Form 10-K for 22ND CENTURY GROUP, INC.
We are a plant biotechnology company specializing in technology that allows for the level of nicotine and other nicotinic alkaloids (e.g., nornicotine, anatabine and anabasine) in tobacco plants to be decreased or increased through genetic engineering and plant breeding. We focused on tobacco harm reduction and smoking cessation products. We own or exclusively control 128 issued patents plus an additional 52 pending patent applications. The patents owned by or exclusively licensed to us include patents issued in 96 countries.
Our long-term focus is the research, development, licensing, manufacturing, and selling of our products to reduce the harm caused by smoking. Annual worldwide tobacco product sales, cigarettes and smokeless products, are approximately $800 billion and most of which are cigarette sales according to Euromonitor International.
� The international licensing of our technology, proprietary tobaccos, trademarks;
� The international sale of our branded proprietary tobaccos;
� The manufacture, marketing and distribution of RED SUN and MAGIC proprietary cigarettes;
� The production of SPECTRUM research cigarettes for NIDA, a part of NIH;
� The research and development of potentially less harmful or modified risk tobacco products and novel tobacco plant varieties;
� The development of X-22, a prescription-based smoking cessation aid consisting of VLN cigarettes;
� The pursuit of necessary regulatory approvals and clearances from the FDA to market in the U.S. X-22 as a prescription smoking cessation aid and BRAND A and BRAND B as reduced-risk or Modified Risk Cigarettes;
� The contract manufacturing of third-party branded tobacco products; and
� The research and development in Canada of unique plant varieties of hemp/cannabis, such as (i) plants with low to no amounts of delta-9-tetrahydrocannabinol, or THC, for the legal hemp industry, (ii) plants with high levels of THC for the legal recreational cannabis market, and (iii) plants with high levels of cannabidiol, or CBD, and other non-THC cannabinoids for the legal medical marijuana markets.
We believe our proprietary technology, tobaccos and products can generate multiple significant revenue streams from licensing of our technology and tobacco and from the sales of our products.
As previously reported, on October 25, 2014, our Board of Directors terminated the employment of Joseph Pandolfino, our former Chief Executive Officer, pursuant to Section 4.2 (Termination Without Cause) of Mr. Pandolfino’s Employment Agreement and formed an Executive Committee of the Board, consisting of the existing independent directors, to assist our management until the Board completes its search for and selection of a new Chief Executive Officer. Although Mr. Pandolfino will not be re-joining us as an employee or officer, he remains a member of the Board of Directors.
Since October 2014, the Executive Committee has been primarily working with management to assist it with forming the proper strategic direction of our business and to streamline and organize our business in light of the termination of Mr. Pandolfino. The Executive Committee expects to hire a third party advisory firm during the first quarter of 2015 in order to assist with the search for and selection of a new Chief Executive Officer.
Please refer to the “Business” section in this Annual Report on Form 10-K for additional information regarding our business and operations.
Results of Operations
Year Ended December 31, 2014 Compared to Year Ended December 31, 2013
Revenue – Royalties from licensing.
In the year ended December 31, 2014, we realized no licensing revenue. During the year ended December 31, 2013 we realized royalty revenue of $7.0 million from the worldwide Research License and Commercial Option Agreement entered into with BAT.
Revenue – Sale of products.
We realized revenue of $528,991 from the sale of products during the year ended December 31, 2014, as compared to revenue of $278,383 during the year ended December 31, 2013, an increase of $250,608 or 90%. The revenue of $528,991 for the year ended December 31, 2014, consisted of $447,535 in revenue derived from the sale of 5.5 million SPECTRUM research cigarettes during January 2014 and from the production of filtered cigars in our North Carolina manufacturing facility in the amount of $81,456. The revenue for the year ended December 31, 2013, was derived from the sale of our proprietary VLN tobacco to a customer in the Netherlands in the amount of $52,500 and from the sale of our VLN tobacco to the FDA as a subcontractor under a government contract between RTI and the FDA in the amount of $225,883.
Costs of goods sold – Royalties for licensing.
During the year ended December 31, 2014, we revised the estimate of the royalty fee due to NRC in connection with the $7,000,000 fee received from BAT in the fourth quarter of 2013. The new amount due to NRC of $660,000 exceeded the estimate of $413,566, originally recorded in the year ended December 31, 2013, by $246,434.
Costs of goods sold – Products.
