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Karelia Tobacco: When A Stock (Or The Board) Just Won't Budge

(note: this article was also published earlier today on my Wordpress blog)

The first article I wrote for Seeking Alpha was about two relatively small tobacco companies from Europe; Swedish Match and Karelia Tobacco. I was long the second stock then and I still am today. Unfortunately I could not really follow up on that thesis because the ticker has been removed from SA. You can still visit the stock's page by going to the URL directly (here). The reason for this removal can probably be traced back to the fact that daily traded volume in the stock is exceptionally low, ranging mostly between 0 and a couple dozen shares. Yet the stock continues to be hugely attractive on every major economic indicator; growing topline, branded consumer products, strong pricing, very high margins, no debt, extremely large cash holdings and a couple of attractive market positions in Greece and Bulgaria.

As is well known in investor circles, pricing power in tobacco is exceptional and appears to have only improved over time. While this applies to Karelia as well, I should note that Karelia is probably less defensive than the well-known tobacco majors, which is due to the fact that it is mostly export-oriented. A very sizeable part of revenues is derived from products sold to African countries, which are vulnerable to economic adversity and political instability. But the company's product is exceptional in terms of margins and the volume outlook for African tobacco markets is very good; in my opinion this should enable Karelia to improve its earnings over time, despite the occasional hick-up due to volatile business circumstances. Its gross margins are somewhat lower than those achieved by most of the tobacco majors, which in my opinion is highly related to its exposure to lower income countries and a relative lack of higher-end branded product. Still, with gross margins in the 50% range and the (adjusted) operating margin around 40% in 2015 there is very little to complain about.

The Discount

So why does this company persistently sell for a massive discount to intrinsic value? In my opinion, there are two reasons for the discount. First of all, it is listed on the Athens exchange of Greece, which over the past 6-7 years has turned into the leper colony of the international capital markets. Absent a total collapse of the Greek state, this depression-riddled environment makes for excellent bargain-hunting grounds as far as I am concerned. Secondly, the company's stock is controlled by roughly 5-6 members of the Karelias family, including some members who run the company's day-to-day operations. Despite a reasonably large market capitalization around €700 million, the low free float of 5.5% of the 2.760.000 shares outstanding ensures that shares trade very infrequently. This probably takes the stock off of most investors' radars: buying a meaningful position can be time-consuming, although sometimes very sizeable blocks change hands. The high nominal value around €250 probably does not help either; there usually is a huge spread between bid and ask prices, sometimes even an inverted spread (which is related to the absence of a market maker in the stock).

I have tried to engage the company's board on two separate occasions to convince them of the rationality inherent in ordering a stock split. In my opinion, a much lower nominal share price, combined with a much larger number of shares outstanding, would stimulate more rational pricing in its shares. So far, the company's board (also filled with family members) has not expressed an iota of interest in my proposal. I am still contemplating further action; in my opinion the board has a fiduciary duty to serve all shareholders, not just the majority-owners, which in this case they rather convincingly fail to do. After all, a company which consistently sells at a discount to intrinsic value will see all its selling shareholders being short-changed on the monetization of their ownership position. The fact that the board has proved itself immune to this line of rational thought is troubling to me. The Karelia family-members are owners; they act like owners in executing business operations, but don't appear to act like owners who care all that much about what happens to their fellow-shareholders. If my estimate of business value is correct (which follows below) their inaction on improving pricing behavior in the stock has cost Karelia shareholders millions of euros over the years. Family board members don't appear to care all that much about the share price either; they never sell a single share and they don't have to, because each one collects millions in dividend checks each year. The two independent directors apparently don't own any shares at all. It is something of a mystery to me why the company maintains a public listing; the family members are wealthy enough to make a public offer for the part they don't own. That would allow them to run their business completely free from financial reporting requirements et cetera. The only reason for the listing may be that it gives them the ability to sell shares to satisfy estate taxes in case of a family member's death.

The Downside in Karelia

Management, led by Andrew Karelias, is firmly in control and seems to be managing the company in a way to ensure its long-term survival; they appear to have no interest in selling out (they have been proposed to) and capital allocation is less-than-optimal. Operationally, there is little to complain about; the company operates just one plant (in Kalamata) and they keep it up to date with modern equipment in order to maintain efficient and low-cost production. Given the high margins of its products and the efficient use of manufacturing assets the company's operational use of capital is supreme and produces highly attractive returns on investment. Therefore, the capital expenditures part of the capital allocation issue is absolutely fine.

It is the use of excess cash, or rather the lack of use, that has me concerned. Even after hugely unfavorable inventory movements in Q4 for instance, the company sits on €266 million in net cash and equivalents, or nearly €100 per share. Considering that at €250 per share the entire business sells for less than 11x (adjusted) net earnings, the 40% cash cushion per share seems absurd (I am not making this up). I do note that this cash cushion came in handy when last year's introduction of capital controls in Greece prevented the company from paying dividends to non-domestic shareholders. Karelia's management postponed the dividend payment in order to ensure equal treatment of shareholders and subsequently dipped into cash held outside Greece in order to facilitate payment. There was some delay in payment versus the announced schedule, but overall I felt the actions taken by management were highly commendable.

