Tobacco manufacturers adapt to Indonesia's more stringent regulatory environment

Representing the world’s fifth-largest tobacco market, Indonesia’s tobacco industry has soared in recent years, with manufacturers vying for market supremacy in a country with an estimated 85m smokers. The market has long been attractive to major international players such as Philip Morris International (PMI) and British American Tobacco (BAT), which both witnessed sharp growth in profits after entering the market.

However, although an expanding middle class should help growth prospects in the coming years, rising awareness of the negative effects of tobacco consumption and an increasingly stringent regulatory environment could slow expansion. Moreover, the newly elected President Joko Widodo rolled out an industry tax hike in early 2015. Although this will significantly boost public coffers, it could also reduce the number of smokers, dampening mid-term growth prospects.

Diverse Market

Indonesia’s tobacco market is large, comprising 672 companies and over 3300 brands. Its tobacco industry employs an estimated 500,000 farmers, with the country offering significant supplies of raw materials, processed at a low cost relative to other ASEAN countries. This has kept cigarette prices down, with packages of 20 costing around $1.20, and single sticks sold on the street for just $0.10. The lack of a minimum legal age to purchase tobacco has also opened the market to a broad consumer base; as of 2012, 67% of men and 5% of women in the country smoked, with Indonesia Investments reporting in 2015 that around 80m-85m Indonesians consumed tobacco.

According to a 2009 report published by the Campaign for Tobacco Free Kids, annual retail sales volumes in Indonesia grew by 26.4% between 1998 and 2008, rising from 132.6bn sticks to 167.6bn. By 2013, this number had grown considerably, to 360bn sticks. Tobacco taxes represent an important source of income for the government, accounting for up to 7.7% of total annual revenues between 1998 and 2010, according to the Tobacco Control Support Centre, and are projected to have reached Rp111trn ($9.18bn) in 2014. Four major producers are listed on the Indonesia Stock Exchange (IDX): HM Sampoerna, Gudang Garam, Bentoel Internasional Investama (BII), and Wismilak Inti Makmur (WIM). HM Sampoerna held a 34.9% market share as of 2014, according to PMI’s 2014 annual report, and Gudang Garam held 20.6%, making them the largest players by market share.

Consumer Habits

The most popular tobacco product is the hand-rolled kretek cigarette, composed of 70% tobacco and 30% ground cloves, clove oil and other additives, and preferred by an estimated 85% of Indonesian smokers over Western “white” cigarettes.

Although cigarette consumption by the lower classes represents a significant slice of companies’ revenues, increased purchasing power has seen middle-class consumers opt for more premium brands of cigarettes. As a result, hand-rolled kreteks are becoming less popular in the country, as evidenced by HM Sampoerna’s decision to close two of its kretek manufacturing facilities in May 2014. At the same time, the relatively untapped market of female smokers could hold considerable growth potential, and despite the negative perception of female smokers in Indonesian society, companies have increasingly found success marketing white cigarettes to middle- and upper-class women as a symbol of independence and affluence.

Expansion continued in 2014, with financial consultancy Saham projecting industry growth of 6-7% last year. Analysts at the firm reported in 2014 that a new regional excise tax of 10% was not expected to make a major impact on sales, while clove prices, which shot to Rp220,000 ($18.19) per kg in 2011, fell to roughly Rp110,000-120,000 ($9.09-9.92) in 2012, and stabilised at Rp150,000 ($12.40) per kg in 2013.

HM Sampoerna

HM Sampoerna stands as the nation’s leading tobacco company, and produces some of the country’s most well-known kretek cigarettes, including Sampoerna Hijau, Sampoerna A Mild, and Dji Sam Soe. In 2005 the company was acquired by PMI, and today distributes cigarettes through 105 sales offices on the islands of Java, Sumatra, Bali, and Kalimantan, as well as in eastern Indonesia.

HM Sampoerna is the market leader in the kretek, white cigarette, and low-tar categories, and is expected to maintain this competitive edge; in June 2014, Matteo Pellegrini, president of PMI Asia, announced to shareholders that as a result of Indonesia’s growing middle class, and the potential for a simplified tax regime, as well as the stabilisation of clove prices, revenues and growth are expected to continue on an upwards trajectory. Indeed, the company reported six straight years of profit and growth to 2013; net profits rose from Rp3.89trn ($321.5m) in 2008, to Rp10.82trn ($894.4m) in 2013, and net sales rose from Rp34.68trn ($2.87bn) to Rp75.03trn ($6.2bn). In 2014, the company sold 314bn sticks of cigarettes, marking a 1.9% increase over 2013, and with projected 2% sales growth in 2015.