In the year ended December 31, 2014, costs of goods sold were $252,002 or 47.6% of revenue. The cost of goods sold consists of $177,696 relating to the production of the SPECTRUM research cigarettes and $74,306 relating to the manufacture of the filtered cigars. In the year ended December 31, 2013, the cost of goods sold were $48,105 or 17.3% of revenue.
Research and development expense.
Research and development expense was $1,249,007 for the year ended December 31, 2014, an increase of $504,777, or 67.8%, from $744,230 for the year ended December 31, 2013. This increase was primarily the result of increases in stock based compensation of approximately $220,000, research and development payroll and related benefits of approximately $104,000, royalty and license fees of approximately $187,000, and $15,000 of costs associated with an FDA modified-risk application, partially offset by a decrease in contractual research and development costs of approximately $39,000 during the year ended December 31, 2014 as compared to the year ended December 31, 2013.
General and administrative expense.
General and administrative expense was $8,793,151 in the year ended December 31, 2014, an increase of $4,686,457, or 114.1%, from $4,106,694 in the year ended December 31, 2013. The increase was primarily due to increases in employee stock based compensation of approximately $1,047,000, employee related costs of approximately $693,000, legal and professional fees of approximately $986,000, costs relating to press releases of approximately $78,000, the write off of an uncollectible advance in the approximate amount of $43,000, NYSE MKT related costs of approximately $176,000, costs associated with severance liability of approximately $637,000, director fee costs of approximately $157,000, the expense associated with the Crede consulting agreement in the approximate amount of $2,091,000, and other administrative costs of approximately $171,000, partially offset by decreases in stock based compensation and cash payments to third-party service providers of approximately $1,318,000 and $75,000, respectively, during the year ended December 31, 2014 as compared to the year ended December 31, 2013.
Pre-manufacturing facility costs.
On August 29, 2014, we completed the transaction to purchase all of the issued and outstanding membership interests of NASCO. The purchase transaction was subject to various conditions, including the required consents of the 46 Settling States of the MSA to an amendment of NASCO’s existing adherence agreement to the MSA, with the Company becoming a signatory to such amended adherence agreement as part of our acquisition of NASCO. On August 29, 2014, the Company became a signatory to the amended adherence agreement. NASCO operates our cigarette manufacturing facility in North Carolina. Prior to the closing of our acquisition of NASCO, the factory was primarily in a pre-manufacturing stage, incurring various expenses relating to preparing and upgrading the warehouse and manufacturing facility for production. Those expenses included salaries and benefits for employees, sub-contract labor, rent, utilities and other miscellaneous costs and amounted to $1,176,676 during the year ended December 31, 2014. There were no expenses relating to the cigarette manufacturing facility during the year ended December 31, 2013. We manufactured a modest quantity of filtered cigars during the year ended December 31, 2014 generating revenue in the amount of $81,456. We also commenced manufacturing our proprietary cigarette brands and an MSA brand for a chain of independent smokeshops during the fourth quarter of 2014. Sales of these brands commenced during the first quarter of 2015. NASCO will also continue to manufacture non-MSA filtered cigars.
Sales and marketing costs.
Sales and marketing costs were $85,930 for the year ended December 31, 2014, an increase of $76,878, or 849.3%, from $9,052 for the year ended December 31, 2013. The increase is primarily the result of costs associated with participation in tobacco industry trade shows, RED SUNpackaging design costs, and materials used for marketing trips to Europe and Asia.
Amortization and depreciation expense.
Amortization and depreciation expense for the year ended December 31, 2014 amounted to $462,772, an increase of $318,483 or 220.7% from $144,289 for the year ended December 31, 2013. Amortization expense relates to amortization taken on capitalized patent costs. Amortization expense for the year ended December 31, 2014 was $232,760 an increase of $91,499 or 64.8% from $141,261 for the year ended December 31, 2013. The increase is primarily due to an adjustment to the 2013 amortization that was recorded in the first quarter of 2014 and by amortization on additional investments in patents during the years ended December 31, 2014 and 2013 in the amount of $641,866 and $332,826, respectively, partially offset by a change in the estimated useful lives of one of the patent families during the year ended December 31, 2013. Depreciation expense for the year ended December 31, 2014 was $230,012, an increase of $226,984 from $3,028 for the year ended December 31, 2013. This increase is mainly due to approximately $2.9 million of cigarette manufacturing equipment placed in service during the second quarter of 2014.
Warrant liability loss – net.
