tobacco coklat djarum splash djarum 76 djarum black tea djarum cherry l.a lights djarum special...

PLEASE SEE ANALYST CERTIFICATIONS AND IMPORTANT DISCLOSURES & DISCLAIMERS IN APPENDIX 1 AT THE END OF REPORT.

Tobacco companies covered in this report

Company name Ticker Rating Market cap (IDRbn)

Target price (IDR/share)

Gross margin (%) ROE (%) P/E (x) FY17F FY18F FY17F FY18F FY17F FY18F

HM Sampoerna HMSP Hold 494,351.8 4,310 24.3 24.1 37.6 39.4 36.9 34.3 Gudang Garam GGRM Trading Buy 155,033.4 91,000 21.5 21.9 17.5 18.8 20.5 17.8 Source: Mirae Asset Sekuritas Indonesia Research

Tobacco It’s all about the price tag

Hefty cigarette consumption in Indonesia

In Indonesia, tobacco industry is considered to be one of the largest industries, given the high domestic cigarette consumption. According to data from the Ministry of Agriculture, buying cigarettes makes up the third largest expenditure of Indonesians in their daily expenses, which indicates a buoyant demand for cigarettes. The habit of smoking has eventually shaped the culture and lifestyle of Indonesian consumers.

Indonesians’ love for kretek offers a natural barrier In total, there are c.34% of Indonesian population who smoke cigarettes, and c.94% of these smokers consume clove-flavored kreteks, or cigarettes made of tobacco and cloves. Speaking of the kretek industry itself, the hand-rolled cigarettes currently hold 20% of the market share, lower than the machine-made full-flavored cigarettes which hold 38% and machine-made cigarettes (SKM) with low tar nicotine which command 39%. The rest is insignificant, with non-kretek or white cigarettes holding only 6% of the total market share. It is clearly evident that the machine-made (SKM) type of cigarettes has gained market shares over the past 5 years, rising from a total 65% in 2012 to 77% at present. The majority of the rising market share is attributed to the full-flavored segment, which has increased by 10%p from 28% in 2012 to 38% in 2017. Given Indonesia’s high preference for clove cigarettes (kretek), we believe the country will continue to put up a natural barrier for white cigarettes (those composed of tobacco only) to gain market share. In addition, global players have tried to launch clove cigarette on their own, which turned out to be unsuccessful. Back in 1984, before acquiring HMSP, Philip Morris had tried to enter the clove cigarette market, which did not end up successful as Indonesian smokers still preferred locally produced clove cigarettes.

Favorable excise tax scheme for 2018F

In the latest PMK, the government stated that new brands’ minimum retail price should not be lower than the existing brands owned by the cigarettes manufacturers. Furthermore, the regulation now only allows for price discount within 15% of the minimum retail price suggested by government. We believe the government’s new regulation should benefit large cigarettes producers and bring disadvantages to smaller players which sell cigarettes at a discounted price. Furthermore, simplified excise tax brackets should benefit the bigger players. The government has planned to simplify the excise tax layers from 10 layers in 2018 to 5 layers in 2021.

Initiate with an overweight stance

All in all, given the favorable environment towards cigarettes sector, we initiate coverage on the tobacco industry with an overweight stance. Our top pick within the sector is Gudang Garam (GGRM/ Trading Buy/ TP IDR91,000).

Overweight

Initiation Report November 20, 2017

Mirae Asset Daewoo Co., Ltd. Consumer Christine Natasya +6221 515 1140 (ext. 233) [email protected]

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Mirae Asset Sekuritas Indonesia Research

C O N T E N T S

Overview of Indonesia tobacco 3 Indonesia’s tobacco industry is too big to ignore 3 Five major players in the industry 6 Cigarette types in Indonesia 10 Types of cigarettes 10 Cigarettes tax structure 13 Indonesia’s framework of regulations on cigarettes 21 Breakdown of cost of goods sold 23 Industry’s mid- to long-term outlook 26

HM Sampoerna (HMSP) 28 HM Sampoerna 29 Company background 29 HMSP’s key brand families 31 Management team 36 Competitive advantage 39 3Q17 Performance review 46 Financial Forecast 49 Valuations 51 HM Sampoerna (HMSP IJ/ Hold/ TP: IDR4,310) 52

Gudang Garam (GGRM) 55 Gudang Garam 56 Company Background 56 Management team 59 Competitive advantage 62 Financial forecast 66 Valuations 67 Gudang Garam (GGRM IJ/ Trading Buy/ TP: IDR91,000) 68

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Overview of Indonesia tobacco

Indonesia’s tobacco industry is too big to ignore

Hefty cigarette consumption

Located in Southeast Asia with five main islands, Indonesia ranks as the fourth most populated country in the world with more than 250mn inhabitants. This huge population base has led to high domestic consumption, totaling more than fifty percent of the nation’s economic output. Likewise, we believe that the country’s high population has contributed to its status as the fourth largest cigarette market in the world.

Figure 1. Contribution to GDP (%) Figure 2. Distribution of cigarette consumption

Source: Bloomberg, Mirae Asset Sekuritas Research

Source: The Tobacco Atlas, Mirae Asset Sekuritas Research

In Indonesia, tobacco industry is considered one of the largest industries, given the high domestic cigarette consumption, especially among Indonesian men. According to data from the Ministry of Agriculture, buying cigarettes makes up the third largest expenditure of Indonesians in their daily expenses, which indicates a buoyant demand for cigarettes. The habit of smoking has eventually shaped the culture and lifestyle of Indonesian consumers.

Figure 3. Percentage of average expenditure per capita per month

Source: Ministry of Agriculture, Mirae Asset Sekuritas Research

54%

7%

32%

Private consumption

Government spending

Investments

Inventories

Statistical discrepancy

Non-profit institutionsspending

Net exports

0%

5%

10%

15%

20%

25%

30%

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November 20, 2017


It is estimated that around 95% of Indonesian smokers are male, leaving their female counterparts measuring up to only c.5%. These figures may be related to the presumption that consuming cigarettes for women is less socially acceptable in Indonesia.

Indonesians’ love for kretek

In total, there are c.34% of Indonesian population smoking cigarettes, and c.94% of these smokers consume clove-flavored kreteks, or cigarettes made of tobacco and cloves. The Atlas, however, predicted that the number of smokers in Indonesia would grow by merely c.3% CAGR over the next eight years.

Figure 4. Estimated number of smokers in Indonesia

Source: The Atlas, Mirae Asset Sekuritas Indonesia Research

Speaking of the kretek industry itself, the hand-rolled cigarettes (sigaret kretek tangan/SKT) currently hold 17% of the market (Figure 6), lower than the machine-made full-flavored cigarettes (sigaret kretek mesin/SKM) which hold 39% and machine-made cigarettes (SKM) with low tar nicotine which command 39%. The rest is insignificant, with non-kretek or white cigarettes representing only 5% of the total market.

It is clearly evident that the machine-made (SKM) cigarettes have continued to gain market share over the past 5 years, rising from 65% in 2012 to 77.6% at present. This rising market share is mostly attributed to the full-flavored segment, increasing by 11%p from 28% in 2012 to 39% in 2017.

97

0

20

40

60

80

100

120

2000 2005 2010 2015 2020 F 2025 F

100mnEstimated no of smokers

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November 20, 2017


Figure 5. Cigarette market share (2012) Figure 6. Current market share (as of 2016)

Source: Company data, Mirae Asset Sekuritas Research


27%

28%

37%

7%

Hand rolled kretek (SKT)

Machine made kretek(SKM)- Full flavoured

Machine made kretek(SKM)- LTN

Non kretek (Whitecigarettes)

17%

39%

39%

5%

Hand rolled kretek (SKT)

Machine made kretek(SKM)- Full flavoured

Machine made kretek(SKM)- LTN

Non kretek (Whitecigarettes)

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Five major players in the industry

Indonesia’s tobacco industry is dominated by five large players that command a total market share of 81.9%. Key tobacco manufacturers include: 1) HM Sampoerna (HMSP), owned by Philip Morris International, with 33.1% market share; 2) Gudang Garam (GGRM) at 21.2%; 3) Djarum (not listed) at 18.6%, and 4) British American Tobacco Bentoel (RMBA) at 6.7%, and 5) Nojorono Tobacco Indonesia (not listed) at 2.8%. The remaining are smaller fragmented producers that hold 17.6% of the total market share. The fact that two of the largest cigarettes companies are among the ten largest Indonesian companies (in terms of market capitalization) listed on the Indonesia Stock Exchange (IDX) speaks for the massive size of Indonesian tobacco industry.

Figure 7. Market share of cigarette companies

Source: Company data, Bloomberg, Mirae Asset Sekuritas Research

Hanjaya Mandala Sampoerna (HMSP)

Hanjaya Mandala Sampoerna (HMSP) leads the industry by securing 33.1% of the total cigarette market share, winning particularly in the mild machine-made cigarette segment. HMSP is a subsidiary of PT Philip Morris Indonesia and an affiliate company of Philip Morris International Inc, the world’s prominent international tobacco company.

HMSP was established by Liem Seeng Tee, a Chinese immigrant who began his business by producing and selling hand-rolled kretek cigarettes at his home in Surabaya in 1913. His small business was among the first to manufacture and market kretek cigarettes under the brand Dji Sam Soe.

0

5

10

15

20

25

30

35

HMSP GGRM Djarum RMBA Nojorono Others

Market share (%)(%)

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November 20, 2017


Figure 8. HMSP’s Dji Sam Soe and A brands

Source: Company data, Internet, Mirae Asset Sekuritas Research

Gudang Garam (GGRM)

Gudang Garam was initially founded by Surya Wonowidjojo in Kediri, East Java in 1958. In 1979, the company’s first cigarette manufacturing machines were installed. The company has been listed on the Indonesian Stock Exchange (IDX) since 1990. GGRM produces a wide range of kretek cigarettes, including low-tar-low-nicotine variants (which are widely known to be light and mild), and traditional hand-rolled kretek cigarettes. The company stands out with its machine-rolled full-flavor brand, GG Surya.

Figure 9. GGRM’s brands


Djarum (not listed)

Djarum is the third largest cigarette company in Indonesia, founded by Oei Wie Gwan of the Hartono family in Kudus, Central Java, in 1951. Djarum’s leading brands include LA lights, Djarum Super, Djarum Super Mild, Djarum Coklat, and Djarum 76.

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November 20, 2017


Figure 10. Djarum’s domestic and international brands


Bentoel International Investama (RMBA/not rated)

The fourth largest cigarette producer in Indonesia is Bentoel (RMBA/not rated). Bentoel was established in 1930 by Ong Hok Liong, before being acquired by Rajawali Group in 1991. RMBA’s top-selling brands include Dunhill, Club Mild, Star Mild and Tali Jagat.

Figure 11. RMBA’s products


Djarum Super Djarum Black Djarum Bali Hai

Djarum Black Capucinno

Djarum Coklat

Djarum Splash

Djarum 76 Djarum Black Tea

Djarum Cherry

L.A Lights Djarum Special Djarum Vanilla

L.A Lights Menthol Djarum Light Djarum Menthol

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November 20, 2017


Nojorono Tobacco International

Nojorono, established in 1932, is located in Kudus, Central Java and is privately owned by five families, which collectively control the company’s management. The company’s market share has been declining from 5% in 2014 to merely 3% currently. Some of Nojorono brands are Djinggo and Clas Mild.

Figure 12. Nojorono brands


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Cigarette types in Indonesia

Types of cigarettes

Tobacco was first introduced to Asia in 1575, when the Spanish brought it to the Philippines. It first stepped on the land of Java (Indonesia) in 1601, brought by Portuguese traders. Therefore, the word tembakau (tembako in Javanese, and tobacco in English) is phonologically closer to the Portuguese word tumbaco. Cigarettes in Indonesia were initially home-produced; they were rolled and wrapped in dried cornhusk, banana, or palm leaves. They were later called kelobot (husk) in Javanese or strootje in Dutch. After a while, the strootjes made a comeback by mixing tobacco with clove buds.

Although in the seventeenth century cloves were already mixed with tobacco, clove cigarettes did not turn into a merchandise success before the 20th century. The first person taking a step in that direction was a man residing in Kudus (Central Java), who popularized clove cigarettes among his friends around 1870. The man had the idea to mix tobacco with cloves and started to sell the hand-rolled cigarettes. The new product was called rokok cengkeh, also known as kretek (clove cigarettes). The word kretek itself is an onomatopoetic term for the crackling sound of burning cloves. After his death in 1880, several other Kudus inhabitants started to produce their own clove cigarettes, which at that time were wrapped in cornhusk. The new product gradually gained popularity outside Kudus. It started off from a home industry which employed hand-operated rollers, while the factories performed the activities of collecting, controlling, packing, and distributing the product. Kretek industry was initially dominated by the Javanese, most of whom were Muslims living in Kudus and the surrounding regions. Later on, several Chinese entrepreneurs were attracted to enter the kretek industry and soon gained competitive advantage at an early stage of development. Indonesian Chinese entrepreneurs that have played an important role in the history of kretek industry are from the largest kretek companies, such as Djarum, Bentoel, Gudang Garam (GGRM), Sampoerna (HMSP).

Before 1968, kretek cigarettes were rolled by hand, and only after 1968 did kretek industry start using machines. At that time, three smaller companies located in Solo and Kudus, including Bentoel, one of the prevailing brand leaders, began to mechanize their production. Most of the larger enterprises which began producing cigarettes with machines in the 1970s and 1980s were Djarum (1976), GGRM (1979), and HMSP (1983). Currently, kretek cigarettes are either hand-rolled or machine-rolled and wrapped like conventional cigarettes in cornhusks or in white, black, or brown paper. In addition, they are manufactured both with and without filters. At present, clove-typed or kretek cigarettes, made of tobacco and cloves and blended with other flavors, are apparently the most popular tobacco products in Indonesia.

Furthermore, in terms of cigarette segment, there are presently 5 major types of cigarettes, specifically segmented into two types, namely machine-rolled (SKM) and hand-rolled (SKT).

Rokok Klobot Kretek (KLB) - cornhusk paper that are made by hand

White cigarettes - Sigaret Putih Mesin (SPM)

Hand rolled cigarettes - Sigaret Kretek Tangan (SKT): filterless kretek

Filtered hand rolled cigarettes - Sigaret Kretek Tangan Filter (SKTF): hand-rolled, filter-tipped kretek

Machine rolled cigarettes - Sigaret Kretek Mesin (SKM): machine-rolled, filter kretek that is often identical to white cigarettes in appearance and divided into: 1) lower tar and nicotine (LTLN), containing only 14-15mg and 1mg respectively; 2) mid tar nicotine, containing only 18-25mg and 1.2-1.7mg respectively; and 3) full-flavored, containing only 31-32mg and 1.8-2.2mg respectively.

