Description

Summary Thesis:

Dufry AG is a travel retail company operating both duty-free and duty-paid stores.  As an industry, the travel retail, is supported by strong long-term secular tailwinds driven by greater accessibility of transport (particularly by air), higher disposable incomes (especially in Emerging Markets) and continued internationalization of travel.  Dufry is a leader in this industry, a position achieved through its operational excellence and successful acquisition strategy. It is also the only pure-play publicly-listed travel retail company.  We believe that the management of the company has the ability to continue its successful growth strategy delivering superior results and therefore the stock is recommended with a 2-year target of CHF175, equivalent to a CAGR appreciation of 20-25% p.a.

Company Overview:

Dufry AG is a travel retail company with a worldwide footprint. It offers various retail concepts, including general travel retail shops; news and convenience stores under the Hudson News brand; brand boutiques for various brands that complement its general travel retail shops as stand alone or integrated within shopping stores; and specialized shops located at airports, cruise liners, seaports, and other touristic locations. The company’s retail shops primarily offer tobacco goods, alcoholic beverages, food and confectionaries, perfumes, cosmetics, newspapers, magazines, books, jewelry, watches, accessories assortments, and electronics. From a tax status, Dufry operates two types of formats – Duty Free and Duty Paid stores.

Duffry has a broad geographical footprint with Latin America 28%, North America 29%, Central America 15%, Europe 12%, Eurasia 9%, Africa 7%.  Overall Emerging Markets represent 60+% of the revenue.

Company History

Dufry can trace its roots back almost 150 years, when Johann Weitnauer took over his brother’s tobacconist shop in Basel, Switzerland. Over time the company evolved into its current business focus. The inflection point came in after the opening of the world’s first duty-free shop at Shannon airport, Ireland in 1947. Launched by local businessman Brendan O'Regan, the store catered for air passengers held up by refueling before crossing the Atlantic. The Weitnauer Trading Company (as Dufry was known then) quickly realized the nascent sector’s potential and established a duty-free wholesaling business the following year. Four years later, the group expanded into retailing, opening its first duty-free store at Le Bourget airport outside Paris, France.  Over the years, Weitnauer continued to expand its duty-free operations and, by the time of the company’s reorganization and subsequent sale to Advent, the private equity group, in 2004, duty free accounted for c.60% of the group’s CHF 1 billion sales. While the group’s wholesaling and tobacco vending machine businesses retained the Weitnauer brand, the retail operations were rebranded Dufry and sold to Advent for a total consideration of CHF 288 million over the course of two transactions in 2004 and 2005. Later that year, Advent listed 30% of the group’s capital (retaining a 53% stake) on the Swiss stock exchange for CHF 80 per share, valuing the group’s equity at CHF 1.1 billion.

Overview of the Travel Market

Travel retail, which includes both duty-free and duty-paid, is a $39bn market, which is forecast to grow by 8% in 2010/2020e. This long-term growth is driven by greater accessibility of transport (particularly by air), higher disposable incomes (especially in Emerging Markets) and continued internationalization of travel. Aside from temporary shocks (such as terrorist attacks, economic downturns or even volcanic eruptions), the travel retail market should continue to benefit from the secular growth in passenger numbers. Despite the long-term industry tailwinds, travel retail is cyclical in nature due to its reliance (70%) on flows of international air travellers. This market therefore varies according to changes in world GDP. It is noteworthy that the travel retail market has outperformed passenger traffic growth by an average of 5% per year since 2003, except in 2009, when air traffic suffered a sharp dip.

Sales in airports (and onboard planes) are the biggest outlet for travel retail (70%) and have the strongest growth prospects. The sector therefore derives full benefit from the buoyant trends in air travel and the development of infrastructure in airports. Airport sales are the most dynamic segment in travel retail and are projected to grow 10% in the next 10 years, in line with the trend in 2000/2010. Airports account for 90% of Dufry’s sales. Sales in airports are buoyed by (1) Buoyant trends in passenger traffic in the medium term, driven notably by the growth of low cost carriers (25% of flights operated worldwide) and the rise of emerging countries; (2) The increase in average spending per passenger, which is driven by an improvement in the mix (increase in sales of perfumes and cosmetics), a broadening of the offering and an increase in the amount of time spent in airports. ?

Other Distribution channels include: (1) Sales onboard aircraft (7% of the market) with forecasted growth of  +3% between 2010 and 2020e,  (2). ?Ferries and Cruises (6% of the market) projected to grow at 6% in the next 10 years; (3) Other (28% of the market): This segment represents sales in stores at borders, in hotels, ports and free zones.

