Pearson (PSO) is one of the largest publishers of education textbooks and materials in the world.

The iconic company’s roots can be traced back to 1844, and its well-known publishing operations began in the 1920s.

In addition to its extensive operating history, Pearson had increased its dividend above the rate of inflation for 24 consecutive years through 2015, garnering a high level of trust with conservative income investors (especially those living off dividends in retirement).

However, that all changed this week. Pearson announced very disappointing results for the fourth quarter and slashed its outlook for 2017 and 2018.

Management froze Pearson’s 2016 dividend and will “rebase” future dividend payments in response to the firm’s weakening profits. In other words, a meaningful dividend cut will be announced shortly.

Pearson’s stock plunged by nearly 30% on the news, marking its steepest one-day decline in company history.

Bloomberg noted that Pearson’s surprise was only magnified by management’s overly hopeful comments about the state of business:

“The capitulation contrasts with months of optimistic statements by Chief Executive Officer John Fallon about the challenges Pearson faces in the U.S., where college enrollments and its testing business are down, and textbook sales unexpectedly declined.”

It’s unusual to see a company with such a strong dividend growth track record come off the rails like this.

Let’s take a look at why Pearson decided to cut its dividend, how investors could have known to avoid the stock, the likely size of the upcoming dividend cut, and what investors should do from here.

Pearson’s Disappointing News

Pearson’s business spans a number of education segments, but higher education courseware (e.g. books) is the biggest chunk.

The company is also very global, reaching 70 countries. However, the U.K and U.S. are the biggest geographies for Pearson.

Pearson PLC (PSO)

Source: Pearson Investor Presentation

Pearson’s North American higher education business generates roughly 45% of the firm’s total profits. Approximately half of this business is tied to print textbooks (the other half is digital).

This part of the business is sensitive to total college enrollments in the U.S. (more students results in more demand for books), as well as book market dynamics (e.g. the rise of digital books and rental services).

Pearson was hurt by both industry drivers. First, college enrollments continued declining rather than stabilizing as management expected. College enrollment tends to decrease as the economy strengthens because more jobs are available, reducing the incentive to get a degree.

Pearson PLC (PSO)

Additionally, textbook rental services ate into new book sales much more than Pearson expected. It’s worth nothing that Amazon (AMZN) entered the digital and print textbook rental markets in 2011 and 2012, respectively.

The continued rise of textbook rental services and digital learning is disrupting the traditional education courseware industry, denting new book sales and pressuring pricing.

Pearson PLC (PSO)

Unfortunately Pearson’s massive size is working against it, making it harder for the company to quickly adjust to these disruptive trends.

Management is working to shift 75% of its North American courseware business to digital by 2020 (up from 50% today) and is also responding by slashing its e-book prices by 50% to make it more competitive. Pearson expects the move to a more digital model will reduce U.S. sales by 5-6% annually during the transition. The company

There is little Pearson can do right now to stop the bleeding. Pearson’s North American business recorded a 30% sales drop last quarter, and full-year sales and adjusted operating profit across the entire company fell 8% and 13%, respectively, in 2016.

Let’s review how investors could have known to avoid Pearson before its disappointing guidance came out.

Pearson’s Dividend Safety Score

While we don’t yet know the magnitude of Pearson’s dividend cut, there were plenty of reasons to be suspicious of the firm’s ability and willingness to continue paying its current dividend.

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.

Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at a company’s most important metrics such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, profitability trends, and more.

Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.

Pearson PLC (PSO)

The chart below plots each company’s Dividend Safety Score on the x-axis and the size of its dividend cut on the y-axis. You can see that almost all companies cutting their dividends scored below 40 for Dividend Safety at the time of their announcements, and companies with lower Dividend Safety Scores generally experienced larger dividend cuts.

Pearson PLC (PSO)

We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their real-time track record has been (including analysis of every dividend cut in the chart above), and how to use them for your portfolio. You can review this analysis by clicking here.

Pearson’s Dividend Safety Score at the time of its dividend cut announcement was 17, indicating that the company’s dividend payment was “Extremely Unsafe.”

It wasn’t new news that Pearson was facing a number of challenges. The company had issued five profit warnings in four years, and Pearson announced it was beginning a restructuring program in January 2016 to reduce costs and better position itself for growth.

The restructuring initiative reduced headcount by 10% and generated ongoing annualized cost benefits in excess of £350 million. However, many “restructuring” plans are a sign that something is wrong or not going as well as management anticipated.

Regardless, none of these actions could arrest the decline in Pearson’s higher education business, which fell much more than expected in 2016.

Stepping back, we can see that Pearson’s free cash flow per share began dropping in fiscal year 2011, with declines accelerating more recently.

Pearson PLC (PSO)

Source: Simply Safe Dividends

Pearson’s free cash flow payout ratio had averaged close to 50% up until 2013. However, its payout ratio spiked to potentially dangerous levels in recent years, once again catching our attention that something might not be right.

Pearson PLC (PSO)

Source: Simply Safe Dividends

The company’s profitability also started slumping in 2012, with margins dropping by nearly a third of their historical level.

