Why I Bought Karelia Tobacco

I believe the biggest hardest thing to do for the average advanced investor is to put matters in perspective and being objective. Warren Buffett used to ignore all outside analysis when he evaluates a stock. And he would make relative comparisons of two comparable investments, so that the analysis is more objective than in a vacuum.

I've owned Philip Morris International (PM) for 15 years, although in the last few years I have reduced my position considerably. The market used to regard tobacco as a sickly industry with a lot of litigation and regulation risk. But today PM has grown to 17 times earnings. This large a PE means the market sees tobacco as a growth industry, at least in the international markets where PM operates. Worldwide cigarette consumption is almost 6 trillion cigarettes per year. The international tobacco industry has grown steadily in recent years. But more importantly cigarette makers now have the pricing power to grow faster than inflation. That is in no small part due to the addictive properties of nicotine.

With PM so richly priced I turned to look at other public tobacco companies and noticed that they had even higher valuations: for example, American Reynolds (NYSE:RAI) trades at 27 times earnings! The one exception to the nosebleed valuations is Karelia Tobacco (ATH:KARE), a small cigarette maker in Greece. The company has a hundred year history, and when it joined the EU it began to expand globally. Today Karelia gets 85% of its sales internationally. Karelia has 0.3% of the world market versus 15% for PM. So obviously Karelia has much more room to grow than PM. This is the size handicap that Buffett so often talks about.

	Karelia	PM
Price	€ 225.000	$ 84.500
Market Cap	€ 621.00 M	$ 130.71 B
P/E TTM	9.8 x	17.1 x
Div yield	4.1 %	4.6 %
ROIC	61.1 %	23.1 %

Both Karelia and PM have increased sales at the same rate over that last five years — about 20-30% total. However, PM has increased EPS only 20% over the last five years while Karelia has almost tripled! The difference is from improved margins at Karelia. Karelia has worked to improve efficiencies through automation and sales channels. PM on the other hand increases earnings through a ton of share buybacks. Share buybacks trade equity for earnings. It's equity is now –$11B! Also comparing PM and Karelia is not all straightforward as PM reports in USD and Karelia reports in Euros. PM's bottom line has suffered from the strong dollar while Karelia has benefited from the strong dollar.

I like tobacco because it is a simple industry. Tobacco companies sell an addictive product, so they have steady reliable demand. And contrary to what some may believe, world cigarette consumption has not decreased in the past. I would guess that will continue for the next 10 years. Sure, it is down in developed countries, but the crucial market for tobacco is going to be developing countries. Just like many other industries, emerging markets is where growth will come.

The one downside to tobacoo is litigation risk. But I don't see a litigation risk discount. The other risk is illict cigarette sales that circumvent excise taxes. Taxes are the biggest part of cigarette sales, and the governments that impose it are also the biggest nemesis to tobacco companies. So the nemesis is also the biggest financial beneficiary of tobacco. That's why I am confident that governments will protect their golden goose by keeping a lid on illicit cigarette sales.

Within the tobacco industry I only see Karelia as cheap. Compared with PM, Karelia earns much more per share. Karelia has € 263M of cash and no LT debt. But PM has $27B of LT debt and negative equity.

Karelia could also be an attractive buyout target. The tobacco industry worldwide has only a few huge players. I am sure the company has had offers in the past that no one knows about. But it is 90% owned by the founding family, so that makes it an unlikely prospect. But who knows, it can happen.