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I wasn't too familiar with Medical Marijuana Inc. (OTCPK:MJNA) until reading an article on Seeking Alpha by an anonymous author, Infitialis, described as a research collective. I was familiar with the author because they had written a similar type of piece on CYBX, where they proclaimed to have a short position and proceeded to share an exposé describing unsavory sales practices. I actually disagreed with the conclusions, though I was impressed by the efforts of their research. I was fascinated by several aspects of the MJNA piece and spent some time looking at the company and some of the other peers in the space, sharing my view several days later that the marijuana stocks are in a bubble. Since I published "Reefer Madness," many of the stocks have already begun to deflate. My motives have been questioned, so let me be clear: I have no position, and I am anti-prohibition.

I am following up with an analysis of MJNA's recent transaction, which was described when the company shared very bullish guidance for not only 2013 but also 2014. I am not an accountant professionally, but that is the angle I am coming from. It could very well be that the transaction I describe is in accordance with accounting rules, but I would expect that it isn't. So, let me be very careful, especially since the company has already threatened to pursue legal action against the anonymous author that this is my opinion only. You should not rely upon me for accounting opinions. If you like the story, by all means invest, but do so with the awareness of what I will describe.

"Sale" of PhytoSPHERE Systems Stake

On March 1st, the company shared a press release describing the sale of assets and inventory simultaneously. MJNA owns 80% of PhytoSPHERE. This news had actually been disclosed previously in a filing, which I will address later. Specifically, MJNA sold certain assets to CannaVEST (FCLS.OB), a publicly-traded entity, for $35mm ($28mm to MJNA.PK): Equipment, inventory, web domain names, phone numbers and existing and pending agreements with hemp production and processing facilities. MJNA also granted an exclusive license. Here is a link to the agreement. Here are the important terms:

  • 12/31/12 transaction date
  • $35mm payment in 5 installments in cash or stock at discretion of FCLS
  • $4.5mm due before 1/31 (paid already), $6mm by 3/30, $8mm by 6/30, $10mm by 9/30 and $6.5mm by 12/31
  • Collar on stock of $4.50-6.00

There is also a supply agreement. The 3/1 press release seems to indicate it's not finalized:

The company and CannaVEST Corp. are currently negotiating the terms of a Supply Agreement whereby it is intended that CannaVEST Corp. will supply the company with its requirements for raw hemp oil product at favorable pricing, in exchange for the Company's agreement to purchase its requirements from CannaVEST.

CannaVEST, though, said:

On February 4, 2013, we entered into an agreement with Medical Marijuana, Inc. whereby Medical Marijuana, Inc. agreed to purchase from the Company either directly, or through one or more of its subsidiaries, up to $15,000,000 of its requirements for raw hemp product. The purchase price will be $25,000 per kilo of product until the time its aggregate purchases equal $7,500,000, at which time the per kilo price will be adjusted to $10,000 per kilo until an aggregate of $15,000,000 in purchases from the Company. At that time, the parties intend to negotiate a new agreement for supplying Medical Marijuana, Inc. with its purchase requirements.

If you have never heard of CannaVEST, you are excused. The company recently took the listing of Foreclosure Solutions and just began trading days ago. Here is how that came to be:

The Buyers purchased all of the 6,979,900 shares in the Cole Purchase Transaction and the Non-Affiliate Purchase Transactions for an aggregate purchase price of $375,000. Upon consummation of the transactions described above, the Buyers collectively acquired 99.7% of the total issued and outstanding shares of common stock of the Company. The funds used for these share purchases were cash loaned to each of the Buyers from Mr. Stuart Titus pursuant to the terms of individual promissory notes entered into by Mr. Titus and the sole member of each of the Buyers.

The stock, purchased for 5 cents per share (on borrowed money), has soared from $5 at the time it first traded last month to $29 as of March 4th. Here is a description from its SEC filing describing the PhytoSPHERE transaction:

Overview

We were incorporated under the name Foreclosure Solutions, Inc. in the State of Texas on December 9, 2010. To date, we have had no revenues and our sole assets consist of the assets purchased on December 31, 2012 from PhytoSPHERE Systems, LLC, as more fully set forth herein. We have incurred losses since inception.

We were incorporated with the intention to commence operations in the business of selling realtor services to prospective homebuyers interested in foreclosed residential properties. We were not able to secure financing for this business plan and have consequently experienced a change of control and a change of business focus. On November 16, 2012, Mai Dun Limited, LLC, Mercia Holdings, LLC, General Hemp, LLC and Bamburgh Holdings, LLC (the "Buyers"), acquired a total of 6,979,900 shares of our common in a series of private transactions. Upon consummation of the transactions, the Buyers collectively acquired 99.7% of our total issued and outstanding shares of common stock.

