Cbdmd, Inc. quarterly report, Q2 FY2018

Business context and reporting period

Period clarification: The filing is a Form 10-Q for the quarter ended March 31, 2019 (fiscal 2019 second quarter), not 2018 Q2. cbdMD, Inc. was formerly Level Brands, Inc.; the name change became effective May 1, 2019.

The December 20, 2018 acquisition of Cure Based Development brought the cbdMD-branded hemp-derived CBD products business into the company. The quarter and six-month results include that business only from the merger closing, so comparisons with 2018 are not like-for-like. The company also operates licensing and entertainment businesses.

Financial performance and position

Quarterly net sales grew 84% year over year, primarily due to the acquired CBD products business. The six-month statement reports sales of $6.92 million; the MD&A contains a conflicting figure of $6.99 million, which investors should reconcile. The quarter’s $2.12 million in sales allowances, compared with $5,000 in the prior-year quarter, also merits review.

The large reported loss was primarily driven by a noncash $30.91 million increase in the fair value of merger-related contingent consideration, largely reflecting the company’s share-price increase. Excluding that item, reported operating performance still showed losses. The quarter also included a $371,000 gain on marketable securities and a $1.08 million income-tax benefit.

Gross margin fell from 83.1% in the prior-year quarter to 62.4%. Management attributed the change to the new product-sales mix and noted that the CBD products division had cost of sales of approximately 36% of sales; it expects that division’s cost-of-sales ratio to remain between 25% and 40%.

• Cash and liquidity: Cash was $4.64 million at March 31, 2019, versus $4.28 million at September 30, 2018. Working capital was $12.27 million; current assets were $14.14 million and current liabilities $1.87 million.
• Cash flow, six months: Operating activities used $4.46 million; investing activities used $1.36 million; financing activities provided $6.18 million. Financing inflows primarily reflected the October 2018 share offering.
• Debt and liabilities: Related-party notes payable totaled $561,770 current, with a further $184,300 related-party long-term note. Total liabilities were $108.25 million, including $102.27 million of merger-related contingent consideration. That fair-value liability is not conventional funded debt.
• Balance sheet: Total assets were $94.84 million and shareholders’ equity was negative $13.42 million. Goodwill was $55.14 million and acquired intangible assets were $24.73 million.

Changes versus the prior comparable period

• The acquisition shifted revenue mix sharply toward products: products contributed 99.5% of quarterly sales, versus 1.0% in the prior-year quarter. Licensing revenue declined substantially, including the loss of a major contract; management said it was assessing how licensing and entertainment could support the CBD business.
• Operating expenses increased 534% in the quarter, with management citing acquisition-related costs and ramp-up in staffing, advertising, marketing, commissions, infrastructure, and public-company support.
• Quarterly earnings shifted from $1.64 million net income to a $31.85 million net loss, principally because of the noncash contingent-consideration remeasurement and higher operating costs.
• Inventory rose to $2.37 million including prepaid inventory, from $123,000 at September 30, 2018. The company also recorded a $139,000 impairment of BPU inventory.

Outlook, risks and unusual items

Management said working capital was sufficient to fund operations and expected growth, and reported no capital-expenditure commitments. Its stated priorities include expanding CBD distribution, developing products, and increasing advertising and sales-channel reach. These are plans, not quantified revenue or earnings guidance.

After quarter-end, shareholders approved issuance of 15.25 million merger-consideration shares; the company reported that the shares were issued April 22, 2019. The merger agreement also permits up to 15.25 million additional shares tied to revenue targets. The filing says these issuances materially dilute existing holders; shares outstanding were 25,420,356 as of May 10, 2019. The company also disclosed planned CBD-brand sports sponsorships expected to add $6.4 million of advertising spend over three and a half years.

• Key risks include the short operating history of the CBD business, integration and execution challenges, intensifying competition, and evolving FDA and other regulation of CBD products.
• Merger consideration depends on valuation assumptions, including share price and revenue projections. Changes in assumptions may materially affect reported liabilities, goodwill, and future earnings.
• The filing describes significant related-party arrangements, including financing and leases associated with the acquired business and agreements involving kathy ireland® Worldwide.
• Management reported disclosure controls were effective and described remediation of a material weakness relating to accounting-standard adoption. No legal proceedings were reported.

Important facts for investors to verify

• Reconcile the MD&A’s six-month sales figure of $6.99 million with the financial statements’ $6.92 million, and investigate the unusually large sales allowances.
• Review the merger valuation, the $102.27 million contingent liability, its sensitivity to share price and revenue assumptions, and the final purchase-price allocation, which remained preliminary.
• Assess dilution from the 15.25 million issued shares and the potential additional 15.25 million earnout shares, including the revenue hurdles and share-issuance terms.
• Evaluate whether cash burn, marketing commitments, and related-party obligations remain supportable as the CBD business scales.