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Monday, February 22, 2016

Fourth Quarter Results Show What's To Come For 22nd Century Group

On February 18, 2016, 22nd Century Group, Inc. (NYSE MKT: XXII) filed its Form 10K annual report for the year ending December 31, 2015. Early this morning the company held a conference call to provide an update for shareholders. Given that the company's two key cigarette brands, MAGIC® and RED SUN®, are still in the early stages of the launch, the most important questions for shareholders to focus on are What's the trajectory of the ramp? and Is the company meeting expectations? I provide answers to these questions and give a brief update following the filing of the annual report below.

We See The Smoke

Let's start with answering the second question first. 22nd Century Group reported revenues in the fourth quarter 2015 of $2.93 million. This compared to negligible revenues in the fourth quarter 2014. I forecasted revenues of $2.70 million in the fourth quarter 2015, so the $2.93 million beat my model. The number also exceeded that of the only estimate posted on Capital-IQ of $2.55 million (Chardan), so for all intents and purposes, 22nd Century exceed consensus expectations as well.

Revenues in the quarter came primarily from three sources, sales of MAGIC® brand cigarettes in Europe, sales of RED SUN® cigarettes in the U.S., and contract manufacturing of third-party branded tobacco products at the company's 61,000 square foot production facility in North Carolina.

MAGIC® is the company's very low nicotine (VLN) tobacco cigarette that contains approximately 95% less nicotine than in leading conventional brand cigarette. Data published in the New England Journal of Medicine shows that individuals who smoked VLN cigarettes during a randomized controlled trial ended up smoking fewer cigarettes per day after six weeks compared to the start of the trial, exposing themselves to less toxic smoke and tar on a daily basis. MAGIC® is a concept that the former U.S. FDA commissioner, Dr. David Kessler, MD, JD, summed up rather nicely in a public comment in June 2010, stating, "The FDA should quickly move to reduce nicotine levels in cigarettes to non-addictive levels. If we reduce the level of the stimulus, we reduce craving. It is the ultimate harm reduction strategy." Beyond the above trial, six other clinical studies support the harm reduction concept of VLN cigarettes. I reviewed these studies in an article for investors posted in January 2016.

RED SUN® is a super-premium brand cigarette that offers the highest nicotine content of any cigarette sold in America. The concept of RED SUN®, somewhat counter to MAGIC®, is that some smokers do not want to quit, and instead are searching for bold and aggressive flavor. The RED SUN® website markets the product to the "unapologetic smoker" who "deserves the best tobacco has to offer". The product is sold at premium tobacco outlets, including Smoker Friendly, a retail chain with more than 800 locations around the U.S. It's the craft beer craze, only with premium tobacco. If MAGIC® is Michelob Ultra, then RED SUN® is a micro-brew double-bach or triple IPA. It is to standard cigarettes what Heady Topper is to Budweiser or a 30-year-old Macallan Fine Oak is to Jim Beam.

22nd Century Group does not break out revenue segments, but considering the distribution of MAGIC® only commenced in September 2015, I assume the bulk of the revenue in the fourth quarter was from RED SUN® and contract manufacturing for third parties. The company makes private label brand cigarettes for premium outlets, including Smoker Friendly.

Also during the quarter, the company shipped approximately 40% of the 4.95 million SPECTRUM® cigarettes order received from the National Institute on Drug Abuse (NIDA) in September 2015. As a reminder, in August 2015, affiliates from NIDA, the U.S. National Cancer Institute (NCI), and the U.S. Centers for Disease Control and Prevention (CDC) met with RTI International and 22nd Century Group to design “research cigarettes” with varying levels of nicotine, to be sold in the U.S. market designed so that the U.S. government can better understand smoking habits and addiction.

Since the initial sub-contract, approximately 22 million SPECTRUM® brand cigarettes, in 24 styles with eight varying levels of nicotine, have been ordered to date. During the fourth quarter, revenues from SPECTRUM® totaled $0.24 million. In January 2016, the remaining 60% of the order was shipped, generating $0.33 million in additional revenue for the company. 22nd Century Group was selected to participate in this study due to the company's unique proprietary technology and ability to grow tobacco across a wide spectrum of nicotine levels. The company owns over 200 issued patents and has 50 new applications pending. The monopoly that 22nd Century has to significantly alter the nicotine content in tobacco means that the company is the sole source of such unique products.

