Lexaria Bioscience Corp. (OTCQX: LXRP / CSE: LXX ... · A human biomarker study initiated in...

Siddharth Rajeev, B.Tech, MBA, CFA

Anthony de Ruijter, BA. Econ

January 12, 2018

2018 Fundamental Research Corp. “10+Years of Bringing Undiscovered Investment Opportunities to the Forefront” www.researchfrc.com

PLEASE READ THE IMPORTANT DISCLOSURES AT THE BACK OF THIS REPORT

Lexaria Bioscience Corp. (OTCQX: LXRP / CSE: LXX) – Initial Cannabis Focused Disruptive Biotech

with Multi-Market Potential

Sector/Industry: Cannabis / Life Sciences www.lexariaenergy.com

Market Data (as of January 12, 2018)

Current Price US$1.50

Fair Value US$4.64

Rating* BUY

Risk* 4 (Speculative)

52 Week Range US$0.27 - US$2.54

Shares O/S 69,912,141

Market Cap US$104.9 M

Current Yield N/A

P/E (forward) N/A

P/B N/A

YoY Return 268.75%

YoY Russell 2000 16.81% *all figures in this report are in US$ unless otherwise specified. **see back of report for rating and risk definitions

Investment Highlights Lexaria Bioscience Corp. (“Lexaria”, “Company”) is a life sciences

company that has recently received patent protection for their DehydraTECH™ technology from the U.S. Patent and Trademark Office.

DehydraTECH™ is the company’s proprietary drug delivery technology that improves the way that active pharmaceutical ingredients are transported through the human gastrointestinal tract.

The company’s recent patent protects their intellectual property with regards to cannabinoids, nicotine, Non-Steroidal Anti-Inflammatory Drugs (NSAIDs), and vitamins. These are huge markets, representing a multi-billion-dollar market.

DehydraTECH’s™ applications have already been market and laboratory tested for cannabis products, with upcoming research projects planned to test the technology’s applications to other potential active pharmaceutical ingredients.

We are initiating coverage with a BUY rating and a fair value

estimate of $4.64 per share

Risks

Inability to apply DehydraTECH™ to other drugs apart from cannabis limits the technology’s commercial potential.

Additional patents required to protect DehydraTECH™ in jurisdictions where Lexaria has not yet secured patents.

Uncertain regulatory outlook for cannabis, the initial focus of Lexaria’s operations.

2018 Fundamental Research Corp. “10+ Years of Bringing Undiscovered Investment Opportunities to the Forefront” www.researchfrc.com


Overview

DehydraTECH

Formed in 2004 as an Oil and Gas company, Lexaria transitioned into the biotech and alternative health space in early 2014. As per the transition, the company has developed a potentially disruptive drug delivery technology that infuses ingestible compounds with lipids to facilitate passage through the human gastrointestinal tract, and dramatically improve bioavailability of the contained drug. On October 31, 2017, the company announced that their DehydraTECH™ technology had received a Notice of Allowance from the U.S. Patent and Trademark Office, which allows the company to now target the nicotine, cannabinoid, Non-Steroidal Anti-Inflammatory Drugs (“NSAIDs”), and fat-soluble vitamin markets. The issuance of the patent was completed on December 12, 2017. This is a breakthrough for the company, as these new markets are significantly large. Nicotine in particular, is a multi-hundred-billion-dollar industry that is rapidly moving away from traditional smoking methods, with no edible nicotine products commercially available at current.

Lexaria’s unique delivery technology, DehydraTECH™, is designed to enhance the performance of certain compounds in consumable products. The now patented technology has been laboratory and market tested, and has been proven to improve the way active pharmaceutical ingredients (“APIs”) are ingested across four categories:

Taste Smell Speed of action Bio-absorption and bioavailability

The table below outlines the advantages that Lexaria’s DehydraTECH™ delivery system exhibits over traditional delivery systems:

Source: Company

The ultimate effect is that DehydraTECH™ increases the bioavailability of ingested compounds whilst reducing the time of onset. According to management, the time of onset for regular delivery technologies ranges from one to two hours usually due to liver metabolism. With DehydraTECH™, the time of onset is reduced to 15-20 minutes, or a minimum of a third of the usual time of onset. The process by which DehydraTECH™ works is as follows:

1. The desired API (i.e. cannabinoids such as THC) is combined with a fatty acid oil (i.e. sunflower oil).



2. The compound is added to a food carrier/ particle such as mannitol. 3. Dehydration synthesis is used to remove water from the compound. Dehydration

bonds the molecules, allowing passage through the gastrointestinal tract with minimal loss of concentration.

The result is that the fatty acids provide protection for the compound and expedite passage through the gastrointestinal tract. Furthermore, the small intestine quickly absorbs long-chain fatty acids into the lymphatic circulatory system (bypassing the first pass liver effect, a phenomenon whereby the concentration of a drug is greatly reduced before reaching systemic circulation) whereas medium-chain fatty acids travel via the portal vein into the liver. As added bonuses, fatty acids are believed to block APIs from bitter taste receptors, improving the natural taste and reducing the need for sugar/ additives that are detrimental towards health. Edibles manufacturers may also use lower cost and less refined API inputs for potentially higher profits, according to the company. DehydraTECH™ has a long history of lab testing and scientific research to back up the potential benefits for prospective licensees.

An in vitro absorption study conducted on August 2015 found that DehydraTECH™ increased bioabsorption of CBD in human intestinal tissue by up to 499%.

A human biomarker study initiated in January 2016 found a 5-10 times increase in salivary nitric oxide (a CBD surrogate) within 15-30 minutes.

A human focus study conducted in May 2016 found that DehydraTECH™ significantly improved the time of onset of THC infused chocolates in volunteers, decreasing time of onset to 15-20 minutes. Commercially available cannabis edibles tend to exhibit a longer time of onset, often in excess of an hour.

In addition, new research opportunities with a focus on Lexaria’s DehydraTECH™ have been signed and are currently underway:

In February 2017, the company signed a collaborative research agreement with the National Research Council of Canada to explore the opportunities of DehydraTECH™ in significantly increasing bioavailability. The research agreement is for an 18-month term, and Lexaria has been given a grant to help cover the costs of research. The grant represents half of the expected cost of C$250,000. We believe this development indicates that DehydraTECH™ has attracted academic and institutional interest at the highest level. Furthermore, Lexaria gains access to state-of-the-art research facilities that will allow the company to further explore the effects of DehydraTECH™.