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Table 1. Machine-rolled cigarettes

Type Tar Nicotine

Lower tar and nicotine (LTLN) 14-15mg 1.0mg Mid tar nicotine 18-25mg 1.2-1.7mg Full flavored 31-32mg 1.8-2.2mg Source: Mirae Asset Sekuritas Research

A natural barrier for foreigners to compete

Given Indonesia’s high preference for clove cigarettes (kretek), we believe the country will continue to put up a natural barrier for white cigarettes, the ones composed of tobacco only, to penetrate the market at a higher rate. As of 2016, cloves cigarettes accounted for more than 80% of HMSP sales, and GGRM had no white cigarettes in their product line up (100% kretek). In addition, global players have tried to launch clove cigarettes on their own, but their attempts failed. Back in 1984 before acquiring HMSP, Philip Morris had tried to enter the market with their own clove cigarettes, which did not end up successful as Indonesian smokers still preferred locally produced clove cigarettes.

Figure 13. HMSP’s revenue breakdown Figure 14. GGRM’s revenue breakdown



Table 2. Fact findings about cigarettes

No. Facts

1 Cigarettes are generally divided into 3 groups: mild cigarettes, clove cigarettes and white cigarettes.

2 Mild cigarettes contain the lowest level of tar and nicotine content compared to clove cigarettes, and this is well controlled / guaranteed by the manufacturer, becoming the selling points of these products in the name of health issues (according to some research, tar and nicotine are usually related to cancer diseases).

3 Mild cigarettes have c.14-15mg of tar and 5mg of nicotine. Because of its lower tar and nicotine content, compared to kretek, mild cigarettes are associated with the word light, for instances, LA Light and Marlboro Light.

4 The light content of tar and nicotine is made possible through: (a) a further processing of tobacco before finely chopped into powder structure; and (b) the use of filter technology by wrapping the end of cigarette sticks with foam in order to filter out the nicotine and tar (research has proven this to be effective).

5 White cigarettes are cigarettes that contain only tobacco, while clove cigarettes are cigarettes containing both tobacco and cloves.

6 Kretek cigarettes have about 20mg of tar and 4-5mg of nicotine. The tar and nicotine content is larger than that of mild cigarettes, so kretek cigarettes are said to have even worse effects on people’s health than regular cigarettes due to its higher percentage of tar and nicotine. An example of kretek cigarettes brands is Dji Sam Soe (owned by HMSP).

7 Kretek cigarettes are made with a blend of tobacco, cloves and other flavors. The word kretek itself is an onomatopoetic term for the crackling sound of burning cloves.

Source: Internet, Mirae Asset Sekuritas Research

90%

9%1%

Machine-madeclove cigarettes

Hand-rolled clovecigarettes

Corn silk clovecigarettes

Paperboard

Others

64%

20%

Export

Machine-madeclove cigarettes

Hand-rolledclove cigarettes

White cigarettes

Others

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November 20, 2017


Distribution channels for tobacco

According to Euromonitor, traditional grocery retailers, which mostly comprise toko kelontongan (small grocery stores that sell all the basic needs), remained the most important distribution channel for tobacco in Indonesia in 2016. Besides selling cigarettes directly to consumers, these outlets also sell cigarettes in bulk to traditional street-side kiosks, which are known as warung, as well as street vendors (pedagang asongan). Although supermarkets, hypermarkets and especially convenience stores have improved significantly as distribution channels for tobacco over the review period, traditional grocery retailers still held onto the biggest volume share during the year.

We believe street vendors and warung are key distribution channels for tobacco manufacturers as cigarettes volume growth largely comes from single cigarettes sold by street vendors to individual buyers who tend to purchase cigarettes per stick rather than per pack.

Figure 15. Warung Figure 16. Street vendors

Source: Various internet sources, Mirae Asset Sekuritas Indonesia Research

Source: Various internet sources, Mirae Asset Sekuritas Indonesia Research

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November 20, 2017


Cigarettes tax structure

Indonesian government has been pushing to raise health awareness

Research by The Tobacco Atlas revealed that more than 200,000 Indonesians die from tobacco-related diseases every year. In response to the health issues, Indonesian government has been pushing to raise awareness of the health hazards of smoking to reduce cigarette consumption, following the lead of many other places in the world.

The government has also put regulations in place affecting the tobacco industry, such as increasing the number of smoke-free areas, imposing a time limit on TV cigarette advertisements, and hiking cigarette excise taxes which are widely known as cigarettes’ excise duty ribbons that comprise of: 1) excise tax; 2) cigarettes tax (10% of excise tax); and 3) VAT. For the VAT calculation, Indonesia uses banderol price (suggested retail price from government’s regulation (Peraturan Menteri Keuangan/PMK)) as the reference price. In some cases, the actual retail price for a pack of cigarette might be lower than the banderol price (eg: GGRM’s Surya Pro Mild is priced lower than its banderol price), which we believe is a strategy in order to increase its sales volume. Note that Surya Pro Mild’s price is still within the maximum 15% discount of the minimum retail price. Cigarettes are only subject to a one-time VAT at the producer level, and the current rate is 9.1% of the banderol price (suggested retail price).

We believe the government has, to some extent, achieved one of its goals, given the declining volume growth in the industry in the recent years. In 2016, the volume growth in Indonesia’s cigarette industry was stagnant at 1% YoY. Moreover, in 2017, Philip Morris International estimated the country’s cigarette volume to decline by around 3% YoY. On a separate note, for 2018, the government also forecasts industry sales volume to decline by 3% YoY. We expect muted growth next year, as we believe the pre-election year would drive up consumer demand, especially cigarettes.

Figure 17. Cigarettes sales volume

Source: Ministry of Finance, Mirae Asset Sekuritas Indonesia Research

-3%

-3%

-2%

-1%

0%

1%

2%

3%

296

298

300

302

304

306

308

310

312

314

316

2012 2013 2014 2015 2016 2017F 2018 F

Cigarettes sales volume (L) Volume growth (R)(Bn Sticks)

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November 20, 2017


Excise tax is one of the revenue sources for the government

Furthermore, as the government needs revenue to perform its tasks and functions, tax becomes one source of revenue (as it contributes to more than 80% of the total state’s annual budget revenue), and excise tax is one of the income sources of the tax revenue. More than 90% of Indonesian government’s customs revenue comes from cigarette taxes, and cigarette excise tax contributes to c.10% of total state’s tax revenue.

Figure 18. Tax as % of state revenue Figure 19. Cigarette tax as % of total excise tax revenue



Table 3. Government revenue from tax

2012 2013 2014 2015 2016 2017F 2018F

Total tax revenue (IDRtr) 981 1,077 1,147 1,226 1,285 1,473 1,609

Excise tax revenue (IDRtr) 95 108 118 128 144 153 155

Cigarettes tax revenue (IDRtr) 91 104 113 123 138 148 148 Source: Ministry of Finance, Mirae Asset Sekuritas Indonesia Research

Figure 20. % of excise tax to total tax revenue Figure 21. Gov’t revenue generated mostly from tax



7.8%

11.2%

9.7%

6%

7%

8%

9%

10%

11%

12% % excise tax to total tax revenue

11.2%

9.7%

9%

9%

10%

10%

11%

11%

12%

-

200

400

600

800

1,000

1,200

1,400

1,600

2012 2013 2014 2015 2016 2017F 2018F

Excise tax revenue (L) Other tax revenue (L) % Excise to total tax revenue (R)(IDRtr)

70%

72%

74%

76%

78%

80%

82%

84%

86%

88%

-

200

400

600

800

1,000

1,200

1,400

1,600

1,800

2,000

2012 2013 2014 2015 2016 2017F 2018F

State revenue (L) Tax as % of state revenue (R)(IDRtr)

95

155

95%

95.5%

95.3%

96.0%

96.1%

95.4%

94.6%

94.8%

95.0%

95.2%

95.4%

95.6%

95.8%

96.0%

96.2%

96.4%

-

20

40

60

80

100

120

140

160

180

2012 2013 2014 2015 2016 2017F 2018F

Excise tax revenue (IDRtr)

%Cigarette tax revenue to total tax revenue

(IDRtr)

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November 20, 2017


Indonesia implements a tiered tax system for cigarettes excise tax

Excise taxes on cigarettes have been levied on Indonesia’s cigarettes since early 1900s. In 1932, the tax rate was the same for all types of tobacco products, which was c.20%. Nevertheless, since 1936, a tiered tax system for cigarettes was instigated with regards to the following types of products: hand-rolled kretek (tobacco and clove cigarettes), klobot (kretek wrapped in cornhusk), and white cigarettes (tobacco only). Later on, differential excise tax rates for both hand-rolled and machine-rolled kreteks were introduced to the industry.

In the 1970s, the tax system was modified based on: 1) production volume; 2) cigarette type (hand-rolled kretek, machine-made kretek, or machine-made white cigarettes); and 3) price, with the highest tax rates corresponding to companies with the highest production volume. We believe that hand-rolled products and companies with smaller scale production levels have consistently enjoyed the most favorable tax rates and that smaller cigarette producers enjoyed higher margins due to less excise tax paid compared to bigger players.

The excise taxes for machine-made, hand-rolled and white cigarettes have increased by an average of 10% (see Figure 27). Nevertheless, the excise tax increase for hand-rolled cigarettes has remained relatively low than that of the machine-rolled cigarettes and white cigarettes in the past three years (Figure 23). The lower excise tax increase for hand-rolled cigarettes is most likely because the hand-rolled segment is already contracting, whereas the machine-made cigarettes volume is still growing. In addition, we believe the government continues to favor the smaller and hand-rolled cigarette factories since they are more labor-intensive.

Figure 22. Cigarette excise tax per stick by category

Source: Ministry of Finance, Customs and Excise Tax Office, Mirae Asset Sekuritas Indonesia Research

2009 2010 2011 2012 2013 2014 2015 2016 2017 2018(PMK

203/ 2008)(PMK

181/2009)(PMK

190/2010) (PMK

167/2011) (PMK

179/2012)(PMK

179/2012) (PMK

205/2014) (PMK

198/2015) (PMK

147/2016) (PMK

010/2017)(sticks) (IDR/stick) IDR IDR IDR IDR IDR IDR IDR IDR IDR IDR

A 290 310 325 355 375 375 415 480 530 590B 280 300 315 345 480C 260 280 295 325

895 A 210 230 245 270 285 285 305 340 365 385B 175 195 210 300 335 370C 135 155 170A 290 310 325B 230 275 295 625C 185 225 245

935 A 170 200 215 235 245 245 270 255 330 370B 135 165 175 190 290 355C 80 105 110 125

1,260 A 200 215 235 255 275 275 290 320 345 365B 150 165 180 245 265 290C 130 145 155A 90 105 110 125 130 130 140 155 165B 80 95 100 115 120 120 140 155C 75 90 90 105 110 110

III A>50mn but not more

than 350mnA 40 65 65 75 80 80 85 90 100

III B Not more than 50mn B 80 80 80No of layers 19 19 19 15 13 13 13 12 12 10

1,120

245 265

Type of cigarettes Group Production group Government's retail

price (HJE)Banderol

Tier

Machine rolled

I >3bn

365 380

355 355 415

II Not more than 3bn715-895 235 245

380 425

II Not more than 3bn640-935 195 195

I >3bn 1,130

220

Hand rolled

I >2bn890-1260 195 205 205 220

White cigarettes

II>50mn but not more

than 2bn

100

180125

495 555

470

400

Tobacco

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November 20, 2017


Figure 23. Cigarette excise tax increase by category


Tax revenue is expected to move up in parallel with the state budget growth; hence, higher excise tax every year is deemed to be normal as the government also needs to increase their state revenue. However, we view higher taxes for high-end cigarettes as a double-edged sword for the government, as they would incentivize the growth of illicit cigarette market as some smokers turn to cheaper illegal cigarettes given the tax rate gap between high-end and low-end cigarette are pretty huge. Therefore, in five years ahead, the government has been proposing to cut the number of excise tax layers into five, from previously nineteen (in the past eight years), in order to close in the gap of the cigarette tax rates, which inevitably has forced the number of smaller players in the industry to increase prices and lose competitiveness against the bigger players. We have seen government’s advancement to simplify the tax structure. For 2018F, the government has reduced the excise tax layers further into 10 from 12 in 2017.

Type of cigarettes 2009 2010 2011 2012 2013 2014* 2015 2016 2017 2018(PMK

203/ 2008)(PMK

181/2009)(PMK

190/2010) (PMK

167/2011) (PMK

179/2012)(PMK

179/2012) (PMK

205/2014) (PMK

198/2015) (PMK

147/2016) (PMK

010/2017)(sticks) (IDR/stick)

Machine rolled I >3bn A 7% 5% 9% 6% 0% 11% 16% 10% 11.3%B 7% 5% 10% 3% 0% 17%

(SKM) C 8% 5% 10% 9%II Not more than 3bn 895 A 10% 7% 10% 6% 0% 7% 11% 7% 5.5%

B 11% 8% 13% 12% 10%C 15% 10%

White cigarettes I >3bn A 7% 5%B 20% 7%

(SPM) C 22% 9%II Not more than 3bn 935 A 18% 8% 9% 4% 0% 29% 12%

B 22% 6% 9% 3% 0% 14% 22%C 31% 5% 14%

Hand rolled I >2bn 1,260 A 8% 9% 9% 8% 0% 5% 10% 8% 5.8%B 10% 9% 8% 5% 0% 11% 8% 9%C 12% 7% 26%

(SKT) II >50mn but not more A 17% 5% 14% 4% 0% 8% 11% 6%than 2bn B 19% 5% 15% 4% 0% 12% 11%

C 20% 0% 17% 5% 0%

III A>50mn but not more

than 350mnA 63% 0% 15% 7% 0% 6% 6% 11% 0%

III B Not more than 50mn B 0% 0%Simple average 17% 6% 12% 5% 10%* 9% 11% 11% 10%

Group Production group Government's retail

price (HJE)Banderol

Tier

400

9%

715-895

1,130

640-935

890-1260

470

16%

12% 4% 0% 12% 12.6%

12% 4% 0% 8%

13%

7%

4%

12%16%

1,120

Tobacco

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November 20, 2017


Government to increase excise tax by 10.04% in 2018F

In the proposed state budget for 2018 (RAPBN 2018), the government expects excise duty revenue target to increase by only 1.5% YoY (from APBNP 2017), with cigarette tax revenue increasing by merely 0.5% YoY. According to Ministry of Finance Regulation No. 146/ PMK 010/ 2017, the government sets the 2018F excise tax per stick to increase by an average of 10.04%. We believe the government is anticipating a small increase in cigarette excise tax revenue due to their expectation of lower volume next year. Therefore, an average excise tax increase of 10.04% should rather be viewed as in line since it is already below this year’s excise tax hike of 10.5%.

The highest excise tax is applicable to white cigarette (SPM) at 12.6%, which we believe will hurt SPM cigarette volume further. As of 9M17, total industry’s white cigarette volume has already dropped by 16% YoY with HMSP’s SPM volume declining by 25%YoY. On the other hand, government is supporting the SKT segment by setting the lowest excise tax increase of a mere 5.8% YoY for the highest tier of hand-rolled (SKT) cigarettes. Furthermore, the highest tier of machine-rolled (SKM) cigarette segment which increases by 11.3% YoY (Figure 23) will likely lead to a flat volume growth next year.