We maintain our business offices at 4660 La Jolla Village Drive, Suite 500, San Diego, California 92122, and our telephone number is (866) 290-2157.

So, a couple of points before I go on. First, the company was nothing but 7mm shares roughly with no business. Second, the office, a suite in a Regus building, is about 7 miles from MJNA corporate offices.

Back to the transaction, a few other points:

  • MJNA is required to buy up to $15mm in raw hemp at $25K per kilo for the first $7.5mm and then $10K per kilo for the next $7.5mm.
  • Michael Mona, Jr., the sole director and President of FCLS, owns or controls over 37mm shares of MJNA now - he can make money with either stock (presuming he is connected to the LLCs that own the bulk - he draws no compensation)

There are a number of potential accounting questions. First, can this be considered revenue? The sale has a certain one-time nature. It seems that the proper accounting would split the sale into the inventory sale (revenue) and an asset sale. Is this a transaction at "arms length"? If not, the "$35mm" is arbitrary. The disclosures of FCLS suggest that it has no assets, bringing into question the potential for revenue recognition. It would seem that the revenue shouldn't be booked until cash is collected, especially since FCLS has going-concern questions and states that it needs to raise at least $5mm. With that said, the company hasn't yet reported Q1, which was when the first payment was made. What is the stock worth, anyway? Just because it is quoted, the price is not really a reflection of the value as the stock is very closely held (7.7mm of the 7.9mm shares are held by 5% holders, and the balance, by my calculation, is held by whomever owned the other 20% of PhytoSPHERE. Finally, given that payment can be in stock and that there are purchase agreements (where money coming from FCLS to buy is then used by MJNA to pay FCLS, creating a circular effect), how can this be considered "revenue"?

Bullish Guidance

The company had told investors it would share annual guidance on Sunday, February 17th. This was delayed apparently due to the Infitialis article. At the time I published my article on the 18th, it had still not been released, but the company finally shared it on the evening of the 18th. The press release indicated that sales in 2013 will be $47mm (up from an unaudited $12.4mm in 2012) with "the potential to increase revenues in 2014 to $155mm." The company also projected operating cash flows of $32mm in 2013 and approximately $95mm in 2014. It wasn't clear if the $28mm (80% of $35mm) is included in the $47mm for 2013.

A few things strike me as odd about the guidance. First, most companies these days have a tough time guiding for a quarter. Somehow, this very young company has the ability to give a pin-point prediction for 2013 and even for 2014. Second, the company curiously left off net income. While the same press release listed net income by quarter for 2012, there is no mention in the guidance. Third, and most important, the guidance is never tied to shares.

Why is this last point important? Because the share count has exploded:

  • 2009: 223mm
  • 2010: 246mm
  • 2011: 559mm
  • 2012: 808mm

In fact, the very last disclosure on the last page of its annual report highlights a 47mm share issuance already in 2013 so that CanChew can fund clinical research, seemingly an operating expense. According to the filing, shares are limited to 950mm, but page 31 suggests that the company will need to increase this amount as it closes on a $15mm line of credit. With such great "operating cash flow" just around the corner, why the borrowing and why the extra shares being issued?

Conclusion

There have been a lot of bullish articles about the industry as well as MJNA.PK, but there has been too little discussion of the investment merit of many of these stocks. Penny stocks are inherently risky, but MJNA.PK appears to be valued very richly based on its current reported results. The share count has soared, with the company suggesting that it will need to increase the authorization beyond 950mm shares. If the company is able to grow operating cash flow to the levels it suggests in 2014 and maintain the share count at 1 billion shares or less, then at .30, the stock could prove to be a reasonable bet. Unfortunately, much of the expected sales growth in 2013 appears to be tied to a transaction that raises a lot of questions. The company also didn't offer any narrative to support its forecasts. Red Dice is the subsidiary that gets the most attention. How is it that the company sold a 60% stake for just $1.45mm less than a year ago? It is also borrowing from MJNA to fund its operations (working capital).

Bottom-line: MJNA issued stunningly high guidance, but the stock reacted poorly, falling as low as .20 a few days after the report. One never knows why the sellers are selling, but a careful look at the transaction with CannaVEST is likely contributing to concerns. I urge any potential investors in the stock to make sure that they are comfortable with the transaction.

Source: Medical Marijuana Inc.'s Recent Transaction And Guidance Raise Questions