A clinical study into the benefits of DehydraTECH™ performed by the University of British Columbia (“UBC”) was planned to commence in November 2017, but has been temporarily delayed. The study’s focus is upon the application of DehydraTECH™ in the company’s TurboCBD product, and comparisons of molecular performance against other CBD products. TurboCBD is one of the company’s product offerings- a hemp oil capsule that incorporates Ginseng and Ginkgo. Management have advised that the study may also identify other possible



combinations of CBD and other molecules (i.e. Viagra), which could lead to future patent filings. The agreement was signed in August 2017.

An in vivo edible nicotine study is expected to produce results in Q1 2018, related to DehydraTECH’sTM ability to avoid the severe gastrointestinal distress currently associated with nicotine introduction into the GI tract. This nicotine study will also measure absorption rates and times. If successful, the company believes this study or follow-ups to it, could provide the foundation for development of the world’s first nicotine edible products.

An in vitro study planned for Q1 2018 will analyze new topical skin formulations Lexaria has created for improved delivery of cannabidiol (CBD) through the skin. The company is exploring whether its absorption technology might have similar penetration benefits in topical skin applications, potentially opening a new area of applicability.

We see the continuous scientific research into DehydraTECH™ as adding value to the company, solidifying the attractiveness of DehydraTECH™ as a product offering and increasing forward demand. Research-backed evidence to support DehydraTECH’s™ benefits is likely to cement the potential value add of the delivery technology to companies that are capable of applying it to their own products. The technology was originally developed by the founders of PoViva Tea LLC (“PoViva”), who filed two initial U.S. provisional patent application filings in 2014. Lexaria acquired 51% of the company in November 2014, granting the company exclusive rights to PoViva’s intellectual property which was eventually developed into DehydraTECH™. Consideration for this initial acquisition was $50,000. Ownership of PoViva was expanded to 100% on October 31, 2017, for total consideration of $70,000, a waiver on certain debts, and a 5%, 20-year royalty on the net profits of ViPova (discussed below) product sales. It is unclear if any of the original inventors are shareholders of the company. Lexaria’s current business model is built around DehydraTECH™, with the majority of revenues coming from technology out licensing.

1. DehydraTECH™ out-licensing: Lexaria licenses their proprietary delivery system to third-party partners/ distributors. In return, the company charges a royalty fee ranging between 5-10% of the partner’s gross sales. We look favorably upon this business model as it spreads risk over multiple distribution partners, reducing Lexaria’s exposure to the sales generation ability of a single partner. Furthermore, it allows Lexaria to focus upon the continued development of their intellectual property assets. The company recorded out licensing revenues of $45,809 in 2017, as well as one licensee agreement signed May 14, 2016, for a two-year period.

2. Product sales and/or white-label relationships are currently a niche focus with potential for longer term growth as organizations such as WADA (World Anti-Doping Agency) and the WHO (World Health Organization) continue to recognize the legitimacy of CBD. Lexaria currently offers their own CBD products. These include ViPova premium CBD teas, coffee and hot chocolate, the Lexaria Energy Foods product line of protein energy bars incorporating CBD, and TurboCBD



The

Opportunity

capsules that are formulated with ginkgo and ginseng. Sales of ViPova products began in January 2015, and first sales of Lexaria Energy bars began in November 2015. TurboCBD products were introduced in March 2017. A manufacturing facility was contracted in 2015 to produce the company’s products, and current disclosures indicate that Lexaria will continue to contract facilities for manufacturing of their products moving forward. For now, the company sells products via dedicated online website stores, though they are actively seeking alternative distribution channels. The company recorded product sales of $16,866 in FY2017.

At current, Lexaria’s intellectual property portfolio consists of 19 patent applications filed in the U.S., international (under the Patent Cooperation Treaty), and national filings in 44 countries. Patent applications include “Methods” claims (which seek to patent a unique production process) and “Composition of Matter” claims (which seek to patent a unique intermixture of two or more ingredients). The company currently has a patent issued in the U.S. and Australia under “Cannabinoid Infused Food and Beverage Compositions and Methods of Use Thereof” which provides protection for the DehydraTECH™ technology as applied to non-psychoactive cannabinoids such as CBD. As mentioned in the introduction, the company has recently received a second patent from the U.S. Patent and Trademark Office covering delivery of other molecules including: psychoactive cannabinoids, nicotine, fat-soluble vitamins (including vitamins A, D, K, E), NSAIDs, and THC. Of interest, this second patent also grants IP protection for the use of DehydraTECH™ technology in the treatment of dozens of health conditions including cardiovascular disease, Parkinson’s, Alzheimer’s, addictions and much more. Lexaria’s most recent patent pending application was for the use of DehydraTECH™ technology for the delivery of phosphodiesterase (PDE5) inhibitors. These are compounds with common trade names such as Viagra and Cialis, and others.

As DehydraTECH™ is applicable to a number of different ingestible compounds, Lexaria is able to target a myriad of industries that could potentially benefit from the use of DehydraTECH™. Management has identified the cannabis, vitamin/ nutraceuticals,

NSAID, and nicotine spaces as potential target markets for out-licensing of their

DehydraTECH™ delivery system. Cannabis

At current, there are three primary ways in which cannabis is ingested into the bloodstream:

1. Inhalation: the smoking of cannabis tends to yield the highest bioavailability, with a 2005 paper by I.J. McGilveray finding that THC bioavailability averaged 30% from smoking. However, smoking or ingestion via combustion is considered to be harmful to the lungs. In addition, the smoking of cannabis is highly visible and may carry a social taboo depending on the regulatory and cultural climate.

2. Sub-lingual (under the tongue): exhibiting bioavailability ranging below that of inhalation and above oral ingestion, sub-lingual consumption of cannabis is typically considered to be sub-optimal in terms of taste.

3. Oral: low bioavailability that ranges between 4%-12% for THC according to the same paper by I.J. McGilveray referred to above. The lower availability is due to the



first pass liver effect mentioned above, which sees drug concentrations decrease as they pass through the gastrointestinal tract.

