CVSI: Growing Retail Footprint and Rising Brand Awareness Drive Strong 1H 2018 Results

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San Diego, California-based CV Sciences, Inc. (OTC:CVSI) manufactures hemp-based phytocannabinoids including cannabidiol (CBD) oil and also develops specialty pharmaceutical therapeutics. The company reported 2Q18 results yesterday that reflect the benefits of its strategy. According to Forbes, “CBD, short for cannabidiol, is a compound found in cannabis that has gained prominence in recent years for its therapeutic properties.” With multiple industrial uses for hemp, including for textiles, paper, auto parts, biofuel, cosmetics, animal feed and nutritional supplements, among others, the market for hemp-based products has expanded dramatically and growth is expected to continue.

Citing The Hemp Business Journal, Forbes notes that the CBD market is estimated to reach $2.1 billion market in consumer sales by 2020, with $450 million derived from hemp-based sources. By comparison, the total CBD market was $202 million in 2015, according to Forbes. CBD is the non psycho-active part of the cannabis plant. A psycho-active chemical stimulates certain receptors in the brain. According to Forbes, CBD “is typically used for health reasons instead of for recreational purposes.”

CV Sciences aspires to benefit from the expansion of this industry through its two business segments. One segment is a drug development division focused on developing and commercializing innovative therapeutics that leverage synthetic CBD. The company is currently advancing its drug candidate CVSI-007. The other segment is a consumer product division that manufactures and sells plant-based CBD products.

Growing Retail Channel

A key part of the company’s strategy has been to grow the retail channel that carries its consumer products. Distribution for CV Sciences’ flagship brandPlusCBD Oil™ continues to expand in the natural, health and organic retail sectors. According to data aggregator SPINS®, PlusCBD Oil is the leading brand of hemp CBD products in the natural products retail channel. Combining all product category sales in food supplements, the company’s brand is ranked #2 in the independent natural products retailer channel, according to SPINS.

With a new production facility online, the company plans to boost its operating scale to meet market demand and simultaneously continue to expand its retail footprint in order to leverage industry growth. The company’s brand was available in 1,968 natural and organic health food stores at the end of 2Q18, which represents an 11.1% expansion compared to March 31, 2018 when there were 1,771 stores. The figure below from CV Sciences’ investor presentation illustrates the growth in the company’s retail footprint from April 2015 to March 2018.

View Exhibit I

2Q18: Y/Y and Q/Q Improvements

The company believes that its retail channel expansion and industry forecasts of robust advances for hemp CBD products create a positive backdrop for its growth prospects. In fact, CV Sciences has reported record revenue, gross profit, cash flow and adjusted EBITDA in the first half 2018. The company also attained its first profitable quarter in 1Q18.

Yesterday, CV Sciences reported 2Q18 revenue of $12.3 million, up 203% year-over-year and 53% sequentially. The company registered gross profit of $9.1 million, a 219% increase versus 2Q17. Net income was $3.2 million versus a 2Q17 net loss of ($1.0) million. Reflecting 2018 year-to-date results, the company believes its products are well-positioned for continued growth, as consumer awareness and interest grow and as it further expands the distribution network within the health and wellness markets.

Patent-Pending Drug Candidate CVSI-007

While CV Sciences continues to grow the consumer side of its business, it is also committed to advancing its developmental patent-pending drug candidate CVSI-007, as demand for tobacco and smokeless tobacco cessation continues to rise. CV Sciences acquired CVSI-007 and simultaneously changed its name to CV Sciences when its predecessor company, CannaVest Corp., purchased CanX, Inc. in December 2015. CV Sciences subsequently initiated a preclinical drug development program for CVSI-007 in 2Q16. Overall, the company’s drug development strategy encompasses pursuing synthetic-based CBD drug candidates in areas that potentially can improve patient treatments and are characterized by large treatment markets.

