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Executive Summary:

This report aims to analyze the financial position of TESCO PLC from the point of view an
investor who seeks to evaluate the prospects of buying shares of a company in food and
retailing sector. The potential investor has selected TESCO PLC and has asked the author
to analyze the investment prospects and present a report on the same.

The analysis shall be based on the most recent annual financial statements available for
TESCO and of other companies in the same industry. The analysis will not take into
account the half yearly and quarterly financial data and updates issued.

The scope of analysis shall be limited to the financial strengths and weakness of the
company through its financial statements of the last year and previous years and by a
comparison within the retailing industry. The scope does not include the strategic strengths
and SWOT analysis of the company however risks or opportunity factors related with
company’s financial weakness or strengths shall be reviewed in this report.

The structure of the report is as follows:

After a brief introduction of the company, the report outlines the methodology employed
for financial analysis and steps involved. Following the methodology, the main sections of
the report then discuss various aspects of the financial analysis including accounting
principles of the company, quality of financial statements and financial performance study
through ratio analysis. Based on the given analysis, the report ends with a conclusion and a
recommendation for the potential investor.

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Introduction of the Company and Sector:

TESCO PLC is one of the world’s leading international retailers. With a turnover of GBP
42.6 billion for year 2006, it is the largest British retailer and the world’s third largest
retailer behind Wal-Mart (USA) and Carrefour (France). TESCO controls 30% of the
grocery market in the UK, which is approximate to the combined market share of its closest
rivals, Asda and Sainsbury's.

Apart from being the national leader in the food sector, TESCO sells almost everything -
books, CD/DVD/mini-discs, hi-fi and household appliances, household equipment, flowers,
wine, apparel - the list goes on and on! With an eye to the future, Tesco has adapted to the
rapid technological changes. It makes an astonishing profit from its on-line sales site -
Tesco.com. Tesco Express also owns gas [petrol] stations and provides financial services: a
joint venture with the Royal Bank of Scotland enables it to offer life insurance and general
insurance (home, car, pet, and travel), credit cards and advantageous loan and savings
schemes.

In addition to 1988 stores in UK, TESCO is well established in Ireland, Central Europe
(Poland, Slovakia and the Czech Republic) and Asia (Thailand and South Korea) totalling
to 1274 stores outside UK (as of 24 Feb 2007 – Annual Report 2007)

The most recent financial statements of the company were issued on 16 April 2007 for the
financial year closing on 24th Feb 2007. Groups Income Statement, Cash flow statement
and Balance sheet are attached to this report in Appendix-A. The notes to financial
statement are not included in the hard copy of this report however are available in the soft
copy issued along with this report.

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Methodology of Financial Analysis:

The financial strength or weakness of a company is measured against the following basic
criteria:

• Liquidity, Solvency, Profitability and Financial efficiency.

From an investor point of view, however, after having measured the company’s financial
strength through above criteria, the most important step is to evaluate whether investing in
the stocks of this company carry the required returns for investment. This shall be done by:

• company’s stock performance

The company’s performance on these dimensions shall be measured through financial


ratios analysis. As there are many variations of ratios available to measure more or less the
same aspect of performance, I have short-listed, in the following table, the key ratios that
will be utilized in the analysis:

Performance Measure or Measure or Ratio Definition


Aspect Ratio

Growth General Growth Time growth of Revenue, Operating Profits


and Profit Margin (%) Profit (loss) before tax / Total Revenue
Profitability ROCE (%) Profit (loss) before tax* / (SH funds+Non cur. liab.)
ROSF (%) Profit (loss) before tax / Shareholders funds

Liquidity, Current Ratio Current Assets / Current Liabilities


Solvency and Sh. holders Liq. ratio Shareholders funds / long term Liabilities
Gearing Solvency ratio (%) Shareholder funds/Total assets
Gearing ratio (%) (Longterm Liabilities + Loans)* / shareholder funds

Financial Stock Turnover Total revenue / Stocks


Efficiency Collection Period Accounts payable / Total revenue x 360 (in days)
Credit Period Accounts recv’bles / Total revenue x 360 (in days)

Stocks P/E Ratio Share Price / Unit share earnings


Performance Share Price trend Historical trend

*Defined as per FAME database


Note: Other ratios may be discussed or analyzed as required in the analysis below.

