Pearson plc's (PSO) CEO John Fallon on Q2 2017 Results - Earnings Call Transcript

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About: Pearson plc (PSO)
by: SA Transcripts

Pearson plc (NYSE:PSO) Q2 2017 Earnings Conference Call August 4, 2017 3:30 AM ET

Executives

Coram Williams - Chief Financial Officer and Executive Director

John Fallon - Chief Executive, Chief Executive of International Education Businesses and Executive Director

Analysts

Matthew Walker - Credit Suisse

Ruchi Malaiya - Bank of America Merrill Lynch

Nick Dempsey - Barclays Capital

Ian Whittaker - Liberum

Thomas Singlehurst - Citi

Alastair Reid - Berenberg Gossler & Company

Katherine Tait - Goldman Sachs

John Fallon

Okay. Good morning, everybody. Thanks for joining us for our half year results presentation. It's John Fallon here. And as you just heard, I’ve got Coram Williams, our CFO, to start alongside me.

Three things we want to do today. One, to walk you to through the half year results and the outlook for the rest of the year; two, update you on the latest strategies of our ongoing work to simplify and transform Pearson, delivering another £300 million in cost savings by 2020. This program also sets us up to be a growing, sustainably profitable company with a more reliable and predictable revenue and cash profile; and three, of course, leave plenty of time for your questions. Coram is going to take you through the details on points one and two. But just before he does, let me give you the headlines.

So as you can see, we’ve made a steady start to 2017, and our guidance for the full year, on a like-for-like basis is unchanged. Sales are up 1% on an underlying basis with the company performing in line with our expectations and a good competitive performance across the business. As we we’re reporting our interims a week later than usual, we can confirm our steady start has continued through July, one of our biggest sales months of the year, though that is, of course, still a long way to go.

First half profits are up £92 million, benefiting from the cost savings from the 2016 restructuring program, and as we continue to make Pearson a leaner and more efficient business. Operating cash flow is £130 million better than this time last year, and as Coram will explain, the balance sheet is in good shape as well. And the interim dividend of £0.05, down from £0.18 last year, is painful, but it’s right for the long-term future of the company.

As fine in January, it results from the planned disposal of our Penguin Random House stake and the more challenging conditions we face in our biggest markets. We’re setting it at a sustainable level from which it can grow as the company grows again. This is an important building block in underpinning the value of the business longer-term. Other building blocks include increased organic investment in the digital transformation of the company and investing too in the ongoing program of simplification, the paying down early for debt and a big increase in pension payments over the last three years to ensure a very well-funded scheme for the future.

We continue to simplify the company as the disposal of a 22% stake in Penguin Random House shows. We’re maximizing the value of text. Barnes & Noble Education, Chegg of the independent stores and are now all signed up as rental partners on our new pilots. The early indications are that reducing eBook prices by 20% to 15% on 2,000 backlist titles is increasing both unit sales and total revenues. To encourage better inventory management, we’re adding a restocking surcharge when books are returned after 30 days to the other the steps we announced clearly this year to manage inventory more tightly. We’re piloting a new unique ID registration system for our print titles, which will enable us to authenticate returns, and importantly, engage directly with print as well as digital uses of our products. I’m working together with channel partners and the industry to take concerted action to tackle counterfeit and piracy.

The next phase of our transformation is, of course, driven by our strategy, which as you know, is all about combining our world-class content and assessment capabilities powered by innovative services and technology to support more effective teaching and deliver a richer learning experience to many more people.

Three factors underpin the way we are transforming Pearson for growth. One, simplifying the business. Streamlining the back office through the increased use of shared services centers, consolidating our supplier base and building partnerships that allow us to serve customers faster, smarter and at lower costs.

Two, accelerating the shift to digital. Developing scalable and reliable platforms with an improved user experience, getting future products and services to market faster, Embedding data insights across the business. Creating products and adapt to the needs of teachers and students in ways that help them to be more successful. You will see all these characteristics and a wave of new products coming to market over the next two years, some of which I previewed in May. And three, to underpin this as well, we're really focusing on the skills and talent we need for high performance culture to drive the shift to digital and increasing simplification of the company.

So what does our opportunity look like in the key areas of our business. Well, in U.S. higher education courseware, it's all about taking a greater share of a higher volume of digital courseware priced to give great value to students going digital and direct to secure higher margins. Over the last 15 years, we've pioneered the adoption of digital courseware with great success, particularly in STEM subjects.

In the near term, we're sitting at the top of the S curve for those digital supplemental products, but we're about to embark on a phase of growth with new integrated digital products serving a broader range of subjects.

In assessment, a fewer better tests empowering teachers, parents and learners with essential feedback and guidance, assessments that doesn't just measure learning but facilitates it. And that's a more profitable business as it goes digital as the improving margin show.

And in services. Online Program Management is already $1 billion global market and a growth opportunity. We're well positioned with the largest client to invest and sign more partners more aggressively to drive our future growth, and the pipeline is strong and getting stronger. A fully digital business with long-term contracts allowing increased visibility and a greater share of value.

And with that, I will now hand it over to Coram.

