Description

Introduction

Over the past 2 weeks, Pearson share price rose 24%. Some of it is was attributable to a pre-Brexit market rally (in expectation to the referendum going for Remain) and some of it was attributable to a post-Brexit rally given the slump in the British Pound. Out of the expected £600m in operating profits to be delivered in 2016, approximately £400m are expected to come from the outside the UK. The 10% in the British Pound post referendum effectively provided Pearson with a translation Fx gain of approximately £40m, or c. 7% of expected 2016 profit. In our view, following its most recent rally that significantly overshot its fundamental improvements, Pearson shares became even more mispriced. Fair value is around £7-7.5 per share or c. 25% below current levels.

Pearson is a leading player in the education market, primarily higher education in the US. As such, Pearson is a structurally challenged business. Current consensus estimates imply the market sees current weakness as purely cyclical and it therefore expects a stabilisation in 2017 and a recovery in 2018. This is on the back of the CEO’s recent comment: “The cyclical and policy related challenges…are persisting…having a bigger impact on profits than we foresaw. But they will start to stabilize by the end of this year and should then provide a modest tailwind”. We disagree – the challenges are mainly structural and won’t go away. Pearson’s apparent low (17x! not so low) valuation is purely optical – PSON is a classic value trap. Since the last profit warning in January ’16 Pearson shares rebounded nearly 50%. We are c. 15% below consensus for 2018 estimates. As the company fails to achieve its stated 2018 targets, multiples will also compress.

Business description

Pearson historically owned a number of non-core assets which are now almost entirely disposed (The Economist, The FT, Mergermarket and others). The only large non-core asset remaining in the group is Penguin Random House, owned 47% which is likely to be disposed in the next 12 months or so.

Quick note on business disclosure – it’s very poor. Pearson owns a number of different businesses within different segments but very little information is given. Furthermore, in 2014 Pearson changed reporting structure so doing historical comparisons is tricky. An interesting angle to this is that we believe the structurally challenged parts of the business (e.g. Print) are very high margin whereas the high growth revenue streams (e.g. digital) are margin dilutive. Pearson doesn’t give this kind of information so it’s very hard to model the business on a granular level. Finally, the business reports in British Pounds but the UK represents only 16% of the total, so FX movements mask true underlying trends.

The company reports under 3 divisions which are based on geography:

• “North America” – US and Canada, representing 65% of sales but over ¾ of profits

• “Core” – representing the UK and some of the Eurozone

• “Growth” – representing China, Brazil, South Africa and India

However, within those 3 geographic segments, the company also gives more detailed breakdown of revenue contribution by sub-segment. This is important because each one has different drivers. There are 14 sub-segments under its geographic breakdown. Unfortunately, we only have overall revenue contribution, not margin contribution which would be much more interesting:

Finally, Pearson give a split by product line which is equally important. The important take-away from this disclosure is that a surprisingly large proportion of revenue is effectively structurally challenged:

• C. 50% of revenues come from Courseware. It is estimated that c. 2/3 of courseware is still in print form, so 1/3 of total. As we shall explain below, print is structurally challenged and, in our view, comes with higher than average margins. At its recent investor day on higher education, the company provided a misleading chart (slide 31) suggesting print is only 1/3 of US courseware revenues. This is misleading as a) c. another 1/3 of revenue is digital bundled with print, effectively print exposed, b) US higher education courseware doesn’t include school courseware which has a higher proportion of printed books revenues and c) it completely excludes UK print revenues which is predominantly print

• C. 30% of the business comes from Assessments, i.e. exams. As we shall see below, a large proportion of this business is structurally challenged, both in the UK and in the US

• The majority of the “Services” part of the business is growing well

The fact that Pearson doesn’t disclose margins by product line is very telling. We tried to back solve this based on management commentary, bits and pieces from slides and sell side commentary. We get to the following breakdown (note the coloured numbers are explicitly disclosed or could be inferred from above slides, the rest is not disclosed):

Below, we shall explain why we believe a number of these businesses are structurally challenged. The point of the exercise will be to demonstrate that over 53% of the business is structurally challenged and that represents c. 2/3 of operating profits:

In Summary, we see over 50% of 2016 EBIT 2016 as structurally challenged:

Structural challenges

Print

The single biggest headwind for Pearson is its still important reliance on print coursework. In our estimates, it represents c. 1/3 of the business but we believe It represents over 40% of profitability:

• We estimate that overall Courseware represents c. 60% of group profitability

• We assume print has higher margin than digital

Print as % of total is declining but the problem for Pearson is that the operating leverage in print is very large. There are big upfront costs in terms of content costs, marketing etc., and fixed cost in book printing. A decline in print volumes will hit margins disproportionally.

