Pearson has a long unbroken record of increasing the dividend paid to shareholders. The Company’s management is committed to build on that tradition, increasing dividends at a rate comfortably in excess of UK price inflation. At the same time, management sees opportunities to earn a return in excess of the Company’s cost of capital through investment in the business and has therefore stated an objective of rebuilding dividend cover (adjusted earnings per share expressed as a multiple of net dividend per share) to a minimum level of two times. In making a dividend recommendation to shareholders the board also takes into consideration the level of the Company’s free cash flow. In addition, the board will consider the return of capital to shareholders when that course of action is justified by a high level of corporate liquidity, a shortage of investment proposals which meet our criteria or the level of the Company’s share price. The board is recommending to shareholders a final dividend of 13p, making a full year total of 21p, representing an increase of 8% on the 1997 total. The recommended dividend is covered twice by adjusted earnings and will be fully funded from 1998 free cash flow.
The Group holds financial instruments for two principal purposes: to finance its operations and to manage the interest rate and currency risks arising from its operations and from its sources of finance.
The Group finances its operations by a mixture of cash flows from operations, short term borrowings from banks and commercial paper markets, and longer term loans from banks and capital markets. The Group borrows principally in US dollars, sterling and euro at both floating and fixed rates of interest, using derivatives where appropriate to generate the desired effective currency profile and interest rate basis. The derivatives used for this purpose are principally interest rate swaps, interest rate caps and collars, currency swaps and forward foreign exchange contracts.
The main risks arising from the Group’s financial instruments are interest rate risk, liquidity and refinancing risk, counterparty risk and foreign currency risk. These risks are managed by the Group finance director under policies approved by the board which are summarised below. These policies have remained unchanged, except as disclosed, since the beginning of 1998. A treasury committee of the board receives reports on the Group’s treasury activities, which are also reviewed periodically by a group of external professional advisers. The treasury department is not a profit centre, and its activities are subject to audit.
Interest Rate Risk
The Group’s exposure to interest rate fluctuations on its borrowings is managed by borrowing on a fixed rate basis and by entering into interest rate swaps, interest rate caps and forward rate agreements. At the beginning of the year the Group’s objective was that at least one-third of its sterling and US dollar borrowings (taken at the year end, net of cash) should be hedged (ie fixed or capped). At the end of 1998 that ratio was 32%. In connection with the acquisition of Simon & Schuster, during the year the Group decided to increase the hedged proportion, particularly for the years 1999 and 2000. In particular it entered into interest rate swaps for a nominal amount of $600m which will only become effective during 1999. Taking into account these swaps together with other hedging transactions effected since the year end, on a pro forma basis the proportion of sterling and US dollar net borrowings which were hedged at the end of 1998 was 53%. On that pro forma basis a 1% change in the Group’s variable sterling and US dollar interest rates would have an £11m effect on its profit before tax. The Group intends to increase further the fixed rate element of its borrowings in 1999.
Liquidity and Refinancing Risk
The Group’s objective is to procure continuity of funding at a reasonable cost. To do this it seeks to arrange committed funding for a variety of maturities from a diversity of sources. It has a policy that the weighted average maturity of its core gross borrowings (treating short term advances as having the final maturity of the facilities available to refinance them) should be between three and eight years, and that non bank sources should provide between 25% and 75% of such core gross borrowings.
At the beginning of the year, the average maturity of such core gross borrowings was 6.1 years, and non-banks provided approximately 51% of them. The acquisition of Simon & Schuster at the end of November was financed with a combination of the cash previously received from disposals and an equity issue and drawings under the new bank facility. At the end of 1998 the average maturity of gross borrowings was 4.4 years, and non banks provided approximately 18% of them. It is the Group’s intention to extend the average maturity of its borrowings through refinancing the bank facility by issues in the medium term capital markets.
The Group believes that ready access to different funding markets also helps to reduce its liquidity risk, and that published credit ratings and published financial policies improve such access. The Group manages the amount of its net debt and the level of its net interest cover, principally by the use of a target range for net interest cover. In the course of considering in March the terms on which it would be prepared to acquire Simon & Schuster, the Group concluded that its improved business risk profile following the acquisition, taken together with the prevalence of low inflation and interest rates in its key markets, would support a higher level of financial risk and, accordingly a lower level of interest cover. Following the success of its bid the Group’s long term credit ratings were reduced from A2 to Baa1 by Moody’s and from A to BBB+ by Standard & Poor’s, and its short-term ratings from P1 to P2 and A1 to A2 respectively. The Group intends, however, to take such action as is necessary to support and protect its current credit ratings. The Group also maintains undrawn committed borrowing facilities. At the end of 1998 these amounted to £835m, and their weighted average maturity was 2.7 years.