Figure 24. Cigarette tax revenue in 2018 draft state budget Figure 25. Tax as % of GDP


Source: Ministry of Finance, Bloomberg, Mirae Asset Sekuritas Indonesia Research

Figure 26. Cigarettes industry volume growth (yoy)

Source: PMI US, Mirae Asset Sekuritas Indonesia Research

6.9%

0.5%

0%

2%

4%

6%

8%

10%

12%

14%

16%

-

20

40

60

80

100

120

140

160

LKPP 2012 LKPP 2013 LKPP 2014 LKPP 2015 LKPP 2016 APBNP 2017 RAPBN 2018

Cigarettes tax revenue (L) Cigarettes tax revenue growth (R)(IDRtr)

11.4%

10.6%

10.4%

8.0%

8.5%

9.0%

9.5%

10.0%

10.5%

11.0%

11.5%

12.0%

12.5%

-

200

400

600

800

1,000

1,200

1,400

2008 2009 2010 2011 2012 2013 2014 2015 2016

Total tax revenue (IDRtr) tax as % of GDP(IDRtr)

-1.6%

-4.7%

-16.4%

-3.1%

-25%

-20%

-15%

-10%

-5%

0%

5%

1Q16 1H16 9M16 FY16 1Q17 1H17 9M17

SKM SKT SPM Industry

Tobacco

18

November 20, 2017


In addition, the increased cigarette excise tax is actually normal as it usually hovers at 8-12% YoY. Thus, its recent change to an incremental excise tax scheme indicates the government’s support for the consolidation in the industry. In our view, the number of illicit cigarettes traders in Indonesia has become one of the government’s reasons to aggressively raise the excise tax. Hence, we believe that cigarette tax increase can limit the number of illicit cigarette companies since, assuming they are selling at the same price, consumers would prefer buying bigger cigarette brands.

Figure 27. Excise tax hike per year


As the excise tax makes up c.70% of cigarette companies’ cost of revenue, the expectation of 10% excise tax growth should hurt companies’ cost of sales, as well as their margin (assuming that tobacco and clove prices will remain the same next year). However, in order for those cigarette companies to retain their margins, we expect that cigarette companies need to raise ASP by c.8% in 2018F to compensate for the excise tax increase.

For 2018F, we expect a muted volume growth as we anticipate moderate cigarette consumption during the pre-election year. We note that in 2016, cigarette tax collection missed the target of the initial state budget by 7.3%, which we attribute to weak volume growth. Meanwhile, we believe the cigarette excise revenue would miss the revised state budget in 2017 by c.5%. This fact, coupled with aggressive excise tax hike, means that we expect a lower realization of their budget as we expect a muted volume growth. In the long run, given the shortfall of state budget as well as the declining tax revenue as % of GDP, we view that excise tax increase will likely pose more risks for the cigarette sector.

0%

2%

4%

6%

8%

10%

12%

14%

16%

2010 2011 2012 2013 2014 2015 2016 2017 2018F

Excise tax hike average

Tobacco

19

November 20, 2017


Low tobacco tax rate as % of government retail price We see that Indonesia’s excise tariff as % of government retail price has been volatile. However, although the increase in tax rates between the year of 2015 and 2017 was quite significant, the excise tariff as a percentage of the government retail prices went down. We believe this is mainly due to the fact that, in absolute terms, Indonesia’s cigarette manufacturer has been able to overcome the excise tax hike, as the price increase was larger than the tax increase, which in turn diminished the effect of the excise tariff hike.

Nevertheless, Indonesia has presently been capping its tobacco excise tariff rate as % of government retail price at 57% according to PMK No146/PMK.010/2017. The tobacco tax as % of government retail price is much lower than the WHO benchmark, set at 75%. Therefore, we believe that at the current level, Indonesia’s tobacco industry seems to have a better taxation scheme, compared to the neighboring countries, such as Vietnam and Malaysia.

Table 4. Excise tax increase and tariff as % of Gov’t retail price

2009 2010 2011 2012 2013 2014 2015 2016 2017F 2018F

Government regulation (PMK

203/2008)

(PMK

181/2009)

(PMK

190/2010)

(PMK

167/2011)

(PMK

179/2012)

(PMK

179/2012)

(PMK

205/2014)

(PMK

198/2015)

(PMK

147/2016)

(PMK

010/2017)

Excise tax hike (average) 17.0% 6.0% 11.5% 4.8% 0.0% 9.4% 11.3% 10.5% 10.0%

VAT 8.4% 8.4% 8.4% 8.4% 8.4% 8.4% 8.7% 9.1% 9.10%

Tax rate - - - - 10% 10% 10% 10% 10%

Machine-rolled excise tax per stick

(>2bn of produced sticks)

290 310 325 355 375 375 415 480 530 590

Machine-rolled (>2bn of produced

sticks) excise tax increase

7% 5% 9% 6% 0% 11% 16% 10% 11%

Gov’t retail price increase 0% 0% 0% 1% 0% 20% 25% 12% 0%

Excise tariff as % of Gov’t retail price (HJE) on machine-rolled cigarettes

43.9% 47.0% 49.2% 53.8% 56.1% 56.1% 51.9% 48.0% 47.3% 52.7%

Source: Peraturan Menteri Keuangan, Mirae Asset Sekuritas Indonesia Research estimates

Figure 28. Excise tariff as % of government retail price

Source: Director General of Customs, Mirae Asset Sekuritas Research

57.5%

0%

10%

20%

30%

40%

50%

60%

70%

80%

http://www.jdih.kemenkeu.go.id/fullText/2017/146~PMK.010~2017Per.pdf

Tobacco

20

November 20, 2017


Along with the excise tax, the government also increased the 2018F minimum retail price (HJE) by 3.7% for hand-rolled cigarettes to IDR1,260/stick and by 9.7% for white cigarettes to IDR1,130/stick. Meanwhile, the minimum retail price for machine-rolled (SKM) cigarettes is flat at Rp1,120/stick (figure 29). The government also stated that new brands’ minimum retail price should not be lower than the existing brands owned by the cigarettes manufacturers. Furthermore, the regulation now only allows for price discount within 15% of the minimum retail price suggested by government. We believe this new regulation should benefit big cigarettes players and bring disadvantages to smaller players which sell cigarettes at discounted prices. In addition to that, the simplified excise tax brackets should benefit the bigger players. The government has planned to simplify the excise tax layers from 10 layers in 2018 to 5 layers in 2021.

Figure 29. Minimum retail price (HJE)

Source: PMK, Mirae Asset Sekuritas Indonesia Research

Table 5. Government’s simplified excise tax structure

Year # of Layer

2018F 10 2019F 8 2020F 6 2021F 5 Source: PMK, Mirae Asset Sekuritas Indonesia Research

-

200

400

600

800

1,000

1,200

1,400

Machine-rolled cigarettes White cigarettes Hand-rolled cigarettes

2017 2018IDR/stick

Tobacco

21

November 20, 2017


Indonesia’s framework of regulations on cigarettes

Until now, Indonesia has not yet signed the Framework Convention on Tobacco Control (WHO FCTC), which is the first global public health treaty under WHO. The FCTC is a health treaty under WHO that lays out specific regulations for any countries to help protect the consumers.

Table 6. Framework Convention on Tobacco Control

No Regulations

1 Protect from exposure to tobacco smoke in indoor workplaces, public transport, indoor public places and, as appropriate, other public places;

2 Eliminate illicit trade of tobacco products, including smuggling, illicit manufacturing and counterfeiting, and the development and implementation of related national law ;

3 Undertake a comprehensive ban on all tobacco advertisings, promotions, and sponsorships; 4 Limit tobacco product packaging and labelling in order to minimize promoting tobacco products by any means that are

false, misleading, deceptive or likely to create an erroneous impression about its characteristics, health effects, hazards or emissions, including any term, descriptor, trademark, figurative or any other signs that directly or indirectly create the false impression that a particular tobacco product is less harmful than other tobacco products, including terms such as “low”, “light”, “ultra-light”, or “mild”;

5 Apply health warnings describing the harmful effects of tobacco use, and these may include other appropriate messages covering at least 30% of a cigarette pack;

6 Implement tax policies on tobacco products so as to contribute to the health objectives aimed at reducing tobacco consumption.

Source: WHO FCTC, Mirae Asset Sekuritas Indonesia Research

While there are 181 countries that have signed the treaty by 2016, Indonesia is among the few that have not done so. This is not surprising since the president, Jokowi, wants to protect the livelihood of tobacco farmers and cigarettes industry’s labors.

In return, Jokowi proposed a regulation to: 1) reduce imported tobacco; 2) increase excise tax on imported tobacco; 3) increase the cigarette excise tax rate; and 4) limit public smoking space. In addition to that, through PP No 19/2003, the government has been slowing down cigarettes growth in order to maintain the consumers’ health by controlling the content of nicotine and tar levels, giving certain requirements for companies in producing cigarettes, as well as limiting cigarettes advertisements and promotions. Therefore, we believe if the FCTC is signed, the impact would be rather minimal as Indonesia has already complied with many of the FCTC regulation requirements.

Nonetheless, in addition to supporting local farmers and the cigarette industry, which therefore will benefit big players, we believe that the government recently seems to also encourage industry consolidation by lowering excise tax rates on tobacco, as well as proposing to cut the number of layers of excise taxes into 10, from previously twelve. Moreover, the government proposed the tax layer to be cut into only five in the next five years.

We believe that the smaller number of tax layers would close in the wide price gaps among cigarette brands as smaller players will have to increase their average selling prices (ASPs) and thereby lose their competitive pricing over the bigger companies. We also believe that the lesser number of layers will impel the government to control the emergence of smaller cigarette companies. Indeed, according to the Director General of Customs, the number of tobacco factories has decreased from 4,198 in 2006 to only 713 in 2015.

http://www.who.int/fctc/about/WHO_FCTC_summary_January2015.pdf?ua=1

http://www.who.int/fctc/about/WHO_FCTC_summary_January2015.pdf?ua=1

https://luk.staff.ugm.ac.id/atur/PP19-2003PengamananRokokBagiKesehatan.pdf

Tobacco

22

November 20, 2017


Figure 30. Decreasing number of tobacco factories

Source: Director General of Customs, Mirae Asset Sekuritas Research

4,198

713

-

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

5,000

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Number of tobacco factories

Tobacco

23

November 20, 2017


Breakdown of cost of goods sold

Excise duty ribbons which include: 1) excise tax, 2) VAT, and 3) cigarettes tax constitute the largest cost components for both HMSP and GGRM (see Figures 31 and 32). Given these largest components of cost of revenue, we believe that a significant increase in excise tax will pose the ultimate risk for the company.

Following the excise duty ribbons (comprising of more than 70% of cigarettes companies’ COGS) as the second largest components of cost of revenue for those cigarettes companies are tobacco (c.10-11% of total COGS) and cloves (4-5% of total COGS).

Figure 31. HMSP’s COGS breakdown as of 2016 Figure 32. GGRM’s COGS breakdown as of 2016

Source: Company data, Mirae Asset Sekuritas Indonesia research


Almost all cloves are locally sourced. On the contrary, due to lack of supply, tobacco leaves are mostly imported, with an exception to GGRM, which sources most of its tobacco leaves locally. The company stated that they want to source everything locally to maintain their costs in Rupiah base. In addition, the company believes that buying tobacco locally would support the livelihood of local tobacco farmers who are mostly kretek smokers.

Figure 33. Indonesia’s tobacco suppliers Figure 34. Indonesia’s import volume of estate crops commodities (Ton)

Source: Kata Data News and Research, Mirae Asset Sekuritas Indonesia

Source: Ministry of Agriculture, Mirae Asset Sekuritas Indonesia research

10%

5%

71%

14%

Tobacco

Cloves

Excise dutyribbons

Others

11%

4%

74%

11%

Tobacco

Cloves

Excise dutyribbons

Others

-

5

10

15

20

25

30

35

40

45

'000 Ton

-

20,000

40,000

60,000

80,000

100,000

120,000

140,000

160,000

2011 2012 2013 2014 2015

Tobacco Clove(Ton)

Tobacco

24

November 20, 2017


We predict the volatility of raw material prices (tobacco and clove) to also be a threat to cigarette companies, although less significant compared to the excise given the smaller composition to the total cost of goods sold (COGS). Nonetheless, in our view, cigarette companies will gradually pass on this cost increase to the consumers. We also believe that HMSP has a greater import component compared to GGRM, provided the global supply chain from Phillip Morris.

Table 7. Component of tobacco and cloves in different types of cigarettes

Types of cigarettes Component Tobacco & Cloves composition

SKT 2gr ±60% tobacco ±40% cloves

SKM – Full flavored 1gr ±70% tobacco ±30% cloves

SKM – Light & Mild Less than 1 gr ±70% tobacco ±30% cloves

Source: Company data, Mirae Asset Sekuritas Indonesia Research

Furthermore, the prices of cloves are typically believed to be more volatile than tobacco leaves as big cigarette companies normally purchase tobacco leaves in bulk to support their raw material continuity since demands may spike up suddenly, given the harvesting season which is only yearly. Tobacco leaves can be stored for nine months to up to three years. Currently, tobacco leaves can only be found in five main regions, namely Bojonegoro, Lombok, Temanggung, Jember and Paiton (East Java).

On the contrary, cloves are available throughout Indonesia that its harvesting months are spread within a year. Therefore, unlike the tobacco leaves, big cigarette companies do not normally keep cloves up until three years (usually c.9month -14 months).

Currently, Indonesia’s clove production is roughly between 70,000MT ~100,000 MT, depending on the climate. The majority of the production (c.90%) is consumed locally by cigarette manufacturers of various local and international brands. In 2011, Indonesian Clove Farmers Association (Asosiasi Petani Cengkih Indonesia/APCI) requested the government to import clove as the nation's harvest was poor and could only supply 30% of the tobacco industry's clove demand. Back then, companies used to hold limited clove reserves and were therefore afflicted by surging clove prices. At that time, clove prices hiked up to IDR220,000/kg (from only IDR50,000/kg a year before). Currently, clove prices hover between IDR120,000~IDR140,000/Kg.

We believe big cigarette companies now safeguard ample clove reserves, owing to their bad experiences in 2011. Currently, cigarettes companies keep their inventory of raw materials (tobacco and cloves) as a buffer in the event of significant increases in tobacco and clove prices. As of 2016, GGRM kept 782 days of raw material inventory, while HMSP kept 446 days of raw material inventory.

Tobacco

25

November 20, 2017


Figure 35. Inventory days


782

458

0

100

200

300

400

500

600

700

800

900

2012 2013 2014 2015 2016

GGRM HMSP(days)

Tobacco

26

November 20, 2017


Industry’s mid- to long-term outlook

Favorable demographics and growing number of young smokers We believe Indonesia’s huge cigarette’s industry and growth drivers are backed up by the government’s support towards this labor-intensive industry by protecting the livelihood of small tobacco farmers and industry’s labors.

In addition, Indonesia has numerous growth drivers in this sector, such as its favorable demographic profile (50.8% of the population are in the age range of 24-54), low real cigarette prices, vast population, rising household income, low excise tax as percentage of cigarettes’ retail price, as well as high pricing power of the big players holding the market share of the tobacco industry.

