$XXII Form 10-K

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Form 10-K for 22ND CENTURY GROUP, INC.


18-Feb-2016

Annual Report

Item 7. Management’s Discussion and Analysis of Financial Condition and
Results of Operations.This discussion should be read in conjunction with the other sections of this Form 10-K, including “Risk Factors,” and the Financial Statements. The various sections of this discussion contain a number of forward-looking statements, all of which are based on our current expectations and could be affected by the uncertainties and risk factors described throughout this Annual Report on Form 10-K. See “Forward-Looking Statements.” Our actual results may differ materially. For purposes of this Management’s Discussion and Analysis of Financial Condition and Results of Operations, references to the “Company,” “we,” us” or “our” refer to the operations of 22nd Century Group, Inc. and its direct and indirect subsidiaries for the periods described herein.

Business Overview

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 more than 200 issued patents plus more than an additional 50 pending patent applications.

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 cannabidiol, or CBD, and other non-THC cannabinoids for the legal medical marijuana markets and (iii) plants with high levels of THC for the legal recreational cannabis market.

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.

Recent Developments

During the fourth quarter of 2015, the following occurred:

� We submitted our Modified Risk Tobacco Product application with the Center for Tobacco Products of the FDA seeking a reduced exposure order so that our “BRAND A” VLN cigarettes may be introduced into commerce in the United States with packaging and marketing that discloses to consumers that BRAND A cigarettes have 95% less nicotine that conventional cigarettes and, as a result, reduces smokers’ exposure to nicotine. BRAND A cigarettes contain less than 0.6 milligrams of nicotine per cigarette and less than 0.05 milligrams of nicotine yield per cigarette. We are the only entity in the world capable of growing virtually nicotine-free tobacco plants.

� The New England Journal of Medicine published two different articles related to our proprietary SPECTRUM research cigarettes. The first article reported on the results of a landmark, double-blind, parallel, randomized clinical trial involving 840 smokers at ten locations that demonstrated the Company’s very low nicotine cigarettes were found to reduce exposure to, and dependence on, nicotine and to reduce cravings. The study was funded by the FDA and the National Institute on Drug Abuse (“NIDA”). The study found that smokers of our SPECTRUM cigarettes consumed far fewer cigarettes per day and doubled their quit attempts versus smokers of conventional cigarettes, all with minimal withdrawal symptoms and without compensatory smoking or any serious adverse events.

� We completed and shipped a substantial portion of the most recent purchase order from NIDA of approximately 5 million SPECTRUM research cigarettes for use in further independent clinical studies on smoking cessation and the nicotine addictive threshold in cigarettes.

� We strategically hired Dr. Paul Rushton as our new Vice President of Plant Biotechnology. Dr. Rushton is uniquely qualified to grow and commercialize our patent portfolio relating to both tobacco and cannabis. Dr. Rushton has extensive experience in tobacco biotechnology, including work at the University of Virginia on our sponsored research projects, as well as nearly a decade working at the world-renowned Max Planck Institute for Plant Breeding in Germany.

� We entered into a new cannabis research collaboration with strategic partner Anandia. As a part of this research collaboration, Anandia will develop and grow proprietary cannabis strains under its licenses in Canada that express highly desirable characteristics and that we expect will lead to exciting commercialization opportunities. We announced last year that we had entered into a worldwide license agreement with Anandia that granted exclusive rights to us in the United States to four genes required for cannabinoid production in the cannabis plant. The license also granted us co-exclusive rights with Anandia to this proprietary technology in all countries outside of the U.S. and Canada. Anandia retained exclusive rights in Canada. The proprietary technology licensed from Anandia allows for the development of cannabis strains that demonstrate either an increase or decrease in the production and content of all, or certain subsets of, cannabinoids. The long-term goals of our research activities relating to cannabis are to develop, protect and commercially produce unique cannabis plant varieties that include high levels of non-THC cannabinoids, such as CBD, for the legal medical marijuana markets, as well as virtually cannabinoid-free cannabis for the commercial hemp industry.