Coram Williams

Thank you, John, and good morning, everyone. I'm going to cover three things today. Firstly, an overview of first half performance, secondly, our approach to capital allocation, balance sheet and dividend policy and thirdly, our simplification plan with more detail of how we introduce the 2020 cost base by GBP300 million.

As we always say at this time of year, our business is very second half weighted and our key selling seasons in many markets lie ahead of us. However, as John has already said, we've had a steady start to the year, and we're on track to land within our guidance range after adjusting to the impact of the Penguin Random House transaction that we outlined on July 11.

So let's look in a bit more detail at our performance in H1. Our sales were up 1% on last year in underlying terms. Headline sales grew by 10%, reflecting the strength of the U.S. dollar against sterling. Taking each geography in turn. In North America, revenues were flat in underlying terms as some of the phasing benefits we saw in Q1 unwound as we expected.

In our key North American higher education courseware business, we saw higher gross sales and lower returns. The picture in H1 is similar to that reported at Q1, with gross sales running a bit ahead of where we thought they would be. But returns whilst down significantly year-over-year are not down quite as much as we had expected. This has led us to top up our returns provision in Q2.

We’re already a month into our key third quarter in U.S. higher education courseware. In trading in July, unfolded in line with our expectations, and we continue to be where we thought we would be at this point in the year. However, it is important to understand we still have two large months left to go in Q3, a very significant period for returns in October and November. And of course, late Q4 sales are still very important to the outcome of our year. So the range of revenue outcomes, we outlined at the beginning of the year for this business of plus 1% to minus 7% remains unchanged.

Turning to other parts of North America. We had a strong performance in professional certification and in the U.S. K-12 courseware. We’ve seen a good performance in Open Territories and in the parts of the adoption market where we’re competing, though some of this is likely to be phasing. Growth there and in U.S. higher education courseware was offset by anticipated declines in U.S. school assessment. Revenues in our U.S. higher education online services business declined in H1 due to Learning Studio, a learning management system that we’re phasing out. The OPM business grew, though near-term enrolment and revenue growth was lower than recent trends as we exited from a couple of contracts that had proved uneconomic. Despite those short-term headwinds, the pipeline to the OPM business has grown significantly over the last 18 months. And this business will continue to be a source of growth for Pearson.

In Core, revenues rose 1% in underlying terms, primarily due to strong growth in Pearson Test of English and OPM services in the U.K. and Australia. Our U.K. qualifications business is stabilizing the way we expected. In growth, revenues grew 1% in underlying terms. In South Africa, revenues grew strongly with Griffith school textbooks, partially offset by weaker than expected enrolment at CTI. CTI has been impacted by higher levels of funding for public universities and a smaller number of qualified students from which to recruit. In Brazil, revenues declined due to macroeconomic pressures and political uncertainty, although the competitive performance was strong. In China, revenues in Wall Street English and English courseware were up. In the Middle East, revenues fell significantly due to further contract exits as we simplify our business.

Turning to profit. H1 is typically a small part of the full year operating profit of Pearson, but we’ve had a steady performance across the business. As you can see from this bridge, the biggest driver of our strong year-over-year improvement is the incremental benefit of our 2016 restructuring program. These benefits have more than offset the impact of cost inflation and other operational factors, including dual running costs and increased amortization, which we told you about at the beginning of the year, and which will abate overtime. FX is positive as sterling was weaker than it was in most of the first half of last year. Penguin Random House has shown a strong performance year-on-year, but most of this is phasing. Trading in the rest of the business is also seeing some benefit from phasing as we expected.

Last month, we updated our guidance for the expected September close of the Penguin Random House transaction and that guidance, as you can see here, remains unchanged. Whilst we'd expect to start the share buyback after the transaction closes, the impact on full year average shares outstanding will likely be small.

Operating cash is always an outflow of the half year, reflecting our normal seasonal increase in working capital. This year, the operating cash outflow was significantly lower than last year, reflecting the improved profit performance. Our net debt rose just over £200 million over the 12 months since June 2016.

Our operating cash covered the cost of restructuring, the dividend, interest and tax. So the increase is explained by two other factors. Firstly, FX increased net debt by GBP89 million year-over-year and secondly, we paid GBP162 million in H1 into the pension fund relating to Penguin. Net debt would have been below last year's level without these two factors.

You remember that the pension arrangement dates back to signing the Penguin Random House joint venture deal in 2013 and resulted in a top-up payment for Penguin's pension liabilities in 2017 regardless of whether we had done a deal or not for the remaining stake. We've previously quantified that at GBP225 million in total so we have around GBP63 million to go.

Turning to capital allocation. Pearson's cash generation is strong and our priorities for how we use our cash remain unchanged. Firstly, maintaining a strong balance sheet and solid investment-grade credit ratings through an appropriate capital structure. This broadly equates to year-end net debt to EBITDA ratio of less than 1.5 times, which in turn is broadly equivalent to less than three times taking into account operating leases and other rating agency adjustments.

