Consumer Products Canadian Equity Research 19 September 2018 BUY PRICE TARGET Price (18-Sep) Ticker C$21.00 C$15.56 CWEB-CNSX 52-Week Range (C$): 9.05-18.00 Market Cap (C$M): 1,636 Shares Out. (M) : 105.2 Implied Return to Target (%) : 35.0 Net Debt (Cash) (C$M): (94) Enterprise Value (C$M): 1,543 FYE Dec 2017A 2018E 2019E 2020E Sales (US$M) 40.0 79.9 169.5 296.6 Gross Profit (US$M) 29.9 61.7 125.8 219.5 EBITDA (US$M) 14.1 28.3 59.0 98.9 EPS (US$) 0.09 0.20 0.37 0.65 EV/EBITDA (x) 84.0 42.0 20.1 12.0 P/E (x) 136.2 59.6 32.2 18.5 18 17 16 15 14 13 12 11 10 9 Sep-18 CWEB Source: FactSet Priced as of close of business 18 September 2018 Charlotte s Web is a market leader in the production and distribution of wellness products made from cannabidiol, a compound extracted from industrial hemp. Based in Boulder, Colorado, Charlotte's Web markets its products to customers across the United States and on a limited basis internationally, through specialty retailers and its website (www.cwhemp.com). All figures expressed in US$ unless otherwise stated Derek Dley, CFA Analyst Canaccord Genuity Corp. (Canada) ddley@canaccordgenuity.com 416.869.7270 Alexander Diakun Associate Canaccord Genuity Corp. (Canada) adiakun@canaccordgenuity.com 1.416.687.6339 A new strain of wellness products Investment recommendation: We are initiating coverage on Charlotte s Web with a BUY rating and C$21.00 target price. Charlotte s Web offers investors exposure to the high-growth cannabidiol (CBD) market through its industry-leading market share and product suite at what we believe is an attractive current valuation. Investment highlights: Charlotte s Web is a market leader in the production and distribution of wellness products made from cannabidiol (CBD), a compound extracted from industrial hemp. Industrial hemp is a species of cannabis with no more than a 0.3% concentration of THC not marijuana which is a key distinction, as this definition allows Charlotte s Web to sell its products across the US and in many countries. In the last two years, the US market for hemp-derived CBD supplements has experienced robust growth and is expected to grow at a 55% CAGR over 2016-2021, according to the Brightfield Group. Charlotte s Web products achieved mass consumer acceptance following the airing of a CNN documentary by Dr. Sanjay Gupta which followed 5-year-old Charlotte Figi, who has a rare form of epilepsy and suffered from over 300 seizures a day. Charlotte was administered a CBD extract and within a week her well-being had significantly improved. In mid-2018, the company adopted the name Charlotte s Web Holdings Inc., representing the inspiring story that propelled the company into the spotlight. Today, while still being used as an antiepileptic, CBD is typically used to promote internal stability and equilibrium in the body. As such, its various benefits are said to include relieving stress, providing users with a sense of calm and focus, and helping in the recovery of exercise-induced inflammation. While legal ambiguities exist, the operations of Charlotte s Web are legal in the United States, where the company generates approximately 97% of its revenue. With that said, we believe the CBD supplements market is poised for robust growth over our forecast period, as CBD supplement products become more widely accepted at both the governmental and consumer level, with transformational regulation expected to become law prior to the end of 2018. Most notably the 2018 Farm Bill, which includes provisions to de-schedule industrial hemp as a Schedule I controlled substance, is expected to be signed into law by President Trump prior to the end of 2018. We are forecasting EBITDA of $28M, $59M and $99M in 2018, 2019 and 2020, respectively, implying a CAGR of 91% over 2017-2020. Valuation: Our target price is derived using a DCF valuation, with an 11.1% WACC and 2.5% terminal growth rate, yielding a value per share of $20.88. Our target implies 16.5x our 2020 EBITDA estimate of $99 million, which we convert to Canadian dollars to account for the company s CSE-listed share price. Charlotte s Web offers investors exposure to the highgrowth CBD supplements market, through its industry-leading market share, impressive management team, established and growing retail relationships, and strong brand power. With the shares currently trading at 12.0x our 2020 EBITDA estimate, we believe Charlotte s Web represents an attractive buying opportunity. Canaccord Genuity is the global capital markets group of Canaccord Genuity Group Inc. (CF : TSX) The recommendations and opinions expressed in this research report accurately reflect the research analyst's personal, independent and objective views about any and all the companies and securities that are the subject of this report discussed herein. For important information, please see the Important Disclosures beginning on page 35 of this document.
