Altria and BAT: Will The FDA Go Menthol?

Yesterday the Wall Street Journal reported that the Biden administration is considering regulations targeting nicotine levels in cigarettes as well as menthol flavorings. With regards to nicotine, an addictive chemical present in tobacco smoke, the measure being considered is to only allow non-addictive levels of the substance in cigarettes. The potential measure with regards to menthol would be to ban it as a characterizing flavor in cigarettes, and possibly in other forms of tobacco as well. According to the report, the decisions regarding both initiatives have not been made yet. 

However, given the uncertainty created by the possibility of regulatory intervention, the market showed an adverse reaction in tobacco stocks like Altria. Regular observers of the tobacco industry can hardly be surprised by this development. The FDA, then under the leadership of commissioner Scott Gottlieb already announced similar intentions several years ago. The regulatory overhang has probably contributed to a significant discount in tobacco stocks since then. Therefore, this news report did not really deliver much of a surprise, but it does raise some questions. Namely;

  1. how likely are scenarios that either one, or both of these measures will be implemented? 
  1. how quickly will these policies be implemented if they are adopted? 
  1.  What will be the economic impact on the tobacco companies of both measures? 

Likelihood of menthol and nicotine regulation

Perhaps it is to be expected that the new administration, with a significantly more progressive agenda than the previous one, would like to move decisively on tobacco control. Regarding the possible implementation of menthol and nicotine content regulation, it should be noted that these ideas constitute very different tobacco control measures. Menthol regulation on the one hand is a tested tobacco control measure that has already been adopted in the European Union and Canada, while nicotine content regulation seems to be a more radical and untested approach. 

The rationale for menthol regulation is that it serves as a gateway for cigarette smoking by making the habit more palatable for new users, thereby fueling addiction and, by extension, long-term health damage. Removing mentholated cigarettes from the marketplace would presumably limit the uptake of smoking among youth, and might make it easier to quit for existing users. The fact that ethnic minorities are overrepresented as consumers of menthol cigarettes is an issue that has become more prominent over time, and has served as something of a rallying cause for minority advocacy groups in recent years. 

Given that menthol is an additive in tobacco products instead of a naturally occuring substance, the practical implementation of a ban would be relatively straightforward. A significant advantage with regards to implementing a menthol ban is that lessons can be drawn from experiences in the EU and Canada, who have already implemented such rules. If evidence can be presented from other countries that a menthol ban leads to a lower smoking rate, this clearly helps in building a public health benefit claim.

Nicotine content regulation on the other hand is a largely untested control measure, as it has not been implemented on a significant scale in other markets. Additionally, nicotine occurs naturally in tobacco leaves and a content rule would be far more intrusive and would likely require far more extensive cooperation from manufacturers in order to be implemented successfully. 

The rationale behind the possible introduction of non-addictive nicotine levels in cigarettes is that addiction to nicotine is the main reason why smokers continue to engage in behavior that causes severe long-term health problems in the majority of users. Taking the amount of nicotine in a cigarette down to non-addictive levels might raise the rate of success of smokers trying to quit, and might lower the risk of addiction in new users, or so the FDA thinks. The issue with this argument is that it is difficult to corroborate with data, because it is not at all clear how a lower level of nicotine would affect smokers’ behavior. For instance, it might lead smokers to smoke more cigarettes or inhale deeper, or it might lead them to different tobacco products, potentially even illicit ones. It would be hard to argue a public health benefit arising from such a rule if it may lead to more risky behavior in users.

Time-frame for implementation

The amount of time it might take for menthol and/or nicotine content regulation to be introduced in the marketplace is highly uncertain, and would depend to a significant extent on the regulatory path chosen to implement the new rules. I expect that the tobacco industry will try to challenge both a menthol and a nicotine content rule in court, something they did not do with regards to the recent tobacco-21 law.

Another unknown variable is the fact that the US senate has historically formed quite a formidable obstacle in the way of more restrictive tobacco laws. I presume that this is part of the reason why new tobacco restrictions in the US usually arise at the local level first. In the case of tobacco-21 measures, the adoption of federal legislation followed, rather than led, the implementation of more advanced age restrictions in many local jurisdictions. It is not entirely inconceivable that menthol regulation will follow a similar path, whereby a rising number of local jurisdictions where menthol sales are banned will at some point force the issue at the federal level.

In my opinion, both a menthol ban and a nicotine content rule would take several years at a minimum before they can be implemented in the marketplace. First, if new tobacco regulations are introduced as legislation, it is not at all a given that this bill would pass the US senate, where democrats currently possess only a razor-thin majority. Second, there is a significant chance that in case new rules are introduced by the FDA as part of its authority granted under existing legislation, these rules would likely be challenged in court.

