Financial Review

Simon & Schuster

The acquisition of Simon & Schuster has had a significant impact on the 1998 Accounts in the following areas:

Exceptional Items

Pearson recorded significant exceptional charges of £120m against 1998 operating income relating to the acquisition of Simon & Schuster. Provisions of £72m were made for the cost of integrating our education companies. Further integration costs are anticipated in 1999 though we do not expect the charge for the two years taken together to exceed £190m. In addition a charge of £27m was made to reflect the alignment of certain Addison Wesley Longman accounting bases with those of Simon & Schuster and a write-down of £37m was taken relating to assets created for the implementation of the Pearson Shared Services Project which are no longer required since Simon & Schuster had already developed its own equivalent project.

Goodwill

The acquisition of Simon & Schuster has resulted in the recording of substantial goodwill, the difference between the purchase price paid and the net tangible assets acquired, on the Group’s balance sheet. The goodwill will be amortised over a period of 20 years, in accordance with an accounting standard discussed in greater detail under ‘accounting policies’ on page 38, and has given rise to a charge of £10m in 1998. A full year charge in respect of Simon & Schuster of approximately £120m will be recorded from 1999 onwards. The charge has no impact on the Group’s cash flow and is excluded from the calculation of adjusted earnings in order to show results on a comparable basis.

Business & Professional and Reference Assets

Pearson announced in May 1998 plans to sell on the business & professional and reference assets acquired as part of the Simon & Schuster transaction to Hicks, Muse, Tate & Furst Inc., a US leveraged buy-out firm. This transaction was not completed and accordingly Pearson has inherited these assets. It is Pearson’s intention to retain Macmillan Computer Publishing and New York Institute of Finance, the majority of the assets by value, but to dispose of the remainder. The businesses being held for resale have been recorded in the balance sheet at their estimated disposal proceeds of $275m less costs.

Provisional Fair Value Adjustments

have been made to the Simon & Schuster net assets acquired and these are set out in note 25 to the accounts. They reflect adjustments to harmonise certain Simon & Schuster accounting policies with those of Pearson Education; the revaluation of net assets to their ‘fair value’; and the inclusion of the anticipated proceeds from the sale of certain business & professional and reference assets referred to above. Since the acquisition was completed so close to the year end further fair value adjustments are anticipated in 1999.

Loan Facility

In order to finance the Simon & Schuster transaction, Pearson negotiated a $6bn loan facility with a group of international banks. This loan facility, which also refinanced all existing structured bank debt, has three elements:

1. A 364 day revolving credit facility (initially for $1.5bn but reduced by cancellation to $349m at the balance sheet date) maturing in May 1999;

2. A term revolving credit facility (for $2bn) which begins to amortise in May 2000 and matures in May 2003;

3. A term loan facility (for $2.5bn, of which $2.21bn was drawn at the balance sheet date) which begins to amortise in May 2000 and matures in May 2003.

There are two key covenants under the terms of this loan facility, one an interest cover covenant and the other a net debt to EBITDA (earnings before interest, taxation, depreciation and amortisation) covenant. The Group does not currently foresee any difficulties in complying with the terms of these covenants.

Non operating items

Non operating items were again significant in 1998 following the disposal of a number of non-core businesses and these helped boost pre-tax profits from £129m in 1997 to £629m. The disposals of Pearson New Entertainment and The Tussauds Group yielded non operating profits of £41m and £157m respectively whilst the disposal of the investment in Société Européenne des Satellites resulted in a non operating profit of £133m.

Interest

Net interest fell slightly to £39m but this figure does not tell the whole story as there were several significant factors which affected the overall financing position of the Group. Debt fell over the first 10 months of the year as the businesses generated cash and proceeds were received from the businesses sold as well as from our equity issue which raised £327m in August. Although floating interest rates in both sterling and US dollars fell during the last four months of the year, taking the year as a whole they were higher in 1998 than 1997 in sterling and virtually unchanged in US dollars.

However, the acquisition of Simon & Schuster at the end of November increased year end net debt to £2.3bn and added approximately £12m to the interest charge for the year. Future gross debt levels are likely to be nearer to the year end debt figure of £2,624m than the levels of previous years and so a significantly higher interest charge will be a feature of the Pearson profit and loss account in the forseeable future.

Interest cover, defined as the ratio of operating profit before exceptional items and goodwill amortisation to net interest payable, stood at 10 times.

Taxation

The tax charge of £188m represents an effective rate of 29.9% on profit before taxation of £629m. The comparable 1997 effective tax rate of 68.9% was abnormally high because there was no current tax relief for a charge of £212m in respect of Mindscape goodwill; excluding this factor the 1997 effective tax rate was 26%. The increase from 26% to 29.9% is largely accounted for by the fact that only limited tax relief has been recognised on the Simon & Schuster integration costs in 1998. The overall tax rate on items excluded to arrive at adjusted earnings was 32.3%; the effect of the treatment of the Simon & Schuster provision was largely offset by the fact that, as in 1997, the tax rate on profits on disposals benefited from the use of losses brought forward and from indexation and other differences between book and tax bases for the calculation of gains.

The tax rate on adjusted earnings fell from 29.4% to 28%. As in 1997, the availability of tax losses in the US meant that no significant tax needed to be provided on the Group’s profits arising there, and this factor alone largely accounted for the difference between the UK statutory rate of 31% and the effective rate of 28% on adjusted profits. The 1998 tax rate also benefited from the release of some provisions for earlier years’ tax following settlement of the liability for those years, and this factor more or less offset the effect of disallowed expenses and the Group’s exposure to higher tax rates in countries other than the UK and the US.

Minorities

Minority interests increased in 1998 to £4m following the strategic alliance with Telefónica, Spain’s leading telecommunications company, which took a 20% stake in Recoletos at the start of the year.