Table of Contents Executive Summary... 3 Overview of operations... 5 Investment Thesis... 10 Risks... 20 Financial analysis and outlook... 22 Valuation... 26 Appendix A: Management... 31 Appendix B: Ownership... 32 Appendix C: Competitors... 33 Appendix D: CV Sciences financials... 34 2 Buy Target Price C$21.00 19 September 2018 Consumer Products 2
Executive Summary Charlotte s Web is a market leader in the production and distribution of wellness products made from cannabidiol (CBD), a compound extracted from industrial hemp. Industrial hemp is a species of cannabis with no more than a 0.3% concentration of THC not marijuana which is a key distinction, as this definition allows Charlotte s Web to sell its products legally across the United States and in many countries. In our view, this positions the company as a health and wellness product distributor, not a cannabis company, which we believe allows for a broader base of investors otherwise hesitant to invest in the cannabis industry. Based in Boulder, Colorado the company is the market leader in hemp-extracted CBD supplements, with a 14% market share in 2017, selling products including tinctures, topical products and capsules. The company participates in the hemp-derived CBD supplement market, which is expected to grow to $1.6 billion, representing a CAGR of 55% over 2016-2021, according to a report from the Brightfield Group, Hemp- Derived CBD, Market Overview & Analysis. We believe the strong brand positioning of Charlotte s Web, the company s vertical integration, and its growing retail presence, has the company well positioned to exceed industry average growth rates and deliver healthy returns to shareholders. As such, we are forecasting revenue to grow from $40 million in 2017 to $297 million in 2020, and EBITDA from $14 million in 2017 to $99 million in 2020 as CBD products gain more acceptance, from consumers as well as from federal and state governments. Investment highlights: Below we highlight four key investment drivers: 1. Rapid market growth expected amidst transformational regulation 2. Market share expansion expected to continue as CBD acceptance increases 3. Robust innovation pipeline positions Charlotte s Web for long-term growth 4. Vertical integration should lead to robust EBITDA margins Rapid market growth expected amidst transformational regulation While legal ambiguities exist, the operations of Charlotte s Web are legal in the United States, where the company generates approximately 97% of its revenue. Importantly, the distinction made in the Consolidated Appropriations Act between industrial hemp and cannabis means Charlotte s Web is able to deduct operating expenses related to the production of its products. This is an important distinction from U.S. cannabis companies, which are subject to section 280E of the Internal Revenue Code. With that said, we believe the CBD supplements market is poised for robust growth over our forecast period, as CBD supplement products become more widely accepted at both the governmental and consumer level, with transformational regulation expected to become law prior to the end of 2018. Most notably the 2018 Farm Bill, which includes provisions to de-schedule industrial hemp as a Schedule I controlled substance, is expected to be signed into law by President Trump prior to the end of 2018. We believe this improving regulatory environment is likely to open up support for CBD products in the near term, giving us confidence in the sustainability of the robust growth recently witnessed in the hemp-derived CBD supplement market. Market share expansion expected to continue as CBD acceptance increases Charlotte s Web is the hemp-derived CBD supplements industry leader, with 14% market share in 2017, almost double 2016 at 8%. We believe this is attributable to 3 Buy Target Price C$21.00 19 September 2018 Consumer Products 3
the company s strong brand recognition and positioning as a product of choice for a number of larger niche and specialty healthcare retailers. The company plans to exit 2018 with over 3,000 retail partners which, along with continued growth in the company s e-commerce platforms, should allow Charlotte s Web to continue to expand its market share. Should regulations surrounding CBD products continue to ease, we believe Charlotte s Web is well positioned to add a mass-market retail relationship, which is not included in our forecast and would further entrench the company s industry-leading status. Robust innovation pipeline positions Charlotte s Web for long-term growth Currently, Charlotte s Web offers ~23 SKUs in a number of different forms and compositions. We believe the company will be able to leverage its proprietary hemp strains and extraction capabilities to develop new, high-growth products over the course of our forecast period. The company intends to introduce 5-7 new products over the next two years, and over the long term, the company s new product pipeline is expected to expand the company s applications into areas such as sports medicine, topical cosmetics, CBD beverages and pet treats. The company s new products which may not all necessarily contain CBD, which we believe will open up the Charlotte s Web brand to a group of consumers previously hesitant to use the company s products. Vertical integration should lead to robust EBITDA margins Charlotte s Web is fully vertically integrated, controlling its product from seed to shelves. We believe this is instrumental and allows the company to generate robust EBITDA margins in the 35-37% range. This is roughly 500-700 bps ahead of CV Sciences (CVSI Not Rated), the company s largest competitor and owner of the PlusCBD brand, which produces product made from externally sourced hemp. Through its ownership of plant genetics as well as proprietary extraction and conversion processes, the company can scale the cultivation of its proprietary hemp plants in a cost-efficient manner which, coupled with its premium pricing ability, should allow Charlotte s Web to continue to generate industry-leading margins. Compelling valuation given margin profile and robust revenue We are initiating coverage with a BUY rating and C$21.00 target price. Our target is derived using a discounted cash flow analysis, which results in a valuation of $20.88 per share. Our target implies 16.5x our 2020 EBITDA estimate of $99 million, which we convert to Canadian dollars to account for the