� We strategically hired a full-time FDA expert, Gregg Gellman, as our new Director of Business Development and Regulatory Affairs. Mr. Gellman was a key member of our team of professionals who worked diligently on creating, completing and submitting our Modified Risk Tobacco Product application with the FDA seeking a reduced exposure order so that our “BRAND A” very low nicotine cigarettes may be introduced into commerce in the United States with packaging and marketing that discloses to consumers that BRAND A has 95% less nicotine that conventional cigarettes and, as a result, reduces smokers’ exposure to nicotine.

� We exported multiple varieties of our proprietary tobacco seeds to Central America for testing and expanded agricultural production of our proprietary tobacco plants for the purpose of making additional seeds for future plantings of increased amounts of our proprietary tobacco in the U.S. and other parts of the world. The United States Department of Agriculture (“USDA”) issued a phytosanitary certificate to us to facilitate our export of our proprietary tobacco seeds to growers in Central America.

� We commenced our search for and collaboration discussions with universities in Western New York at which we are seeking to open specialized laboratories dedicated to new scientific research at substantially lower costs than sponsored research projects at third-party universities. Dr. Paul Rushton, our Vice President of Plant Biotechnology, will lead this new scientific initiative. The new laboratories are intended to accelerate the development of new nicotine-free tobacco varieties as well as the invention of other important tobacco products.

In the year 2016, we anticipate that we will be able to achieve the following:

� We will continue to work to have our Modified Risk Tobacco Product application approved in 2016 so that our “BRAND A” very low nicotine cigarettes may be introduced into commerce in the United States with packaging and marketing that discloses to consumers that BRAND A has 95% less nicotine that conventional cigarettes and, as a result, reduces smokers’ exposure to nicotine.

� We will plan “proof of concept” exposure studies for “BRAND B” extremely low tar-to-nicotine ratio cigarettes. If the results of these exposure studies allow, and provided sufficient funds are available, we will begin work on a Modified Risk Tobacco Product application for “BRAND B” cigarettes that may ultimately be introduced into commerce in the United States with packaging and marketing that discloses to consumers that the “BRAND B” exposes smokers to substantially less “tar” and substantially less smoke than the current market leading brands in the United States.

� We will continue to identify and meet with pharmaceutical companies, national retail chains and other significant potential strategic partners in our on-going efforts to contract with a third party to fund Phase III clinical trials for X-22. We believe X-22 is more effective than any current smoking cessation therapy on the market and presents smokers with no new side effects and minimal or no withdrawal symptoms. We also believe that smokers will overwhelmingly prefer the prospect of attempting to quit smoking using our very low nicotine cigarettes over Chantix� and all nicotine replacement therapies (“NRT’s”).

� We will further continue to work on expanding our RED SUN product sales in the United States and MAGIC brand sales in Europe while exploring opportunities for our products in Asia. Several important regional distributors have already inquired about securing distribution rights for our VLN products in Asia. Asia represents a significant market for our Company’s unique tobacco products.

� We will work to bring in additional work into our factory in North Carolina, which is now underutilized because our factory capacity is greater in size and cost than what is currently required by our operations. However, the vertical integration provided by our factory allows us to promptly, accurately and strategically produce our own proprietary, highly specialized products and the factory gives us the independence and self-determination to produce our proprietary products in a very competitive, increasingly regulated retail marketplace. Our factory also allows us to fulfill our contracts to produce SPECTRUM research cigarettes, and to bring in new contract manufacturing business.

We will further continue to work on expanding our product sales in Europe and launching our products in Asia and in the Middle East. Several important regional distributors have already inquired about securing distribution rights for our VLN products in Asia and the Middle East. Both Asia and the Middle East represent significant markets for our Company’s unique tobacco products.

Registered Direct Offering

On February 5, 2016, we closed a registered direct offering of 5,000,000 shares of common stock and warrants to purchase up to 2,500,000 shares of common stock at an exercise price of $1.21 per share. The purchase price per unit was $1.10 and resulted in net proceeds of approximately $5.1 million. We expect cash on hand and the results of this offering to be sufficient to fund operations through October 2016. Accordingly, we will be required to raise additional capital to fund operations and achieve FDA approval of our products.

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, 2015 Compared to Year Ended December 31, 2014 and Year Ended December 31, 2014 Compared to Year Ended December 31, 2013

Revenue – Sale of products.

