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April, 2007

Kretek Faces the Future

By Heneage Mitchell

The pungent clove cigarettes continue their domination of the Indonesian tobacco market.

Indonesia enjoys a long and exotic reputation as one of the world’s leading suppliers of spices. In fact, for centuries the more than 17,000 islands comprising the world’s largest archipelago have been known as the “Spice Islands.” The country is perhaps most well known for its pungent cloves, a mainstay of ancient trade routes and long a prized luxury in the kitchens and bakeries of the world.

It was only relatively recently, at the end of the 19th century, that cloves, long regarded as beneficial in the treatment of a variety of ailments, began to find their way into cigarettes, and only since the 1970s, when the first machine-rolled kretek first appeared on the market, that the pungent, sweet-smelling mixture of tobacco and cloves so beloved by Indonesians grew from a humble pleasure confined mainly to rural communities and exploded into the national market, stripping the previous almost total market share of white cigarettes down to today’s mere 7% or so.

There has never been a phenomenon like it in any tobacco market in the world, an almost universal acceptance of an alternative product to the white cigarette that has gained virtually complete dominance of the domestic market — in this instance, Indonesia, the world’s fifth largest consumer of tobacco products and one of the few markets that most analysts expect to continue adding new smokers to its ranks for the foreseeable future.

How it happened
Prior to the 1970s all kretek cigarettes were hand rolled and filterless.

“White cigarettes had the image in those days, kretek was simply regarded as a satisfying smoke,” said Muhaimin Moeftie, chairman of GAPRINDO, the white cigarette manufacturers association. “Many kretek smokers may even have been ashamed to smoke kretek in pubic, and preferred to be seen smoking white sticks. Kretek was more usually smoked in the privacy of one’s own home.”

This started to change in the early 1970s, when Bentoel introduced the first machine-rolled kretek, and hard packs became more common. By 1975, a new breed of machine-made, filtered kretek began to make inroads into white stick territory, employing good-looking packaging, sophisticated marketing, and a modern distribution network.

By 1980, kreteks had acquired their own positive image, and the advantage white cigarettes enjoyed in this respect diminished accordingly. For many Indonesians, kretek was simply a more enjoyable smoke than plain white cigarettes, and now they were able to smoke them openly as the social stigma attached to them was evaporating rapidly as new, sophisticated products were launched into the market.

By the early 1990s, kretek had joined the mainstream and was seriously undermining the white stick market share.

Prior to 1991, cigarettes were taxed uniformly based on packet prices, and kretek was taxed by volume (production capacity). Then the government started to experiment with excise structures on white cigarettes, which some analysts claim caused a favorable shift toward kretek for many consumers. Kretek prices at the time were fixed by the government, in part in recognition of the fact that the kretek industry directly employs around 500,000 Indonesians, primarily in the hand-rolling sector, a factor that remains highly relevant to this day. The supply and pricing of cloves, at that time a monopoly controlled by one of then-President Suharto’s sons, was fixed at different rates for different sized companies (the larger the company, the higher the rate), an effective way to ensure stable costs for the industry, and a further advantage for kretek manufacturers.

By 1999, the government “simplified” the excise rates across the board, combining tariffs for kretek and white sticks and establishing break-points based on production scale, setting the scenario for today’s multi-tiered approach.

The government regards the tobacco excise not as a “sin tax,” but rather as an effective way to meet tax targets. In the first years of this century, most especially between 2001 to 2003, the government repeatedly raised excise rates and changed the parameters of the tier structure, and in the process, according to many in the industry, created unnecessarily harsh conditions for larger manufacturers of both kretek and white sticks. A series of regular (up to three a year) and exorbitant (some as high as 20% or more) tax increases had a huge impact on industry volumes from 2001 until a “tax holiday” was imposed in late 2003, in part due to the outcry from the tobacco and related industries at the devastating effect the increases were having on their profitability as consumers down-traded to cheaper brands at the expense of the companies whose brand portfolios were unable to benefit from such moves. Most observers say that Sampoerna in particular benefited from possessing a portfolio that was able to absorb many of its competitors’ customers.

The tax holiday lasted until July 2005, when a 15% excise hike was imposed, but the industry is generally optimistic that the devastation caused by steep, regular excise increases is less likely to be repeated as the government may have learned not to kill the golden goose: The tobacco industry pays over Rp30 trillion (US$3.2 bn) to the government in excise revenues annually, excluding VAT receipts, accounting for about 10% of the government’s total revenue. The government expects to earn a record Rp38 trillion from tobacco excise in 2006.

The government has adopted the “banderol” as the most effective means of collecting excise. Banderols include the recommended retail price for the product they are attached to, and excise is collected based on this amount. Basically, manufacturers purchase banderols from the government and attach them to the packaging of the finished product. While the system can be abused (such as by placing banderols for lower-priced products on packaging), in general most industry players regard it as a fair and effective way to deal with government revenue collection.