company s CSE-listed share price. In our view, Charlotte s Web represents an attractive buying opportunity at current levels, trading at 12.0x our 2020 EBITDA estimate of $99 million. This represents a discount to health and wellness-focused supplement manufacturers, which trade at 13.2x 2020 EBITDA estimates. We believe Charlotte s Web should be valued at a premium to its peer group as we think the company is positioned for higher near-term growth than its peers. As well, Charlotte s Web maintains greater financial flexibility given its $72 million net cash position, which leaves the company fully funded over our forecast period to achieve our estimates. Potential risks (see Risks section on page 20 for details) CBD research discovers negative side effects or lack of efficacy FDA increases intervention in the operations of the company 2018 Farm Bill not signed into law Agricultural operations risk Increased industry competition 4 Buy Target Price C$21.00 19 September 2018 Consumer Products 4
$ mm $ mm Charlotte's Web Holdings, Inc. Overview of operations Charlotte s Web is the industry leader in hemp-derived CBD extracts, with a market share of 14% in 2017 Figure 1: Current product portfolio Charlotte s Web is a market leader in the production and distribution of wellness products made from cannabidiol ( CBD ), which is a compound extracted from industrial hemp. Based in Boulder, Colorado the company currently markets its products to customers across the United States and, on a limited basis, internationally. Importantly, Charlotte s Web distributes extracts made from industrial hemp, which is hemp that contains no more than a 0.3% concentration of tetrahydrocannabinol ( THC ), the psychoactive compound found in cannabis. In our view, this positions the company as a health and wellness product distributor and not a cannabis company, which may ease concerns for some investors. The company markets products through its owned brand, Charlotte s Web, which currently offers ~23 SKUs with a focus on CBD extracts. Products are sold in numerous forms, including tinctures (liquids/drops), capsules, and topical products, along with a product line specifically designed for canines. Charlotte s Web is the industry leader in the high-growth, hemp-derived CBD extracts market, with an estimated 14% market share in 2017, up from 8% in 2016, in a market that is forecasted to grow at a 55% CAGR over 2016-2021. Extract Oil CBD Isolate Capsules Cream Paws Source: Company web site Figure 2: Historic revenue Since 2014, Charlotte s Web has grown its cultivation practices to three states (Colorado, Kentucky, and Oregon), while selling its products both online and through 2,700 retail partners. The company generated revenue of $40 million in 2017, and EBITDA of $14 million. Figure 3: Historic EBITDA and EBITDA margin 45 40 35 30 25 20 15 10 5 0 40 30 15 16 2016 2017 H1/17 H1/18 25 20 15 10 5 0 35% 35% 30% 14 14% 11 5 2 2016 2017 H1/17 H1/18 40% 35% 30% 25% 20% 15% 10% 5% 0% 5 Buy Target Price C$21.00 19 September 2018 Consumer Products 5
Fully vertically integrated, maintaining control over its products from seed to shelves Vertically integrated model Importantly, Charlotte s Web is fully vertically integrated, allowing the company to maintain control over its products from seed to shelves. The company leases or has contracts in place for over 300 acres of agricultural farmland in Colorado, Kentucky, and Oregon, which is used to cultivate industrial hemp. In Colorado, the company owns the cultivation, as the state has progressive regulations which allow for commercial hemp cultivation. In Kentucky and Oregon, the company uses contract manufacturing, partnering with farmers licensed under the state s pilot programs. In 2018, Charlotte s Web expects to produce 250,000-350,000 pounds of industrial hemp, up from 63,000 pounds in 2017. While we do not expect the company to sell through the entirety of its 2018 harvest in the same fiscal year, we estimate that production of 250,000-350,000 pounds of industrial hemp would generate approximately $160-220 million in revenue. Furthermore, Charlotte s Web owns and operates a 40,000 square foot manufacturing facility, as well as a warehouse and distribution center in Colorado, where the company extracts CBD from its harvested industrial hemp. The company utilizes both carbon dioxide and alcohol extraction processes at the facility, both of which are proprietary. This facility currently has the capacity to bottle 16,000 30 ml bottles or 8,000 100 ml bottles per day. Figure 4: Breakdown of 2018 cultivation acreage by state Current cultivation acreage: 300 ac. 23% 45% 32% Colorado Kentucky Oregon Proprietary genetics and breeding operations allow for improved scalability in cultivation Charlotte s Web also operates a 2,800 square foot plant breeding facility, where it owns the genetics and cultivates its most popular strain of hemp plants. The company has developed a feminized seed protocol, which allows for greater standardization across the company s hemp production, while also providing greater scalability. These proprietary genetics consistently produce a CBD:THC ratio that is far superior to that of the competition, with only a limited number of cannabis strains even approaching this ratio. In addition to the company s genetics, the company s extraction and conversion processes, as well as designs, are also proprietary. In our view, the company s proprietary genetics and breeding operations allow the company to scale its cultivation in a manner which would be difficult to replicate through a simple plant cloning process, which is common throughout the industry. The company currently sells its products both online and through brick-and-mortar retail channels, with e-commerce sales accounting for approximately 64% of sales in 2017. The e-commerce strategy currently has roughly 200,000 opt-in email 6 Buy Target Price C$21.00 19 September 2018 Consumer Products 6
