Morningstar has initiated credit coverage of Pearson (PSON) with an issuer rating of A-, which reflects the company's narrow moat, healthy free cash flows, and moderate credit metrics. Pearson is a diversified publisher, and its education business generates about two thirds of overall operating profit. The firm holds a leading position in both textbook publishing and assessment testing in the United States (K-12). A single educational programme competing for adoption can cost hundreds of millions of dollars to develop. Only the three major publishers (Pearson, McGraw-Hill, and Houghton Mifflin) have the financial muscle to effectively compete for these dollars. Pearson captured 37% market share in 2009. As such, Pearson has been awarded a narrow moat.
Pearson's financial health is solid. Long-term debt totalled £2.0 billion as of December 2009, with a debt/capital ratio of 0.32. Leverage is moderate at 2.3 times adjusted debt/EBITDA, and the company's debt maturities are manageable, in our view. We expect EBITDA to cover interest expense about 9 times on average through 2014. In addition, Pearson has ample liquidity with £700 million in cash and £1.75 billion available under its credit facility. Pearson generates strong free cash flow (roughly 10% of sales during our forecast period). We estimate that the Cash Flow Cushion (cash on the balance sheet and future cash flow divided by debt and debtlike commitments) will be about 1.3 over the next five years. While the company has been acquisitive in the past and we believe future acquisitions are likely, acquisitions have been largely funded through free cash generation as opposed to debt. The firm has a history of modestly increasing its dividend, and we expect this continue over the next five years.