Table 1: Selection and definition of Performance measures

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Acknowledging the limitations of the ratio analysis, the ratios shall be analyzed with time-
trend and in comparison with peer group or industry. Also, the ratio analysis shall be done
in specific context and in conjunction with other complementary analysis.

Systematic analysis shall be done in following sequential steps:


Step-1: Definition of Peer group and selection of companies for comparison

Step-2: Review of accounting policies and comparison with peers to ensure a like-
for-like comparison

Step-3: Review of auditor’s opinion to ensure that any audit qualifications are
duly noted during comparison

Step-4: Check of any irregular / exceptional items in the financial statements

Step-5: Financial ratios / measures analysis (as per Table 1 above)

Finally, a summary of company’s financial strengths and weaknesses shall be presented


and a recommendation shall be made regarding the prospects of investment in the company
stocks.

STEP 1: Definition of Peer Group

A standard peer group available in FAME database with companies ranked in the order of
turnover of last financial year is as follows:

Company Name Year Turnover


th GBP
Median LY 6,436,500
TESCO PLC 2007 42,641,000 1
J SAINSBURY PLC 2007 17,151,000 2
WM MORRISON SUPERMARKETS P L C 2007 12,462,000 3
SAFEWAY LIMITED 2007 6,436,500 4
SOMERFIELD LIMITED 2006 5,249,000 5
WAITROSE LIMITED 2007 3,497,300 6
ICELAND FOODS LIMITED 2007 1,565,337 7

Table 2: Selection of peer group

SOMERFIELD has been making losses recently and WAITROSE and ICELAND FOODS
are relatively much smaller companies with whom bench marking TESCO will not be

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accurate and appropriate. Therefore, for a proper comparison purposes, I have reduced
TESCO’s peer/competitor group to include only the top 4 UK companies in this sector
which are:
• TESCO PLC
• J SAINSBURY PLC
• WM MORRISON SUPERMARKETS P L C
• SAFEWAY LIMITED

STEP2: Review of Accounting Policies:

Before starting to analyze the financial statements, it is important to review that accounting
policies adopted by the company are in general in line with industry norms and practices
and that there is no specific policy which may make the comparison of some ratios or
performance irrelevant merely sue to way it is applied. Therefore, in this section, we will
discuss these policies in comparison with peer group / competitors in the same sector. Only
for a review the accounting policies, we have added two non UK international companies
for comparison and these are Carrefour and Wal-Mart.

Accounting and Reporting Standards:


Until 2005, TESCO was reporting financial results in line with UK GAAP but from 2006
onwards, last two years financial reports have been issued in accordance with IFRS which
is now mostly adopted standards in almost 100 countries including EU, India, Australia,
Russia, GCC, Singapore and other countries. Except Wal-Mart which has not clearly
mentioned the accounting standards in the notes, all other European companies TESCO,
Sainsbury and Carrefour have used IFRS.

Goodwill:
Goodwill represents the excess of purchase price over fair value of net asset acquired.
Goodwill is recognized as an asset on the balance sheet and allocated to each Cash
Generating Unit (CGU) as per IAS 36. Goodwill is no more capitalized and amortized, but

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now in accordance with IFRS 3, goodwill is subject to impairment tests which are
conducted at least once a year or whenever a need is realized.
TESCO (and its peers/competitors including J. Sainsbury, Carrefour, and Wal-Mart) treat
goodwill as an asset and impairment tests are done annually or when needed.
The impairment test procedure may be different in different companies, but in principle,
there is no significant difference in TESCO practices from industry specific usage.

Other Intangible Assets:


No major differences in accounting practices are found between TESCO and its
peers/competitors including J. Sainsbury, Carrefour, and Wal-Mart. All of them use a
straight line depreciation of definite-lived intangible assets (licenses or software etc.). For
R&D Expenses, these are amortized over project’s useful life.

