Pearson PLC

LSE:PSON

Earnings Call Transcript 2018-Q1

[Operator]

Hello, and welcome to the Pearson Q1 trading update. [Operator Instructions] And just to remind you, this conference call is being recorded. Today, I'm pleased to present John Fallon, the CEO; and Coram Williams, the CFO. Please go ahead with your meeting.

[John Joseph Fallon]

Okay. Good morning, everybody. Thank you for joining us for our Q1 trading update. John Fallon here. I have with me Coram Williams, our Chief Financial Officer. We're going to start by giving you a brief overview of the quarter, which, as you know, is our smallest of the year. As you'll have seen in this morning's release, overall trading was in line with our expectations and our guidance for the full year remains unchanged. With that in mind, Coram and I are going to keep our detailed comments short this morning before opening the call to questions. As our introduction is going to be, you might say, uncharacteristically brief, you might want to start thinking about your questions now. And with that, I'll hand over to Coram.

[Coram Williams, CFO & Executive Director]

Thanks, John. Good morning, everybody. Total sales increased by 1% in underlying terms, with North America up 3%, Core up 6% and our Growth segment down 12%. Within that, there are 3 noteworthy elements around the phasing of quarterly revenues. Firstly, in North America, higher education courseware benefited from lower returns from the channel, which, in the seasonally small first quarter, offset the market pressures that we've described previously. This phasing effect is in line with our expectations and will unwind later in the year as we enter our more significant selling periods. And we continue to expect revenues in this segment to be flat to down mid-single-digit percent, in line with our earlier guidance. Secondly, in Core, revenues benefited from good growth in Pearson Test of English and OPM. Pearson Test of English, which saw accelerating growth through 2017, has easier comparisons in the first quarter than the rest of the year. And thirdly, in Growth, last year, we benefited from an unusually large order in South African school courseware in the first quarter, something we flagged at the time and which provided a tough comparison for this year's first quarter. This is a timing issue, which we expect will largely unwind as the year progresses. Underlying trends in the rest of the business are consistent with our expectations, and we continue to forecast a modest increase in full year revenues in the Growth segment in 2018. Our balance sheet remains strong. In Q1, our net debt is significantly lower than last year but a little higher than it was at the end of 2017, in line with the normal seasonal pattern of cash flow and reflecting the outflow for the completion of the buyback, partially offset by proceeds from the disposal of Wall Street English. We continue to expect our full year net debt to be in line with prior year. Our guidance for 2018 is, as John noted, all unchanged. Back to you, John.

[John Joseph Fallon]

Thanks, Coram. So Pearson made good progress against our strategic priorities last year, and as you can see, that's continuing in the first quarter of 2018. The majority of the year is still ahead of us, but we remain confident that we're going to make good further progress in our digital transformation this year and grow our underlying profit. And with that, Coram and I would be very happy to take your questions.

[Operator]

[Operator Instructions] And our first question comes from the line of Sami Kassab of Exane BNP Paribas.

[Sami Kassab, Media Research Director, Co]

Sami here. Three questions, please. First one, can you comment on U.S. higher ed course adoption? Are they up or down on last year? Secondly, can you provide the latest update on the Inclusive Access model? How many institutions have signed up with Pearson? Perhaps how many do you believe have signed up with the publishing industry in general? And lastly, how would you characterize OER penetration in institutions, which haven't really signed up to this model, please?

[John Joseph Fallon]

Okay, Sami, let me start. So on U.S. higher ed courseware adoptions, we're obviously right in the midst of the selling season at the moment. It runs from really through till early, mid-June, really, by the time most of the major decisions have been made. We obviously track every single adoption that we are competing for in every campus across the country, and as I say, whilst there are still some weeks to go, we are feeling very good about our performance year-to-date. I think we're having a very strong competitive performance. Obviously, we'll have more to say when we get to the half year, but we're feeling very good about it. In terms of Inclusive Access, good to see that we're continuing to make good progress. We're continuing to add lots of new institutions to the program, and we're continuing to the rate of growth that we recorded at the full year. And we'll again give you further updates on that when we get to the half year. As important, you remember, it's not just about signing up more institutions; it's increasing the sell-through of the existing institutions. And that's going exceptionally well, and we do believe that our Inclusive Access model really lands because it's all about affordable choice and better outcomes and recognizes the reality that our market has to meet the needs of 3 distinct customers groups: college leadership, college professors and students. And you need an offering that meets the needs of all 3, and Inclusive Access is absolutely hitting that sweet spot because of the breadth and strength of our offerings, both in terms of the content, the courseware, the knowledge, the authorship that we continue to invest in and value very highly, combined with our leading adaptive learning assessment capabilities, all able to offer at a compelling price to students with better outcomes for faculty. That's really landing exceptionally well. And then on OER, it's playing out much as we said it would. As I say, when we track adoption, we're looking at adoptions that we win or lose against competitors, including OER, and what we're seeing is very much in line with what we said at the start of the year. Coram reaffirmed this morning that we're expecting the -- we're running this business on the basis that revenues will be 0 to down 5%, and within that there's a minor negative drag, probably about 1% or 2% -- about 1% from OER.

