: the pearson goals :

A review of Pearson’s performance in 2000 needs first to be put in the context of our goals and targets. What are we trying to achieve? How do we measure progress? What are the rewards of success, and the penalties of failure? These goals provide the bridge between the group’s strategic objectives which Marjorie has just outlined and the review of performance which follows.

The starting point for all our targets is that we are aiming for faster growth and a higher quality of financial performance than our peers in the media industry, in Europe and the US, and than the broader stock market indices to which we belong.

We manage Pearson’s operations with the help of a variety of key performance indicators which allow us to monitor performance against consistent criteria. Some of these are specific to individual businesses – only the FT Group need be concerned with the mix of circulation and advertising revenues for example – while others are relevant to every part of Pearson.

There are six financial measures which we track carefully and use to drive improvements in performance across Pearson. Three of them, the corporate measures, relate to the performance of Pearson as a whole. The others, the operating measures, provide the framework for the financial plans of each individual business.

The corporate measures directly align our targets with the preferred valuation criteria of our shareholders and support the requirement to fund a rising stream of dividend income. They are used to determine both short and long-term rewards for senior corporate management.

The operating measures form the basis of annual management bonus plans within each company. They are agreed as a package, so that excessive emphasis on cash generation does not jeopardise sales growth, or vice versa. We have created separate measures for our internet enterprises, which we discuss towards the end of this section.

Before internet enterprises, goodwill, integration costs and non-operating items.

Before internet enterprises, goodwill, integration costs and non-operating items.
Prior year earnings per share and free cash flow per share ahve been restated to reflect the rights issue.

1. Adjusted earnings

In 1997 we committed to increase adjusted earnings per share, the best definition of underlying earnings growth that we could find, at a double digit annual rate. The purpose was to deliver superior growth in the measure of performance most widely used by our shareholders and also to express our commitment to deliver this growth year in, year out. We subsequently excluded internet enterprises from this definition of earnings since it was clear that, in the early stages of their development, these enterprises were not being valued by our shareholders on the basis of earnings (or lack of them) and since the application of the double digit standard to our total adjusted earnings would have resulted in our internet enterprises being starved of much-needed investment.

We have achieved this double digit growth in each of the four years since the target was set. In 2000 adjusted earnings per share increased by 14.7% to 54.6p. This growth was helped by a two point reduction in the rate of tax used to calculate adjusted earnings (though we would have achieved our double digit target even without the benefit of this lower tax rate).

2. EBITDA

In addition to earnings per share we focus on two corporate financial indicators which help us chart our course and, where appropriate, correct it. The first is EBITDA (earnings before interest, tax, depreciation and amortisation) which is a close proxy for operating cash flow but, like earnings per share, can be derived from a review of the profit and loss statement. As changes in accounting standards relating to deferred tax, goodwill amortisation and other non-trading items make it more difficult, in our view, to track underlying changes in performance from year to year through earnings per share, we shall place greater emphasis on EBITDA as a measure of performance. It is increasingly used by analysts as a basis for valuing media companies such as Pearson.

The table illustrates progress over the past five years. Last year EBITDA (before internet enterprises and integration costs) increased by 16% to £780m, while over the whole five year period the compound rate of growth has averaged 22%.

3. Free Cash Flow

Free cash flow per share (operating cash flow less tax paid on operating profits and interest paid) is another highly relevant measure since it defines the capacity of the company to reinvest in the business and fund dividends to shareholders without incurring additional debt. The progress of free cash flow needs to be measured over a period of years however, since performance in any one year can be affected by large individual investment programmes or even by the timing of the collection of receivables from key customers.

2000 saw free cash flow of 49.1p per share, a modest increase on 1999 which was a year of exceptionally strong cash performance. Growth in free cash flow per share currently determines the award of Pearson Equity Incentives in the senior management reward plan.

4. Underlying sales growth

Achieving superior growth in sales, from both established and emerging markets, is critical to Pearson’s success. We exclude from our calculation of sales growth the impact of acquisitions and disposals on the one hand and currency movements on the other. This gives us, we believe, the best proxy for underlying growth.

We have accelerated Pearson’s underlying sales growth in each of the past four years due largely to a programme of internal investment across the company. At the same time we have changed the mix in the overall Pearson portfolio towards higher growth assets. Last year’s underlying sales growth of 9.2% was the highest on record.

5. Trading margin

Trading margin measures our ability to turn sales into profit. Since the sales contribution of associates and passive investments is not included in our consolidated revenue, we also exclude their profit contribution in arriving at a definition of trading profit.

The consistent strengthening of margins reflects increased levels of profitability in each of our key businesses. We believe that the FT Group, Pearson Education and Penguin are now achieving margins which are ‘best in class’ for their respective industries. The higher level of profitability reflects both attention to costs and the impact of higher sales growth on operating profit.

6. Cash conversion

We believe that Pearson should be able to convert at least 80% of its profit into cash flow after funding the working and fixed capital investments necessary to deliver superior growth. In 1998 and 1999 we exceeded that target by a healthy margin as the group benefited from a number of non-recurring cash items and timing variances. In 2000 we reverted to a more normal pattern but still exceeded the 80% threshold with a few per-centage points to spare. The effective management of working capital, in particular, will remain a high priority for us in 2001 and beyond.

CAPITAL ALLOCATION

In addition to the performance measures described above, we determine the allocation of capital within the company with the support of a financial model which relates the expected return on investment to the company’s weighted average cost of capital, the two most important components being the cost of equity and the cost of debt. This model is used to appraise acquisition proposals as well as internal investments. We also employ it to analyse the subsequent performance of major acquisitions and investments.