Print revenue is in structural decline:

• Volumes are declining – students shift to online offerings or to book rentals (Chegg)

• Prices are falling as students are not able / willing to bear the costs. The average amount of students spend on textbooks has been declining steadily over the last 10 years. This has been driven primarily by unsustainable price inflation in textbooks making it increasingly unaffordable for students

The National Association of College Stores released some figures showing average similar trends, with spend on course material falling in 2014-15 to $563 from $701 in 2007-08. According to a recent study from Student PIRGs, nearly 30% of students used financial aid to pay for their textbooks while this numbers grows to 50% in community colleges. These figures would suggest that students are spending c. $3.15bn a year in financial aid on textbooks. This is clearly seen as unsustainable.

The other reason for lower demand for books is the increase in market share in rented books. CHEGG and Amazon offer such services. It’s becoming increasingly accepted not to buy books in universities. The percentage of students not purchasing any textbooks went from zero in 2007 to 11% in 2014. Similarly, the Book Industry Study Group showed that the percentage of students who believe one or more textbooks are required of their course fell from c. 70% in 2011 to c. 40% in 2014.

The number of printed textbooks in the US purchased per semester has been declining for 5 years now and will continue to do so. According to Student Monitor, in 2015 60% of the acquired books in a semester are either used or rented.

Higher Education deflation

Rising student debt in the US is unsustainable and this was partially driven by high education fees as well as educational books and supplies inflation well above CPIs.

We have reached the point where the return on investment in education is so low that many students are put off. This has 2 effects:

• Structurally lower enrolment rates

• Deflationary pressure on books and supplies

There is increasingly more evidence that newer generations are a lot more cost conscious than previous ones in respect to university textbooks and are less likely to incur in high debt to fund their studies.

We note how all of the above suggests Pearson is still over-earning in the US notwithstanding the recent declines in profitability. According to a Goldman Sachs book comparison, Pearson still charges 70% more in the US for the same book compared to the UK. Above described deflationary pressures could continue for years.

For Profit Universities in structural (terminal?) decline

Pearson is over-index to for-profit universities (6% of total) and two year community colleges (31% of total) and this is expected to remain a headwind for the foreseeable future. Community colleges have seen the biggest deflationary pressure for courseware material. In its recent Q4 results, Barnes & Noble Education mentioned how it expected two-year community college enrolments to continue to decline for a further 12-24 months. For profit universities could well be in terminal decline.

Open Resources and new competition

The courseware market has been a source of supernatural profits until recently due to Pearson dominant position. Until recently, the US print courseware market has been a closed oligopoly enjoying strong pricing power. Pearson is the market leader followed by Cengage and McGraw-Hill Education. Both Cengage (just emerged from bankruptcy) and McGraw-Hill (acquired by Blackstone in 2012) had their own issue until now, providing Pearson a market with very little aggressive competition. The renewed competition from these players and the advent of OER as well as new digital textbooks is creating long term structural headwinds for Pearson.

For example, online resources have been so far a strong engine growth for Pearson. Looking at MyLab registrations though, it looks like number of registration are plateauing after a decade of strong growth. Some of the drivers of this weakness are cyclical (as we’ll see below). Some has to do with a resurgent competition from the likes of HMH, McGraw Hill and Cengage (see below), but a good proportion of the headwind is structural. One of the issues has been OER.

Open Education Resources (OER) are openly licensed teaching and learning materials which are freely accessible in the public domain. OER has the potential to disintermediate the incumbent publishers. It has the obvious benefits of giving more freedom to single professors in the choice of coursework and it’s clearly cheaper, but there are numerous barriers to adoption for now. However, lots of VC money went into OER, suggesting pressures are just building up. Competition isn’t coming just from VS funded start-ups but also from a number of non-profit organisations aimed at reducing the cost of education in the US.

The availability of OER is pushing many universities to rethink their approach to courseware spending. In Maryland for example, as of autumn 2015, UMUC no longer expects any graduates to spend any money on textbooks. The university estimates that 84k students will save cumulatively north of $10m per year in textbooks. This is the tip of the iceberg of what is about to happen to Pearson’s key profit driver. Similar moves were introduced in the last 2 years in Minnesota (South Central College), Virginia (William & Mary Student Assembly), Georgia (Georgia Highlands Colleges) and California (Santa Barbara Community College).

Pearson would argue that OER does not provide any support, adaptive learning, analytics etc. (see slide 46 of their recent higher education investor day) and it therefore cannot substitute traditional textbooks. A recent study by students at Virginia State University School of Business found that students using OER materials “tended to have higher grades and lower failing and withdrawal rates than those in courses that did not use”. OER can certainly provide a credible alternative to traditional publishers-cured textbooks.