Two, simplifying our portfolio and investing in the business to drive sustainable organic growth. We're investing more than GBP700 million per year in product development in CapEx, more than ever before in building better digitally powered businesses. And three, delivering shareholder returns through a sustainable and progressive dividend policy and returning surplus cash to shareholders via buybacks or special dividends where appropriate.

As you know, we plan to use part of the proceeds from the Penguin Random House transaction to buy back £300 million of ordinary shares after the closing of the deal. We have a strong funding position as a result of the actions we've taken and we are taking more to optimize that position, including bond buybacks earlier this year and announced today. Together, these actions will drive a reduction in interest costs of around GBP20 million on an annualized basis.

On pensions, our UK scheme is an accounting surplus and is near to self-sufficiency on an actuarial basis, thanks to effective management by the scheme trustee and just under GBP400 million of deficit contributions the company will have made between 2015 and the end of this year.

And so to our dividend. Our intention here is to set the dividend at a sustainable level that preserves our ability to one, maintain a strong balance sheet, two, invest in our businesses for long-term growth; and 3, allow us to grow the dividend over time. In line with that policy, the board is today declaring a GBP0.05 interim dividend. Our final dividend will be set in February 2018 with reference to both the dividend policy and the performance of the business in the second half. Historically, the ratio here between our interim and final dividends has been roughly one-third, two-thirds and this remains a good way to think about the base level for our 2017 dividend.

Finally, I want to look at the details of our plans to take another £300 million of costs out of the business. Over the last four years, we’ve taken more than £650 million of costs out of Pearson in two restructuring programs. That effort has made us leaner, and it has also created further opportunity to make Pearson a simpler business. In May, we told you that the biggest opportunities to reduce costs further are, one, globally, in human resources, finance and technology facilitated by our back office change program. And two, in North America, where we need to adjust our cost base to the reality of the smaller or higher education courseware business. We size that opportunity of £300 million on an annualized basis. Today, we’re announcing details of the actions we intend to implement over the next 2.5 years to realize this opportunity.

Many of the savings will come from the simplification of our technology architecture, which allows the increased use of shared service centers, enabling us to standardize processes and reduce headcount that in turn facilitates the opportunities such as the greater centralization of procurement and the reduction in the number of our office locations. As a result, we will ultimately be able to reduce Pearson headcount by approximately 3,000 FTEs with the focus on managerial positions. These characteristics make this a complex and ambitious plan, which unfolds over a longer time frame than our 2016 restructuring program, but ultimately, has a greater transformational impact on our business.

That approach drives the phasing of the costs and the benefits that you see here. We have to lay the foundations of the program by making further technology changes and creating shared service centers before we can start to reduce headcount and other costs. It also means we incurred some one-off costs in technology and property in the second half of this year before the benefits really start to flow in 2018. Overall, restructuring costs will be around £70 million in 2017, £90 million in 2018 and £140 million in 2019 as we complete the program for cumulative one-off cost of £300 million. That will start to generate significant cost savings from next year with around £70 million in 2018 and incremental £130 million in 2019, and the remaining incremental £100 million impacting 2020. The net result will be to reduce our annualized cost base exiting 2019, i.e. in 2020 by £300 million.

Back to you, John.

John Fallon

Thanks, Coram. So we’ve had a solid first half. We’re making good progress on our strategic priorities and our guidance for 2017 remains unchanged. Strong cash generation, prudent management of the balance sheets are enabling us to invest in our product our technology and our transformation. And that will in time, position us to be the winner in digital education, and in time it will create long-term sustainable value for our shareholders.

And with that, Coram and I will be very happy to take your questions. Sahir, back to you.

Question-and-Answer Session

Operator

Thank you [Operator Instructions]. Our first question is over to the line of Matthew Walker at Credit Suisse. Please do go ahead Matthew, your line is now open.

Matthew Walker

Hi good morning. I've got three questions if that's okay. The first is on the Digital Direct Access deals. How many of you signed in total up to now? And what is the sort of rough revenue impact from those? Then on the book return surcharge you mentioned, how much is that per book? And also can you tell us whether bookstores are allowed to return books over 12 months old? And how many books do you think are in the chain which are over 12 months old? And lastly, there has been a dispute with Follett's, and the reasons for that dispute are disputed. Can you tell us why that's happening? And are their claims about you trying shut down the low cost options for students and OER business. If that's actually correct, how would you characterize the nature of the disputes? And any progress that's being made on that?

John Fallon

Okay. Matthew, I'll take the third one, and then Coram will pick up on the other two. Look, I mean, I think working with the rest of the industry and with our channel partners, we have a responsibility both to our office and to our shareholders to protect our intellectual property, counterfeit and piracy is an issues that we have to deal with as many other industries or many other sectors do. And the actions we're doing are legitimate and proportionate to protect the intellectual property in a way that's fair to all parties.

You will have seen that implementing that approach, we have reached agreement with a range of partners, including Barnes & Nobles, Chegg, and others and this is just part of our ongoing work and ongoing program. It's responsible and proportionate. And you'll understand that I don't want to comment on any specific engagement with any single partner. Coram, did you want to pick up on the book surcharge on the.

