Description

Summary

Karelia Tobacco AE is a Greek family-owned tobacco company with a market cap of €710m. Despite its excellent track record (400+ bagger over past 35 years; 90%+ ROIC; 15% ROE; consistent volume, sales & dividend growth), it is one of the cheapest tobacco companies in the world and trades for only 5x EV/FCF; 3x EV/EBIT & 9.8x P/E (TTM). The company has no debt and €456m in cash and debt securities (€165 per share) on its books. It is trading so cheaply because of it is unknown, illiquid, Greek, excessively capitalised and 95% family-owned, and because of fears relating to the growth of smokeless tobacco. However this does not reflect economic reality.

Covid has had minimal impacts on its business and its super-strong financial position will allow it to deal with any further economic shocks. Even if the company continues to hoard cash and its low valuation persists, there should be at least a 10% IRR in a very conservative base case scenario over the next 5 years with a huge margin of safety. Returns will be substantially higher if there is multiple expansion or the company returns some of its excess capital to shareholders.

Please note that this stock is very illiquid and the free float is only ~€35m, so this is only suitable for smaller funds and PAs.

Historical Background

Karelia Tobacco traces its roots back to 1888 in the pipe tobacco business and is credited with purchasing Greece's first ever automatic cigarette manufacturing machine in 1916. After many decades of expansion in the Greek domestic market, the company was listed on the Athens Stock Exchange in 1976 when the company won the rights to produce RJ Reynolds's brands of cigarettes. Karelia then added Camel to its brand portfolio in 1981.

The modern version of Karelia started to take shape in the 90s with the development of new original brands (Karelia Lights, Karelia Slims, George Karelias and Sons) and increased international expansion. The ending of the product relationships with Japan Tobacco for the RJ Reynolds brands in 1999 has resulted in Karelia focusing exclusively on its own brand portfolio over the past 20 years. 

Business Overview

Today Karelia is one of the most successful independent, family-owned tobacco companies in the world, and a 0.32% worldwide market share. It is focuses purely on smoke tobacco products and has particularly strong market positions in Greece (17% market share) and Bulgaria (20% market share). It has focused on niche areas (slims, menthol, RYO tobacco) and duty-free shops to gain a foothold in its other export markets throughout Europe, Africa, and Asia. Exports currently account for 75% of sales. The stellar historical performance of the tobacco industry has been well documented. Tobacco companies have been able to consistently earn supernormal profits due to number of structural and regulatory factors (regulatory capture, addictive product, pricing power, barriers to entry, minimal ad spend, economies of scale etc.). Karelia's performance of the past couple of decades has been excellent:

This performance was achieved through relatively modest volume growth, price increases, and significant margin expansion. What is most impressive is that this growth was entirely self-funded and organic. Karelia made zero acquisitions and employed zero debt during that period (these are in fact Karelia family business principles going back generations). Also impressive is Karelia's ability to generate volume increases in markets with large barriers to entry and large multinational competitors who enjoy significant incumbency and scale advantages.

Management deserves a lot of credit here for focusing on less competitive niche smoke products like slims, superslims, menthols (however these are now banned in the EU), and fine-cut tobacco (31% volume CAGR since 2010). Karelia has been able to successfully develop completely new cigarette brands despite the structural and regulatory difficulties in doing so in modern tobacco markets, e.g. the OME Slims brand was launched in 2009 and immediately experienced rapid sales growth. The managing director stated many years ago that consolidation in the tobacco industry has actually created many opportunities for Karelia. Its financial strength and lack of bureaucracy has allowed it to capitalise on opportunities in niche product markets ahead of the larger multinational tobacco companies. 

While the management of the tobacco business has been excellent, capital allocation is excessively conservative. Karelia has no debt and has now piled up €456m of excess cash and securities on its books (€165 per share/65% of the market cap). This consists of €346m in cash and €110m in various money market funds (managed by UBS, Danske Bank, and Deutsche Bank), US government bonds, corporate bonds, and other debt instruments. As a protection measure against capital control measures in Greece, ~90% of the company's cash balances are held outside of Greece. Karelia is legally required to have a 35% dividend payout rate (after accounting for a statutory reserve), however the cash pile has grown significantly over recent years and has reduced Karelia's ROE. In fairness to management, its conservatism has allowed the company to weather significant economic headwinds over the past century (wars, revolution, GFC). The cash pile is a clear benefit in the current economic environment and may allow Karelia to improve its market position in many of its markets.

Unjustified Valuation

Karelia is clearly a very high quality company, yet it is probably one of the cheapest tobacco companies in the world. It currently trades for 5X TTM EV/FCF, 3x EV/EBIT, and less than 10x P/E, while having 65% of its market cap in cash and low risk securities and no debt. This is a 35-80% discount to a broad basket of peers depending on what metric you use.

A certain valuation discount to the big tobacco companies is justified (less scale advantages, smaller market share, inability to do buybacks etc), however Karelia’s €258 share price is way too cheap for a company of this quality. There are a number of reasons why Karelia trades so cheaply, however these are not justified by economic reality in my view.   The 5% free float and the illiquidity of the shares will preclude many from investing in Karelia, however this is not an issue for smaller investors with permanent capital. Some investors will simply not invest in tobacco companies due to moral objections or ESG mandates, but this of course has nothing to do with the economic fundamentals of the business. Many investors are wary of Greek companies or having exposure to the Greek economy, however Karelia is predominantly an export company and keeps the majority of its cash & securities in foreign accounts. The most compelling bear cases relate to Karelia’s 95% family ownership and fears relating to the decline of the smoke tobacco industry, however I do not believe these are valid reasons for the low valuation.

