Description

We believe that Pearson is a best-in-class education publisher that is exceedingly well-positioned in its various end markets.  In many ways it is a great ‘fire and forget’ long-term holding due to strong market position, defensive growth profile and valuation relative to historic levels (8% FCF yield vs. 5% historically).  We are also fans of countercyclical stocks given the current macroeconomic climate.

In addition, we believe that there is significant upside in the intermediate term.  Education publishing in the U.S. is facing several headwinds that are weighing on the stock: within K-12, Common Core continues to delay textbook adoptions and education budgets remain under pressure; in College, new book sales remain challenged due to the emergence of rental and the cannibalization from digital.  We believe Pearson is uniquely positioned to benefit from these headwinds, which combined with international growth will allow Pearson to continue to increase market share and cash flow generation while narrowing the gap to historic multiples, leading to >30% upside from current valuation levels of ~£12 / share

Pearson is in theory a diversified publishing company but education is the real driver accounts for over 85% of earnings.  Pearson reports in the following segments:

Education (75% of revenues and 85% of earnings): Pearson appears to be the best run education publishing company.  North America accounts for ~57% of Education revenue, where Pearson is the leader in both U.S. K-12 as well as college publishing (with the business split roughly 50 / 50 across these two fundamentally different markets).  The balance is International (34% of revenues) and Professional (8% of revenues)

Penguin Group (18% of revenues, 12% of earnings): Penguin is one of the largest book publishers in the world but is in secular decline, with organic declines of 3-4% / yr despite transitioning to digital as fast as possible

FT Group (7% of revenues, 8% of earnings): In addition to the FT (the majority of the business), the FT group also includes Mergermarket as well as 50% of The Economist.  The quality of the media portfolio is pretty high although secular challenges remain (e.g., print decline, decreasing ad yields)

Our analysis focuses on the U.S. education segment, where we believe the headwinds are misunderstood and Pearson has the opportunity to drive significant earnings upside

College

Pearson is the clear #1 player in the college publishing market with the best sales force and most advanced digital capabilities.  The next two largest publishers are Cengage and McGraw Hill and each have their own issues.  Cengage was a peak buyout in ’07 (Apax and OMERS) and has since underinvested whilst being dogged by management turnover and sales force issues.  McGraw Hill is a distant third and is about to be acquired by Apollo, which will further impair the ability to invest.

College – Halting the decline in new book sales

Education publishing has been struggling with declining book sales in 2012 – AAP data reports -4% through September with a number of contributing factors. 

First is enrollment - Fall ’12 enrollment was down over 2% due to declines at for-profits and community colleges with the latter accounting or the majority of the enrollment decline as they represent over 30% of enrollment.  We fully expect the for-profit decline to continue, but are positive on community colleges for Fall ’13 enrollment as we believe Fall ’12 was driven a countercyclical ‘dip’ in response to perceived macroeconomic recovery.

Second is the growth of rental.  Companies such as Chegg (likely an interesting IPO in the next year as an aside) have carved out a sizable chunk of the market, offering students a new option to acquire books at low prices without any resale risk.  However, we believe growth in rental has started moderating, and SKU level analysis (for Pearson in particular) shows that publishers are increasing the portion of ‘custom publications’ which are effectively non-rentable due to shorter publication cycles as rental companies need 3 rentals to breakeven.

College – Successful digital transition

A lot of questions have been asked about how education publishers are going to address the digital transition, especially given the rapid growth of e-books in recent years.  Our analysis suggests that this is the wrong question to ask.  While there is no doubt that e-books as a segment will grow, we believe there is a clear delineation between e-books and digital supplements, with digital supplements being the much larger and more positive opportunity.  Digital supplements do not replace textbooks but are instead ‘attached’ and offer personalized learning, homeworks, assessments.  In addition, digital supplements offer publishers the opportunity to monetize segments that were previously not addressable (e.g., students who bought used textbooks).  Publishers simply have not emphasized e-books – as an example, the business model fundamentally flawed as they effectively represent a 1-2 year rental (DRM enforced) at 70-80% of the list price of a new hardcopy book with a poor user interface and experience (e.g., limitations on printing out copies).  Instead, they have tried to migrate as much value as possible to digital supplements.  This has a net positive impact on publisher financials, as we estimate that e-books are only ~20% of the digital market today vs. digital supplements at 80%.

Pearson is by far the market leader in digital supplements by virtue of higher investment levels and issues at competitors - Cengage has been capital constrained (its MindTap product is only making it to market now after several stop / starts in development), and McGraw Hill is subscale.  Pearson’s product portfolio in this space includes MyLab which saw registrations increase >20% to 8.9M in 2011.  As a result, we expect Pearson to benefit twofold – by demonstrating significantly higher attach rates of digital supplements, and by using digital supplements as a differentiator to gain even more share within the college publishing market

K-12

Although the markets are very different, the competitive landscape is eerily familiar.  Pearson is also the clear leader within K-12 with a clear lead over HMH and McGraw Hill.  HMH recently emerged from bankruptcy but is overweight the core basal / supplemental textbook market which is a declining segment. McGraw Hill is being acquired by Apollo and it is unclear if they will be able to match the investment levels of a deleveraged HMH and Pearson

K-12: Basal / supplemental textbook market not in secular decline but will pop in 2014

The U.S. K-12 core basal and supplemental market is in decline; AAP reports textbook sales down 17% through September, primarily due to pushed out / downsized adoptions in anticipation of Common Core. 

Very briefly, states fall into two categories – Open Territory and Adoption (roughly equal in size on a normalized basis).  Open Territory states give districts plenty of discretion over what textbooks to purchase and when, whereas Adoption states have long competitive product development cycles on a per-state basis where states standardize on 1-2 textbooks for a specific subject.  However, this is set to change due to the adoption of Common Core standards  – which will (a) create a common set of standards (technically 85%) across all 46 states and (b) mandate digital assessments in SY14 that enable cross-state and international comparisons.  Historically the adoption states were seen as big windfalls but this has stopped being the case in 2011 and 2012, as many states have delayed or even cancelled adoptions in order to avoid spending before new Common Core aligned textbooks are released (e.g., California delaying all adoptions until Common Core texts becoming available).  While we don’t anticipate a lift from Common Core in 2013, we think 2014 and 2015 will be very big years as the ‘pent-up’ demand comes back.  This may create more attractive investment opportunities at a slightly later time (e.g., early ’14), we believe there is enough near-term upside from other areas

K-12: Growing outside of traditional instructional material categories

Based on Pearson’s broader and more ambitious definition of education, we see them continuing to outgrow peers and drive continued earnings growth despite headwinds facing the K-12 space, especially as districts gain even more discretion over spending due to loosening of categorical funding requirements.  As an example, Texas spent only ~$20M of the $220M+ adoption through September but drastically increased spend on edtech and hardware

Pearson is actively consolidating niche education and edtech companies in a smart way.  As an example, it acquired Connections Academy for ~$400M in late 2011. Connections is a digitally-based, distance learning business that is completely immune to the headwinds facing the instructional materials category with ~$200M of revenues and is growing rapidly.  This is not a traditional education publishing business and is more like a for-profit K-12 school – even AAP strips this out of their #s when calculating publisher revenues.

EdTech is another area where Pearson appears to have laid some smart bets such as participating in Knewton’s Series D (customized learning platform), ~$90M of preferred equity in Nook Media, $650M for EmbanetCompass (learning management systems and digital solutions)

Risks

* Continued enrollment issues in higher ed

* Continued adoption delays / cancellations in K-12

* Overpaying for acquisitions

Catalyst