How BAA is surviving without cheap booze and fags

By Michael Harrison

If you have passed through a UK airport this summer and bemoaned the loss of duty-free, then spare a kind thought for Mike Hodgkinson, the new boss of BAA. To the man in charge of Heathrow, Gatwick and Stansted, duty-free is a living, not a travel perk. On his first day in the job last October, BAA was forced to issue a profits warning after realising the abolition of duty-free for passengers travelling in the European Union would hit company profits much harder than anyone in the City had expected.

If you have passed through a UK airport this summer and bemoaned the loss of duty-free, then spare a kind thought for Mike Hodgkinson, the new boss of BAA. To the man in charge of Heathrow, Gatwick and Stansted, duty-free is a living, not a travel perk. On his first day in the job last October, BAA was forced to issue a profits warning after realising the abolition of duty-free for passengers travelling in the European Union would hit company profits much harder than anyone in the City had expected.

"The profits warning came as a big shock," says Mr Hodgkinson. "The loss of duty-free was one of the biggest events in the history of the company and yet people had assumed we would sail through it. But there was total confusion among passengers, well in excess of what anyone expected. The next problem was the adage in the City that you never have one profits warning. There are always two or three, so there was an automatic assumption we had not declared all the bad news."

BAA now makes more money out of retailing than charging airlines to land. To its critics, the group's seven airports have now become shopping centres with the odd runway attached. So the duty-free warning had a predictable impact. The company's share price crashed 40 per cent. Though it has recovered a lot of that lost ground, 11 months on, BAA is still worth less than it was when Mr Hodgkinson took over, and there is still confusion about the duty-free rules among the travelling public, particularly those who perhaps fly only once a year on holiday.

But at least there is a lot less confusion. When BAA surveyed its airport customers it discovered fewer than 2 per cent could name all 15 member states in the European Union. There were also anomalies. Those travelling to the Canary Islands, a popular holiday resort and part of Spain, can still fill up on duty-free booze and fags.

But overall, Mr Hodgkinson reckons, the situation has improved 80 per cent. Part of the improvement has come from intensive advertising campaigns, saying shopping is still cheaper at the airport. Partly, it has come from experiments in new airport layouts. At Stansted, for instance, passengers are channelled into green or blue retail zones, depending on where they are travelling. In a zone, they know they can buy everything on the shelves.

The changes are paying dividends. After duty-free was abolished in July last year, profit per passenger fell 25 per cent. Now it is only 13 per cent down, not far short of BAA's 11 per cent target.

As revenues recover, so BAA's reputation in the City is being rehabilitated. Mr Hodgkinson says: "The share price fall was a massive over-reaction. What people have subsequently seen is that it was the one and only profits warning - but it takes a year for people to believe that. Second, we have delivered in line with what we said we would do. Third, we are seeing unbelievably buoyant levels of business with everybody wanting to travel. That is quite extraordinary."

The first thing Mr Hodgkinson did when he took over the chief executive's seat from Sir John Egan, was to bring in a firm of consultants, Lek, to advise him on strategy. The advice he got was that BAA should stick to its knitting, concentrate on the core UK airport business and target overseas expansion. Mr Hodgkinson took that to heart. He has accelerated the sale of non-airport property interests and begun the process of extracting BAA from two of the messes it landed in during the Egan era.

First, Mr Hodgkinson has signalled BAA intends to sell off chunks of its World Duty-Free division. BAA paid £406m for the business in 1997. Last year it lost £4m. BAA was also forced to write-down £147m of goodwill after deciding the prospects for the business are not as rosy as first thought. Second, BAA has begun legal moves to end its 15-year contract to run the retail facilities at Eurotunnel's Folkestone and Calais terminals. The contract is costing BAA £800,000 a month. By the time the case reaches the High Court next spring, if it ever gets that far, BAA's losses are likely to be in the region of £20m.

At the same time, Mr Hodgkinson has begun to reshape BAA's balance sheet, raising cash from asset sales and embarking on a share buy-back programme.

On the international scene, BAA has abandoned its ambitions to enter China, and sees its future in those markets where it already has a presence, in particular the US where BAA has interests in five airports and would dearly love to get its hands on New York's JFK and La Guardia airports. The strategy has begun to win plaudits from the City. Wynn Ellis, transport analyst at Commerzbank, says: "Hodgkinson has done some pretty sensible things and made a good start. The profits warning was a sensible move. He saw there was a problem and decided to get it out in the open. It was also a way of distancing himself from the Egan era and the mistakes made. It is unbelievable how they screwed up on the Eurotunnel deal. It was naive of them to get involved in the first place."

He also applauds the asset sales and share buy-backs. "This is a much better use of the balance sheet. Given the nature of BAA's revenues it is a company which can stand a higher level of gearing."

Mr Hodgkinson's down-to-earth and affable management style, developed first in the car industry then the food and drink sector before he joined BAA in 1992, also appears to be going down well with the troops. His predecessor, Sir John, was an urbane super-salesman, brought in from Jaguar as much to turn BAA's airports into retail experiences as places to fly from. He charmed the City and secured a premium rating for BAA and he moved effortlessly in political circles.

