Bill Guerin, Jakarta – Indonesia's tobacco market, the world's fifth-largest, is primed for foreign takeovers. Tough economic conditions have recently taken the buzz out of Indonesia's top four cigarette producers' profits, as spiraling inflation and higher excise taxes have driven the country's estimated 141 million smokers to trade down from premium, high-margin brands to cheaper sticks.
The cigarette industry has witnessed a 12.4% decline in sales in the first half of this year, with national cigarette consumption down to 94.8 billion smokes compared with 108.3 billion during the same period in 2005. Cigarettes are huge business in Indonesia, and foreign investors are just beginning to get into the action. Some 70% of men and nearly 20% of women smoke, and last year Indonesian smokers puffed their way through 225.5 billion cigarettes, according to industry statistics.
PT Gudang Garam Tbk and PT HM Sampoerna are Indonesia's top two cigarette producers, followed by Djarum and Bentoel. Nearly 92% of all cigarettes sold in Indonesia are clove-based, known locally as kreteks. Although many big foreign tobacco companies have long peddled their products here, they have fared poorly competing against local kretek producers.
But the rules of the market are changing fast. US tobacco giant Philip Morris International, the tobacco arm of Altria Group and producer of Marlboro cigarettes, last year paid Rp48 trillion (US$5.2 billion) to take a 98% stake in Sampoerna. Faced with big legal bills in the United States, Philip Morris's Indonesian investment has so far paid off nicely: Sampoerna is the only major producer to increase its sales and net income so far this year and is currently the sixth-largest capitalized firm on the Jakarta Stock Exchange, with a market capitalization of nearly $3.8 billion, equivalent to about 3.9% of the weight of the Jakarta Composite Index.
Gudang Garam, with total assets valued at about Rp22.1 trillion at the end of last year, is currently Indonesia's biggest cigarette producer. Lately, though, the company has hit a rough patch, where net profits have fallen by about 50% – from just over Rp1 trillion to Rp545 billion – in the first half of this year compared with the same period in 2005. The company's total market share, meanwhile, has fallen slightly from 31% last year to about 29.5% now. Foreign-owned Sampoerna's market share has over the same period surged to 28.6% against 22% previously.
Hedru Budimean, Gudang Garam's director and corporate secretary, attributes the massive drop in profits to increased operating costs and recent rises in excise and value-added taxes. However, some industry analysts criticize Gudang Garam's apparent failure to predict that Indonesian smokers would opt for cheaper hand-rolled cigarettes during tough economic times as the main reason for its loss of market share to its main rival Sampoerna. Smokers outside urban centers largely buy cigarettes by the stick rather than the pack.
Foreign rolled
The slip in financial performance has set new rumors in motion about another big foreign takeover. Chinese-Indonesian businessman Surya Wonowidjojo founded Gudang Garam in 1958 and his eldest son, Rachman Halim, who is listed by Forbes as the richest man in Indonesia with a net worth of $2.5 billion, is now rumored to be in talks with publicly listed British American Tobacco (BAT) about a possible sale.
BAT, Philip Morris's global arch-rival, is currently the industry leader in Asia. Although it has had a presence in Indonesia since 1917, nearly 90 years later the company's Lucky Strike and Dunhill brands have negligible market share in clove-smoking Indonesia. Although BAT denies any takeover talks, the Gudang Garam management, with profits flat and market share shrinking, is certain to be considering its options.
Philip Morris had also been in Indonesia for nearly a half-century, but had captured just 4.4% of the market with its Marlboro brands. A BAT acquisition of Gudang Garam, industry analysts predict, would lead to a battle of the titans to win the hearts and lungs of Indonesia's millions of kretek addicts.
"To participate fully in the Indonesian market, you have to offer what the consumer wants," Altria chief executive officer Louis Camilleri told reporters in a conference call after the Sampoerna sale was announced last year.
Foreign management has arguably bolstered Sampoerna's earning power. The company booked a net income of almost Rp1.9 trillion through June, an increase of 20.9% compared with the almost Rp1.6 trillion it earned over the same period in 2005 – notably before Philip Morris's takeover. Revenue also increased 29.4% to Rp14.6 trillion from almost Rp11.3 trillion over the same half-year period; locally run Bentoel and Gudang Garam, meanwhile, have experienced a decline in net income and revenue over the same period.
Analysts say at least part of the difference comes down to marketing. Sampoerna's better performance is underpinned by the strong brand equity of its brands, the hand-rolled Dji Sam Soe and Sampoerna A Hijau and factory-packaged Sampoerna A Mild. Djarum's leading brands are Djarum Super and Djarum Coklat, but the company has wholly failed to make inroads into the mild kretek market, now dominated by Sampoerna's A Mild.