Figure 36. Indonesia’s young demography

Source: United Nations, Department of Economic and Social Affairs, Mirae Asset Sekuritas Research

The regulation on the minimum age to smoke or buy cigarettes in Indonesia is more lenient than in other countries, and as a result, the number of young smokers in Indonesia keeps increasing, in our view. According to the National Commission for Children's Protection, nearly 2% of Indonesian children start smoking at the age of four. In addition to that, Basic Health Riset reveals that the number of teenage smokers in Indonesia almost reached 25% as of 2016, gradually improving compared to 10 years ago (Figure 37).

We believe that the large number of Indonesian young generations taking up smoking is due to the accessibility of buying a single cigarette, rather than one whole package. Thus, despite increased taxes on tobacco, young people still find it affordable to buy a standard pack of 16 cigarettes, priced at around IDR13,000-IDR22,000/pack and available at many street stalls, which also sell single cigarettes for as cheap as c.IDR1,000-IDR1,200/stick.

Tobacco

27

November 20, 2017


Figure 37. Young smokers in Indonesia

Source: Basic Health Riset (2007,2010,2013), Mirae Asset Sekuritas Research

Expecting moderate industry growth in 2018F We expect next year’s regional government election (June 2018) and pre-election period (the start of presidential campaign in October 2018) to entice the purchasing power of mid- to low-income consumers and thus spur better growth for Indonesia’s cigarette industry. In addition, we do not see that a higher increase in excise tariff by 10.04% is a big risk to the consumption of cigarettes as it is still within the normal range of its historical. In addition, cigarettes companies will carefully increase their ASP next year in order to pass on their cost of goods sold.

0

5

10

15

20

25

2007 2010 2013 2016

10-14 years old 15-19 years old%

Tobacco

28

November 20, 2017


HMSP is a top-listed tobacco company that manufactures and distributes cigarettes in Indonesia. Currently, the company leads the industry by holding 33.1% of the total cigarette market share. Machine-made cigarettes contribute to the majority of HMSP total revenue (>60% of HMSP’s revenue) with mild segment contributing more than the machine-made full-flavor, followed by hand-rolled cigarettes at 20%, and white cigarettes at 15%. Meanwhile, HMSP’s export market contributes insignificantly to the company’s revenue at less than 1% of HMSP’s consolidated revenue. HMSP is a subsidiary of PT Philip Morris Indonesia and an affiliate company of Philip Morris International Inc, the world’s leading international tobacco company.

Solid balance sheet- small debt and manageable capex going forward Since 2015 (the year when the company did a rights issue to comply with the free float requirement), HMSP’s debt has been very small as the company boosted up its cash ever since the rights issue. In addition, although the company has greater financial stability, the company requires only minimal capex ahead as their current capacity can fulfill the market demand for cigarettes. The company only needs capex of c.IDR1.1-IDR1.2tr per year for repair and maintenance. Thus, we believe HMSP will have a positive free cash flow going forward, given our assumption that its capital expenditure as percentage of sales will just be stable.

Diversified products to cater to all segments of target market

Currently, HMSP sells machine-rolled mild cigarettes (SKM mild) with three market segments, such as A mild for the premium market, U mild for the middle market, and Magnum Mild for the mid- to low-end market. Meanwhile, for the machine-rolled full flavor (SKM FF), HMSP has three market segments, such as Dji Sam Soe Magnum Filter 12 for the premium market, Marlboro Filter Black for the middle market and U Bold for the mid- to low-end market.

Initiate with a Hold call (TP: IDR 4,310/share)

We initiate our coverage on HMSP with a hold rating and a target price of IDR3,410/share, which was derived by using a 2018F target multiple of 38x. We like HMSP on the back of its strong position in the cigarette market, despite its recent declining market share. Nevertheless, its premium valuation and declining market share of its flagship brands, which we believe has higher margins, such as Sampoerna A and Sampoerna U (SKM Mild), lead to our hold recommendation. In addition, HMSP’s SKM FF brands (U Bold and Marlboro Filter black) might deteriorate the company’s margins.

HM Sampoerna (HMSP) Hefty valuation

2014 2015 2016 2017F 2018F Revenue (IDRbn) 80,690 89,069 95,467 100,203 107,906 Gross Profit (IDRbn) 20,500 21,764 23,855 24,388 26,028 Operating Profit (IDRbn) 13,805 14,048 16,020 16,371 17,396 Net profit (IDRbn) 10,181 10,363 12,762 12,918 13,923 EPS (IDR) 88 89 110 111 120 BPS (IDR) 116 275 294 295 304 P/B (x) 35.3 14.9 14.0 13.9 13.5 P/E (x) 46.8 46.0 37.4 36.9 34.3 Note: All figures are based on consolidated FS Source: Company data, Mirae Asset Sekuritas Indonesia Research

(Initiate) Hold

Target Price (12M, IDR) 4,310

Share Price (11/17/17, IDR) 4,100

Expected Return 5.1%

OP (18F, IDRbn) 17,396 Consensus OP 18F, IDRbn) 18,187

EPS Growth (18F, %) 8.1 Market EPS Growth (18F, %) 16.6 P/E (18F, x) 34.3 Market P/E (18F, x) 28.9 Market Cap (IDRbn) 496,678.2 Shares Outstanding (mn) 116,318.1 Free Float (%) 7.5 Foreign Ownership (%) 2.1 Beta (12M) 1.2 52-Week High 4,340 52-Week Low 3,350

(%) 1M (%) 1M Absolute 4.9 5.9 8.5 Relative 3.1 -0.2 -8.1

85

95

105

115

125

11

/16

12

/16

1/1

7

1/1

7

2/1

7

3/1

7

3/1

7

4/1

7

5/1

7

5/1

7

6/1

7

7/1

7

7/1

7

8/1

7

9/1

7

10

/17

10

/17

11

/17

JCI HMSP(D-1yr=100)

Tobacco

29

November 20, 2017


HM Sampoerna Company background Hanjaya Mandala Sampoerna (HMSP) is a top-listed tobacco company that manufactures and distributes cigarettes in Indonesia. The company is a subsidiary of PT Philip Morris Indonesia and an affiliate company of Philip Morris International Inc, the world’s leading international tobacco company. Other than machine-made cigarettes (SKM), HMSP also produces hand-rolled cigarettes (SKT) and distributes the product of PT Philip Morris Indonesian (PMID), Marlboro, in Indonesia.

Currently, HMSP leads the industry by holding 33.1% of the total cigarette market share as of 3Q17. Machine-made cigarettes contribute to the majority of HMSP total revenue (>60% of HMSP’s revenue) with mild segment contributing more than the machine-made full-flavor, followed by hand-rolled cigarettes at 20%, and white cigarettes at 15%. Meanwhile, HMSP’s export market contributes insignificantly to the company’s revenue at less than 1% of HMSP’s consolidated revenue.

Figure 38. Market share of cigarette companies Figure 39. Revenue breakdown (IDRbn)

Source: Company data, Nielsen, Mirae Asset Sekuritas Research


Figure 40. HMSP’s revenue breakdown Figure 41. HMSP’s quarterly volume sales by segment



0

5

10

15

20

25

30

35

HMSP GGRM Djarum RMBA Nojorono Others

Market share (%)(%)

16.7 17.0 18.3

4.7 4.8

5.3

3.5 3.1

2.7

10

12

14

16

18

20

22

24

26

28

30

1Q15 3Q15 1Q16 3Q16 1Q17 3Q17

White Hand-rolled Machine-madebn sticks

64%

20%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2012 2013 2014 2015 2016

ExportOthersWhite Cigarettes (SPM)Hand rolled clove cigarettes (SKT)Machine made clove cigarettes (SKM)

0

10,000

20,000

30,000

40,000

50,000

60,000

70,000

80,000

2010 2011 2012 2013 2014 2015 2016 2017 F 2018 F

Machine made clove cigarettes (SKM)Hand rolled clove cigarettes (SKT)White Cigarettes (SPM)OthersExport

IDRbn

Tobacco

30

November 20, 2017


HMSP was established by Liem Seeng Tee, a Chinese immigrant who began his business by producing and selling hand-rolled kretek cigarettes at his home in Surabaya in 1913. His small business was among the first to manufacture and market kretek cigarettes under the brand Dji Sam Soe. In 1959, HMSP’s operation was then passed on to the second generation of the family, Aga Sampoerna, who focused on the production of SKT (hand-rolled cigarettes). The company turned into a public company in 1990.

The company produces some of the best-known kretek (clove) cigarette brand families, such as Sampoerna A, Sampoerna Kretek, Sampoerna U, and Dji Sam Soe, which is considered the legendary “King of Kretek.” Given the success of its business, HMSP drew the interest of PT Philip Morris Indonesia, which has acquired the majority of ownership of HMSP in May 2005.

Figure 42. HMSP’s brands


Figure 43. HMSP’s revenue breakdown by volume


0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2011 2012 2013 2014 2015 2016 2017 F 2018 F

Export SPM SKT SKM

Tobacco

31

November 20, 2017


HMSP’s key brand families

Sampoerna A brand family comprises of SKM variants. Sampoerna launched A Mild in 1989, which became a pioneer in the LTLN (low tar low nicotine) cigarette brand in Indonesia.

Figure 44. The Sampoerna A brands

Source: Mirae Asset Sekuritas Research

Table 8. The Sampoerna A brands

Type Launching year Tar Nikotin A Mild 16 1989 14 mg 1.0 mg A Mild 12 1998 14 mg 1.0 mg A Mild Menthol 16 1998 14 mg 1.0 mg A Gold 2013 14 mg 1.0 mg A Mild Blue 2015 14 mg 1.0 mg A Motion 2015 14 mg 1.0 mg A Flava 2010 14 mg 1.0 mg A Flava Bold 2010 14 mg 1.0 mg Source: Wikipedia, Company data, Mirae Asset Sekuritas Research

Tobacco

32

November 20, 2017


Table 9. A Mild Slogan

Slogan Year

A Mild How Low Can You Go? 1994-1996 A Mild Bukan Basa Basi 1996-2008 A Mild Others can only follow 2002-2004 A Mild Tanya Kenapa? 2005-2008 A Mild Go Ahead 2009- Now A Mild Menthol: Go Ahead Refresh 2014- Now A Mild Limited Edition: Open New Ways 2015- Now Source: Wikipedia, Company data, Mirae Asset Sekuritas Research

Dji Sam Soe is the first SKT brand produced by Handel Maatschappij Liem Seeng Tee, which later became Hanjaya Mandala Sampoerna.

Dji Sam Soe has both variants of SKT and SKM brands. Dji Sam Soe is positioned as a premium kretek brand in Indonesia and continues to be the leader in the SKT segment. Dji Sam Soe’s SKM segments are Dji Sam Soe Filter, Dji Sam Soe Magnum Filter, and Dji Sam Soe Magnum Blue (launched in early 2014), while Dji Sam Soe SKT’s segments include Dji Sam Soe Kretek and Dji Sam Soe Super Premium.

Sampoerna’s SKT products, namely Dji Sam Soe (established since 1913) and Sampoerna Kretek, are still manufactured by hand today in 5 Sampoerna's manufacturing facilities and 38 facilities that belong to the third party’s operators throughout Java.

Figure 45. Dji Sam Soe display at House of Sampoerna (Surabaya)

Source: Mirae Asset Sekuritas Research

Table 10. Dji Sam Soe (without filter)

Type Details

Dji Sam Soe 234 10 sticks Dji Sam Soe 234 12 sticks Dji Sam Soe 234 16 sticks Dji Sam Soe 234 20 sticks Dji Sam Soe 234 Tin of 50 sticks Dji Sam Soe 234 Super Premium Source: Wikipedia, Company data, Mirae Asset Sekuritas Research

Tobacco

33

November 20, 2017


Table 11. Dji Sam Soe (with filter)

Type Details

Dji Sam Soe 234 Filter Dji Sam Soe 234 Super Premium Dji Sam Soe 234 Gold Dji Sam Soe 234 Magnum Filter Dji Sam Soe 234 Magnum Blue Dji Sam Soe 234 Super Premium Masterpiece Dji Sam Soe 234 Super Premium Magnum Filter Dji Sam Soe 234 99 Limited Edition Dji Sam Soe 234 100th Tin Case Source: Wikipedia, Company data, Mirae Asset Sekuritas Research

Figure 46. Dji Sam Soe’s brands

Source: Internet, Company data, Mirae Asset Sekuritas Research

Sampoerna Kretek is a hand-rolled kretek cigarette that was first manufactured in 1968 in Denpasar, Bali, by Aga Sampoerna, who represented the second generation of the Sampoerna family. Combining high-quality tobacco and cloves, Sampoerna Kretek has succeeded in producing the best hand-rolled kretek cigarette in its class.

Figure 47. Sampoerna Kretek


Tobacco

34

November 20, 2017


U Mild is a machine-made cigarette launched in 2005 as part of Sampoerna's LTLN portfolio along with A Mild. U Mild has seen continued growth in sales volume since its launching.

Figure 48. U Mild


Marlboro, one of the biggest international brands in the market, was launched in 1984 in Indonesia by PMID and is distributed by Sampoerna. Marlboro currently has five variants, namely Marlboro Red, Marlboro Lights, Marlboro Black Menthol, Marlboro Lights Menthol, and Marlboro Ice Blast.

Figure 49. Marlboro products


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Figure 50. HMSP’s corporate structure


As of 2016, HMSP operates 7 manufacturing facilities in Indonesia:

• Hand-Rolled Kretek Cigarette (SKT) production facilities: 3 in Surabaya and 1 each in Malang and Probolinggo.

• Machine-Made Kretek Cigarette (SKM) production facilities: 1 each in Pasuruan and Karawang.

HMSP has successfully retained its leading position in 2016. The company, however, continued to witness stronger competition from the second player, a local company named Gudang Garam (GGRM). Although HMSP keeps launching several new product variants, the company has continued to focus on the performance of its machine-rolled kretek (SKM) brands. The company presented a considerable threat to some other leading players through its established distribution network and solid tie-ups with various retail vendors around the Indonesian archipelago.

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Management team

Board of Directors

President Director: Mindaugas Trumpaitis

He is a Lithuanian citizen, born in Lithuania on May 29, 1975. He was appointed Sampoerna’s President Director at the Extraordinary General Meeting of Shareholders (EGMS) of the Company held on November 18, 2016. Mindaugas Trumpaitis joined PMI Lithuania in 1998 as a Merchandiser. Over the ensuing 18 years, he garnered progressive experience in managing tobacco businesses in medium and large markets within PMI’s global affiliates, including 10 years of experience as a General Manager/Managing Director in Finland, the Baltics, Mexico and Canada. He holds a Bachelor Degree in Economics and a Master’s Degree in Business Management from Klaipeda University in Klaipeda, Lithuania, and an Executive MBA Courses from INSEAD in France.

