Medbox (MDBX.PK) sells vending machines that dispense marijuana. The company also helps individuals and groups establish new marijuana clinics and retail stores. While I am in favor of legalized marijuana, I think Medbox provides a good shorting opportunity. The shares are extremely overvalued and the company's business model contains multiple levels of risk. Given the fact that federal law still considers marijuana to be an illegal drug, it's a strong testament to capitalism that the company even exists.
The shares have surged from $0.03 up to over $200 in the last few months and are currently trading at around $88. I estimate fair value to be in the $2-$4 range, and that's assuming the company has a workable business model. If I'm correct in my analysis, investors who initiate a short position at today's share price could easily realize at least a 50% near-term gain.
Here's why the shares have gone into fantasyland:
Number one: Media loves this story, and the company has received a lot of coverage, not because it presents a sustainable business model, but because marijuana stories attract readers.
Number two: Colorado and Washington recently passed laws that made possession of up to 1 ounce of marijuana legal. Investors interpret this as the beginning of a so-called green rush, but the reality is that this is a potential industry that may not take off for at least 10 years.
Number three: The stock is thinly traded and is attracting a handful of retail buyers hoping to get in on the next big thing. It takes very little volume to move the stock.
Although I admire the company for attempting this difficult endeavor, I'm just not convinced the company's business model is going to work. The idea of vending machines that sell marijuana will not go over well with the average soccer mom. Parents in general don't want their kids smoking marijuana, and the idea of marijuana vending machines will create controversy, socially and politically. There is just too large a percentage of people who do not want to see it legalized, and those groups will not sit still for marijuana vending machines. This will create serious headwinds for Medbox. Maybe in 10 years, US society will be ready for this concept, but not yet.
Why I'm concerned about the Medbox business model:
Number one: Medbox is primarily engaged in a hardware business, which historically means low margins and stiff competition.
Number two: Selling marijuana is still illegal on a federal level, and Medbox could face numerous legal hurdles. Nearly 500 marijuana dispensaries have been closed or shut down by the federal government in the past year. We have no way of knowing whether the Obama administration will shut down another 100 or 1000 dispensaries in 2013.
Number three: If this were to become a viable business, there is no barrier-to-entry for competitors. From my perspective anyone can manufacture and market biometric vending machines.
Number four: Marijuana has a history of successful distribution channels without the use of vending machines. In my opinion, these machines just aren't needed, which is why you don't see them in your local Walgreen dispensing prescription drugs. If marijuana ever were to become legal on a federal level, the pharmacy system would work beautifully, just as it has for the past hundred years.
A big obstacle for Medbox is the fact that there is just too much stigma attached to marijuana. A federal law called the Controlled Substances Act still ranks marijuana as a dangerous and addictive drug, in the same class as heroin. While that law is not realistic, it cannot be ignored. Even though marijuana's image has improved since the reefer madness days, a large portion of the US population still sees marijuana as a bad drug. Most parents don't want their kids smoking marijuana, and they certainly don't want their kids to have easy access to the drug.
Medbox's marijuana vending machines shouldn't make it any easier for kids to obtain marijuana, because they are based on biometric identification, (fingerprint sample). But the problem for Medbox has been one of perception. People imagine marijuana vending machines to be located alongside Coke and candy machines, which is not Medbox's intention. And of course if vending machines were selling marijuana, kids could get someone to buy for them, just like they do with alcohol now.
Shares are trading for at least 25 times fair value
On occasion, we will see a company that is trading at 20% to 50% above fair value, but rarely will we see a company like Medbox, which is trading at about 25 times what I consider to be fair value. This provides tremendous opportunity for shorts, given the incredibly large margin of error.
Medbox founder warned investors that shares are overpriced
To the company's credit, according to a Seeking Alpha article, Medbox founder Vincent Mehdizadeh, logged onto a message board and warned: "I hope no one buys at $35 per share, even as the founder of the company, I feel that's way inflated."
If the founder is telling investors that Medbox is way inflated at $35 a share, think how inflated the shares are at the current $88 share price. This is an example of market inefficiency at its best, and at the root of all investment opportunity.
Message boards are not the best format for communicating with investors
Last summer Netflix (NFLX) CEO Reed Hastings posted a public update on his Facebook page. In it, he mentioned that members watched over 1 billion hours of Netflix in June. The SEC thinks Hastings broke disclosure rules (Reg FD) that say companies need to make material information available to all investors simultaneously via SEC filing or press release. The SEC recognizes that a Facebook posting only reaches certain investors, not all investors. As a result, Netflix was hit with a Wells Notice which means it could face action from the SEC.
The Medbox CEO's posting was well-intentioned, but in general, I think it's better if management sticks to SEC filings or press releases, and stays away from messageboard postings. The last thing Medbox wants is an SEC investigation.
What are Medbox shares really worth today?
Let's look at the publicly available numbers, and come up with a fair valuation for Medbox shares. According to the company's website, FY 2012, revenue should be about $5 million, with $877,000 in EBITDA earnings. The company doesn't give us a net profit figure (necessary for calculating earnings per share), but let's be generous, and say EBITDA translates directly into net profit. With 11 million shares outstanding, that gives us an earnings per share of $0.08 for FY 2012. If we use an aggressive price-to-earnings ratio of 30, that would give us a share price of $2.40.