Chandra S Pasaribu, an industry analyst, said Sampoerna's position is still quite solid given that its premium products are aimed at a loyal consumer sector with higher income levels. At the same time, cigarettes are priced to sell in Indonesia, with many cheap brands selling for less than 50 cents per pack. Yet lost in all this profit is the human toll in a country where most smokers can't afford even basic health care, let alone expensive treatments for advanced respiratory illnesses.
With the financially crippling legal hassles the tobacco industry now faces in many Western countries – where suffering smokers have sued and won against cigarette companies over the adverse health impacts of prolonged smoking – Indonesia's lightly regulated market and less-than-litigious society represents a potential cash cow for foreign tobacco firms. Indonesian politicians are so far not prone to politicize the cigarette market because it is one of the government's biggest earners. At Rp35 trillion, tobacco taxes are estimated to contribute about 7% of total tax revenue this year, and the industry is the single biggest contributor to national coffers, with upwards of 90% of all excise revenue coming from tobacco.
Evocative fragrance, deadly pull
For potential foreign buyers, however, the export potential would probably be limited, particularly to litigious Western markets. Behind the evocative clove fragrance lies a mysterious, but potentially deadly, pull on puffers. Eugenol, a phenolic compound in cloves, has sedative properties that give smokers a "feel good" high. Along with the mood fix, smokers also get massive doses of nicotine and tar. Kretek cigarettes contain on average about four times as much nicotine and tar as even the strongest Marlboros. Gudang Garam tops the list at 53.2 milligrams of tar per cigarette, while the bulk of the brands hover at about 40mg, and only one contains less than 30mg.
Dji Sam Soe, Philip Morris-owned Sampoerna's flagship best-selling brand, accounts for more than half of the company's total sales. The brand also has twice the amount of nicotine and three times the amount of tar of a conventional cigarette. Tests have shown that eugenol alone causes extensive lung damage when smoked over sustained periods. The compound also enhances the effect of the tar, according to laboratory tests. While there are no legal storm clouds linking cigarette smoking to respiratory illnesses on Indonesia's immediate horizon, civil-society groups are increasingly on the offensive against the industry. More than 20 non-governmental organizations and professional organizations, grouped under the so-called National Movement to Prevent Smoking Problems, have recently lobbied President Susilo Bambang Yudhoyono to stop the expansion of cigarette companies. In particular, they have criticized the government for its recent approval of Sampoerna's investment in a new factory to be built in Karawang regency, West Java.
Sampoerna currently produces cigarettes from its plants in Pandaan, Rungkut and Malang, all in East Java province. The company's planned investment prompted National Investment Coordinating Board chairman Mohamad Lutfi to say it was a "strategic initiative to regain trust from potential foreign investors that would stimulate economic growth in Indonesia". (In the first six months of 2006, total foreign direct investment and in-house investment in Indonesia increased by more than $45.2 billion, representing a 12% jump over the same period last year.)
But Farid Anfasa Moeloek, chairman of the Indonesian Doctors Association and a former health minister, warned: "The new factory is able to produce 9 billion cigarettes a year. This will be an insidious danger for the youth and poor people because it will increase cigarettes' availability in the country."
There has been some movement on those sentiments, albeit somewhat tentative.
In February, Jakarta implemented a smoking ban in certain public areas. In particular, the ban prohibits people from lighting up in public places such as shopping malls, office buildings, health-care centers, children's activity areas, places of worship and schools and on public transport. Also included in the regulation is the requirement for building management to set aside rooms equipped with exhaust fans for smokers, while offenders can be fined up to Rp50 million.
Should other Indonesian cities and provinces introduce their own smoking bans, analysts predict that those hardest hit would be the cigarette brands sold mainly to middle- and high-income smokers, namely Dji Sam Soe, A Mild and Marlboro. Yet despite this first-ever smoking ban and an increasingly strong anti-smoking sentiment among civil-society groups, Indonesia is still one of the last countries in the world that has not signed into the World Health Organization's Framework Convention on Tobacco Control.
The Department of Trade is rumored to be considering a proposal from the anti-smoking lobby that the industry should be placed in the so called "negative investment" list, which could potentially close it to new foreign investments. The bill is now being deliberated by the House of Representatives' Trade and Investment Commission.
As interest rates start to drop, consumption growth may pick up and, with most Indonesian households reportedly spending less on food and clothing than on tobacco, prospects for the industry look bright. And for now, at least, Indonesia is still very much a smoker's delight for local and perhaps soon more foreign cigarette makers.
[Bill Guerin, a Jakarta correspondent for Asia Times Online since 2000, has worked in Indonesia for 20 years, mostly in journalism and editorial positions. He has been published by the BBC on East Timor and specializes in business/economic and political analysis related to Indonesia. He can be reached at softsell@prima.net.id.]