Financial Review

Although our strong operating performance meant that operating profits from continuing operations increased by 3% to £426m, we charged a loss against reserves for the year of £568m. This table reconciles the difference between the two, as well as the cash impact of the individual items.

Some of these items – interest, integration costs and dividends – have a cash flow impact roughly equivalent to the charge on the profit and loss account. Others – goodwill and amounts written off investments – have no cash impact even though they account for the majority of the difference. To complicate matters further, the non-operating items generated cash for the company but were a debit in calculating profit, while tax produced a profit and loss credit but was a negative item in the cash flow statement.

The sale of our 22% share in RTL was not concluded until the end of January 2002 and, as a result, the proceeds of E1.5bn are not reflected in the 2001 accounts. However, the cash received has allowed us to reduce our net debt to around £1.5bn since the year end. Both Standard & Poor’s and Moody’s took account of this disposal in deciding to maintain unchanged credit ratings for the company earlier in the year. This formed a key part of our risk management strategy which we refer to in more detail below.

financial statements

goodwill amortisation

We took a charge of £382m for goodwill, a balance sheet item which represents the difference between the price paid for acquisitions and the fair value of the assets acquired. This goodwill is amortised, typically over 20 years. The major reason for the increase over last year of £204m is that NCS and Dorling Kindersley – the two major acquisitions of 2000 – incurred full year amortisation of goodwill for the first time. This accounted for £69m of the increase.

goodwill impairment

This £61m charge resulted from a review of the carrying value of goodwill on our balance sheet, required under FRS 10 (Goodwill and Intangible Assets) and FRS 11 (Impairment of Fixed Assets and Goodwill), which led to a decision to impair the value of Dorling Kindersley by £50m.

Dorling Kindersley was purchased in May 2000 for a price of £318m plus embedded debt of £49m. Although Dorling Kindersley adds value both to Penguin and our education businesses, and is expected to return to profit in 2002, the integration has taken longer to achieve than we initially envisaged and we have also reduced the revenue base in order to eliminate unprofitable publishing. Taken together with a difficult economic environment, which has affected Dorling Kindersley’s travel guides in particular, we thought it prudent to write down the value of goodwill by just under 15%.

We also took a total of £11m in write-downs on various other businesses, the largest of these relating to a Latin American subsidiary. We undertook a detailed review of our 2000 acquisition of NCS but found no reason to reduce the goodwill we carry on our balance sheet as a result.

integration costs

Integration costs of £74m relate to the one-off costs of integrating significant recent acquisitions into our existing businesses. £45m was incurred in integrating Dorling Kindersley into the Penguin Group and the remaining £29m related to the integration of NCS into Pearson Education. This expenditure was in line with our forecasts at the time of the transactions.

non-operating items

A charge of £123m for non-operating items relates to losses on the sale or closure of businesses and fixed assets. It includes our share of the loss on sale of the Journal of Commerce (£36m) by The Economist Group, a loss on sale of iForum (£27m), an internet-based training company, our share of the net loss on disposals by the RTL Group (£17m), and the disposal or closure of various smaller businesses (£43m). In 2001 we also sold FT Energy and received net cash proceeds of £43m. There was no significant profit and loss impact.

amounts written off investments

We concluded a thorough review of our fixed asset investments, principally in the dot.com arena. We have provided for £55m against these investments, the biggest items being for Business.com (£17m) and TimeCruiser (£10m).

We also reviewed the carrying value of Pearson shares held to secure employee share option plans created at the time of more buoyant stock markets. We determined that the most appropriate course of action was to ‘mark them to market’ – to write them down to the market price on 31 December, 2001 resulting in a charge of £37m and bringing the total amount written off investments to £92m.

interest

Net interest rose by £12m to £169m, with average net debt increasing by £375m. This increase in net borrowing more than offset the effect of a general fall in interest rates during the year. The weighted average three month LIBOR rate, reflecting the Group’s borrowings in US dollars, euros, and sterling, fell by 230 basis points, or 2.3%. The effect of these falls was mitigated by our existing portfolio of interest rate swaps, which converted over half our variable rate commercial paper and bank debt to a fixed rate basis. As a result, the Group’s net interest rate payable averaged approximately 6.4%, falling 0.5% from the previous year.

taxation

The Group recorded a total pre-tax loss of £438m in 2001; tax relief on this loss was £67m – an effective rate of 15%. The non-operating tax credit (£159m) includes £143m attributable to settlement of the tax position on the BskyB and Tussauds disposals which occurred in 1995 and 1998 respectively.

The tax rate on adjusted earnings after internet operations increased from 26% to 31%, and from 23% to 24% before internet operations. This increase was mainly attributable to the increase in the overall tax on profits (including those of associates) arising outside the UK and the US. As in previous years, the main reason for the tax rate on adjusted earnings being lower than might be expected from the UK and US statutory rates, is the continued availability of losses in the US consolidated tax group. The tax rate used in calculating adjusted earnings is likely to rise as a result of the implementation of FRS 19, which is discussed later in this section.

minority interests

Minority Interests include a 40% minority share in IDC and a 21% minority share in Recoletos.

dividends

The dividend payment of £177m which we are recommending in respect of 2001 represents 22.3p per share – a 4% increase on 2000. The dividend is covered 1.0 times by adjusted earnings after internet enterprises, and 1.1 times by cash flow.