Pearson PLC (PSO)

Source: Simply Safe Dividends

Revenue growth was also challenging to come by. Sales struggled to go anywhere since the financial crisis and declined by 4.8% annually over Pearson’s last five fiscal years.

Pearson PLC (PSO)

Source: Simply Safe Dividends

Some of the revenue decline was driven by spinoffs of non-core businesses, but that can also be a sign of a company under pressure. Through the first nine months of 2016, Pearson’s organic sales were down 7% as well, another sign of a struggling company.

Simply put, Pearson’s business was obviously struggling to keep up with the many changes transforming the education industry – especially within the publishing niche, which is increasingly becoming more digital and cost-effective.

As CEO John Fallon said, “The education sector is going through an unprecedented period of change and volatility.”

Secular changes take many years, or even decades, to play out. They can impact a company’s results far longer and more severely than many analysts (and even management teams) expect.

Pearson’s inability to adapt in a timely and profitable fashion ultimately led to its rather stunning dividend cut.

An equity analyst said Pearson’s decision to cut the dividend was “startling for investors” and that the company’s CEO was “seriously testing investors’ faith,” according to the Financial Times.

Current shareholders must now decide if they want to cut their losses and move on or give Pearson even more time to try and find a path back to profitable growth.

Expectations are obviously much lower than they were yesterday, but Pearson still has many makings of a value trap.

No one knows how profitable a digital-centric business model will be, and education needs to become much more accessible and cost-effective for people, two negatives for the future profitability of a company such as Pearson.

Let’s take a look at the potential dividend reduction current shareholders are facing.

Pearson’s Impending Dividend Cut

We don’t yet know how large Pearson’s dividend cut will be. However, it seems likely to be steep.

Management said that Pearson will be “rebasing” its dividend to reflect the absence of contribution from its equity stake in Penguin Random House (Pearson decided to sell its stake); challenging market conditions; and accelerated digital investment.

Management’s guidance for adjusted earnings per share in 2017 is 48.5 pence to 55.5 pence, representing a projected payout ratio of 100% at the midpoint (Pearson’s dividend payments totaled 52 pence in 2016).

The question is what payout ratio management will target for the dividend as Pearson doubles down on its restructuring efforts and works to protect its credit rating.

As we saw earlier, the company’s free cash flow payout ratio averaged close to 50% up until the last few years.

Here is a table showing the company’s payout ratio (based on 2017 earnings guidance) and Pearson’s dividend amount at each level.

2017 EPS Payout Ratio New Dividend Amount (pence per share) Dividend Reduction
40% 20.8 -60%
50% 26 -50%
60% 31.2 -40%
70% 36.4 -30%
80% 41.6 -20%

My best guess would be for a dividend cut of at least 30%. Management seems to have very little visibility into the future (2018 operating profit guidance was taken off the table), and such a reduction would bring Pearson’s payout ratio down to a level more in line with its long-term history.

However, an even steeper reduction in dividends wouldn’t be a big shock because management plans to invest more heavily in digital operations and strengthen Pearson’s balance sheet. Paying less in dividends frees up more cash for these initiatives and provides some extra breathing room.

Another way to think about the upcoming dividend cut is to look at the magnitude of missed expectations for profitability.

Pearson paid about £423 million in dividends in 2015 (and a similar amount in 2016 once financial statements are available). The company is beginning 2017 with a “base level of underlying profitability that is around £180 million lower” than management had expected in early 2016.

If the dividend were to be reduced by the miss in expectations for 2017 profits (£180 million), it would represent a 43% cut.

The one big wild card in all of this is Pearson’s planned exit of its 47% stake in Penguin Random House.

This sale could fetch Pearson over £1 billion, infusing substantial capital into the business to restore the balance sheet, invest for digital growth, and potentially return some capital to shareholders.

In other words, management has some leeway with how much they ultimately decide to cut the dividend later this year.

Closing Thoughts on Pearson

Just because a company has paid rising dividends for more than two decades doesn’t necessarily mean its dividend is still safe or that the business is a good investment.

The world is constantly changing, and some companies are always going to be in the crosshairs. The key is to identify riskier dividend stocks before they get into major trouble. Where there is smoke, oftentimes there is fire.

Pearson had been giving off a number of distress signals for several years – declining profit margins, shrinking free cash flow, spiking payout ratios, and deteriorating credit metrics were all clues that the firm’s 24-year dividend growth streak could prove to be unsustainable.

Tracking and monitoring all of this information is a lot of work, which is why we created Dividend Safety Scores to do much of the heavy lifting for us for thousands of dividend-paying stocks.

Our Dividend Safety Scores flagged Pearson as one of the riskiest dividend stocks in the market prior to today’s announcement, helping us sidestep this torpedo in our dividend portfolios as we continue pursuing our objectives of capital preservation and safe, growing dividend income.

Income investors can learn more about Dividend Safety Scores and view their complete performance in 2016 by clicking here.

Article by Simply Safe Dividends