Coram Williams

Direct Digital Access deals. So on the Direct Digital Access deals, we've signed 100 this year, and that's up on what we'd signed this time last year. It is still a relatively small percentage of our turnover because this is a relatively new way of going to market, but it's growing nicely. And as you'll remember from our bridge for the full year guidance is a positive for us of about a percentage point on a year-on-year basis. So we're very happy with the progress that we're making there. In terms of the book surcharge, I don't want to get into the specifics of the amount per book. It will be charged as a percentage of sales, and it will be based on a particular set of criteria, which obviously, we will discuss with our retailers. But we do think it will provide the right incentive to manage inventory in the channel which taken together with the other moves that we've made, particularly the move from gross to net, will ensure that inventory levels continue to be well controlled.

In terms of where inventory levels are, we do believe, based on the visibility that we have, that they are lower than they were at this time last year. And I think you’re seeing that in our returns -- in returns levels, which are significantly down year-on-year. But we don’t have perfect visibility into the channel. And on your final piece around 12 months old, yes, it is possible to return books beyond 12 months, although obviously, the way in which we interact with our retailers discourages that.

Operator

We’re now over to Ruchi Malaiya of Bank of America Merrill Lynch. Please go ahead.

Ruchi Malaiya

Hi, good morning And John, you mentioned in your comments that you’re focusing on the skills and talents that you need to shift the business towards digital. So, I was just wondering how you think about the potential costs of this wage inflation, maybe, sort of shifting need to then your sales force, so you’re wider and the staff base and the re-inflation as a bonus pool. And how you think about that over the coming years?

John Fallon

So, good question. I think the -- we have factored, and you should have factored into the guidance that we’ve given you cost inflation and wage inflation, and you can see that in the bridge in the first half of the year. We are -- as you know, you saw it with the -- with department people like Kevin Capitani, who came into to lead our North American go-to-market organization last year. Some of the new hires that we’ve made around product management capabilities as we accelerate the digital shift, then move to services, increasing support for customer operations to move to be a much more sophisticated data and insight driven sales organization is really exciting.

Some of the really good new talent that we’re bringing into the company, clearly, they expect to be paid and rewarded competitively. And they see it for all the challenges in Pearson short-term, long-term opportunity to be part of something pretty special. And they’re all attracted by the mission and the purpose. So, I think they see both great turnaround opportunity over the next few years from which they can personally benefit, but also the chance to do something important. And neither of those factors should be underestimated in our ability to attract really great talent to the company.

Operator

We are now over to Barclays and Nick Dempsey. Please go ahead.

Nick Dempsey

Yeah. Good morning, guys. I’ve got three questions. So first of all on Side 13, where you show the steps for profit movements. So, the £50 million of inflation and other operational factors, can we think about that as a kind of standard number? Or is it particularly inflated by anything in the first half? What I’m already getting at is when I’m thinking about step/chart like this for 2018. Do I need to put £100 million of inflation and other operational factors in there offset by £70 million of savings that you've guided to. Second question, Cengage this week, suggested that the returns picture for them in Q2 was better than they’d expected, down 40% year-on-year of actual returns. Is it likely you‘re seeing a very different situation for them for timing reasons or anything? Or perhaps their expectations were just different than yours at the start of the year. And third question, can you reassure us that the organic net sales growth in July for North America higher ed courseware was inside your guidance range of plus 1% to minus 7%?

John Fallon

Okay. Nick, I’ll take the second and third questions, and then Coram, you can pick up first and then if he wishes to. The important thing to remember is the key returns period in the first half of the year is Q1, not Q2. So, we should be wary of big percentage declines on relatively small numbers. For the first half of the year, for the first six months of the year, as we've said, our returns are down significantly, and they are down in line with the market. We know that because we see monthly data as we talked about previously for ourselves on our five of our major competitors. So I think we should be encouraged by the fact that those returns are not down by quite as much as we'd expected. They are down very significantly.

However, the second major returns period in the year comes in the Fall back-to-school. So that's really sort of October, November. So I think frankly, it is too early for anybody to be calling anything on returns. We really need to get through to the full year. And yes as we said, the picture that we saw at the end of June, which was slightly better than expected growth sales, returns down significantly but not by quite as much as we saw the good growth in digital revenues. That picture continued through the end of July.

So yes, that is the case. But again, we still got five big months of the year to go. No student has yet really set foot on campus for the Fall back-to-school, that happens next week. So really, it's too early for anybody to be calling anything, and there are not really any new reliable data points beyond what we gave you in January and then talked about in February. And it won't be until we get to the October trading update that we'll be able to give you an update on anything that really carries any rigor or reliability that anybody can read anything much into. Coram, I don't know if you want to add anything on that as well as deal with the inflation point.

Coram Williams

I don't think there is anything to add. I think it's very clear that we're tracking in line with our expectations, but clearly, there are some significant selling in returns periods to come. And on the inflation and cost factors point, you'll remember that at the prelims, when we put the 2017 bridge together we quantified the inflation at GBP55 million and other operational factors at GBP60 million. And what you're seeing at the half year is roughly half both of those are flowing through. So I think the way we're thinking about 2017 is still right.

