Description

GW Pharmaceuticals (NASDAQ: GWPH) is an opportunity to short a speculative marijuana stock masquerading as a pharmaceutical company.  At a valuation of $1.5 billion, Wall Street analysts have already priced in FDA approval and successful commercialization of GW’s two primary drugs, Sativex and Epidiolex.   In addition to the risk of FDA denial (Sativex just failed its first stage 3 trial), analysts have ignored the risks of GWPH’s weak patent portfolio, accounting gimmicks and the ground-up legalization of medical cannabis competitors in 23 states.  If investors take these risks into account, we think GWPH is only worth $20 - $30 per share, a decline of 60% - 75% from current prices.

Short Selling Highlights:

• GWPH is attempting to patent extraction of a naturally occurring compound - it is akin to patenting caffeine extracted from a coffee bean.  
• GWPH is filing “method of making” and “route of administration” patents which are easily designed around by competitors.
• Dozens of competitors are emerging and selling cannabis-based therapeutics in states with legalized medical cannabis (now 23 and counting).
• GWPH is overstating its revenue and margins by classifying R&D reimbursements as regular revenue instead of reimbursed expenses.
• GWPH’s management is cashing out, selling $41 million of personal stock alongside the Company’s recent secondary offering.  CEO Justin Gover sold $12M, more than 37% of his personal holdings.
• GWPH’s assets are cash $267M ($13.5 per share) and its Orphan Drug pipeline, which is generously worth  $100M - $300M for a total value of $400M - $600M ($20 - $30 per share).
• We think GWPH’s future is that of a patent troll, spending its cash stockpile to sue state-legalized competitors in attempt to monetize its IP portfolio.  Thus cash returned to shareholders will likely be closer to zero.

Reason for Mis-pricing:

GWPH is a small foreign company operating in a new, misunderstood market.  Few investors have any experience analyzing medical cannabis companies, much less cannabinoid science and patent viability.  As a former long/short manager operating a cannabis therapeutics company, I have unique insights into the industry.

Sativex / Company Background:

GWPH was founded by current Chairman Dr. Geoffrey Guy in 1998, ten years after the discovery of the human endocannabinoid system.  Sativex commenced clinical trials in 1999 as the first pharmaceutical grade product extracted from the cannabis plant.  In 2001, GWPH listed on London’s AIM exchange to fund ongoing research and commercialization of Sativex, which is now approved in 25 countries for treatment of Multiple Sclerosis.  Despite 16 years of research and global commercialization, GWPH only earned $7.1M in revenue from Sativex in 2014.  Thus, unless the United States approves Sativex for cancer pain (not MS, its current indication), it is unlikely GWPH will ever recover its Sativex R&D cost.

Despite the lackluster marketing of its primary drug, GWPH’s stock rose dramatically after its NASDAQ listing at $8.9/share in May 2013.  The stock was driven by the release of Dr. Sanjay Gupta’s “Weed” documentary on CNN in August 2013, along with subsequent cannabis legalization craze.  While most marijuana stocks (MedBox, etc.) popped and quickly dropped back to penny-stock land, GWPH priced a $82.6M follow-on offering at $36.0/share in January 2014, and another $98.0M follow-on at $86.8/share in June 2014.  

Management also sold $41M worth of stock in June 2014.  CEO Justin Gover sold $12M, 37% of his personal holdings while other key executives sold between 63% - 76% of their personal stakes in GWPH.  Total Executive and Directors holdings of GWPH declined from 14.2% of market cap to 8.9% of market cap - a significant liquidation event for insiders.

Epidiolex / CBD:

GWPH’s valuation has been primarily sustained by speculation that its second drug, Epidiolex, which received an Orphan Drug Designation (ODD) will be approved for intractable childhood epilepsy.  Epidiolex is an extraction of purified cannabidiol, or CBD, a non-psychoactive compound found in the cannabis plant.  CBD has been widely popularized in the states by cannabis activists pushing for legalization.  In line with this popularity, GWPH’s investor presentations and filings have shifted focus from Sativex to Epidiolex, despite the fact that GWPH has fewer (and weaker) patents supporting Epidiolex.  

