Pearson: Capital Allocation Matters (Rating Upgrade)

Elevator Pitch

I award a Buy investment rating to Pearson plc (NYSE:PSO) [PSON:LN] shares.

Earlier, I wrote about how generative AI could potentially change PSO's business outlook in my prior update for the company published on June 20, 2023. With the current write-up, my attention turns to Pearson's recent actions associated with capital return and capital investment.

On one hand, PSO has been returning more capital to shareholders with its dividend hike and new share buyback plan. On the other hand, Pearson continues to restructure the company's portfolio by selling non-core businesses and investing in new growth areas. I have decided to upgrade my rating for PSO from a Hold to a Buy on the basis that the company's capital allocation practices are sound and should create value for its shareholders.

Shareholder Capital Return Initiatives

Pearson is expected to return a larger proportion of the company's excess capital to its shareholders in the near future.

In late April this year, PSO had disclosed its plans to "commence a buyback to repurchase £300m of shares" in 2H 2023. At the company's most recent Q2 2023 results briefing in end July, Pearson confirmed that it will start to execute on the £300 million ($380 million) share repurchase program in the third quarter of the current year.

The company's share buyback plan is significant, as it represents about 5% of the stock's current market capitalization. This is also the right time for Pearson to be buying back its own shares, taking into account its undemanding valuations.

As per valuation data taken from S&P Capital IQ, Pearson is now trading at 14.0 times consensus forward next twelve months' normalized P/E, which is just +4% above its three-year historical trough P/E ratio of 13.4 times. As such, share repurchases will be value accretive at PSO's current price levels.

PSO isn't merely returning capital via share buybacks. The company has recently raised its interim dividend per share payout by +6% YoY from £0.066 in 1H 2022 to £0.070 for 1H 2023, as indicated in its earnings presentation slides.

Looking forward, the market's consensus financial forecasts point to Pearson's dividend per share growing by a CAGR of +8% from £0.215 for fiscal 2022 to £0.273 (source: S&P Capital IQ) in FY 2025. The sell-side analysts' positive view of PSO's dividend growth prospects are aligned with the company's dividend policy; Pearson has reiterated its "commitment to progressive and sustainable dividends" in its 1H 2023 earnings presentation.

In a nutshell, it is reasonable to assume that PSO intends to distribute more capital to the company's shareholders via both dividends and share repurchases.

Portfolio Restructuring Moves

I am of the opinion that Pearson is doing a decent job in allocating capital, and this isn't just restricted to capital return. PSO is monetizing the company's non-core assets and businesses as a means of funding its future investments.

Pearson revealed in its Q2 2023 results press release that the company had divested its interest in "POLS (Pearson Online Learning Services), Pearson College and our international courseware local publishing business in India" for the first half of this year. PSO stressed in the company's second quarter earnings release that the sale of these businesses are part of efforts "focusing Pearson's portfolio towards future growth opportunities."

On the flip side, PSO spent £152 million to buy an assessment solutions business known as Personnel Decisions Research Institutes, LLC or PDRI in 1H 2023, which forms part of the company's Assessment & Qualifications business arm now. At its second quarter results call, Pearson highlighted that the acquisition of PDRI enables it to offer "services to the U.S. federal government" and gain a foothold "in the recruitment assessment space.

Pearson has the financial strength to finance both organic and inorganic investments going forward. PSO's net debt-to-EBITDA or net leverage ratio was pretty comfortable at 1.77 times (source: S&P Capital IQ) as of June 30, 2023. The company's actual operating cash flow jumped from £9 million in 1H 2022 to £79 million for 1H 2023. Moving ahead, the sell side sees Pearson's free cash flow increasing significantly by +81% from £222 million in the prior fiscal year to £402 million as per S&P Capital IQ's consensus data.

In the decade between FY 2013 and FY 2022, PSO had suffered from revenue contraction in seven of the past 10 years. But Pearson has set a target of registering a top line CAGR at the mid-single digit percentage level for the FY 2022-2025 time frame. Pearson emphasized at its Q2 2023 earnings call that it has "continued to shift resources, costs and capital between (different) areas of the business" that are part of plans relating to "reshaping the portfolio." As such, PSO is in a good position to reignite its revenue growth with its portfolio restructuring efforts.

Closing Thoughts

The market is currently valuing Pearson's shares at a mid-teens P/E multiple that is close to a three-year low for the stock. PSO has maintained a good balance between capital investment and capital return, and I think that investors will eventually assign a higher P/E metric to Pearson in view of the company's optimal capital allocation approach that is expected to enhance shareholder value.

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