Director: Mimi Kurniawan

She is an Indonesian citizen, born in Palembang on August 12, 1973. Mimi Kurniawan was appointed Sampoerna’s Director of Human Resources at the Annual General Meeting of Shareholders (AGMS) of the Company held on April 27, 2016. She first joined Sampoerna in 1996 as a Project Officer and then progressed through a number of positions in Sampoerna until her appointment as a Director in 2016. She received a Bachelor Degree in Industrial Engineering from Universitas Kristen Petra in 1996.

Director: Andre Dahan

He is a Lebanese citizen, born in Beirut on July 10, 1969. Andre Dahan has served as a Sampoerna’s Director since April 18, 2013. He joined Philip Morris Switzerland in 2003, progressing through several key positions in marketing at PMI affiliates in Poland, Hungary, the Czech Republic and Russia, as well as building 16 years of experience in the industry. He earned his Master’s Degree in Business Administration from Institut d’Etudes Politiques de Paris, Paris, France, and his Bachelor of Arts Degree in International Economics from L’université Paris-Sorbonne, Paris, France. He was reappointed Sampoerna’s Director of Marketing at the AGMS on April 27, 2015.

Director: Michael Scharor

He is an Austrian citizen, born in Austria on September 20, 1966. Michael Scharer was appointed Sampoerna’s Director of Operations at the EGMS of the Company held on November 18, 2016. He has 24 years of experience in tobacco industry operations, including 19 years of experience within numerous PMI global affiliates beginning in 1997. He holds a Master’s Degree in Mechanical Engineering and Business Management from the Technical University of Vienna.

Director: Troy J.Modlin

He is a U. S. citizen, born in Colorado on October 19, 1971. Troy J. Modlin has served as a Sampoerna’s Director of Corporate Affairs, appointed at the EGMS, since September 18, 2015. He joined PMI in 2005 in Switzerland as a Manager and was later appointed Director of Government Affairs before assuming the Director of Corporate Affairs position in Hong Kong and Bangkok. He has 10 years of experience in the industry. He earned his Bachelor of Science Degree in Business Administration from the University of Colorado in Boulder, Denver, USA, and a Master’s Degree in International Management from the University of Denver, Daniels College of Business, USA.

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Director: Michael Sandrittor

He is a German citizen, born in Heidelberg on May 12, 1968. Michael Sandritter has served as a Sampoerna’s Director since May 9, 2014. He joined PMI in 1994 and assumed several key roles in Finance at PMI’s Operations Center in Lausanne, Switzerland, and at PMI’s affiliates in Hungary and Germany. He was reappointed Director of Finance at the AGMS held on April 27, 2015. He holds a Diploma in Business Administration from the University of Cooperative Education, Mannheim, Germany.

Director: Yos Adiguna Ginting

He is an Indonesian citizen, born in Cilacap on January 19, 1969. Yos Adiguna Ginting has served as a Sampoerna’s Director since June 2003. He joined Sampoerna in 2002 as an Organization Development Specialist, after which he progressed through several key positions at Sampoerna and other PMI affiliates, gaining 14 years of experience in the industry. He was reappointed Director at the AGMS on April 27, 2015 and lastly appointed Independent Director at the AGMS on April 27, 2016. He earned a Bachelor of Science Degree in Chemistry and a Doctor of Philosophy Degree in Theoretical Chemistry from the University of Tasmania, Australia.

Director: The Ivan Cahyadi

He is an Indonesian citizen, born in Semarang on June 29, 1974. The Ivan Cahyadi was appointed Sampoerna’s Director of Sales at the AGMS of the Company held on April 27, 2016. He joined Sampoerna in 1996 as a Sales Trainee. Over his 20 years of experience with the Company, he has progressed through a number of positions in Sampoerna and PMI’s affiliates in Malaysia. He received a Bachelor Degree in Economics from Universitas Surabaya in 1996.

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Board of Commissioners

President Commissioner: John Gledhill

He is an Australian citizen, born in Liverpool on January 18, 1954. John Gledhill has served as Sampoerna’s President Commissioner since July 18, 2012. He joined PMI in 1983 and progressed through various senior roles in sales, marketing, and general management at a number of PMI affiliates, including serving as President Director of Sampoerna during the period of 2009-2012. John Gledhill was reappointed Sampoerna’s President Commissioner at the AGMS held on April 27, 2015. He holds a Higher National Certificate in Business Studies from Liverpool Polytechnic and completed the International Executive Program INSEAD, France, in 1999.

Vice President Commissioner: Wayan M. Tantra

He is an Indonesian citizen, born in Singaraja on July 2, 1962. Wayan Mertasana Tantra has served as a Director at Sampoerna since May 27, 2008, and was subsequently appointed Independent Director on May 9, 2014. At the AGMS held on April 27, 2016, Wayan Mertasana Tantra was appointed Vice President Commissioner of Sampoerna, replacing Charles Herve Bendotti. He has been with Sampoerna for more than 28 years, beginning his career in the industry at one of Sampoerna’s affiliates as a Sales Supervisor and subsequently assuming several key positions. He holds a Bachelor Degree in Economics from the University of Surabaya and a Master’s Degree in Management from Universitas Airlangga, Surabaya.

Commissioner: Niken Rachmad

She is an Indonesian citizen, born in Malang on February 25, 1950. Niken Kristiawan Rachmad has served as Sampoerna’s Commissioner since January 1, 2011. She joined Sampoerna in 1998 as the Head of Corporate Communications and later assumed the positions of Communications Director and Corporate Affairs Advisor. She was reappointed Sampoerna’s Commissioner at the AGMS held on April 27, 2015. She earned a Bachelor of Science Degree from Universitas Gadjah Mada, Yogjakarta.

Independent Commissioner: Goh Kok Ho

He is a Malaysian citizen, born in Selangor on July 3, 1946. Goh Kok Ho has served as an Independent Commissioner since April 27, 2012, formerly holding several key positions at PMI affiliates until 2001. He was reappointed Independent Commissioner at the AGMS held on April 27, 2015. He obtained his Bachelor of Arts Degree in Economics from the University of Malaya.

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Competitive advantage Solid balance sheet- small debt and manageable capex going forward Since 2015 (the year when the company did a rights issue to comply with the free float requirement), HMSP’s debt has been very small as the company boosted up its cash ever since the rights issue. In addition, although the company has greater financial stability, the company requires only minimal capex ahead as their current capacity can fulfill market demand on cigarettes. The company only needs capex of c.IDR1.1-IDR1.2tr per year for repair and maintenance. Thus, we believe HMSP will have a positive free cash flow going forward, given our assumption that its capital expenditure as percentage of sales will just be stable. To note, in 2015, the company paid all their excise tax payable and charged it as an expense in the profit and loss statement, turning its free cash flow to a minus state.

Figure 51. Gross gearing Figure 52. Net gearing



Figure 53. HMSP’s stable capex as % of sales to boost free cash flow


0%

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November 20, 2017


High interest income yielded from its high cash We believe the current cash level has enabled HMSP to benefit from a high interest income as of 2016 which yielded more than 40% of its average past four year cash level (2013-2016). HMSP’s interest income in 2016 is even higher than its cash prior to its rights issuance back in 2012-2014. We expect to see a lesser interest as percentage of cash in 2017F and 2018F yet expect the interest income to grow next year by 48% YoY as we estimate a higher cash balance, due to better topline and muted capex rate. Thus, our estimate for HMSP bottom line margin is slightly higher for 2018F by 40bps at 13.4% compared to 2017F.

Figure 54. Interest income


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Diversified products to cater to all segments of target market We believe Indonesia’s cigarette industry growth is driven by the country’s strong smoking culture among the society, albeit several restrictions which are imposed on the sector. In addition, cigarettes’ low prices, mounting disposable income, as well as innovative products launched by cigarette-producing companies keep up the development of the industry. In our view, HMSP’s market dominance benefits the company, owing to its size and dawning brand recognition. Currently, HMSP is the market leader with some of its leading brands, such as Sampoerna A and Dji Sam Soe. We also believe that HMSP’s wide range of products, from the cheapest to the most premium, is expedient for the company as it caters to all target markets in the industry.

Currently, HMSP sells machine-rolled mild cigarettes (SKM mild) with three market segments, such as A mild for the premium market, U mild for the middle market, and Magnum Mild for the mid- to low-end market. Meanwhile, for the machine-rolled full flavor (SKM FF), HMSP has three market segments, such as Dji Sam Soe Magnum Filter 12 for the premium market, Marlboro Filter Black for the middle market and U Bold for the mid- to low-end market. In addition, HMSP also distributes white cigarettes under different brands, such as Marlboro Red, Marlboro Ice Blast, Marlboro Lights, Marlboro Black Menthol, and Marlboro Lights Menthol. Since the company only acts as a distributor for the white cigarettes, the profitability of Marlboro in HMSP is lower than PMI US.

Figure 55. SKM Mild & SKM FF

Source: Internet, Mirae Asset Sekuritas Indonesia Research

SKM Mild SKM FF

Marlboro Filter Black

Retail price = IDR21,500

Magnum Filter

Retail price = IDR16400

U Bold


A Mild


U Mild


Magnum Mild


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November 20, 2017


Table 12. GGRM vs HMSP retail price per pack (IDR)

GGRM HMSP

Hand-rolled Hand-rolled GG Merah 12,490 Dji Sam Soe 17,200 Djaja - Sampoerna Kretek 12,900 Sriwedani - Klobot - GG Deluxe Machine rolled- Full flavored Machine rolled- Full flavored GG Surya (16) 21,000 U Bold 12,600 GG Filter International (12) 16,500 Marlboro Filter Black 21,500 GG Signature (12) 14,500 Dji Sam Soe Magnum Filter 16,400 GG Signature (16) 15,750 Surya Exclusive (16) 23,500 Machine rolled- Mid tar Machine rolled- Mid tar Surya Professional (16) 16,200 Dji Sam Soe Magnum Mild (16) 13,083 Machine rolled- LTLN Machine rolled- LTLN GG Mild (16) 17,500 A Mild (16) 21,290 Surya Pro Mild (16) 16,500 A Mild (12) 14,900 GG Signature Mild 16,800 U Mild 16,767 Avolution (20) 25,900 White cigarettes Marlboro Red 25,700 Marlboro Ice Blast 27,600 Marlboro Lights 26,500 Marlboro Black Menthol 25,500 Marlboro Lights Menthol 23,190 Source: Company data, Mirae Asset Sekuritas Indonesia research

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Continuously innovating new products Given the growing competition in cigarette market, HMSP continuously develops new brands to strengthen its position in the market. In particular, the company has been innovating its brand portfolio in the SKM Mild, SKM mid-tar, and SKM full flavor. Therefore, despite its declining market share, the company is still a major player in the cigarette market.

Figure 56. HMSP as the market leader in the industry Figure 57. HMSP’s overall market share

Source: Nielsen, Mirae Asset Sekuritas Indonesia Research

Source: PMI US, Mirae Asset Sekuritas Indonesia research

Firstly, although HMSP is the pioneer in the SKM mild segment (SKM LTLN), the competition within the segment is getting tougher, given the emergence of products from competitors. HMSP launched their first SKM mild in 1989 with the brand Sampoerna A. Meanwhile, GGRM has just started producing their SKM mild in 2002. We believe the recent decline in the HMSP’s SKM Mild (LTLN) market share is due to the competition that comes from cheaper products in the market, especially brands under GGRM Surya Pro Mild which are priced at below that of HMSP’s A Mild. As we believe, in order for HMSP to be able to survive in the market, the company has been introducing new SKM mild brands into the market. For instance, HMSP launched Avolution 20 (SKM Mild) at the end of 2015.

Nonetheless, we view that HMSP’s SKM mild segment is recently losing consumers’ appetite as full flavor or mid-tar segment has gained their attention. HMSP’s A Mild and U Mild have recently seen declining audience shares, which we believe is due to consumers’ growing appetite for mid-tar cigarette segment that has a similar pricing (c.IDR21,000/pack), such as GG Surya and Djarum Super.

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HMSP GGRM

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Figure 58. HMSP’s mild cigarette Figure 59. HMSP’s mild cigarette (newer brand)

Source: Internet, Mirae Asset Sekuritas Indonesia research


Secondly, we believe the company is also aware of the emergence of SKM mid-tar segments which have gained consumers’ attention recently, especially from GGRM’s Surya Professional. Thus, HMSP also rebranded their Magnum Blue brand into Magnum Mild. Magnum Blue, initially launched in 2014, did not sell as good as Magnum Filter, which is more towards the SKM FF segment. Magnum Mild was rebranded in the middle of this year, priced at around IDR12,500-IDR13,000 in the supermarkets, much lower than Surya Pro’s price per pack. In addition, the company’s Dji Sam Soe portfolio products are seen to be declining; thus, we believe the company aims to strengthen their portfolio by rebranding their Magnum Blue to Dji Sam Soe Magnum Mild with hopes to regain market share. At the current price, Magnum Mild is now catering to the needs of mid- to lower-income smokers compared to previously when it was targeted at middle- to upper-income smokers.

Our ground checks confirmed that consumers feel the current price is reasonable compared to Magnum Blue. Nonetheless, Dji Sam Soe Magnum Mild is priced at c.25% below the government’s suggested price. Therefore, according to the latest PMK regulation, HMSP needs to raise its Magnum Mild price as the government now only allows 15% of maximum discount from the minimum retail price (HJE) which may impede consumers’ preference as the pricing will be similar to U Mild which has experienced a declining sales volume, in our view. According to HMSP, the company needs to raise its Magnum Mild price by March 2018F.

Figure 60. HMSP’s SKM Mid tar Figure 61. HMSP’s SKM FF



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Thirdly, we believe HMSP is also aware of the fact that SKM FF has always been the favorite among Indonesian smokers. Therefore, the company launched a new SKM full-flavored segment in February 2015, such as U Bold. According to the company, only one year after the launch of U Bold, distribution was expanded to reach 55 cities across the country and has managed to improve its market share after several months of launching the products. HMSP’s U Bold is priced at 30% of discount from GGRM’s GG Surya, which is also SKM Mild.

Furthermore, in September 2016, the company has introduced another SKM FF brand, which is Marlboro Filter Black 20. The brand was launched in 25 cities across Indonesia. HMSP stated that they are going to sell Marlboro Filter Black nationwide by the end of the year. We believe the company has strengthened its presence in the SKM Full-flavor segment and has been successful in selling their U Bold and Marlboro Filter Black recently. According to data from PMI US, HMSP was able to increase their SKM FF market share by gaining 130bps market share to 3.6% in the beginning of the year. In addition, HMSP was able to gain its market share in Marlboro segment which is supported mainly from the continued share growth of Marlboro Filter Black. Nonetheless, we are concerned about the company’s margin due to higher contribution from products with lower margins (U Bold and Marlboro Filter Black).

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3Q17 Performance review Slightly improving market share on a quarterly basis In the 3Q17, HMSP has been able to sell 26.2bn sticks of cigarettes which grew by 4% YoY. Meanwhile, the industry is estimated to have grown by 6.5% YoY in the 3Q17. We believe HMSP’s third quarter higher volume growth was mainly driven by Eid Al-Fitr seasonal effect. Therefore, HMSP 3Q17’s sales volume was higher than 2Q17 and 3Q16 (both were in the high season of Eid Al-Fitr). In the 3Q, HMSP’s overall market share slightly improved on a quarterly basis to 33.1% from 32.8% in 2Q17.