But as one observer says: "There was also a patrician air about him. It is not easy to imagine Sir John sitting down to chat to a baggage handler." Mr Hodgkinson is a different proposition. Before he took over as chief executive, he spent seven years as BAA's group airports director and he has lost none of the hands-on approach. BAA's reaction to last month's Concorde crash outside Paris is a good example.

"The minute we heard it was a tyre burst we introduced additional runway inspections and in particular a dedicated one immediately before Concorde takes off," he says. "Somebody senior in British Airways rang me and told me there might be a problem. I had that conversation at seven o'clock at night and by the time I got to the office at eight o'clock in the morning there was an e-mail telling me exactly what procedures had been put into effect."

BA, of course, is BAA's biggest customer, with some 38 per cent of all take-off and landing slots at Heathrow. Although 115 million passengers passed through BAA's seven airports last year - 70 per cent of all those who flew in and out of the UK - its real customers are the airlines who supply that traffic and pay BAA's landing charges.

For the last six years BAA and its airline customers have been joined in a common cause, to persuade the world that Heathrow needs a fifth terminal. At first they argued that Heathrow was so congested that without T5 London would lose business to Frankfurt, Paris and Amsterdam. But BAA's ability to cope with 8 per cent annual passenger growth with no extra capacity blew a large hole in that argument. Now Mr Hodgkinson says T5 is all about improving the "quality experience" for Heathrow passengers.

"We have managed to handle a much larger number of passengers than anybody thought possible at higher quality levels," he says. "But it's a piece of elastic. You can stretch it only so far. The big challenge is to last seven more years until T5 opens, and it is beginning to look virtually impossible to maintain quality levels if we do not get approval for new buildings. It is very important for London that its premier airport is genuinely world class."

He says accommodating the Airbus super-jumbo, the 600-seater A3XX, without more terminal space at Heathrow will be very difficult.

Although the report of the T5 planning inspector is to go to ministers this autumn, no one, including Mr Hodgkinson, expects a decision from government before the next election. If the answer is yes, then there will have to be a big increase in landing charges to pay for the investment, some £2.25bn, shows BAA's latest estimates.

But there are those who believe the Civil Aviation Authority, the body which regulates BAA, should order a big increase in landing charges at the three London airports, irrespective of their investment needs, if Britain is to achieve a balanced and environmentally friendly airport policy.

Heathrow is the busiest and most popular international airport in the world. Scores of airlines are locked out of it. And yet it also has some of the lowest landing charges in the world, half those of New York's JFK airport for instance.

Vincent Cable, the Liberal Democrats' trade and industry spokesman, has been one of the most trenchant critics of BAA and the system under which it is regulated. He describes the present arrangements as "economically nonsensical, environmentally unfriendly, anti-competitive and damaging to the public purse".

He says the "single till" approach to airport regulation, which has enabled BAA to hold down landing charges by using the profits from its vast retailing operations, has skewed airport policy. "Decisions over where to expand are determined primarily by the interests of BAA shareholders," he says, "not by the needs of the region or by competing claims of different airports."

If airport charges were to be ringfenced and an economic rent paid for using Heathrow, the danger, of course, is that BAA would end up making super-profits.

Mr Cable's answer is to introduce congestion charging. "One underlying reason why there is relentless pressure to build more terminal capacity and land more flights at Heathrow is that airlines do not pay a proper price for landing there." He estimates that congestion charging - a levy on landing charges or the auctioning of slots - could bring the taxpayer a windfall of £1bn a year to be spent on public transport. The argument over how BAA should be regulated goes to the heart of whether its monopoly should be broken up and real competition introduced into the airline industry. Though the Deputy Prime Minister, John Prescott, is conducting an inquiry into airport competition, Mr Hodgkinson questions whether it will ever see the light of day and detects no threat to BAA's monopoly. "We think the steam is running out of the idea as people start to understand the issues," he says. "There are several reasons. One is that we have attempted to run the company as close to a competitive model as we could. Second, there is no competition between the airports because there are no available slots at Heathrow and Gatwick.

"When we did have slots at Stansted and Gatwick we were happy for an airline to leave Heathrow, but that didn't happen because Heathrow is the most profitable airport in the world for airlines to fly into. When you really understand the dynamics of the business, you realise the competition element is illusory."

The one thing that would make competition real is if another runway was built in the South-east of England.

Everyone knows a new runway will be needed if air traffic continues to grow at forecast rates. In 15 years, demand in the South-east is expected to double to 184 million passengers a year.

Where to build that runway is the contentious issue. BAA has asked the T5 inspector to rule out permanently another runway at Heathrow.

So what about Gatwick? Or perhaps Stansted, where BAA has begun sounding out the local community on an increase in capacity from 15 million to 25 million passengers and, perhaps, eventually 35 million.

Diplomatically, Mr Hodgkinson prefers not to answer the question. Like everyone else in the industry he has taken a vow of silence until the Government publishes its White Paper on aviation and airports policy late next year.

All he will say is: "There are many, many possibilities. including the possibility of a whole new airport in the Thames estuary."

Then again, Mr Hodgkinson will be long gone from BAA by the time a decision is taken, much less a new runway built. Under the company's rules he must retire at 60, leaving him only three more years in the job.