Because DehydraTECH™ decreases the time of onset, increases bioavailability, and masks unfavorable flavors, the company believes they can leverage DehydraTECH™ to capitalize in opportunities in the cannabis sector. The company believes that their technology can facilitate a move away from the smoking of cannabis to oral ingestion. We are particularly

bullish on the cannabis-infused products segment of cannabis market, as the segments

tends towards higher margins and receives less competition from the cannabis black

market.

Source: Marijuana Business Daily

The cannabis space is experiencing rapid growth, due to sweeping legalization movements across North America that are leading a global loosening of cannabis regulations. In Canada, where recreational use is set to become legal by July 2018, the cannabis industry has swelled as investors see potential in the medical and recreational uses of the drug. Deloitte, in a recent publication, estimated that the base market for legal recreational cannabis could start at between C$4.9 billion and C$8.7 billion (depending on whether those who were likely to consume given legalization were taken into account):

Deloitte estimates of Retail Cannabis Market in 2018, post-legalization

Source: Deloitte

However, the base market estimate is unlikely to capture the full economic impact of legalizing recreational cannabis use, which Deloitte predicts could be as large as $22.6 billion once all the ancillary services needed to support a legalized recreational market are



accounted for. Deloitte estimates of Retail Cannabis Market plus Ancillary Market in 2018, post legalization

Source: Deloitte

According to Arcview Market Research, North American marijuana sales could grow at a CAGR of 27% through to 2021. Arcview also estimates the +20% growth could continue past 2021, as North American sales grow aided by continuing legalization throughout the United States.

Source: Arcview Market Research

Nicotine

Though not the initial focus area for Lexaria’s operational activities moving into 2018, DehydraTECH’s™ potential applications for the delivery of nicotine could open up a market in excess of $700 billion in the near future. In an industry that is rapidly moving away from the combusting/ inhalation of tobacco, we believe that DehydraTECH™ could potentially prove to be a disruptive technology.

On September 13, 2017, Phillip Morris International Inc. (NYSE: PM) announced that it would put US$80 million per annum in to the Foundation for a Smoke Free World.

British-American Tobacco PLC. (LSE: BATS) has invested over US$1 billion in “next-generation products” that include cigarette alternatives such as electronic cigarettes (“E cigarettes”)/ vaporizing.

The US Food and Drug Administration (“FDA”) announced in July 2017, that it was contemplating the reduction of nicotine levels in cigarettes to non-addictive levels.

At current, there are no edible nicotine products commercially available, due to difficulties in absorbing nicotine via the gastrointestinal tract. The result has been that the most popular



alternatives to cigarette products has been alternative methods of smoking, such as electronic E cigarettes/ vaporizing. An estimate by BIS research forecasted the global market for E cigarettes and vaporizers at $50 billion by 2025, reflecting a CAGR of 22.36% since 2015.

Source: BIS Research Estimates

However, academics are mixed on the overall healthiness of E-cigarettes/ vaporizing. Many prominent research entities, such as the UK Royal College of Physicians, encourage cigarette smokers to switch to E cigarettes/ vaporizing as a less detrimental method to ingest nicotine. However, a 2017 study by Qasim et. al. published in the Journal of the American Heart Association found that E cigarettes are not emission-free and do in fact emit various potentially harmful chemicals.

Top 10 Cigarette Makers by Volume

Source: Euromonitor International

According to Euromonitor International, the global retail value of cigarette sales in 2016 totaled $683.4 billion. This amounts to over 5.5 trillion cigarettes sold in 2016. As sales shift from developed markets (where smoking prevalence is declining, and the regulatory environment is restrictive) to developing markets (where the regulatory environment is lax), the share of the market going to cigarettes is expected to decrease. In its place, alternative



methods of nicotine ingestion, including E cigarettes and vaporizing, are expected to claim a larger share of the market.

Cigarette Market Value Estimates

Source: Bloomberg/ Euromonitor International

Lexaria is currently planning in vivo studies for 2018 to test DehydraTECH’s™ ability to facilitate nicotine passage via the gastrointestinal tract. If the company is able to return favorable results and advance this research, we believe that DehydraTECH™ could attract significant attention from players in the nicotine/ tobacco industry. The nicotine market, which is currently in excess of $700 billion, is orders of magnitude larger than the current cannabis industry.

NSAIDs

NSAIDs, including drugs such as Aspirin, Ibuprofen, Naproxen and Celecoxib, are the most commonly used pain relief medicines in the world. The use of NSAIDs is particularly prevalent in older populations, where an increase in the frequency of chronic pain disorders such as arthritis increase the demand for NSAIDs. Though the use of NSAIDS as a pain relief medicine is considered effective, they also carry numerous risks, including:

Increased risk of heart failure: a study published in the British Medical Journal on September 1, 2017, found that NSAIDs increase the risk of heart failure by 19%. The study was based on a population across four European countries: Netherlands, Italy, Germany, and the UK.

Gastrointestinal damage: a well-known detrimental side effect of NSAIDs is the increase in occurrences of stomach bleeding and ulcers. According to the American Gastroenterological Association, half of all bleeding ulcers are caused by NSAIDs.

Higher risk of renal failure: a 1991 research paper published in the Journal of Clinical Pharmacology found that NSAIDs can induce renal abnormalities, the most common of which was excess fluid retention.

The result has been that dependence and overuse of NSAIDs has led to significant NSAID-related deaths- an article in the American Journal of Medicine estimated in a 1998 issue that



there are at least 16,500 NSAID-related deaths per annum. Furthermore, on average over 100,000 patients are hospitalized per year due to NSAID-related gastrointestinal tract complications. Despite the evidence pointing to significant health risks from NSAID usage, consumption remains significant. Medscape, an online source of medical information for physicians and patients, states that over 70 million NSAID prescriptions are written and over 40 billion doses are consumed annually in the U.S. alone. Using DehydraTECH’s™ ability to bypass the liver and increase the bioavailability of ingestible compounds, Lexaria believes that they may be able to improve the NSAID market via three distinct avenues:

Reduce the required dosage currently used in NSAID medications available today. Though considered generally less harmful than opioids, NSAIDs still present a degree of harm to patients. By improving bioavailability, patients can experience the same desired effect whilst ingesting a reduced dosage.