Tangible Fixed Assets:


Property, plant and equipment are depreciated by straight line method over useful life. A
slight variation in lifetime is noticed between different companies on deciding the lifetime
of the equipment but these differences are minor. For example Carrefour and Tesco have a
maximum life limit of 40 years for buildings while Sainsbury and Wal-Mart have it set at
50 years. Again no significant differences are found.

Impairment tests are done for all tangible or intangible assets are done at least once a
year. This is consistent across the retailer industry as seen from statements of TESCO,
Sainsbury, Carrefour and Wal-Mart. Example of such test is an entry in TESCO’s income
statement where impairment losses are registered for a cash generating unit at GERRADS
Cross Site (see Income Statement 2007)

Borrowing costs directly attributable to the acquisition or construction of qualifying assets


are capitalized by TESCO and its peers.

Inventories at TESCO are valued at lower of cost and fair values less cost to sell by using
weighted average method. Sainsbury differentiates inventories at warehouse and at retail

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outlets and values latter ones at average cost price. No such differentiation is mentioned in
notes of TESCO statements.

Foreign Operations and Exchange rates:


About 25% of TESCO sales and profits are coming from operations outside UK. It makes
the foreign exchange sensitivity important. At Tesco foreign currency transaction are
converted to GBP on the day of transaction. The notes to accounting statement of TESCO,
Sainsbury and Wal-Mart do not make any mention of inflation adjustment in high inflation
countries as done by Carrefour which adjusted for Turkey in 2005. Nevertheless all of the
companies reflect any differences in the income statement on the last day of financial year
end.

Similarly other practices related with financial assets, investment properties, employees’
benefits, income tax and income per share calculations are in principle similar in all of
these companies.

Therefore, in this section we don’t record any specific caution regarding TESCO financial
statement impacted by their accounting policies and we can move on next section without
qualifications.

STEP 3: Review of Auditor statement

Auditors report is an indicator of credibility of financial statements. Before assessing a


company’s financial position, it is important to know about auditor’s opinion about these
financial statements.

The opinion of the auditors (PricewaterhouseCoopers LLP) on the TESCO PLC financial
statements for the last year confirms that financial statements give a “true and fair” view of
the affairs as on 24/02/2007 - last day of the financial year in accordance with applicable
accounting standards (IFRS) and that statements are prepared in accordance with legal
requirements of the Company Act and IAS regulation.

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The auditors report is clean and unqualified and confirms the credibility (fairness and truth)
of the financial statements. Therefore, the first and most basic financial reporting quality
check is complete and we can proceed to further analysis.

STEP 4: CHECK of Irregular Items:

Irregular items include such items that will most likely not be repeated next year like
discontinued operations, extra-ordinary items and changes in accounting principles etc. As
an investor should mainly be concerned with future performance of the company he must,
therefore, ensure that he has understood the impact of these items on the company’s income
statement and these don’t form significant part of the company’s earning for the given year.

Category Item description Stated % of net Assessment/


Impact income Adjustment
(GBP, (GBP 1,899 Gain(loss)
millions) m)
Discontinued Operations Profit(loss) from 18 0.95 % 0
Exceptional items Impairment of Gerrads Cross site (35) - 1.84 % ??
(Note …)
Pension Adjustments – Finance 258 13.6% ??
Act 2006 (Note 23)

Table 3: Irregular Items in TESCO financial statement 2007

We briefly review both the exceptional items as follows:

Gerrads Cross Site: Company’s Operating and Financial Review mentions that company
is:
‘….. facing continuing uncertainty … complex legal situation following the tunnel
collapse. …. We have written off the carrying value….an impairment charge of 35m). We
are not yet in a position to assess any recoveries or liabilities in respect of ongoing claims.’
(TESCO PLC Annual report and financial statement 2007, page 6)

The scope of the current report (academic assignment) does not extend to assess the
legality of the claims and an assessment of potential risks and liabilities that company may
face in this instance, however it is to be acknowledged that a provision may be necessary to

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be made in order to evaluate more accurate the return of investment in the company stocks.
For purpose of current report we will assume the auditors have reviewed this point and
have agreed that allocation of impairment charges is a fair and true reflection of total
liability exposure.