We note that historically, Pearson has had a much rehigher lative market share in digital education than in print. The bull case behind Pearson has always been that it is over-indexed to digital and it’ll therefore outperform the market. The problem with this notion is that digital is the segment specifically targeted by all these new entrants.

Recent developments in US courseware that will affect Pearson

We think it’s interesting to note how Pearson briefly dismissed OER as non material to their earnings. At their higher education investor day, Pearson disclosed that OER faculty adoption is just 1% of courseware in subjects like science and 3% for math and statistics. These stats are completely backwards looking: most of the new entrants didn’t exist 3 years ago and pressure on Pearson is just starting. We know that when Amazon enters a market, it does so with the ultimately goal to disrupt it. When they bought TenMarks in 2013, nobody paid much attention to it. Now TenMarks is the core backbone of Amazon Education which is just about to roll out. We believe growth in OER is going to be exponential with much bigger impact on Pearson than the street expects. Just to mention a couple of recent developments:

• In June 2016, The national community college reform network Achieving the Dream (ATD) announced the largest initiative of its kind to develop degree programs using high quality open educational resources involving 38 community colleges in 13 states

• In California, the Affordable College Textbook Act took effect on January 1st 2016 creating a fund to encourage California state universities to use OER

• In April 2016, Amazon won a $30m contract to supply the educational content for the NYC public school system

• In Q216 Amazon is set to launch Amazon Inspire, an OER for K-12

• Kindle Direct Publishing Select is an Amazon program that demands exclusivity and just entered the educational market, effectively cutting out Pearson from its potential publishers

• In June 2016, Open SUNY Textbooks (OST) announced, in collaboration with Lumen Learning, SUNY OER Services, to support State University of New York (SUNY) faculty and SUNY campuses with their efforts to expand effective adoption, creation and use of OER

We are seeing an incredible surge in education providers for OERs. To dismiss OER as something small / marginal would be, in our view, very miopic.

Testing market in decline

There are some strong structural headwinds in both the UK and in the US on the test market. In 2012, Pearson was awarded the contract for Partnership for Assessment and Readiness for College and Careers (PARCC). Pearson provides standardised tests across 25 states in the US. However, since 2014, many states complained about excessive level for testing, arguing that pupils were sitting more time in exams than learning. These tests were standardised across states via Common States Standards. There has been a big backlash against this, many states wanted to reclaim independence and didn’t want to follow what has become known as the Obama-Core. Pearson became the face of this disaster and many states cancelled the contract (Arkansas, Mississippi and Ohio) switching to other providers (e.g. Questar, ACT, SBAC consortia). Some of these contracts are rolling off in 2016 so 2017 should prove to be an even harder year for Pearson in the test market.

Similarly, in the UK, BTEC declined 20% in 2015. BTEC is very high margin segment for Pearson.

Competition

For many years Pearson was the undisputed leader in the US K-12 as well as higher education market. Pearson benefitted from some tailwinds that are now turning into headwinds. Many of its competitors were in financial distress and weren’t appropriately capitalised to compete effectively. This is now changing and competitors are much more aggressive:

• HMH competes in the K-12 market and emerged from bankruptcy in 2013

• Cengage competes in the Higher Education market and emerged from bankruptcy in 2014

• McGraw Hill competes in the Higher Education market. The business was struggling until it was purchased by Apollo in 2012 and is now rumoured to be IPO’d

At its FY results 2016 in May, Cengage reported weak numbers highlighting increased competition in the market leading to weak pricing. Cengage in turns had to moderate its pricing to stay competitive exacerbating the competitive environment for Pearson.

We note how both HMH and McGraw Hill exited the Assessment market. This is indicative of the opposition to standardised testing and the perception that publishers should not “grade their homework”. Pearson is therefore at disadvantage going forward being perceived as “conflicted”.

Within testing itself Pearson has lost market share to non-profit organisation such as AIR and ETS as well as to competitor Questar.

Finally, we note how some large tech companies are making investments in education (Facebook invested $100m in Alt School, Google put $40 in Renaissance Learning). Apple is working on education tools for the iPad and recently acquired LearnSprout. All this competition may eventually erode Pearson margins further.

Cyclical challenges

Low enrolments in the US

Enrolments are highly correlated to unemployment – if people can’t find jobs, they go to university. As unemployment rate has been falling, US enrolments also fell. As we approach low levels of unemployment, it’s possible to envisage a cyclical recovery in 2018-19. However, recent commentary from Barnes & Noble Education as well as from J Wiley, suggest that headwinds to higher education enrolments will continue well into 2017.

From a long term structural perspective, we have a negative view on higher education from a simple demographic perspective. Birth rates in the US have been declining driving down high school graduates. Since 2010, the number of high school graduates in the US has been declining. Since 60% of higher education students are coming directly out of high school, if the pipe that feeds the majority of the market contracts, either the balance will need to accelerate or overall enrolments will fall.