The only problem is, since 1999, both kretek and white sticks manufacturers have been selling their products at less than the banderol price to subsidize their products in an effort to retain customers in a market that is largely cash-strapped and struggling to cope with inflation and soaring commodity prices.

“The increase in oil prices and commodities, the increased access to credit and a series of tax increases on tobacco products from 2001 to 2003 that amounted to around 30% compounded annually has left its mark on sales and affected consumer spending habits significantly,” said Lekir Daud, corporate and regulatory affairs director of BAT Indonesia. “Rising oil prices had a major impact as they eroded the disposable income of many consumers, removing an estimated US$8 to $10 billion of available spending power. The white stick market in particular suffered as economic realities forced many white stick smokers to downtrade to cheaper kretek.”

In Indonesia, kreteks are usually offered in packs of 16 or 12, and can be purchased individually, while white sticks are sold in packs of 20, making them a more expensive proposition altogether. White stick sales have seen a steady decrease in market share since a 25-year peak in 1998, when sales reached 31.5 bn against kretek’s 124.5 bn machine-rolled and 66.5 bn hand-rolled. Since then, sales of white sticks have declined annually to less than half of that figure today.

Mild phenomenon
Within the kretek sector, lights and milds have seen a staggering increase in market share since the introduction of A-Mild, the first “mild” kretek brand introduced by Sampoerna. The segment has since taken off, attracting smokers from both the kretek and white stick markets. In fact, with a market share of 17.2%, the mild kretek segment is the only segment to have posted a sustained year-on-year growth in both market share and volume. The segment includes brands from the “big four” kretek manufacturers such as Sampoerna’s A-Mild, Bentoel’s Star Mild and X-Mild, Djarum’s Djarum Lights, L.A. Lights, and L.A. Lights Menthol and Gudang Garam’s Deluxe Mild and Deluxe Menthol Mild.

“Light,” in the context of kretek, is a relative term: 12 to 15 mg of tar constitutes a “light” kretek. Nonetheless, mild kretek cigarettes are boosting the export potential of the four largest manufacturers as consumers around the world discover the sweet, aromatic alternative to white sticks.

Marketing restrictions hamper these efforts, although as Hadi Suryo, Djarum international sales manager, pointed out, “One needs simply to light up a kretek for the aroma to be noticed. After that, it’s simply a matter of pointing the customer in the right direction for him to be able to try one for himself. In that respect, a kretek’s sidestream smoke is one of our biggest allies in introducing kretek to new markets.”

Export markets
Existing markets outside Indonesia include Malaysia, which was the largest Asian market for most Indonesian kretek exporters until recent changes in the law and excise structure favored cigarette sellers maintaining production bases within the country.

“It is now impossible to compete in West Malaysia without a factory,” according to Chrisdianto Tedjawidjaja, a Bentoel director. “It is actually now cheaper to manufacture in Malaysia than to import product!”

While China represents an enigma for kretek manufacturers, Taiwan is seen as another potential Asia market, and Hong Kong and Macau are existing buyers of Indonesian cut-rag from Bentoel.

Djarum operates a factory in Brazil that supplies South American markets with its products, and the region in general is a popular destination for kretek exports. South Africa is perceived as the most promising potential market in Africa, while the Middle East has a solid kretek market share.

In general, any country that has a high number of Indonesian contract workers is likely to be a good export market, and to a large extent, it is the availability of kretek among this workforce that tends to introduce the products to a wider national market.

The United States is both a promising and a frustrating market for kretek. On the one hand, U.S. smokers have shown a willingness to try new smoking products and an interest in kretek in particular. On the other hand, there are significant challenges encountered satisfying existing legal requirements, such as the posting of bonds in states where products are sold in lieu of Master Settlement Agreement participation, and new issues, such as the inclusion of cloves in a list of “flavorings” that would be banned under the DeWine/Kennedy bill currently under consideration.

Europe — especially Holland, a traditional stronghold of kretek consumption thanks to ancient colonial ties, and Germany, which has seen positive growth over the last four to five years — is another promising market. Belgium and the UK are showing growth, although the markets are currently quite small, while Spain and France (although the French have shown a willingness to try and persist with kretek smoking) remain problematic as kretek manufacturers have little or no control over distributors, making distribution a haphazard, zero-marketing possibility game.

Russia’s tough regulations make it a difficult nut to crack, although market research is still ongoing, while Eastern Europe is another promising area, with the Czech Republic and Hungary having been recipients of kretek imports for the last four years or more. Meanwhile, market growth in Poland, the most recent country Djarum has targeted, has been “amazing,” according to Djarum’s Suryo.

Domestic issues
Indonesia did not ratify the FCTC and is therefore technically not bound to its suggestions or imperatives. Nonetheless, Indonesia passed some landmark legislation in 1999 that in part specified tar and nicotine levels. However, it was subsequently decided by the ministry of trade that “specific clauses on tar and nicotine levels would be impossible to achieve,” and these remain unlegislated until now.

