22Nd Century Group, Inc. quarterly report, Q1 FY2012

Business context and reporting period

22nd Century Group, Inc. filed this unaudited Form 10-Q for the three months ended March 31, 2012. The company develops genetically engineered tobacco and related products, including the X-22 smoking-cessation product, potential modified-risk cigarettes, RED SUN and MAGIC cigarettes, and SPECTRUM research cigarettes. It reported no revenue in the quarter and has operated at a loss since 2006.

Financial performance and position

Metric	Q1 2012	Q1 2011
Revenue, including grant income	$0	$166,672
Operating loss	$(447,316)	$(637,661)
Net loss attributable to common shareholders	$(2,122,756)	$(649,300)
Basic and diluted loss per share	$(0.08)	$(0.03)
Cash used in operating activities	$(276,229)	$(1,653,309)

With no revenue in Q1 2012, a gross margin for the period is not meaningful. Q1 2011 included $117,456 of product revenue and $49,216 of therapeutic grant income.
At March 31, 2012, cash was $177; current assets were $905,837 and current liabilities were $3,150,630, resulting in negative working capital of approximately $2.2 million.
Total assets were $2,294,987, total liabilities $5,190,630, and shareholders’ deficit $2,895,643.
Current liabilities included $174,925 of demand bank loans, $487,000 of notes payable, and convertible notes with a face value of $1.84 million and a net carrying value of $949,343. The filing reports $140,000 of long-term notes payable separately.
The warrant liability was $1.9 million at quarter-end, after a $1.243 million fair-value loss in Q1. The company uses Level 3 valuation inputs for these warrants.
Cash used in investing activities was $500; financing activities provided $24,657. The company issued 1,025,000 common shares for services and accounts payable, and 115,000 shares upon conversion of convertible notes.

Material changes versus the prior comparable period

Revenue fell from $166,672 to zero. Management attributed the absence of Q1 2012 revenue to the timing of SPECTRUM deliveries; the company was preparing another order for 2012.
Operating expenses declined to $447,316 from $804,333, mainly reflecting reduced R&D after suspending X-22 FDA activities and sharply lower sales and marketing spending. Despite lower operating expenses, the net loss increased by $1.47 million, primarily due to the warrant revaluation and increased interest and debt-discount amortization.
Operating cash use declined by approximately $1.38 million year over year, partly due to lower working-capital cash use. Cash nevertheless fell from $252,249 at year-end to $177.
Negative working capital worsened from approximately $1.9 million at December 31, 2011 to approximately $2.2 million at March 31, 2012.

Outlook, risks, contingencies and unusual items

Liquidity and going concern: Management said available cash was insufficient to fund operations or pay obligations as due. Continued operations during 2012 depended on raising equity and obtaining significant licensing arrangements; neither was assured. Additional equity financing would dilute existing shareholders.
Financing plans: The company disclosed a private placement planned at $0.60 per unit, with each unit consisting of one common share and a five-year warrant exercisable at $1.00. Estimated proceeds were approximately $1 million, including $90,000 related to acquiring Goodrich Tobacco minority interests. The filing does not establish that the offering was completed.
Product development: The X-22 Phase II-B trial did not show a statistically significant difference in quitting versus the active control. The company suspended further sponsored trials pending results from independent trials, one recently completed and another expected in Q2 2012. Management said it might resume trials after reviewing those results.
Regulatory and commercial outlook: The company announced plans to file applications in the second half of 2012 for two potential modified-risk cigarette products. RED SUN and MAGIC sales and marketing were paused pending an arrangement with a participating manufacturer; the company was discussing distribution of RED SUN, but did not expect an arrangement before Q3 2012 at the earliest.
License exposure: Approximately $842,000 owed to North Carolina State University (NCSU) for patent costs and license fees was past due and included in payables. NCSU agreed not to exercise termination rights for nonpayment or nonperformance until October 15, 2012. If still delinquent thereafter, NCSU could give 60 days’ notice and an opportunity to cure; approximately $690,000 of patent assets related to potentially terminable licenses.
Other debt and collateral: A $25,000 note issued in March carried 15% interest and was secured by company and subsidiary assets; the lender’s managing member was a company officer. A further secured $25,000 note was issued April 13, 2012. The bank demand loan was also secured by a lien on all company assets, and the company had not met its annual 30-day repayment “clean-up” requirement, although the bank had not demanded payment.
Unusual accounting and transactions: Convertible-note discount amortization and conversion-related charges materially increased interest expense. In January, the company settled approximately $260,000 owed to Foley & Lardner with $50,000 cash and 1,000,000 shares valued by the parties at approximately $381,000; the agreement included up to $171,000 in future legal-service credit.
Controls and legal matters: Management concluded disclosure controls and procedures were ineffective and that previously reported material weaknesses in internal control over financial reporting remained. The company reported no material legal proceedings and no material change in risk factors from its 2011 Form 10-K.

Important facts for investors to verify

Whether the planned equity placement or licensing agreements produced enough cash to support operations and meet near-term obligations.
Current cash, working capital, payable balances, and repayment status of the notes due in 2012, including the past-due NCSU amounts.
Whether NCSU’s license protections were extended or its termination rights became exercisable after October 15, 2012.
Results of the independent smoking-cessation trials, any decision to resume X-22 trials, and progress on the planned modified-risk applications and manufacturing/distribution arrangements.
The assumptions behind the $1.9 million warrant-liability valuation and the resulting potential effects on reported earnings and dilution.
Reconciliation of common shares outstanding: the balance sheet reports 28,349,646 at March 31, while the cover page reports 29,049,646 as of May 7, 2012.
Progress in remediating the disclosed material weaknesses and improving disclosure controls.