The air in Indonesia hangs heavy with smoke from the distinctive clove-scented kretek cigarettes that account for the bulk of production in one of the world's most distinctive and largest tobacco industries. The sector is large in terms of production, employment and number of firms, and is responsible for generating major revenues for the government through taxes, while also forming a distinct part of Indonesia's culture.
The tobacco industry clearly faces challenges, however. Excise duties, land allocation and the call for greater tobacco control are three pressing issues, though insiders remain confident that despite ongoing debates over these matters, the sector will continue to see strong growth and international interest in the years ahead.
Indonesia is the seventh-largest tobacco producer in the world, with a mass of companies involved in the growing, production, distribution and retailing of its products. Around 7m people are directly and indirectly employed in the sector, supplying some 70m smokers in the domestic market according to a recent World Heath Organisation report.
More than 90% of the 250bn cigarette sticks produced each year is sold domestically, making Indonesia the world's fifth-largest market by volume after China, the US, Japan and Russia. In fact, Indonesia accounts for some 46% of all smokers found throughout South-east Asia.
Indonesia, despite lower retail prices, through the sheer volume sold, is also considered to be a top-10 global market by profit. The tobacco industry is also a key generator of tax revenue for the country and in 2007 was estimated to have contributed over $4.5bn in taxes – nearly 10% of all government tax earnings accrued.
While the majority of production is concentrated in the hands of a small group of players, insiders estimate that there are currently over 5000 different manufacturers of cigarettes; a phenomenon that can be largely explained by the current excise tax regime. As part of this programme, manufacturers are divided according to whether they are large, medium-sized or small. These three categories are then further subdivided according to the type of cigarette they produce.
The most popular variety is kretek, which accounts for nine out of 10 of all cigarettes sold. Kretek is made by blending tobacco, cloves, and other spices and dried fruits. The other variety sold is the more familiar "white" cigarette known throughout most of the Western world. For excise tax purposes, kretek are divided according to how they are made, resulting in three basic varieties: machine-made kretek, hand-made kretek and white cigarettes.
Excise duties, meanwhile, vary widely between types and sizes of manufacturer, with small-scale enterprises typically paying only 4% excise tax on hand-made kretek, while a large-scale manufacturer may pay 40% excise on the machine-made variety. For this reason, and given the fact that tobacco crops often command higher prices than other agricultural crops, many small-scale enterprises have set up in rural areas
Historically, the white cigarette and kretek markets have largely kept separate, with few smokers switching from one to the other. This has made it a tough market to penetrate for companies that seek solely to distribute their international brands in Indonesia.
The most significant kretek players in the Indonesian market are Sampoerna, Gudang Garam, Djarum, and Bentoel. Each have a long and rich history in the country, and are considered pioneers in the industry having achieved a strong and loyal following for their distinctive brands over the years.
With white cigarettes occupying only a minimal part of the market, major international firms are looking to buy into local players in order to gain access to the lucrative and growing kretek segment.
"The majority of growth in the market is coming from kretek," said Ian Morton, the president director of British American Tobacco's (BAT) Indonesia operations. "Smoking kreteks is an ingrained part of Indonesian culture."
In 2005, Philip Morris International (PMI), acquired 98% of Sampoerna's shares for $4,8bn. and has since turned the company into the local market leader with a 29% share of domestic sales. Gudang Garam and Djarum presently rank second and third, with approximately 21% and 19%, respectively, followed by Bentoel with 7%.
In mid-June of 2008, BAT acquired an 85% stake in Bentoel, with the announced intention of purchasing a full stake in the company by year-end. They have also indicated that they will be eyeing additional purchase opportunities should other companies present themselves. The purchase price of $480m is considered to be at a 20% premium over Bentoel's listed value, demonstrating the attractiveness the Indonesian kretek market presents. Global producers are experiencing falling sales in more developed markets such as the US and Western Europe due to growing health concerns, increased smoking bans, higher duties and advertising restrictions. In that sense, Indonesia represents a rare case of both a large and growing market in an industry that is retracting worldwide.
In conventional (white) cigarettes, PMI's Marlboro brand continues to have the largest share, with the company launching a Marlboro kretek line in 2008. BAT, meanwhile, has some 5% of the overall market.
A growing issue for the sector in recent years is tobacco advertising, with Indonesia so far not a signatory to the Framework Convention on Tobacco Control (FCTC). Over 162 countries to date have ratified the agreement, which requires members to raise the retail price of cigarettes and places restrictions on advertising and distribution channels. This has led to some disadvantages for international companies operating in Indonesia, as they are required to work to international FCTC standards. Local outfits may choose to advertise, for example, close to schools and colleges, while international firms adhering to home country restrictions may not. There is thus growing pressure for Indonesia to introduce stricter tobacco controls and sign up to the FCTC. Cigarette firms in Indonesia are estimated to spend $196m annually in advertising, which accounts for nearly 6% of total advertising expenditure.
Another issue is that of land use. Pressure on the land bank for food is increasing, yet while tobacco prices remain robust, farmers prefer to grow this crop instead. The government could eventually begin pressuring farmers to move away from tobacco planting, which will have consequences for supply.
For now, there are still plenty of opportunities in the sector, with growth in kretek smoking having jumped six-fold in the last 40 years. Some firms are also looking to move Indonesian smokers to higher-quality blends and types, and away from the high-tar and more unhealthy varieties.
A spokesperson for Djarum, which has been manufacturing kretek for over 50 years, explained to OBG that becoming leaner and more efficient through implementing research and development and manufacturing technology does not act as a hydrant to maintaining the traditional appeal of the kretek cigarettes produced. "In fact, technology helps enhance the appeal and experience of kreteks," said the spokesperson
Djarum, like other leading producers, is also exporting and marketing its kretek brands overseas. It cites Malaysia and the US as the most important international markets, with growth potential identified in emerging markets such as Brazil.
"Indonesia has the capability, should it choose, to produce high-quality tobacco and grow its market beyond the domestic arena," said Morton. BAT is currently involved in this process directly, seeking to develop new tobacco varieties across the country, while also exporting to other BAT operations in the region.
Indeed, the industry may be well placed to use its growing domestic market as a pair of strong shoulders to stand on in an effort to reach further into the regional and international markets in the years ahead.