Economic impact 

Regarding the economic impact of a menthol ban and a nicotine content rule, I would argue that a nicotine content rule would likely be more damaging to the tobacco industry’s long-term economic prospects. Of course a menthol ban would cause disruption in the US market, but in my opinion this would largely be a transitory issue. The US is the largest market for menthol cigarettes by far, estimated to constitute as much as a third of all cigarettes sold annually, but the dynamics of a ban are nevertheless likely to play out along the lines of what we have seen in Canada and the EU.

As we have seen in these markets, once menthol products disappear from the marketplace the addicts remain and usually switch their consumption to non-menthol cigarettes or other nicotine products. Some users will probably use the ban to try and quit completely. But because users overwhelmingly switch to other nicotine products, the impact of a menthol ban on tobacco companies usually comes down to a manageable event. After all, these companies are usually the ones that sell the alternatives as well. The most significant impact will therefore be related to changes in market share between different manufacturers, as well as differences arising from disparate profit contributions per product.

A nicotine content rule would in my opinion be far more disruptive to the tobacco industry because it potentially takes away or minimizes the addictive characteristics of the tobacco product in question. A tobacco product devoid of nicotine would probably experience a lot of problems in maintaining its marketplace relevance, given that it would no longer deliver the dopaminergic effects of nicotine to the brain. The delivery of nicotine to neuro-receptors in the brain and the pleasure effect it induces is the main reason why people find smoking enjoyable. Taking away or impairing this mechanism would probably severely disrupt the tobacco market over a prolonged period of time, the effects of which would only be ameliorated to the extent that consumers are offered satisfactory alternatives.

Despite this observation, a low-nicotine rule is unlikely to be the Holy Grail of tobacco control as some might like to conclude. First of all, it would be far more difficult to introduce successfully than a menthol ban would be, not in the least because manufacturers would have to be forced to materially alter a product they have marketed legally for many decades. Additionally, a low nicotine product landscape would likely leave many users with a nicotine addiction with few options to satisfy their craving. This might form an ideal breeding ground for an illegal market to arise in force, which would be an absolutely undesirable outcome.

For this last reason alone, I do not believe a low nicotine rule would be an effective tobacco control measure. A menthol ban on the other hand, would likely only temporarily cause disruptions in the US market but might deliver real health benefits to the extent it contributes to a lower smoking rate in the US population. It constitutes a more targeted and more reasonable measure than a nicotine content rule, is backed up by substantially more empirical evidence from similar measures taken elsewhere, and is therefore a substantially more likely candidate for successful introduction in the US than a low nicotine rule would be.

Disclosure: the author owns shares of British American Tobacco

Imperial Brands: A Weak Pulze

It has been quite an eventful year for tobacco purveyor Imperial Brands. Not only did Imperial cut its dividend for the first time ever as a public company, but it also saw a nearly complete overhaul of its senior leadership. Long-time CEO Alison Cooper has made way for Stefan Bomhard, formerly of Inchcape, and new appointments of a chief financial officer and a chief consumer officer were also recently made. 

In addition, the company has finally managed to close the long-awaited sale of its premium cigar business to a consortium of buyers from Asia. The sale of the premium cigar business was part of former management’s commitment to raise approximately £2 billion from asset sales, the proceeds of which were intended to strengthen the balance sheet and to put additional investment behind next generation products such as vaping devices and heated tobacco products.

The fact that the company fell substantially short of its divestment target is but a minor example of its failure to deliver on promises under former CEO Alison Cooper. When pressure from disgruntled investors started building a couple of years ago, there was little room for more disappointments. 

When the company’s US vaping sales were caught up in the fall-out from the EVALI uproar and the FDA’s subsequent crackdown on vaping products, Alison Cooper did not have enough credit left to ride out the storm. One week or so after the company warned on profit in the fall of 2019, the CEO’s departure was announced.

A man with a plan

More than a year later the company’s new CEO has recently presented a new strategy, which he believes will set Imperial Brands on the right track again. In my opinion, the new management team offered a very clear analysis of the company’s current shortcomings, which they primarily relate to its lack of a data-driven marketing approach, insufficient focus on key markets, and the distractions caused by next-generation products. As indicated in the presentation below, too many times in the past business decisions have been made without sufficient data to back them up, leading to subpar performance and significant market share losses in many markets.

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Key items detailing the new team’s assessment of past lackluster performance

Management’s analysis of Imperial’s business failures was followed by a detailed plan for how they will seek to improve the company’s marketing operations, and how this will gradually improve the company’s performance. The plan they shared was quite detailed and, as far as I can tell, it should be within the new management team’s capabilities to execute on it. Yet for me, the thoughts that lingered were not related to the plan on how to get the combustible business back on track, but rather the question of how the company intends to move forward with regard to next-gen products. And how difficult it will be for them to close the gap with its competitors.