Extraction of purified CBD from cannabis flowers is a nearly identical process to extracting purified caffeine from coffee beans.  Both are done via supercritical CO2 extraction (among various other methods), and neither chemical compound is patentable as they are both naturally occurring.  Instead, GWPH is patenting the method of growing cannabis and extracting CBD under a descriptive set of operations for CO2 extraction.  These methods can be very easily recreated to extract CBD in a manner that does not breach GWPH’s patents. GWPH can still patent CBD-based medicines (several companies have patented novel combinations of caffeine with other compounds as well as different routes of administration), but GWPH cannot prevent competitors from creating slightly different CBD-based medicines.  

Finally, there is a growing body of research showing CBD alone is not as effective as the combination of multiple cannabinoids from the cannabis plant.  There are over 70 active cannabinoids and nearly 500 other natural compounds in the cannabis plant that work together in the human endocannabinoid system.  This is known as the “entourage effect” and is a fundamental principle of cannabinoid therapeutics.  The entourage effect also explains why sales of Marinol, the original synthetic THC drug, were lackluster, and why Sativex has suffered a similar fate as Marinol.  Sativex is simply a purified form of 2 cannabinoids in equal portions: THC and CBD.

Legalized Cannabis Competitors:

The nationwide push for cannabis legalization has been led in large part by parents of children with epilepsy.  There have been numerous examples of children with several hundred seizures per day (Dravet and Lennox-Gestaut syndromes) dropping to 1-5 per week after taking CBD oils.  This group of parents has become a powerful lobby driving decriminalization and licensing of state-based medical cannabis companies.  To this group, 3-5 years of clinical trials is an unacceptable solution when a nearly identical substitute can be made available by legislative action.

Currently, 33 states have relaxed or decriminalized laws prohibiting cannabis.  23 have legalized medical cannabis, of which 10 have successfully licensed private companies to begin production of cannabis flowers and/or extracts.  Though disorganized and underfunded, dozens of companies have been formed to produce and sell cannabis-based medicines.  Within the next 12-18 months, we expect many of these companies to begin selling high-quality CBD extracts.  By the time GWPH comes to market (assuming they pass FDA trials), they will face intense competition from alternatives with established customer bases. 

For those who may scoff at state-legalized cannabis competitors, consider this: peak sales of Marinol, the synthetic THC drug, reached $190M before its patents expired.  Last year, legal cannabis sales reached $2.4 billion, of which more than $1.7M were medical cannabis sales.  

Revenue Overstatement / Expanded Access Studies:

81% or $39.4 of GWPH’s $48.7M of revenue is “Research & Development Fees”.  This is R&D expenses funded by research partners, primarily the Sativex cancer pain study funded by Otsuka pharmaceuticals.  These fees are expensed back out as part of R&D expense, but it has the effect of increasing revenues and gross margins.  For most companies, reimbursable revenue is usually netted out or at the most footnoted, but GWPH touts it as follows in the 2014 20-F: “We consider our R&D fees to be recurring revenues.  As illustrated above, over the last five years there has been a consistent growth trend in these revenues.”

Given the poor performance of Sativex, I suspect GWPH is leveraging research partnerships and government grants to increase revenues and margins to the casual observer.  This seems likely to increase through their 21 “Expanded Access” (EA) studies for Epidiolex.  EA studies have popped up across the United States (typically to delay states considering legalization of medical cannabis), and are usually funded through government grants to research universities.  The studies cannot be used for clinical evaluation by the FDA, but the R&D fees paid by university research partners can be run through GWPH’s income statement.  