The warrant liability loss of $3,676,691 for the year ended December 31, 2014 was due to an increase in the warrants liability recorded in the first quarter of 2014 in the amount of $3,841,943 in conjunction with the Warrant Amendment program offset by a decrease in the estimated fair value of the warrants during the year in the amount of $165,252, primarily attributable to the decrease in the Company’s underlying stock price from $2.14 per share at December 31, 2013, as compared to $1.65 per share at December 31, 2014.
In a private placement in the first quarter of 2013, we issued warrants which were accounted for as derivatives and upon issuance a liability at the estimated fair value was recorded. At the date of issuance of these warrants, the value exceeded that total consideration received by an aggregate of $3,987,655 resulting in an immediate charge to expense for this amount. In connection with the exercise of 1,101,034 Series B Warrants in July 2013, we issued a like number of Series C Warrants which were accounted for as derivatives and upon issuance a liability at the estimated fair value was recorded. At the date of issuance of these warrants, the value was estimated to be $1,622,069 which exceeded the sum of the net proceeds received in the exercise and the reclassification of warrant liability to capital by $343,079 resulting in an immediate charge to expense for this amount. These two charges added to the loss on warrant liability of $19,271,977, resulting from an increase in the fair value during the year ended December 31, 2013 for all warrants we have issued, resulting in a total loss on warrant liability-derivative for the year of $23,602,711. The loss on warrant liability of $19,271,977 was primarily the result of an increase in the Company’s underlying stock price from $0.75 per share at December 31, 2012, as compared to $2.14 per share at December 31, 2013.
Future periods will reflect a gain or loss based on the change in the fair value of the derivatives, which is based on a number of factors including the Company’s stock price.
Loss on equity investment.
The loss on equity investment of $101,165 for the year ended December 31, 2014, consists of (i) our 25% share of Anandia’s net loss from our initial April 11, 2014 investment in Anandia through December 31, 2014 in the amount of $84,350, plus (ii) amortization of the intangible asset represented by the difference between our equity investment in Anandia and our portion of the book value of the net assets of Anandia in the amount of $16,815.
Interest expense and amortization of debt discount and expense.
Interest expense and amortization of debt discount and debt issuance costs decreased during the year ended December 31, 2014 to $7,094 from $748,605 during the year ended December 31, 2013. This decrease of $741,511 or 99.1% was primarily the result of a decrease in the amortization of debt discount and debt issuance costs relating to convertible notes issued on August 9, 2012 that were converted into common stock in August of 2013, payment of the majority of the Company’s interest bearing debt in the fourth quarter of 2013, and the recording as interest expense the excess of the fair value of warrants issued during the year ended December 31, 2013 over the proceeds realized in the amount of approximately $509,000. The Company’s demand bank loan is the only remaining interest bearing debt outstanding at December 31, 2014.
We had a net loss for the year ended December 31, 2014 of $15,595,358 as compared to a net loss of $26,153,158 for the year ended December 31, 2013. The decrease in the net loss of $10,557,800 or 40.4%, was primarily the result of a decrease in the warrant liability loss – net in the amount of $19,926,020, a decrease in interest expense and amortization of debt discount in the amount of $741,511, a decrease in the warrant amendment inducement expense of $3,591,765 and an increase in the gain on the sale of machinery and equipment of $71,121, offset by a decrease in gross profit of $6,786,157, an increase in operating expenses of $6,763,271, and a decrease in other income of $206,374.
Liquidity and Capital Resources
As of December 31, 2014, we had working capital of approximately $8.0 million, as compared to working capital of approximately $6.8 million at December 31, 2013, an increase of approximately $1.2 million. The $1.2 million increase in working capital was primarily the result of net working capital remaining from the net proceeds of the $9.3 million raised in the September 2014 common stock private placement after operating and investing activities during the year ended December 31, 2014.
We must successfully execute our business plan to increase revenue in order to achieve positive cash flows to sustain adequate liquidity without requiring additional funds from external sources to meet minimum operating requirements. The Company’s Form S-3 universal shelf registration statement was filed with the U.S. Securities and Exchange Commission (“SEC”) on April 18, 2014, and became effective on June 5, 2014. The universal shelf registration statement will allow, but not compel, the Company to raise up to $45 million of capital over a three-year period through a wide array of securities at times and in amounts to be determined by the Company. There can be no assurance that additional capital, if required, will be available on acceptable terms or at all.