customers, and recently has added an average of 10,000 new email customers every month. In addition to having products available through the company website (www.cwhemp.com), Charlotte s Web products are also listed through multiple vendor sites. The e-commerce strategy allows customers to sign up for a subscription program, and importantly, approximately 80% of sales are generated from repeat customers, demonstrating the strength of the company s brand power. Figure 5: Overview of assets Facility (all in Colorado) Size (sq. ft.) Administrative office 7,100 HQ/processing/R&D 40,100 Distribution 23,000 Horticulture/breeding 6,700 Customer service 3,000 Greenhouse 16,000 Greenhouse & office 16,000 Source: Company reports Company history Charlotte s Web has an inimitable and meaningful history that is important to the branding and overall purpose of the company and which, in our view, has led to the company s industry-leading position and 14% market share. Figure 6: Company history timeline 2008 Stanley Brothers begin researching medicinal properties in plants 2012 Stanley Brothers first meet Charlotte Figi December 2013 Stanley Brothers Inc. is founded May 2015 The company expands product line to include health and wellness products June 2017 Expands operations to include a 23,000 sq. ft. storage and distribution facility 2008 2010 2012 2013 2014 2015 2016 2017 2018 2010 The brothers begin breeding plants with a high-cbd, low-thc content August 2013 CNN documentary by Dr. Sanjay Gupta airs on CNN featuring Charlotte Figi March 2014 The company establishes its first commercial cultivation operation June - Dec 2015 The company plants its first crops in Kentucky; moves to current 40,000 sq.ft. manufacturing facility August 2018 As Charlotte s Web, the company goes public and begins trading on the CSE as CWEB Source: Company reports The company was founded by seven brothers from Colorado, known as the Stanley brothers. The brothers began working with cannabis and researching its medicinal properties after their uncle was diagnosed with cancer in 2008. In 2012, the Stanley brothers met Charlotte Figi, a 5-year old girl with a rare form of epilepsy who suffered from over 300 seizures a day. With early research showing the applications of CBD as an antiepileptic, the Stanley brothers developed a hemp-derived CBD extract for Charlotte which, after being administered by her parents, substantially improved her condition. Inspired by Charlotte s story, the brothers founded Stanley Brothers Inc. in 2013 and began distributing high-cbd, low-thc hemp-derived extracts under the brand Charlotte s Web. In mid-2018, the Stanley brothers changed the name of the company to Charlotte s Web Holdings Inc., representing the inspiring story that propelled the company into the spotlight. 7 Buy Target Price C$21.00 19 September 2018 Consumer Products 7
Cultivates in three U.S. states with products sold in 2,700 retail locations Charlotte s Story Charlotte s Web products achieved mass consumer acceptance following the airing of a CNN documentary by Dr. Sanjay Gupta. The documentary followed 5-year-old Charlotte Figi and her parents. Charlotte (whom the company is named after) has a form of epilepsy called Dravet Syndrome and as a result suffered from more than 300 seizures a day. Charlotte s parents had been looking for a treatment and decided to try CBD, given the published research indicating the applications for CBD as an antiepileptic. The Stanley brothers, who had been developing a strain of hemp high in CBD content and low in THC, created an extract from this plant which Charlotte s parents administered, following approval from her doctor. Within a week, Charlotte s well-being had significantly improved. Following the airing of this documentary, Charlotte s Web had a waitlist for its product of over 15,000 families. We believe the media attention received by Charlotte s Web in relation to the CNN documentary has helped propel the company to its industryleading market share. Furthermore, Charlotte s story was instrumental in developing broader consumer acceptance of CBD and its potential applications. Today, while still being used as an antiepileptic, CBD is typically used to promote internal stability and equilibrium in the body. As such, its various benefits are said to include relieving stress, providing users with a sense of calm and focus, and helping in the recovery of exercise-induced inflammation. About hemp & CBD To understand why hemp-derived CBD has been shown to have various positive effects on the human body, it is important to understand the science behind CBD and, more importantly, the endocannabinoid system ( ECS ). First, we will discuss the difference between hemp and marijuana, which leads to our classification of Charlotte s Web as a consumer-packaged goods company, and not a cannabis company. A key distinction between hemp and marijuana As previously mentioned, we believe Charlotte s Web to be a distributor of health and wellness products and not a cannabis company. The key distinction is in the definition of cannabis. While it is broadly assumed to refer to marijuana, which is cannabis with a high level of THC, the term cannabis refers to the species of plant called Cannabis sativa (L.). Hemp is also derived from the cannabis species; however, it is defined as being cannabis with no more than a 0.3% concentration of THC. This difference is substantial, as THC is the main psychoactive cannabinoid found in cannabis. The lack of legal distinction between marijuana and hemp is the reason why hemp has been included in the United States Controlled Substances Act ( CSA ) as a Schedule I drug, yet is still allowed to be legally transported and sold across state lines. While research remains in its infancy, CBD efficacy is well documented Given the fact that the shift in sentiment behind cannabinoids has only ramped up within the last decade, the research behind the applications for hemp and hemp products remains in its infancy. That being said, there are numerous early indicators that point towards the efficacy of CBD for various applications, one of the first of which being US Patent 6,630,507 issued in October of 2003. While this patent outlines the multiple applications for cannabinoids, it notes the potential application for CBD as an antiepileptic. More recently the FDA approval of the drug Epidiolex, developed by GW Pharmaceuticals, further supports the efficacy of CBD, as it was approved for the treatment of seizures associated with Lennox-Gastaut and Dravet syndrome, two rare forms of epilepsy. Additionally, we believe there are eight other drugs currently conducting clinical research on treatments for various conditions such as epilepsy and 8 Buy Target Price C$21.00 19 September 2018 Consumer Products 8
