“The FTSE 100 firm cited “unprecedented” trading conditions in the American courseware market, noting a 30% year-on-year drop in fourth-quarter revenues and an 18% plunge across the year as a whole.
“This raises the question of whether Pearson’s problems are structural and not cyclical – and the decision to cut eBook rental prices by 50% across 2,000 titles suggests the company is now facing the very real threat of being hollowed out by the price-crushing powers of the internet.
“Pearson’s prime educational content has always been a source of strength of the firm but the rise Open Education Resources (OER) proving to be a formidable problem.
“Universities are now making best-of-breed lecturing and educational materials freely available, so other students and lecturers can copy, use, append and even modify the documents, and cut down on the expense of buying or renting the sort of textbooks provided by Pearson.
“The price cuts are clearly designed to combat this trend but such a move is an acknowledgement that the issue is not a short-term, cyclical one caused by changes in student numbers or excess book inventory, but one which cuts to the very heart of the company’s business model and competitive position.
“Pearson now expects 2017 operating profit to come in between £570 million and £630 million. This compares to the £630 million recorded in 2016 and leaves the company with no chance of meeting its £800 million target for 2018, which has now been withdrawn.
“The fall in profits expected for 2017 also means the dividend will be cut. CEO John Fallon had already announced a flat dividend of 52p for 2016, to end Pearson’s membership of the select club of FTSE 100 firms who could point to an unbroken run of 10 consecutive increases (or more) in its annual shareholder payout.
“Even before today’s warning, dividend cover was just 1.2 times, based on the consensus earnings per share estimate for 2017 of 64p against 57p in 2016, so the revised profit guidance leaves cover at just 1.0 to 1.1 times.
“This means the 6.5% yield which Pearson was in theory offering for 2017 as of the close yesterday was a mirage, to again warn investors of the dangers of over-reaching for income.
“There are few worse investments than an income stock that cuts its dividend, since share price falls will almost certainly add capital loss injury to dividend yield insult, as shown by Pearson today.
“It therefore remains as important as ever to check earnings cover, free cash flow cover and the strength of a company’s balance sheet before deciding whether a forecast payment is safe or not.
“Within the FTSE 100 only easyJet and Sainsbury’s have cut their dividends for 2016, after around a dozen firms cut for 2015, but dividend cover across the FTSE 100 overall remains thin at around 1.65 times.
“A ratio of 2.00 would give much greater comfort that the UK’s corporate elite will pay the forecast dividends and not be forced to cut them as soon as something goes wrong – as has happened at Pearson today.”