Investing in Indonesia's cigarette companies

Sala Kannan - Mon 19 Jun, 2006

...Cigarette companies are the second largest employer in the country. And Indonesia's three biggest cigarette makers are also among the largest taxpayers...

- Indonesian households spend more on tobacco than they
do on clothing and meat. This bizarre fact does not
automatically mean that Indonesian cigarette stocks are
a great investment, but neither does it mean that they
are not. So I flew to Indonesia to find out for myself.

- Ironically, I arrived here in the capital city of
Jakarta on World Anti-Tobacco Day. But there is no such
thing in Indonesia...

- Cigarette companies are the second largest employer in
the country. And Indonesia's three biggest cigarette
makers are also among the largest taxpayers. The
industry contributes 12% of Indonesia's tax revenue.

- Smoking is a passionate pastime in Indonesia. The
thick, spicy smell of the country's clove-based "kretek"
cigarettes is everywhere. Children as young as 10 years
old smoke on street corners. And it seems like every
wall in Jakarta is plastered with kretek advertisements.

- Kreteks are made from a mixture of cloves and tobacco,
giving them a characteristic spicy flavour. 92% of all
cigarettes sold in Indonesia are kreteks. It is said
that an Indonesian called Nitisemito invented kreteks.
Claiming that cigarettes relieved his asthma, he mixed
tobacco with crushed cloves and rolled it in corn
leaves. He began selling these cigarettes in 1906. When
one smoked Nitisemito's corn husk-rolled cigarettes, the
burning husk made a "kretek-kretek" sound. Hence the
name.

- I met economist Kahlil Rowter to talk about
Indonesia's consumption trends. He brought along Rani
Sofjan, head of equity research at Mandiri Securities.
We met in Jakarta's Auto Mall - a shopping centre-cum-
car exhibition. On the first floor there were Isuzu,
Harley-Davidson, Suzuki and Nissan vehicles on display.
On the second floor was a line of shops and eateries.

- We sat down in a cafe and chatted over cappuccino and
camomile tea. "Do you mind if I smoke?" Kahlil asked,
pulling out a pack of Sampoerna 'A' Mild kretek
cigarettes. Around us, everyone in the cafe was lighting
up. A thick cloud of smoke hung over every table.

- Over 50% of Indonesians smoke. The evidence is
everywhere - in malls, on the roadside, after work,
during lunch - Indonesians are addicted to smoking. And
they start young. The Indonesian health department
estimates that 22.9% of urban 10-year-olds and 24.8% of
rural 10-year-olds smoke. I asked if there have been any
nonsmoking regulations. "Look at how full this cafe is,"
Rani Sofjan said, pointing with her Marlboro Light. "A
few months ago, the cafe tried to implement a no-smoking
rule. Its sales fell by half. Nobody wanted to come here
anymore if they couldn't smoke. Then it lifted the ban
and now business is good."

- "Guess why Indonesians smoke so much?" Rani asked. "We
are a Muslim country. We're not allowed to drink. So we
turn to the other vice - smoking," she laughed. And
although it is a health hazard, most smokers seem to
ignore the negative effects of smoking. "Nobody is
worried about dying from smoking when there is the bird
flu, earthquakes, volcanoes and tsunamis," said Rani.

- Such complacency on the part of Indonesian consumers
has only helped the cigarette makers. Sampoerna is
Indonesia's fastest-growing kretek maker. Its market
share has grown from 4% in 1992 to 25% today. In fact,
Sampoerna's growth and performance were so attractive
that tobacco giant Altria bought out the company last
year. The other significant players in the kretek market
are Gudang Garam and Djarum.  

- "Cigarettes are a good play on domestic consumption,"
said Kennyarso Soejatman, portfolio manager at First
State Investments Indonesia. "The commodity boom has
also put more money in people's hands," J.P.Morgan head
of equity research, Rizal Prasetijo, told me.
"Purchasing power is on the rise."

- Indonesia is a significant producer of oil and gas,
coal, copper and coffee. Record-breaking price increases
in all these commodities have improved revenues for
corporations and purchasing power for individuals.
Already, demand for kreteks is so high that Indonesia
has gone from a net exporter of cloves to a net
importer.

- Rizal also gave me an important investing tip: "Buy
stocks in the nontradable sector." Nontradables are
those goods that cannot be dumped in a foreign market
when there is excess production domestically. Rizal
explained, "For example, if Malaysia built excess
telephone lines, it couldn't bring them and sell them
here in Indonesia. So telecom is a nontradable sector.

- "If China built excess roads, it couldn't export the
excess, so infrastructure is a nontradable sector. So
are banking and real estate. The nontradables are
buffered from foreign competition...

- "Interestingly, kreteks are nontradable. If a foreign
country produced excess cigarettes, it would never be
able to export them to Indonesia, because Indonesians
don't smoke regular cigarettes. So our cigarette
industry is buffered from foreign competition."

- Kreteks in Indonesia are a classic case of emerging
market consumerism. Mark Mobius of Templeton Funds says,
"Commodities play a key role in an emerging-market
investment strategy. But just as important are the
consumer-oriented stocks." Mobius notes that spending
power among citizens in developing countries is rising
rapidly, and consumer-product companies are benefiting.

- Often, consumption patterns are culturally defined.
Like cigarettes in Indonesia, tortillas in Mexico or
Tata cars in India, looking for what an entire
population buys is a great starting point for scouting
out investment opportunities.


Regards,

Sala Kannan
for The Daily Reckoning