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.

Pfizer, PMI and Cisco Report Solid Earnings

Pfizer reported GAAP earnings of $0.43 per share in the most recent quarter. GAAP is the benchmark I feel we should use GAAP as a starting point for understanding a company's earnings performance. But a lot of companies have factors that would skew this result. Pfizer is one such example because the company acquired several large companies, most notably Wyeth in 2009. Acquisitions affects the company's earnings because of the marked value of inventories from acquired companies. Pfizer explains away such purchase accounting with a adjusted income value. Pfizer's adjusted income is $0.53 a share. I give Pfizer the benefit of the doubt and use this figure for Pfizer's income. I then estimate Pfizer trades at a PE of 13 (current price divided by adjust income). In addition, Pfizer has saved more than $7 billion in each of the last two years due to synergies from their acquisitions. Pfizer's report does not state how much it can save in the future but I hope that these savings can bring the company's PE close to 10 in the next two years. So to summarize, PFE is nothing too fancy, just a solid performer in a lucrative industry. I have a long term hold on it.

Philip Morris International (PM) recently announced that it earned $5.17 per share for the most recent year. This is an increase of 7% over a year earlier. The company has a 3.7% dividend yield. But as it trades at $91, it's PE is getting close to 20. And to me that is getting close to overvalued territory. As I mentioned before this is a sea change in opinion from a little more than a decade ago, when the market thought tobacco companies were getting sued to oblivion. I have sold a bit here and there as PM rose above 60. I will sell more if it goes above $100.

Cisco is another stock that has experienced a sea change of opinion in the last decade. The market once made it the most valuable company in the world. Now, the company just announced that it earned $1.49 GAAP per share last year. This gives it a PE of 14 with and a net-net of $4 per share. I consider it a value investment at this price. Cisco is my fifth largest holding mainly because of legacy positions and recent purchase as a value play. I would like to close my position however if it gets from $21 today to around $25; I generally do not like tech investments.