The company also believes that improved NSAID effectiveness could provide an offset or alternative to the usage of opioids, which are another drug used for pain relief, and considered particularly harmful to users due to the large amount of deaths via respiratory depression. Successful application of DehydraTECH™ may increase the pain relief effects of NSAIDs making them a viable alternative to Opioids. Though more dangerous, opioids are considered more effective for severe pain management.

Via the negation of the first pass liver effect; DehydraTECH™ could potentially reduce the overall API content in NSAIDs whilst also reducing input costs for manufacturers. Lexaria’s ability to validate its theorized mode of action through the lymphatic system instead of through liver metabolism, would have its most profound effects in the delivery of NSAIDs.

Lexaria intends to test DehydraTECH™ for NSAIDs in 2018.

Vitamins

Generally divided into water soluble and fat-soluble categories, DehydraTECH™ facilitates higher bioavailability than most existing delivery systems. According to management, fat soluble vitamins, such as vitamins A, D, K and E, are generally more difficult to absorb in the intestine. DehydraTECH™ provides an alternative delivery system that negates the need for variants or additives in order to increase vitamin bioavailability in the gastrointestinal tract. Like the company’s view for other ingestible compounds, Lexaria believes that their proprietary delivery technology can add value to the vitamin industry by increasing bioavailability, and subsequently reducing input costs. Another large market opportunity that could potentially be open to Lexaria, the vitamin and dietary supplements market is a sizeable industry. According to Euromonitor International, the U.S. market alone was valued at $27.6 billion, and could grow to $31.7 billion by 2021. The implied CAGR for U.S. vitamins and dietary supplement sales is 2.81% during this period. Though this is significantly lower than the expected growth rate for the North American cannabis market, the absolute size of the U.S. vitamin industry is still significantly



Management

Overview

larger in absolute terms.

Source: Euromonitor International

The company’s board of directors has four members, two of which are independent. We believe that a company’s board of directors should include independent or unrelated directors who are free of any relationships or business that could materially interfere with the director’s ability to act in the best interest of the company. As shown in the below table, management and board own 24% of the outstanding shares, strongly aligning their interest with investors.

Management and Board of Directors Share Ownership

Management & Board Shares % of Total

Chris Bunka - CEO, Chairman 14,114,923 19.97%

Nicholas Baxter - Director 330,000 0.47%

John Docherty - Director 2,127,000 3.03%

Ted McKechnie - President, Director 431,104 0.62%

Allan Spissinger - CFO 227,500 0.33%

17,230,527 24.42% Source: FRC, Company

Brief biographies of the senior management and board members, as provided by the company, follow: Chris Bunka – CEO, Chairman

Chris has been Chairman of the Board and CEO since 2006 and was primarily responsible for the corporate pivot from older business activities to bioscience. Chris is a serial entrepreneur and has been involved in several private and public companies since the late 1980’s. He was well known for more than a decade as a part-time business commentator in print and radio, as well as an author. He has extensive experience in the capital markets, corporate governance, project acquisition and corporate finance. He is a named inventor on some of Lexaria’s pending patents.

John Docherty – President, Director

John became President of Lexaria in the Spring of 2015 and joined its board of directors a



year later. Mr. Docherty was former President and Chief Operating officer of Helix BioPharma Corp. (TSX: HBP), where he led the company’s pharmaceutical development programs for its plant and recombinantly derived therapeutic protein product candidates. Mr. Docherty is a senior operations and management executive with over 20 years of experience in the pharmaceutical and biopharmaceutical sectors. He has worked with large multinational companies, as well as emerging private and publicly-traded start-ups. At Helix, Mr. Docherty was also instrumental in the areas of investor and stakeholder relations, capital raising, capital markets development, strategic partnering, regulatory authority interactions and media relations, and he also served as a management member of its board of directors. Prior to this, Mr. Docherty was president and a board member of PharmaDerm Laboratories Ltd., a Canadian drug delivery company that developed unique microencapsulation formulation technologies for use with a range of active compounds. Mr. Docherty has also held positions with companies such as Astra Pharma Inc., Nu-Pharm Inc. and PriceWaterhouseCoopers’ former global pharmaceutical industry consulting practice. He is a named inventor on issued and pending patents and he has a M.Sc. in Pharmacology and a B.Sc. in Toxicology from the University of Toronto.

Allan Spissinger – CFO

Prior to concentrating on finance and accounting, Mr. Spissinger worked within the Informational Technologies (IT) sector for over a decade; specializing in corporate IT infrastructure and software development projects. Mr. Spissinger joined the audit and assurance department at PricewaterhouseCoopers (PwC) where he obtained his Chartered Professional Accountant (CPA) designation focusing on financial reporting and Sarbanes-Oxley (SOX) compliance in the following sectors: resources, manufacturing and technologies. Mr. Spissinger joined Lexaria in September 2014 as a corporate controller. His positive mentorship, excellent communication and extensive leadership skills have enabled him to successfully manage a variety of private businesses for over 20 years.

Nicholas Baxter – Director

Nick was appointed as a member on the board of directors of Lexaria Corp. in 2009. Nick received a Bachelor of Science (Honours) from the University of Liverpool in 1975, and has worked on oil & gas projects in many areas of the world. Since the 1980’s, he has worked with companies in the public markets both in the U.K. and in Canada. Nick brings extensive real-world experience as a board member.

