Pearson Downgraded But Remains Undervalued

Over the past three years, Pearson has experienced almost the perfect storm of negative events: declining university enrolments, an uptick in rental in the higher education courseware market, the loss of testing contracts in the United States, a slowdown in emerging markets, and benign growth in primary school age educational spending. This caused the share price to fall by more than 60% over the past three years.

Pearson now finds itself at a crucial juncture. Having shed predictable but declining publishing businesses such as the FT and The Economist, Pearson’s portfolio is now focused on the educational sector. As digital learning slowly replaces traditional textbook-based learning, there is a large structural opportunity for Pearson to not only transition to a higher-margin product but also further integrate itself with schools and universities, increasing the sustainability of its revenue stream.

This strategy is not without risks. As schools and universities shift from traditional textbooks, there is the danger that they may broaden their horizons to digital learning products provided by companies outside the traditional oligopoly in educational publishing. There is also a risk that schools and universities may use the transition to digital learning to demand lower-cost materials, given the high margins that have existed in textbooks for many years.

As the largest educational provider globally, Pearson is in an advantageous position. Given its ability to outspend peers, we believe the company will be at the forefront of digital development. The risk surrounding the shift to digital is also mitigated in some regard by the fact that Pearson has been slowly managing the shift to digital for a number of years, and 40% of its business is now digital. Pearson’s ability to manage this and its experience in doing so should prove crucial over the coming years. Although investors need to be aware of the risks brought by the changes taking place in the traditionally stable publishing sector, we believe Pearson is well positioned to capitalise on the structural opportunity that presents itself.

Valuations Range From 510p to £10.10 Per Share

We have reduced our fair value estimate to 740p per share. Within this, we forecast average revenue growth of 0.4% over the explicit forecast period, affected heavily by the issues in the North American higher education business. Ultimately, we believe that sales within this division will stabilise, with top-line growth for the group turning positive in 2019 and returning to GDP-level growth by 2020.

Over the next two years, we forecast significant margin decline in Pearson's North American higher education business, affecting the group as a whole, with adjusted operating margins declining from 14% in 2016 to 12% in 2017. Over the medium term, however, we believe the shift toward digital learning from traditional textbooks will allow the company to remove significant costs from its publishing operations. With cost savings derived from the current restructuring program and a more scalable digital product, we forecast operating margins improving moderately from 2018, returning to 2016 levels by the end of our explicit forecast period.

Under our bull-case scenario, we assume a highly supportive external environment, combined with a strong pickup in volume and margin growth as the takeup of digital learning products ramps up materially. This scenario requires a stabilisation in college enrolments to drive demand growth, in addition to a moderate improvement in allocated state spending on education. Under this scenario, we model 3.4% revenue growth on average over the explicit forecast period. While unlikely, at least in the near term, this scenario points us to a fair value estimate of £10.10, a 35% premium to our base case.

Our bear-case scenario gives us a fair value estimate of 510p a share, a near 30% discount to our base case, and incorporates a highly negative outlook on a number of fronts. Internally, this scenario suggests immaterial benefits from the recent restructuring programme, combined with external pressures such as a continuing decline in college enrolments and an anaemic takeup of digital products to replace the natural decline in printed materials. We forecast negative 2.6% revenue growth on average over the explicit forecast period and an average operating margin of just 9%, less than the average level achieved over the past decade with a higher-cost business model and incorporating lower-margin publishing businesses.

Pearson’s Competitive Advantages

Pearson’s narrow competitive advantage – or moat - centres on two key sources: intangible assets and switching costs. Over 60% of Pearson’s business focuses on providing educational/learning resources, which the company expends significant resources in developing. The firm has a dominant market position, and smaller competitors struggle to match the levels of research and development required to produce learning resources to rival those of Pearson.

As the incumbent in the educational market, Pearson has the advantage of being able to liaise and work closely with schools and universities to continually develop and tailor their material to ensure that it is relevant and at the vanguard of educational resources, an ability that peers looking to enter the industry do not possess. The ability to outspend peers on research and development, or R&D, combined with important insights into the requirements of educators and students, means that Pearson’s intangible assets are a highly valuable resource.

For the sector as a whole, there is an added danger that the digitalisation of educational materials will bring with it other challenges. These include increased demand for bespoke products, more regularly updated material and lower pricing, all of which entail margin dilution. For Pearson, we believe this risk is mitigated by the progress it has made so far, with 40% of educational materials already in digital form. This change has been achieved without diluting margins and with similar levels of development costs to the traditional print form.

Overall, the advent of digitalisation brings with it opportunities and challenges. As the largest educational provider globally, with a strong record of delivering high-quality educational materials, Pearson has the knowledge and resources to maintain its strong market position while effectively managing the transition from print to digital, in our opinion.