resume do not have with clear seasonal deadlines. SDG can release products when they want and the priority is producing them to the best of their ability.

Lisa also stressed the importance of their brands an in particular highlighted in her interview, the brand cachet that Morris Co have - as William Morris, the brands founder, is considered in her words ‘the father of interior design.’ The challenge for a company like SDG, much like the luxury historical brands she has worked for in the fashion industry, is to modernise these historic brands to appeal to the modern customer without destroying their history which is what gives the brand value, something which licencing their designs has allowed them to do. As well as this, Lisa stressed her view of the need to continually invest in updated printing technology, both to provide cost efficiencies and to work towards their goal of net zero by 2030 which they are ahead of schedule on. These measures should help SDG use less power and water, providing useful cost savings along with the green benefits. Digital Fabric printing in particular should provide a lot of cost savings by reducing the need for harsh chemicals used in traditional methods and allowing them to print only what they need, reducing waste.  

Expansion and Licensing

Any real value in this company going forward is in their US expansion. In the above referenced interview Lisa described the groups lack of presence in the US as ‘inconceivable’ and explained that really there were no excuses to not have a strong brand presence there. Part of this was put down to a lack of consumer awareness of their products, mostly due to the strange operating structure and use (or lack thereof) of the US subsidiary prior to her arrival. Consumers were therefore unaware of brands such as Clarke & Clarke or Morris Co meaning they made little impression on the interior design market stateside. A lot of work has been done under her tenure in cleaning up the brand identities and decluttering their offering which has not only helped their UK business but sets them up for growth in America with clear appeal to the average consumer and interior designers. Lisa was very candid about the relative inexperience they have when it comes to the US market but explained that they are constantly learning. The home furnishings industry is relatively devoid of performance indicators and datasets to make operational decisions, in part due to the slow moving nature as mentioned earlier – people are not changing their wallpaper every 6 months for you to spot trends in where the overall industry is going. This means there are not nearly as many KPIs on which companies like SDG can make key decisions on, meaning that everything they are getting through from their US operations are invaluable to understanding what works and what doesn’t. This includes information about consumer behaviour differences state to state and Lisa seemed very aware of key differences in the tastes of each individual area they are currently active in the US. This is a nuance that they will have to figure out over time but also illustrates the value to their licencing model’s growth to get their brand name out there through already established players like Williams Sonoma.

Of course, licensing on its own is a huge part of the growth they will see in the US and worldwide, not only because of its ability to generate cash but also due to its ability to raise brand awareness, in turn generating more demand for its IP, increasing sales. Huge companies like Williams Sonoma in the US and John Lewis in the UK have partnered with SDG on licencing deals, getting SDG brand designs used for their products which effectively acts as free advertising for their huge portfolio of IP. SDG’s Disney collaboration was hugely successful and Lisa mentioned they were shocked by the amount of sampling orders they had from consumers and hoped to turn these into real orders. I will be keenly monitoring the growth of their US footprint, with showrooms a key indicator as well as ongoing announcements of new licensing deals they sign with companies in the US. Just to stress, this is basically free money. All SDG need is to approach a company or be approached and negotiate a fee before allowing them to use their designs which are already in existence. No design work is required and this deal simply allows a company to use their IP. If they continue to grow well in America, this could prove to add multiples of its current value to the bottom line providing the biggest upside opportunity for the group.

Valuation

I’m not really big on concrete valuations for stocks I’m interested in but rather prefer invest in things that are just clearly undervalued. SDG currently trades at a PE of under 8, and EV/EBITDA of 3 with Cash on its books of over 16 Million with just over 5 Million in debt. This very reasonable valuation is one reason why I think they could be a takeout candidate. The good news is that management clearly see the value of the licensing model and are doing what they can to grow this. This business is far more valuable than the manufacturing side. I honestly would not pay over a PE of 3 for the manufacturing side which is highly cyclical and not particularly profitable. The licencing business however easily warrants a PE of over 20 in my view with great margins and growth prospects. I would say the combined business in its current state deserves a rerate to 15 when the market understands the value of the brands and how this is being monetised by the company. Especially with the continued growth of the international market as well as contracts signed with brands such as John Lewis, the market will begin to see how the brand have transformed themselves under the current management. Another key factor will be diversifying this revenue among various brands both in the UK and in the US and continuing to renew these contracts to show their long-term durability. If management can do this, people will begin to wake up. They have already shown progress over the last 5 years with initial short term deals developing into multi year contracts, a huge positive. If this growth coincides with good trading conditions for the manufacturing segment, the share price gain could be even more than anticipated. My hope is that SDG will be an easy double (Still below its 2021 highs) and that it will continue its growth over the long term.

With net cash and the prospects of the licencing segment being very attractive, I think it is clear that SDG is undervalued. My one slight concern is what they will do with this surplus cash. I personally would like to see buybacks (would you believe) as this would illustrate management confidence in their plan and likely the best use of their money given a lack of a clear acquisition at this moment. As unlikely as this is for any UK micro-cap, I would still like to ask management to consider this, especially at their low valuation. If we take their 2018 EPS of 17p, that would put them at a PE of under 5. These earnings as already mentioned were done prior to the start of the licencing segment which is the main attraction to the business for me. This illustrates the possible upside and also the margin of safety provided by earnings for the manufacturing side returning to normal levels. A return to earnings in this range with additional earnings of 11 EPS last year which was essentially entirely made up of licensing revenue gives you a total of 28p per share, a PE of under 3. I’m not expecting the stars to align with everything firing at all cylinders all at once but even if we conservatively expect 20p EPS to be achieved at some point within the next few years, you get a PE of just over 4 before any growth of licencing, US sales increases or multiple expansion to my suggested fair PE of 15. Good value here for sure.

I am slightly worried by the lack of insider ownership from the board and key managers. In total insiders own just over 0.7% of the float and particularly it is hard to pitch things such as buybacks to managers who are not significant shareholders. I can understand if the lack of significant insider shareholders puts you off and this is understandable. I do feel however that at such a low valuation this risk is minimised and Lisa in particular seems to have done a good job turning the business around over the last 5 years despite the challenging circumstances. The licensing revenue also protects against management incompetence as it does not require a great CEO to execute these agreements as it is so low maintenance. As Buffett would say, the licencing segment could quite literally be run by a complete idiot and you probably would not notice as it self advertises and customers approach you. The danger is the aforementioned concern that Lisa and her team will focus too much on the 2 manufacturing sites and invest money here without adequate returns. I would say that in my view the benefits of digital printing clearly add value and therefore I cannot be that upset at further investments in this area at least in the short term and in theory should preserve the value of the group’s manufacturing plants if they were ever sold.

Conclusion

I think if you were a private equity company you would be looking at SDG with a great deal of interest, but not because of the manufacturing segment at all. I think it is possible that a company would see the potential of the licencing segment and put in a substantial offer for SDG and then sell off the manufacturing divisions. I struggle to see a world where SDG do this themselves. Despite this, I think there is a future where this licencing revenue shines through and the manufacturing business becomes passable as a minor, tolerable inconvenience of owning a great and durable IP portfolio with worldwide reach. My job is to make sure that the manufacturing segment does not destroy the incredible value that is in SDG’s IP. From my research, I think it is highly likely that SDG grow their revenues significantly over the next 10 years and I am presented with an opportunity to buy it at trough sentiment with potential for a uptick in earnings within the next 2 years from their core business as well as the potential for investors to notice their 65% gross margins and wonder how on earth a wallpaper and fabrics manufacturing company have achieved such a thing.