Following yesterday’s profit warning, Morningstar equity analysts have materially reduced their earnings forecast for publisher Pearson (PSON), resulting in a cut of just over 20% to the fair value estimate for the shares, to £7.40 from £9.50.
The reduced visibility in what was a defensive business is a concern for shareholders
A confluence of factors affecting Person’s North American higher-education courseware business, which generates more than 25% of group revenue, has led to a full-year decline in this segment of 18%. The company have attributed this decline as 12% to destocking issues, 4% to the impact from increased rental of books and the remaining 2% to lower college enrolments. While Pearson ultimately expect the destocking issues to reverse, college enrolments have historically been countercyclical; thus, weakness could persist. Similarly, the issue of increased book rental appears to be structural, with 35% of all textbook usage now rentals.
Remedial actions announced yesterday could potentially alleviate some of Pearson’s problems, but are by no means clear-cut solutions. A commitment to spending an additional £50 million on developing their software offering could expedite the shift from print to digital; however, with 50% of courseware sales still in print form, this shift will take time. The company’s plan to enter the rental market, slashing prices of e-book rentals is ambitious, but there is a clear cannibalistic impact on sales from renting an e-book for $89 that lists for $260.
We believe that the primary concern for investors, evidenced in the sharp fall in the share price today, is the reduced visibility in what was previously a relatively defensive business. While acknowledging the high level of uncertainty in Pearson’s business, we believe that the market is currently discounting a permanent decline in profitability. As the largest educational provider globally, Pearson has significant resources at its disposal to adapt to changing trends, and we believe that the shares offer material upside from the prevailing level.
We have essentially taken a knife to our forecasts for Pearson’s North American division, with an implied cut of 18% to the higher-education courseware business for 2017, in line with the reported fall for 2016. For 2018, we have forecast zero growth for the entire North American division, implying a further fall of over 6% in the higher-education courseware business. Although management has guided to a fall of just 7% in 2017, we believe the lack of visibility in this division, particularly surrounding the timing around the end of the destocking issue, warrants a wider margin of safety.
Pearson’s Content Providers Business Buffer
Our narrow moat rating for Pearson is based on the company’s intangible assets, effectively its content, and the switching costs involved in moving from Pearson to another supplier. While, in our view, the issues faced by Pearson’s North American higher-education courseware in 2016 do not bring into question the validity or relevance of the company’s content, investors are clearly concerned as to whether the switching cost argument still makes sense.
While we acknowledge the rising trend toward renting books versus outright purchasing, the impact of this was just 3%-4% of the 18% drop in sales in this division in 2016, with the rest purportedly due to destocking effects, and to a lesser extent, lower college enrolments, factors that do not bring into question the switching cost argument.
There is a clear challenge from the rental market, which now represents 35% of usage, but we believe it is worth recognising that this is not a shift away from Pearson content, but simply a change in the way that users consume Pearson content. This earnings call has been the first in which management has openly acknowledged the scale of the threat posed by book rental, which we believe now paves the way for remedial actions.
Management’s plan to enter the rental market brings with it the risk of cannibalising existing book sales; however, the debasement of assumptions for this division should allow Pearson to regain ground lost to competitors in the rental market.