2015 vs. 2014

We realized net revenue from the sale of products in the amount of $8,521,998 during the year ended December 31, 2015, as compared to net revenues of $528,991 during the year ended December 31, 2014, an increase of $7,993,007. Included in net revenue were sales of SPECTRUM research cigarettes in the amount of $242,658 and $447,535 for the years ended December 31, 2015 and 2014, respectively. The increase for 2015 was due to the sale of products from the continued growth of the manufacturing operations in our North Carolina factory as we transitioned from our pre-manufacturing status during the majority of 2014.

2014 vs. 2013

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.

Revenue – Royalties from licensing.

2015 vs. 2014

During the years ended December 31, 2015 and 2014, we realized no revenue from licensing activities.

2014 vs. 2013

During the year ended December 31, 2014, we realized no revenue from licensing activities. During the year ended December 31, 2013 we realized royalty revenue of $7,000,000 from the worldwide Research License and Commercial Option Agreement entered into with BAT.

Costs of goods sold – Products.

2015 vs. 2014

During the year ended December 31, 2015, cost of goods sold were $9,102,560 or 106.8% of net revenue. Excise taxes and certain regulatory fees in the approximate amount of $5,703,000 are included in the cost of goods sold. We were not operating the factory at full production capacity during 2015. As a result, the cost of goods sold, which included the cost of raw material components, direct manufacturing costs and an overhead allocation, was in excess of net sales revenue.

In the year ended December 31, 2014, costs of goods sold were $252,002 or 47.6% of revenue. The cost of goods sold consisted of $177,696 relating to the production of theSPECTRUM research cigarettes and $74,306 relating to the manufacture of the filtered cigars.

2014 vs. 2013

In the year ended December 31, 2014, costs of goods sold were $252,002 or 47.6% of revenue. The cost of goods sold consisted of $177,696 relating to the production of theSPECTRUM research cigarettes and $74,306 relating to the manufacture of the filtered cigars. In the year ended December 31, 2013, cost of goods sold were $48,105 or 17.3% of revenue.

Costs of goods sold – Royalties for licensing.

2015 vs. 2014

During the years ended December 31, 2015 we realized no revenue from licensing activities and accordingly there were no associated costs. We did not realize any revenues from licensing activities during the year ended December 31, 2014, however, we revised an estimate of the royalty fee due in conjunction with licensing revenue received from BAT in 2013 resulting in cost of goods sold in the amount of $246,434. See the discussion below in the 2014 vs. 2013 comparison for additional details.

2014 vs. 2013

During the year ended December 31, 2014, we revised the estimate of the royalty fee due to the National Research Council of Canada (“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.

Research and development expense.

2015 vs. 2014

Research and development expense was $1,669,387 for the year ended December 31, 2015, an increase of $420,380 or 33.7%, from $1,249,007 for the year ended December 31, 2014. This increase was primarily a result of an increase in costs associated with our BRAND A modified risk application filed with the FDA in the approximate amount of $343,000, an increase in payroll related costs of approximately $50,000, a net increase in R&D contract costs, sponsored research costs, and patent maintenance costs of approximately $209,000, and an increase in the amortization of various license fees of approximately $65,000, partially offset by a decrease in equity based compensation in the approximate amount of $164,000, during the year ended December 31, 2015, as compared to the year ended December 31, 2014.

2014 vs. 2013

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.

2015 vs. 2014

General and administrative expense was $7,760,127 for the year ended December 31, 2015, a decrease of $1,063,407, or 12.1%, from $8,823,534 for the year ended December 31, 2014. The decrease was primarily due to decreases in employee equity based compensation of approximately $909,000, employee related costs of approximately $147,000, legal and accounting fees of approximately $592,000, costs relating to press releases of approximately $91,000, NYSE MKT related costs of approximately $66,000, costs associated with the severance liability of approximately $637,000, and director fee costs of approximately $62,000, partially offset by increases in equity based compensation and cash payments to third-party service providers of approximately $23,000 and $758,000, respectively, and expenses incurred by our factory of approximately $627,000, during the year ended December 31, 2015 as compared to the year ended December 31, 2014.

2014 vs. 2013

General and administrative expense was $8,823,534 in the year ended December 31, 2014, an increase of $4,716,840, or 114.9%, from $4,106,694 in the year ended December 31, 2013. The increase was primarily due to increases in employee equity 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 $202,000, partially offset by decreases in equity 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.

