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Operating and Financial Review

2005 overview

Pearson predicted that 2005 would be a year of strong growth and financial progress, driven by education, our largest business. We have reported that Pearson Education had its best year ever; that the FT Group achieved a further significant profit improvement; and that we see good prospects for continued growth in 2006 and beyond.

Pearson's sales increased 9% in 2005, the fastest rate of growth for five years. Adjusted operating profit increased by 22%, well ahead of sales, with profits improving in all businesses. Operating margin improved by 1.6% points to 12.4%. Adjusted earnings per share were 34.1p, up 24%.

In 2005, Pearson generated more cash than ever before, increasing operating cash flow by 152m or 36% to 570m and free cash flow by 147m or 52% to 431m. Cash conversion was particularly strong at 113% of operating profit. The average working capital to sales ratio at Pearson Education and Penguin improved by a further 2% points to 27.4%, even as we continued to make a significant investment in new products and services that will support our future growth.

Our return on invested capital improved to 6.7%, or 7.2% at constant currency, from 6.2% in 2004.

Our statutory results show an increase in operating profit to 536m (2004: 404m) and in statutory basic earnings per share to 78.2p (2004: 32.9p), benefiting from a 302m profit from Recoletos. We ended the year with net debt of 996m, a 225m reduction on 2004 despite the sharp increase in the value of the US dollar to 1:$1.72 at 31 December which increased our dollar denominated net debt by 121m. The 426m proceeds from the sale of our interests in Recoletos and MarketWatch were partially used in a series of bolt-on acquisitions in education and financial information, including AGS, Co-nect and IS.Teledata.

The board is proposing a dividend increase of 6% to 27.0p. Subject to shareholder approval, 2005 will be Pearson's 14th straight year of increasing our dividend above the rate of inflation, and in the past eight years we have returned approximately 1.5bn or one-quarter of our current market value to shareholders through the dividend.

Signed by
Rona Fairhead, Chief financial officer

Adjusted earnings per share:
05 34.1p / 58.7¢;
04 27.5p / 47.3¢;
03 27.6p / 47.5¢;

Our progress We increased adjusted earnings per share by 24% on an underlying basis. We expect future strong underlying earnings growth in 2006 as we continue to increase margins and grow ahead of our markets.

Free cash flow:
05 431M / $741M;
04 284M / $488M;
03 190M / $327M;

Our progress Our free cash improved by 147m or 52% to 431m, helped by strong operating performance and working capital efficiencies. Although our cash flow benefited from some one-off factors, we expect another good cash performance in 2006.

Return on invested capital:
05 6.7% (7.2%*);
04 6.2%;
03 6.0%;

* at constant currency

Our progress Our return on invested capital improved from 6.2% in 2005 to 6.7% or 7.2% at constant currency. We expect a further significant improvement in 2006.

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