Ted McKechnie – Director

Ted is a well-recognized thought leader in the Canadian food industry. In the past, Ted was president of Maple Leaf Foods, an owner and senior executive at Humpty Dumpty and a senior leader at Pepsi Co. After a distinguished career as an executive and marketer specializing in food manufacturing, he now focuses on moving the Canadian food sector into the future. Besides being the chairman of Food Starter’s board, Ted is also the Chairman/CEO of The Davies Group and William Davies Consulting Inc. Ted is also a chairman of the board for Advanced Technology for Food Manufacturing, and the Director of Lexaria Bioscience Corporation. Ted is often called upon by think tanks, the government



Financials

and industry leaders to offer insights on how to grow the food sector and add more value to the Canadian economy. For the year ended August 31, 2017, the company had revenues of $63,639, compared to revenues of $40,718 reported at the end of same period in 2016. According to management, the majority of revenues were from out-licensing of the company’s proprietary DehydraTECH™ technology. As of August 31, 2017, the company had only one licensee, who had entered into an agreement to license Lexaria’s technology for utilization in their own cannabinoid products for a two-year period. Licensing revenues in 2017 were $45,809, compared to 2016 licensing revenues of $7,500. However, sales of the company’s proprietary line of products dropped from $31,743 in 2016, to $16,866 in 2017. The decline in product sales was due largely to challenges in securing distribution opportunities, production issues, and changes in payment processing. The segmented revenues for 2016 and 2017 are provided below:

Lexaria Segmented Revenues at Year End

Source: Company

The company believes that product sales will demonstrate growth moving forward, due to an increasingly friendly regulatory environment and increased demand for cannabinoid infused products. However, the company has indicated that moving forward, licensing revenues will grow to represent a larger portion of Lexaria’s revenues. This is due to the expectation of additional licensees utilizing Lexaria’s technology in their own product lines. We believe that this is a reasonable expectation, as the cannabis-derived products segment is a high-margin space that has multiple incumbents and will likely attract new entrants. By contrast, the patented proprietary DehydraTECH™ is likely to remain a unique offering with few substitutes in the short-term. Furthermore, the possibility of DehydraTECH™ to facilitate cost savings for cannabis product providers indicates potentially outsized future demand for out-licensing. The consolidated income statement for the company is provided below.



STATEMENTS OF OPERATIONS

(in US$) - YE Aug 31st 2014 2015 2016 2017

Revenue 14,702 40,718 63,639

COGS 29,883 45,615 29,750

Gross Profit - (15,181) (4,897) 33,889

EXPENSES

SG&A Expense 1,291,301 1,530,450 1,212,436 1,835,429

Inventory Write-off 44,040 68,611

Share-based Compensation 97,002 256,051

Research & Development 146,466 9,024 54,185

EBITDA (1,388,303) (1,948,148) (1,270,397) (1,924,336)

Depreciation 619 1,488

Amortization

EBIT (1,388,303) (1,948,148) (1,271,016) (1,925,824)

Financing Costs 165,790 31,544 2,250 6,015

EBT (1,554,093) (1,979,692) (1,273,266) (1,931,839)

Non-Recurring Expenses

Taxes 5,248 3,578 3,983 -2,374

Net Profit (Loss) (1,559,341) (1,983,270) (1,277,249) (1,929,465)

Management reported that the increase in operating expenses over the period were commensurate with the expansion of its business, with higher consulting fees and fees associated with patent and trademark filings. The result has been negative EBITDA, EBIT, EBT and net profit margins, despite revenue growth. Looking forward to 2018, management have provided the following budgetary guidance for 2018:

Management’s Budgetary Guidance for 2018

Source: Company

Note that the company has raised sufficient working capital from recent financings to execute the expected budget. The following table provides a summary of Lexaria’s balance sheet:



BALANCE SHEET

(in US$) - YE Aug 31st 2014 2015 2016 2017

ASSETS

CURRENT

Cash and Cash Equiv. 703,030 260,075 93,409 2,533,337

A/R 97,003 31,382 131,083 45,293

Inventory 167,986 134,724 67,174

Assets Held-For-Sale 1,400,000

Prepaid Expenses 367,441 215,290 150,950 149,691

Total Current Assets 2,567,474 674,733 510,166 2,795,495

Patent 36,989 53,997 62,827

Equipment 2,475 1,856

Medical Marijuana Investments 67,662

Total Assets 2,635,136 711,722 566,638 2,860,178

LIABILITIES

CURRENT

A/P 93,553 33,073 90,010 32,574

Loans Payable 776,936

Share Subscription Receivable 45,780

Unearned Revenue 12,500 17,083

Due to Related Parties 1,769 22,052 331,371 42,690

Total Current Liabilities 918,038 55,125 433,881 92,347

Convertible Debt 45,000

Total Liabilities 918,038 55,125 478,881 92,347

SHAREHOLDERS EQUITY

Share Capital 34,249 43,838 51,288 67,976

Additional Paid-In Capital 10,033,438 10,814,460 11,515,419 16,108,270

Shares to be Returned -35,200

Accumulated Deficit -8,315,389 -10,085,889 -11,300,662 -13,169,939

Non-Controlling Interest -115,812 -178,288 -238,476

Total shareholders’ equity (deficiency) 1,717,098 656,597 87,757 2,767,831

Total Liabilities and Shareholders Equity 2,635,136 711,722 566,638 2,860,178 Source: Company

At the end of 2017, the company had a cash position of $2.53 million and working capital of $2.7 million, as well as assets totaling $22.5 million and zero debt. The below table outlines the company’s liquidity and capital structure. (in US$) - YE Aug 31st

Liquidity & Capital Structure 2014 2015 2016 2017

Cash 703,030 260,075 93,409 2,533,337

Working Capital 1,649,436 619,608 76,285 2,703,148

Current Ratio 2.80 12.24 1.18 30.27

LT Debt 0 0 45,000 0

Total Debt 776,936 0 45,000 0

LT Debt / Capital - - 0.34 -

Total Debt / Capital 31.15% 0.00% 33.90% 0.00%

EBIT Interest Coverage -8.37 -11.75 -40.29 -855.92

Total Invested Capital 1,791,004 396,522 39,348 234,494 Source: Company Data

Below is a summary of the firm’s cash flows. Note that the company’s net cashflows have increased significantly in 2017, due to a significant increase in cashflows from financing activities:



Valuation

Summary of Cash Flows

($, mm) 2014 2015 2016 2017

Operating -$0.52 -$1.50 -$0.66 -$1.55

Investing -$0.08 $0.68 -$0.02 -$0.01

Financing $1.23 $0.37 $0.51 $4.00

Effects of Exchange Rate $0.00 $0.00 $0.00 $0.00

Net $0.64 -$0.44 -$0.17 $2.44

Free Cash Flows to Firm (FCF) -$0.59 -$0.82 -$0.68 -$1.56 Source: Company Data

Stock options and warrants: we estimate that the company has 3.38 million stock options (weighted average exercise price of $0.19), and 7.14 million warrants (weighted average exercise price of $0.31) outstanding. All options and warrants are currently in the money. The company has the potential to raise up to $2.82 million if all the 'in-the-money' options and warrants are exercised. Consolidated Revenue Forecasts