What I find troubling however is the fact that the proposed dividend for fiscal year 2015 has been lowered from €9.30 last year to €8.50 this year. Taking into account the 10% withholding tax, this means shareholders will receive €7.65 net payment for a current yield of 3.06%. Management noted that reported profits were down during 2015 (they were, but only because of a non-cash charge taken because of a court verdict) and that 2016 will be a year with significant uncertainties (by which they mean the EU TPD and economic turmoil in emerging markets). Reported earnings were €19.53 because of the €14 million charge taken, but I should stress that adjusted earnings were more like €23.28 and €25.32 if we count the foreign exchange gains on cash holdings (which are partly in US dollar). I believe it would have been more reasonable to keep dividends at the same level or even slightly higher (which I actually expected). After all, with current cash holdings the company could afford to lose €26 million in every one of the next ten years before running out of cash, which is an absurd idea when we consider the fact that Karelia hasn't had a negative free cash flow year in at least 15 years.

Despite the advantages of being able to dip into sizeable cash holdings, both domestically and internationally, Karelia is being managed on an excessively conservative basis. Its financial policies are so conservative that Karelia may in fact be the last to fall in the unlikely case that Greece is taken into the abyss by the government headed by Alexis Tsipras. Meanwhile, all that cash is earning next to nothing in money-market funds and is therefore worth much less than 100 cent on the dollar. Many investors oftentimes subtract cash holdings from enterprise value and subsequently calculate the earnings multiple. That would make total sense in a control situation, in which case I would gladly value Karelias' cash holdings at 85 cents on the dollar (accounting for the 15% withholding tax on pay-out). In the current non-control situation with the poor (non-operational) capital allocation skills displayed by Karelia's management, I believe that the company's cash should probably be excluded from any valuation of its intrinsic worth. Its cash has significant value in guaranteeing the company's survival and dividend payments but should not be expected to compound at attractive rates of return. Alternatively, capital invested in Karelias' manufacturing operations does generate highly attractive rates of return; returns on tangible assets approximate 100% and return on equity runs at slightly over 15%. If you take out the cash component (which is earning nothing) return on equity jumps to an incredible 76.75%; that is one attractive business operation they are running in Kalamata!

If you consider the fact that Greeks cannot freely take their money out of the country and, prior to the bail-out agreement reached during the summer of 2015, held little hope of having a future in the Eurozone, any rational observer would conclude that Greek business operations with substantial non-domestic earnings, like Karelia or Sarantis, are exceptionally attractive for purchase at these low prices. First of all, your money won't be in a bank (which can fail) or in a mattress (which can be emptied by an unfriendly stranger) but will compound at attractive rates of return in a business with no need for additional cash. There were plenty of news reports last year that Greeks were converting their cash into physical goods like cars and groceries in order to save some value in the face of imminent danger; apparently the teachings of Warren Buffett have not been translated into Greek yet, because a far more rational approach would have been to buy unlevered businesses at the supremely depressed price levels they were (and still are) trading for.

Concluding Remarks

Karelia continues to represent an attractive opportunity at current prices. I have been rereading some of Buffett's letters in recent weeks and noted with some interest that his 1991 letter says it would make sense to pay a 25 multiple of net earnings for a business compounding its earnings at 6% into eternity (using a 10% discount rate). I immediately ran those numbers in an excel sheet and saw that he is right. Karelia certainly has the ability to grow earnings at an attractive clip over the coming years. Tobacco has real pricing power and is therefore hugely attractive as a business; the renewed appreciation of this fact is largely responsible for the enormous run-up in tobacco stock prices in the US and the UK over the past 7 years or so. Whereas there used to be a tobacco discount in stocks like Altria, there now seems to be a tobacco premium (the earnings multiples have expanded at least 50% on their own).

Philip Morris for instance has on numerous occasions touted their ability for upward pricing of 6-7% annually. I am not sure whether Karelia has the same sort of pricing ability; I would probably estimate it to be in a somewhat lower range but, contrary to most tobacco companies, it has succeeded in expanding its volumes over the years despite losing a lot of volume domestically. I therefore think that Karelia definitely has the ability to compound its earnings at rates close to 6% or even higher. Given the earnings multiple of 11 this means the asset may be undervalued by as much as 50% (not counting its cash holdings). In fact, if we run those numbers in a simple DCF, we quickly learn that the stock should be worth slightly over €600 per share, assuming a 6% growth rate and 10% discount rate. This translates into a private buyer valuation of close to €700 per share (including cash). This makes the current €250 asking price seem exceptionally attractive in my opinion.

(Disclosure: I am long Karelia Tobacco. The stock is listed on the Athens Exchange under the KARE ticker. All readers contemplating investment action are strongly urged to perform their own due diligence and research before trading in any of the stocks mentioned in my articles. Also: be sure to use limit orders on this stock!)

Disclosure: I am/we are long KCIGF.