CannaVest Makes Big Non-Cash Profit And Terminates HempMedsPX

Aug.18.14 | About: CV Sciences, (CVSI)

Summary

$3.01 Million 2Q/14 Revenue was dwarfed by $8.3M non-cash asset sale.

CannaVest terminates its distribution agreement with Medical Marijuana, Inc's HempMedsPX. It's not now clear how CannaVest will market, sell and ship products.

The investment asset sold for $8.3M was valued at $400,000 just a few weeks earlier, but there is no explanation in 10-Q for the 2000% increase in valuation.

Over the past few weeks, CannaVest (OTCQB:CANV) stock had been taking a beating, falling from approximately $13 per share at the end of June to a closing low of $2.17 on August 12, 2014. The likely reason for this was that several million restricted shares, originally purchased for $1 each by non-affiliated accredited investors between November, 2013 and January, 2014, had reached the end of their six-month restricted period, and once the restricted status was removed, could be sold into the open market.

On August 14, 2014, a few hours before the U.S. stock markets opened, CannaVest filed its 10-Q for the Second Quarter of 2014, which showed that the company saw increased revenue from the first quarter, made a small operating profit, a large net profit on a non-cash asset sale, and terminated a non-exclusive license and distribution agreement with its sole distributor, Medical Marijuana, Incorporated's HempMedsPX.

As debate about the quality of the earnings and termination of HempMeds raged on the message boards, the markets opened, and CANV stock immediately rose from the previous day's close of $2.61 to approximately $3.00, a level at which it traded for the next three and one-half hours. Then, at 1:15PM EDT, the company issued a mid-day press release highlighting select information from its second quarter results. Within moments, the price of CannaVest stock spiked to $4.08 -- up 56.3% from the previous day's close before settling back to end day at $3.26, up $0.65 (+24.9%).

Amazing what a little PR can do, especially when certain information from the 10-Q is conspicuously absent from the press release. This article will attempt to fill in some of the gaps.

The press release noted that net income for 2Q/2014 was $8,040,430, or $0.24 per share (basic and diluted,) and while it did mention later in the release that approximately $7.9M of the income was the gain on the sale of an equity investment in KannaLife Sciences, the amount of product sales ($3.01M) was missing. Nor was there any mention of the fact, disclosed on page 14 of the 10-Q, that on August 11, 2014, CannaVest had terminated its distribution agreement with its main distributor, Medical Marijuana, Incorporated's (OTCPK:MJNA) HempMedsPX.

While we'll get back to the financials a little further later in this article, the termination of the HempMedsPX distribution agreement was the real shocker. The following shows the text of the 10-Q filing, and indicates that CannaVest believes that HempMeds was not meeting the terms of the agreement:

On August 11, 2014, the HempMeds Agreement was terminated by the Company in accordance with the terms of the HempMeds Agreement which permitted the Company to terminate the HempMeds Agreement in the event of certain defaults by HempMeds. The Company had previously notified HempMeds that it was in breach of various provisions of the HempMeds Agreement including provisions regarding HempMeds distribution of competing products, the requirement that HempMeds obtain prior approval of marketing and promotional materials, the Company's ability to access HempMeds sales data, and HempMeds payment of amounts due under the HempMeds Agreement, amongst others.

The filing states that either party may terminate the agreement "upon 90 days prior notice of termination or otherwise in accordance with its terms", but it is not clear, at least to this author, whether the August 11, 2014 date was the start of the 90 day period or the end. In other words, it is not clear if HempMedsPX will continue operating under the agreement for 90 more days, or if it is no longer doing so.

It is possible that the termination of the agreement simply means that HempMeds and MJNA may continue as a non-exclusive retailer/distributor of CannaVest's end consumer products and hemp oils sold to third-party manufacturers, but with less favorable pricing and payment terms.

Whatever the case, CannaVest may now have to build its own online and offline sales organization, or contract with another company for those services. There are some clues in the 10-Q that CannaVest may be building up its Plus CBD subsidiary to take on these tasks, but CannaVest will quickly need to issue more information to shareholders about this transition, especially about how, or if, it will affect revenue in the second half of 2014.