STATEMENTS OF OPERATIONS

(in US$) - YE Aug 31st 2018E 2019E 2020E 2021E 2022E 2023E 2024E 2025E

Revenue 3,752,967 16,050,545 36,623,975 67,739,393 102,970,788 141,988,473 181,273,500 226,134,370

COGS 225,597 992,270 2,779,911 4,857,474 7,427,821 10,632,310 14,539,649 19,794,479

Gross Profit 3,527,370 15,058,275 33,844,064 62,881,919 95,542,967 131,356,163 166,733,851 206,339,891

EXPENSES

Operating Expenses 3,075,297 4,575,055 6,929,397 10,367,639 14,250,149 18,547,224 22,910,565 27,874,973

EBITDA 452,073 10,483,221 26,914,666 52,514,280 81,292,818 112,808,939 143,823,286 178,464,918

Depreciation 742 1,931 2,940 3,903 4,908 6,024 7,310 8,821

Amortization

EBIT 451,331 10,481,290 26,911,726 52,510,377 81,287,910 112,802,914 143,815,976 178,456,097

Financing Costs

EBT 451,331 10,481,290 26,911,726 52,510,377 81,287,910 112,802,914 143,815,976 178,456,097

Non-Recurring Expenses

Taxes 117,346 2,725,135 6,997,049 13,652,698 21,134,857 29,328,758 37,392,154 46,398,585

Net Profit (Loss) 333,985 7,756,155 19,914,677 38,857,679 60,153,053 83,474,156 106,423,822 132,057,512 Source: FRC

To reflect uncertainty in future licensing revenues from non-cannabis markets (as DehydraTECH™ has yet to be tested for products in these markets), we include 50% of our forecasted nicotine, NSAID, and vitamin licensing revenues. 100% of the forecasted cannabis revenues are considered.

Gross margins for the company’s out-licensing segment, and product segment, of 95% and 50%, respectively.

The assumptions for the revenue forecasts by market, are given below. These lines are amalgamated into the above consolidated revenue forecasts.



Cannabis

2018E 2019E 2020E 2021E 2022E 2023E 2024E 2025E

CBD Product Revenue 84,330$ 421,650$ 2,108,250$ 3,267,788$ 5,065,071$ 7,850,859$ 12,168,832$ 18,861,690$

CBD Product COGS 42,165$ 210,825$ 1,054,125$ 1,633,894$ 2,532,535$ 3,925,430$ 6,084,416$ 9,430,845$

Cannabis Market Size 12,228,790,000$ 15,416,835,553$ 19,436,004,582$ 24,502,970,976$ 29,403,565,171$ 35,284,278,206$ 42,341,133,847$ 50,809,360,616$

Edibles Market 1,467,454,800$ 1,850,020,266$ 2,332,320,550$ 2,940,356,517$ 3,528,427,821$ 4,234,113,385$ 5,080,936,062$ 6,097,123,274$

Lexaria's Market Share (Cannabis) 73,372,740$ 185,002,027$ 349,848,082$ 588,071,303$ 705,685,564$ 846,822,677$ 1,016,187,212$ 1,219,424,655$

Lexaria Royalty Sales (Cannabis) 3,668,637$ 9,250,101$ 17,492,404$ 29,403,565$ 35,284,278$ 42,341,134$ 50,809,361$ 60,971,233$

Lexaria Royalty COGS (Cannabis) 183,432$ 462,505$ 874,620$ 1,470,178$ 1,764,214$ 2,117,057$ 2,540,468$ 3,048,562$

Total Revenues 3,752,967$ 9,671,751$ 19,600,654$ 32,671,353$ 40,349,349$ 50,191,993$ 62,978,193$ 79,832,923$

COGS 225,597$ 673,330$ 1,928,745$ 3,104,072$ 4,296,749$ 6,042,486$ 8,624,884$ 12,479,407$ Source: FRC

Our assumptions for Lexaria’s forecasted revenues from the cannabis space include:

A North American cannabis market worth $12.2 billion in 2018, growing at a CAGR of 26.07% till 2021 to reach $24.5 billion. This is based on a recent estimate by BDS Analytics and Arcview Market Research group. We forecast the industry growth rate will slow to 20% from 2021 onwards and a terminal growth rate of 3% by 2025.

Management expects that Lexaria will provide licenses to cannabis companies with dominant market share. In our models, this represents that the market share available to Lexaria is 20% of the North American cannabis edibles market. However, we believe that it will take time for the industry to recognize and adopt Lexaria’s technology, and initial market share available is lower than 20% and grows to this level over time.

We forecast that the edibles market will be equivalent to 12% of the wider North American cannabis industry. In Colorado, Washington, and Oregon, where adult use is legal at the state level, BDS analytics have reported edibles market share of 12%.

Licensing revenues equal to 5% of Lexaria’s market share. This is based on a royalty of 5%.

Nicotine

2018E 2019E 2020E 2021E 2022E 2023E 2024E 2025E

Nicotine Market Size 99,088,060,000$ 102,060,701,800$ 105,122,522,854$ 108,276,198,540$ 111,524,484,496$ 114,870,219,031$ 118,316,325,602$ 121,865,815,370$

Lexaria's Market Share (Nicotine) 255,151,755$ 525,612,614$ 1,082,761,985$ 1,672,867,267$ 2,297,404,381$ 2,957,908,140$ 3,655,974,461$

Lexaria Royalty Sales (Nicotine) 12,757,588$ 26,280,631$ 54,138,099$ 83,643,363$ 114,870,219$ 147,895,407$ 182,798,723$

Lexaria Royalty COGS (Nicotine) 637,879$ 1,314,032$ 2,706,905$ 4,182,168$ 5,743,511$ 7,394,770$ 9,139,936$ Source: FRC

Our assumptions for Lexaria’s forecasted revenues from the nicotine space include:

A U.S. tobacco/ nicotine market in 2016 valued at $93.4 billion. As the nicotine market is a mature market, we assign a long-term growth rate of 3%. We include only the U.S. nicotine market, as this reflect the company’s current patent protection. We do not include provisions for the issuance of similar patents globally to maintain conservatism.