K-12 adoption states cycle (c. 3-4% of total EBIT)

Please refer to Chris815 write up on HMHC where the challenges to K-12 publishers are well explained. In summary, in the US, school text books purchases occur in different manner depending on whether the state is an “adoption” one or an “open territory”.  Under the former, school districts must purchase educational materials that have been selected at the state level. Decisions are centralised and this add a degree of cyclicality as each state has its own new textbook adoption cycle. Open territories allow schools to purchase material independently so they are less cyclical. There are 19 adoption states and 31 open territory states, with roughly 50% of industry textbook sales each. We are currently in a down cycle for adoption territories and this should revert in 2017, as indicated by HMHC in their latest presentation. We’d note that the structural challenges affecting higher education from OER are present also in the K12 market (e.g. CK12). We are not going to spend further time on this market since we believe K12 courseware contributes c. 3-5% of consolidated EBIT so it’s not a material profit centre.

Growth markets not growing

C. 16% of Pearson market is defined as “growth” but it’s actually not growing at all. It’s suffering from difficult macro conditions in South Africa and Brazil offsetting some of the growth in China and India. Whilst we believe at some point this market will rebound, marginality is very low (it was negative in 2015) so we don’t believe it will be a big contributor of EBIT growth going forward even assuming a favourable macro backdrop.

Balance sheet concerns and lack of cash generation

One of the reason behind the rally since the last profit warning is the dividend. Pearson has a dividend yield of almost 6% and the CEO pledged it will be maintained. We think there is a high risk of a dividend cut if the company fails to achieve its targets. The company is effectively leveraging up to pay the dividend as FCF to dividend cover is well below 1x.

Furthermore, whilst not massively leverage, Pearson needs to be careful if it wants to maintain its investment grade rating (BBB now). The rating agency capitalise their operating leases to get to Net Debt:

Looking at it this way, Pearson has a net debt to EBITDA in excess of 3x and in our numbers it’s going to increase. We therefore think the likelihood that Pearson will need to cut the dividend is high.

It’s possible that in order to defend the dividend, Pearson will divest its stake in Penguin Random House in 2017 (they have a put option to Bertelsmann) and will raise some £1-1.1bn but given PRH’s high profitability, it’ll be earning dilutive.

Pearson 2018 target doesn’t seem to make any sense

Pearson guided for £800m in operating income in 2018. The company provided the following bridge analysis for 2016 which is the basis for the 2018 target:

Assuming the company hits its 2016 target of £600m in adjusted operating income, it is expected to generate a further £200m to get to £800m in 2018. This will be achieved through:

• £100m in additional EBIT through organic growth in the business

• £100m in additional EBIT through additional cost savings.

We believe both assumptions are highly questionable. First and foremost, the company has an average EBIT margin of in the low teens. Even assuming 20% operating leverage, in order to achieve £100m in EBIT growth, Pearson would need to achieve £500m in top line growth over 2017-18, or c. £250m a year, which is equal to c. 5% organic growth a year. As a reminder, Pearson organic growth was negative 2% in 2015 expected to fall to negative 5% in 2016. Over 50% of the business is, in our view, structurally challenged and will continue to fall. In order to grow 5% per year at consolidated level, one would need to assume that the structurally challenged business stops falling and the rest of the business grows at 10%. Both of these assumptions seem highly unlikely.

Regarding further cost savings, Pearson will cut 10% of the workforce in 2016 at a cost of £320m which will give total savings of £250m. We think such a large restructuring will have commercial consequences which will make further cost cuts much harder to achieve.

Summary financials and valuation considerations

We built a summary model based on our top-down understanding of the business, whereby we see about half of Pearson structurally challenged. 2015 figures are historical, 2016 are based on company guidance and 2017-18 represent our estimates. We effectively don’t see any profit growth in 2017-18 except for c. £40m which is simply a boost from the fall in the British Pound.

Consensus EBIT 2018 is £750m Vs company guidance of £800m and our estimate of c. £650m. The biggest delta to consensus comes from the US division. Because the majority of the segment is structurally challenged, we don’t expect and profit growth notwithstanding some cyclical recovery as well as recovery in K-12 adoptions. The issue with the US division is that in our view, c. 50% of EBIT comes from Higher Education Courseware which is challenged for all reasons explained above.

In terms of valuation, Pearson historically traded on average around c. 10x EV / EBITDA and c. 14x P/E. We believe it should trade at lower multiple than this as the company is now clearly structurally challenged. At 12x 2018, we see c. 25% downside in our base case scenario that assumes c. 60p in EPS in 2018 against consensus at c. 70p.

Catalyst

• 2016 results miss
• Revision to long term margins
• Reduction of dividend