The Group’s risk of loss on deposits or derivative contracts with individual banks is managed in part through the use of counterparty limits. These limits, which take published credit ratings (among other things) into account, are approved by the Group finance director.
Although the Group is based in the UK, it has a significant investment in overseas operations. The acquisition of Simon & Schuster greatly increased the amount of the Group’s trading which is conducted in the US dollar, making it by far the most important currency for the Group, although the value of its operating profits from sterling and the euro bloc are also significant.
In 1997 the Group determined that transactional conversions between currencies (for example, to pay receivables, payables or interest) should be effected at the relevant spot exchange rate. This policy continued to be followed in 1998. As in previous years, no unremitted profits were hedged with foreign exchange contracts. During the year the Group reviewed and amended its policy for the use of foreign currency debt. At the beginning of the year the policy was normally to borrow in each principal foreign currency around 20% of the capital employed (inclusive of purchased goodwill) in that currency. The policy has been amended to align the composition of the Group’s debt more closely with the currency in which operating profits arise. Long term core borrowing is now limited to the US dollar, sterling and the euro, reflecting their collective share of total Group operating profit. However, the Group still borrows small amounts in other currencies, typically for seasonal working capital needs.
The new policy aims to dampen the impact of changes in foreign exchange rates on consolidated interest cover and earnings. At the year end US dollar borrowings accounted for 75% of total borrowings, sterling borrowings for 19%, Spanish peseta borrowings for 4% and French franc borrowings for 2% (so that pro forma euro borrowings accounted for 6%).
European Monetary Union
With over 50% of the Group’s sales outside continental Europe and the UK, even prior to the impact of the acquisition of Simon & Schuster, the introduction of the euro is not an issue for sizeable parts of the Pearson Group. Those businesses affected have focused in 1998 on preparation for the treasury and related administrative issues and on completing strategic reviews of the impact of the euro on their competitive environments. Recoletos, Les Echos and other business units based in continental Europe have been working in dual currencies with little or no difficulty since 1 January 1999. Within the UK based businesses, the FT Group has been most affected, with FT Information launching an entire portfolio of euro-based products on 1 January 1999. All UK operations have established contingency plans in the event the UK decides to join the euro-zone. The financial costs of preparations for the euro have not been material to the Group.
The significant accounting policies of the Group are shown on pages 58 and 59. During the year a number of new UK Financial Reporting Standards were either issued or became effective. FRS9 ‘Associates and Joint Ventures’ has been implemented with the result that the profit and loss account now shows separately the operating profit and interest from associates and additional disclosure is given in the notes. The prospective implementation of FRS10 ‘Goodwill and Intangible Assets’ has significantly changed the appearance of both our profit and loss account and balance sheet. Purchased goodwill is now required to be shown as an asset on the balance sheet and amortised over its useful economic life, presumed to be not greater than 20 years unless shown otherwise. The amortisation charge is taken through the profit and loss account. In order to show results on a comparable basis, this goodwill amortisation has been excluded from adjusted earnings.
FRS13 ‘Derivatives and Other Financial Instruments’, which requires additional narrative and numerical disclosures in respect of financial instruments, has been implemented as has FRS14 ‘Earnings Per Share’ which has also added to the disclosure requirements, now requiring diluted earnings per share to be shown in addition to changing the calculation of the weighted average number of shares in issue.
FRS12 ‘Provisions, Contingent Liabilities and Contingent Assets’ will be adopted in the 1999 Accounts although the provisions held in the balance sheet at December 1998 do meet the criteria imposed by the new standard. The effect of the standard is to relate the timing of provisions more closely to the period in which the sums provided will actually be spent.
The Group control department, which has an independent reporting line to the Audit Committee, checks our effectiveness at managing risk. Through regular audits and reviews, it seeks to identify under-managed risks, and then works with the responsible line management to resolve any issues arising. This includes ensuring that the policies and procedures operating throughout the Group, which were reviewed and revised during 1998, are suitably comprehensive and up-to-date.
All the main operating companies in the Group are visited regularly by members of Group control. Smaller companies not visited are required to complete control and risk assessment questionnaires. Responses are monitored by Group control in conjunction with the divisions and appropriate actions are taken to mitigate any under-managed risks.
The acquisition of Simon & Schuster presents the Group with considerable challenges, as well as great potential for growth and efficiencies. The integration of the Simon & Schuster and AWL businesses into Pearson Education is managed by a Steering Committee which has board representation. This group has been working for several months with the line managers selected to lead the combined organisation on the key decisions and processes required to ensure a smooth integration into the new division. Group control monitors progress against plan and undertakes various audits and reviews to support an efficient and timely integration.