If the world of tobacco was anything like it had been for decades, the plan management presented might well have met a more welcoming reception from investors. Instead, Imperial’s share price has languished near multi-year lows as investors were left to contemplate whether the new strategy will put the company back on track. In my opinion, navigating Imperial out of its troubled state and onto a more rewarding course will be a tough process for two reasons: 

  1. its development and commercialization of next-gen products is lagging significantly behind all of its major competitors
  2. turning the focus back to cigarettes and fine cut tobacco may deliver better economic results in the medium term, but goes against society’s decreasing acceptance of cigarette products

Regarding the first issue; Imperial Brands is so far behind the competition in next generation products that a significant consolidation of its efforts in vaping products has been deemed necessary by its new management. The leadership team under Mr. Bomhard intends to focus on a smaller number of vaping markets going forward, while keeping its oral nicotine products focused on markets with a preexisting habit of oral nicotine consumption. 

CEO Stefan Bomhard has referred to the  company’s blu vaping products as having previously been expanded too quickly, into too many markets, and without proper insights on consumer needs. The implication of this observation seems to be that these products are failing to gain significant traction in the marketplace, racking up substantial losses for Imperial, while lacking a clear path to profitability.

Retrenchment in next-gen may be the most obvious option available to the company, but admitting this has also highlighted Imperial’s NGP weakness. And while its larger competitors are racing to launch more new products into more markets, Imperial is proposing to move largely in the opposite direction. This  can only mean that the new management team has recognized how weak the hand is they are playing in these new categories. And although the decision might seem rational, the question investors should ask themselves is why they would want to join this management in playing a weak hand?

Imperial’s weak Pulze

Imperial’s heated tobacco product seems to be in even worse shape than its vaping products, where the company at least has a widely-recognized product in the market. Mr. Bomhard has referred to the heated tobacco product as showing promise, and having received too little prioritization under previous management. It is important to note that Imperial’s Pulze tobacco heater and accompanying tobacco sticks have barely put a dent into the Japanese market, which is currently the most important market for this type of product.

Compare this with Philip Morris’s IQOS product, which already has a presence in some 65 markets, or British American Tobacco’s Glo, which is currently present in 17 or so markets. When we add Japan Tobacco’s hnb product Ploom and KT&G’s lil, both of which currently have fairly limited but still meaningful geographic footprints, the inevitable conclusion is that Imperial is at best contending for a fourth or fifth place in this growing segment. 

Contending for fourth place is usually not a great position in any consumer product category but, given the unusual economic returns of the tobacco business, being a moderately sized contender has historically been a more than decently profitable position. It is not at all clear that this would be true for heated tobacco products as well. 

The amount of R&D dollars that Philip Morris has already spent on developing and commercializing IQOS strongly suggests that only those companies with significant market positions will be able to afford the expenditures that are required to develop and scale a successful heated tobacco device and still make a good return on investment. Aiming for fifth place, which in my opinion is really all Imperial can hope to achieve in this segment, is therefore a business strategy with a highly uncertain payoff.

Feeling blu

Imperial will likely withdraw its blu vaping products from certain countries where there is either poor demand for vaping products or blu currently holds a weak position. Instead of spreading its operations far and thin, as it did under Mrs. Cooper, from now on Imperial will focus on those markets that are already well-developed or show a very promising outlook. Consolidating its efforts on just a few important battlegrounds, such as North America and Northern Europe, seems sensible as these markets currently account for the overwhelming majority of vaping sales (outside of China). Gaining a strong market position in these markets will be key to building scale and a profitable business.

However, it is not a foregone conclusion that Imperial can turn its chances around, even if it is competing in a smaller number of markets. Imperial’s vaping products business is in particularly urgent need of improving its position in the US, a market where blu has long been an established player. In recent years the brand has lost a lot of ground to competitors Juul and Vuse though. Imperial’s pods-based vaping product MyBlu is estimated to currently hold a #4 position, at a very substantial distance to the dominant players. Stefan Bomhard has blamed the poor development of blu’s position in the US in part on insufficient retail support, and disruptions caused by the transition from Lorillard’s sales force, its previous owner, to ITG’s sales network (ITG is Imperial’s US subsidiary). 

The problem is that, even if Imperial increases sales support for blu and manages to increase its retail distribution, blu will likely still operate at a substantial disadvantage. Market leader Juul enjoys the benefits of its size in the market, and also has ties to the market leader in US cigarettes, Altria. Number 2 Vuse is owned by Reynolds, BAT’s US subsidiary, which occupies a strong number 2 position in US cigarettes, and benefits from its tobacco sales force. ITG on the other hand, has a weak number 3 position in US cigarettes, which means blu is unlikely to ever match its competitors’ strengths in distribution.

