Duty-free Retail Finds New Paths For Expansion

Duty-free Retail Finds New Paths For Expansion
The pandemic is pushing the industry further away from cigarettes, booze and airports, and towards China

Hainan, a tropical island 450km south-west of Hong Kong, used to be a sleepy backwater populated by budget resorts catering to Chinese tourists unable to afford a trip to Hawaii. Today it draws travelers with considerably fatter wallets. Buying a Gucci gown or a Tiffany trinket in one of Hainan’s giant, posh malls feels no different from shopping on Fifth Avenue in New York or Avenue Montaigne in Paris—until the tills are rung. Instead of walking out with their bling, visitors from mainland China pick up their items at the airport on their way home or get them dispatched there directly. Under rules devised a decade ago, which mean that for duty purposes Hainan is treated as a separate zone from mainland China, they are exempt from a variety of taxes and duties. Savings can reach 30% as a result.

Duty-free shopping conjures up images of crowded airport terminals. As the covid-19 pandemic has emptied these of passengers, the shops inside have suffered commensurately. Having reached $86bn in 2019, according to Generation Research, a consultancy, duty-free sales collapsed by two-thirds last year. Mauro Anastasi of Bain, another consultancy, forecasts travel-retail sales will not reach those levels again in real terms before the second half of the decade. Intercontinental passengers and business travelers, the biggest spenders, are likely to take the longest to return to the skies. Chinese tourists, by far the most prized by duty-free operators, are shunning countries with poor track records at handling the pandemic.

Shoppers will one day return to airports. Yet when it emerges from the current crisis, duty-free shopping will have been profoundly transformed: unabashedly focused on luxury, less connected to travel, and closer to Asian high-rollers. Hainan points the way.

Before covid-19, selling stuff to travelers had been one of the few bright spots of the brick-and-mortar retail world. The practice has been popular ever since cruise ships on the high seas plied their passengers with booze and cigarettes free of government levies. In 1950 Ireland applied the principle to aviation. As mass tourism took hold, airports the world overturned themselves into tax-free shopping malls with departure gates. Annual growth of around 8% in recent pre-pandemic years—twice the figure for other shops—was fuelled by sales of cognac, sunglasses, purses, and other knick-knacks. Sales have grown eight-fold since the late 1980s (see chart). Excited marketers referred to duty-free shops as “the sixth continent”.

Covid-19 has deflated that enthusiasm. It has also, as in many other areas, accelerated pre-existing trends that were reshaping the duty-free business. The first has to do with the mix of stuff sold duty-free. Alcohol and, particularly, cigarettes have dwindled over the years. Posh brands became mainstays of airport concourses as they cottoned on these were good places to pitch to wealthy people, particularly Asian passengers. Luxury goods, perfumes, and cosmetics now dominate travel retail, accounting for two-thirds of sales.

The second development is the shift away from airports. Though the terminal remains its natural habitat, duty-free shopping has in recent years expanded into locations farther afield. Spending per passenger in airports was sagging even before the coronavirus hit.

At the same time, specialized downtown shops in tourist hotspots have lured visitors eligible for tax discounts if they repatriate what they buy. These locations, particularly popular in Asia, now represent nearly 40% of all sales. Rules vary globally, but some allow shopping even from those with a tenuous link to travel, for example, a ticket booked several months hence.

Tax-exempt outlets are popping up across mainland China, catering to domestic travelers who have returned from overseas (and, soon, who plan to travel there in the future). Chinese shoppers in Hainan, for example, now enjoy a duty-free allowance of 100,000 yuan ($15,500), thanks to a recent tripling of the tax break.

The final trend, also on display in Hainan, is duty-free’s eastward drift. In 2011 Asia-Pacific overtook Europe as the largest regional market. (America, where most flights are domestic, has always been a laggard.) Before the pandemic, Seoul’s Incheon, a two-hour flight from Beijing, became the biggest airport shop in the world. Revenues for Prada and Hermès in Asia excluding Japan have jumped by over 40% in 2020, owing heavily to splurges in Hainan. Sales there are reported to have reached $5bn last year, more than doubling from 2019. Industry watchers predict they could grow five-fold within a decade.

Although Chinese buyers have been the world’s biggest luxury consumers for years, accounting for a third of global sales, brands were reluctant to consider places like Hainan as top-tier luxury venues. Around two-thirds of Chinese spending on handbags, watches, and other baubles took place overseas. The Communist Party is keen to change that. The ever-more-generous tax breaks for the well-heeled are “the key tenet of a long-term government mission to maximize domestic consumption and repatriate travel-related shopping from abroad,” says Martin Moodie of the Moodie Davitt Report, a travel-retail newsletter. Daniel Zipser of McKinsey, a consultancy, expects the overseas share of luxury spending to decline. As a result, luxury groups’ attitudes towards venues like Hainan “have changed dramatically”, says Cherry Leung of Bernstein, a broker.

If the Chinese continue to buy their baubles at home, that will suck away more business from the duty-free operators that have historically dominated non-Chinese airports, such as Dufry of Switzerland and DFS, part of the LVMH luxury empire. Last year China Duty-Free, a state-controlled group, overtook Dufry as the world’s largest purveyor of tariff-free luxury goods. The market capitalization of China Duty-Free’s Shanghai-listed arm has more than tripled over the past year to $112bn, making it one of the most valuable retailers in the world.

In an acknowledgment of the shifting balance of spending power, some travel retailers from Europe have tried to muscle in on Hainan. Dufry has sold a stake to Alibaba in the hope that the Chinese e-commerce giant can improve its fortunes there. Last month Lagardère Travel Retail, part of a French conglomerate, launched a second shop on the island.

Airports will remain good places to find well-off shoppers. Bored people waiting for their flights to be called are perfect marks for luxury brands. Most retailers spend fortunes attracting customers to their shops or websites, points out Julián Díaz González, boss of Dufry. “For us, it is just moving them from the corridor to the shops.” As the industry continues to evolve, Mr. Díaz may increasingly find it is a matter of moving duty-free shops to the customers.