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XXII > SEC Filings for XXII > Form 10-K on 18-Mar-2013All Recent SEC Filings

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


18-Mar-2013

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 Report, 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.

On January 25, 2011, 22nd Century Limited, LLC completed a reverse merger transaction (the "Merger") with 22nd Century Group, Inc. 22nd Century Limited, LLC is a wholly owned subsidiary of 22nd Century Group, Inc. which continues to operate the business of 22nd Century Limited, LLC. All references to shareholders or common shares include the historical members and membership Units of 22nd Century Limited, LLCbecause, in the Merger, such Units were exchanged for common shares on a one-for-one basis and from an accounting standpoint, they are equivalent. The Merger is being accounted for as a reverse acquisition and a recapitalization; 22nd Century Limited, LLC is the acquirer for accounting purposes. Consequently, the assets and liabilities and the historical operations that are reflected in the financial statements prior to the Merger are those of 22nd Century Limited, LLC and are recorded at the historical cost basis of 22nd Century Limited, LLC, and the consolidated financial statements since completion of the Merger include the assets and liabilities of 22nd Century Limited, LLC, historical operations of 22nd Century Limited, LLC and operations of 22nd Century Group, Inc. from the closing date of the Merger. 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.

Recent Developments

Private Placement of Preferred Stock and Warrants

On January 11, 2013, we entered into and closed the transactions described in a Securities Purchase Agreement with certain accredited investors identified therein (collectively, the "Purchasers"), whereby we sold 2,500 shares of newly created Series A-1 10% Convertible Preferred Stock (the "Series A-1 Preferred Stock") and Warrants (as defined below) for an aggregate purchase price of $2,500,000. The Company realized net proceeds of approximately $2.125 million. We also entered into a Registration Rights Agreement whereby we agreed to file a registration statement to register the resale of the shares of our common stock that are potentially issuable under each of the securities described below.

The shares of Series A-1 Preferred Stock are initially convertible into a total of 4,166,666 shares of the Company's common stock at a conversion price of $0.60 per share (the "Conversion Price"), subject to future adjustments based on the market value of our common stock during prescribed periods and upon certain events. The Series A-1 Preferred Stock will pay a 10.0% annual cash dividend, which may be payable in shares of our common stock in certain circumstances, and will have a liquidation preference equal to the stated value of the Series A-1 Preferred Stock of $1,000 per share plus any accrued and unpaid dividends thereon. The Series A-1 Preferred Stock has no voting rights.

The Series A-1 Preferred Stock has been issued subject to certain negative covenants, which are restrictions on the Company that will remain in effect for as long as any shares of Series A-1 Preferred Stock are outstanding, unless the holders of at least 67% in stated value of the then outstanding shares of Series A-1 Preferred Stock have otherwise given prior written consent.

We also issued to the Purchasers a Series A warrant (the "Series A Warrant"), a Series B warrant (the "Series B Warrant"), and a Series C warrant (the "Series C Warrant") (with the Series A Warrant, Series B Warrant and Series C Warrant being collectively referred to herein as the "Warrants"). The Series A Warrant allows the Purchasers the right to acquire, initially before any adjustments to the conversion price, up to an additional 4,166,666 shares of the Company's common stock at an exercise price of approximately $0.72 per share over a period of five (5) years. The Series A Warrant also allows for such warrant to be exercised on a cashless basis. The Series B Warrant allows the Purchasers a one-year period to exercise an overallotment option as contained in the Series B Warrant to purchase, initially before any adjustments to the conversion price, up to an additional aggregate of 2,083,334 shares of the Company's common stock at a price of $0.60 per share. The Series B Warrant may not be exercised on a cashless basis except only in certain limited circumstances. In the event the Purchasers exercise, in whole or in part the overallotment option as contained in the Series B warrant, then the Purchasers shall have the right to exercise on a pro rata basis the portion of the Series C Warrant issued to the Purchasers to acquire, initially before any adjustments to the conversion price, up to an additional aggregate of 2,083,334 shares of the Company's common stock at an exercise price of approximately $0.72 per share over a period of five (5) years. The Series C Warrant allows for such warrant to be exercised on a cashless basis.

The Series A-1 Preferred Stock and the Warrants contain exercise and conversion limitations providing that a holder thereof may not convert or exercise (as the case may be) to the extent that, if after giving effect to such conversion or exercise (as the case may be), the holder or any of its affiliates would beneficially own in excess of 9.99% of the outstanding shares of common stock immediately after giving effect to such conversion or exercise (as the case may be).

