Join our community of smart investors

Worse yet to come at Pearson

Poor earnings forecasts and a dividend cut have created a bleak outlook for Pearson investors
January 26, 2017

A little over 20 years ago Pearson (PSON) was a media empire built through acquisition and investment in a large number of distinct businesses. But, gradually, parts have dropped off. In 1995 Pearson sold its 17.5 per cent stake in Sky (SKY) when the broadcaster - then BSkyB - floated. In 2011 its remaining stake in index provider FTSE International was sold to the London Stock Exchange (LSE). And in 2015 it sold the FT Group (the publisher of this magazine) and The Economist. Now management is hoping to sell its 47 per cent share of Penguin Random House, the world's biggest book publisher.

IC TIP: Sell at 589p
Tip style
Sell
Risk rating
Medium
Timescale
Long Term
Bull points
  • Stable balance sheet
  • Recovery plan of action in place
Bear points
  • Slow to adapt to digital
  • Textbook rental market challenge
  • Costs from business realignment
  • 2017 dividend cut

What's left is an education group specialising in textbooks and assessment with a key geographical focus in North America, which made up 62 per cent of last year's sales and 70 per cent of profit. But rapidly changing market conditions means this is an industry that management may wish it hadn't put all its weight behind. In the US, a good jobs market means lower college enrolment, while the number of people taking free online courses is on the rise. Meanwhile, high textbook prices are driving students to rentals or piracy and sites such as Amazon (US:AMZ) and eBay (US:EBAY) have facilitated a boom in second-hand sales.

Pearson is not facing these struggles alone; a number of US peers cited a decline in higher education enrolment as the reason for their own poor results. However, others seem to have better managed the pivotal transition to digital publishing. UK peers including Relx (REL) and Informa (INF) now offer most of their materials in digital form as well as in print, while the chief executive of US publishing behemoth McGraw-Hill Education thinks that textbooks no longer matter. But for Pearson print publishing still accounts for about half of North American sales.

And so, perhaps unsurprisingly, trading at the FSTE 100 group has not been good. The most recent profit warning revealed that Pearson would only make its 2016 profit targets because management cut £55m-worth of staff bonuses. Underlying profitability is £180m lower than the group had previously expected. The North American higher education courseware division has had a particularly dismal time, with net revenue falling 30 per cent in the final quarter.

 

 

Pearson blames a lot of this drop on an inventory correction which it was forced to make after book retailers wrongly ordered stock. But inventory visibility is likely to remain poor due to the rise in the second-hand textbook market. Broker Liberum has cited the issue as the cause of a "red flag" due to the estimation involved in a number of Pearson's contracts (such as the expected number of book returns in a year) creating a material amount of risky deferred revenue.

Looking forward, Pearson has pencilled in 2017 operating profit at between £570m and £630m. But with a record of five profit warnings in four years, it is hard to be very confident in the guidance, especially without the Penguin Random House contribution. Dividends from the group's 47 per cent stake in the publisher added £90m to operating profit in 2015.

What's even more concerning for shareholders is the news that Pearson is going to cut its dividend to better reflect its EPS. Taking the midpoint of the 2017 earnings guidance at 52p and an assumed two times dividend cover would mean a halving of the dividend to 26p. The forecasts from Liberum used in our table are even worse. And while the balance sheet should provide some support for the payout, management's intention to increase spending on courseware's digital transition will weigh on cash flows. And broker Liberum calculates that were debt-like lease obligations (accounting rule changes mean these will have to be brought "on balance sheet" by 1999) lease-adjusted net debt would account for two times lease-adjusted cash profits compared with an unadjusted net-debt-to-cash-profit ratio of 1.2.

 

Pearson's dividend cover looks under increasing pressure

  

PEARSON (PSON)

ORD PRICE:588.5pMARKET VALUE:£4.8bn
TOUCH:588-588.5p12-MONTH HIGH:990pLOW: 552p
FORWARD DIVIDEND YIELD:3.9%FORWARD PE RATIO:13
NET ASSET VALUE:785p**NET DEBT:22%

Year to 31 DecTurnover (£m)Pre-tax profit (£m)**Earnings per share (p)**Dividend per share (p)
20135.0766470.148.0
20144.8765866.051.0
20154.7862664.252.0
2016**4.3156956.652.0
2017**4.0646645.322.7
% change-6-18-20-56

Normal market size: 2,000

Matched bargain trading

Beta: 1.04

*Includes intangible assets of £5.6bn, or 683p a share

**Liberum forecasts, adjusted PTP and EPS figures