The travel retail industry has its own idiosyncrasies compared to its traditional counterparts. This excerpt from the Dufry 2008 Annual Report points to the intricacies of the travel market:

“Travel retailing differs from traditional retailing in ways that have a significant impact on operations. The client base has a different buying behavior compared to the high street and tends to be more affluent. From a logistics perspective, it is more demanding: the customer is at the shop only once, with no ability to come back in the event of lack of stock; furthermore, store locations have limited access (in secured areas). The market is characterized by captive customers, who generally have above average purchasing power and in most cases have the time to shop while travelling.”

Another important difference between travel retailing and traditional mall-based and high street retailing is the type of and relationship with landlords. Most travel retailers’ locations, or concessions, are generally agreed with the owner of the facility (airport, train station, cruise ship, etc.), often a local authority. Concessions are typically awarded following a public tender process or through a private negotiation. In these instances, the local authority determines the type and number of concessions to be granted, often on an exclusive basis (either by product category or even for a whole station/terminal). Very often, the local authorities may choose to become a minority partner with the travel retailer and share part of the economics. Dufry has a number of such minority partners and affiliates.

Given the exclusive nature of most locations, this means that once a concession has been awarded, ‘local’ competition is generally limited and hence the operator’s competitive position is strong. However, with most concession contracts structured on a percentage of turnover basis (often with a contractual minimum fee), local authorities not only seek to maximize their concession fee, but also to ensure that the winning retailer can deliver a higher sales base.

This has led to two developments over the last 5-10 years. First, concession fees, as a percentage of sales, have increased steadily over time and, second, operators that are more efficient have forced industry consolidation as local authorities seek to maximize their potential revenue streams.  It is also worth noting that contract lengths can vary significantly by location (e.g., Dufry’s Milan Malpensa airport concession runs until 2041 while about a tenths of Dufry’s shops are up for renewal this year and next) and that long concession contracts represent a significant competitive advantage in management’s view.

When looking at travel retail, one also needs to distinguish between duty-free and duty-paid sales. Duty-free sales are conducted in a restricted area and can only be transacted by international travelers leaving a destination (duty-free departure shops) or by travelers arriving from international travel (duty-free arrival shops). Restrictions on quantities (either by monetary value or by volume/number of items) exist in most jurisdictions. Duty-free sales are, as the name would suggest, exempt from most forms of local taxation. It is also worth noting that the EU abolished duty-free retailing between member states in 1999. Duty-paid, on the other hand, refers to all other forms of travel retailing and is typically carried out without any restrictions. The most common formats are newsagents, bookshops and confectionery/foods. According to Verdict Research, the duty-free market accounts for c.65% of global travel retail sales, with the balance coming from duty-paid.

One of the effects of the abolishment of duty-free sales within the EU has been the change in sales mix. Historically, the travel retail market (in particularly in duty-free) was dominated by highly taxed products such as alcohol and tobacco.  At present, the industry’s focus over the last ten years has been to broaden its sales base, especially in the face of declining tobacco sales. For instance, the share of wines, spirits and tobacco sales has declined by 8% to just 25% over the last nine years while perfumes, cosmetics and luxury goods have been responsible for 75% of the industry’s growth during the same period and now account for 65% of global sales.

Dufry’s Market Positioning

The market includes six global players (DFS (LVMH), Dufry, Lagardère Service Travel Retail, Autogrill, The Nuance Group and Gebr Heinemann), which control over a third of the market. Additionally, there are around 2,500 regional players, which are either large players but which operate on single big markets with leadership positions (Lotte Duty Free Shilla, Dubai Duty Free), or smaller players operating on single markets. These regional operators are the most likely targets in the future consolidation of the sector.