Another point of weakness is the fact that vaping is more of a scale business than conventional tobacco is. Just like heated tobacco devices, the amount of R&D expenditures involved in the development and marketing of vaping products is quite significant. The dominant players will increasingly benefit from their ability to charge large R&D and marketing expenditures against a much larger number of devices and refills sold, and will therefore benefit from having lower marginal product costs. Those savings can be put to productive use in regulatory compliance for instance, to an extent smaller competitors like blu simply cannot match.

Tobacco in an ESG world

While innovation is a very important driver of economic value (and value destruction) in any economic activity, the tobacco industry does not solely have an economic reason for innovating and trying to move beyond combustible products. It also has an increasingly urgent social acceptability problem with regards to its traditional business. The serious health consequences of tobacco consumption mean that tobacco stocks are increasingly avoided by investors looking for a financial as well as a social return on their capital. 

The rise of purpose-driven investment has been quite profound in recent years, in part because of increasing concerns over environmental impact, and is usually referred to as ESG (environment, social, governance) investing. With regards to tobacco companies this trend can be witnessed clearly in the increasing numbers of signatories to such initiatives as Tobacco Free Portfolios, which is a pledge institutions can sign to divest all tobacco-related investments from financial portfolios.

The decline in social acceptance has gone hand in hand with increasing regulation, thereby casting doubts over the tobacco industry’s future. While the industry has, from an economic standpoint, generally been quite effective in navigating these challenges, the risk of regulation has in recent years had quite a detrimental impact on public tobacco company valuations. The combination of decreasing social acceptance and increasing regulatory risk make the effort to develop products that are less harmful not just a matter of thriving in a competitive market, but also of earning a ‘license to operate’ from society. 

It is quite evident in today’s market that companies with rapidly increasing sales of ‘reduced-risk’ products, such as Swedish Match and Philip Morris International, are valued at substantially higher multiples of earnings than companies that have been slower to move in this direction. Imperial Brands unfortunately fits in with the latter group; fixing its conventional tobacco business may make perfect sense, but if society becomes even less forgiving towards its main business, it may not lead to an much improved share price at all.

Disclosure: the author owns shares of British American Tobacco.

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 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.

Karelia Tobacco: Minority Shareholders Held Hostage in Family Feud

It’s been a while since I last wrote about Greek cigarette company Karelia Tobacco, mostly for lack of developments on the business front or otherwise. My campaign to convince the board of directors to initiate a split of the company’s  listed shares has unfortunately been met with consistent silence. Fortunately, the company’s business performance has been somewhat satisfactory, with lower exports to Africa mostly offset by higher-margin sales in Greece and Europe. This enforces my notion that the company’s business is cared for in a satisfactory manner, while its corporate governance is in decidely worse shape.


A House Divided

It is quite difficult to find reliable information about the company, or the Karelias family behind it (in English at least). But over time some pieces of this Greek enigma have started falling into place. I was always aware of the fact that there are currently two factions in the extended Karelias family, one intimately involved in daily operations, led by CEO Andrew Karelias, and another group consisting of the widow (Asimina Spyropoulou) and daughter (Ioanna Karelia) of deceased company executive Kostas Karelias. Kostas’s death in the Kalamata marina in 2009 is surrounded with mystery, but it appears he fell into the water and drowned. This unfortunate event appears to have deepened (or created) the rifts within the family.

Conflicts within well-to-do families are about as common as get-rich-quick schemes on the internet, so it really is not that surprising we are seeing the same thing at Karelia. But the rift in the Karelia family has only become apparent to those looking closely at company filings. Last year’s annual meeting was, at the request of Ioanna Karelia and Asimini Spyropoulou, postponed until a later date. This request was within their rights as owners of a significant block of shares, but somewhat unsatisfactory to outsiders since it meant shareholders had to reconvene and suffer through the postponement of the dividend payment (by more than a month).

The official explanation was that they had requested additional documentation, which they wished to study before casting their votes. They subsequently voted against all measures on the reconvened meeting in July, which meant all items on the agenda passed with very slight majorities. In my opinion, something else is likely behind this obstruction; there may be disagreement within the two branches of the Karelia family, possibly over capital allocation (dividends), board seats or the strategic future of the company.

Ioanna and Asimina currently have no board representation at all, which is highly remarkable given their 40-something percentage stake in the business. The other faction has three board seats with Andrew, Stathis and Victoria Karelia all holding seats and only two ‘independent’ directors. It is therefore possible that Ioanna and Asimina are using their right to ask for a postponement simply to express their discontent over some issue unknown to us, which is unfortunate for minority shareholders.


Victoria, Andreas (or Andrew) and Stathis Karelias are all substantial shareholders and all three currently hold board seats. Photo credits (presumably) belong to the Karelia Tobacco co.