Pension Adjustment:
In April 2006, Finance Act revision was agreed. This change altered company’s pension
scheme assumptions and resulted in reduction of future liability by GBP 258 m which is
has been recognized in last year income statement. This one-off 258 million addition
increases the ROCE by about 1%. Although this adjustment may seem to be unrelated with
company’s sales revenues, however, this one-off item is in line with accounting principles
and is justified. For the purpose of this report, , however a detailed analysis of note 23
(regarding Pension and post employment funds income/expense) is beyond the scope of
current report and mere acknowledgement of presence of such one-off item in the income
statement and noting its possible impact on the returns is sufficient for the purpose of this
report.

STEP 5: FINANCIAL RATIO ANALYSIS:

ASPECT 1: Revenue Growth and Profitability

Since last 5 years, Tesco’s sales revenue has consistently grown while other competitors
have had difficulties even in maintaining their sales. Moreover, this increase in revenue has
not caused any drop in profit margin and TESCO has been consistently maintaining profit
margin above between 5 and 6% which is above its peer group average. Especially during
2003-05 when all of its peers / competitors were suffering losses and industry average went
to loss, TESCO managed to maintain its profits.
These numbers indicate a very well managed business in its sector.

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Figure-1: Turn-Over – Comparison and Trend


Source: FAME (fame.bvdep.com) Version Feb 2008

Figur-2: Profit Margin - Comparison and trend


Source: FAME (fame.bvdep.com) Version Feb 2008

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Looking at the ROCE and ROSF, Tesco has shown consistency and growth in returns of
capital and returns of shareholder funds.

Figure-3: ROSF - Comparison and Trend


Source: FAME (fame.bvdep.com) Version Feb 2008

Figur-4: ROCE – Comparison and Trend


Source: FAME (fame.bvdep.com) Version Feb 2008

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Comparing the 2007 numbers internationally, revenue growth of TESCO was 10.9%
compared with 4.3% of Carrefour and 11.7% of Wal-Mart. ROSF was 25.25% (TESCO),
26.5% (Carrefour) and 22% (Wal-Mart). This indicates that TESCO may be 3rd in its
revenue size but it’s profitability is very much comparable to its international competitors.

ASPECT 2: LIQUIDITY, SOLVENECY and GEARING:

Gearing:
The increase in revenue and profits reported above, from an investor perspective, is to be
looked at in combination with the gearing ratio and interest cover. It is important to check
how far the business is bringing these returns out of loan financing and what the company’s
exposure to borrowing risks is and how much times the yearly profit covers the interest
payable. Lower the level of interest coverage, the greater the risk for investors. High
gearing, in itself, is not a problem as long as the company can source loans at a more
attractive rate than the rate of return the business can generate from additional loan.

The values and trends of gearing for TESCO and peer group confirm that gearing in
TESCO is controlled and management seems to be in full control of borrowings.

TESCO GEARING HISTORY


100

90

80
Gearing
70 (%)

60
ROSF
RATIOS

50
(%)

40 ROCE
(%)
30

20 Interest
Cover
10 (Times)

0
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
ANNUAL REPORT

Figure-5: Effect of Gearing on ROSF/ROCE


Graph data sourced from FAME (fame.bvdep.com) Version Feb 2008

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As we can see from the 10 year Gearing history graph, the company had to increase the
gearing i.e. take more loans during 2001 to 2003. This is the time (as seen form figures
above) when competitors are having financial difficulties and TESCO has an opportunity to
make acquisitions and that’s the reason why TESCO management went for borrowings to
increase their market share.(takeover of its competitor T & S Stores in January 2003). From
2003 onwards, it seems company’s strategy has paid off and the ROCE and ROSF are
increasing while the gearing is reducing. At the last annual report (2006), the gearing
stayed at 75% against peer group average of 122%.
Although the current level of gearing at 75% is still quite high, and it should be a cause of
concern for potential investor; however these concerns are somewhat eased by available
interest cover of 13 times. The profit margin has to really drop a lot for the interest to
become an issue for the company. At this point, it can be considered as not the major issue
but this concern has to be reviewed along with wider retailing industry prospects (discussed
below).