In terms of how to think about 2018, we have talked to you about both of these factors before, and in the short-term they certainly continue in that way, though obviously, as the cost base comes down, the inflation amount will come down a little bit. And on the other operational factors, which is primarily dual running costs in IT while we've got multiple systems running side-by-side and product amortization reflecting phasing of the investment. Those will abate over time. And we have said that before. So none of that is new news. So the anything I'd expect you to be doing to your model, Nick, is to be adding the GBP70 million of incremental benefits that we've just quantified in terms of the restructuring.

John Fallon

Okay? Is that clear?

Nick Dempsey

You didn't say whether you were between plus 1 and minus 7. Perhaps you didn't want to answer it, but I didn't want you to forget.

John Fallon

Well, I thought, sorry, Nick, I thought we did answer it clearly, which we said our guidance for the full year is unchanged though that is the range of our guidance. So we are trading within that range, but to be absolutely clear, it is too early in the year to say where in that range we will land because there is five months of trading still to go.

Nick Dempsey

My question is whether July, itself, year-on-year was within range. I’m probably happy if you know the to answer, but that was the specific question.

John Fallon

So Nick, you’ll understand we’re not going to comment on monthly sales numbers. But just to be clear, what I said in my script was July had traded in line with our expectations and John has just quantified our expectations.

Operator

We’re now over to Ian Whittaker of Liberum. Please go ahead, Ian.

Ian Whittaker

Thank you very much. First of all, just -- again, going back to what Cengage said earlier this week. One thing they did sort of mention was they think the declines in the community college enrolments are more structurally driven. On then now, when you had your Investor Day last year, you’ve sort of pointed out that 31% of the U.S. higher education -- or 31% of all U.S. higher education enrolments come from community colleges. But at that stage, you’ve made up 43% of your U.S. higher education publishing business. So, you’re obviously, overexposed. I mean, first of all, I'd be interested just in your sort of views are on what they’re saying. And second of all, whether there’s been any noticeable shift in terms of your reliance on the community college segment.

The second thing is just sort of -- it sort of goes back to Ruchi's question. Just in terms of sort of the cost savings you’re putting through in terms of the £300 million cost saving program. It’s the way that we should think about this sort of medium to longer term, in that you’ll have to sort of reinvest some of those savings within that business. So that -- should we think about £300 million were -- as a gross figure and some of that will actually have to come back in some of the initiatives that you’re launching? Or you’re quite happy in terms of sort of people just assuming £300 million of the cost base in terms of 2020?

And the third question is just in terms of the sort of digital side of things and how things are going there. And there was an interesting quote from the CEO of Chegg, is that five years ago you predicted print textbooks would be dead. And actually, print textbooks are still 70%, 80% of the market sort of depending on where you look at. Sort of -- is there sort of a issue here that while you may want your business to transform to digital, but quite frankly, students don’t want to. Still prefer the print product. And in that case, how do you actually sort of -- as it were, how do you avoid the possibility of dual learning costs?

John Fallon

Okay. So let me take the first and the third, and then Coram will pick up on the second. First of all, in terms -- I think it was on your college -- community college, I think that’s two parts of the question. One was about our relative weighting to the sector, and second was around is there cyclical or structural decline. To take the second part the question first, if you remember, back to our Investor Seminar a year ago, we shared with you the shift in waiting of our revenues over the last five years. And essentially, what that told you is what you have just asserted was true back in the late 2000s, but it's no longer true. So in other words, at the peak of the market we were overweight to the community college sector, but now our revenues are proportionate compared to the rest of the industry and the sector.

On your -- first, on the first of part of that point, I think community college enrolments, if you look back since the late 40s, have moved in line with the economic and the employment cycle. What you just said is there is some sort of speculation, is that going to change. Are people going to move to short-term more career oriented courses, to be honest, if they do, that’s a good thing from a Pearson point of view because one of the fastest-growing parts of our business is really looking at that different pathways, different means of linking college and career training to employment. That's what our Online Program Management business in part is addressing, and we've other sort of opportunities. If it does go that way, there's a growth opportunity because our revenue per enrollment in that model is higher than it is in the courseware model. But I think to be honest, it's too early for any of us to make that judgment. We'll have to see how that plays out over the next few years.

On your question on sort of do students want textbooks, we will continue to publish text as well as digital for as long as our customers and the markets wants it. And I think we've set out the way in which we can maximize the value of text, and we described a whole series of initiatives to do that. A couple of data points that might help. If you remember last year, our net revenues in U.S. higher education courseware were just over $1.3 billion and the weighting was almost 50-50 digital print. Just under 50% digital, just over 50% print.

I think as you're seeing with digital revenues up in high single digits in the first half of the year, that we're continuing to accelerate the shift to digital as we provide more value. So we're accelerating the yield, if you like that we get from the 11 million digital supplemental registrations that we have. The other 50% of the market is still print, of our revenues is print. Half of that, we think, is going straight into rental market today.