Meanwhile the company’s independent directors are, as far as I’m concerned, perhaps not so independent at all. Mr. Vassilopoulos is alternately referred to as either a consultant or a director, which raises the suspicion that he is also performing consultancy services for the company (and presumably compensated for it). If this is the case his independence would be in doubt. The second non-family director is Mr. Rob Lewellyn Joy, a British national and the only non-Greek, and a person with little information publicly available. The company description offered on Mr. Joy at the time of his nomination as a director has made me wonder about his qualifications for this board.


Obstruct, Fail, Repeat

On to the issue at hand: In June, the Annual Meeting for approving the company’s financial statements for 2017 and this year’s dividend payment was held. Surprise, surprise, Ioanna Karelia and her mother Asimina once again requested to postpone the Annual Meeting, this time to July 19th 2017. Which once again means the dividend payment was delayed, and of course both the company and the outside family members have failed to provide any clarification regarding the real reason why.

To me, the situation now has all signs of a family feud being waged at the expense of minority shareholders, despite all the exemplary words on corporate governance in the company’s financial statements. Perhaps it would be overly dramatic to cast this family tragedy on the larger stage of Greece’s troubles as a whole, but certain similarities are quite obvious. After all, conflicts over the entitlements of a fool-hardy ruling class being waged at the expense of the average guy feels all to familiar by now. Because the Karelia family has consistently displayed a complete and utter disregard for the interests of the minority shareholders, I have recently decided to sell all my shares in the company.

Second to my concerns over the Karelia family’s internal affairs, I also feel less certain about the company’s business prospects. Karelia has generally maintained a product line that was in line with market demand trends in slim cigarettes and rolling tobacco. But the aggressive movements into reduced-risk products by Philip Morris could push them into a defensive position fairly quickly. PM, which is the Greek market leader through its subsidiary PM Papastratos, is in the process of converting its facility in Greece to produce RRP Heatsticks, which would make it logical for this product to be introduced in Greece as well.

While we do not yet know whether PM will be able to replicate the success of iQos/Heatsticks in markets other than Japan, I have been impressed by the aggressiveness of their bet on this product. Smaller companies like Karelia would probably face an uphill struggle competing in this product line, which has given me an additional reason to sell. Luckily I am exiting with a decent profit, but also with a particularly bad aftertaste.

Karelia Tobacco: Letters Written & Answers Not Received

As shared last week on this blog, I have tried to pursuade the board of Karelia Tobacco, that the company and its (minority) shareholders would benefit from a stock split. The identification of a liquidity problem and a proposed solution are detailed in my letters (found below), and I will therefore not go into repetition by going over it in this short little intro. I will say this about the proposal:

  1. I am not criticizing management in any way; quite the opposite in fact, because I believe they have done an excellent job in a difficult environment.
  2.  I am not proposing any change in management, oversight, capital returns policy, or anything else about the way the Karelias family manages their company.
  3. My proposal instead aims to solve (or alleviate) a real problem that hurts minority shareholders in a very significant way. The cost to the company in terms of time and monetary expense is very moderate and much proportionate to the benefits expected to arise for its shareholders.

I therefore believe my proposal is both reasonable in its scope and rational in its content. Sadly, my first two letters went unanswered, which is perhaps to be expected, but I still decided to follow up with a third letter (sent last week). I have reached out to some other bloggers in order to drum up some support for my proposal and now I am putting the letters up for everyone to see. If you are a shareholder yourself, please feel free to use the last letter, sign your own name to it and sent it in (to with the request that it be delivered to the board (you can also reach out to me). Better make it soon though: the agenda for the AGM can probably be expected shortly. I am still weighing the benefits of attending the company’s upcoming meeting of shareholders.


Third Letter – Spring 2016

For the attention of: Board of Directors

Victoria C. Karelia

Andreas G. Karelias

Efstathios G. Karelias

Vassilios G. Antonopoulos

Robin D. Joy

Karelia Tobacco Company Inc.

Via email to:

Athinon Street

241 00 Kalamata, Greece


May 12th 2016

Dear Lady and Gentlemen:


As a shareholder of Karelia Tobacco, I have taken the liberty to write this letter in order to bring some items to the attention of the company board. First of all, let me congratulate you on the strong performance achieved by the company during 2015. I have no doubt that significant efforts have been required from both management and employees to achieve such a sizeable increase in revenues and margins. I know you have expressed some conservatism in your forward-looking comments, included in your latest financial statements, but I have some hope of seeing another strong performance in 2016. My main reason for writing this letter is, however, something other than a discussion of operational achievements, however much these are worthy of praise. No doubt you may know by now what I am referring to, namely the ever-present discount to intrinsic value at which your share continues to trade. I have brought this to your attention on two earlier occasions, but sadly the problem persists. If I held the conviction that the problem was unsolvable, I would not go to these lengths to bother you with it, but since the problem is both serious in its impact and entirely solvable, I feel I have little choice but to continue addressing it.