We believe HMSP’s overall machine-made cigarettes sales volume saw an improvement both on quarterly and yearly basis, mainly due to its SKM FF. However, HMSP’s flagship brands, Sampoerna A and Sampoerna U (SKM Mild), which we believe have higher margins compared to their latest launched products, remained under pressure during the quarter as they booked lower market shares. According to the conference call held in the beginning of November, U Mild sales volume dropped by 24%YoY in 3Q17.

Figure 62. HMSP’s quarterly volume sales Figure 63. HMSP’s quarterly volume sales by segment



Figure 64. Sampoerna A’s market share Figure 65. Sampoerna U’s market share



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Growth from cheaper products In 3Q17, HMSP recorded higher “Dji Sam Soe” market share, which is particularly attributed to its cheaper brand, Magnum Mild (SKM Mid tar). As of 3Q17, Magnum Mild contribution to total HMSP sales volume was c.6-7%. In addition, HMSP also saw a rising cigarette market share in Marlboro Filter Black (SKM FF) in 3Q17. We believe that the selling of Magnum Mild and Marlboro Filter Black at lower prices has caused HMSP’s 3Q17 gross margin to deteriorate to 24.1% compared to last year’s (24.5%), as the product’s price per stick is much lower compared to the prices of similar full flavor cigarette products in the market (GG Surya, GG International and Djarum Super). HMSP stated that they are going to sell Marlboro Filter Black nationwide by the end of the year.

Table 13. Price comparison

Company Brand Price/pack (IDR) Price / stick (IDR/Stick)

HMSP Marlboro Filter Black (20) 21,500 1,075 GGRM GG Surya (16) 21,000 1,312 GGRM GG International (12) 16,500 1,375 Djarum Djarum Super (16) 21,250 1,328 Source: Mirae Asset Sekuritas Indonesia research

Figure 66. Dji Sam Soe’s market share Figure 67. HMSP’s market share from other brand segments



Figure 68. HMSP’s overall market share Figure 69. Sales volume contribution to revenue (%)


Source: Company data, PMI US, Mirae Asset Sekuritas Indonesia research

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White Hand-rolled Machine-made

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Table 14. Cigarette industry and HMSP volume (bn sticks)

Item 3Q16 2Q17 3Q17 QoQ YoY 9M16 9M17 YoY Volume Total cigarette industry 72.3 75.7 79.2 5% 10% 233.1 225.9 -3.1% Total HMSP 25.1 24.8 26.2 6% 5% 79.2 74.4 -6.1% HMSP market share 34.7% 32.8% 33.1% HMSP volume by brands Sampoerna A Mild 10.4 10.6 10.5 -1% 0% 33.3 30.9 -7.1% U Mild 3.1 3.6 3.3 -7% 7% 10.1 10.4 3.2% Dji sam soe 4.8 4.8 6.4 32% 34% 15.4 15.7 2.4% Marlboro 3.5 3.1 2.7 -13% -24% 11.6 8.7 -25.0% Others 3.3 2.8 3.4 21% 2% 8.3 8.7 5.1% HMSP volume by segment SKM 16.8 17.0 18.3 7% 9% 52.0 50.7 -2.5% SKT 4.8 4.8 5.3 11% 11% 16.3 15.0 -7.9% SPM 3.5 3.1 2.7 -13% -24% 11.6 8.7 -25.0% Source: PMI US, Mirae Asset Sekuritas Indonesia research

Table 15. HMSP’s market share and Industry breakdown

Item 3Q16 2Q17 3Q17 QoQ (%p)

YoY (%p)

PMI market share Sampoerna A 14.4% 14.0% 13.2% -0.80 -1.20 U Mild 4.3% 4.7% 4.2% -0.50 -0.10 Dji sam soe 6.6% 6.4% 8.1% 1.70 1.50 PMI market share SKM 30.2% 29.1% 29.7% 0.60 -0.50 SKT 38.6% 36.2% 38.4% 2.20 -0.20 SPM 79.7% 73.4% 67.3% -6.10 -12.40 Overall HMSP Market share 34.7% 32.8% 33.1% 0.33 -1.55 Cigarette industry breakdown SKM 76.7% 77.1% 77.6% 0.50 0.90 SKT 17.2% 17.4% 17.4% - 0.20 SPM 6.1% 5.5% 5.0% -0.50 -1.10 Source: PMI US, Mirae Asset Sekuritas Indonesia research

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Financial Forecast

Revenue growth mainly supported by higher ASPs We forecast HMSP’s revenue to grow by 5% and 8% YoY in 2017F and 2018F respectively. Our revenue forecast is basically supported by higher average selling price (ASP) assumption to offset the higher excise tax per segment. As to our volume assumptions, however, we forecast lower volume for white cigarettes at 8% and 6% YoY in 2017F and 2018F, mainly on the back of weaker preference among Indonesian smokers. In addition, white cigarettes will see the highest increase in excise tax per stick in 2018F, which is 12.6%. Indeed, HMSP’s 9M17 white cigarettes’ (SPM) volume has declined by 25% YoY. Meanwhile, for hand-rolled cigarettes (SKT) segment, we forecast a decline by 3% for 2017F and 2018F along with the downward trend of the company’s SKT sales revenue contribution to total revenue. We expect HMSP’s SKT segment contribution to total revenue to slightly decline to 19% next year. On the other hand, we still believe in SKM segment as SKM FF and mid tar products are now favored by smokers. We project a slightly higher volume of SKM segment by 1% for 2018F, as we also expect the consumption to slightly recover next year. In addition to that, we believe SKM FF and mid tar segments have a better chance to increase their ASP next year, especially for Magnum Filter Black as it is gaining volume and still priced very low compared to its closest counterparts.

Figure 70. Revenue forecast Figure 71. Gross margin



Expect a soft gross profit growth and margin We forecast HMSP’s gross margin to grow by 4% CAGR during 2016-2018F. We believe the company is currently facing a structurally declining gross margin due to its lower capacity to increase its higher margin products, especially A Mild, which is much higher than GGRM’s Surya Pro Mild (16) and GG Mild (16). In addition, the company also sells lower margin products which have recently gained smokers’ attention, such as Magnum Mild and Marlboro Filter Black. Magnum Mild’s which was introduced in May 2017, was able to increase its market share to 2.2% in the 3Q17. We expect the company’s margin to experience a slight decline in 2017F and 2018F by 0.6%p and 0.2%p YoY, respectively.

On the other hand, we project a stable bottom line margin, mainly supported by the company’s ability to book net interest income as the company has ample cash reserves as well as a flat capital expenditure for the company going forward. Given ample cash and minimal capex going forward, we expect the company’s payout ratio to be stable at a high rate of 100% going forward.

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November 20, 2017


Figure 72. Gross profit forecast Figure 73. Bottom line forecast



Figure 74. High dividend payout ratio


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Valuations

We initiate our coverage on HMSP with a hold rating and a target price of IDR4,310/share, which was derived by using a target multiple of 2018F of 36x.

We like HMSP on the back of its strong position in the cigarette market, despite its recent declining market share. Nevertheless, its premium valuation, structurally declining market share and tight competition in the market lead to our hold recommendation on the company. HMSP’s flagship brands, Sampoerna A and Sampoerna U (SKM Mild), which we believe have higher margins compared to their latest launched products, remain under pressure in the 3Q17 as they booked lower market shares. In addition, HMSP’s SKM FF brands (U Bold and Marlboro Filter black) might deteriorate the company’s margins.

Currently, HMSP is trading at 34.3x forward PE, still lower than its average 5-year +1 standard deviation at 35.7x.

Figure 75. HMSP Forward P/E Band

Source: Bloomberg, Mirae Asset Sekuritas Indonesia Research

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HM Sampoerna (HMSP IJ/ Hold/ TP: IDR4,310)

Table 16. Forecast and valuations 2015 2016 2017F 2018 F Revenue (IDRbn) 89,069 95,467 100,203 107,906 EBITDA (IDRbn) 14,467 16,615 17,032 18,117 Net profit (IDRbn) 10,363 12,762 12,918 13,923 EPS (IDR/share) 89.1 109.7 111.1 119.7 DPS (IDR/share) 105.3 89.0 109.6 110.9 ROE (%) 32% 37% 38% 39% Dividend yield (%) 3% 2% 3% 3% P/E ratio (x) 46.0 37.4 36.9 34.3 P/BV ratio (x) 14.9 14.0 13.9 13.5 EV/EBITDA (x) 32.8 28.4 27.8 26.1 Source: Mirae Asset Sekuritas Indonesia Research

Table 17. Income statement projection IDRbn 2015 2016 2017F 2018 F Revenue 89,069 95,467 100,203 107,906 COGS -67,305 -71,612 -75,816 -81,877 Gross Profit 21,764 23,855 24,388 26,028 Opex -7,716 -7,834 -8,016 -8,632 Operating Profit 14,048 16,020 16,371 17,396 Other income/(expenses) -76 159 237 255 Interest income 99 854 635 933 Interest expense -138 -22 -23 -25 Profit before income tax 13,933 17,011 17,219 18,559 Income tax expenses -3,569 -4,249 -4,301 -4,636 Minority interest 0 0 0 0 Net profit 10,363 12,762 12,918 13,923 EBITDA 14,467 16,615 17,032 18,117 Source: Mirae Asset Sekuritas Indonesia Research

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Table 18. Balance sheet projection IDR bn 2015 2016 2017F 2018F Cash and equivalents 1,719 5,056 3,352 4,390 Receivables 4,727 4,996 5,317 5,726 Inventories 19,072 19,442 19,043 18,377 Others 4,290 4,153 4,778 4,980 Total current assets 29,807 33,647 32,490 33,473 Fixed assets - net 6,281 6,895 7,508 7,973 Others 1,922 1,965 2,129 2,303 Total non-current assets 8,203 8,861 9,637 10,276 Total assets 38,011 42,508 42,127 43,749 ST bank loans and CM - Accounts payables 3,191 3,871 3,518 3,799 Others current liabilities 1,348 2,558 2,690 2,891 Total current liabilities 4,539 6,428 6,207 6,690 Deferred tax liabilities - - - - Others 1,456 1,905 1,575 1,696 Total non-current liabilities 1,456 1,905 1,575 1,696 Total liabilities 5,995 8,333 7,782 8,386 Minority interests - - - - Shareholders' equity 32,016 34,175 34,345 35,363 Source: Mirae Asset Sekuritas Indonesia Research

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Table 19. Cash flow statement projection IDRbn 2015 2016 2017F 2018F CF from operation Net profit 10,363 12,762 12,918 13,923 Depreciation/amortization 419 595 660 721 Change in working capitals -13,621 1,336 -839 647 Others 136 417 -449 -104 CF from operation -2,703 15,110 12,291 15,188 CF from Investments Net capex -781 -1,209 -1,273 -1,187 LT investments -182 19 -64 -60 CF from investments -963 -1,190 -1,337 -1,247 CF from financing activity Increase/(decrease) in debt -2,835 0 91 0 Increase/(decrease) in equity 20,414 -19 0 0 Dividend payments -12,250 -10,352 -12,749 -12,905 Others -8 -212 -1 2 CF from financing activity 5,319 -10,583 -12,659 -12,903 Increase (Decrease) in Cash 1,654 3,337 -1,705 1,038 Beginning balance 65 1,719 5,056 3,352 Ending balance 1,719 5,056 3,352 4,390 Source: Mirae Asset Sekuritas Indonesia Research

Table 20. Key ratio 2015 2016 2017F 2018F Growth (%) Revenue 10% 7% 5% 8% EBITDA 2% 15% 3% 6% Net profit 2% 23% 1% 8% Profitability (%) Gross margin 24% 25% 24% 24% Operating margin 16% 17% 16% 16% EBITDA margin 16% 17% 17% 17% Net margin 12% 13% 13% 13% ROE 32% 37% 38% 39% ROA 27% 30% 31% 32% Leverage (X) Current ratio 6.6 5.2 5.2 5.0 Quick ratio 2.4 2.2 2.2 2.3 Debt to equity 0.2 0.2 0.2 0.2 Net debt to equity 0.1 0.1 0.1 0.1 Interest coverage 101.5 717.6 698.7 689.4 Source: Mirae Asset Sekuritas Indonesia Research

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Gudang Garam was initially founded by Surya Wonowidjojo in Kediri, East Java in 1958. In 1979, the company’s first cigarette manufacturing machines were installed. The company has been listed on IDX since 1990. GGRM produces a wide range of kretek cigarettes, including low-tar-low-nicotine variants, widely known as light and mild, as well as traditional hand-rolled kretek.

Expect a double-digit topline growth for 2018F

We expect GGRM to book 10.5% YoY growth in its topline in 2018F, mainly on the back of higher average selling price (ASP) of c.8%, which we believe should be sufficient to offset higher excise tax and other raw material price increases in the cost of goods sold. We forecast flattish volume growth for GGRM’s SKT segment and 1% volume growth for GGRM’s SKM segment as the company sees more potentials in the SKM full-flavor segment.

Robust free cash flow, expect higher dividend per share

We expect GGRM to book robust free cash flow going forward as the company sees less capex burden compared to five years ago (2011-2015). In addition, given lesser capex going forward, we estimate a stable payout ratio at 75% (similar to 2017F), and expect higher dividend per share going forward.

Full-flavored cigarettes as the winner

As GGRM’s product mix is still dominated by machine-made (SKM) full-flavored cigarettes, we believe the company is well positioned to embrace the growing machine-made full-flavored segment; its well-received brand image among smokers should support its growth agenda. According to Nielsen, the industry’s machine-made (SKM) FF market share has grown from 28% in 2012 to 38% today. Indeed, GGRM saw an increase in its SKM FF volume contribution. In 2013, GGRM SKM FF products’ contribution to total volume was 74%. Currently, the figure has amplified to 77%.

Initiate with a Trading Buy call (TP: IDR 91,000/share)

We initiate our coverage on GGRM with a trading buy rating and a target price of IDR91,000/share, which was derived using DCF with a 7-year life span. Our WACC assumption of 9.5% is derived from the following assumptions: Risk free (Rf) rate of 6.5%, market risk premium (MRP) of 5%, terminal growth rate of 3%, and equity beta of 0.9x. GGRM is currently trading near -1std deviation at 22x forward P/E, 13% discount from HMSP which is trading at 19.5x. We are taken with GGRM as the company is projected to register higher free cash flow, stable margins, and benefits from higher selling price due to lesser competition in the market.

