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.

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