So I think the question is as we've talked about previously, how quickly does that other 50% of our print revenue, in other words, 25% of the 1.3 billion, go into rental. Our guidance for the next two year assumes that they decline at a rate of 15% per year. So in other words, that the further deterioration from the growth in rental in our text is quite significant. So that's the basis of our assumptions. The other point I'd just make is students are still paying, on average $800 per course to use our products and services. The challenge is we only get $55 for those $100. And as we shift to digital, we can increase the proportion of values that we take.

Ian Whittaker

Can I just follow-up on your things. I think you said the community college enrollment, you're not overexposed to community colleges. If I look at Slide 27, of your Investor Day presentation from last year, when it talks about the 2015 revenues by segment, the slide there says 31% of enrollments went to your community colleges. But for your revenues, 43% are into your community colleges. So that would seem to imply that you are still overexposed to community colleges.

John Fallon

Yes, and that's why in our guidance, our assumption about the impact of our decline on enrollments is greater than the overall growth. So in other words, we are assuming a bigger decline in our revenues from enrollments than the overall decline in enrollments is. So we have weight, so that weighting of the industry as a whole to community college enrollments has taken account of our guidance for the year. So that makes sense?

Ian Whittaker

It certainly does. I apologize.

Coram Williams

So in other words, if our overall enrollments decline by 1.5%, 2%, we're expecting the decline on our revenues will be more like 3%. And that takes account of the fact that there is a greater weighting to the community college sector.

Ian Whittaker

Apologies. I interpreted the answer sort of the reinvestment in the business as well.

Coram Williams

Yeah, I’ll take that one, Ian. So, we’ve been really clear. I think that the £300 million saving is flowing through directly. So our cost base at the beginning of 2020 will be £300 million lower than it is today. If -- and we’ve already touched on this on the call, but in previous sessions, we’ve given you an idea of how to think inflation and investment and way that other operational costs of through our P&L. And we’re very comfortable -- making. So this £300 million is flows through directly and is additive to whatever assumptions you’ve been making up until now for your 2020 profit.

Operator

We’re going over to Citi and Thomas Singlehurst. Please go ahead.

Thomas Singlehurst

Good morning, good morning. So, a bit of a niche question. So I apologize about this, but on your sort of services businesses, both of them are showing revenue declines. Obviously, some one-off items happened. Can you just talk through just the scale of impact from some of those specific sort of either platforms that you’re closing down in the case of Online Program Management. And then some of this sort of in-house services and connections. And then linked to that you talked about a number of new degree programs coming on within the OPM. So, do they have any significant impacts on profitability? I know they -- you do tend to is sort of in terms set up investment associated with your degree program. So, that was the first question. The second one very quickly on net debt. I think that sort of your commentary had implied that year-end net debt for this year would be at or around £800 million. I was wondering whether you’re still comfortable with that and, specifically, whether you’re comfortable with it included in the incremental restructuring costs?

John Fallon

Okay. Coram, do you want to take both of those?

Coram Williams

Sure. Yeah. Say, on the services businesses. Actually, I think, we were clear, Tom, that on OPM, the business actually grew, excluding the impact of Learning Studio, which is a learning management platform that we’re retiring. That will be a drag on the overall online services revenue for the next couple of years, but it is a diminishing one. We’re very sort of optimistic about OPM. The enrolment growth is still there. It’s been impacted a little bit this year by the exiting of the couple of contracts, which were not economic for us. But our pipeline is actually stronger than it’s been at any time over the last 24 months. So that’s we think you’ll see some good growth flowing through there.

On connections, we’re seeing significant enrolment growth continues to be up high single-digit, low double-digits. And what’s impacting us in the first half there is some of our partners taking some services in-house these tend to be low margin services, which they think they can undertake as the contract matures. But I think it's a timing issue. You'll see the enrollment growth really come through in the second half as a result of the way that we recognize revenue in that business. So we’re feeling good about the prospects for both of those businesses.

In terms of the profitability of OPM, you're absolutely right to highlight that in the early stages of the contract, we do see more costs than we do revenue. And that takes two to three years before those contracts breakeven. But the overall profitability of that business is driven by the portfolio of contracts and the spread of maturities that you've got. And we've said before that this is overall a profitable business for Pearson and as more contracts reach maturity, it becomes more profitable. On net debt, we are absolutely still on track to come in at or under GBP800 million at year-end. That's driven by a combination of good cash generation in the second half and also the proceeds from Penguin Random House. So yes that we're definitely still on track for that.

Coram Williams

Okay, thanks Charles.

Operator

We now go to a question that's comes through on the web from Stuart Wilson at IVI, and his question for you is, could you give us some detail on what the £700 million, £750 million in product development is actually being spent on?

John Fallon

Okay, thanks Stuart. I mean, it's a mixture of investment in new product development and in CapEx around transforming the platforms and systems that we used to run the business. But Coram, do you want to have a go on that a little bit?

