S&P: U. K.-Based Education Company Pearson PLC 'BBB' Ratings Affirmed On Continued Restructuring; Outlook Negative

S&P Global Ratings said today that it affirmed its 'BBB' long-term and 'A-2' short-term issuer credit ratings on U. K.-based education company Pearson PLC. The outlook is negative.

At the same time, we affirmed the senior unsecured debt ratings on Pearson at 'BBB'.

The ratings affirmation reflects our view that Pearson has improved its financial position and credit metrics, although risks remain in the business while the group progresses through its restructuring plans and positions for sustainable growth. The outlook remains negative while we await further evidence of stabilization and sustainable growth in group earnings, improving margins, and a successful restructuring effort. Our base-case forecast is that adjusted leverage metrics will remain anchored at 2x–2.5x for the next 24 months.

Pearson reported revenue in 2017 of ?4.5 billion, an underlying decline of 2% from 2016 revenue--or 1% on a statutory basis. A primary contributor to the sales decline was North America, in particular in U. S. higher education courseware, with underlying growth down 4%. U. S. higher education courseware accounted for about 25% of Pearson's fiscal year 2017 (FY17) revenue and the group is guiding toward a continued gross sales decline of about 6% in this segment in 2018. On a net sales basis, after returns, this decline is expected to be 0%-5%.

Revenue in the group's other segments outside of North America, described as "Core" and "Growth", which include businesses such as student assessment, professional certification, and English language businesses, were flat year-on-year overall. Pearson reports that digital sales now account for 32% of the group, digitally enabled 27%, and nondigital 41%. Digitally enabled includes computer-based testing, but in physical testing centers, for example.

Adjusted operating profit for 2017 (company reported) was ?576 million, down from ?635 million in 2016. This decline was driven by disposals, underlying trade performance, and cost inflation. We understand that operating profit was at the upper end of the company's guidance expectations. Pearson reported EBITDA in 2017 of ?738 million. We forecast this translates to S&P Global Ratings-adjusted EBITDA of ?730 million-?800 million in 2017.

During 2017, Pearson sold a 22% interest in Penguin Random House (PRH) to Bertelsman, for approximately ?1 billion in total proceeds. Pearson also sold the Gedu English business for approximately ?80 million in net proceeds. The group is intending to sell its U. S. K-12 courseware business in FY18, and we understand Pearson closed the sale of its Wall Street English business in Q1 2018. The group has used the proceeds from sales to reduce its bond debt to about ?1.1 billion as of FY17, from ?2.4 billion in FY16, and also initiate a ?300 million share buyback program, which has about ?150 million remaining in FY18.

We view positively the significant debt reduction the group made in 2017. We note that Pearson has about ?500 million cash on balance sheet at year-end FY17, and the $1.75 billion revolving credit facility (RCF) is undrawn.

While Pearson is guiding toward a decline of about 6% in U. S. higher education courseware in 2018, or a 0% to 5% decline net of returns, the group expects underlying growth from the remainder of its business operations in aggregate. However, we forecast that on a statutory basis, reported sales and adjusted profit will be lower due to the impact of annualized disposals and foreign exchange. Our adjusted forecast also includes lower dividends from PRH in FY18 and higher restructuring charges. Our estimate of restructuring charges is in line with the group's estimates of approximately ?90 million in FY18 and approximately ?130 million in FY19. Pearson expects accumulated run-rate savings of ?95 million and ?200 million in FY18 and FY19, respectively, having achieved cumulative savings of ?15 million in FY17 under the restructuring plan.

In our view, Pearson has strengthened its financial position. However, we continue to foresee potential risks while the group implements its strategy over the next 24 months. We await further evidence of a track record of sustained and growing earnings momentum, while maintaining market positions. Additionally, we await stabilization and then positive momentum in margin trends, demonstrated by success in the group's restructuring efforts.

The following assumptions underpin our base-case scenario for Pearson PLC:GDP growth in the U. S. of 2.8% and 2.2% in FY18 and FY19, respectively. GDP growth in the U. K. of 1.0% and 1.3% in FY18 and FY19, respectively. We view the different operating businesses of Pearson as having somewhat delinked drivers of growth from GDP. We view the growth dynamics of professional certification and online program management businesses more favorably than U. S. higher education courseware businesses, for example. Historically, in addition to structural market changes, courseware has been influenced by enrollment and admission trends, which we observe have some negative correlation with GDP growth. We forecast 5%-10% revenue decline in FY18 and stabilization in FY19, which includes asset disposals inclusive of Wall Street English and U. S. K-12 courseware. Adjusted EBITDA of about ?730 million-?800 million in FY17, which includes positive adjustments of ?146 million and ?167 million for PRH cash dividends and operating lease adjustments, respectively. Additionally, negative adjustments of ?133 million and ?79 million for capitalized development costs and restructuring costs, respectively. Adjusted EBITDA of ?630 million-?680 million in FY18 and FY19. The decrease over FY17 primarily reflects lower forecast reported EBITDA, lower cash PRH dividends, and higher restructuring charges. Neutral working capital movement in FY17-FY19.Reported capex of about ?200 million-?250 million in FY17-FY19.Remaining buyback of about ?150 million in FY18 and dividends of about ?130 million-?150 million in FY17-FY19.Based on these assumptions, we arrive at the following credit measures:Adjusted EBITDA margins of 16%-18% in FY17-FY19.Forecast adjusted leverage of between 2.0x–2.5x in FY17-FY19.FOCF/debt greater than 25% in FY17-FY19.

The negative outlook reflects our view that there remains some pressure on Pearson's earnings in the next 24 months. We see potential risks from continued challenges in U. S. higher education courseware and ongoing restructuring and portfolio shaping to drive improved performance and growth from the business. We also forecast lower earnings from PRH dividends, disposal proceeds predominately used for rewarding shareholders, and potential currency movement risks to earnings.

We could lower the rating if, in our view, there was a weakening in the business strength, such as operating performance. We could also lower the rating if management's strategy and financial policy were insufficient to mitigate a weakening of the group's operations and its impact on the group's credit metrics. Specifically, this would include a scenario in which adjusted leverage was at or above 2.5x, or FOCF fell below 25%.

We could revise the outlook to stable if Pearson was able to demonstrate a track record of sustainable growth in its underlying operational performance, including increasing earnings and positive margin improvement, while maintaining market share and positions. This would need to be in conjunction with the maintaining of a financial policy commensurate with leverage anchored below 2.5x and FOCF/debt above 25%.

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