Gudang Garam (GGRM)

Cheap yet powerful

Item 2014 2015 2016 2017F 2018F Revenue (IDRbn) 65,186 70,365 76,274 82,912 91,578 Gross Profit (IDRbn) 13,380 15,485 16,617 17,825 20,060 Operating Profit (IDRbn) 8,525 9,906 9,972 10,805 12,292 Net profit (IDRbn) 5,369 6,426 6,677 7,329 8,414 EPS (IDR) 2,790 3,340 3,470 3,809 4,373 BPS (IDR) 17,151 19,698 20,522 21,729 23,245 P/B (x) 4.5 4.0 3.8 3.6 3.4 P/E (x) 27.9 23.3 22.5 20.5 17.8 Note: All figures are based on consolidated FS Source: Company data, Mirae Asset Sekuritas Indonesia Research

(Initiate) Trading Buy

Target Price (12M, IDR) 91,000

Share Price (11/17/17, IDR) 77,975

Expected Return 16.7%

OP (18F, IDRbn) 12,292 Consensus OP 18F, IDRbn) 12,218

EPS Growth (18F, %) 14.8 Market EPS Growth (17F, %) 16.6 P/E (18F, x) 17.8 Market P/E (18F, x) 28.9

Market Cap (IDRbn) 154,744.8 Shares Outstanding (mn) 1,924.1 Free Float (%) 23.8 Foreign Ownership (%) 81.4 Beta (12M) 1.2 52-Week High 83,100 52-Week Low 60,025

(%) 1M 6M 12M Absolute 20.9 5.9 23.8 Relative 19.2 -0.2 7.3

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Gudang Garam Company Background Gudang Garam was initially founded by Surya Wonowidjojo in Kediri, East Java in 1958. In 1979, the company’s first cigarette manufacturing machines were installed. The company has been listed on IDX since 1990.

GGRM produces a wide range of kretek cigarettes including low-tar-low-nicotine (LTLN) variants, widely known as light and mild, as well as traditional hand-rolled kretek. The company has apparently become the leading manufacturer of Indonesian Kretek (clove cigarettes) and is well known for its signature machine-rolled full-flavor cigarette brands, GG Surya and GG International. In addition to that, the company’s new brand, Surya Professional, has been able to gain market share due to its competitive pricing compared to similar brands in the industry.

Figure 76. GGRM’s product lines


According to Nielsen, GGRM is currently the second largest cigarette producer in Indonesia after HMSP. The company mostly produces machine-made (SKM) full-flavored cigarettes which contribute to around 77% of the company’s sales volume, followed by machine-made (SKM) LTLN at 12%, and hand-rolled (SKT) cigarettes at 11% of total volume.

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Figure 77. GGRM’s revenue breakdown Figure 78. GGRM’s sales volume breakdown



Figure 79. GGRM’s main products


Table 21. GGRM’s ex-factory price/pack (as of October 31, 2017)

Types of cigarettes Ex-factory price (as of January 2017)

Ex-factory price (as of October 31,2017)

Current Retail price

Banderol price

Hand-rolled GG Merah IDR 10,250 IDR 10,900 IDR 12,490 IDR10,680 Machine-rolled (FF) GG International (12) IDR 14,100 IDR 14,900 IDR 16,500 IDR 14,250 GG Surya (16) IDR 18,200 IDR 18,800 IDR 21,000 IDR 18,500 Machine-rolled (Mild) Surya pro mild (16) IDR 12,000 IDR 13,400 IDR 16,500 IDR 17,925 GG Mild IDR 13,300 IDR 13,800 IDR 17,500 IDR 17,925 Source: Company data, Mirae Asset Sekuritas Indonesia Research

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GGRM is currently operating two production facilities at two main sites, each having its own primary and secondary kretek manufacturing operations. The first site is in Kediri, where the company was founded (Gudang Garam headquarters). The second site is located in Gempol, East Java (50 km away from Surabaya).

GGRM is also operating an in-house printing facility and five major operating subsidiaries, such as:

• Surya Pamenang producing paperboard for Gudang Garam packaging

• Surya Madistrindo sole distributor of the company’s products

• Surya Air and Galaxy Prime Ltd providing non-scheduled air transport services

• Graha Surya Media engaged in entertainment services

Table 22. GGRM directly-owned entities

Entity's name Commenced commercial operations Principal activities PT Surya Pamenang 1993 Paper industry PT Surya Madistrindo 2004 Trading PT Surya Air 2011 Non-scheduled air transport services PT Graha Surya Media 2013 Tobacco processing industry PT Surya Inti Tembakau not yet commenced its commercial operations Tobacco processing industry PT Surya Abadi Semesta not yet commenced its commercial operations Electrical cigarettes industry Galaxy Prime Ltd 2015 Non-scheduled air transport services Surya Dhoho Investama not yet commenced its commercial operations Investment Source: Company data, Mirae Asset Sekuritas Indonesia Research

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Management team

Board of Directors

President Director: Susilo Wonowidjojo

Mr Susilo Wonowidjojo was appointed President Director in June 2009. He was a former Vice President Director since 1990 and previously a Director since 1976 with responsibilities for procurement of raw materials, flavors, inventory, and production management. He is related to Juni Setiawati Wonowidjojo (President Commissioner) and is affiliated to the company’s shareholders. Concurrently, he is serving as President Commissioner of PT Surya Madistrindo and Commissioner of PT Surya Air and PT Surya Dhoho Investama. He is also the President Director of PT Suryamitra Kusuma and Director of PT Suryaduta Investama, PT Suryaduta Mandiri, and PT Surya Halim Karya Sejahtera.

Figure 80. GGRM’s president director


Director: Heru Budiman

Mr Heru Budiman was appointed Director in 2000. He joined the company in 1990 with responsibilities for Treasury and Investor Relations and was appointed Corporate Secretary in 1996. His background includes senior management positions at international and leading national banks. He holds a Bachelor Degree in English from Satya Wacana University. He is currently a Commissioner of PT Graha Surya Media and PT Surya Abadi Semesta. He is also serving as President Director of PT Surya Madistrindo.

Director: Herry Susianto

He was appointed Director of Finance in 2007. His previous positions was an Internal Audit Head from 2002 to 2007 and the Head of Accounting Division from 2001 to 2002. He joined the company in 1983 and was assigned to the accounting division. He holds a Degree in Law from Airlangga University, Surabaya and a Master’s Degree in Management from Gajayana University, Malang. Currently, he is serving as a Commissioner of PT Surya Madistrindo, PT Surya Inti Tembakau, and PT Bukit Dhoho Indah. He is also the President Director of PT Graha Surya Media and Director of PT Surya Air and PT Surya Abadi Semesta.

Director: Buana Susilo

He was appointed Director of Manufacturing Technology in 2008. He draws upon extensive experience with the company in equipment design, process planning, and configuration. Previously, he served as Deputy Director of Technical Division since 1991 and in early 2000 was in charge of the greenfield construction and development of the second manufacturing facility at Gempol. He joined the company in 1981 and was responsible for the modernization of primary processing. He is also a Director of PT Surya Inti Tembakau.

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Director: Istata Taswin Siddharta

He was appointed Director of in 2012, primarily responsible for Information Technology. He joined the company in 2008 and served as Deputy Marketing Director from 2008 to 2010. He also formerly served as a partner of KPMG Indonesia and has got extensive experience as a public accountant for 20 years. He holds a Bachelor Degree in Accounting from Universitas Indonesia, Jakarta. He is concurrently serving as a Commissioner of PT Surya Pamenang, PT Surya Zig Zag and all subsidiaries of PT Surya Madistrindo. He is also a Director of PT Surya Madistrindo, PT Surya Dhoho Investama, and PT Grandsurya Resortindo, in addition to being an Audit Committee member of PT Goodyear Indonesia Tbk.

Director: Lengga Nurullah

She was appointed Director in 2015 with responsibility for SKM production at Kediri. She formerly served as Deputy Director of Production at Gempol in 2014-2015 and, prior to this, was the Head of LTN (low tar nicotine) production in 2013-2014. She joined the company in 2012, working in the Technical Division. Previously she worked in automotive manufacturing at Bosch in Germany. She is a graduate from the Technical University of Berlin. She is also serving as a Director of PT Bukit Dhoho Indah.

Independent Director: Sony Sasono Rahmadi

He joined the company in 2012 and was appointed Director with responsibility for printing operations of cigarette packaging. From 2008-2012, he served as Director at PT Cipta Kretek Nusantara and PT Karyadibya Mahardhika. Prior to that, he worked at PT Surya Zig Zag, during which he served as the General Manager and Management Representative. He was appointed Independent Director in 2014. He holds a Bachelor Degree in Chemical Engineering from Institut Teknologi Sepuluh Nopember, Surabaya.

Figure 81. GGRM’s board of directors


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Board of Commissioners

President Commissioner: Juni Setiawati Wonowidjojo

She was appointed President Commissioner of the company in June 2009. She has been a Commissioner since 1983. She is related to Susilo Wonowidjojo, the President Director and is affiliated to the company’s shareholders. Concurrently, she is serving as President Commissioner of PT Suryamitra Kusuma as well as Commissioner of PT Suryaduta Investama, PT Surya Wisata, and PT Taman Sriwedari. She is also the President Director of PT Surya Pamenang and PT Surya Zig Zag.

Figure 82. GGRM’s president commissioner


Commissioner: Lucas Mulia Suhardja Dr Suhardja was appointed a commissioner of the company in June 2009. A general practitioner by professional background, Dr Suhardja formerly served the company as the Head of the Jakarta representative office from 1976 until 2009. He is a graduate from the Medical School of Universitas Airlangga, Surabaya.

Independent Commissioner: Frank Willem van Gelder Frank Willem van Gelder was appointed Independent Commissioner of the company in March 2002. Currently, he is a Managing Partner of the consulting firm New Frontier Solutions Pte. Ltd, Singapore and formerly served ABN AMRO Bank for 12 years. He holds a Master’s Degree in Civil Law from Leiden University, the Netherlands.

Independent Commissioner: Gotama Hengdratsonata He was appointed Independent Commissioner of the company in June 2014. He has been a Commissioner of PT Semesta Indovest Securities, Jakarta since 2000. He formerly served Lippo Bank from 1985 to 2004, during which he served as Group Head for East Indonesia. He graduated as a Civil Engineer from Feng Chia University, Taiwan.

Figure 83. GGRM’s board of commissioners


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Competitive advantage Stable dividend payout ratio and debt

GGRM has been maintaining average payout ratio of c.36% over the past 10 years. The company had spent c.IDR18.4tr for capex throughout 2011-2015 to replace machineries, build new production machinery, refurbish factories as well as establishing modern warehouses, which clearly explains why its dividend payout ratio was very low during those years (c.35%). Going forward, we believe GGRM will maintain its capex low as the current plants’ capacities are able to cater to demands from consumers.

Last year, GGRM increased its payout ratio to 78%, with dividend per share increasing by 225% on a YoY basis from IDR800/share to IDR2,600/share in 2016. The company confirmed that this year, they will spend the same amount of dividend per share at IDR2,600, which translates into 75% of dividend payout ratio.

Although GGRM’s recent plan of land acquisition worth IDR850bn with a total area of 2.68m² to construct an airport in Kediri is a key concern to the capex going forward, we judge the amount to be insignificant. Hence, we believe the company will still be able to maintain its low capex over the years ahead. Furthermore, even if the company were to proceed with the airport construction (which we assume to be at c.IDR1.5tr-IDR2tr), we expect the total lost to be spread across a span of 3-4 years. All in all the financial burden is estimated at IDRIDR400bn-IDR700bn/ year, which would still be low at c.2% of sales compared to the previous years’ 6.3% of sales (assuming GGRM does not spend hefty capex on production capacity plant in the next several years).

Figure 84. GGRM’s capex and capex rate as % of revenue


Since GGRM no longer spends hefty amount of capex going forward and is still going to maintain its bank borrowing amount, (maintaining good relationships with the banks), we assume the company will still be able to maintain stable dividend payout ratio at the current rate going forward. With the current low interest rate in the market, we favor the company’s initiative of using debt to finance their expansion as it will generally be cheaper than the cost of equity. Based on our calculation, any increase of 25%p in GGRM’s payout ratio should also increase the company’s return on equity (ROE) by 100bps.

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http://market.bisnis.com/read/20170803/192/677771/bangun-bandara-kediri-gudang-garam-ggrm-beli-lahan-rp84531-miliar

http://www.solopos.com/2017/07/19/infrastruktur-jatim-bandara-di-kediri-dibangun-tahun-2018-835050

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Figure 85. GGRM’s dividend per share and payout ratio Figure 86. GGRM’s gearing and net gearing



Full-flavored cigarettes as the winner

GGRM mostly produces machine-made (SKM) full-flavored cigarettes which contribute to around 77% of the company’s sales volume. In 2013, GGRM’s sales volume declined after rebranding the overall packaging design of its machine-made full-flavored (SKM FF), GG Filter International Merah (GG International), as well as hand-rolled (SKT) products, namely GG Djaja and GG Merah. The company turned to a rebranding strategy in order to gain fresher and younger profile of smokers, most of whom fall in their mid-age (30+ years old). Nonetheless, many smokers who found different taste in the new GG International were disappointed and switched to other brands, causing weak sales volume of GG International in 2013. Nevertheless, since GG International is priced lower than GG Surya 16, which is also GGRM’s SKM FF products, and has a more intensive flavor compared to GG Surya, this brand’s products were able to regain high volume in 2014 onwards.

In fact, as GGRM’s product mix is still dominated by machine-made (SKM) full-flavored cigarettes, with GG International being the second largest product portfolio after GG Surya, we believe the company is well positioned in the growing machine-made full-flavored segment due to its well-received brand image among smokers. According to Nielsen, the industry’s machine-made (SKM) full-flavored market share has grown from only 28% in 2012 to 38% today. Indeed, GGRM saw an increase in its SKM FF volume contribution. In 2013, GGRM machine-made (SKM) full-flavored products’ contribution to total volume was 74%. Currently, the figure has amplified to 77%.

In addition to that, we have regard for the company’s diversification into a premium price cigarette in the SKM FF. GGRM’s first premium product, launched in 2013 under the brand GG Surya Exclusive, invited good market responses. We expect warm reception from the market to continue and GGRM to enhance its market share in SKM FF.

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The favorable mid-tar type of cigarette

According to our discussion with the company’s investor relation team, GGRM’s SKM mid-tar segment, Surya Professional (Surya Pro), has been recording higher sales volume growth due to its ability to sell at a cheaper price compared to other cigarettes in the similar type in the industry, such as LA Bold and Dunhill Kretek Filter (SKM mid-tar).

Surya Pro, commonly referred to as Surya PROfessional, is the first innovation produced by the company, launched in the 1990s. Initially, the products did not sell good in the market. However, GGRM has started advertising this new cigarette type within the year of 2016-2017 in order to increase the sales of Surya Pro itself. Surya Pro essentially offers a strong sensation of full-flavored cigarettes but with an innovation of having a smaller diameter of cigarette stick and containing slightly lower tar than that of FF (mid-tar). We believe this reflects the spirit of the company to always innovate in order to increase their sales volume. Our ground check on smokers reveals that Surya Pro seems to be the right answer for people who want a distinctive sensation from full-flavored cigarettes but with an acceptable size of stick among younger consumers, especially those aged 18-30 years old who feel reluctant to try the FF type of cigarette due to its “old” image. Surya Pro has started to re-launch its product in November 2016 with a slogan of "Never Quit", reflecting youth spirit to allure younger smokers.