schizophrenia. In our view, the increasing number of clinical studies being conducted with CBD is strongly supportive of the efficacy of the compound. Figure 7: List of drugs with CBD in development Drug name Company Status Intended Treatment Epidiolex Arvisol ZYN002 GW Pharmaceuticals Echo Pharmaceuticals Zynerba Pharmaceuticals Approved by FDA Phase I clinical study Phase II clinical study Seizures in patients with Dravet and Lennox- Gastaut syndromes Various neurological disorders, including schizophrenia and epilepsy Fragile X Syndrome, Epilepsy and Developmental and Epileptic Encephalopathies N/A Bionorica N/A N/A World Health Organization has recently found the CBD compound to have a good safety profile N/A N/A N/A PTL101 N/A STI Pharmaceuticals INSYS Pharmaceuticals INSYS Pharmaceuticals PhytoTech Therapeutics Ananda Scientific Phase II clinical study Phase II clinical study Phase III clinical study Phase I clinical study Phase I clinical study Source: World Health Organization CBD Critical Review Report, Canaccord Genuity estimates Marijuana-induced subjective effects Childhood absence seizures for Prader-Willi syndrome Infantile spasm-type seizures Pediatric intractible epilepsy Lastly, in terms of the safety of the compound, the World Health Organization (WHO) recently published a Critical Review Report on CBD. Importantly, it found the compound to have a good safety profile, with the only adverse effects resulting from drug-drug interactions with other patient medication, while noting that CBD exhibits no effects that would indicate any potential for substance abuse or dependence. It was also mentioned that there is early evidence that the compound has antitumor, neuroprotective, antiepileptic, antipsychotic, anti-inflammatory and anti-asthmatic properties. The endocannabinoid system and the science behind the efficacy The ECS is a regulatory system in the human body that works to promote homeostasis, which is internal stability and equilibrium in the body. The ECS contains two main cannabinoid receptors (CB1 & CB2) as well as cannabinoids, which are either produced in the body (endocannabinoids) or can be found in different foods in our diet. These endocannabinoids bind to activate the cannabinoid receptors. CBD impacts the ECS by inhibiting the metabolic enzymes that break down endocannabinoids, thereby increasing the levels of endocannabinoids in the body and promoting more activity in the cannabinoid receptors. In addition to promoting homeostasis, the ECS has been found to be involved in other processes such as sleep, digestion, energy, memory, metabolism, neuro-protection, hormones and heart function. Management and ownership Charlotte s Web is led by a strong and experienced management team with an emphasis on consumer-packaged goods experience. CEO Hess Moallem was previously a consumer-packaged goods executive, and most recently General Counsel at Onnit Labs. CFO Rich Mohr has over 25 years experience as a CFO with Nasdaqand TSX-listed companies. N/A 9 Buy Target Price C$21.00 19 September 2018 Consumer Products 9
Stanley Brothers maintain 34% ownership while management and insiders own 10% The Stanley brothers remain involved with Charlotte s Web, with Joel Stanley serving as Chairman of the Board of Directors, and Jared Stanley serving as VP Cultivation as well as a member of the Board. We estimate that the Stanley brothers own ~34% of the shares outstanding, while insiders and management own ~10% of the shares outstanding. Investment Thesis While legal ambiguities exist, the operations of Charlotte s Web are legal in the United States In our view, Charlotte s Web is well positioned to expand its already industry-leading market share, given the following: 1) Rapid market growth expected amidst transformational regulation 2) Market share expansion expected to continue as CBD acceptance increases 3) Robust innovation pipeline positions Charlotte s Web for long-term growth 4) Vertical integration should lead to healthy EBITDA margins Rapid market growth expected amidst transformational regulation While sentiment and awareness as it relates to industrial hemp continues to improve, regulations in the United States remain ambiguous. As of the writing of this report, industrial hemp is classified as a Schedule I drug as defined by the Controlled Substances Act ( CSA ), and thus the laws and regulations regarding industrial hemp are enforceable by the Drug Enforcement Administration ( DEA ). As well, while many hemp-derived CBD products are currently being marketed as dietary supplements, the viewpoint of the Food and Drug Administration ( FDA ) is that CBD is a drug, requiring the appropriate approval processes to be sold in the United States. The landscape the company operates in is quite complex; therefore, we have provided an in-depth discussion of the legal complexities below. While this analysis is necessary to understanding the risk profile of the company, it is important to note that in the United States, it is currently legal to: 1. Cultivate and produce hemp in 41 U.S. states, 2. Distribute hemp between all U.S. states 3. Sell hemp and hemp products anywhere in the U.S. As such, while legal ambiguities exist, the operations of Charlotte s Web are legal in the United States. We present a brief summary in the table below of the key regulations relating to hemp, ahead of the more in-depth analysis below. 10 Buy Target Price C$21.00 19 September 2018 Consumer Products 10
Figure 8: Summary of hemp-related legislation in the United States Regulation title Effective Summary of hemp-related regulation Impact on industrial hemp U.S. Controlled Substances Act May 1, 1971 Cannabis (inclusive of hemp) classified as a Schedule I drug with cultivation, manufacturing and distribution strictly regulated by the DEA Industrial hemp scarcely cultivated in the United States until 2014 Agricultural Act of 2014 (2014 Farm Bill) February 7, 2014 Introduces definition of industrial hemp and allows for cultivation and marketing of hemp under an Agricultural Pilot Program U.S. states now allowed to regulate hemp cultivation; currently 36 states with pilot programs in place Consolidated Appropriations Act (2015-2018) December 16, 2014 Specifies that no federal funds can be used to prohibit industrial hemp provided it was cultivated in accordance with the 2014 Farm Bill Hemp and hemp products can be sold anywhere in the United States without the intervention of federal administrations Agricultural Improvement Act of 2018 (2018 