Industry Investing in CBD Companies? Watch Out for These Warning Signs Alan Brochstein, The Cannabis Capitalist February 26, 2018 Share Twitter Facebook Share Print Labyrinth aus Hanfpflanzen auf einem Feld

Interest in cannabidiol (CBD) has taken off over the past five years since Sanjay Gupta, the Chief Medical Correspondent at CNN, highlighted its promise in the documentary Weed. GW Pharma (NASDAQ: GWPH) has submitted a New Drug Application for its CBD-based Epidiolex with the FDA, and it is probable that the agency will approve it later this year. That would mark the first time a pharmaceutical derived from botanical cannabis, which is likely to fuel even more interest in the cannabinoid.

Consumer interest in cannabidiol has skyrocketed. The US market for hemp-derived CBD was $50 million in 2014. By 2020 it's expected to hit $736 million.

CBD can be produced in a variety of ways, including both naturally and synthetically. Several biotech companies are developing pharmaceuticals based on synthetic CBD. This method may prove to be more economical in the long term if synthetic CBD is as efficacious as plant-derived CBD, but it’s too early to make that call. Zynerba (NASDAQ: ZYNE) has experienced two clinical trial failures to date, though it’s not clear that the source of CBD in their trial drug played a role in those failures. Synthetic THC has never been able to deliver the efficacy of plant-derived THC and appears to have more risk factors.

Botanical CBD can be extracted from cannabis plants, including the low-THC variety known as industrial hemp, which is defined as having a THC content of 0.3% or less. Many researchers believe that CBD is most efficacious when it’s delivered in combination with small amounts of THC, producing what’s known as the entourage effect. Additionally, industrial hemp plants contain relatively low amounts of CBD, meaning that a lot of plant material has to be processed to produce a small amount of CBD. That can lead to a greater risk of pesticides and other impurities in the final product.

And, of course, CBD may be extracted from higher-THC cannabis plants. From a business perspective, extracting CBD from non-hemp cannabis is not as legally limiting as it was just a few years ago, as most states now allow some form of legal CBD production for medical patients. But it still restricts a company to sales only within the state in which the CBD was produced.

CBD derived from industrial hemp gets around this limitation, though the legality isn’t particularly clear. Historically, much of the source material for hemp-derived CBD has been imported from Europe, though the Farm Act of 2014 has led to some companies perhaps pushing the envelope a bit and using domestic industrial hemp to extract CBD.

Big Tobacco Entering the Space

The Hemp Business Journal suggests that the market for CBD derived from industrial hemp will grow from about $50 million in 2014 to $736 million in 2020.

Look for independent reviews on the products being sold, and ask people in the industry if they are familiar with the products or the companies.

Earlier this month, a global tobacco company, Alliance One (NYSE: AOI), invested $10 million to buy a 40% stake in Criticality, a company that is one of ten that are licensed by the state of North Carolina to grow industrial hemp. The company states that it intends to be a major producer of CBD from industrial hemp.

In Canada, several federally licensed producers of medical cannabis have made substantial investments in advance of potential regulatory changes there that will permit CBD extracted from lower-THC plants to be sold legally to all adults, not just registered medical patients.

With so much interest in CBD, and bigger companies starting to make investments in the sector, many investors are interested in capitalizing on the trend. Several publicly-traded companies offer the ability for anyone to invest, but I suggest being very cautious, as many of them have red flag issues in my view.

Four Key Considerations

Over the course of five years, I have built a list of over 600 companies that purport to be in the cannabis industry. One trend I have noticed lately has been a lot of new entrants focused on CBD extracted from industrial hemp. There are a few filters I apply when I evaluate them before diving in deeper:

Do they file with the SEC?

Are they generating significant revenue?

Does the company clearly explain the source of its CBD and the methods of production?

Is there any sort of independent evaluation of their products?

When it comes to buying into publicly traded cannabis stocks, I always caution investors to avoid companies that don’t file with the SEC, as they lack transparency. For example, company insiders can dump stock without having to file electronic disclosures. Unfortunately, a lot of these publicly traded CBD companies don’t file with the SEC.

Another caveat: Several of the companies that purport to be in the CBD business don’t have material operations. It’s a highly competitive space, and companies with no traction to date are very risky in my view. It’s easy to say that you are in the business, but much more difficult to actually produce and sell successful products.

Another thing I like to do when investigating these companies is to go to their website or read through their public disclosure documents to learn more about how they are making or acquiring their products. Surprisingly, many of them don’t share this information.

Finally, I like to look for independent reviews on the products being sold, though often they don’t exist. I will ask people in the industry if they are familiar with the brands or the companies. If that brand awareness isn’t there, I become concerned that the products may lack quality. The FDA has called out several companies over the past few years for quality issues and marketing violations (ie, making health claims). Here’s a tip: If the Hemp Business Journal doesn’t list the company, it is likely not a leader in the space.

Be Careful With These CBD Sellers

The list of companies that I find to be potentially troublesome as investments is much longer than those I am discussing today, but the three that stand out include Medical Marijuana, Inc. (OTC: MJNA), PotNetwork Holdings (OTC: POTN) and Ubiquitech Software (OTC: UBQU). One common characteristic is that none of them file with the SEC.

