(FORTUNE Magazine) – , THE TOUR GUIDE holds a small flag over his head, and his gaggle of newly arrived Japanese tourists trails closely behind him. He leads them swiftly through the San Francisco airport to buses that are waiting to deposit them at their hotel. But before we get to the hotel, he says, we'll make a brief stop at the duty-free store where the prices are the absolute lowest in town. What the tour guide doesn't tell his flock, usually zonked after the nine- hour flight from Tokyo, is that some products sold at the store are not, in fact, duty-free and that local retailers sell a few of the same goods for the same price. The guide also says nothing about the commission he receives for every sale made to a member of his tour group. Welcome to the dog-eat-tourist world of international duty-free retailing, a big business with sales of $10 billion in 1987, the most recent year for which statistics are available. The industry is growing rapidly: 1987's sales were nearly twice the $5.5 billion in 1984. Even adjusting for the decline in the dollar, says David Bernstein, president of the International Association of Airport Duty Free Stores and chairman of Duty Free International Inc., a retailer, ''we're seeing at least 10% to 15% real growth annually.'' All the important duty-free merchants are privately owned or divisions of large conglomerates that do not break out their revenues and profits. The world's largest retailer is Duty Free Shoppers Group Ltd., a secretive partnership based in San Francisco that took in an estimated $2 billion in 1988 from 160 stores scattered around the Pacific Basin. It is owned by two hugely successful entrepreneurs, Robert W. Miller and Charles F. Feeney, who were Cornell University classmates back in the mid-1950s. The folks who have to try harder are Allders International, a division of England's Hanson PLC, with $500 million in sales coming from Britain, Canada, and Australia. As anyone who has ever had to kill a couple of hours between planes knows, duty-free shops sell liquor, perfumes, tobacco, jewelry, leather goods, and other such portable property to departing travelers. The stores sell more liquor than any other product ($3.2 billion worth in 1987), followed by perfume and cosmetics ($2.3 billion) and cigarettes ($1.5 billion). Because the merchandise is not going to be used in the country where it is bought, the price is free of all import, luxury, sales, and excise taxes. Duty-free shops exist not only in airports but also on ships, ferries, and airplanes, at international border crossings, and even downtown, where they deliver duty-free goods to points of departure. Some South American and Middle Eastern airports also have ''arrival stores'' selling a wide array of items including refrigerators and washing machines to returning natives. These caveat emporiums survive on the widespread belief that their prices are substantially below ordinary retail, and often that's true. But, says David Bernstein, ''not everything you see in a duty-free shop is really duty free.'' Though the stores always sell merchandise free of sales, excise, and value-added taxes, an item made in the country where it is sold has no import duties anyway. That's why the bottle of bourbon you bought at Dulles International is not ''duty free'' as most travelers understand the term, but rather tax-free. MOREOVER, how much travelers save on ordinary retail prices depends entirely on where the duty-free store is located and which retail store is used for comparison. A liter of Johnnie Walker Red, the most popular liquor with travelers, sells for $9.50 in the Honolulu airport, $10.90 in France's Charles de Gaulle, and $3.75 in Dubai. Buy the same bottle at a liquor store in Tokyo, and you'll need a drink: $31.68. Conversely, 7.5 ml of Yves St. Laurent's Opium perfume costs $70.57 at Tokyo's Narita airport but only $60.74 at Duane Reade, a New York City discount drugstore chain. The U.S. accounts for 12% of the industry's revenues even though import duties in the U.S. are minimal. Americans aren't much impressed with shopping duty free. The Japanese make one-quarter of the world's duty-free purchases. Beginning this month, the Japanese government will eliminate the huge tariffs on luxury imports and replace them with a 3% consumption tax on all consumer goods. Duty-free shopping is still likely to thrive since departing travelers -- especially honeymooners -- get lavish gifts and are expected to reciprocate upon their return. Some retailers estimate that a typical Japanese international traveler will spend between $1,200 and $1,500 per trip on gifts and perhaps $300 to $400 of that in duty-free stores. The champion at separating the Japanese from their yen is the industry leader, Duty Free Shoppers. In 1987 the average duty-free sale per international passenger was $9.13. But Duty Free Shoppers took in $182.93 per passenger in Guam, $182.86 in Saipan, and $168.26 in Honolulu -- all three ! destinations popular with Japanese honeymooners. The concession in Anchorage, Alaska, a major refueling stop for flights between Europe or the eastern U.S. and Japan, hauled in $112.14. The company isn't giving away any sales tips, but two years ago a news program on KRON-TV in San Francisco revealed a few of them. Duty Free Shoppers pays Japanese tour operators and guides to hustle customers to its stores, where most of the salesclerks speak Japanese. The company guarantees to repair or replace any defective merchandise at its office in Tokyo, and it willingly extends credit to Japanese citizens -- but not to anyone else. Perfumes and other high-ticket gifts that Japanese customers prefer -- leather goods, ties, jewelry -- are gaining market share at the expense of liquor and cigarettes. These shoppers want designer names -- Cartier, Fendi, Lanvin, Gucci -- on the grand luxe baubles they buy for reciprocal giving. Carl Reimerdes, vice president of Duty Free International, which runs the concession at the United Airlines terminal in New York City's Kennedy airport, reports that Japanese travelers often buy cognac in crystal decanters that cost as much as $1,700 each or solid-gold Mont Blanc pens, as much as $800 per. Says Reimerdes: ''We can't get enough fine watches or Hermes scarves. We're constantly out of stock.'' Manufacturers of such expensive consumables are paying increasingly close attention to the duty-free industry. Perfume