[Sami Kassab, Media Research Director, Co]

John, I didn't -- thank you for the update. I just meant, within the institutional -- within the institution that signed up for the Inclusive Access model, is there less appetite to go to OER? Is the penetration of OER within these institutions lower than within institutions that do not sign up for the institution -- for the Inclusive Access model? Or is there no comment we can make on...

[John Joseph Fallon]

I think that's directionally true, but the broader point I'd make, I'd say that the -- what's demonstrated is [ the type ] to take-up OER is relatively low generally, and that's because the strategy that we're pursuing by offering affordable choice with better outcomes, we're actually giving them what they perceive to be the economic benefits of shifting to OER, but with much higher-quality content, much better authorship and much better outcomes for students because we can invest in the personalized adaptive learning that is so important. So I think, yes, Inclusive Access helps, but what also helps is the quality of our content and our adaptive learning technology as well.

[Operator]

Our next question comes from the line of Tom Singlehurst at Citi.

[Thomas A Singlehurst, Director and Head of European Media Research]

From Citigroup. Actually, just one more quick question on the adoption to the process. So -- well, in particular, Cengage, I suppose, has been talking about the white-glove service it's trying to sort of put work to convince more, I suppose, course administrators to sort of adopt their courseware. I'm just wondering whether in that process you have had to put in more effort to -- put more effort in terms of the level of service that you're sort of committing alongside obviously just the courseware itself. And then the second question, I presume given that you don't mention it in the release, that the shape of growth, both in terms of gross sales and returns, is exactly in line with your expectations. That was the first point. And the second point was, is there any lagging impact from some of the sort of changes that you've made in terms of incentives for sales force? Or is there any other -- is there any remaining sort of seasonal sort of effect to work through in terms of that returns profile?

[John Joseph Fallon]

Thanks, Tom. I'll let Coram pick up on the shape and phasing the sales, I'll take up on the first point. I think if you talk to customers, one of the things they will recognize and tell you is the breadth and quality of the service that Pearson provides in support of its digital curriculum and tools is second to none and that this is something that we have taken a steady, consistent and long-term view of. And so I think the service we provide is of a very high quality and it has been consistently so over many years. And that's one of the reasons why we have a strong leadership position around Inclusive Access. It helps that we have the biggest and best breadth of content. It helps that we are twice as big as the rest of the industry combined in terms of our leadership in learning technology. But it also helps the fact that we have consistently invested in the service and support over a period of time and therefore, customers have confidence that what we have in place today they can trust will be there tomorrow because we've been very consistent in the way we've approached this.

[Coram Williams, CFO & Executive Director]

And let me pick up on the second question, Tom. I mean, I don't want to overemphasize this, but it is a small quarter for us, as both John and I mentioned in our introductory comments. It's less than 20% of Pearson sales overall, and in higher ed it's around 10% of our net actual sales. So it's good to have the quarter under our belts, but it's not necessarily a leading indicator. Just to pick up on the question around sort of trends that we're seeing. There really are 3 trends, I think, that we've been describing over the past 12-or-so months. So one, a shift in terms of buying patterns so that students and channel partners are buying slightly later in the semester. Secondly, caution in the channel. We commented on that at the end of last year, which, in turn, then is driving a positive effect in terms of lower returns. And I think you can see from our commentary this morning that we are seeing all of those factors play through, and that's why gross sales are down but returns are significantly better than they were this time last year. So when you put all of that together, then we are very much trading in line with our guidance and our expectations.

[Operator]

Our next question comes from the line of Nick Dempsey of Barclays.

