What should investors in Pearson (LSE: PSON) be worried about?
Popularly known as the owner of the Financial Times and publishers Penguin, Pearson (LSE: PSON) (NYSE: PSO.US) is really an education and training business -- the education market accounts for 80% of revenues, 10 times that contributed by the Financial Times. And as such, this £9.7bn FSTE 100 (UKX) constituent is a business with very definite attractions, last year earning a pre-tax profit of £1.1bn on revenues of £5.9bn.
And with margins like that, it's no wonder that defensively positioned Pearson is popular with many investors. Today, with its shares changing hands at 1,185p, the company is rated on a prospective price-to-earnings (P/E) ratio of 13, and offers income investors a tempting forecast dividend yield of 4%.
But how safe is that share price? And -- of vital importance to income investors -- how safe is that dividend? In short, how could an investment in Pearson adversely impact investors' wealth?
In this series, I set out to help investors answer just these questions. My starting point: Pearson's latest annual report, where the company's directors are obliged to address the issue of risk.
One immediate thing that I'm looking for is an acknowledgement that risks do exist, and that they need managing.
The good news? As you'd expect from a business of Pearson's size and calibre, the company has in place a risk management policy, a system of regular reviews, and a number of high-level committees tasked with monitoring the risks that the business has identified.
But what, precisely, are those risks that the company faces?
Read the small print, and Pearson identifies no fewer than nine risks as having a significant prospective impact on the company's financial performance. They range from piracy to reputational risk, and from testing and quality failures to constrained demand due to economic uncertainty.
So let's take a look at three of the biggest.
Pearson describes itself as "the world's leading learning company...with 41,000 people in more than 70 countries helping people of all ages to make progress in their lives through all kinds of learning". As noted, 80% of revenues come from education -- and a whopping 60% of all revenues come from North America, where government finances are under as much strain as in the UK. As Pearson puts it:
"Our US educational solutions and assessment businesses and our UK training businesses may be adversely affected by changes in government funding resulting from either general economic conditions, changes in government educational funding, programmes, policy decisions, legislation and/or changes in the procurement processes."
What can Pearson do about it? In both countries, it is working hard to make sure that it maintains -- or grows -- its share of whatever business is available.
In the United States, for instance, it actively monitors changes in the market through participation in advisory boards, and through representation on standard setting committees. Customer relationship teams are charged with maintaining a detailed knowledge of the market in each state. Similarly, in the smaller UK market, the company also works closely with government departments and agencies to make sure it is offering what the market wants.
Computers, the internet, electronic whiteboards and handheld devices such as Amazon's Kindle and Apple's iPad are changing the process of education. Clearly, an educational business that is overly reliant on paper runs the risk of following the dodo to extinction. As Pearson puts it:
"Our education, business information and book publishing businesses will be impacted by the rate of and state of technological change, including the digital evolution and other disruptive technologies."
That said, Pearson seems fully aware of the dangers, and is actively managing the risk. As the company notes: "We are transforming our products and services for the digital environment along with managing our print inventories. Our content is being adapted to new technologies across our businesses and is priced to drive demand."
Will this be enough? Time will tell. But clearly, Pearson's track record so far, judging from its growth in revenues and sales, has been reasonable.
Intellectual property rights
But the digital era has a dark downside: piracy. Digitising content, in short, makes it easier to duplicate -- as owners of music and video content have found to their cost. As Pearson puts it:
"If we do not adequately protect our intellectual property and proprietary rights, our competitive position and results may be adversely affected, and limit our ability to grow."
What can Pearson do about it? More than you might think. The company has established a piracy task force, for instance, charged with identifying weaknesses and preventing breaches of its intellectual property rights. National markets are monitored for activities and regulations that might impact the business, and the company works with other publishers and trade associations to protect itself -- as well as going to court, if necessary. Will it be enough? Again, time will tell.
Risk vs reward
Two superstar investors who are well-used to weighing risks are Neil Woodford and Warren Buffett.
On a dividend re‑invested basis over the 15 years to 31 December 2011, Neil Woodford delivered a return of 347%, versus the FTSE All-Share's distinctly more modest 42% performance. Warren Buffett, for his part, has delivered returns of over 20% per annum since 1965, transforming himself into the world's third-wealthiest person.
Each, as it happens, are the subject of two special reports prepared by Motley Fool analysts. And they're yours to freely download, without any obligation.
So click here to download this free special report profiling the investment logic behind eight of Mr Woodford's largest and most successful current picks.
And click here to discover which beaten-down British share Warren Buffett has been buying of late -- and why he bought it, and the price he paid.
> Malcolm doesn't own shares in any companies mentioned here.