In reality, I think $877,000 is an excessive figure, considering that in November, the company reported net income of only $78,000 for the quarter ending in September. Realistically, FY 2012 net profit at best will hit $400,000, giving us a share price of $1.08.
Okay, some of you are probably thinking that next year things will be better, and the profit will increase. Maybe, maybe not. Even if Medbox were able to double the $877,000 figure in FY 2013, that would still only give us a share price of $4.78 which is a long way from the recent $100 price.
Another widely followed Seeking Alpha author estimates that 2016 revenues will allow for a share price of only $4.50. That would've been an exciting estimate back when the shares were trading at three cents, but given today's share price, that figure is a death knell for today's investors who hold a long position.
Medbox management may have omitted vital accounting facts
Another risk for shareholders involves the fact that OTC Pink marketplace has no financial standards or reporting requirements. Dig into the accountant's statement in Medbox's most recent financials, filed Nov. 1, and you will find that "Management has elected to omit substantially all of the disclosures required by accounting principles generally accepted in the United States of America. If the omitted disclosures were included in the consolidated financial statements, they might influence the user's conclusions about the company's financial position and results of operations. Accordingly, these financial statements are not designed for those who are not informed about such matters."
Basically the company is saying that the financial statements are only of value to insiders who have access to the disclosures that have been omitted. What is the use of releasing information to the public and then telling the public that this information really isn't useful because important disclosures have been omitted?
You have to ask yourself, why would a company omit substantially all disclosures, unless certain disclosures made the company look bad. If these disclosures portrayed the company in a positive light, I would think the company would just include them.
We just have no way of knowing how reliable Medbox financials really are. But even if we give the company the benefit of the doubt and assume that they are reporting accurately, the best case scenario only gives us a share price of $4.78.
But let's say all my calculations are flawed, and the only information we have to go by is the CEO's statement that the shares are tremendously overvalued at $35. Even if the CEO believes the shares are fairly valued at $10 or $15, there is still a lot of money to be made by shorting the stock.
Founder selling $30 million in shares on the open market
Medbox only has $1 million on its balance sheet, so a financing appears to be necessary. I don't believe institutional investors would have bought shares at the recent $100 level, so Medbox came up with a creative financing solution.
According to a recent press release, here is my understanding of what Medbox is going to do:
Number one: Through an affiliate, the founder will sell $30 million worth of his common shares in the open market over the next 12 months.
Number two: The affiliate will then reinvest all proceeds less tax liabilities into Medbox restricted stock.
Number three: Medbox will then take this cash and complete the acquisitions that are in the pipeline.
When $30 million worth of shares hit the market, even if spread out over 12 months, the share price should fall. This is not good news for current shareholders, and I believe the smart money will begin selling before the founder starts to sell his shares. I would.
The company also stated that these transactions would add additional shares to the public float. This could create some amount of downward pressure on the stock, but at this point, we don't know to what level the public float will increase.
What bothers me most about this announcement is that the company is planning to use the cash for numerous acquisitions. I'm all in favor of acquisitions once the company is generating sufficient cash to support the acquisitions. Medbox hasn't proven itself yet, and in my opinion this premature action could hurt shareholders.
No more positive catalysts on the horizon
The media blitz is no longer boosting the share price as it did in the past, so we can't count on additional media interest to drive the share prices higher. As is always the case, the media will soon back away from marijuana stories, and move on to other subjects. The elections are over, so we won't see any positive catalyst on that front. The small number of retail buyers that have propped this stock up will not continue buying forever, and once their buying stops, the share price could drop quickly. If anything, negative catalysts are more probable at this point, and the slightest bit of negative publicity will send shares tumbling.
Big tobacco companies don't yet see marijuana as a viable product
If selling marijuana ever became big business, the tobacco companies would be the first to jump in. But tobacco companies do not appear to be interested in this illegal drug, although that could change within the 20 years, if the federal laws were ever to be altered.
Bryan Hatchell, a spokesman for the second largest cigarette maker, Reynolds American (RAI), maker of Camel and Pall Mall, among many others had this to say when asked about the recent laws passed in Colorado and Washington:
"Reynolds American has no plans to produce or market marijuana products in either of those states," Hatchell said. "It's not part of our strategy."
It appears Philip Morris (PM) and Altria (MO) are taking the same stance. Hopefully these companies will be able to profit from marijuana in the future, but that's a long ways off. You will notice that investors are not flocking to these companies based on anticipation of marijuana production and sales.
Big Pharma could sell marijuana through existing channels
If marijuana became legal on a federal level, big Pharma could easily transition into marijuana sales. These companies are already used to dealing with controlled substances with heavy regulation and legal checks and balances. They have the sales and distribution teams in place and in my opinion, they would not be using Medbox's vending machines.
I could easily see Johnson & Johnson (JNJ), Pfizer (PFE), or Glaxo SmithKline (GSK) jumping on the bandwagon if the federal government ever makes marijuana legal. Given their ongoing problem of expiring patents, marijuana could add a significant boost to their bottom line.
Medbox's extreme overvaluation will not last forever. I don't know when shares will fall, but at some point investors will realize that this company should not be valued at $1 billion. If a large number of shareholders try to sell this thinly-traded stock, we will see a more accurate valuation of this company in short order. Market inefficiency has provided investors with an excellent shorting opportunity.
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Disclosure: I am short MDBX.PK.