Compared to LA Bold and Dunhill Kretek Filter, both of which are in the mid-tar segment (tar level of 18-25mg), Surya Pro is priced at a more competitive price. Based on our channel check, Surya Professional red is priced at IDR16,200, while Dunhill Kretek Filter and LA Bold are priced at IDR17,900 and IDR20,600, respectively.

Table 23. Price comparison

Company Machine-rolled Mild Price per pack Price per stick GGRM Surya Pro (16) 16,200 1,013 Djarum LA Bold (20) 20,600 1,030 BAT Dunhill Kretek Filter (16) 17,900 1,119 Source: Company data, Mirae Asset Sekuritas Indonesia Research

Figure 87. Machine rolled (SKM) mid-tar segment

Source: Internet, Company data, Mirae Asset Sekuritas Indonesia Research

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A relatively cheaper valuation compared to its closest counterpart

GGRM is currently trading at 17.8x 2018F P/E, at relatively much cheaper compared to its counterpart, HMSP, which is trading at 34.3x 2018F P/E. We believe the company’s discounted valuation as compared to HMSP is merely due to its less visible capex. The company has not disclosed its plan for expansion in the near term as it is yet to plan for the launching of new products. However, their plan to construct an airport in Kediri, as well as expanding to air transportation business under Surya Air label (GGRM has established a 100% owned subsidiary, PT Surya Air), remains a key concern for investors.

Nevertheless, we believe that should GGRM spend a high capex in the future, it will translate into a strong revenue generation. As evident, the company was successful in selling and promoting GG Mild products (launched in April 2013). Meanwhile, we believe GGRM valuation is currently very attractive given the expectation of strong full flavor sales volume, as well as less competition in the cigarettes industry post recent regulation on PMK that specifies minimum cigarette retail selling prices at the maximum discount of 15% from government’s suggested retail price (HJE). We view this as an advantage for big players, including GGRM, as we believe its market share will be maintained going forward.

Figure 88. GGRM vs HMSP P/E


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Financial forecast

Expect double-digit topline growth for 2018F

We expect GGRM to book 10.5% YoY topline growth in 2018F, chiefly on the back of higher average selling price (ASP) of c.8% to offset the higher excise tax and other raw material price increases in the cost of goods sold. We forecast flattish volume growth for GGRM’s SKT segment and 1% volume growth for GGRM’s SKM segment as the company sees more potentials in the SKM full-flavor segment. As full-flavored segment has a lower tobacco cost compared to SKT, we expect the segment will stabilize GGRM’s gross margin going forward. GGRM has higher inventory compared to HMSP in order to secure a large amount of tobacco (due to ageing process) and cloves (due to fluctuating prices). Thus, we believe the company is able to overcome fluctuating raw material prices.

Figure 89. Revenue forecast Figure 90. Stable gross margin forecast



Robust free cash flow, expect higher dividend per share

We expect GGRM to book a robust free cash flow going forward as the company needs less capex compared to five years ago (2011-2015). In addition, given a lesser capex going forward, we estimate a stable payout ratio going forward at 75% (similar to 2017F), and expect higher dividend per share going forward.

Figure 91. Free cash flow and capex as % of sales Figure 92. Dividend and payout ratio



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100,000

2012 2013 2014 2015 2016 2017 F 2018 F

Revenue growthIDRbn

17%

18%

19%

20%

21%

22%

23%

-

5,000

10,000

15,000

20,000

25,000

2012 2013 2014 2015 2016 2017 F 2018 F

Gross profit (L) Gross profit margin (R)IDRbn

78% 75%75% 75%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

-

1,000

2,000

3,000

4,000

5,000

6,000

7,000

2011 2013 2015 2017 F 2019 F

Dividend (L) Dividend per share (L)

Payout ratio (R)

IDRbn

0%

2%

4%

6%

8%

10%

12%

(4,000)

(2,000)

-

2,000

4,000

6,000

8,000

2011 2012 2013 2014 2015 2016 2017 F 2018 F

Free Cash Flow (L) Capex as % of sales (R)IDRbn

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Valuations

We initiate our coverage on GGRM with a trading buy rating and a target price of IDR91,000/share, which was derived using DCF with a 7-year life span. Our WACC assumption of 9.5% is derived from the following assumptions: Risk free (Rf) rate of 6.5%, market risk premium (MRP) of 5%, terminal growth rate of 3%, and equity beta of 0.9x.

GGRM is currently trading at slightly above its 5-year average P/E at 17.8x forward P/E, 48% discount from HMSP which is trading at 34.3x. We are taken with GGRM as the company is projected to register higher free cash flow, stable margins, and benefits from lesser competition from smaller players in the market given the company’s strong position in the SKM FF segment.

Figure 93. GGRM’s forward P/E band


-1 Std Dev

Avg PER

+1 Std Dev

-2 Std Dev

+2 Std Dev

10

12

14

16

18

20

22

24

01/13 01/14 01/15 01/16 01/17

( x )

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Gudang Garam (GGRM IJ/ Trading Buy/ TP: IDR91,000)

Table 24. Forecast and valuations 2015 2016 2017F 2018F Revenue (IDRbn) 70,365 76,274 82,912 91,578 EBITDA (IDRbn) 11,653 12,058 12,998 14,623 Net profit (IDRbn) 6,426 6,677 7,329 8,414 EPS (IDR/share) 3,339.5 3,470.3 3,808.9 4,372.7 DPS (IDR/share) 800.0 2,600.0 2,602.7 2,856.7 ROE (%) 17% 17% 18% 19% Dividend yield (%) 1% 3% 3% 4% P/E ratio (x) 23.3 22.5 20.5 17.8 P/BV ratio (x) 4.0 3.8 3.6 3.4 EV/EBITDA (x) 1.5 1.5 1.3 1.1 Source: Company data, Mirae Asset Sekuritas Indonesia Research

Table 25. Income statement projection IDRbn 2015 2016 2017F 2018F Revenue 70,365 76,274 82,912 91,578 COGS 54,880 59,657 65,087 71,518 Gross Profit 15,485 16,617 17,825 20,060 Opex 5,579 6,644 7,019 7,768 Operating Profit 9,906 9,972 10,805 12,292 Other income/(expenses) 109 109 116 128 Interest income 50 41 48 93 Interest expense -1,430 -1,191 -1,237 -1,331 Profit before income tax 8,635 8,931 9,733 11,183 Income tax expenses -2,182 -2,258 -2,461 -2,828 Minority interest -27 4 57 59 Net profit 6,426 6,677 7,329 8,414 EBITDA 11,653 12,058 12,998 14,623 Source: Company data, Mirae Asset Sekuritas Indonesia Research

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Table 26. Balance sheet projection IDR bn 2015 2016 2017F 2018F Cash and equivalents 2,726 1,595 4,653 7,217 Receivables 1,568 2,090 2,188 2,417 Inventories 37,256 37,545 39,109 41,036 Others 1,019 703 665 730 Total current assets 42,568 41,933 46,615 51,401 Fixed assets - net 20,106 20,499 20,462 20,421 Others 830 520 544 579 Total non-current assets 20,937 21,018 21,007 21,000 Total assets 63,505 62,952 67,622 72,400 ST Loan and CM 20,561 19,753 21,472 22,894 Accounts payables 2,370 1,118 1,446 1,589 Others current liabilities 1,114 767 965 993 Total current liabilities 24,045 21,639 23,883 25,477 Deferred tax liabilities 338 371 391 450 Others 1,114 1,377 1,405 1,556 Total non-current liabilities 1,452 1,749 1,797 2,005 Total liabilities 25,498 23,387 25,680 27,482 Minority interests 108 77 134 193 Shareholders' equity 37,900 39,487 41,808 44,725 Source: Company data, Mirae Asset Sekuritas Indonesia Research

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Table 27. Cash flow statement projection IDRbn 2015 2016 2017F 2018F CF from operation Net profit 6,426 6,677 7,329 8,414 Depreciation/amortization 1,715 2,063 2,193 2,330 Change in working capitals -1,702 -1,488 -1,311 -2,094 Others -3,357 56 218 200 CF from operation 3,082 7,308 8,427 8,850 CF from Investments Net capex -2,848 -2,455 -2,156 -2,289 LT investments 0 0 0 0 CF from investments -2,848 -2,455 -2,156 -2,289 CF from financing activity Increase/(decrease) in debt 2,414 -808 1,719 1,422 Increase/(decrease) in equity 0 0 0 0 Dividend payments -1,539 -5,003 -5,008 -5,497 Others 30 -173 75 78 CF from financing activity 904 -5,984 -3,213 -3,996 Increase (Decrease) in Cash 1,138 -1,131 3,058 2,564 Beginning balance 1,588 2,726 1,595 4,653 Ending balance 2,726 1,595 4,653 7,217 Source: Company data, Mirae Asset Sekuritas Indonesia Research

Table 28. Key ratio 2015 2016 2017F 2018F Growth (%) Revenue 8% 8% 9% 10% EBITDA 16% 3% 8% 13% Net profit 20% 4% 10% 15% Profitability (%) Gross margin 22% 22% 21% 22% Operating margin 14% 13% 13% 13% EBITDA margin 17% 16% 16% 16% Net margin 9% 9% 9% 9% ROE 17% 17% 18% 19% ROA 10% 11% 11% 12% Leverage (X) Current ratio 1.8 1.9 2.0 2.0 Quick ratio 0.2 0.2 0.3 0.4 Debt to equity 0.7 0.6 0.6 0.6 Net debt to equity 0.6 0.6 0.5 0.5 Source: Company data, Mirae Asset Sekuritas Indonesia Research

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APPENDIX 1

Important Disclosures & Disclaimers

Stock Ratings Industry Ratings

Buy Relative performance of 20% or greater Overweight Fundamentals are favorable or improving

Trading Buy Relative performance of 10% or greater, but with volatility Neutral Fundamentals are steady without any material changes

Hold Relative performance of -10% and 10% Underweight Fundamentals are unfavorable or worsening

Sell Relative performance of -10%

* Ratings and Target Price History (Share price (----), Target price (----), Not covered (■), Buy (▲), Trading Buy (■), Hold (●), Sell (◆))

* Our investment rating is a guide to the relative return of the stock versus the market over the next 12 months.

* Although it is not part of the official ratings at Mirae Asset Sekuritas Indonesia , we may call a trading opportunity in case there is a technical or short-term

material development.

* The target price was determined by the research analyst through valuation methods discussed in this report, in part based on the analyst’s estimate of

future earnings.

The achievement of the target price may be impeded by risks related to the subject securities and companies, as well as general market and economic

conditions.

Analyst Certification

Opinions expressed in this publication about the subject securities and companies accurately reflect the personal views of the Analysts primarily responsible

for this report. Except as otherwise specified herein, the Analysts have not received any compensation or any other benefits from the subject companies in

the past 12 months and have not been promised the same in connection with this report. No part of the compensation of the Analysts was, is, or will be

directly or indirectly related to the specific recommendations or views contained in this report but, like all employees of PT Mirae Asset Sekuritas Indonesia

Indonesia, the Analysts receive compensation that is impacted by overall firm profitability, which includes revenues from, among other business units, the

institutional equities, investment banking, proprietary trading and private client division. At the time of publication of this report, the Analysts do not know

or have reason to know of any actual, material conflict of interest of the Analyst or PT Mirae Asset Sekuritas Indonesia Indonesia except as otherwise stated

herein.

Disclaimers

This report is published by PT Mirae Asset Sekuritas Indonesia Indonesia (“Daewoo”), a broker-dealer registered in the Republic of Indonesia and a member

of the Indonesia Exchange. Information and opinions contained herein have been compiled from sources believed to be reliable and in good faith, but such

information has not been independently verified and Daewoo makes no guarantee, representation or warranty, express or implied, as to the fairness,

accuracy, completeness or correctness of the information and opinions contained herein or of any translation into English from the Bahasa Indonesia. If this

report is an English translation of a report prepared in the Indonesian language, the original Indonesian language report may have been made available to

investors in advance of this report. Daewoo, its affiliates and their directors, officers, employees and agents do not accept any liability for any loss arising

from the use hereof. This report is for general information purposes only and it is not and should not be construed as an offer or a solicitation of an offer to

effect transactions in any securities or other financial instruments. The intended recipients of this report are sophisticated institutional investors who have

substantial knowledge of the local business environment, its common practices, laws and accounting principles and no person whose receipt or use of this

report would violate any laws and regulations or subject Daewoo and its affiliates to registration or licensing requirements in any jurisdiction should receive

or make any use hereof. Information and opinions contained herein are subject to change without notice and no part of this document may be copied or

reproduced in any manner or form or redistributed or published, in whole or in part, without the prior written consent of Daewoo. Daewoo, its affiliates and

their directors, officers, employees and agents may have long or short positions in any of the subject securities at any time and may make a purchase or sale,

or offer to make a purchase or sale, of any such securities or other financial instruments from time to time in the open market or otherwise, in each case

either as principals or agents. Daewoo and its affiliates may have had, or may be expecting to enter into, business relationships with the subject companies to

provide investment banking, market-making or other financial services as are permitted under applicable laws and regulations. The price and value of the

investments referred to in this report and the income from them may go down as well as up, and investors may realize losses on any investments. Past

performance is not a guide to future performance. Future returns are not guaranteed, and a loss of original capital may occur.

Disclosures

As of the publication date, PT Mirae Asset Sekuritas Indonesia, and/or its affiliates do not have any special interest with the subject company and do not own

1% or more of the subject company's shares outstanding.

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Distribution

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professionals falling within Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2005 (the “Order”), and (ii) high net

worth companies and other persons to whom it may lawfully be communicated, falling within Article 49(2)(A) to (E) of the Order (all such persons together

being referred to as “Relevant Persons”). This report is directed only at Relevant Persons. Any person who is not a Relevant Person should not act or rely on

this report or any of its contents.

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major institutional investors as defined in Rule 15a-6(b)(4) under the U.S. Securities Exchange Act of 1934. All U.S. persons that receive this document by

their acceptance thereof represent and warrant that they are a major institutional investor and have not received this report under any express or implied

understanding that they will direct commission income to Daewoo or its affiliates. Any U.S. recipient of this document wishing to effect a transaction in any

securities discussed herein should contact and place orders with Mirae Asset Sekuritas Indonesia (America) Inc., which accepts responsibility for the

contents of this report in the U.S. The securities described in this report may not have been registered under the U.S. Securities Act of 1933, as amended,

and, in such case, may not be offered or sold in the U.S. or to U.S. persons absent registration or an applicable exemption from the registration requirements.

Hong Kong: This document has been approved for distribution in Hong Kong by Mirae Asset Sekuritas Indonesia (Hong Kong) Ltd., which is regulated by

the Hong Kong Securities and Futures Commission. The contents of this report have not been reviewed by any regulatory authority in Hong Kong. This

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All Other Jurisdictions: Customers in all other countries who wish to effect a transaction in any securities referenced in this report should contact Daewoo or

its affiliates only if distribution to or use by such customer of this report would not violate applicable laws and regulations and not subject Daewoo and its

affiliates to any registration or licensing requirement within such jurisdiction.

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