Fool's Eye View

[ March 6, 2000 ]

No 'Net Mugs at Pearson

By Bruce Jackson (TMF Googly)

Pearson (LSE: PSON), the company best known as the owner of the Financial Times, this morning released annual results for the year ended December 1999. For a company with a market capitalisation of £15 billion, on the surface, the following growth numbers look impressive.

Sales                  +39% to £3,332m 
Adj. Operating profit  +41% to £  549m 
Adjusted EPS*          +27% to   53.3p 
 
*pre Internet enterprises 

I couldn't help but chuckle to myself about the separation of "Internet enterprises" within the numbers. What a luxury! But why should there be that distinction? Pre-Internet and all its stock market hype, all a company would have to say is something like "earnings have been held back in 1999 due to investment in an area of the business we think offers excellent growth opportunities." Then again, perhaps I'm being pedantic, especially since adjusted earnings per share (EPS) post-Internet enterprises still jumped a very respectable 15%.

Pearson's shares rose 137p to 2440p in morning trading as results came in at the top end of expectations. They also gave more details about their new media investments, the highlights of which were:

• An agreement with AOL (Nasdaq: AOL) whereby Pearson is the preferred supplier of educational content and on-line learning tools across the AOL distribution network.
  
• Strategic alliances and equity investments in at least 3 "leading Internet educational companies."
  
• FT.com will soon launch its first major US marketing campaign. That part of the business trebled 1999 revenues to £6m and lost £35m. But, hey this is the Internet, and losses are okay.
  
• The launch of FTMarketwatch.com in June, a joint venture with popular US financial website Marketwatch.com. This, coupled with a French version of FTYourMoney.com, form part of Pearson's strategy of building a Europe-wide web-based news and personal finance sites.

Pearson are no mugs when it comes to the Internet. Unlike some media companies -- Reed International (LSE: REED) comes to mind -- from the early days they've seen the potential of this new medium. There has been some dithering along the way, and no doubt a lot of board room debate, about the strategy (for example, there were plans for FT.com to be largely a subscription-only site), but they now seem to be forging ahead on many fronts.

Pearson is one of the companies featured in our brand new Industry Focus 2000, on sale from the site later today. One thing that concerned me about them was cash generation. At the halfway point of 1999, Pearson had managed to turn an operating (accounting) profit of £46m into a cash outflow before exceptional integration costs of £12m. The culprit was a build-up in working capital. Come the full year, shareholders must have been pleased to see that situation reversed, with operating profits of £318m being translated into cash inflow before exceptional integration costs of £540m. As a company is ultimately valued on the value of its future cash flows, you can see how important this oft-overlooked part of the business model is.

Whilst all the excitement this morning surrounds Pearson's Internet ventures, it shouldn't be forgotten that there are other solid businesses within the group. They split things four ways -- Education, Financial Times, Pearson Television and Pengiun -- with each of them having solid organic growth prospects. In fact the company in general appears not to be short on growth prospects, a nice position to be in. Couple that with the prospect of further expansion of the operating margin -- up from 13% to 15.2%, but still well short of the 23% margins achieved by Reed in 1996 -- and you can easily see how Pearson will achieve their stated objective of annual double digit earnings growth for the next few years at least.

With the shares at 2440p, they trade on a trailing adjusted post Internet price to earnings (P/E) ratio of 50. That's not cheap, but at the moment the market is forcing investors to pay up for quality, and Pearson passes that test. And, unlike many Internet companies, it has the resources to continue investing in new media opportunities, and it's profitable. Finally, if there is to a shake-out of valuations amongst Internet companies, Pearson should be relatively immune.

Related Links
• Fool's Eye View on Reed International
• How To Value Shares -- Discounted cash flow