According to the American Cancer Society, “smokeless tobacco is a less lethal, but still unsafe, alternative to smoking.” The company is optimistic about CVSI-007, which combines synthetic CBD and nicotine. It is moving forward with the preclinical studies that it will need to obtain FDA approval and plans to submit an Investigational New Drug (IND) application in 2019 and begin clinical trials.

“Overall, cigarette smoking among U.S. adults (aged ≥18 years) declined from 20.9 percent in 2005 to 15.5 percent in 2016,” according to the CDC. On a global basis, smoking rates of traditional cigarettes are declining by roughly 1% per annum according to studies, while simultaneously regulations are tightening in many markets. For example, the EU recently adopted strict rules banning flavors such as menthol and requiring that cigarettes be sold in packs of no fewer than 20. Many markets require plain packaging in an effort to discourage consumer purchases.

However, e-cigarettes and other smokeless devices have been on the rise. Battery operated, e-cigarettes contain nicotine but not tobacco. In place of smoke, they produce vapor via a heating element that vaporizes a liquid nicotine solution inside. Vaporizers have a tank or chamber, a heating element and a battery. The user fills the tank with e-liquid or fills the chamber with dry herb or leaf. The vaporizer battery can be recharged and the tank and chamber can be refilled.

The overall e-cigarette market grew rapidly from 2010 to 2013. For example, the percentage of smokers who had used e-cigarettes more than tripled from 9.8% to 36.5%, according to a CDC study. The overall vapor category (VMT – vapors, tanks, and mods) has overtaken e-cigarettes, according to Wells Fargo.

Alternative smoking products face potential increased regulatory oversight. In May of 2016, e-cigarettes and vapor products in the EU were placed under the regulation of the Tobacco Products Directive. E-cigarettes had been less regulated than traditional cigarettes in the U.S, but the FDA extended its regulatory authority to e-cigarettes in August 2016. New rules require e-cigarette manufacturers to submit their products for FDA review, include a health warning and only use vending machines in places where young people don’t have access.

A key consideration for US regulators appears to be the potential impact of alternative devices on the youth market, with surveys noting a significant increase in the number of middle and high school students using e-cigarettes. Their numbers increased from 79,000 in 2011 to 250,000 in 2013. In all, over 263,000 teenagers who have never used a tobacco cigarette are reported to be using e-cigarettes. This trend is alarming to domestic legislators because: 1) long-term impacts of e-cigarette usage are not documented at this early point and 2) there is the potential that usage of e-cigarettes could eventually lead to smoking of traditional cigarettes. At the same time, marketing of e-cigarettes to teens is up 321%, according to TIME.

It’s still early to know for sure, but the new U.S. and EU regulations could hurt sales of existing and potentially future alternative products. Similar regulation could follow in other markets. For instance, “Asia… has a somewhat confused– occasionally outright hostile – relationship with electronic smoking devices as far as legislation is concerned,” according to Tobacco Asia.

However, attracted by the growth in smokeless tobacco and vapor sales and reflecting stagnant or declining sales of traditional cigarettes, big tobacco companies have entered the e-cigarette sector. Lorillard, one of the leading big tobacco players, got into the niche in 2012 with its $135 million acquisition of blu e-cigarettes. Altria launched MarkTen and subsequently purchased e-cigarette marketer Green Smoke on February 3, 2014 for $110 million. Reynolds American introduced its propriety Vuse brand in 2013.

Demand began to shift away from e-cigarettes towards vaporizers or VMTs. At an estimated $2.5 billion as of September 2014, the overall vapor category grew 23% in 2014 compared to 2013, according to Wells Fargo.

With all this activity by big tobacco, as well as the proliferation of mom and pop vape stores, smokeless tobacco addiction appears to be a growing problem. This treatment of smokeless tobacco addiction market has been estimated at more than $2 billion, according to management, and the market is forecast to surpass $4 billion by 2022. Certain studies indicate that over-the-counter nicotine replacement therapies have resulted in high (as high as 93%) relapse rates within the first six months. CVSI-007 is designed to treat the actual sources of addiction by combining nicotine and cannabidiol.

