Can Scardino Get Pearson out of This Pickle?

So far, her growth strategy has only managed to shrink the stock

It was one of the great business tales of recent years. Texas native Marjorie M. Scardino takes over stodgy British blue chip Pearson PLC (PSO ) and electrifies the company and its share price with folksy cheerleading and a blaze of deals. Unfortunately, the story didn't end there. Like most media companies, Pearson is now in investors' bad books. The stock price, which had tripled under Scardino by the spring of 2000, is now just below where it was at the start of her tenure in 1997. Not surprisingly, her moves, once applauded, are getting poor marks. "If she were to leave now, she would be judged a failure," says Matthew Owen, media analyst at Morgan Stanley in London and an early Pearson skeptic.

Scardino, 55, has a ready answer. "If you want to judge me by the stock price, fair enough," she says. "But to toot my own horn, I have changed the company entirely. It is a company with huge growth potential and great earning power. The culture is [now] completely different, and people underestimate the importance of that to the company's ability to perform."

Maybe so, but for now she has to keep taking the heat. Pearson's operating income before Internet losses and amortization for all of 2002 will likely be about $945 million on sales of $6.8 billion, according to Sanford C. Bernstein & Co. in New York. If so, that means another flat to down year after a 6% drop in 2001. Investors are growing skeptical that Scardino will ever deliver the hoped-for high returns that drove the stock price skyward in the late 1990s. Bernstein figures, for instance, that Pearson is only earning 3.3% on invested capital. They also worry that education, where she has put most of her chips, isn't the growth industry that it's cracked up to be and that she may not be able to control costs in what is turning out to be a sharper downturn than expected. "If you look at the returns that Pearson is delivering, it is a worse company now than when Scardino took over," says Terry Smith, CEO of London brokers Collins Stewart Ltd.

Hardest hit is Pearson's crown jewel, the Financial Times. The FT's ad revenues are down an estimated 20% this year, on top of a 20% drop in 2001. BusinessWeek, a division of McGraw-Hill, has experienced even worse back-to-back ad declines, as has The Wall Street Journal. Pearson doesn't expect a recovery until 2004 and is considering additional cuts to the substantial ones already made at the FT, where Pearson gets 10% of its revenues. Educational publishing, in which Scardino has invested more than $7.2 billion, is also proving far more vulnerable to the economic cycle than she reckoned. With U.S. state and local governments slashing expenditures to deal with declining tax revenues, Michael Nathanson, European media analyst at Sanford C. Bernstein, thinks that the overall market for U.S. school textbooks, where Pearson has placed its biggest bet, could decline by 3% this year and next after recording 10% annual growth in recent years. McGraw-Hill, a leading textbook publisher, is facing similar pressures.

To be sure, many of Scardino's problems are a result of today's tough environment for equities, and for media stocks in particular. Few would deny that she's sharpened Pearson's focus. She sold off noncore assets such as Tussauds Group wax museums. After a whirlwind 120 deals, Pearson has just three main businesses: education, which contributes almost two-thirds of operating revenues; the FT Group; and publisher Penguin Group.

It's a clear setup. But Scardino cannot easily boost growth from these divisions by adding on new properties. The markets are likely to pan any major acquisitions because investors consider her, along with other 1990s-vintage media executives, a profligate spender. "Her record is appalling," says Hugh Hendry, a partner at Odey Asset Management Ltd. in London. "She made highly priced acquisitions at the most inopportune times." Scardino justified her big acquisitions and major expansion of the Financial Times on the grounds that the world was entering a global age where the demands for financial information and educational materials would explode. The Internet, she theorized, would be a key delivery vehicle for products in both areas. It sounded reasonable, and the vision may still be on the money, but the dream has been delayed.

Thus, Scardino has few options besides controlling costs and tightly managing capital. Late in the day, she is sharply scaling back Pearson's enormous ambitions in online education, where the company has blown about $185 million trying to establish an education portal for consumers called The Learning Network. She has also slashed expenses at the online version of the FT, which has run up $230 million in losses. Overall Internet losses are expected to fall from $215 million last year to $93 million this year. Scardino has deputized former Finance Director John Makinson, considered a possible successor, to take over the Penguin publishing group. One of his main tasks there is to make Dorling Kindersley, the flashy but money-losing British publisher that Scardino paid $482 million for in 2000, profitable. Pearson took a $77 million write-off on DK last year.

Scardino has also averted a ratings downgrade by slashing debt. Last Christmas Eve, she sold Pearson's 22% stake in RTL Group, the largest European broadcaster, to Bertelsmann for $1.5 billion. The sale brought debt down to about $2.2 billion and slashed interest costs to about $170 million for this year, compared to $263 million in 2001. But it also reduces advertising-driven businesses at Pearson from 18% to just 10% of revenues, according to Bernstein estimates. That reduces the lift the company will gain once the media industry recovers.

If already hard times get harder, high-profile initiatives could be threatened. Expansion of the FT, which now has a 501,000 circulation, has been halted. Some analysts, including Collins Stewart's Smith, would even like to see Scardino explore selling the FT, arguing that this trophy asset might get a big price.

Investors are also waiting for that big payoff in education. Scardino turned Pearson into the biggest player in education overnight by making a knockout $4.6 billion offer to Viacom Inc. for Simon & Schuster's educational publishing assets in 1998. Then she took what many analysts consider a step too far by paying $2.5 billion, a 26% premium over the market, for a little-known Minnesota-based educational testing company called National Computer Systems Inc. in 2000.

Some investors are skeptical that these businesses will achieve the high growth Scardino expected from them. Bernstein forecasts that Pearson Education's revenues will grow by only 2% in 2002, to $4.1 billion, and by just 3% in 2003. Sources close to the company, however, say that 5% per year is more realistic. The college and high school divisions remain strong, while professional and data- management texts have fallen off sharply thanks to the technology slump. International educational publishing, for which Scardino had big hopes, has been hurt by economic woes in Latin America. NCS has scored a coup by securing $315 million in U.S. government contracts for screening airport security personnel, processing immigration forms, and online education for the Navy. But it has disappointed in education software. Some investors would like to see Pearson write off some of its $2.5 billion investment in NCS.

A mixed record. Yet Scardino seems to have retained the confidence of Pearson's board, which is blaming the moribund performance of the stock on the markets rather than on her management. "I am not sure I would bet against Marjorie Scardino," says Jonathan Newcomb, formerly CEO of Simon & Schuster and now a principal at Leeds Weld & Co., a New York-based private equity firm that specializes in education. Scardino herself says she plans to stay as "long as I can to prove that I can deliver on the promise of this company." Over the next few quarters, Scardino will show whether she is the talented manager she seemed to be early in her tenure or whether she was just another lucky CEO riding the boom.

Read a letter to the editor about this story.

By Stanley Reed in London

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