Business context and reporting period
22nd Century Group, Inc. filed this unaudited Form 10-Q for the three months ended March 31, 2013. The company develops and licenses tobacco biotechnology, cigarettes and smoking-cessation products. Its main initiatives include RED SUN and MAGIC cigarettes, SPECTRUM research cigarettes, potential modified-risk cigarettes, and X-22, a smoking-cessation product. The company reported no revenue in either Q1 2013 or Q1 2012.
Financial performance and position
| Metric | Q1 2013 / March 31, 2013 | Comparable period / prior year-end |
|---|---|---|
| Revenue | $0 | $0 in Q1 2012 |
| Operating expenses | $1.392 million | $447,316 in Q1 2012 |
| Operating loss | $1.392 million | $447,316 in Q1 2012 |
| Net loss | $2.513 million; $0.07 per share | $2.124 million; $0.08 per share in Q1 2012 |
| Cash used in operating activities | $1.137 million | $276,229 in Q1 2012 |
| Cash | $278,884 | $188 at December 31, 2012 |
| Current assets / current liabilities | $1.605 million / $1.861 million | $1.281 million / $4.603 million at December 31, 2012 |
| Total liabilities | $10.705 million | $8.776 million at December 31, 2012 |
| Shareholders’ deficit | $7.733 million | $6.131 million at December 31, 2012 |
Gross margin is not meaningful because the company reported no revenue. Management reported negative working capital of approximately $0.26 million, improved from $3.32 million negative at year-end. The balance sheet included $1.225 million of notes payable, $143,031 of convertible notes net of discount, and a $174,925 demand bank loan. Separately, the warrant liability was $8.669 million. Financing activities provided $1.444 million net cash, principally from the January preferred-stock financing; investing activities used $28,605.
Material changes versus the prior comparable period
- Net loss increased $388,992, or 18.3%. R&D expense rose to $190,748 from $87,734, and general and administrative expense rose to $1.148 million from $309,790, primarily due to stock compensation and professional fees.
- Operating cash use increased to $1.137 million from $276,229, reflecting higher cash use in working capital and operations.
- Interest expense and debt-discount amortization declined to $105,525 from $433,896, mainly because discounts on the December 2011 convertible notes had been fully amortized by year-end 2012.
- The company received $2.035 million net proceeds from a January private placement of 10% convertible preferred stock and warrants. Convertible notes with approximately $1.409 million carrying value were converted into common shares and warrants or otherwise discharged. Common shares outstanding were 37.709 million at quarter-end and 39.001 million as of May 7, 2013.
- The reported warrant-related expense was approximately $1.016 million. The filing describes a $3.988 million charge when newly issued warrants were valued, partly offset by a $2.971 million gain from the quarter’s decrease in the estimated fair value of warrant liabilities. These noncash valuations are sensitive to assumptions; management estimated a 10% change in volatility could change the liability by about $2 million.
Outlook, risks, contingencies and unusual items
- Liquidity and going concern: Management said quarter-end cash was insufficient to fund operations and obligations for the remainder of 2013. Without an out-licensing agreement, it estimated about $2.5 million of additional capital would be needed over the next 12 months, including approximately $1 million of obligations coming due. There is no assurance that financing or a significant license will be obtained.
- Licensing: Management was pursuing domestic and international licensing and expected to close at least one agreement before the end of Q3 2013. Failure to raise funds or secure licensing could jeopardize continued operations.
- Debt and payables: A $226,780 vendor note due May 3, 2013 was reported as in default after quarter-end. Approximately $490,000 was owed to North Carolina State University for patent costs and license fees, with amounts past due; NCSU agreed not to terminate the license for nonpayment or nonperformance before October 1, 2013. The company also had not met the annual clean-up requirement on its $174,925 demand bank loan, although the bank had not demanded repayment.
- Commercialization and regulatory risks: Goodrich Tobacco applied for a federal manufacturing permit and to participate in the Master Settlement Agreement; approvals would facilitate U.S. sales of RED SUN and MAGIC. Management estimated factory start-up costs of $250,000. The company had delivered no SPECTRUM cigarettes in Q1 2013 or Q1 2012.
- Product development: The company suspended further sponsored X-22 trials pending analysis of independent studies. Its Phase II-B trial did not show a statistically significant quitting difference versus the active control. Management estimated about $14 million to complete remaining X-22 trials and $5 million for U.S. marketing; further trials depend on a joint-venture funding partner. It estimated FDA authorization work for each potential modified-risk cigarette would cost at least $2 million, subject to additional capital and FDA requirements.
- Preferred-stock terms and dilution: The January financing carries a 10% dividend and conversion-price adjustment provisions; its warrants have down-round features and are recorded as derivative liabilities. In April, preferred holders converted 259.08 shares into 431,800 common shares. In May, the company agreed to pay specified accrued dividends in common shares rather than cash. The filing lists 24.4 million warrants and other potential common shares excluded from diluted loss per share as anti-dilutive.
- Controls and legal matters: Management concluded disclosure controls were not effective and that previously identified material weaknesses in internal control over financial reporting remained. The company reported no material legal proceedings and no material change to risk factors from its 2012 Form 10-K.
Important facts for investors to verify
- Whether the company secured new capital or licensing revenue sufficient to meet near-term obligations and sustain operations.
- The status and resolution of the defaulted vendor note, past-due NCSU amounts, and demand-loan clean-up requirement.
- Progress on TTB and MSA approvals, manufacturing plans, and any commercial sales or SPECTRUM orders.
- Whether independent X-22 trial results support further development, and whether a partner funds additional trials.
- Changes in warrant fair value, preferred conversion terms, common shares outstanding, and potential dilution.
- Remediation of the disclosed material weaknesses and improvement in disclosure controls and internal control over financial reporting.