Now, let's get back to the financials:

Revenues from product sales were $3.01 Million, up approximately 14% sequentially from 1Q/14's $2.63M. That's not bad, but some of that revenue growth was driven by the startup of KannaWay, a MLM (Multi-Level Marketing) company that sells products that use CannaVest's hemp oil in its products. KannaWay went "live" in April, 2014, and as with many MLM companies, the startup was accompanied by a wave of initial orders from members who are required to purchase some products in order to lock-in or protect a position in the compensation plan. Quite often, once the initial surge ends, members drop out, and the promoters/managers have to scramble to find new members in order to maintain the MLM's growth.

We won't know for another quarter or two if KannaWay will follow the same boom and bust path of other MLMs. The termination of the distribution agreement with HempMedsPX, which was handling the shipments to KannaWay's members, along with bringing a new marketing and sales team onboard, will further muddy the waters with regards to revenue estimates.

Operating income was $131,892, or approximately $0.004 per basic and diluted share. While it's nice to see an operating profit, four tenths of a cent per share in operating income doesn't warrant a 25% increase in the closing price. What attracted traders was the announced twenty four cents per share in net income that was the product of a $7.9 million gain on an equity investment, attributable to the sale to Phytosphere of CannaVest's investment in KannaLife Sciences.

Phytosphere is 80% owned by MJNA, with the remaining 20% held by HDDC (Hemp Deposit and Distribution Corporation,) MJNA's partner in many of its ventures. In addition, Medical Marijuana, Inc already had an investment in KannaLife. When CannaVest bought the Phytosphere hemp operation on January 29, 2013, 900,000 restricted shares of CANV were allocated to Phytosphere Systems, LLC. The 500,000 CannaVest shares paid by Phytosphere for the KannaLife investment likely came from this "stash".

The non-cash transaction was priced at the June 2, 2014 closing price of $16.60, for a total value of $8.3 million and a net profit to CannaVest of $7.9M. This author wishes that CannaVest had explained the reason for the $8.3M valuation, because just a few weeks earlier, when CannaVest filed its 10-Q for 1Q/2014 on May 15, it stated that the KannaLife investment was worth only about $400K.

What happened in the intervening weeks to make this investment increase by nearly 2000%, and why would MJNA/Phytosphere agree to pay 500,000 shares at $16.60, rather than 24,096 shares at $16.60, for a total of $400,000?

Both CannaVest and Medical Marijuana, Inc need to explain this valuation increase to their shareholders. CannaVest, because the huge non-cash gain dramatically increased its net EPS, and MJNA, because its shareholders will want to know why it was willing to pay $8.3 million of the marketable securities on its balance sheet to a seller who, just a few weeks earlier, told the world that the KannaLife investment was worth only $400,000.

Finally, while the initial wave of selling of the $1 restricted shares that were sold between Nov/2013 and Jan/2014 may have crested, a total of approximately 2.5 million, out of a total ten million, were offered and sold before the end of 2013, with the remainder sold during the first quarter of 2014. There are likely another 5-6 million shares that will be eligible to have their restricted status removed by the end of September, 2014. In addition, CannaVest sold another 781,666 restricted shares at $1.50 in April, 2014. Those shares could have their restricted status changed as soon as this November.

With more than 33.6 million shares outstanding, less than $0.02 in operating income in the first half of 2014, the termination of the sales organization that was responsible for 100% of its revenue, the lack of a clear successor to HempMedsPX, an untested multi-level marketing company as a major customer and a large number of $1 shares soon to come off of restriction, CannaVest, at approximately $3.50 per share, appears well overvalued.

Then again, it is an OTC stock that this past February, with very few free-trading shares, ran to $201 while a large shareholder, Stuart Titus and his company, General Hemp, sold $7M worth of its CANV holdings as the price rose and fell.

Buyer beware.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

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