Cash demands on operations
In 2014, we had an operating loss of approximately $11.7 million and used cash in operations of approximately $6.6 million during the year ended December 31, 2014. Excluding contract growing of our proprietary tobacco with farmers, extraordinary expenses such as potential clinical trials, capital expenses for our factory, and initial expenses associated with the launch of our RED SUN cigarette brand, our monthly cash expenditures are approximately $500,000. We believe that cash on hand at December 31, 2014 of $6,402,687 is adequate to sustain operations and meet all current obligations as they come due for a period of approximately 12 months.
Net Cash (used in) provided by Operating Activities
In the year ended December 31, 2014, $6,582,730 of cash was used operating activities compared to $3,855,834 of cash provided by operating activities in the year ended December 31, 2013, a decrease of $10,438,564. This decrease in cash provided by operations was mainly due to the license revenue received from BAT under the Research License and Commercial Option Agreement in the amount of $7,000,000 in 2013 as compared to no revenue from licensing in 2014. In addition, approximately $3,400,000 in additional cash was consumed in operating activities.
Net Cash used in Investing Activities
In the year ended December 31, 2014, we used $2,707,992, as compared to $3,742,789 of cash used in investing activities during the year ended December 31, 2013, a decrease of $984,797. The decrease in cash used in investing activities is primarily due to a decrease in the acquisition of machinery and equipment in the amount of $3,239,966, and an increase in proceeds received on the sale of machinery and equipment in the amount of $631,484, offset by increases in the acquisition of patents and trademarks of $436,653, license fees of $1,450,000, the cash portion of the equity investment in Anandia of $700,000, and the cash portion of the NASCO transaction of $250,000.
Net Cash from Financing Activities
During the year ended December 31, 2014, we generated $9,862,810 from our financing activities, as compared to $5,717,366 of cash generated from financing activities during the year ended December 31, 2013, an increase of $4,145,444. The $9,862,810 generated during the year ended December 31, 2014 was mainly the a result of net cash proceeds received from a common stock private placement in September 2014, in the amount of $9,324,088, and net cash proceeds from the exercise of stock warrants and stock options in the amount of $535,251. The $5,717,366 of cash generated during the year ended December 31, 2013 was primarily the result of the net proceeds from the Series A-1 Preferred stock placement in the amount of $2,034,664, net cash proceeds received from the exercise of warrants in the amount of $2,254,999, proceeds received from the issuance of notes payable in the amount of $150,000, proceeds received from the exercise of stock options in the amount of $5,200, and net cash proceeds received from the Warrant Exchange Program in the amount of $3,239,385. These proceeds raised were partially offset by payments on notes payable, convertible notes payable and net payments to related parties and officers in the amount of $1,620,299, $339,250 and $8,993, respectively.
Critical Accounting Policies and Estimates
Accounting principles generally accepted in the United States of America, or U.S. GAAP, require estimates and assumptions to be made that affect the reported amounts in our consolidated financial statements and accompanying notes. Some of these estimates require difficult, subjective and/or complex judgments about matters that are inherently uncertain and, as a result, actual results could differ from those estimates. Due to the estimation processes involved, the following summarized accounting policies and their application are considered to be critical to understanding our business operations, financial condition and results of operations.
We recognize revenue at the point the product is shipped to a customer and title has transferred. Revenue from the sale of our products is recognized net of cash discounts, sales returns and allowances. Federal cigarette excise taxes are included in net sales and accounts receivable billed to customers, except on sales of SPECTRUM and exported cigarettes in which such taxes do not apply.
We were chosen to be a subcontractor for a government contract between RTI International (“RTI”) and NIDA to supply research cigarettes to NIDA. These government research cigarettes are distributed under the Company’s mark SPECTRUM. Future revenue under this arrangement is expected to be related to the delivery of SPECTRUM and will be recognized at the point the product is shipped and title has transferred. In September 2013, we received a purchase order for an additional 5.5 million SPECTRUM research cigarettes that were manufactured and shipped in January 2014. Total revenue from this order was approximately $447,535 and a down payment on the order was received in the fourth quarter of 2013 in the amount of $179,014. The down payment has been recorded as deferred revenue on the Company’s balance sheet at December 31, 2013. There were no SPECTRUM cigarettes delivered during the year ended December 31, 2013.