Farm Bill) TBD (estimated prior to the end of CY 2018) The lack of legal distinction between marijuana and cannabis has resulted in the strict regulation of hemp Industrial hemp de-scheduled in the U.S. CSA; U.S. states to regulate hemp production while the bill provides no authorization to interfere with interstate commerce of hemp and hemp extracts Cultivation, production, distribution and marketing of hemp allowed across the U.S., creating legal clarity across all U.S. states The main reason behind the strict regulation of industrial hemp is that it is technically cannabis. While the intention behind the laws is to regulate marijuana, the lack of legal distinction between marijuana and industrial hemp has resulted in tight restrictions imposed on industrial hemp, notwithstanding the fact it contains no psychoactive compound and is not addictive or dangerous. Despite the legal ambiguity, 2018 is proving to be a transformational year for the legalization of hemp, with numerous bills pushing for less regulation of hemp and its extracts. We believe the passing of these bills will be a transformational event not just for Charlotte s Web, but for the entire hemp industry, which has experienced unjust and strict regulation for close to a century. In our view, the removal of this legal overhang is a key inflection point for industrial hemp, and we expect it to allow the industry to flourish. Brief history of hemp in the United States The cultivation of hemp in the United States traces its roots as far back as the early 1600s, when settlers of an early English settlement in Virginia were required by law to grow hemp to produce rope, sails and clothing. In fact, throughout the 17 th and 18 th centuries, hemp production was required by farmers across many colonies, as its applications were widely used in the production of warships and merchant vessels, for which there was substantial demand at the time. Cultivation of hemp began to decline in the 19 th century, as the demand for these ships requiring hemp was displaced by demand for steam ships. 11 Buy Target Price C$21.00 19 September 2018 Consumer Products 11
Figure 9: Legal timeline for hemp in the United States Early 1600 Settlers in Virgina required by law to grow hemp; used in the production of warships 1937 Marihuana Tax Act introduced, regulating the importation, cultivation, possession and distribution 1998 The U.S. begins to import food-grade hemp products 2014 2014 Farm Bill signed into law, allowing for the cultivation and marketing of hemp under U.S. state pilot programs 2018 2018 Farm Bill passes senate, if signed into law it would deschedule hemp from being a Schedule I drug 1600 1700 1900 1970 2000 2014 2015 2018 1700s Many American colonies legally required settlers to grow hemp 1970 Controlled Substances Act lists cannabis, including hemp, as a Schedule I drug 2007 Two farmers in North Dakota granted licenses to cultivate hemp 2015-2018 Consolidated Appropriation Acts prohibit federal funds from interfering with the Hemp Pilot Program 2014 Farm Bill allowed for the cultivation of hemp under state regulated agricultural pilot programs In the 1900s, regulation in the United States would cause further hemp production declines, first with the Pure Food and Drug Act of 1906 which required drug labelling to list ingredients that were considered to be addictive or dangerous. This list of ingredients included 10 drugs, in addition to cannabis (whose definition included industrial hemp), including morphine, cocaine, heroin and chloroform. Further restrictions on cannabis occurred with the passing of the Marihuana Tax Act of 1937 ( MTA ), which regulated the importation, cultivation, possession and distribution of cannabis in the United States. A few decades thereafter, in 1970, the Controlled Substances Act was signed into law by Richard Nixon. This act listed cannabis as a Schedule I controlled substance, imposing strict regulations on its cultivation. Introduction of the 2014 Farm Bill and the Hemp Pilot Program A key breakthrough in the distinction between marijuana and hemp occurred with the passing of the Agricultural Act of 2014, also known as the 2014 Farm Bill. Importantly, the bill included the definition of industrial hemp, defining it as the plant Cannabis sativa L. with a THC concentration of not more than 0.3%. As well, the Farm Bill established an Agricultural Pilot Program to study the growth, cultivation and marketing of industrial hemp. It allowed for the cultivation of industrial hemp by either an institution of higher education or a U.S. state s department of agriculture. While the bill laid out some preliminary framework for the cultivation of industrial hemp, it remained a Schedule I controlled substance and as such, enforceable by the DEA at the federal level. Consolidated Appropriations Act, 2015-2018 Given the high degree of ambiguity with the Hemp Pilot Program and the 2014 Farm Bill, former US President Barack Obama signed into law the Consolidated and Further Continuing Appropriations Act of 2015. The act prohibited federal funds from contravening the Hemp Pilot Program. Obama then signed into law the Consolidated Appropriations Act of 2016, which further specified that federal funds could not be used to intervene in the transportation, processing, sale or use of industrial hemp, so long as it is cultivated in accordance with the Hemp Pilot Program. Since taking office, President Donald Trump has signed into law the Consolidated Appropriations Acts of both 2017 & 2018, which have the same language with respect to the Hemp Pilot Program as the Act of 2016. In our view, this bipartisan support for the hemp industry is a strong indication that the sentiment around hemp 12 Buy Target Price C$21.00 19 September 2018 Consumer Products 12