The $2.93 million in revenue during the fourth quarter 2015 was not enough to drive the company to profitability. In fact, these revenues barely covered the gross production costs of $2.92 million during the quarter due to, fixed costs, excise tax, and regulatory fees. For the full year 2015, revenues totaled $8.52 million and costs of goods totaled $9.10 million, with $5.70 million of that excise tax and regulatory fees. These are fees that the company believes will become a smaller percent of revenues as the top-line continues to ramp in the coming quarters.

With respect to fixed costs, the company's 61,000 square foot manufacturing facility in North Carolina is far below capacity, so growing RED SUN® and finding additional third parties where 22nd Century can be the private label manufacturer is paramount to seeing gross margin improvement. The facility contains over $3 million in production and manufacturing equipment, and right now the business is only operating at levels just above the fixed costs. This presents the opportunity for leverage as the business grows. For reference, three of the world's biggest tobacco manufacturers, AltriaGroup/Philip Morris, Reynolds American, and British American Tobacco, averaged between 50% and 60% gross profit over the past six to eight quarters. I suspect this is the level where 22nd Century Group will ultimately be as revenues continue to ramp.

In the meantime, 22nd Century Group lost $0.04 per share in the fourth quarter, an improvement from the $0.09 loss in the fourth quarter 2014. Cash at the end of the quarter stood at $3.76 million; however, in February 2016 the company raised $5.14 million in cash through a private placement of common stock at $1.10 per share.

Soon We See The Fire

However, the questions that investors really want to know the answer to is, Where is the top-line heading over the next few years?

Earlier in the year, management provided guidance for expected product revenues in 2016. The company expects product sales from MAGIC® and RED SUN® to exceed $12.0 million. I model revenues in 2016 of $12.5 million, up 47% from the reported $8.52 million in 2015. I think the ramp is just beginning, and that ultimately RED SUN® is a $150 million product in the U.S. in the next several years.

One of the primary reasons for my confidence that the rollout of RED SUN® will continue to gain steam in the coming years is because of the management team at 22nd Century. The current CEO at 22nd Century, Henry Sicignano, previously served as the Vice President and Marketing Director at Santa Fe Natural Tobacco, maker of the American Spirit brand, from 1997-2002. Mr. Sicignano helped grow Santa Fe annual revenue from $30 million to $145 million before the company was acquired by R.J. Reynolds for $356 million in July 2002. The marketing message of American Spirt was "all natural" and "100% additive-free" tobacco.

American Spirt® is the perfect model for RED SUN®. Both products play to the bold and aggressive flavor smokers can expect from a super premium brand. American Spirt's edge is its claim that the tobacco is 100% additive-free natural tobacco. The interest in the American Spirt brand is analogous to consumers shopping for "organic" foods. Yes, smoking causes harm, but some smokers are still keenly interested in an additive-free product. I've already covered the marketing message for RED SUN® above. Craft beer is hot right now, as are gourmet potato chips and premium barbecue sauces. People want quality. For example, high-end cigars have always appealed to smokers; I think we are on the verge of seeing this with RED SUN® cigarettes. The product appeals ideally to the high-end smoker looking for and willing to pay more for quality. With $150 million in peak sales, RED SUN® would still only control 0.2% of the U.S. cigarette market.

MAGIC® is at the opposite end of the market. It's for the smoker looking to kick the habit, and based on market research, that's nearly 50% of the entire $75 billion U.S. market. For example, according to a report published by JP Morgan in 2005, 90% of smokers would be willing to try a new brand if it were “safer” than their usual brand. Recall, "light" and "ultra-light" cigarettes had 83.5% of the market prior to 2010 when the Tobacco Control Act, which gave the U.S. FDA broad authority to regulate the manufacture, distribution, and marketing of tobacco products in the U.S., banned the use of such terms.

It is important for investors to understand, 22nd Century Group cannot claim that MAGIC® offers reduced risk or help you quit smoking relative to standard cigarettes. The marketing message around MAGIC® in Europe is simply that the product has very low nicotine. For the company to claim smoking VLN cigarettes leads to reduced risk to smokers or can be used to aid in the cessation of smoking, the U.S. FDA must get involved. 