In my opinion, the illiquid nature of Karelia’s stock listing continues to cause its stock to trade at a significant discount to any rational valuation of its business. As I have stated earlier, I believe that a stock split can serve to solve, or at least alleviate, this problem by lowering the nominal value while increasing the tradeable number of shares. Improved liquidity will probably lead to an upwardly revised stock price, which would help shareholders who elect to sell in realizing a fair value for their holdings. And what after all are shareholders other than partners in a business? One partner may hold a substantially larger piece of a business than his fellow shareholder, but they are partners nonetheless. Should partners not ensure that any other partner, even one who is giving up his ownership, can realize the value of his holdings at something close to the business’s underlying worth? It is my opinion that partners should indeed care to realize such an outcome, if at all possible. As members of Karelia’s board, appointed as company overseers by the shareholder’s assembly, I assume you feel this responsibility and take it seriously. In fact, I know you do because it is included in the company’s corporate governance code; “Moreover, the fair and equitable treatment of all shareholders should be ensured, including minority shareholders and foreign shareholders”. The company’s commendable actions regarding its dividend payment, amidst the advent of capital controls last year, confirm my belief that you do indeed care deeply about upholding this principle. I greatly appreciated the way I was informed on the course of action taken to ensure timely payment, and realize that it has been the actions and guidance of Karelia’s management and board that have established the sound footing from which the company was able to keep its promise. For this I would like to thank you.

I therefore believe I can convince you of taking action regarding the irrational pricing behavior in the share price as well. In my opinion, there are at least three strong indications that pricing action in Karelia’s stock suffers from the consequences of low liquidity, caused at least in part by a high nominal value and a low free float. The first indicator is the fact that Karelia consistently sells at a huge discount to its international tobacco sector peers. In the table below I have included a list of consumer tobacco companies listed on public markets. All of these companies sell at significantly higher multiples of earnings than Karelia, with the discount versus the trailing sector price/earnings multiple at least 40%. I should also add that this is on the basis of Karelia’s reported earnings; the discount is substantially larger if instead we used underlying earnings (adjusted for the legal charge taken against earnings).


Table above includes data from the Yahoo! Finance website for all companies except Karelia Tobacco (for which I relied on reported financials).

The second indicator for irrational pricing action in the share of Karelia Tobacco’s is the regular occurrence of inverted bid/ask spreads. I have included screenshots from 6 instances in which this occurred, but I can testify to the fact that it has happened more often. I believe the irrationality of an inverted spread is quite obvious: the seller is after all pricing his shares below the highest current offer, thereby directly damaging his own financial interest.


Above: On the 26th of February 2015 the bid/ask in the share showed an inverted spread of more than 5%.Screenshot taken around 11:52 AM local time of the stock’s profile page on


Above: On the 18th of August 2015 the bid/ask spread was a negative 11%. Screenshot taken around 12:02 PM local time of the stock’s profile page on


Above: On the 5th of November 2015 the stock’s bid/ask was a negative 4.3%. Screenshot taken around 12:02 PM local time of the stock’s profile page on


Above: On the 9th of December 2015 the stock’s big/ask was a negative 4%. Screenshot taken around 14:59 PM local time of the stock’s profile page on


Above: On the 20th of January 2016 the stock’s bid/ask spread was a negative 5.9%. Screenshot taken around 15:39 PM local time of the stock’s profile page on


Above: On the 21st of April 2016 the stock’s bid/ask spread was a negative 10.1%. Screenshot taken around 14:30 PM local time of the stock’s profile page on


The third indicator of irrational pricing action in Karelia Tobacco’s share is the regular occurrence of excessive price movements. I have included a particularly striking example below.


On the 29th of December 2015 there were some highly unusual fluctuations in the company’s share price. The stock dropped by €40 (-15.69%) versus the last recorded transaction price on volume of 24 shares.


By 13:43 PM another transaction involving 25 shares had taken place at €230 per piece.


Then, by 15:59 PM another 26 shares had changed hands, this time at €226.


At the end of the day, the stock closed at €235.95 due to a transaction involving another 30 pieces.


Only one day later, on December 30th 2015, the stock traded 2 pieces at €231 and 93 pieces at €250.


The example above shows that within a period of 24 hours, the valuation assigned by the market to Karelia Tobacco fluctuated by roughly 16.3%, on no news whatsoever. This constitutes a valuation difference of €96.6 million in the company’s market capitalization, which seems highly undesirable to me. If we take the example of the shareholder who sold 24 pieces on the morning of December 29th 2015, and assuming the €250 price is the more rational one, his gross proceeds were impaired by €840 (24x€35 difference). This may not seem like a lot but will add up to very significant sums over years, which directly impacts the financial results a selling shareholder achieves from his investment in Karelia. In this particular example his proceeds could have been higher by 16.3%, or almost 4.5x current net annual dividends of €7.65. I believe we can all agree that this type of stock price behavior is far from rational, highly undesirable and something that should be addressed.