The problem is that it is impossible to control the tar and nicotine levels in a hand-rolled kretek, and as an estimated 500,000 Indonesians work in the hand-rolled kretek segment, to enforce tar and nicotine levels would be to effectively spell disaster for the industry and put half a million Indonesians out of work, something no government is willingly going to do. Another less well-documented but easier to remedy problem is the lack of adequate testing equipment in government hands to ensure compliance.

Government regulation 19/2003 among others restricts advertising of cigarettes and tobacco products on TV and radio to between the hours of 9:30 P.M. to 5 A.M.

While technically there is no national legislation on billboard displays, other than that actual cigarettes cannot be displayed and 15% of the ad must display a health warning, recent legislation devolving certain powers to local administrations has seen some local laws enacted curtailing billboard advertising and smoking areas. For example, the governor of Jakarta has imposed a ban on billboards carrying tobacco advertising in the central business district of Jakarta once existing lease agreements expire, and he has created a new set of smoking ordinances banning smoking in education and health establishments and other buildings where children gather, up to the fences of such properties. Smoking is also banned on public transport in Jakarta, and the regulations stipulate that buildings must provide smoking areas inside the premises or provide a space outside for smokers. Other municipalities have passed similar legislation, although in some instances the regulations passed may conflict with existing national laws.

Currently the government is working on further comprehensive FCTC-inspired legislation strongly advocated by the Ministry of Health (MOH). The MOH has in fact revised its draft several times, perhaps an indication of its increasing understanding of the many unique problems and issues legislating against one of the nation’s largest income earners creates. Although the MOH would like to see the draft legislation before Parliament this year, in all probability it will be the third quarter of 2007 at the earliest before the bill is introduced for debate as there are “other, more important issues to be discussed.”

Proposals in the new draft Revision of Excise law introduced by the ministry of finance and scheduled for parliamentary discussion by the end of 2006 as it is regarded as an urgent piece of legislation include several issues of concern or interest to the tobacco industry including a mandatory minimum sentence of two to five years upon conviction for the sale or production of illegal (counterfeit) products, a move that many believe will give teeth to the current five-year maximum sentence and no mandated minimum sentence that is seeing convicted smugglers and counterfeiters escaping with sentences of a few months and fines less than the excise value of the products they are marketing illegally.

A rather more alarming proposal is the increase of the maximum excise rate from the current 55% to 65%, a move that could potentially open up the recent scars the harsh excise policies of 2001 to 2003 created.

Lastly, the draft seeks to reduce the credit terms for the purchase of banderols to two months across the board. Currently, machine-made kreteks have two months credit, while hand-rolled kreteks get three months to pay for their banderols. Analysts believe reducing credit terms for hand-rolled kreteks may cause negative repercussions for that segment of the industry.

One significant development in the face of impending additional legal constraints on the industry is the resolution and unity that the tobacco industry has shown in representing itself in discussions with the government.

All the tobacco companies see the need for effective and reasonable legislation, and are working actively though their respective trade associations (GAPRINDO for white sticks and GAPRI for kretek) to attempt to influence the government to develop legislation that will be effective and fair for all parties. One major milestone achieved recently is the cooperation between GAPRI and GAPRINDO.

“We were already thinking along the same lines, that we needed a task force to represent our respective constituencies,” said GAPRINDO’s Moeftie. “We share the same understanding of the issues, and neither association is allergic to any legislation, provided it is sensible. We will both accept any sensible legislation, but to arrive at it we propose to tell everyone concerned that we should be involved in all steps of the process directly or indirectly as a consultative body.”

Illicit trade
Although smoking remains a relatively cheap pastime compared to other countries in the region such as Singapore and consumer preferences revolve around kretek rather than white sticks, Indonesia has still seen a modest increase in both the number of illicit products intercepted and available in the market. BAT has seen its Ardath brand counterfeited in small numbers, and notes that the fake products it has encountered are improving over the years, in terms of product quality and packaging, although the best fakes do not reach the standards of taste and quality of the real thing.

While the numbers are thought to be low for smuggled and counterfeit cigarettes, one phenomenon that is growing is the so-called “copycat” brand segment. In essence, these are products bearing similar names to existing products, often presented in packaging that is very similar to the original products they seek to emulate. Copycat brands tend to focus more on kretek than while sticks, so Sampoerna’s premium Dji Sam Soe 234 might be suggested by a brand with similar packaging named Dji San So 235, for example. Aside from the obvious issues of trademark infringements and brand theft, the government is also losing money on these products as they are frequently untaxed or undertaxed.

Among other aspects of impending legislation is a “get-tough” policy on fake banderols and illicit traders in general, a strategy that has the whole-hearted support of legitimate manufacturers.

What other aspects of the current raft of legislation being considered will garner similar support from the industry remains to be seen and whatever does achieve it will no doubt be the result of continuing hard work behind the scenes by the likes of GAPRI, GAPRINDO, and industry lobbyists.

Tobacco International - April, 2007

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