- Shares of Pearson (NYSE:PSO) fell 3.9% today in London after Berenberg (Sell) dropped its price target to 400p, implying 38% downside.
- Key points from the note, via FT:
- Pearson has a major problem: In fiscal 2015, higher education courseware contributed 40-45% of group EBIT. This key division faces serious structural and cyclical issues, which will continue until industry profits have normalised at much lower levels. We do not see a short-term fix.
- Leverage is higher than assumed: With returns likely to have impacted 2016 year-end cash flows, and the new strategy affecting cash flow in future, leverage is higher than the market thinks. We note recent negative statements by both Moody’s and S&P. Thus, Pearson is unlikely to return any cash to shareholders following a sale or recapitalisation of PRH.
- Is there opportunity for more cost savings? Pearson has already spent £610m on two restructurings in the last five years, yielding cumulative savings of £586m, before cumulative reinvestment of £100m and normal cost inflation. We do not see further opportunities for major savings, other than via cuts that would negatively impact the core business, such as reducing the size of the salesforce.
- We do not see industry consolidation as likely: Pearson is market leader (with a c40% share) in US higher education courseware, an industry that is already highly consolidated; we therefore do not see anti-trust authorities approving further concentration, which might have generated meaningful synergies in the event of a deal. The K-12 courseware and testing markets are also oligopolies, again suggesting anti-trust issues.
- What about private equity? With no easy cost savings, relatively high leverage, and no potential to sell a cleaned up Pearson to a competitor, we think private equity will steer clear. Anyone buying Pearson must have a clear view of how to fix higher education, and how to do it quickly. Private equity is hardly getting rich quick on the back of this industry - see McGraw-Hill and Cengage results - which won’t encourage new investors.
- Could a breakup work? The problem is that so much of group profit is declining. This is not a case of cutting off a diseased limb: it is a diseased body. If Pearson sold its attractive assets - Connections Education and Embanet, for example - it would be even more reliant on the declining higher education asset. Conversely, a sale of that unit looks very unlikely.