Crazy about duty free

By Kim Da-ye

Behind the departure control desk near Gate 28 at Incheon International Airport is an escalator that leads to a dimly lit space seemingly under construction.

After passing through the dark alley, people pick numbers from a machine and wait until an electronic board shows the numbers — like they do in a bank.

The lady behind the counter checks the passport and fetches bags from the storage half covered by a screen and brightly lit by fluorescent lamps and hundreds of shiny, transparent plastic bags hanging on the racks.

The utilitarian atmosphere makes a stark contrast to the contents tightly sealed in thick vinyl envelops. They are duty-free goods ranging from a $28 Lancome mascara to a Fendi tote worth thousands of dollars.

Tourists purchase goods in advance outside the airport — in downtown outlets or online — and pick them up here. The pick-up station belongs to Shilla Duty Free, a unit of Samsung Group affiliate Hotel Shilla.

This non-glamorous yet practical way of buying designer goods changed the local duty free business into a genuine cash cow whose future looks only brighter because of the influx of Chinese tourists and the regulation that insulate them from new competitors.

The duty free business is often run by high-end hotel chains such as Lotte, Shilla and SK Networks’s Walkerhill. Although those companies are better known for the hotels, the duty free units generate most of their income.

Hotel Lotte, the country’s largest duty free seller by sales with a 47.2 percent market share in 2010, made nearly 80 percent of its total revenue from the duty free business in the first half of this year, according to a financial disclosure.

The 1.08 trillion won in sales by the duty free unit, which consists of three downtown outlets, two airport operations and an online store, dwarfs by far the 180.9 billion won by the hotel unit with six five-star hotels in Korea and Russia and the 97.3 million won made from the Lotte World theme park.

The always crowded theme park located in the heart of eastern Seoul made less than one tenth of what the duty free unit generated.

Hotel Shilla, the second largest duty free seller with a 26.8 percent market share in 2010, also earned an 84.3 percent of the total revenue or 650.7 billion won from the duty free business, compared to a 13.4 percent or 90.6 billion won made by the hotel unit.

It’s no surprise Incheon International Airport is the world’s second largest duty free and travel retail location with annual sales surpassing $1 billion, after Dubai International Airport, according to Generation Research, a Swedish industry analyst.

“The duty free industry won’t shrink, but will only grow,” says Kim Ju-nam, the director of Lotte Duty Free’s marketing team.

Lotte, the world’s sixth largest travel retailer, aims to be among the top three by 2018. It will open a branch in Jakarta International Airport in Indonesia — the first overseas outlet of a Korean travel retailer — by the end of this year.

X-factors

What made the Korean travel retailers thrive? It’s a combination of the license to operate downtown stores, high barriers to entry, a brilliant selection of luxury brands and Koreans’ exceptional hunger for designer goods.

Lotte Duty Free, for example, generates about half of its income in three downtown stores and the other half at two airports.

A Lotte official, who wished not to be named, said that the airport charges a very high amount of rent for concessions, so most of the profit comes from downtown stores that are conveniently built into prime spots already owned by them.

Downtown outlets also have powerful assets — e-stores. As competition stiffens online, the websites are luring tourists with discounts and vouchers. About 15 percent of Lotte’s Sogong-dong branch in central Seoul comes from the online unit.

While airport rents remain the biggest financial burden to duty free businesses, this year’s parliamentary inspection found Incheon airport earned 1.29 trillion won from leasing concessions only, which represents a 50 percent of the revenue.

Shilla paid Incheon 198 billion won in an annual rent last year, and was asked to pay 240 billion won this year, Hyundai Securities analyst Han Ik-hee said in a report. Lawmaker Cha Myung-jin found that a bookstore paid 920 million a year and a pharmacy 840 million won.

Downtown duty free stores are a rarity abroad — existing in only a few Asian countries including Thailand and Philippines — thanks to geographic reasons.

In Korea, a peninsula whose north side is effectively blocked, the majority of tourists leave the country from Incheon. Pick up stations at Incheon are adequate to cater for downtown shoppers while in Europe, travel retailers cannot afford multiple pick up stations for people crossing the border in cars and in trains.

Downtown outlets make a great business model, but obtaining a license to operate them has become de-facto impossible for newcomers.

Under a 2007 revision, the Korea Customs Service will only give a license to newcomers only when more than half of customers in all downtown stores are foreigners and sales to foreigners count for more than half of the total the previous year. In addition, the number of foreign tourists to the region the outlet would open has to have increased by 300,000.