Liquidity and Solvency:


Liquidity refers to business’ ability to pay its bills, dues and similar other short term
obligations (as and when they become due) without affecting the normal operations.
Solvency is a measure of business ability to pay back its long term debts.

Current ratio of Tesco has improved over time and in last year statement it stood at 0.56.
Although it may seem low (some thumb rules suggest it be higher than 1.5:1), but in fact it
depends on the nature of the industry. In retailing business, the average current ratio is low
as it holds only fast moving inventories of finished goods and stock turn over period is in
days. A low level of current assets keeps this ratio low. This is confirmed by the current
ratios comparison with peer group (as in fig-7):

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Figure-7: Current Ratio - Comparison and Trend


Graph data source: FAME (fame.bvdep.com) Version Feb 2008

The long term solvency ratios for TESCO have slowly declined as shown in Fig.-8

TESCO - Short term Liquidity ratios


0.8

0.7

0.6

0.5
Current Ratio
Ratio

0.4

0.3
Liquidity Ratio
0.2

0.1

0.0
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
ANNUAL REPORT
Figur-6: TESCO - Liquidity Trends
Graph data source: FAME (fame.bvdep.com) Version Feb 2008

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Solvency or Equity/Assets or Equity/Debt ratio is reciprocal of gearing. As explained


above, increased gearing or reduced solvency should not be a cause of concern as the
company has increased the debt financing required for expansion and acquisitions and
shareholders have benefited from such expansions. Figure-6 and figure-8 actually tell the
same story with inversion of denominator and numerators.

TESCO - Long term Solvency Ratios


5.0 60.00

Equity / Assets Ratio


(%)

Solvency (Equity / Asset) ratio (%)


50.00
4.0
Shareholders liquidity
(Equity / Debt) Ratio

40.00
3.0

Equity / Debt ratio 30.00

2.0
20.00

1.0
10.00

0.0 0.00
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
ANNUAL REPORT
Figur-8: TESCO – Solvency Trends
Graph data source: FAME (fame.bvdep.com) Version Feb 2008

ASPECT 3: Financial Efficiency


Financial efficiency ratios look at how well business resources are managed. The key ratios
in this aspect of performance deal with questions like how quickly does the business turn
over its inventory as the assets in inventory represent funds tied up which can not be used
for other purposes. How long it takes to collect the accounts receivables. Tesco’s
performance in this area is represented by following graphs and compared with its peer
groups.

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Figure-9: Stock T/over - Comparison and Trend


Source: FAME (fame.bvdep.com) Version Feb 2008

Figure-10: Creditors Payment comparison and trend


Source: FAME (fame.bvdep.com) Version Feb 2008

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TESCO average stock turnover between 20 and 25 days is equal or better than its peer
group average of 24 to 32 days. Similarly, TESCO’s average creditors’ payment period
ranging between 26 and 30 days is more or less equal to its peer group average.
Information regarding settlement period for accounts receivable is not available in FAME
database.

ASPECT 4: Company Future Outlook and Stock Performance.

Despite TESCO’s consistent performance over the years as shown above by profitability
ratios, its share price is susceptible to economic downturns that could affect consumer
spending. However, this effect is same for all other retailers and in general FTSE100.

The following graphs show that historically TESCO shares have outperformed FTSE100
average and also that of food and retailers industry average.

Figure-11: Total Share Price History. (Source: http://www.tescocorporate.com/)

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From an investor perspective, there are two important parameters to note when studying the
performance of certain stocks. These are:

• Total Shareholder Returns (TSR is notional return from a share or index based on
share price movements and declared dividends).
• P/E Ratio: P/E ratio takes into the market value of the share and the company
earnings per share. This is the ratio of the two.

