Pearson's (PSON) third-quarter trading update revealed that sales growth underperformed expectations, and management cut guidance by 6% at the midpoint of the range. We are lowering our fair value estimate to £12.50 from £13 for the ordinary shares as a result, but we think the market reaction is greatly overblown. Pearson was trading down 16% in morning trading in London.
Underlying growth from continuing operations fell; we are not entirely surprised by the slowdown
Our narrow economic moat rating and negative moat trend ratings remain in place. This reflects Pearson's strong competitive positioning in traditional channels and the seismic changes taking place in higher-education publishing as the industry transitions from print to digital publications.
Reported third-quarter sales increased 2% year over year, a material slowdown from the 5% growth reported in the first half of the year. Underlying growth from continuing operations fell 2%. We are not entirely surprised by the slowdown, and we had previously forecast 2015 EPS at the bottom of the previous guidance range. We have lowered our EPS estimate for the year to 70p from 75p, again at the lower perimeter of management's guidance, but this barely moves the needle on our valuation.
The primary impact on our fair value estimate comes from a modest lowering of our medium-term growth assumptions. This will be the fourth consecutive year that the firm has delivered organic growth that we believe is below the level that it can achieve in the long term, and we think the political stalemate over Common Core in the United States could dampen growth in that market over a multiyear time period. Therefore, we now assume 3% medium-term revenue growth and 4% earnings before interest growth in our model, down from 4% and 5%, respectively.
We understand investors questioning whether Person's underperformance is indicative of its eroding position in the marketplace. However, Pearson claims it took share in the quarter, and we believe its narrow economic moat – the ownership of content in an industry in which trust in the content is paramount, given the focus on learning standards and outcomes – should offer Pearson some protection against new entrants as the publishing industry shifts from print to digital. There is certainly a risk of new entrants during that transition, and that is reflected in our negative moat trend rating.
We would revise our valuation downwards, perhaps significantly, if we believed massive open online courses and open educational resources were taking significant share from Pearson, but we believe it is premature to declare that Pearson's underperformance stems from disruption to its business model. As demonstrated by Pearson's third-quarter trading update, the transition to digital publishing will be a difficult one, with more bumps on the road to come, and this is reflected in our high uncertainty rating.
For long-term investors who believe content is the critical competitive advantage in this industry, however, today's drop in Pearson's stock could provide an attractive entry point.