2018 Farm Bill set to remove hemp from the purview of the Controlled Substances Act The pro-hemp version of the 2018 Farm Bill passed the senate with a vote of 86-11 has changed in the United States and that the government, at the federal level, is willing to support the burgeoning industrial hemp industry. 2018 Farm Bill to remove industrial hemp from the marijuana definition The Agricultural Improvement Act of 2018, otherwise known as the 2018 Farm Bill, is the most important piece of legislation for the industrial hemp industry and is currently working its way through Congress. There are three key items proposed by the bill that are very positive for the production of industrial hemp in the United States (all items below are included in the Hemp Farming Act, which is included in the senate version of the 2018 Farm Bill): 1. The removal of hemp (and all derivatives/extracts) from the definition of marijuana, effectively de-scheduling hemp and removing it from the purview of the Controlled Substances Act. As well, this classifies hemp as an agricultural commodity allowing it to be distributed and sold between states. 2. Allow U.S. states to regulate the production of hemp within their own jurisdiction. 3. The bill does not authorize any interference with the interstate commerce of hemp and hemp extracts. After passing the House of Representatives on June 21, 2018, the bill had overwhelming support in the Senate and passed with a vote of 86-11 on June 28, 2018. A conference committee is now reconciling the amendments made to the bill in the House and Senate before bringing it to President Trump to be signed into law, which is expected to occur later in the year. Importantly, the contentious differences being reviewed are of no relation to the hemp regulation put forth. In our view, the anticipated passing of the 2018 Farm Bill is a transformational event for Charlotte s Web and more broadly the hemp industry, for three key reasons: 1. It would allow for the cultivation, production, distribution and marketing of hemp-derived products across the United States. 2. The de-scheduling of hemp provides increased legal clarity as the industry will no longer need to rely on the annual renewal of the Consolidated Appropriations Act to ensure the DEA does not intervene in its operations. 3. The removal of the stigma associated with being a Controlled Substance is expected to increase consumer acceptance as well as household penetration, while increasing the likelihood of Charlotte s Web securing distribution agreements with mass market retailers. 13 Buy Target Price C$21.00 19 September 2018 Consumer Products 13
Figure 10: U.S. states allowing the legal cultivation of hemp Source: mapchart.net, Canaccord Genuity The passing of the 2018 Farm Bill is a key step in supporting the development of the industry, as the laws currently in place are too ambiguous to allow individual states to apply them consistently. A prime example of this is in Texas, where the Department of State Health Services announced it would ban the sale of all CBD products and seize all products containing CBD from store shelves earlier in the year. The department recently put a hold on the action, as there was strong disapproval among the public given the legal ambiguity. The department indicated it would wait for further legislative clarity before carrying out further action. In our view, passing the 2018 Farm Bill would remove any ambiguity relating to the legality of hemp products. Industrial hemp and section 280E of the Internal Revenue Code Section 280E of the Internal Revenue Code states that companies cannot deduct any expenses that relate to the trafficking of a Schedule I controlled substance. While industrial hemp is still classified as a Schedule I controlled substance, it is important to note that the Consolidated Appropriations Act prohibits federal funds from intervening in the transportation, processing, sale or use of industrial hemp, so long as it is cultivated in accordance with the Hemp Pilot Program. As such, we believe Charlotte s Web falls outside of the scope of the Internal Revenue Services enforcement of section 280E. Furthermore, if the senate version of the 2018 Farm Bill becomes law, industrial hemp will no longer be a Schedule I controlled substance, and will no longer be within the scope of section 280E. FDA and the marketing of a dietary supplement While the viewpoint held by the FDA on CBD provides further legal complications for Charlotte s Web, we believe this to be non-material given the increasing amount of research suggesting that CBD is considered a safe product. In the United States, the regulation governing food and drugs is the Federal Food, Drug and Cosmetic Act ( FDCA ) while the Dietary Supplement Health and Education Act ( DSHEA ), which is an amendment to the FDCA, defines and regulates dietary supplements. Both are enforced by the FDA, and the stance of the Administration is that CBD cannot be marketed as a dietary supplement as there is evidence the FDA accepted an Investigational New Drug application ( IND ) for a drug containing CBD in 2006. Under the DSHEA, an IND containing CBD would exclude CBD from being a dietary supplement. 14 Buy Target Price C$21.00 19 September 2018 Consumer Products 14
We believe Charlotte s Web is poised to capture market share as CBD products gain further consumer acceptance To date, the FDA has issued a warning letter to Charlotte s Web which focused on the health benefits and claims being made through the marketing on its website. Charlotte s Web has since adjusted the website and does not make any claims that its products are safe and effective as treatment for any conditions. In our view, there are a variety of reasons why the FDA s stance is non-material to the operations of Charlotte s Web: 1. Under the 2018 Farm Bill, there is no authorization to interfere with the operations of companies selling hemp and hemp extracts, meaning the FDA cannot intervene provided the company is selling hemp-derived extracts containing CBD. 2. Cannabis and its cannabinoids have been used therapeutically and consumed for centuries, which provides strong support for CBD being a dietary supplement. 3. Charlotte s Web firmly believes there is no evidence that substantial clinical investigations were made public prior to its products being marketed as a dietary supplement. 