Seeking Alpha • Jan 18
Pearson: Expensive For What It Is
Summary
Education provider Pearson shows positive business momentum, though it is uneven.
While its strategic shift to education makes sense in theory, the evidence for its positive financial impact remains mixed for now.
Accordingly, I see the current share price as overvalued and maintain my "sell" rating.
Education group Pearson (PSO) has had a good run lately in the stock market.
I last covered the company in April with my bearish piece Pearson: Not Unlocking Much Value On Its Own. Since then, the shares have increased in value by 21%. However, I continue to see the shares as overvalued relative to the company’s earnings generation potential. Accordingly, I maintain my “sell” rating on the name.
Business Performance is Decent
While not stellar, recent business performance has been decent and arguably good.
At the interim stage, sales were up 12% and earnings per share soared albeit from a low base last year.
company announcement
The company said after its third quarter that it expected to deliver sales and adjusted operating profit consensus expectations for the full year, with sales growth in the first nine months of 7% compared to the prior year period.
This is positive momentum for the business. But I do not think the results are great. I think some of the strong performance in the assessment and qualifications and English language learning divisions are basically clearing a post-Covid backlog, so expect sales growth in those divisions to slow sharply over the next couple of years. It is also worth noting that Pearson has struggled to convert sales into operating profits consistently, as shown in the first half results.
company announcement
Has the company’s strategic pivot towards education in recent years worked? I think there is not yet sufficient evidence to say that it has. For example, virtual learning in the first half grew by double digits in percentage terms (a change in reporting segments means one can make no direct comparison to the prior year, though I think this growth was from a strong base) but adjusted operating profit was flat and the adjusted operating profit margin was a meagre 3.6%. Maybe a shift towards more virtual learning in coming years can help boost the top line, while lower costs can improve the bottom line. The company has identified cost savings of at least £100m for this year, on top of the efficiencies the company expects from its prior reorganisation of divisions.
However, none of this is yet compelling in my view. The strategy makes sense to me, but its long-term impact remains unproven and it is not clear how financially attractive the pivot to education will turn out to be. It has not yet delivered high growth, so I see it as premature for shares to be valued on the expectation that it will do.
Valuation Looks Stretched
Currently Pearson has a market cap of £6.6bn. Net debt at the end of June was £810m (up 231% in a year), meaning the enterprise value is £7.4bn.
That looks high to me. Last year’s profits after tax were £160m, meaning the price to earnings ratio stands at 42. For the current year, the company outlook is for adjusted operating profit of £416m. But that is broadly in line with last year, when although the reported profit was £160m, the adjusted operating profit was £385m. So, if excluding adjustments and the operating profit level and focussing instead on basic reported earnings after tax, which I see as a more relevant measure, the prospective P/E ratio is likely in the mid-twenties to mid-thirties depending on the size of the adjustments. In recent history, Pearson has had a history of frequent substantial adjustments.Seeking Alpha • Aug 09
Pearson: Watch Pandemic Recovery And Digital Metrics
Pearson's Assessment & Qualifications business segment witnessed a substantial recovery in sales and operating earnings in 1H 2022, as examinations proceeded as per normal in the absence of pandemic lockdowns.
But PSO's key digital revenue growth metrics like Higher Education US digital registrations and OPM student enrollments weren't as good as what investors would have hoped for.
I retain my Hold investment rating for Pearson, in view of a mixed outlook implying slower top line growth and stronger profitability.
Elevator Pitch
I continue to rate Pearson plc's (PSO) shares as a Hold.
I last wrote about PSO in an article published on October 12, 2021, and I discussed about Pearson's digital textbook platform and the company's portfolio optimization plans in that earlier update.
Pearson's 1H 2022 performance wasn't as good as what headline numbers imply. PSO's Assessment & Qualifications business delivered solid growth as examinations were no longer delayed or cancelled due to COVID-19 restrictions. But Pearson's digital growth metrics, which are a key indicator of the company's progress in pivoting towards digital learning, were below expectations. In the medium term, PSO's revenue growth will likely slow as a result of lower-than-expected enrollments, but this will be offset by better-than-expected profitability thanks to the success of its cost optimization initiatives. This suggests that a Hold rating is the most appropriate for Pearson.
Good Recovery From The Pandemic
Pearson did reasonably well in the first half of the current year. The company's revenue and core operating income expanded by +6% YoY and +22% YoY to £1,788 million and £160 million, respectively in 1H 2022 as per its most recent interim results press release.
PSO's Assessment & Qualifications business segment benefited from a low base in 1H 2021 when the business division was negatively affected by COVID-19 related lockdowns. With the relaxation of pandemic restrictions, the Assessment & Qualifications business saw its core revenue and operating income grow by +16% YoY and +34% YoY, respectively in the most recent interim period.
Notably, Pearson's Assessment & Qualifications segment contributed 86% of the company's core operating profit in 1H 2022, which meant that the recovery of this business segment was the main reason for Pearson's strong growth in the first half of the year.
Pearson highlighted at its 1H 2022 results call that "exam timetables returned to normal", which helped its Assessment & Qualifications business to perform well for the first six months of 2022. In comparison, examinations were disrupted last year due to new COVID-19 waves.
Digital Growth Metrics Were A Disappointment
It will be misleading to conclude that all is well at Pearson based on the company's good headline financial metrics (revenue and operating income) as mentioned in the preceding section. This is because investors are more concerned about Pearson's long-term growth outlook in a post-pandemic environment, and they are watching the progress of Pearson's push into digital learning very closely.
In that respect, Pearson's metrics relating to digital revenue growth would have most probably disappointed the majority of investors. As indicated in the company's 1H 2022 earnings media release, PSO's Higher Education US digital registrations declined by -9% YoY from 5.3 million in the first half of 2021 to 4.8 million in the recent interim period. Also, OPM (Online Program Management) student enrollments for its Virtual Learning segment came in at 143,000 for 1H 2022, which represented a -0.7% contraction as compared to 1H 2021.
The weak operating metrics for Pearson's Virtual Learning and Higher Education business segments translated into poor financial performances for these two business divisions in the most recent interim financial period. Core operating income for PSO's Virtual Learning business fell by -21% YoY in 1H 2022, as increased investments more than offset a modest +3% YoY rise in segment revenue over the same period. Pearson's Higher Education business segment turned from a positive operating profit in 1H 2021 into an operating loss for 1H 2022, as the division was hurt by a -4% YoY decrease in segment sales and negative operating leverage.
Mixed Outlook
The intermediate term financial outlook for Pearson is mixed.
Based on the analysts' consensus financial estimates taken from S&P Capital IQ, PSO's top line expansion is forecasted to slow from +8.7% in fiscal 2022 to +4.2% and +4.3% for FY 2023 and FY 2024, respectively.
As I indicated earlier, PSO's solid +6% revenue growth for 1H 2022 was helped by the fact that 1H 2021 was a low base for the company as a result of pandemic disruptions. As such, it isn't a surprise that Pearson's top line growth will moderate in the subsequent years ahead. Moreover, Pearson has guided for "increased pressure on enrolments in OPM and Higher Ed (Education)" going forward as per its management comments at the 1H 2022 earnings briefing. Specifically, PSO acknowledged at its interim results call that "there is an enrolment issue", considering that "many people who have yet to finish their college degrees because they were impacted by the pandemic."
On the other hand, the sell-side's consensus financial projections point to Pearson's EBIT margin improving from 11.6% in FY 2022 to 14.6% for FY 2023 and 15.4% for FY 2025.
