Media

Chris Hughes is a Bloomberg Gadfly columnist covering deals. He previously worked for Reuters Breakingviews, as well as the Financial Times and the Independent newspaper.

John Fallon has gone straight to the bottom of the class. It's hard to see how Pearson Plc's CEO can now avoid expulsion.

The educational publisher's profit warning and dividend cut on Wednesday sent the stock down as much as 30 percent, destroying almost 2 billion pounds ($2.5 billion) of market value.

Pearson Popped
The stock sank by the most on record following the publisher's profit warning
Source: Bloomberg
Intraday times are displayed in ET.

Pearson admitted it had been over-optimistic about recent U.S. student enrollment numbers, and the revenue they would bring in. An improving economy means people are choosing jobs over study. Meanwhile, would-be customers are balking at the sky-high cost of textbooks and are instead buying them second-hand, or renting physical or digital versions.

Those trends have left American booksellers with excess stock of Pearson publications. Late last year, they exercised their right to return this to the company. As a result, revenue from U.S. college books fell some 30 percent in the fourth quarter, bringing the annual drop to 18 percent.

A big shock, right? The reality is that many analysts have been worried about these trends for months. Berenberg, among others, warned about them repeatedly last year.

Fallon and his team deserve strong criticism for misreading the dynamics of their own marketplace so badly. Amazon seems to understand the situation far better: the U.S. retailer is distributing Pearson content using a locker system that makes it easy for students to rent books on campus.

Can Fallon atone for all this in his response? It may be too late for that. Pearson is now expanding its own rental offering by slashing online prices and lending hard copies. This won't directly benefit financial results, but it should give it a bit more of a handle on student trends.

Fallon needs to shift the company to a subscription-based digital model faster than has been the case. Even if the recent spike in returns is a one-time adjustment, the days of Pearson printing money by selling textbooks at astronomical prices are history.

This is a strategic problem given Pearson gets almost all its profit from education after Fallon sold the Financial Times and its half of the Economist Group. The company plans to offload its stake in publisher Penguin Random House.

With the shares trading for less than 600 pence, investors may be hoping a bidder might relieve their misery.

After all, Pearson should benefit from an exciting long-term demographic trend with the general expansion of education. There may be some logic in a U.S. tech firm acquiring the content and completing Pearson's digital strategy. And private equity is flush with funds and eager for restructuring opportunities.

But the shares may still not be cheap. Its guidance for 2017 operating profit is about 15 percent less than what analysts predicted before the warning. Add in a discount for poor visibility and it's hard to argue the stock is better value than last week, when it traded on about 13 times forward earnings. What's more, Pearson is quite big for a buyout. Even after the warning its market value is 4.7 billion pounds.

Trailing Peers
Pearson is trailing its peers in the FTSE 100 Index
Source: Bloomberg

Fallon was already in a tight spot, with Pearson among the worst performing FTSE 100 stocks over the past three years. In his defense, the woes may stem partly from under-investment by his predecessor, Marjorie Scardino. But he might not get the chance to finish a turnaround.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Chris Hughes in London at chughes89@bloomberg.net

To contact the editor responsible for this story:
Edward Evans at eevans3@bloomberg.net