Gudang Garam

Gudang Garam is the second-largest tobacco producer by market share, and stands as a leading manufacturer of kretek cigarettes, as well as low-tar and low-nicotine products. The company holds primary and secondary kretek manufacturing operations at two sites in the country: Kediri and Gempol, both located on Java. Similar to HM Sampoerna, Gudang Garam has witnessed sharp growth in recent years. Net profits rose from Rp1.88trn ($155.4m) in 2008 to hit Rp4.33trn ($357.9m) in 2013, while domestic net sales nearly doubled during the same period, rising from Rp28.55trn ($2.36bn) to Rp53.12trn ($4.39bn).

BII & WIM

In addition to PMI, BAT has also made inroads in the Indonesia market, after moving to acquire BII in January 2010. BAT stands as the world’s second-largest tobacco group, with brands sold in over 180 markets, and BII is Indonesia’s fourth-largest cigarette manufacturer, with a 7% market share, according to Indonesia Investments. In addition to kretek cigarettes and cigars, the company also sells the Dunhill, Lucky Strike, and Pall Mall brands. BII is the sole major manufacturer to have recorded losses in recent years, with net losses rising from Rp323.4bn ($26.73m) in 2012, to Rp2.28trn ($188.46m) in 2014. Revenues have nonetheless risen sharply, in line with industry trends, growing from Rp8.9trn ($735.67m) in 2010 to Rp14.09trn ($1.23bn) in 2014, while gross profits have declined moderately, from a five-year high of Rp2.31trn ($190.94m) in 2012, to Rp1.51trn ($124.82m) in 2014.

WIM, meanwhile, reported that production stood at 3bn sticks of hand-rolled kretek cigarettes, machinemade kreteks, and cigars as of 2013. The company launched an initial public offering on the IDX in December 2012, raising Rp366bn ($30.25m), and net profits stood at Rp128.4bn ($10.61m) in 2011, Rp77.2bn ($6.38m) in 2012, and Rp132.2bn ($10.93m) in 2013. Net sales, meanwhile, rose from Rp925.2bn ($76.48bn) in 2011 to Rp1.59trn ($131.43m) in 2013.

Hazy Future

Although Indonesia’s tobacco producers are among of the most profitable companies in the country, sales and profits are expected to take a hit in the coming years, as the nation’s anti-tobacco lobby gains a stronger foothold and the Widodo administration moves to increase industry taxes.

Indonesia is one of just a handful of countries that has not yet ratified the World Health Organisation’s Framework Convention on Tobacco Control, which aims to protect people from the the harmful impact of tobacco consumption through a set of universal standards governing the production, sale, distribution, advertising and taxation of tobacco. According to a 2014 report by the Associated Press, tobacco-related illnesses kill at least 200,000 Indonesians each year. With around 35% of the total population considered smokers, Indonesia’s smoking rate is surpassed only by Russia.

Tobacco Reforms

The government’s domestic tobacco roadmap envisions limiting production to 260bn sticks by 2020, and Indonesia Investments reports that cigarette production fell by 7% in 2013, after recording a 9% increase in 2012. In 2014, new regulations required cigarette manufacturers to include graphic health warnings on all cigarette packages, although few had complied with the new regulations when they became effective in June. The Widodo administration launched a new excise regime for the tobacco industry in 2015. As of January 2015, producers faced an average tax hike of 8.7% on all tobacco products. The tax on machine-rolled cigarettes rose to Rp355 ($0.03) per stick, and hand-rolled cigarettes to Rp290 ($0.02) per stick. Taxes were previously set at between Rp80 ($0.01) and Rp275 ($0.02) per hand-rolled cigarette, and as low as Rp245 ($0.02) per machine-rolled cigarette. Hand-rolled taxes remain lower due to the high number of people employed to manufacture them.

According to Indonesia Investments, the government expects tobacco-related revenues will rise 9.1% in 2015 to reach Rp120.5trn ($9.96bn), and the industry will continue to provide critical support to planned infrastructure investment. Although new taxes and rising production costs may impact profits in the longer term — PMI reported a $398m spike in manufacturing costs in Indonesia in 2014 — the industry is expected to record moderate growth in 2015, and remains a critical source of income and growth for the country.