Valuation:

Comparable valuation and DCF methods are used to value GWPH.  The best comparable is clearly INSYS Therapeutics (NASDAQ: INSY).  INSY sells the Subsys(R) sublingual spray and has also received Orphan Drug Designation for a synthetic CBD for treatment of Dravet and Lennox-Gestaut syndromes.  INSY generated $65M of TTM EBITDA from sales of Subsys, which is worth $1.3B at a 20x EV/EBITDA ratio (while high, 20x is still lower than the average for cash flowing pharmaceutical companies in the SPDR “XPH" Pharmaceuticals Index).  With a market cap of $1.7B, that implies a value of $0.4B for INSY's pipeline of 5 drugs entering stage III trials, or $0.1B per Orphan Drug in stage III trials.  This is in-line with average stage III Orphan Drug Designation valuations from Drug Discovery Today (see link here: http://www.argentumlux.org/documents/Financing_Drug_Discovery_for_Orphan_Diseases.pdf) of $0.3B. 

For DCF valuation, we used sales of Marinol adjusted for prevalence differences between epilepsy and anorexia-cachexia in HIV patients. At their peak, sales of Marinol reached $190M per year, at an average price of $9 per 5mg ($1,800/gram) and dose range of 5-20 mg/day (see FDA Orange Book resources here: http://www.fda.gov/ohrms/dockets/dockets/05n0479/05N-0479-emc0004-04.pdf).  Assuming an average dosage of 10mg/day, the average Marinol patient is worth $6,500 per year and the peak patient population is 29K, 4% of the total 800k person prevalence of anorexia-cachexia in HIV.  For Sativex, the prevalence of orally-treated, acute cancer pain that is not responsive to opioids is 400k.  Dosage is similar to Marinol, so in broad strokes we can assume Sativex will reach about half the annual sales of Marinol if approved.  The PV10 value for 7 years of sales at $100M at 50% EBITDA margins is $240M.

For Epidiolex, the US prevalence of Dravet and Lennox-Gestault is 5.5k and 19k people, respectively.  Of those, approximately 10%, or 2,500, are not responding to other Anti-Epileptic Drugs (AEDs).  Thought the market is small, dosage is significantly higher for Epidiolex at 200-300 mg/day.  If Epidiolex prices similar to Marinol ($9 per 5mg) and an average dose of 250mg/day, the daily cost of Epidiolex treatment would be $450, or $165,000 per year.  Multiplied by the patient population of 2,500, Epidiolex could generate $410M per year if approved.  The PV10 value for 7 years of peak sales at 50% EBITDA margins is $998M.

Combined in this best-case scenario ($998M for Epidiolex and $240M for Sativex) GWPH is worth $1.2B - exactly in line with its current enterprise value.  There is no margin of error.  GWPH investors are pricing-in FDA approval, full commercial success and premium pricing of two drugs in stage III trials, one of which just failed a key trial.  INSY has the exact same stage III Orphan Drug pipeline , but the implied value is only $100M per Orphan Drug Designation.  Moreover, the risk of state-legalized competitors that cannot be pursued for patent infringement is totally ignored.  Charlotte’s Web oil - the most widely known alternative to Epidiolex - is sold for $0.25 per 5mg, 97% less than Marinol and forecasted Epidiolex pricing.  Even if Epidiolex wins FDA approval, we think poor efficacy and lackluster sales similar to Sativex will lead GWPH to become a patent troll, suing its state-legalized competitors to attempt recouping its R&D costs.  

Therefore, the risk-adjusted value for Epidiolex is $100M - $300M and less than $50M for Sativex (consider its lackluster sales despite distribution in 25 countries).  Add-in cash of $267M, and GWPH's market cap should be $400M - $600M, or $20 - $30 per share, a decline of 60% - 75% from current prices.

Catalyst

1. Ramp-up of sales from state-legalized competitors
2. Reversal / end of government grants for EA studies
3. Increased awareness of cannabinoid therapeutics and the entourage effect
4. Investors recognizing these risks