A stock split, ideally one with a high denominator, would in my opinion serve to reduce the irrational pricing by narrowing the bid/ask spread, increase the chances of daily pricing and allow investors to benefit from the improved liquidity a higher number of outstanding shares can provide. The effect of stock splits has been well researched by the academic world and it has been reasonably well established[i]  that there is a meaningful benefit with regards to liquidity and pricing. I therefore propose that the board of Karelia Tobacco acts to alleviate the negative consequences minority shareholders continue to suffer from the low liquidity in its stock listing.


[i] For examples see ‘Liquidity Changes Following Stock Splits’, Copeland, T.E, The Journal of Finance, Vol. XXXIV, no.1, March 1979 as well as ‘Liquidity and Stock Returns’, Amihud, Y. and Mendelson, H., Financial Analysts Journal, May/June 1986, Vol.42, Issue 3. Other examples are ‘Investor Relations, Liquidity and Stock Prices’, Brennan, M.J. and Tamarowski, C., Journal of Applied Corporate Finance, Vol.12, Issue 4, January 2000, pg. 26-37 as well as ‘Long-Run Common Stock Returns Following Stock Splits and Reverse Splits’, Desai, H. and Jain, P.C., The Journal of Business, vol.70, no.3, July 1997, pg. 409-433.


Second Letter – Spring 2015


Board of Directors

Karelia Tobacco Company Inc.

Via email to:

Athinon Street

241 00 Kalamata




Victoria C. Karelia (Chairwoman)

Andreas G. Karelias (Managing Director)

Efstathios G. Karelias (Vice Chairman)

Vassilios G. Antonopoulos (Member)

Robin D. Joy (Member)

June 11th 2015

Dear Lady and Gentlemen:


This letter is a follow-up on my earlier message dated October 24th 2014 in which I addressed an issue regarding the trading of your share on the Hellenic Stock Exchange. Unfortunately I have not received a reply or witnessed a modified course of action initiated by you, constituting the board of directors of Karelia Tobacco. Since my earlier letter was send only to the general e-mail account mentioned as contact information on the investor relations page of your website, there is a possibility that my message never reached its destination. Another possibility is that you disagree or fail to see the benefits inherent in my proposal for a stock split. With the Annual General Meeting of shareholders due to take place within a week’s time I have taken the effort to raise the issue with you once more. Reading through the materials published with regards to this meeting I noticed shareholders who succeed in assembling a 5% minority interest behind a certain proposal can, according to your bylaws, request that it be placed on the agenda of the shareholder meeting. According to my information however, the extended Karelias family either directly or indirectly controls about 94.48% of total shares outstanding. Since this leaves only a 5.52% interest in the hands of public shareholders, the chances of either controlling a sufficiently large interest or gaining the support of those who on a cumulative basis own such an interest is exceptionally small. Since I do not have the votes to require the admission of my proposal on the agenda I will try, in an effort to change your mind, to make a convincing case to you once more regarding the benefits of a stock split.

In my October letter I focused mostly on the interests of selling shareholders, who may not get a fair price due to the current undervaluation of your share. I still believe your share to be significantly undervalued and this argument therefore still stands. However, the Greek stock market as a whole trades at depressed levels due to reasons well-known to all with a vested interest. Liquidity has also been drained from the Hellenic Exchange due to the long-lasting uncertainties caused by the current level of stress in the Greek government’s fiscal position. Obviously, this is an issue outside your control and responsibility. I concede that this situation may have caused lower levels of liquidity in Karelia Tobacco’s shares as well. However, regarding the low level of free float and the high nominal value of Karelia shares I still think a notable improvement could be gained from executing a stock split. In my letter from October I mentioned a stock split could be performed through issuing a stock dividend on the existing share count. As you are probably aware this may cause accounting problems in case Greek law prohibits the issuance of shares below their nominal book value. In order to avoid such an issue a stock split can also be performed by actually splitting the existing shares into more shares with a lower nominal value, thereby avoiding a stock issuance.