[Nicholas Michael Edward Dempsey, Research Analyst]

First of all, on the rental partnerships, Cengage moved to offering all their books for rental on that basis -- on a revenue share basis. McGraw-Hill is moving up in terms of the proportion of their offers on that basis. I think you guys are still kind of at a smaller number there. When you look at Cengage, they saw a 4-point drag from that last year, McGraw-Hill talking about a 1- to 2-point drag from their approach. They both say it's going to be beneficial over time. Will you guys increase the number of titles you offer in this kind of rental partnership model? And if so, should we expect a drag on your growth at some point? And the second question, you talked about U.K. assessment as an area that's improving this year. Don't we have to worry about the introduction of T levels over time and the effect that will have on BTEC volumes? And won't we, in the next couple of years, enter a phase where those BTECs start to decline again, just like we saw before for different reasons?

[John Joseph Fallon]

Yes. Thanks, Nick. I'll take the second question and Coram might want to add on the first one. I mean, I think we -- to be clear, that T levels are very much in the similar space that we saw the attempt to move to diplomas a few years ago. So it's much more in that sort of apprenticeship, vocational, Post-16 space. This is an area where BTECs have proven over many years to be incredibly popular with universities, with employers, with schools and colleges, and most importantly, with students themselves. I think in the latest proposals, the government recognizes that with this category of applied general, which will continue to be funded, and BTEC is an applied general qualification. So I think there's some work to do as the T levels are still being evolved and evaluated before they actually finally come into being. But I think we feel very confident that, one, there will be very clear funding and support for BTECs as part of that and that no one should bet against the sort of enduring popularity of BTECs with all those different constituent groups because they do deliver important pathways to progression and better career opportunities for large numbers of young people. On the first point, Coram, do you want to pick up on the rental partnerships issue?

[Coram Williams, CFO & Executive Director]

Sure. I mean, I think it's important to remember that the way in which we manage our rental program is different to other parts of the market. So just to reiterate, when we move a title into rent, it is not possible to buy that title from then on, and therefore we are, if you like, constrained by the speed at which the edition cycle changes because you cannot move a title into the rental program unless you're moving into a new edition. We think that's the right way to do it because that gives us control and visibility over a challenging part of the channel and it means you are genuinely moving from an ownership to an access model. In terms of the financial impact that, that has, I think we've said previously that it does mean there's a drag in the first year, and indeed, slightly in the second year as well because you're moving from monetizing the value of the content upfront to monetizing it over the life of the edition in the access model. We do think it's economically neutral over the life of that rental period base. So as we ramp up the program, yes, there will be a drag, but we are happy with the speed at which we are going and we think we can manage that financial effect.

[John Joseph Fallon]

Yes, and key point that Coram made is when we shift our titles into the print rental program, they are then only available to rent. It is not possible to buy them because clearly that's fundamental to shifting from a secondary to a primary market. Okay. Thanks, Nick.

[Operator]

Our next question comes from the line of Katherine Tait of Goldman Sachs.

[Katherine Tait, Associate]

A few more questions for me. I just wondered if you can quantify how much gross sales were actually down in numbers and also what the sort of offsetting impact was from the lower returns. I guess we can [ prove out ] that from your release. And then also just I suppose on the point of returns, anything that you can sort of share with us in terms of your visibility into sort of inventory levels and for the channel and how we could perhaps expect that to trend in the following few quarters? Secondly, on the 3 distinct customers you talked about or you sort of outlined, I think we're quite familiar with the students and the professors, but perhaps you could just share a little about what the key focuses are for the institutional leaders in your negotiations, particularly around Direct Access, and what the key sort of factors of importance are for them when you are making these agreements. And then finally, just coming back to rental, can you just confirm what proportion of your books are currently within this rental program? And what proportion you would expect that to be by the end of the year?

[John Joseph Fallon]

Okay. Let me pick up on the college leadership approach to Inclusive Access and then Coram can pick up on the gross sales and returns and the rental program. So it's the same key themes for institutional leadership, college presidents and the like: it's about affordable choice and better outcomes. The choice is important because they respect the academic freedom of faculty. So they want faculty to be able to choose the courses and the offers that they think will do the best job of helping them to teach the course the way that they want to teach it. They are interested in affordability because, clearly, they want to deliver good value to their students. And they are also very focused on better outcomes, and better outcomes come from ensuring that every student has full access to all the materials they need to be successful in their course on the first day of class. It's also about ensuring that students are getting immediate, insightful, helpful feedback as they work through the course. So that helps to personalize and adapt it to their needs. And obviously, they're also increasingly interested in aggregating that feedback on a department- or university-wide level so that they can spot trends and areas that they can use to improve their own performance and the overall teaching and learning experience for the students. So you've got to be able to play across all those areas, and so for the reasons I've talked about earlier, because we have the best and broadest breadth of content and offers, because we have -- are investing more and have, by far, the best digital technology and adaptive learning capabilities, and because we have consistently provided very high-quality services to our institutional customers, and obviously an increasing synergy there with our Online Program Management business as well, that puts us in a very strong position to meet the needs of college leadership. Coram, do you want to pick on the other 2 points?