sales at duty-free boutiques, for example, are rising three times as fast as at ordinary retail stores. Duty- Free News International, a British trade publication, reports that Givenchy and Gres each get 33% of their worldwide perfume sales from duty-free stores, while Nina Ricci takes in 40% and Carven 50%. When courting duty-free merchants, manufacturers make deals similar to those they offer ordinary retailers, such as volume discounts, cooperative advertising in catalogues and brochures, and merchandise for special promotions. Sometimes they package their products specifically for duty-free customers and will test-market high-priced lines in the stores when the product's target is a prodigal consumer. Three years ago Seagram launched Chairman's Reserve II, a high-priced, 25-year-old Chivas Regal in Stuart crystal decanters, from duty-free shelves. Gebr. Heinemann even created a brand of cigarettes -- Airports -- that can be bought only in duty-free shops and therefore announces that the gasper is a globe-trotter. Camus, the French cognac maker, has distilled its fortune from duty-free outlets. Two decades ago the company began pouring old brandy into new bottles designed specifically for Japanese gift-givers. Today Camus's Special Vieille Reserve cognac blend in a Baccarat crystal decanter or a Limoges porcelain ''book'' with gold-edged ''pages'' costs $130 to $750. Says Norberto Herrero, chairman and managing director of Camus International: ''Most of the sales of premium cognac throughout the world are duty free.'' Thus, Camus has more than 20% of the world market for premium cognac, the largest single share, even though it sells almost exclusively in duty-free shops and is only the world's fifth-largest cognac distiller in total case sales. Duty-free retailers court customers as aggressively as the manufacturers court them. In the wooing process, the merchants dispense what they call ''promotional allowances'' to tour guides who herd their charges into the shops and to bus drivers who arrange pit stops at border stores. Sterling Airways, a Scandinavian charter airline, actually subsidizes its cut-rate ticket prices with a duty-free assault on passengers in flight. In 1987 Sterling Airways sold $52.5 million worth of merchandise, more than any other in-flight duty-free merchant. After a Sterling jet takes off, flight attendants pass through the cabin pushing carts piled high with liquor, perfume, cosmetics, cigarettes, and gifts selling at discounts of more than 50% off Scandinavian retail prices. The FASTEN SEAT BELTS sign stays on whenever sales are in progress, trapping willing and unwilling customers. Flight attendants are encouraged to cook up their own hard-sell patters and are paid a 6% commission on every sale. Sterling even sends flowers to high-grossing stewardesses. Sterling planes carry nearly two tons of duty-free merchandise per flight. Says Christian Funch, the in-flight sales manager: ''If we take one-third back, we have hit the target.'' TODAY'S duty-free industry began quietly in the 1930s on cruise ships steaming outside international three-mile limits. The first airport store opened in 1947 at Ireland's Shannon airport, which was then a refueling stop for transatlantic flights. The idea behind Shannon was to promote Irish whisky and woolens, and today many governments support duty-free shops as a powerful tourist attraction. For example, the shopping area at Schiphol airport in Amsterdam, which has a firm policy of selling at the lowest prices in Europe, has undergone a $9 million remodeling at the expense of a private company owned by the Dutch government. To lure international travelers away from Schiphol, the Danish government and private investors spent $7 million last year to upgrade the shopping arcade at Copenhagen's airport, which now houses a champagne-and-oyste r bar along with boutiques selling Georg Jensen silver and Birger Christensen furs. Inspired by Schiphol, the Emirate of Dubai opened a duty-free store five years ago at its international airport, a major Middle Eastern refueling stop. Dubai airport's duty-free store, operated and subsidized by the government, stocks an extraordinary 25,000 separate items -- including furs, gold, and Cuban cigars sold from a walk-in, humidified room -- at prices that are lower than any duty-free outlet in Europe. Duty-free retailing in the U.S. existed with the uncertain indulgence of the Customs Service for 30 years until the 1988 Omnibus Trade act specifically legislated the industry into being. Retailers must be approved by two divisions of the Treasury Department: the Bureau of Alcohol, Tobacco, and Firearms and the Customs Service. The feds are so persnickety about keeping track of every tax-free item that Duty Free International's JFK outlets take inventory three times a day, at each change of shift. ''Dealing with Customs,'' says a weary airport manager, ''is like trying to push fog through a keyhole with a fork.'' FOR THE MOST PART, duty-free shops compete with each other only when leases are up for renegotiation. Airports, for instance, commonly award concessions to the highest bidder: In the U.S. that means the merchant must agree to pay the airport 20% to 30% of gross sales annually, while the rent in Europe can run as high as 50%. London's Heathrow and Gatwick airports together collect between (pounds)110 million and (pounds)120 million annually from their duty- free concessions. In 1992 the European Economic Community plans to abolish all intra-European duties, thus costing European duty-free retailers as much as two-thirds of their business. For this reason, the sharks circle whenever leases come up for renewal in the U.S. and the Pacific Basin. The fiercest contests will be over destinations that are popular with the Japanese. Last year, when the lease on Honolulu's duty-free concession, which includes the airport and a store downtown in Waikiki, was up for bidding, Duty Free Shoppers was so afraid of ! losing it to competitors that it offered $1.15 billion -- the winning bid -- to be paid in rising installments over five years. Duty Free must believe the World Tourism Organization's estimate that international travel will rise 54% by the year 2000. The $1.15 billion bid was slightly more than the company's total take from its two Honolulu outlets over the previous five years.

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