As described above, we license our patented technology to third parties. Revenue is recognized from licensing arrangements as contractually defined in licensing agreements. We account for milestone elements contained in licensing agreements in accordance with ASC 605. Simultaneous with the signing of the Research License and Commercial Option Agreement, BAT paid us a non-refundable $7,000,000. Revenue was recognized for this amount since delivery of the patented technology took place, we had no further performance obligations, and the fee was fixed. We will be entitled to receive additional payments from BAT, up to an additional $7,000,000, during the Research Term in the event certain milestones are met by BAT with respect to BAT’s research and development of our patent rights licensed by the Company to BAT. There are four separate milestones, two of which BAT would pay us $2 million for each milestone achieved, and two of which BAT would pay us $1.5 million for each milestone achieved. In addition, the Company could earn additional future royalties if BAT elects to exercise the Commercial Option Agreement during the Research Term.
No amount related to the research milestones was recognized during 2014 or 2013. A portion of the patented technology sublicensed to BAT was exclusively licensed to 22nd Century Ltd. by NRC. Pursuant to the terms of the license agreement with NRC, 22nd Century Ltd. was obligated to make a royalty payment to NRC from the monies received from BAT. During the quarter ended September 30, 2014, 22nd Century Ltd. and NRC mutually agreed on a payment of $660,000 that was paid in December 2014. 22nd Century Ltd. had previously estimated the payment to be $413,566. The difference in the amount of $246,434 has been recorded as Royalty for licensing in the Cost of goods sold section of the Company’s Consolidated Statements of Operations for the year ended December 31, 2014.
Impairment of Long-Lived Assets
We review the carrying value of amortizing long-lived assets whenever events or changes in circumstances indicate that the historical cost-carrying value of an asset may no longer be appropriate. We also assess recoverability of the asset by estimating the future undiscounted net cash flows expected to result from the asset, including eventual disposition. If the estimated future undiscounted net cash flows are less than the carrying value of the asset, an impairment loss is recorded equal to the difference between the asset’s carrying value and its fair value. Non-amortizing intangibles (e.g., patents and trademarks) are reviewed annually for impairment. We have not recognized any impairment losses during the two year period ended December 31, 2014.
Amortization Estimates of Intangible Assets
We generally determine amortization based on the estimated useful lives of the assets and record amortization expense on a straight-line method over such lives. The remaining life of the primary patent in each patent family is generally used to determine the estimated useful life of the related patent costs.
Valuation of our Equity Securities
We use a fair-value based method to determine compensation for all arrangements under which Company employees and others receive shares, options or warrants to purchase common shares of 22nd Century Group. Stock based compensation expense is recorded over the requisite service period based on estimates of probability and time of achieving milestones and vesting. For accounting purposes, the shares will be considered issued and outstanding upon vesting.
The Company recognizes deferred tax assets and liabilities for any basis differences in its assets and liabilities between tax and GAAP reporting, and for operating loss and credit carry-forwards. In light of the Company’s history of cumulative net operating losses and the uncertainty of their future utilization, the Company has established a valuation allowance to fully offset its net deferred tax assets as of December 31, 2014 and 2013.
Derivative Financial Instruments
We do not use derivative instruments to hedge exposures to cash flow, market or foreign currency risks. We evaluate all of our financial instruments to determine if such instruments are derivatives or contain features that qualify as embedded derivatives. For derivative financial instruments that are accounted for as liabilities, the derivative instrument is initially recorded at its fair market value and then is revalued at each reporting date, with changes in fair value reported in the consolidated statement of operations. The methodology for valuing our outstanding warrants classified as derivative instruments utilizes a lattice model approach which includes probability weighted estimates of future events including volatility of our common stock. A financial asset or liability’s classification within the hierarchy is determined based on the lowest level input that is significant to the fair value measurement. The warrant liability is measured at fair value using certain estimated factors such as volatility and probability which are classified within Level 3 of the valuation hierarchy. Significant unobservable inputs are used in the fair value measurement of the Company’s derivative warrant liabilities include volatility. Significant increases (decreases) in the volatility input would result in a significantly higher (lower) fair value measurement. A 10% increase or decrease in the volatility factor used as of December 31, 2014 would have the impact of increasing or decreasing the liability by approximately $22,000.
The classification of derivative instruments, including whether such instruments should be recorded as liabilities or equity, is evaluated at the end of each reporting period. Derivative instrument liabilities are classified in the balance sheet as current or non-current based on whether or not net-cash settlement of the derivative instrument could be required within twelve months of the balance sheet date.
Inflation did not have a material effect on our operating results for the years ended December 31, 2014 and 2013.
Off-Balance Sheet Arrangements
We do not have any off-balance sheet arrangements as defined by Item 303(a)(4) of Regulation S-K.
MAPH Enterprises, LLC | (305) 414-0128 | 1501 Venera Ave, Coral Gables, FL 33146 | firstname.lastname@example.org