The Investment Column: BAA shares will take off when the duty free issue is resolved

IN COMMON with many former state-owned companies, BAA, the airport operator awaiting the outcome of the review into European duty free, is perceived as being unable to deliver earnings growth from its regulated asset base.

Since 1995 the shares have underperformed the market - despite investments in activities outside the regulated UK airports business. However, yesterday's annual results suggest the core business is BAA's most promising division. But investors expecting a re-rating should not hold their breath.

BAA's UK airports and their retailing activities account for 90 per cent of BAA's profits. Passenger numbers increased 7.6 per cent last year, ahead of expectations. Retail income per passenger rose by a meagre 0.4 per cent, but that masks an interesting upward trend. In the fourth quarter it grew 5 per cent as BAA stepped up its marketing and consumer confidence returned.

With air passengers set to increase by 5 per cent annually for the next 20 years, BAA has almost-guaranteed earnings growth from its UK airports such as Gatwick, Stansted or Heathrow's proposed Terminal 5. Meanwhile, it aims to grow income per head in line with inflation. These factors should more than mitigate the expected pounds 30m hit from the loss of duty free trading in Europe, expected on 1 July.

Yesterday the shares added 22.5p at 693p, well below their net asset value of 792p, and despite the optimistic outlook.

Part of the problem is perception. BAA is not seen as the defensive stock it is because of the uncertainty hanging over duty free, the hefty investment in the Heathrow Express rail-link and the impending departure of chief executive Sir John Egan. The other problem is the piecemeal nature of BAA's non-regulated activities which have tied up much of its capital in poor-performing activities.

BAA's core skill is managing airports, but it would run foul of the regulators by buying more UK sites. Local authorities in the US, BAA's target market, are loathe to sell airports. So Sir John has instead invested in disappointing overseas duty free activities, where most of the cut goes to the government, or on non-airport retailing in the UK. Combined operating profits from these are just pounds 61m.

With analysts forecasting pre-tax profits of pounds 490-530m and earnings of 37-40p next year, the shares are on a forward p/e of 17. Until Sir John's successor is named and the duty free situation is clarified, the shares are likely to continue to underperform.