Lexaria’s entry to the market in 2019. The company has a planned study for 2018, if the results are positive, we believe that they may be able to enter the market the



following year. NSAIDs

2018E 2019E 2020E 2021E 2022E 2023E 2024E 2025E

NSAIDs Market Size 60,000,000,000$ 61,800,000,000$ 63,654,000,000$ 65,563,620,000$ 67,530,528,600$ 69,556,444,458$ 71,643,137,792$ 73,792,431,925$

Lexaria's Market Share (NSAIDS) 337,652,643$ 695,564,445$ 1,074,647,067$ 1,475,848,639$

Lexaria Royalty Sales (NSAIDS) 16,882,632$ 34,778,222$ 53,732,353$ 73,792,432$

Lexaria Royalty COGS (NSAIDS) 844,132$ 1,738,911$ 2,686,618$ 3,689,622$ Source: FRC

Our assumptions for Lexaria’s forecasted revenues from the NSAID space include:

As per an Allied Market research report published in 2015, we estimate the value of the U.S. NSAIDs market at $60 billion. As the NSAID market is a mature market, we assign a long-term growth rate of 3%.


Lexaria’s entrance to the market in 2022. The company has a planned study for 2018, but we believe that the NSAID market is not an immediate focus, and management have advised that application of their technology to NSAIDs will likely encounter greater regulatory review.

Vitamins

2018E 2019E 2020E 2021E 2022E 2023E 2024E 2025E

Vitamins Market Size 29,280,840,000$ 30,159,265,200$ 31,064,043,156$ 31,995,964,451$ 32,955,843,384$ 33,944,518,686$ 34,962,854,246$ 36,011,739,874$

Lexaria's Market Share (Vitamins) 155,320,216$ 319,959,645$ 494,337,651$ 678,890,374$ 699,257,085$ 720,234,797$

Lexaria Royalty Sales (Vitamins) 7,766,011$ 15,997,982$ 24,716,883$ 33,944,519$ 34,962,854$ 36,011,740$

Lexaria Royalty COGS (Vitamins) 388,301$ 799,899$ 1,235,844$ 1,697,226$ 1,748,143$ 1,800,587$ Source: FRC

Our assumptions for Lexaria’s forecasted revenues from the vitamin space include:

As mentioned earlier, we estimate the U.S. vitamins market was valued at $27.6 billion in 2016. As the vitamin market is a mature market, we assign a long-term growth rate of 3%.


Lexaria’s entrance to the market in 2020. The company has a planned study for 2018, but we believe that the vitamins market is not an immediate focus, and so we conservatively delay market entrance to 2020.

Discounted Cash Flow Valuation

Our DCF Valuation on Lexaria’s shares is $4.64 per share.



Risks

DCF Model 2018E 2019E 2020E 2021E 2022E 2023E 2024E 2025E Terminal

EBIT(1-tax) 333,985$ 7,756,155$ 19,914,677$ 38,857,679$ 60,153,053$ 83,474,156$ 106,423,822$ 132,057,512$

Depreciation 742$ 1,931$ 2,940$ 3,903$ 4,908$ 6,024$ 7,310$ 8,821$

Investment in WC -532,399 $ -2,450,312 $ -4,273,242 $ -6,247,235 $ -7,148,701 $ -6,512,570 $ -8,605,631 $ -11,403,219 $

CFO -197,671 $ 5,307,773$ 15,644,376$ 32,614,347$ 53,009,261$ 76,967,610$ 97,825,501$ 120,663,114$

CAPEX -3,713 $ -4,455 $ -5,346 $ -6,416 $ -7,699 $ -9,239 $ -11,086 $ -13,304 $

FCF -201,384 $ 5,303,318$ 15,639,029$ 32,607,931$ 53,001,562$ 76,958,372$ 97,814,415$ 120,649,810$ 124,269,304$

PV -170,665 $ 3,808,760$ 9,518,396$ 16,818,808$ 23,167,471$ 28,507,808$ 30,706,393$ 32,097,454$ 220,402,517$

Discount Rate 18%

Terminal Growth Rate 3%

Total PV 364,856,943$

Cash - Debt 2,533,337$

Equity Value 367,390,280$

Shares O/S (dil) 78,557,536

Fair Value 4.64$ For our discount rate, we utilized a WACC of 18%. This is based on the 5-year average ROE and debt-to-capital structure exhibited in the Pharmaceuticals, Biotech and Life Sciences industry. We also used a return on debt that reflects the average rate of 10-year corporate debt yields, as reported by Moody’s. An additional discretionary risk premium has been included to reflect uncertainty of the company’s forward operations.

WACC

Debt-to-Capital Ratio 18%

Equity-to-Capital Ratio 82%

5-year average ROE 11%

10-year average Baa yield 6%

After-tax ROD 4%

Un-adjusted WACC 10%

Discretionary Risk Premium 8%

WACC 18% Based on our review of the company’s business model, the quality of the management

team and their execution plan, and our valuation models, we are initiating coverage on

Lexaria with a BUY rating and a fair value estimate of $4.64 per share. We believe this valuation reflects the potential upside of the company whilst reflecting the potential risks of the company’s business model. We encourage investors to monitor the company’s research and development progress, as confirmation of DehydraTECH’s™ successful (or unsuccessful) application to Lexaria’s targeted APIs will materially impact their valuation as presented in this report.

Risks

We believe the company is exposed to the following risks (list is non-exhaustive):

Possible inability to apply Lexaria’s delivery technology to any (or all) of the proposed market segments mentioned above will materially impact the company’s valuation.

Lexaria’s patent does not guarantee international protection of their technology- further patents from relevant authorities will be needed to protect the company’s technology in other jurisdictions.

The cannabis regulatory environment in North America exhibits high levels of uncertainty and is open to external interference beyond Lexaria’s control. Adverse



political or regulatory changes may materially impact the Company’s valuation. The company has yet to exhibit a track record of profitability, despite operations

generating revenue. Exchange rate risk. Access to capital and share dilution.

We are initiating coverage with a risk rating of 4 (Speculative).



