Summary
We wrote in December last year that we believed UK sector conditions in 2008 would be
tougher than those of 2007, not for reasons of demand but due to an acceleration in supply
growth and an increase in competitive intensity as the big four UK food retailers fought
harder over a diminishing pool of available sales gains. We had seen the first signs of this in
H2 2007 with the UK food retailers absorbing more input price inflation to drive better volume
growth and this has continued into 2008. With two of the UK food retailers now having
reported results for H2 2007/early 2008, the impact on P&Ls is quite clear, with Morrisons’
gross margin down 10bp in H2 having been up 100bp in H1 and Tesco’s UK LfL only 3%
during Q4.
The last time we saw inflation stats suggesting this degree of real deflation by the food
retailers was in 2004, a tough year when the industry as a whole aggressively reduced prices
in anticipation of the Morrisons/Safeway merger, Sainsbury completely repositioned on price
(costing 3 profit warnings in the process) and Tesco reinvested all the benefit of stellar likefor-
like growth into catching Asda on pricing. Clearly we’re not facing a shift in industry
conditions in 2008 nearly as significant as the events of 2004. But having gone through two
years of very stable conditions, with convergence in LfL gains (no competitors doing
particularly well or badly) and a general inclination to pass inflation through to consumers
(maybe particularly by Tesco given slowing UK LfL growth), we continue to maintain that
2008 will be tougher than 2007 or 2006, even before taking into account any change in
consumer confidence and/or disposable incomes.
Figure 1: Food Retailer Inflation Pass Through: COGS

Table of Contents
Summary............................................................................................ 3
How Difficult Really is it Out There?................................................ 8
What has happened before in these circumstances? ...............................................................9
We’re Still Not Concerned About Demand .............................................................................12
Shouldn’t this be a zero sum game?.......................................................................................15
Food and Non Food Growth ...................................................................................................18
Food Spend Should Be Stable: Inflation isn’t “Free Growth” .................................................20
Valuation .......................................................................................... 23
Appendix 1 ....................................................................................... 26