2015 vs. 2014

There were no pre-manufacturing costs for the year ended December 31, 2015. During the year ended December 31, 2014, we incurred various expenses related to preparing the warehouse and manufacturing facility, which amounted to $1,176,676 and consisted primarily of expenses for salaries and benefits for employees, sub-contract labor, rent, utilities and other miscellaneous costs.

2014 vs. 2013

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.

Sales and marketing costs.

2015 vs. 2014

Sales and marketing costs were $1,357,518 for the year ended December 31, 2015, an increase of $1,271,588, or 1,479.8%, from $85,930 for the year ended December 31, 2014. The increase in the sales and marketing costs were primarily the result of costs incurred to launch our proprietary cigarette brands, RED SUN and MAGIC, in the U.S. and Europe, respectively, and to grow our contract manufacturing business. Sales and marketing costs include payroll for sales and customer service personnel, point of sale materials, trade shows, advertising, promotional campaigns and travel related expenses for our sales personnel.

2014 vs. 2013

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 SUN packaging design costs, and materials used for marketing trips to Europe and Asia.

Depreciation.

2015 vs. 2014

Depreciation expense for the year ended December 31, 2015 amounted to $319,699, an increase of $89,687, or 39.0%, from $230,012 for the year ended December 31, 2014. This increase is primarily due to a full year of depreciation taken in 2015 on the cigarette manufacturing equipment as compared to depreciation taken in 2014 for only three-quarters of the year.

2014 vs. 2013

Depreciation expense for the year ended December 31, 2014 amounted to $230,012, an increase of $226,984 from $3,028 for the year ended December 31, 2013. This increase is primarily due to approximately $2.9 million of cigarette manufacturing equipment placed in service during the second quarter of 2014.

Amortization.

2015 vs. 2014

Amortization expense, relating to amortization taken on capitalized patent costs, for the year ended December 31, 2015 amounted to $356,590, an increase of $123,830, or 53.2%, from $232,760 for the year ended December 31, 2014. The increase is primarily due to amortization on additional patent costs incurred during the years ended December 31, 2015 and 2014 in the amounts of $654,069 and $1,780,596, respectively.

2014 vs. 2013

Amortization expense, relating to amortization taken on capitalized patent costs, for the year ended December 31, 2014 amounted to $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 due to amortization on additional investments in patent costs during the years ended December 31, 2014 and 2013 in the amount of $1,780,596 and $269,742, respectively, partially offset by a change in the estimated useful lives of one of the patent families during the year ended December 31, 2013.

Warrant liability gain (loss) – net.

2015 vs. 2014

The warrant liability gain of $144,550 for the year ended December 31, 2015 was due to the decrease in the estimated fair value of the warrants during the period. The decrease in the estimated fair value of the warrants was primarily attributable to a decrease in the Company’s underlying stock price from $1.65 per share at December 31, 2014, as compared to $1.40 per share at December 31, 2015, and with certain warrants aging closer to their expiration dates with the passage of time.

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.

2014 vs. 2013

The warrant liability loss of $3,676,691 for the year ended December 31, 2014 was described in the above comparison of 2015 to 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.

Warrant amendment inducement expense.

2015 vs. 2014

There was no warrant inducement expense for the year ended December 31, 2015. In March 2014, we entered into warrant amendments with existing warrant holders with the goal of reducing our warrant liability by offering certain financial inducements to such warrant holders. We calculated the cost of inducement as the difference between the fair value of the warrants immediately after the warrant amendments closed, less the fair value of the warrants immediately prior to the closing of the warrant amendments. We estimated the total cost of inducement to be $144,548 for the year ended December 31, 2014.

2014 vs. 2013

During the fourth quarter of 2013, we initiated a warrant amendment program with existing warrant holders with the goal of reducing our warrant liability by offering certain financial inducements to such warrant holders. We calculated the cost of inducement as the difference between the fair value of the warrants immediately after the warrant amendments closed, less the fair value of the warrants immediately prior to the closing of the warrant amendments. We estimated the total cost of inducement to be $3,736,313 for the year ended December 31, 2013. As discussed above, the warrant amendment inducement expense was $144,548 for the year ended December 31, 2014.

Litigation proceeds.

2015 vs. 2014

On April 10, 2015, we entered into a settlement of legal disputes with an . . .

 

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