From January 1, 2013 through February 6, 2013, convertible notes that were issued on December 14, 2011(the "Convertible Notes") with a carrying value at December 31, 2012 of approximately $1.41 million were converted into 2,035,720 shares of common stock and warrants to acquire 2,662,769shares of common stock. While both these steps significantly improved the Company's financial position, we will need additional financing or one or more licensing arrangements for its technology and products in order to complete the cash requirements to fund operations and meet its obligations during 2013. There can be no assurance that the Company will be able to raise sufficient financing or obtain a significant licensing agreement.

Overview

22nd Century Ltd, our wholly-owned subsidiary, is a plant biotechnology company and we believe the global leader in modifying the content of nicotinic alkaloids in tobacco plants through genetic engineering and plant breeding. We own or exclusively control 107 issued patents and exclusively control 39 patent applications; we own 12 issued patents plus 22 patent applications and we license on an exclusive basis 95 issued patents and 17 patent applications. Hercules Pharmaceuticals, LLC ("Hercules Pharmaceuticals") and Goodrich Tobacco Company, LLC ("Goodrich Tobacco") are wholly-owned subsidiaries of 22nd Century Ltd. Goodrich Tobacco is focused on commercial tobacco products and potential Modified Risk cigarettes. Hercules Pharmaceuticals is focused on X-22, a prescription smoking cessation aid in development.

We believe that our proprietary technology will enable us to capture a share of the global market for approved smoking cessation aids and the emerging market for modified risk tobacco products. The Company is primarily involved in the following activities:

The international licensing of 22nd Century Ltd's technology, proprietary tobaccos, trademarks and brands;

The development of its X-22 prescription smoking cessation aid in development;

The development of its modified risk tobacco products;

The pursuit of necessary regulatory approvals and clearances at the U.S. Food and Drug Administration (the "FDA") to market X-22 as a prescription smoking cessation aid and BRAND A and BRAND B as Modified Risk Cigarettes in the U.S.;

The manufacture, marketing and distribution of RED SUN and MAGIC proprietary cigarettes; and

The production of SPECTRUM research cigarettes for the National Institute on Drug Abuse ("NIDA").

We have operated at a loss since 2006 when we increased our research and development expenditures. In the years ended December 31, 2012, 2011 and 2010 we realized revenues of $18,775, $788,601 and $49,784, respectively mainly from our research cigarette program, and in 2009 we realized sales of $27,612 from limited test marketing of our cigarettes. We are in the process of transitioning from solely developing proprietary technology and tobacco to developing and commercializing our own technology and products.

Our prospects depend on our ability to generate and sustain revenues from (i) sales of RED SUN and MAGIC, our X-22 smoking cessation aid, our potential Modified Risk cigarettes and our proprietary tobacco and (ii) licensing of our technology and products. Our ability to generate meaningful revenue from X-22, especially in the United States, depends on FDA approval, and our ability to generate meaningful revenue from our potential Modified Risk cigarettes in the U.S. depends in large part on obtaining FDA authorization to market these products as Modified Risk cigarettes. If our products are approved and authorized by the FDA, we must still meet the challenges of successful marketing and distribution and consumer acceptance. We are currently in the process of identifying potential joint venture partners to fund the remaining X-22 clinical trials. There is no guarantee that we will (i) obtain the funds necessary to complete additional clinical trials, (ii) identify potential joint venture partners to fund the remaining X-22 clinical trials, (iii) obtain FDA approval, or (iv) capture significant share of the smoking cessation market upon FDA approval.

In March 2011, our subsidiary, Goodrich Tobacco introduced two of our products, RED SUN and MAGIC cigarettes into U.S. commerce. Goodrich Tobacco has thus far had its brands contract manufactured by a non-participating manufacturer to the "Master Settlement Agreement" or "MSA," a settlement among 46 states and the tobacco industry administered by the National Association of Attorneys General ("NAAG"). After attempting throughout 2012 to negotiate a contract manufacturing agreement with multiple participating manufacturers to the MSA to have RED SUN and MAGIC produced by a participating manufacturer to the MSA, and not coming to terms, on January 23, 2013, Goodrich Tobacco applied to the Alcohol and Tobacco Tax Trade Bureau ("TTB") for a federal permit to manufacture its own tobacco products. Being a federally licensed tobacco product manufacturer is a primary requirement of becoming a participating manufacturer of the MSA. On February 26, 2013, Goodrich Tobacco applied to the NAAG to become a participating manufacturer to the MSA. Both of these measures, if approved by the TTB and NAAG, will greatly facilitate the sales and distribution potential of RED SUN and MAGIC. To facilitate Goodrich Tobacco becoming a participating manufacturer of the MSA, we have curtailed the sales and marketing of these products, especially in 2012 because the more RED SUN and MAGICthat is sold while being produced by a non-participating manufacturer, the greater settlement cost Goodrich Tobacco likely has to pay to become a participating manufacturer of the MSA.