Financial and Deleveraging Initiatives

In addition to these strategic initiatives, the company is also deleveraging its balance sheet to improve its financial strength and flexibility. CV Sciences eliminated its convertible debt in 2018. During 1Q18, the company reduced its debt balance by $300,000 and repaid all remaining outstanding convertible debt in full. CV Sciences’ debt balance was $850,000 at March of 2018, with this debt due in May 2019. The debt is not convertible and the company has noted that it expects to repay it over the next several quarters from internally generated cash flow.

In fact, the company generated positive cash flow from operations of $1.654 million In 1Q18. Management believes it has sufficient cash to fund its two business segments and meet its working capital needs over the next year from cash on hand of $3.1 million as of March 31, 2018 and cash flow.

Last month following a settlement with the SEC, the company’s former president and CEO resigned. The CFO, Joseph Dowling, was named CEO, as well as CFO. The company intends to discuss its growing retail footprint and positive sales trends, as well as its other strategic initiatives, at its annual investor day on August 4, 2018. Strategic 2018-19 priorities include

‣ strengthening its distribution channel by further growing the number of retail stores that carry the company’s brand
‣ increasing consumer awareness of the brand
‣ expanding the market in the natural product retail channel of hemp-based CBD nutritional and beauty products
‣ advancing CVSI-007, including submitting an IND application and launching clinical trials
‣ improving operational efficiencies
‣ uplisting CVSI shares to a major national exchange

Earlier this month, the company announced that it had submitted an application to list its shares on the Nasdaq. Management expects this anticipated transition to increase corporate visibility, improve trading liquidity of the shares and boost awareness of CV Sciences among retail and institutional investors. In conjunction with the anticipated uplisting, the company’s board also approved a reverse stock split in order to meet the Nasdaq minimum share price requirement.

In 20I9, CV Sciences expects to move CVSI-007 forward and, as noted, plans to submit an IND application and launch clinical trials. The company also intends to continue to add distribution channels and improve operational efficiency, with a particular focus on improving cash flow and profitability.

Risks Include Competitive and Regulatory

The growth of the CBD market has drawn other players into the space. Thus, CV Sciences faces competitive risk, as well as potential regulatory risk, among other risks. Although the hemp CBD product category is legal in many states, Forbes notes that “CBD is not legal in all 50 states — even though it is widely available. At best, the law is murky and open to differing interpretations.” For example, the California Department of Public Health recently issued a FAQ on Industrial Hemp and Cannabidiol (CBD) in Food Products and announced that it would not allow the use of hemp-based CBD oil in food products. If the 2018 Farm Bill is passed, it could help standardize regulation across states regarding hemp-based CBD and management believes it would be positive for the company.

Summary: Company Expects Momentum to Continue on Retail Expansion and Rising Brand Awareness

CV Sciences aspires to benefit from the expansion of the CBD industry. A key part of its strategy has been to grow the network of retail outlets that carry its consumer products. The company’s brand was available in 1,968 stores at the end of 2Q18, up from 1,771 stores at the end of 1Q18. Management believes its retail channel expansion and anticipated robust growth of hemp CBD products auger well for the company’s growth prospects. In fact, in 1Q18 CV Sciences reported record revenue and has pre-announced 2Q18 revenue of $12.3 million, up 203% year-over-year and 53% sequentially. CV Sciences is also committed to advancing CVSI-007, its developmental patent-pending drug candidate that is designed to help in the treatment of tobacco and smokeless tobacco cessation. Management estimates this to be a $2 billion plus market. The company is also deleveraging and strives to improve operating efficiencies. Risks to CV Sciences’ continued growth include competitive and regulatory, among others, in our view. Management believes potential passage of the 2018 Farm Bill could benefit the company.

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