Perhaps you consider the current situation not in need of change, which I can understand to a certain degree. I would like to direct your attention to the possibility that Karelia itself might benefit from having a more highly traded share. With the Greek market having become, to a certain degree, a stock market with a great many ‘penny stocks’ and a relatively small amount of stocks of large capitalization, your company’s share may become eligible for promotion to certain indices of the Greek stock market. Even with only slightly over 5% of the company’s share count in public hands the free float would, at the present market capitalization, constitute over €30 million. That may be enough, depending on liquidity, to grant Karelia a place in a stock index such as the ATHEX. The benefit to Karelia would be an increase in status and visibility of the company and its products, which may help it gain more recognition with potential customers and with consumers of tobacco products. In my opinion this could be beneficial to the company, which due to the advertising limitations on tobacco products has limited possibilities for increasing the awareness and visibility of its products. A more visible stock listing would in my opinion contribute to an elevation of the company’s profile among potential customers. The retail establishments that sell your products are oftentimes part of large retail companies that may have a public stock listing as well. Many of your competitors meanwhile already enjoy a highly visible status through being a part of consolidated tobacco companies such as Philip Morris or Japan Tobacco. Improved visibility of your status as a listed and well-performing company could in my opinion add to your image of being a trustworthy and strong potential business partner. Some relatively small expenditures on outside consultants or regulatory measures aside, this added visibility has the potential to function as a form of free publicity, which should be attractive to any company. It could also raise your profile among domestic consumers, which may at this point be sensitive to supporting Greek industry through their consumption. Awareness of your company’s status as an independent Greek business and job provider could be exploited as a strength in the Greek tobacco market for instance.

Concluding my arguments I would like to say that a stock split should benefit both shareholders and the company itself, which of course are both important for you to consider as board members. I hope you will reconsider my proposal regarding a stock split, perhaps as soon as on the AGM one week from now.


First Letter – Fall 2014


Board of Directors

Tobacco Industry Karelia A.E.

Via email to:

Athinon Street

241 00 Kalamata




Victoria C. Karelia (Chairwoman)

Andreas G. Karelias (Director)

Efstathios G. Karelias (Vice Chairman)

Vassilios G. Antonopoulos (Director)

Robin D. Joy (Director)

24th October 2014

Dear Lady and Gentlemen:


As a shareholder of your company I would like to address an issue regarding the current way in which your stock trades on the Athens Exchange. Allow me to start by saying the following; I have been reading up on your company from the time of my investment, mostly through reading your annual reports of the past years. Unfortunately I do not speak or read Modern Greek so I have had to rely on translated versions of your quarterly reports to catch up with the latest developments. From what I have learned my impression is that Karelia Tobacco is a good business that has been managed well throughout the years. Especially since tough competition and harsh conditions on your domestic market have made your company’s operating environment quite challenging. I’m impressed by the way you’ve handled these circumstances by focusing more on exports and emphasizing innovation. If my information is correct Karelia has been able to claim a meaningful share of the Bulgarian cigarette market since its liberalization and is currently the largest international player on the market. Your strongly risen exports to the markets of North Africa have also captured my eye. All things considered I’m quite satisfied with the way Karelia is being run. To paraphrase American investor Warren Buffett: your company seems to be “a high class business run by high-class people”. I hope you understand therefore that this letter is not in any way intended to criticize management or oversight of the company.

As stated, the issue I want to bring to your attention is the reservations I have about the way your stock is traded on the Athens Exchange. You will be aware that trading activity in Karelia’s shares is very thin or even sporadic, with sometimes no daily volume traded at all. It has struck me that the spread between bid and ask prices is oftentimes very large, which is related to these low levels of liquidity. The result of this is that the stock can swing quite wildly on any given day, due to mismatches in supply and demand. The problem this causes in my perception is that current shareholders may be forced to accept prices that do not reflect the underlying value of your company. Karelia shares currently trade near €200, which constitutes a meaningful discount to fair value*. In my opinion the current undervaluation of the stock is unrelated to operating performance but is due to low liquidity, which is an issue that is at least partly addressable. The action I propose is intended to increase the volume traded while at the same time reducing bid and ask spreads. I think this can be achieved by means of a stock split, which will increase the number of shares outstanding while lowering the nominal price of individual shares. Splitting a company’s stock, usually by way of a stock dividend, of course does not change a shareholder’s percentage ownership in the company and will not alter or erode in any way the family-controlled nature of the company. My proposal is to issue a 39 shares stock dividend to current shareholders, effectuating a 40-1 stock split that would reduce the (current) share price from around €200 to around €5 per share, while increasing the outstanding share count to 110.4 million. I am aware of the low free float in the share base, given the substantial holdings by Karelias family members. In my opinion however both a lower nominal price of the stock and the larger total share count should improve daily trading volumes as well as lead to more rational pricing action. This will then hopefully reduce the chance of existing shareholders that wish to sell being forced to accept prices that significantly undervalue their holdings. I hope you will evaluate this proposal and consider taking action. I look forward to hearing from you.



*My estimate of fair value is based on the average multiple paid in tobacco company buy-out transactions over the past 15 years. For an average multiple of 12x EV/Ebitda my estimate of your company’s underlying value would be €293 per share excluding net cash holdings or €355 including cash, implying a discount of 46.5% – 77.5% for the shares of your company at the current share price of €200.