22Nd Century Group, Inc. annual report, FY2012

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22nd Century Group, Inc. — Form 10-K Summary

Reporting period: Fiscal year ended December 31, 2012. This is an annual report, not a quarterly filing. The company develops tobacco biotechnology and products, including the investigational X-22 smoking-cessation aid, potential modified-risk cigarettes, RED SUN and MAGIC cigarettes, and SPECTRUM research cigarettes. Its business remains early-stage, with revenue historically limited and substantial dependence on financing and licensing.

Financial performance and position

  • Revenue: $18,775 in 2012, versus $788,601 in 2011. 2011 also included $223,540 of therapeutic grant income, bringing total revenue and other income to $1,012,141. 2012 revenue was primarily from SPECTRUM deliveries; the filing reports 2.7 million cigarettes delivered in 2012. The large year-over-year decline reflects the substantial 2011 research-cigarette delivery.
  • Costs and operating loss: Cost of goods sold was $67,967, exceeding revenue; the company supplied some research cigarettes without charge amid production delays. Operating expenses were $3.26 million, down from $4.77 million, and operating loss narrowed to $3.24 million from $3.76 million. Research and development expense fell 65% to $729,225 after X-22 trials were suspended; general and administrative expense rose 24% to $2.21 million.
  • Net loss: $6.74 million, or $0.22 per share, versus $1.35 million, or $0.05 per share, in 2011. The deterioration reflected a $1.998 million net warrant-liability expense and $1.495 million of interest and debt-discount expense; 2011 had a $2.512 million warrant-liability gain.
  • Cash flow: Operating activities used $1.76 million, compared with $3.45 million in 2011. Investing activities used $162,774; financing activities provided $1.68 million. Year-end cash was just $188, down from $252,249.
  • Liquidity and balance sheet: Current assets were $1.28 million, including $1.23 million of inventory, against current liabilities of $4.60 million. Negative working capital was approximately $3.3 million, versus $1.9 million a year earlier. Total liabilities were $8.78 million and shareholders’ deficit was $6.13 million.
  • Debt and other obligations: Current notes payable totaled $617,000; convertible notes had a $1.894 million carrying value; the demand bank loan was $174,925. Warrant liability was $4.17 million. The company was not meeting the bank loan’s annual 30-day repayment “clean-up” requirement, although the bank had not demanded repayment.

Material changes and subsequent financing

  • Revenue fell sharply as the large 2011 SPECTRUM delivery was not repeated at a comparable level. R&D and sales and marketing costs declined, while G&A and financing-related expenses increased.
  • 2012 private placements generated approximately $1.47 million in net proceeds. Subsequent to year-end, a January 2013 preferred-stock and warrant financing generated approximately $2.125 million net. The Series A-1 preferred stock carries a 10% annual dividend and is initially convertible into approximately 4.17 million common shares at $0.60 per share, subject to adjustment; associated warrants and reset provisions create potential dilution.
  • From January through February 6, 2013, notes with a year-end carrying value of approximately $1.41 million were converted into common shares and warrants. These transactions improved the capital position, but management said additional financing or licensing arrangements were still needed to fund 2013 operations and obligations.
  • After year-end, the company paid NCSU $400,000 and issued it a $474,893 note; NCSU agreed not to invoke termination rights under the license for nonpayment or nonperformance until October 1, 2013. Other past-due obligations were also renegotiated or repaid.

Outlook, risks and unusual items

  • Management was seeking domestic and international licensing deals and expected to close at least one licensing agreement by the end of the third quarter of 2013. Without an out-licensing agreement, it estimated approximately $1.6 million of additional cash would be required through 2013, including about $1 million of obligations coming due. It also anticipated about $250,000 in cigarette factory start-up costs.
  • The independent auditor’s report and management’s disclosures raise substantial doubt about the company’s ability to continue as a going concern. The company had recurring losses, minimal cash, negative working capital, and ongoing financing needs. The audited financial statements include no adjustments for the outcome of this uncertainty.
  • The company’s X-22 Phase II-B trial, completed in the first quarter of 2012, did not show a statistically significant quitting advantage over the active control. Further company-sponsored trials were suspended pending analysis of independent trial results and identification of a joint-venture funding partner. The FDA had declined Fast Track designation in 2011.
  • Management planned to pursue FDA authorization for BRAND A and BRAND B as modified-risk cigarettes, with applications expected in 2013. FDA authorization is uncertain, additional exposure studies may be required, and management said significant additional capital would be needed.
  • Goodrich Tobacco applied for a federal manufacturing permit and for participating-manufacturer status under the Master Settlement Agreement (MSA). Approval could improve distribution prospects for RED SUN and MAGIC; sales and marketing had been curtailed while the company addressed MSA-related costs.
  • Warrant accounting was a major source of earnings volatility. The warrants are measured using significant unobservable inputs; management disclosed that a 10% change in the volatility assumption would change the warrant liability by approximately $875,000.
  • Management concluded disclosure controls and internal control over financial reporting were ineffective at year-end because of a material weakness in segregation of duties. Management said it performed additional analyses and post-closing procedures, but the weakness remained.
  • Key risks include the need to raise capital, potential substantial shareholder dilution, regulatory and clinical uncertainty, lack of established sales and manufacturing arrangements, competition, tobacco-industry regulation and litigation, and reliance on licensed intellectual property. No material legal proceedings were reported as pending.

Most important facts for investors to verify

  • Whether the company secured sufficient financing or a material licensing agreement, and whether it met 2013 obligations without further dilution.
  • Current cash, working capital, debt maturities, and the status of the preferred-stock conversion resets, warrants, and other potentially dilutive securities.
  • Full results and peer-reviewed publication of the independent X-22-related trials, any decision to resume company-sponsored trials, and subsequent FDA feedback.
  • Whether FDA applications for BRAND A and BRAND B were filed and what studies, timelines, and funding the FDA requires.
  • Whether the TTB and NAAG approved Goodrich Tobacco’s manufacturing and MSA applications, and the resulting costs and distribution access.
  • Whether the segregation-of-duties material weakness was remediated and whether disclosure controls and financial reporting controls improved.