Fundamental Research Corp. Equity Rating Scale:

Buy – Annual expected rate of return exceeds 12% or the expected return is commensurate with risk Hold – Annual expected rate of return is between 5% and 12% Sell – Annual expected rate of return is below 5% or the expected return is not commensurate with risk Suspended or Rating N/A— Coverage and ratings suspended until more information can be obtained from the company regarding recent events. Fundamental Research Corp. Risk Rating Scale:

1 (Low Risk) - The company operates in an industry where it has a strong position (for example a monopoly, high market share etc.) or operates in a regulated industry. The future outlook is stable or positive for the industry. The company generates positive free cash flow and has a history of profitability. The capital structure is conservative with little or no debt. 2 (Below Average Risk) - The company operates in an industry where the fundamentals and outlook are positive. The industry and company are relatively less sensitive to systematic risk than companies with a Risk Rating of 3. The company has a history of profitability and has demonstrated its ability to generate positive free cash flows (though current free cash flow may be negative due to capital investment). The company’s capital structure is conservative with little to modest use of debt. 3 (Average Risk) - The company operates in an industry that has average sensitivity to systematic risk. The industry may be cyclical. Profits and cash flow are sensitive to economic factors although the company has demonstrated its ability to generate positive earnings and cash flow. Debt use is in line with industry averages, and coverage ratios are sufficient. 4 (Speculative) - The company has little or no history of generating earnings or cash flow. Debt use is higher. These companies may be in start-up mode or in a turnaround situation. These companies should be considered speculative. 5 (Highly Speculative) - The company has no history of generating earnings or cash flow. They may operate in a new industry with new, and unproven products. Products may be at the development stage, testing, or seeking regulatory approval. These companies may run into liquidity issues, and may rely on external funding. These stocks are considered highly speculative.

Disclaimers and Disclosure

The opinions expressed in this report are the true opinions of the analyst about this company and industry. Any “forward looking statements” are our best estimates and opinions based upon information that is publicly available and that we believe to be correct, but we have not independently verified with respect to truth or correctness. There is no guarantee that our forecasts will materialize. Actual results will likely vary. The analyst and Fundamental Research Corp. “FRC” does not own any shares of the subject company, does not make a market or offer shares for sale of the subject company, and does not have any investment banking business with the subject company. Fees were paid by Lexaria to FRC. The purpose of the fee is to subsidize the high costs of research and monitoring. FRC takes steps to ensure independence including setting fees in advance and utilizing analysts who must abide by CFA Institute Code of Ethics and Standards of Professional Conduct. Additionally, analysts may not trade in any security under coverage. Our full editorial control of all research, timing of release of the reports, and release of liability for negative reports are protected contractually. To further ensure independence, Lexaria has agreed to a minimum coverage term including an initial report and three updates. Coverage cannot be unilaterally terminated. Distribution procedure: our reports are distributed first to our web-based subscribers on the date shown on this report then made available to delayed access users through various other channels for a limited time. The distribution of FRC’s ratings are as follows: BUY (73%), HOLD (6%), SELL / SUSPEND (21%). To subscribe for real-time access to research, visit http://www.researchfrc.com/subscribe.php for subscription options. This report contains "forward looking" statements. Forward-looking statements regarding the Company and/or stock’s performance inherently involve risks and uncertainties that could cause actual results to differ from such forward-looking statements. Factors that would cause or contribute to such differences include, but are not limited to, continued acceptance of the Company's products/services in the marketplace; acceptance in the marketplace of the Company's new product lines/services; competitive factors; new product/service introductions by others; technological changes; dependence on suppliers; systematic market risks and other risks discussed in the Company's periodic report filings, including interim reports, annual reports, and annual information forms filed with the various securities regulators. By making these forward looking statements, Fundamental Research Corp. and the analyst/author of this report undertakes no obligation to update these statements for revisions or changes after the date of this report. A report initiating coverage will most often be updated quarterly while a report issuing a rating may have no further or less frequent updates because the subject company is likely to be in earlier stages where nothing material may occur quarter to quarter. Fundamental Research Corp DOES NOT MAKE ANY WARRANTIES, EXPRESSED OR IMPLIED, AS TO RESULTS TO BE OBTAINED FROM USING THIS INFORMATION AND MAKES NO EXPRESS OR IMPLIED WARRANTIES OR FITNESS FOR A PARTICULAR USE. ANYONE USING THIS REPORT ASSUMES FULL RESPONSIBILITY FOR WHATEVER RESULTS THEY OBTAIN FROM WHATEVER USE THE INFORMATION WAS PUT TO. ALWAYS TALK TO YOUR FINANCIAL ADVISOR BEFORE YOU INVEST. WHETHER A STOCK SHOULD BE INCLUDED IN A PORTFOLIO DEPENDS ON ONE’S RISK TOLERANCE, OBJECTIVES, SITUATION, RETURN ON OTHER ASSETS, ETC. ONLY YOUR INVESTMENT ADVISOR WHO KNOWS YOUR UNIQUE CIRCUMSTANCES CAN MAKE A PROPER RECOMMENDATION AS TO THE MERIT OF ANY PARTICULAR SECURITY FOR INCLUSION IN YOUR PORTFOLIO. This REPORT is solely for informative purposes and is not a solicitation or an offer to buy or sell any security. It is not intended as being a complete description of the company, industry, securities or developments referred to in the material. Any forecasts contained in this report were independently prepared unless otherwise stated, and HAVE NOT BEEN endorsed by the Management of the company which is the subject of this report. Additional information is available upon request. THIS REPORT IS COPYRIGHT. YOU MAY NOT REDISTRIBUTE THIS REPORT WITHOUT OUR PERMISSION. Please give proper credit, including citing Fundamental Research Corp and/or the analyst, when quoting information from this report. The information contained in this report is intended to be viewed only in jurisdictions where it may be legally viewed and is not intended for use by any person or entity in any jurisdiction where such use would be contrary to local regulations or which would require any registration requirement within such jurisdiction.

Lexaria Bioscience Corp. (OTCQX: LXRP / CSE: LXX ... · A human biomarker study initiated in...

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Transcript of Lexaria Bioscience Corp. (OTCQX: LXRP / CSE: LXX ... · A human biomarker study initiated in...