The company seeks to maintain a balance between the requirements of our shareholders, including our many private shareholders, for a rising stream of dividend income and the re-investment opportunities that we see across the Group. This balance has been expressed in recent years as a commitment to increase our annual dividend faster than the prevailing rate of inflation while progressively reinvesting a higher proportion of our distributable earnings in our business. While this commitment remains unchanged, we believe that the income requirements of our shareholders should take priority over reinvestment this year.

other financial items

pensions

The company resumed contributions to its UK Pension Fund following a prolonged ‘holiday’ period. The cash contribution is expected to increase in 2002. The rate of funding of pension liabilities is kept under regular review by the company and Fund trustees. The proposed changes in the accounting for Pensions are discussed in the next section.

accounting disclosures and policies

In this report we illustrate the impact of FRS 17 (Retirement Benefits) for pensions and other post retirement benefits ahead of full adoption for 2003. Under the new standard the method of accounting for our defined benefit pension schemes will change significantly from the current practice under SSAP 24. FRS 17 approaches pension cost accounting from a balance sheet perspective with the net surplus or deficit in Pearson’s pension schemes being incorporated into the balance sheet. Changes in this surplus or deficit will flow through the profit and loss account and the statement of total recognised gains and losses. In this report we have disclosed the effect on the closing balance sheet at the end of 2001 in the notes to the accounts (see note 11).

FRS 18, ‘Accounting Policies’, has been adopted but has had no significant impact on the results in 2001. FRS 19, a standard on deferred tax, was introduced in 2000 and we will be adopting this standard in 2002. FRS 19 will introduce full provisioning for deferred tax and this will have a significant effect on Pearson’s effective tax rate. The tax benefit of US tax losses is currently accounted for as the losses are utilised. Under FRS 19 this benefit will no longer arise.

managing our financial risks

This section explains the Group’s approach to the management of financial risk.

treasury policy

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 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, euros and sterling, 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 2001. A treasury committee of the board receives reports on the Group’s treasury activities, policies and procedures, which are reviewed periodically by a group of external professional advisers. The treasury department is not a profit centre and its activities are subject to internal 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. Since December 2000 the Group’s policy objective has been to set a target proportion of its forecast borrowings (taken at the year end, with cash netted against floating rate debt) to be hedged (i.e. fixed or capped) over the next four years of 50% to 65% for the first two years, and 40% to 60% for the next two years. At the end of 2001 that ratio was 59%. On that basis, a 1% change in the Group’s variable rate US dollar, euro and sterling interest rates have a £10m effect on profit before tax. Since the year end, the disposal of Pearson’s interest in RTL has resulted in a significant reduction in floating rate debt. We have cancelled a number of swap contracts in order to bring the balance of fixed and floating rate debt back within our policy parameters.

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. Since May 2000 the Group’s policy objective has been 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 ten years, and that bank and non-bank sources should each provide at least £250m of such core gross borrowings.

In April 2001 the Group issued [EuroSymbol]250m of bonds due 2003. In June 2001 the Group issued $500m of notes due 2011. As a result, at the end of 2001 the average maturity of gross borrowings was 5.3 years and non-banks provided £2,078m (75%) of them (down from 5.6 years and up from 56% respectively at the beginning of the year). The proceeds of the bond and note issues were used to repay part of the Group’s syndicated bank facility.

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. All of the Group’s credit ratings remained unchanged during the year. The long-term ratings are Baa1 from Moody’s and BBB+ from Standard & Poor’s, and the short-term ratings are P2 and A2 respectively. The Group continues to operate on the basis that the board will 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 2001 these amounted to £1,172m, and their weighted average maturity was 3.5 years.

Counterparty risk 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 limits (among other things) into account, are approved by the group finance director. In addition, for certain longer dated higher value derivative contracts the Group has entered into mark to market agreements whose effect is to reduce significantly the counterparty risk of the relevant transactions.

Currency risk Although the Group is based in the UK, it has a significant investment in overseas operations. The most significant currency for the Group is the US dollar, followed by the euro and sterling.

The Group’s policy during the year on routine transactional conversions between currencies (for example, the collection of receivables, and the settlement of payables or interest) remained that these should be effected at the relevant spot exchange rate. As in previous years, no unremitted profits were hedged with foreign exchange contracts.

The Group’s policy is to align approximately the currency composition of its core borrowings in US dollars, euros and sterling with the split between those currencies of its forecast operating profit. This policy aims to dampen the impact of changes in foreign exchange rates on consolidated interest cover and earnings. Long-term core borrowing is now limited to these three major currencies. However, the Group still borrows small amounts in other currencies, typically for seasonal working capital needs.

At the year end the split of aggregate net borrowings in its three core currencies was US dollar 68%, euro 13% and sterling 19%.