3 Key Risks to Consider Before Jumping into Charlotte’s Web Stock

The bull case for Charlotte’s Web (OTCMKTS:CWBHF) stock seems reasonably easy to make. The producer of hemp and hemp-derived CBD (cannabidiol) oil has a massive growth opportunity akin to that of marijuana stocks. Yet with the passage of the Farm Bill late last year, Charlotte’s Web products should be clearly legal in the U.S. That suggests a larger, nearer-term market opportunity for Charlotte’s Web – and perhaps more potential near-term gains for Charlotte’s Web stock.

CBD a tailwind for Cronos Group stock

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Indeed, I recommended Charlotte’s Web stock at the end of last year. That’s proven to be a smart call. CWBHF stock has gained nicely, rising about 70%. Those gains are roughly in line with most marijuana stocks: Canopy Growth (NYSE:CGC) has gained 80%, and Cronos Group (NASDAQ:CRON) about 60%. Clearly, optimism toward the Farm Bill and a broader ‘risk-on’ sentiment in equity markets have helped cannabis and hemp stocks across the board.

At current levels, however, there are risks to CWBHF stock. Marijuana stocks on the whole look potentially stretched, and while Charlotte’s Web has some advantages over that group, its valuation too incorporates quite a bit of growth. An awful lot of good news seems priced in at this point – but there are risks that could send Charlotte’s Web stock tumbling.

The Valuation of Charlotte’s Web Stock

The story behind Charlotte’s Web, as a business, looks attractive. The company is a leader, and likely the leader, in the growing CBD oil space. Its hemp production has soared, rising more than tenfold to 675,000 pounds in 2018, per the Q4 release. And now larger retailers are coming on board: Walgreens (NASDAQ:WBA) and Rite Aid (NYSE:RAD) both announced recently that they would add CBD products to their stores.

In other words, there are several avenues for growth. Charlotte’s Web has the potential to take market share in what looks to be an extremely fragmented industry, either through acquisitions or through the eventual failure of some of the myriad producers in CBD. Points of distribution are going to rise. Charlotte’s Web on its website cites 4,000 retail locations at the moment. Walgreens has over 18,000 stores, and Rite Aid nearly 2,500.

To be sure, neither Walgreens nor Rite Aid is launching CBD products in all of its stores immediately. Rite Aid is limiting its initial exposure to just topical products in a few states. But the broad point still holds: Charlotte’s Web can take more share in a market set to reach more customers through more stores.

One key risk, however, is that the story isn’t exactly unknown by investors at this point. Charlotte’s Web stock now has a market capitalization over $2 billion. It trades at about 30x 2018 revenue and 100x 2018 Adjusted EBITDA. Those are huge numbers, mostly in line with larger marijuana stocks. Yet Charlotte’s Web, in part because it had a larger 2017 base, isn’t growing as fast as most THC-based companies.

Sales rose ‘just’ 74% in 2018. That’s an impressive rate, certainly, but lags the triple-digit rates seen elsewhere in the space. Adjusted EBITDA rose 48%. But that includes a year-over-year decline in the fourth quarter. As impressive as Charlotte’s Web market opportunity is, recent growth must repeat for years to support the current valuation. Anything less simply isn’t good enough.

Is CBD a Fad?

And that growth requires that CBD demand continue to grow at the same nearly exponential rate at which it has of late. That seems possible but hardly guaranteed. The Charlotte’s Web origin story, as Matt McCall detailed in calling Charlotte’s Web stock his best pick for 2019, is that a girl named Charlotte saw her seizures decrease dramatically when she started taking CBD oil. Many other customers swear by the product for myriad other uses.

But as the New York Times pointed out in February, at least so far there’s little scientific evidence backing the effectiveness of CBD oil. In fact, there’s little standardization even of dosing, particularly given the various types of applications. Swallowing CBD oil results in a very different dose of cannabidiol than a topical cream.

Anecdotal evidence appears to support some use for the product, admittedly. But advocates and CHWBF bulls are expecting adoption and persistence rates to stay as high going forward as they have been of late.

It remains to be seen whether that will be the case. A product that supposedly cures so many afflictions will inspire demand. But it will also raise expectations. If new customers expect CBD oil to be a super-supplement and it fails, what then?

Indeed, we’ve seen similar trends come and go, particularly in dieting. Atkins was huge, then it faded. Gluten-free sales soared among customers without specific allergies, then faded.

CBD oil obviously is different from those products. But there’s still a valid question: is it a wonder drug, or just another fad that will come and go? At this point, the jury still is out.

Where Do Margins Go?

Even assuming the market continues to grow, there’s a key question in terms of profit margins: what does a mature CBD market look like? Is it akin to food and beverage markets, where there are differentiated, branded products at the high end and low end? Or does CBD, the benefits of which supposedly are based on the underlying compound, become commoditized?

This question is key for marijuana stocks as well. But in CBD, it seems even more pressing. Charlotte’s Web at the moment has an edge over smaller rivals because it seems more trustworthy. It’s been around longer. It’s respected. Consumers can trust the manufacturing process, and trust that the CBD content is accurately measured. Smaller, less well-known rivals may not have the same level of trust.

At some point, however, that changes. A major company like Coca-Cola (NYSE:KO) may enter the space. Or clearer legalization may allow for more standardized manufacturing and more transparent production processes and labeling.

If CBD oil is simply a commodity, Charlotte’s Web almost certainly loses pricing power. If there’s no “better” CBD oil, producers will compete more on price and less on branding. Charlotte’s Web’s first-mover advantage will evaporate and margins will decline.

There are similar worries on the cannabis side. Legalization in Oregon, for instance, has led to plunging prices. The same Farm Bill that led to so much optimism behind Charlotte’s Web stock could lead to a similar outcome in CBD oil. And at 100x EBITDA and 130x net income, Charlotte’s Web stock is not priced for falling prices or stagnant margins.

That’s the broad worry at this point. Even with a decline in recent sessions, Charlotte’s Web stock still looks priced for something close to perfection. But risks lurk. At this price, it only takes one of the risks to lead CWHBF to tumble.

As of this writing, Vince Martin has no positions in any securities mentioned.

Article printed from InvestorPlace Media, https://investorplace.com/2019/04/3-key-risks-charlottes-web-stock/.

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