Medical Marijuana Inc. (MJNA) began trading publicly in 2009, the first publicly-traded cannabis stock, though its original founders exited in 2011. Control of the company went to a group led by San Diego-based entrepreneur Michael Llamas. His group began developing CBD from industrial hemp in 2008. The company promised to get audited financials in 2013 and begin filing with the SEC, but still has not done so. (Llamas exited in 2012; the company is now run by CEO Stuart Titus.) In its financials for the quarter ending 9/30, it reported over 3.2 billion shares, meaning that the company has a market capitalization in excess of $325 million. Most of its sales are derived from its multilevel marketing arm, Kannaway. The company regularly generates large operating losses and has a significant amount of convertible debt (in excess of $11 million). Despite its long operating history, the company is very weak financially, and the valuation seems very high.

PotNetwork Holdings (POTN) acquired First Capital Venture Holdings, the maker of Diamond CBD, a year ago. The company has been heavily promoting its stock, which is always a red flag. But it’s the lack of info about its products and the people behind the company that I find most disturbing. Take a hard look at the products the company markets: There’s no mention of the amount of CBD per serving or per package. The company does post some lab tests, though many them are not current. The company also makes questionable claims on its website: “Our products are legal across all fifty states, USA-made, and produced with federally-legal Cannabidiol (CBD).” The issue is that phrase “federally-legal.” In late 2016, the DEA declared CBD a federally illegal Schedule 1 drug, although a coalition of hemp and CBD companies are currently challenging the DEA’s move in a San Francisco federal court.

Further, many states have cracked down on the sale of CBD from industrial hemp, most notably Indiana. The company’s unaudited financials suggest the company had sales of $14.5 million in 2017, with a net profit of $213,802. With 570 million shares outstanding, the stock has a market cap of $308 million, or about 20X sales, which is not justifiable in my view.

Ubiquitech Software (UBQU), which operates HempLife Today and markets CannazALL CBD Products, is extremely promotional with respect to its stock as well. While the absolute valuation of the company isn’t nearly as high as the other two I have discussed, it’s important to understand that the company issues shares at $0.001 through convertible notes, a price that is about 95% below the price at which the stock trades. In fact, in the quarter ending 8/31, it issued over 147 million shares for conversion of debt. The company reported sales of $3.3 million in the first nine months of its fiscal year ending Nov. 30, 2017, and operating income of $316,000, though it’s not clear if all of the sales are from CBD products. There are few, if any, independent reviews of CannazALL products, and the company’s website provides little information about the sourcing of its CBD offerings (made in the USA) or the people running the company.

Three That Look More Promising

There are three companies that pass my initial screening criteria. I will mention these as being worthy of further investigation and share some brief background, but readers should not construe my comments as a recommendation.

CV Sciences (OTC: CVSI) was actually spun out of MJNA in 2013, but it looks to be a much better company to me. Their products can be found on the shelves of health food stores, and the financials are decent. Sales in Q3 ending Sept. 30, 2017, were $5.6 million, which represents growth of 90% from a year ago. The company has a decent balance sheet with slightly positive cash flow from operations. The company is also developing a synthetic CBD and nicotine gum that it hopes to get through the FDA regulatory process. One issue that concerns me is that the SEC is suing the company and its CEO for alleged fraud related to the spin out from MJNA. Were it not for this issue, I would be even more enthusiastic about the stock, which has a market capitalization of about $35 million, which compares quite favorably to both MJNA and POTN at over $300 million.

Elixinol Global recently conducted an IPO in Australia and trades exclusively on the Australian Stock Exchange under the symbol of “EXL.” Elixinol has a highly regarded CBD product marketed out of Colorado, but the company has an even larger hemp food company in Australia and is expected to enter the Australian medicinal cannabis market in the near future.

Isodiol International (CSE: ISOL) (OTC: ISOLF) is based in San Diego but began trading last year in Canada. The company sells CBD products derived from industrial hemp and posted sales of C$5.06 million (roughly $4 million) for the quarter ending Sept. 30, 2017. Many of the members of the management team left MJNA to join Isodiol. The company has been able to raise significant capital through the sale of equity, and it’s vertically integrated, using its own raw ingredients to develop and offer both consumer products as well as wholesaling to other pharmaceutical companies.

Bottom line: CBD from industrial hemp is taking off, but investing in the industry is challenging. A few companies that are doing things the right way in my view may be worth considering, but the others are too speculative for long-term investors.

Next up: I discuss publicly-traded companies with a significant focus on the California cannabis market

As an owner of New Cannabis Ventures, Alan works with several publicly-traded and privately held cannabis companies as he discloses here. In the event he mentions a company that is a client, he will disclose it in the article as well.

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Alan Brochstein, The Cannabis Capitalist Alan Brochstein, CFA, covers the cannabis industry full time from Houston, running 420 Investor, a subscription-based service for those interested in publicly-traded cannabis stocks, and New Cannabis Ventures, a news and information platform that highlights promising companies and influential investors in the cannabis industry. Before focusing on the cannabis industry in 2013, Alan worked as an independent equity research analyst following two decades as a portfolio manager, trader, and analyst. View Alan Brochstein, The Cannabis Capitalist's articles