[Coram Williams, CFO & Executive Director]

Sure. So in terms of breaking apart the sort of gross sales and returns, I'm not going to do that because this is a small quarter and I think there is a risk of reading too much into relatively small numbers. We told you that it is up slightly and that, as I mentioned in my response to Tom, we're in line with expectations. So I think you can assume that the trends that we were expecting to see are very much in evidence. You might then be asking yourself, well, why is it up slightly if our guidance is 0 to mid-single digits down? And that's because there's a phasing effect, and you'll remember this from last year, that the returns have a disproportionately higher benefit in the first half and the pressures on the gross sales line tend to be felt in the second half. So just to be really clear, we are trading in that range and all of the moving parts are in line with expectations. In terms of returns, they are down year-on-year, which is what we were expecting. I think that's really because of the actions that we've taken over the last 12 months in terms of moving our salesforce from gross to net incentives and the returns restocking charge so that everybody in the channel is aligned. And then, finally, on the rental program, we have around 150 titles in the program at the moment. We generally have just over 1,500 in our active [ front ] list, so you can see the rough proportion. We are committed to increasing that, but you'll understand that as part of that -- any discussions to put something into rental, we have to negotiate with authors and we have to make sure that we thought through the consequences. So you will see that increase, but we're not going to put a number on it.

[Operator]

Our next question comes from the line of Matthew Walker of Crédit Suisse.

[Matthew John Walker, Research Analyst]

Two questions, please. The first is on the adoption and also on DDA. You mentioned -- you said DDA's going exceptionally well, especially in terms of sell-through to existing institutions, and then you talked about having a very good [ capacity ] performance in the adoptions. Does that mean that you feel pretty confident of being more towards the top of your higher ed range? Because, obviously, that does have a knock-on impact into the second half of the year. And could you update us on how -- I think you had 500 DDA institutions, if you could update us on where you are now, that would be helpful. The second thing is on K-12. Can you just explain the time length behind the process, why it's so complicated? And give us a feel -- given your guidance and net debt, you're going to be not close to 0 net debt, but you're not too far away from 0 net debt, maybe GBP 300 million or GBP 400 million. Are you very likely to use the proceeds of K-12 for a buyback in the same way you did with PRH?

[John Joseph Fallon]

Okay. Thanks, Matthew. Well, I'll deal with the process around K-12 and how -- the performance and adoptions on DDA, and then Coram can remind you of our approach to capital allocation. We've probably shared more on the K-12 process than we would normally when we're in the middle of a disposal, purely because of the fact that we were holding the business separate for sale in the 2017 accounts. But we have, as you know, sold many businesses over many years, and the one thing I've learned along that process is say as little as you possibly can until the moment that you've got something substantive and definitive to announce. And so we'll stick with that policy, if that's okay. On the first issue, clearly we are right in the midst of the season, so I don't think it's helpful to give a day-by-day, blow-by-blow account. Suffice to say, as I said earlier, I think both in terms of signing up new institutions, improving sell-through with existing institutions and winning adoptions, we're feeling very confident and comfortable on all that front. In terms of our market share, I think the latest MPI data -- which, to remind you, is the data that tells us how we are performing competitively against the other 5 major players in higher education courseware. As I think you've heard me say before, we trend pretty consistently in [ FA ], somewhere slightly below 40 and slightly above 41. We're currently towards the top end of that range and we would expect to be sort of within that range for the full year.

[Coram Williams, CFO & Executive Director]

So just to pick up then on the question of sort of net debt and use of proceeds. Just to remind you how we guided to net debt at the beginning of the year, we said we thought it'd be in line with prior year. So that's roughly GBP 400 million [indiscernible] before any impact of FX, and as you know, that can move the number. And the reason for that is that the positive cash flow is being used for 2 things, really. Firstly, the completion of the buyback, which we had GBP 150 million outstanding at the beginning of the year; and obviously, restructuring costs, which will go out during the year in cash terms. So that's the guidance. On the use of proceeds from K-12, I mean, just to remind you of our capital allocation priorities: first is to maintain a strong balance sheet; second is to invest in our business; the third is to have that sustainable and progressive dividend; and then fourthly, to return excess capital if we believe there is any, and I think the board have demonstrated an appetite to do that. You saw that last year. But you'll understand that we will only make that decision once we have actively completed the K-12 deal.