4. There is increasing evidence that is supportive of CBD being a safe product, highlighted by WHO s Critical Review of CBD in June of 2018, which found that CBD did not exhibit any effects in humans that were indicative of any abuse or dependence potential, and found it to be well tolerated with a good safety profile. As well, as per Congressional finding 13 in the DSHEA, the federal government s intention is not to impose unreasonable regulatory barriers to slow the flow of safe products to consumers. As such, we believe it is outside the scope of the FDA to explore further legal action against Charlotte s Web. In summary, while the legal landscape in the United States is ambiguous and at times challenging to navigate, we believe the new regulations, which are expected to become law in late 2018, are positive for Charlotte s Web and more generally the hemp industry. Following de-scheduling, we expect the company to expand and diversify its cultivation within the United States, increasing its seed production capacity while reducing its reliance on a small number of geographic regions. In our view, the company is poised to benefit from the improving regulations as the descheduling of hemp is expected to remove the Controlled Substances overhang on the product. This should allow Charlotte s Web to increase household penetration while expanding into mass market retailers that would not support selling products containing a Schedule I drug off the shelf. We believe the company s industry-leading market share and management s strong consumer-packaged goods experience provide the company with the best positioning in the industry to be a pioneer in new mass-market retail channels. Market share expansion expected to continue as CBD acceptance increases While the market for CBD extract products is forecast to grow at a robust 55% CAGR between 2016 and 2021 (according to Brightfield Group), Charlotte s Web has more than doubled the industry growth rates, with revenue increasing 172% YoY in 2017 to $40 million. We are forecasting continued market-leading revenue growth of 100% in 2018 to $80 million. In our view, as CBD products gain further consumer acceptance, Charlotte s Web s strong brand positioning, industry-leading market share, and commitment to product quality, have the company well positioned to deliver robust growth exceeding the industry average. 15 Buy Target Price C$21.00 19 September 2018 Consumer Products 15
Website visits ('000s) Charlotte's Web Holdings, Inc. Figure 11: 2016 Hemp-derived CBD supplement market segmentation 8% 80% 5% 2% 2% 2% CW Hemp PlusCBD Oil HempMeds CannazAll Elixinol Other E-commerce sales accounted for 64% of 2017 revenue; expecting this to be 50% over our forecast period Charlotte s Web almost doubled its market share of the CBD supplement market in 2017, growing its market share to an estimated 14% from 8% in 2016. Outside of Charlotte s Web and its largest competitor Plus CBD, which we estimate has approximately 8% market share in 2017, no other brand has more than 2% market share of the $287 million (and growing) CBD supplements market. While PlusCBD, which is owned by CV Sciences (CVSI-US Not Rated), continues to gain share in the industry, we believe the growth of Charlotte s Web is outpacing that of PlusCBD, and Charlotte s Web continues to expand its market leadership position, as growth in website traffic continues to outpace that of the company s largest competitor. Figure 12: Hemp-derived CBD website traffic 600 500 400 300 200 100 0 Feb-18 Mar-18 Apr-18 May-18 Jun-18 Jul-18 Charlotte's Web PlusCBD In our view, the complex regulatory framework in the United States has been the key driver of the high degree of fragmentation in the industry to date. State-regulated pilot programs have created a barrier to entry for hemp-derived CBD producers to scale operations nationally. While regulation of hemp is still expected to exist at the state 16 Buy Target Price C$21.00 19 September 2018 Consumer Products 16
Revenue ($mm) CWEB market share Charlotte's Web Holdings, Inc. level under the 2018 Farm Bill, we believe the de-scheduling of hemp will reduce the industry s barriers to entry. With that said, we believe the proprietary genetics and operations of existing producers are key barriers to entry for the industry. For Charlotte s Web, the company s proprietary genetics allow it to contract cultivation globally while consistently producing products with less than 0.3% THC. We believe it will be difficult for entrants to the industry to scale operations as efficiently as Charlotte s Web does, as reliance on outsourced cultivation, with unknown origins of hemp genetics, may result in hemp extracts with a THC concentration above 0.3%. In our view, this will force potential entrants to invest in owned genetics. As such, despite the evolving regulatory landscape, we believe Charlotte s Web remains poised to capture share of the hemp-derived CBD market. Charlotte s Web expected to be a pioneer in brick-and-mortar expansion In 2017, e-commerce accounted for 64% of Charlotte s Web s revenue, with brickand-mortar sales accounting for the remainder. While not included in our estimates, we envision this sales breakdown moving to a more balanced 50-50 split over the course of our forecast period as competitors gain distribution in larger mass market retailers. Figure 13: Charlotte s Web hemp-derived CBD market share estimate 700 600 500 400 300 200 100 0 30% 31% 26% 489 19% 14% 297 8% 169 80 15 40 2016 2017 2018E 2019E 2020E 2021E 35% 30% 25% 20% 15% 10% 5% 0% Products currently sold in 2,700 retail locations with plans to be in 3,000 by the end of 2018 We believe one of the keys to the company s growth will be adding incremental brickand-mortar retail locations. The company currently sells its products in over 2,700 locations, with a target of 3,000 locations by the end of 2018. Today, the company has focused on selling products through smaller, niche, health focused grocery store chains or natural health stores, such as Thrive Market, Lucky s Market, Erewhon, Fresh Thyme, New Seasons, Lassens and Earth Fare. Furthermore, Charlotte s Web s first-mover advantage in developing retail relationships, along with its exclusive distribution agreement with the leading United States natural health product distributor, has the company well positioned to remain the market leader, as new competitors potentially look to enter the market. In fact, we believe Charlotte s Web will continue to increase its market share as consumer acceptance of CBD products increases. Mass market represents meaningful incremental upside to our estimates As CBD supplements gain further consumer acceptance, and perhaps as soon as late 2018 pending President Trump s signing of the 2018 Farm Bill, we believe larger national grocery and drug store chains will look to partner with Charlotte s Web. This should allow the company to continue to gain market share and grow revenue well above industry average growth rates. Furthermore, as Charlotte s Web products 17 Buy Target Price C$21.00 19 September 2018 Consumer Products 17