Coram Williams

I think we've broken this down previously at about 450 to 500 on product development, that is direct R&D spend. Majority of it is capitalized on the balance sheet and then amortized, but there is a small portion that flows through the P&L. But that really is an investment in future product to drive the top-line. And then we have about GBP250 million of capital investment, which is a mix of the usual maintenance on CapEx. That's about 150 to 170. And then the increased incremental amount is the systems investment that we're putting it in the back office to drive the simplification of the business and which ultimately has facilitated this next round of cost savings that we've given clarity on today.

John Fallon

Okay? Thanks for that. Sahir, where are we going next?

Operator

We're going over to Berenberg and Alastair Reid.

Alastair Reid

Good morning, thanks very much. Firstly, just to clarify, with the dual running costs, should that be anything incremental in terms of their amount specifically coming through next year and then secondly, could you give us some more color on the trends you're seeing with MyLabs on a global basis? What's behind the decline in registrations that you're now seeing? And then lastly, could you clarify your treatment of profits from GEDU and Penguin Random House with regards to their inclusion in adjusted profit numbers given they are classified as held for sale? Thanks a lot.

John Fallon

Okay Alastair I'll pick up on the second question and then ask Coram to pick up on the first and the third. So just to remind you, I think we think about digital growth in respects, one around revenue and one around registrations. As I mentioned early, we've had good high single-digit revenue growth in the first half of this year, that's we have about 11 million MyLab & Mastering and related registrations in North America. This is what we call the digital supplemental model. So this is where the digital product is a supplement to the text in either a print or eBook format.

And we are now really working very hard to transfer more value from text-to-digital by launching things like Early Alerts and Skill Builder and the other things that we've talked about. And that is working well. With MyLabs and Mastering, that digital supplemental model, the growth now comes from revenue, not registrations. And that's because we are -- as we talked about at the Investor Seminar last year, at the top of the S curve, the digital supplemental model worked best in the STEM subjects where we have high market share, and we already have very high conversion to digital. The registration growth is going to come through creating a new S-curve around this idea of integrated digital in disciplines where currently we have lower share, and where there’s lower digital conversion. That’s off to a promising start. You’re seeing the good growth, very strong growth we see in REVEL registrations in the first half of this year, but we are still right in the foothills of that curve.

And to be frank, we are being quite cautious about driving it too hard until we sort out the underlying complexity and fragmentation of some of our technology and platforms, which I talked to you about earlier this year. So, I think you should expect in our U.S. higher ed business that for the next 12 months or so, the primary growth in digital is going to come through revenue from raising higher yield in conversion in MyLabs and Mastering. And the registration growth is not going to pick up until we really launch in anger many of the new products that we talked about on the call earlier this year on the global learning platform. And that’s really going to be piloting later this year, first half of next year and full commercial launch later in 2018 and into 2019. And then Coram, do you want to pick up on the dual running costs and on PRH?

Coram Williams

So in terms of the dual running costs, I think I’ve said previously that they reflect about half of those operational factors. And these are costs that are incurred because we’re effectively running two set – two architecture, two sets of systems side-by-side, while we are replacing our legacy of ERP platforms and other systems with a single global ERP system. And that runs is certainly through 2018. And then, actually, we get close to being able to turn off a chunk of the legacy architecture in 2019. So you should see those dual running costs abate during the year.

And from 2020 onwards, we should be free from them. And that’s consistent with the way I’ve described them before. In terms of GEDU and Penguin Random House, you're right we are treating them as held-for-sale. That’s an accounting treatment, which is driven by the fact that we have made the decision and are very clearly on a path towards selling them. It means we separate them out on the balance sheet. And you can see separate assets and liabilities on the main balance sheet, but we do include their results in the P&L, and we will do so until we sell both of them. That’s not material on GEDU, but obviously, the third quarter for Penguin Random House is a significant quarter. So that will continue to be included in our adjusted operating profit.

Operator

We’re going back to the web. And now over to Chris Meyer from Blackrock. And his question for you is what’s the target of the liability management exercise in terms of the total promotional amount of bonds that you’re seeking to redeem?

John Fallon

Okay. I think, I'll say that’s definitely one for you, Coram.

Coram Williams

You’re absolutely right to say that. So there two separate actions that we’ve announced today. The first is that we are making whole the GBP 300 million bond which we thought outstanding until 2018, which has a coupon of 4.625%. Obviously that means we will fully redeem that because it is close to its maturity and therefore, it’s economic for us to do so. The other thing that we’ve announced is a tender on two separate bonds, both of which were $500 million each 2022 and 2023 obviously because it's a tender offer I can't tell you what we're going to get until we have completed that exercise. But what I have done is quantified what I think will be the impact of those actions on our interest rate as well as the liability management that we undertook earlier in the year. And we think that saved us about GBP20 million next year on the interest line. And obviously, it also strengthens our balance sheet considerably.

Operator

Okay, well we have is over to Katherine Tait at Goldman Sachs. Pease go ahead Catherine. Your line is open.