PE ratio of TESCO shares has been close to 15 which indicate a good level of market
confidence about TESCO future performance.

Performance of TESCO stocks when measured by total shareholders return has been
comparatively better than FTSE100 average and also food and retailers industry average.

Figure-12: Total Shareholder Returns (TSR is notional return from a share or index based on share price
movements and declared dividends). Source: http://www.tescocorporate.com/

During 2007, Tesco shares have performed very well due to increase in market share and
international acquisitions. However during Q4-07 and Q1-08, the share price is falling due

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to effect of consumer spending resulting from credit crunch. Following news confirms that
TESCO has been asking government to cut interest rates to offset the effect on their sales.
From The Times December 5, 2007

Tesco has turned up the pressure on the Bank of England to cut interest rates tomorrow in an
effort to revive consumer confidence in the run-up to Christmas and the new year.
Andrew Higginson, Tesco’s group finance director, said: “The problem is not inflation but
consumer sentiment. It’s important that [the Bank of England] starts to show interest rates are
going to come down.”

The threats to Tesco shares are, therefore, not coming from company performance but
actually from external economic environment. This threat is however a short term threat
and in the long term TESCO is though to perform better because of company’s strong
management controls and growth strategies in international market.

Conclusion and Recommendation:

TESCO strength comes from its market share and turn over in UK which is more than sum
of its two immediate competitors. TESCO has been consistently growing its revenue and
profitability and efficiently employing the gearing to its benefits through wise management
strategies. Not only has it outperformed its competitors inside UK, it has also achieved
consistent growth outside UK through international expansion and acquisitions.

All the financial performances indicators and ratios clearly show the outstanding
performance and growth achieved by TESCO over the past years which has put it in a clear
leading position among its peers in UK.

TESCO, however, faces a threat from external economic environment which may cause
food items inflation and drop in consumer spending. Although TESCO product mix and
market mix seems well diversified to counter such UK based threats, but still in the short
term it will have a negative impact on its revenue growth and the share price – the sign of
which are already starting to appear.

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From investment point of view, retailing industry shares in general are not recommended
for a short term investor due to forecasted effects of credit crunch and signs of increasing
inflation. However, a long term investor seeking to invest in retailing industry may in fact
benefit from this short term drop in share price and is recommended to buy TESCO stocks
as soon as they fall below 350 pence per share.

We conclude our analysis by following quote:

From The Times December 5, 2007

Andrew Kasoulis, an analyst at Credit Suisse, said that the performance of Tesco was in line with
expectations. “We continue to view Tesco as the best long-term investment in the European food
retail sector,” Mr Kasoulis said.

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LIST OF APPENDICES:

Appendix- A: TESCO – Financial Statement 2007

Appendix- B: FAME – Standard Report – TESCO Profile (10 years)

Appendix- C: FAME – Standard Report – TESCO Statement (10 years)

Appendix- D: FAME – Standard Report – TESCO Ratios (10 years)

References:

Artill, Peter and McLaney, Eddie (2006). Accounting and Finance for Non-Specialists.
5th edition. Harlow, Pearson Education Limited.

Laínez, J. A. and Callao, A. (2000). The effect of accounting diversity on international


financial analysis: empirical evidence. The International Journal of Accounting Vol. 35,
No. 1, 2000.

FAME Database: http://fame.bvdep.com/ (Accessed Version Feb 2008)

TESCO PLC Corporate Website: http://www.tescocorporate.com/

J-SAINSBURY Corporate website: http://www.j-sainsbury.co.uk/

CARREFOUR Website http://www.carrefour.com/

WAL-MART Investor information Website:


http://investor.walmartstores.com/phoenix.zhtml?c=112761&p=irol-irhome

FINANCIAL TIMES: http://www.ft.com/

TIMES ONLINE: http://business.timesonline.co.uk/

INVESTOPEDIA - A Forbes Media Company http://www.investopedia.com/

And Various Other Internet Resources