On December 31, 2015, 22nd Century Group filed a modified risk tobacco product (MRTP) application with the Center for Tobacco Product (CTP) division of the U.S. FDA for Brand-A, the code-name for a new very low nicotine cigarette for the U.S. market. The MTRP application, which will be reviewed by the agency much like a new drug application (NDA) or biologic licenses application (BLA), if approved, opens the door to potentially tens of millions of American smokers looking to reduce harm from smoking.

I took a look at the market potential for Brand-A in an article last month for investors. The numbers are staggering. Approximately 18% of American's smoke. That's nearly 60 million people who smoke 265 billion cigarettes per year. Nearly 50% of all smokers in the U.S. attempt to quit on a regular basis, but only 2-5% will succeed per year. The average number of attempts before success is between 8 and 11 attempts. According to the U.S. CDC, 12.6% of smokers tried e-cigarettes in 2014. Over the counter sales of nicotine gums, patches, and lozenges totaled $2.4 billion in 2014. Pfizer's Chantix® (varenicline) posted sales of $671 million last year and cumulatively has posted over $6 billion since its approval in 2006. The smoking cessation market is enormous, and according to JP Morgan, 90% of smokers would be interested in a product like Brand-A. A prescription version of Brand-A, dubbed X-22, is also under clinical development.


I'm encouraged by the quick response and interest from the U.S. FDA on 22nd Century Group's MRTP application. Recall, the FDA requested a meeting with the company and 42 members of the agency's staff only a week after the MRTP application was filed. I think Brand-A intrigues the agency, and the evidence supports government interest in this area with SPECTRUM®. I'm not expecting final approval of Brand-A until the fourth quarter of 2016, but I fully expect the product to become a sizable player in the U.S. market once commercialized. 

For example, Altria Group (NYSE: MO) holds approximately 45% of the U.S. retail market for cigarettes. The recently merged Reynolds American (NYSEMKT: RAI) and Lorillard control another 35% of the market. A product like Brand-A is very interesting in the hands of the big boys looking to hold onto market share and stay on top. If approved, Brand-A would be the first MRTP on the market and the industries biggest players might like having that niche in their pocket. It's also potentially very interesting to tertiary players like Imperial Tobacco, British American Tobacco (NYSEMKT: BTI), and Japan Tobacco looking to gain share in the U.S. with a disruptive technology. Recall, 22nd Century Group already has a licensing agreement with British American Tobacco to research and develop altering levels of nicotinic alkaloids in tobacco plants.

In the meantime, we can use the aforementioned industry leaders to try to get a sense of what 22nd Century Group is worth today. The company trades with a market capitalization of only $80 million. As noted above, the company put out guidance expecting revenues in 2016 of at least $12 million. That equates to an EV-to-EBITDA ratio of 6.7x, comparable to Altria at 6.2x, Reynolds at 5.7x, and BAT at 5.6x, and this includes no contribution from Brand-A and RED SUN® tracking at less than 5% of what I ultimately believe are the products peak sales. The launch of MAGIC® only just took place, and management is working through supply issues before commencing full distribution in Europe commences, but the opportunity there is tremendous as well. 

Quite simply, I think investors can buy 22nd Century Group today and pay essentially fair-value for a commercial business at its infancy. Investors almost never have the opportunity to pay fair value for a biotech company on the verge of a blockbuster product approval. Valuation of a pre-commercial biotech company involves a lesson in existential philosophy as much as it does algebra and financial modeling. Understanding the value of 22nd Century Group is simply paying fair value today and then watching the trajectory and expectations.

If RED SUN® follows the path of its distant relative, American Spirt, revenues could be up ten-fold in the next few years. If Brand-A is approved and captures just 10% of the market from e-cigarettes, it too is a $150 million product. If 1% of the roughly 60 million Americans looking to quit tries Brand-A to help reduce cravings, it's a multi-billion dollar product. 

That being said, at its heart, 22nd Century Group is a plant biotechnology company, with proprietary technology protected by over 200 issued patents and 50 pending applications. The company's expertise in transcription factors and gene regulation allows for the production of varying levels of nicotine in tobacco. This is the technology behind RED SUN®, MAGIC®, Brand-A, Brand-B, and X-22, and I believe it will ultimately prove far more valuable than the sales these products are generating today.


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