[Operator]

Our next question comes from the line of Chris Collett of Deutsche Bank.

[Christopher Anton Giles Collett, Research Analyst]

Yes, I just had 2 questions, and apologies if you covered it earlier on, but I just wanted to just go back to -- on Core and the modest growth expectations that you gave us back in February. Could you just sort of help us with the factors that would just sort of impact the phasing from where we were the first quarter over to the balance of the year? And then also on Growth, I think, Coram, you mentioned that in your remarks but could you just explain to me once again just about whether you're still expecting a modest increase in revenues and how the South African sales would impact the phasing? Did they all come in the first quarter of 2017?

[John Joseph Fallon]

Coram, do you want to take the first?

[Coram Williams, CFO & Executive Director]

Sure. I'll actually pick up on both those. Let me start with Growth. The reason for the underlying decline of 12% is really all about South African courseware. We had a very significant order, which we did flag at the time, in Q1 of '17, which came mainly from the Eastern Cape, and that's a tough comparative for us. If you exclude that, so if you're looking for an underlying trend, then actually the Growth division as a whole is up 1%, not down 12%. So that tells you what's happening in the rest of the business. In terms of our South African courseware, and then I'll answer the sort of wider question about Growth, South African courseware is a lumpy business, but we do expect to claw most of that back through those orders. But just to remind you, actually our guidance for South African courseware was that it would be down slightly in '17. So that's why I'm saying we'll get most of it back, but not all of it. In terms of the rest of Growth, our guidance was modest increase in revenues on the back of new English products and growth in Pearson Test of English, and we're seeing that at this stage come through. So I think we're feeling fine at the end of the first quarter about the Growth business. In terms of Core, there are really 2 drivers of where we're at, at the end of the first quarter, which is, firstly, a strong performance in Pearson Test of English, which as you know has been something of a success story for us over the last couple of years. Now those comparatives get tougher because we saw really strong growth in PTE all the way through last year. So some of the benefit that you're seeing in that 6%, I think, will unwind because of PTE. The other driver of growth in Core is OPM, and we've recently signed a deal with Sussex, which is a sign of the progress that we're making. I think we're feeling good about that business. And then the other major component is U.K. qualifications where you're seeing stabilization in BTECs, which is a good thing, but ongoing disruption in the apprenticeships market, which we did flag in our guidance, and it's really too early to call at the end of the first quarter.

[Operator]

Our last question comes from the line of Patrick Wellington of Morgan Stanley.

[Patrick Thomas Wellington]

Two very simple questions, really. I think you said at the full year stage, about your 0 to minus 5 forecast for higher education, that you had a good degree of confidence that you would be within that range. So the question is, where is that gauge of good degree of confidence after the first quarter? And then, secondly, your other statement, the full year was at least 70% of Pearson was in Growth, i.e., broadly speaking, everything except U.S. higher education. How confident do you feel about that, and in particular, around the other bits of North America, which seemed to have performed relatively well in Q1 as opposed to a fairly haphazard performance last year?

[John Joseph Fallon]

Thanks, Patrick. So on the first one, yes, I think you've -- we are on track. We made a good solid start to the year and we're retaining our guidance from that. Our confidence is probably that little bit higher than it was at the start of the year because we're a little over 3 months through trading and clearly, every month we go by where the higher education market performs in line with what we're expecting on the basis of the huge amount of work we did about 15 months ago after the shocks at the end of 2016 to make sure we really understood what's going on, every month that ticks by, the confidence levels just tick up slightly with them. So I think that's the first point I'd make. The second thing, just to clarify. I think what Coram said was that, collectively, the businesses that make up the 70% sales outside higher education would grow. We did not say that every one of that 70% would grow. We're saying that cumulatively, the other 70% of Pearson will grow this year. And on the basis of the performance in the year-to-date, we're very much on track to do that. Just to answer specifically your question in North America, clearly the professional certification business, Pearson VUE, is off to a good start to the year, helped by the new medical contract, medical admissions contract that we have. And we're obviously also seeing encouraging growth in enrollments in both our Online Program Management business and our virtual schools business. And you will have seen in both, we've been signing up new partners as well. Thanks, Patrick.Okay. I think that was the last of our questions. That's concludes today's call. For those of you interested, our Annual General Meeting is 12 noon today, at IEG (sic) [ IET ], which is the building just along from our offices at The Strand. And look forward to seeing any of you and any shareholders who wish to join us. Thanks very much, and we'll talk to you again in the near future.

[Operator]

This now concludes our conference call. Thank you all for attending. You may now disconnect your lines.