In 2010, 12,688 Korean nationals bought duty free goods worth $1.88 billion, compared to 8,139 foreigners purchasing $1.75 billion, according to a parliamentary inspection. The 50/50 requirement isn’t likely to be met in the near future.

The talk of the town nowadays is the government’s plan to give out more licenses for downtown duty free stores for foreigners only as some municipal governments have requested them to foster their tourism sectors.

The existing travel retailers anxiously observing the progress as new outlets could eat into their market share while doubting if foreigner-only duty free shops coule take off or be sustainable.

The high entry barriers have obviously fattened a handful of existing players. Lotte and Shilla account three quarters of the $4 billion market. In 2010, the rest was shared by AK Duty Free (4 percent), JDC Duty Free (6.7 percent), Dongwha Duty Free (4.4 percent), the Korea Tourism Organization (4.3 percent), Paradise Duty Free (2.8 percent) and Walkerhill (2.9 percent).

The number of the players is shrinking as a result of mergers and acquisitions. Hotel Lotte acquired AK Duty Free of Aekyung Group last year, renaming it Lotte DF Global, whose accounting is separated from Hotel Lotte’s.

Furthermore, industry insiders speculate that in 2018, when the Incheon airport receives the third bids for concessions, the tourism organization could drop out and DFS Galleria, the world’s largest travel retailer, could replace it.

Challenges faced by smaller businesses include difficulties to host luxury brands and to make profit even if they do.

When luxury brands and travel retailers strike a deal, retailers are fully in charge of renting concessions, decorating them inside and outside and managing the shops. A portion of the sales — which gets smaller the more prestigious the brand is — will be paid to the retailer.

Paying fully for doing the exteriors and interiors doesn’t come cheap.

“Fitting up a shop costs about 100 million won ($83,200) per pyeong (3.3 square meters). A shop that occupies 100 pyeong would cost the retailer 10 billion won,” an industry source close to the matter said.

“There aren’t many retailers who can afford that. Even if they do, the store has to be profitable enough for the retailer to pay off the investment.”

Once retailers are on a sound footing in the industry, they face only few risks, the biggest of which is rents for concessions at airports.

In addition, because they import cosmetics, perfume, liquor and tobacco, their revenue in Korean won could fluctuate on the volatile exchange rate.

Free trade agreements (FTAs) with Europe and the U.S. have also been regarded as risks to cut down the demand for duty free goods. But the Korea-EU FTA showed luxury brands aren’t willing to mark down their prices even after double-digit tariffs are gone.

The recently controversial restraint on the domestic travel retailers may be the customs authority strictly taxing duty free purchases over $400.

Koreans refrain from buying Louis Vuitton and Chanel bags at Incheon airport because the history of the purchases is passed on to the customs authority.

The authority frequently screens bags and attaches the much-dreaded beeping yellow plastic tags to the suspicious ones. If tourists are found to have not declared any purchases over $400, they will be imposed extra customs.

A travel retailer’s official said, “Koreans now buy more designers goods abroad to avoid paying taxes. The purchases could have been made here if the limit wasn’t so low.”

The customs authority considered lifting it up to $1,000, but decided in September not to, reasoning that doing so wouldn’t boost domestic consumption but benefit affluent jet setters only.

Obsession with luxury

On Sept. 10, Shilla debuted Louis Vuitton’s first airport duty free outlet in Incheon.

The opening was symbolic of the status of the domestic travel retail industry that has become large and sophisticated enough to host the rarity; of the over-the-top competition between Lotte and Shilla; and Koreans and Asians’ insane love for discounted luxury goods.

Lotte and Shilla made a bid for the Louis Vuitton store, and the latter was awarded the contract in November last year at conditions that many industry insiders regarded as too favorable toward the French luxury brand.

The 160-square-meter outlet scrapped 200 seats in the waiting area for travelers as well as a bookshop and a cafe. Louis Vuitton would also pay a very low rent under 10 percent, which outraged other luxury brands. Protesting against the discrimination, Chanel and Gucci moved out of Shilla’s turf in Incheon and moved into Lotte’s.

Lotte had filed at an Incheon court an injunction against the Louis Vuitton deal between Hotel Shilla and the airport, which was dismissed.

On Oct. 1, this reporter visited the store whose front was being guarded by three Shilla staff members in black suits who asked visitors to line up.

A queue formed quickly with some 20 Asian travelers, and wouldn’t shorten in the next 10 minutes. A glance into the left side of the store found a handful of shoppers. Eight people came out, but the staff wouldn’t let anyone in, instead asking those waiting get closer to each other.

No one complained. They waited, staring at large brown paper bags held by shoppers exiting the store.