The Motley Fool

The Pearson (PSON) share price has crashed 15%. Here’s what I’d do.

Pearson (LSE: PSON) shares had been performing nicely over the past two years, but a big drop Thursday wiped away much of the gain.

The education publisher had been enjoying growing optimism following a few tough years, as its renewed strategy of moving away from print publications towards online offerings looked like it was bearing fruit. A 30% EPS rise in 2018 reversed two years of falls, and looked like setting the scene for a return to longer-term growth.

Profit warning

But a profit warning on Thursday sent the share price crashing 19% at one point in the morning. The company had previously issued guidance of £590m-£640m for adjusted operating profit for the full year, and now tells us it expects something around the bottom of that range, after an unexpectedly tough third quarter.

The cause of the downgrade was summed up by Pearson chief executive John Fallon, who said: “The third quarter has been significantly weaker than we expected in US Higher Education Courseware.”

He added that the company is “exploring new ways of deploying our new technology platform” to boost its appeal to students, offering an attempt at reassurance for shareholders with: “We still expect revenue across Pearson as a whole to stabilise this year.

It was a bad day generally for FTSE 100 profit warnings, with Imperial Brands losing 10% on its own bad news, and International Consolidated Airlines set to suffer from the effects of pilot strikes and European disruptions. But times like this can often throw up oversold bargains. Is Pearson one of them?

My Motley Fool colleague Rupert Hargreaves has been doubtful of Pearson’s prospects, saying: “This is a highly competitive market, and while the enterprise might have size on its side, the fact net income has hardly grown over the past six years speaks volumes.” It’s looking increasingly like his analysis is spot on.

Tough business

I think the biggest problem facing Pearson is the competition that Rupert mentions, and the move of the whole industry to online offerings only makes things easier for competitors. In the days of big capital investment in paper publishing houses and the production of books and other physical products, the bigger companies had the advantage with their greater financial clout, and that helped maintain something of a defensive moat.

But the internet is a great leveller, and it’s really helping smaller companies by greatly lowering barriers to entry.

The other thing that puts me off Pearson right now is that it’s yet another company that’s only partway through a restructuring and recovery plan. We’re repeatedly seeing early optimism in such cases turning out to be premature, and more often than not, companies are facing further bouts of pain before things come good.

I think Pearson’s share price valuation shows excessive optimism now. Before Thursday’s shock, the shares were on P/E multiples of around 14, with dividend yields modest at about 2.5%. And I don’t think that valuation offers a sufficient margin of safety to cover the remaining recovery risk.

You Really Could Make A Million

Of course, picking the right shares and the strategy to be successful in the stock market isn't easy. But you can get ahead of the herd by reading the Motley Fool's FREE guide, “10 Steps To Making A Million In The Market”.

The Motley Fool's experts show how a seven-figure-sum stock portfolio is within the reach of many ordinary investors in this straightforward step-by-step guide.

Simply click here for your free copy.

Alan Oscroft has no position in any of the shares mentioned. The Motley Fool UK has recommended Imperial Brands and Pearson. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.