Dufry, the world’s number 2 in the sector with 8% market share, is a key player on the travel retail market in emerging countries and tourist destinations. It is developing an aggressive growth strategy in these countries and generates high FCF, which allows it to rapidly digest its acquisitions and satisfy its growth ambitions. The group main characteristics include:

• Dufry is a diversified player (present in 45 countries and 153 airports) and the leader on the fast-growing travel retail market, with a strong presence in emerging countries (60% of sales) and a positioning on top-end products. The group is organized in 6 regions (to be consolidated into 4 next year) - Europe, Africa, Eurasia, Central America/Carribean, North America and South America.  The latter two regions are the largest and most profitable, in particular South America (with group leading EBIT margins of 18%).  In North America, Dufry is largely represented through its Hudson brand, which is the largest travel retailer in the US with 40% market share.  Dufry acquired Hudson in 2008 and is in the process of ramping its expansion globally and integrating its store format into the larger group. The “weakest” link among the regional divisions is Europe, accounting for 14% of revenues and 8% of EBITDA (it has the lowest margins also partly because of the inclusion of corporate overhead).
•  Dufry is set to continue to outperform its markets, thanks notably to its expertise in emerging countries where it has critical size and scale and is a key player.  Since concessions are structured as a percentage of revenues, travel authorities grant them to the most productive operators. One of the main reasons why Dufry has emerged as a leader in gaining concessions is its operational excellence and rising productivity. The company has grown its top line at a rate of 23% (7% organic/LFL growth) over the last 9 years and its EBITDA margins have risen from 7% in 2003 to 14% in 2012.  Its profitability per sq.m. is $1,500-$1,600, in line with some of the most profitable retailers. Dufry’s concessions are fairly diversified in terms of duration (7 years on average), with about a quarter of its contracts having a term of 10+ years. It also has a very high concession renewal rate of 85%, so clearly airport operators value its expertise. Laslty, due to its captive, high-income/jet-setting audience, Dufry’s 1,500 suppliers view the company’s shelves as an important marketing display and often launch new product introduction in its stores, which to a certain extent provides leverage to Dufry.
• Dufry will benefit from the integration of acquisitions, thanks to its very high cashflow generation (FCF yields of 8-10%).  Given the high profitability and low capex requirements (Capex at 3% and Net WC at <7% of sales), the company generates significant cashflow. Dufry maintains a net debt / EBITDA ratio of 3x and deploys its excess capital to make accretive acquisitions.  The company has demonstrated an exemplary track record of achieving acquisition synergies historically (typically through enhanced turnover, stronger purchasing power, and integration/reorganization).  Given the very fragmented nature of the duty-free market, Dufry has ample opportunities to grow profitably through additional acquisitions.
• FX stability: Given that Dufry reports in CHF, the strong rise of CHF last year hurt results from a translation perspective. The stabilization of the CHF relative to the euro thanks to the action of the SNB to hold the exchange rate to CHF1.20 should provide greater stability to reported results.

Despite its very strong positioning and profitable growth, Dufry does face some potential challenges/risks. They include: 1) cyclicality of travel retail 2) competition for concessions 3) leveraged balance sheet 4) potential legal disputes in Brazil regarding concession grants 5) currency fluctuations 6) overhang from continued ownership by Advent.

Valuation and Upside/Downside Targets
Dufry has very few if any comparable companies, so our valuation analysis is based more on absolute metrics and relative valuation to it own history.  As of June 30, 2012, Dufry had revenues and EBITDA of CHF 3.0bn and CHF 425.0mm (EBITDA margin of 14.3%).  During the first half of 2012, Dufry grew these two income statement components at 12% and 20%, respectively. Historically the 1^st half of the year has been weaker than the 2^nd.  Furthermore, we have highlighted that Dufry grew its top line at a CAGR of 23% in the last 9 years.  Let’s assume for the sake of conservativism, that for the second half of 2012 as well as for 2013 and 2014, top line growth will be 10%. That would lead to revenues of CHF 4bn in 2014.  In terms of EBITDA margins, Dufry, has achieved margin improvements of 75-100bp in the last three years, lets assume that margins don’t improve any more in 2012 and rise by 50bp only in 2013 and 2014. This implies EBITDA margins of 15.5% in 2014 and an EBITDA figure of CHF of 620mm. 

Dufry generates significant amounts of cash – its FCF has averaged c. CHF 300mm in the last three years (9% FCF yield).  Let’s assume that this FCF does not grow and only half is used for acquisitions (we are assuming after all a minimal top line growth in our revenue line, i.e. very minor acquisitions).  Therefore, one can project that the current net debt of c. CHF 1.5bn will be down to CHF 1.2 bn in 2014.

Lastly, Dufry has traded at 9-10x EV/EBITDA on NTM figures, which is not aggressive given that our conservative projections imply 20% EBITDA growth over the next 2 years.  Adding all these we come up with a valuation range for Dufry in the range of 165-185CHF in the next 24 months, i.e. a compounded rate of 20-25% p.a.

Catalyst