Katherine Tait

Good morning everyone. Just a couple of questions from me. Firstly, on U.S. higher education courseware. In your conversations with customers, I'm just curious to understand the key reasons for the higher gross sales. Is it -- that what you're hearing from them. Is it optimism for selling more books? Or is it something else that driving that? Obviously, we'd appreciate a sort of gross sales number. But looking into the second half, I'm just curious to understand, I mean, how they're thinking about the movement, obviously given the sort of gross net dynamic in play? And then secondly, just on OPM. You've mentioned about the contracts that you would do from that were not economic. I wonder if you could just give us a bit more color on that. My understanding was that these contracts were quite long-standing contracts, sort of 10-years or so given, obviously, upfront investments that's required. I just wondered what's driving these sort of the lower economics. Is it lower enrollment, is it lower revenue or higher costs? And any sort of color on that would be really helpful. Thank you.

John Fallon

Yes. Okay, Katherine, I'll take both of those. I mean, on the second one, you'll understand that we don't want to get into too much specific comment on individual contracts with individual partners. But just to remember the nature of the Online Program Management business is you are partnering with a university to launch new online degree programs. And inevitably when you're partnering with a number of universities, some of those partnerships will work more effectively than others, sometimes the leadership or the personnel changes, sometimes as you get more into the detail of it, they decide they want to change the strategic direction of the University.

So not inevitably, not every partnership is going to work successfully. And that's why, although, the top line growth of the business is strong, it's not completely linear and it is a bit uneven because if we jump or we had 20% plus growth in the first half of last year, it's very much driven by when you're signing the partnerships, getting them going and then getting them to scale. And that's why partnerships like the one we have with ASU, the partnership that we're forging with Maryville, where you're really building a more deeper longer-term strategic partnership is an important part of the mix as well.

On your first question, I'll go back to my early answer. It is too early. I could try and give you with details a detailed answer, and I would worry that I would be very misleading. So I'll go back to what I've said earlier. The first students go back to school next week, that's when sell-in starts to turn to sell-through. And that's why the point at which we can say something meaningful that ads with data to what we told you back earlier in the year, the first time we can do that will be at the time of the October trading update.

Operator

Our final question for today is over the line of Patrick Welllington at Morgan Stanley. Please go ahead.

Patrick Wellington

Yeah. good morning everybody. I suspect you might not give me specific answer, so some general ones. John, when you look at high returns and -- sorry higher gross sales, but also higher returns. Which do you prefer, I mean, if you lie in bed at night, you’d say, I’d really like to have higher gross sales, or, I’m worried about the higher returns. And which is it, if you like a better health indicator for the business? And secondly, on Cengage, I mean, their Q1 to the end of Q4 to the end of March returns were down 30%.

So I don’t know whether you want to tell us how your returns look against those if that’s the important quarter. Or in general, I think if we look at the remarks for Cengage and McGraw-Hill about their higher education market in 2017, their attitude is, look, we had a confluence of horrible events in 2016. The market is still tough in 2017 but it’s not nearly as bad. I mean, would you go along with that? And then thirdly, a point of clarification, I think during the presentation, you said that the eBook initiatives were increasing total revenues. Is that actually right? I didn’t think that they were supposed to increase total revenues straight away. And they were actually going to have a negative short-term impact. So which is correct?

John Fallon

So the -- to deal with the last point, what I was saying is that unit sales of eBooks and the revenues generated by those sales are both up. Clearly, to the extent that they have cannibalized the sales from elsewhere in the portfolio then the economic effect would be neutral in the year, so just to sort of clarify on that point. On your second point, our expectations for 2017 are as we set them out at the start of the year, we are running the business on the basis that underlying demand is likely to be around 7% lower on a like-for-like basis than last year, declining college enrolments, continuing growth in the secondary market, continuing growth in OER offset by some benefits from digital and the growth in the Direct Digital deals, and Direct Digital Access deals.

And we have -- to the point, I made at several times we have no new information or data that would give us any reason to change that expectation at this point in the year. To be clear, for the year-to-date through to the end of June, you have to look at returns across Q1 and Q2 to have a reliable view. And also to be clear, it’s not that our returns are up and not our returns are down very significantly on prior year they’re obviously not down by quite as much as we expected them to be. And to repeat the point I made earlier in year, early in the presentation, our returns are down in line with the industry as a whole. So in other words, what we see is how we’re doing month year-to-date, 12 months rolling average, and how the rest of the industry is doing.

And as a percentage terms, our returns are down as much as the industry, excluding Pearson is down through the end of June. And I think again, I worry that to answer your first question would lead to people interpreting far more into it than it would be wise to breathe into it at this point in the year. I think the fact that gross sales are a bit more than we thought and returns are down, but not quite as much. I don’t think you should read anything into that other than because this is not a precise science, as we all know, is that broadly speaking, things are where we would have expected them to be at this point in the year.

Patrick Wellington

Great. Thank you.

John Fallon

Okay. Thanks, Patrick. And Hugh, I think we have finished some questions. Thanks, everybody joining us. I realize we are coming to the end of what's been a pretty busy reporting season for all of you. So thanks for taking the time. Thanks for your interest in the company. Joe, Tom and Anjali, are all on the call, at all around throughout the day to take up any follow-up questions that you have. Thanks very much. And I hope you'll have a good summer.

Operator

This is now to conclude today's session. So thanks for attending, and you can now disconnect.