Family Ownership

The Karelia family own 95% of the outstanding share capital. The lack of control and protection for minority shareholders will be a red flag for many. However it should be noted that there are two distinct factions of the Karelia family within this 95% ownership.  There has been an ongoing dispute between the 2 factions for the past 20 years (I can go into further details on the family feud in the comments section). This internal discord will be another red flag for many. However my variant perception here is that this actually protects minority shareholders.

The “majority” faction consists of the late George Karelia’s sons (Andreas & Efstathios) and widow (Victoria through her charitable foundation). They are directly involved in the management of the company, with Andreas acting as managing director, Victoria as chair, and Efstathios as vice-chair.  The “minority” faction consists of the daughter (Ioanna) and widow (Asmina) of Konstantinos Karelias who tragically drowned in 2009. 

Minority interests are protected because there is strong 45.35% group of minority shareholders who aggressively hold the larger faction to account. They have used various legal powers at their disposal to query certain corporate governance activities in the past and have stated that they will continue to do so in the future. However they have never called into question the Andreas Karelias’ excellent operation of the business, and have always approved the dividends and annual financial statements of the company.  Ioanna and Asmina have no incentive to undermine the performance business Karelia stock is their primary source of wealth and Karelia dividends are their primary source of income. This situation actually creates a unusual form of checks and balances, indirectly protecting minority shareholder interests.  It should also be noted that members of the majority faction all earn minimal salaries for operating the business, and they too rely on dividends as their primary source of income. Thus, the interests of both factions are ultimately aligned with minority shareholders.

Some investors have written to management in the past requesting certain corporate actions which have gone simply ignored. Expecting to influence management in this way is to fundamentally misunderstand the nature of the company and the character of the family controlling it. Like most European family companies, minority shareholders are not in the driving seat but rather hitching a ride in the family limo. While the company is over-capitalised and capital allocation is too conservative, minority shareholders have enjoyed the same stellar returns as the Karelia family over the long term (400+ bagger over past 35 years; ~15-20% IRR across multiple decades). And it is certainly possible that management will eventually return some of the excess capital to shareholders.

Decline of Smoke Tobacco Products

Karelia is a pure play smoke tobacco products company. Thus there is a clear chance that Karelia is a melting ice cube if the tobacco industry moves from smoke to smokeless. Management have stated that they have no plans to enter the Heat-not-Burn (HnB) or vaping markets. They have admitted that the company does not have the financial resources required to compete with the big multinationals in developing these products. Furthermore, they are skeptical of the financial viability of these products at this early stage, especially when compared with the smoke tobacco business. Smokeless tobacco is a growing industry, but is not clear that it will ever enjoy the same economic advantages that has made smoke tobacco so profitable over the last century.

I agree with management’s skepticism of smokeless tobacco, but the most important factor to bear in mind is Karelia’s geographic market spread. Karelia primarily sells to markets where cigarette volume is either growing or declining less rapidly such as central and eastern Europe, Africa, and Asia. The majority of the growth in the e-cigarette market (before the vaping scandal) was in North America and Western Europe.  which are minor markets for Karelia. If HnB takes off outside of Japan, it is much more likely to be in North America and Western Europe than in Karelia’s core markets. Thus, Karelia is relatively insulated from this potential paradigm shift in the tobacco industry.

Growth Prospects

Karelia should be able to impose increase prices in the region of 2-5% per annum going forward. It is also very possible that it will continue its volume growth over the next decade. The company experienced volume growth in cigarettes its domestic and international markets in 2019. Volume has been growing in most of their export markets (Africa excepted). Q1 2020 sales in Asia saw a massive 140% increase YoY.  Karelia’s fine cut tobacco business has grown rapidly at ~30% per year over the past decade. Fine cut tobacco for the RYO market is a major source of future growth for the company and will continue to benefit from economies of scale as volume increases.

One point of concern is Africa, one of the few regions expected to grow in volume terms over the next few decades. After a long period of rapidly increasing sales in Africa, this ultimately peaked in 2015 and sales have since declined by 50%. Management chalked this up to political and currency factors, but a reversal of this trend will be crucial to the company’s continued volume growth.

Covid has certainly had a negative impact on some of the big tobacco companies. For instance, BAT recently reduced guidance due to declining sales, however this is due to particularly bad sales in emerging markets like Bangladesh, Vietnam, Malaysia, Mexico, and of course South Africa (where an outright ban has been imposed). Sales of e-cigarettes and HnB products have declined. Karelia on the other hand have not yet experienced such declines, with management describing the effects of the pandemic as being “somehow mild”. To be sure, sales will probably decline in the short term in a recession and the closure of duty free shops is affecting sales and will limits their ability to grow in certain export markets (management estimate they’re losing €1.6m a month of profit while duty free is suspended; duty-free is 16% of sales). However tobacco is a resilient, defensive, and non-cyclical business. Karelia has as clean a balance sheet as possible and will likely improve its market position coming out of the crisis as it has done in the past. Karelia may actually benefit from other economic consequences of covid such as high inflation or even a black swan event like the collapse of the euro.

Using conservative estimates (3% sales growth and very modest margin expansion), Karelia could easily be earning €100m+ in EBIT and €30+ eps 5 years from now. Even if Karelia continues to hoard up cash and trade at its current bargain basement price, it is hard not to get at least a 10% IRR over the next 5 years in a conservative base case scenario. Returns will be substantially higher if there is a rerating to a more reasonable multiple (say 8x EV/EBIT) or some of the excess cash balance is put to better use/returned to shareholders. There is a big margin of safety with the resilience of the business, €456m in cash and securites, no debt, and an extremely low valution.

Catalyst

Deployment/Return of excess capital 

Continued sales and volume growth

Value as a catalyst