Karelia Tobacco: A Quick Drag

Karelia Tobacco (GR:KARE) released its financial results for 2017 a couple weeks ago and the report provided an interesting perspective on the current tobacco landscape. As expected, the company has continued to do well in its domestic Greek market, as well as in the EU. The company is one of the oldest tobacco companies of Greece and one of the few still in domestic hands. After a long running decline its market share sank below 10% in 2009, but has steadily recovered since then on the back of new product introductions.

The gains made in its EU export markets are surprising given that the company generally holds only very modest share outside of Greece and Bulgaria. Given the restrictions on advertising in most markets, it is somewhat unclear how they communicate with consumers about their products, but it seems likely that their extensive presence in the travel retail channel and exposure through tourism play a significant role. The company has also wisely focused on relatively niche products, such as slims and roll-your-own. In the graph below I have compiled some data about their geographic segment sales performance.

karelia

Karelia Tobacco’s net sales per geographic segment since 2010 (in 000s). Net sales exclude excise taxes collected on behalf of governments.

As can be seen clearly, export sales to the African markets (presumably Egypt and certain West-African markets) provided an important growth area for Karelia between at least 2010 and 2015. Since then, sales to Africa have declined quite substantially, mostly as a result of an expensive dollar and foreign currency scarcity in those markets. In general, these sales are mostly lower-margin, meaning the decline has not impacted their bottomline to the same extent.

Sales in Greece and exports to the EU have done well over the same period, especially as the company has managed to take back significant Greek market share since 2009. Export growth to the EU markets have provided the most dependable growth over this period, growing from €28 million  in 2010 to €53 million last year. This makes the EU the second largest segment in terms of sales, while it was in fourth place back in 2010.

Domestic sales were up to €44 million last year, a notable improvement from €36 million in 2010. The achievement is even more impressive when considering the fact that the Greek market was essentially cut in half over the same time in volume terms, as a result of economic hardship and higher taxes. A significant amount of consumption has leaked into the illegal market since then.

 

2017 Performance

While sales were down somewhat due to lower African exports, its earnings per share eroded more forcefully because the company faced a significant foreign currency headwind on its US dollar holdings. EPS were down to €19,83 last year, meaning the company’s P/E hovers around 13,9x earnings on a share price of €276. The dividend was increased to €9,20 per share, implying a net yield of 2,83% after accounting for the 15% dividend tax. This means the company’s valuation gap with its international peers has closed down considerably, while its yield has remained much lower.

On top of that, Karelia faces an increasingly uncertain outlook because of the technological developments in the tobacco industry. From the annual report;

“There have been many claims by our competitors about the future of new smoking product technologies such as Heat not Burn (HnB) and Vaping. We follow this situation very closely.
The HnB technology has been developed through a large investment by the “Big 4” global tobacco companies and their products are heavily protected by patents. The investment needed to follow this route is considerable and outside the scope of our company. 

The vaping or e-cigarette technology is different in that there are many independent suppliers of both the hardware, the electronic equipment used for vaping and the liquids themselves. This has led to a fragmented market with many suppliers and a route to market which differs from cigarettes, as it includes specialist vaping shops and internet sales. The technology for this segment is also evolving rapidly.

The appeal of these alternative products is also due to rates of taxation that are much lower than equivalent conventional tobacco products leading to lower retail prices. Whether this situation will continue is not known, neither are the regulations which will apply to these sectors. For example, there is debate about whether EU TPD2, the revised Tobacco Products Directive should apply to vaping liquids whether they contain nicotine or not.

It is the company’s view that, at present, attempting to enter either of these markets at this early stage, when the tax and regulatory frameworks surrounding them are still undecided by governments, is too high a risk. We will ontinue to monitor developments closely to build our understanding of this sector but in the meantime we believe that there are still profitable opportunities to be developed in conventional tobacco product categories.”

In other words, Karelia continues to bet solely on traditional tobacco products, and to its own admission would not even be able to compete succesfully in HnB or vaping categories. We may soon find out whether this is a smart strategy on the company’s part. Philip Morris has already rededicated its Greek facility to produce HnB sticks only, and has booked modest progress in HnB market share in the Greek market.

So it’s fair to say that Karelia faces increasing uncertainty as a small independent operator as the technology gap with its competitors increases. Since I sold my shares last year I have continued to keep an eye on the company, but I don’t consider its current valuation attractive enough to plan a re-entry at this level, especially not now when the industry is entering a potentially transformational period.

 

Disclosure: no position.

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