Our Investigational New Drug Application for X-22, a kit of very low nicotine ("VLN") cigarettes, was cleared by the FDA in July 2011. Our X-22 Phase II-B clinical trial was completed in the first quarter of 2012 and did not demonstrate a statistically significant difference in quitting between X-22 and the active control, a cigarette containing conventional nicotine levels. In evaluating the results of this trial, we believe we may have reduced the nicotine content of X-22 by too great a percentage, to a level less than half the nicotine content of VLN cigarettes used in various independent smoking-cessation clinical trials that have demonstrated that use of VLN cigarettes increases smoking quit rates. We continue to believe that our VLN cigarettes are effective as a smoking cessation aid. However, we have suspended sponsoring further X-22 clinical trials pending a complete analysis of results of two independent smoking-cessation trials that were completed in 2012 (ClinicalTrials.gov Identifiers NCT01050569 and NCT01250301), which utilized a different version of our VLN cigarette with a nicotine content similar to those used in previous successful smoking-cessation trials and higher than that used in our own sponsored Phase II-B trial. A portion of the results of these two trials has been disclosed at the 2013 annual meeting of the Society for Research on Nicotine and Tobacco. These preliminary results are promising for the further development of X-22.

The full set of results of these 2 independent clinical trials are expected to be published in peer reviewed journals and will be compared to results of other independent clinical trials of our VLN cigarettes and results of our Phase II-B trial to determine which variables optimize cessation. One preliminary hypothesis, in conjunction with results of various other studies of our VLN cigarettes, is that having two types of prescription VLN cigarettes available may be advantageous for increased smoking cessation in the general population; one having a higher nicotine content than the other. Upon identifying a suitable joint venture partner to fund further X-22 clinical trials, we will then request a meeting with the U.S. Food and Drug Administration ("FDA"), and thereafter we may resume our own sponsored X-22 clinical trials.

The Company expects to file applications in 2013 with the FDA for two types of Modified Risk cigarettes in accordance with the FDA's issued Modified Risk Tobacco Product Applications Draft Guidance released on March 30, 2012. This provides the framework for applicants to submit data for modified risk product candidates. Goodrich Tobacco, our subsidiary, has developed two types of potential Modified Risk cigarettes. The first proprietary cigarette, referred to as BRAND A, is a VLN cigarette containing approximately 95 percent less nicotine than the leading U.S. cigarette brands. 22nd Century's recent Phase II-B clinical trial and studies by independent researchers have demonstrated that smoke exposure (and cigarettes per day) is significantly reduced with VLN cigarettes. The second proprietary cigarette, referred to as BRAND B, is a low-tar cigarette with a relatively high nicotine content, effectively the world's lowest tar-to-nicotine ratio cigarette. Unlike low-tar/low-nicotine brands currently on the market (previously labeled "light" or "ultra- light" before these descriptors were banned in the U.S. by the Tobacco Control Act in 2010), the nicotine yield of BRAND B is not reduced. Studies have demonstrated that for those smoking low-tar research cigarettes, similar to BRAND B, compensatory smoking is greatly curtailed as compared to those smoking regular cigarettes. Additional studies will be necessary to establish whether BRAND B cigarettes achieve similar results.

The National Institute on Drug Abuse ("NIDA"), a component of the National Institutes of Health ("NIH"), provides the scientific community with controlled and uncontrolled research chemicals and drug compounds in its Drug Supply Program. In 2009, NIDA included an option to develop and produce research cigarettes with various levels of nicotine (from very low to high), or Research Cigarette Option, in its request for proposals for a five-year contract for Preparation and Distribution of Research and Drug Products. We have agreed, as a subcontractor to RTI International ("RTI") in RTI's contract with NIDA for the Research Cigarette Option, to supply modified nicotine cigarettes to NIDA. In August 2010, we met with officials from NIDA, FDA, RTI, the National Cancer Institute and the Centers for Disease Control and Prevention to finalize certain aspects of the design of these research cigarettes. These government research cigarettes are distributed under the Company's mark SPECTRUM. The Company delivered approximately 9 million SPECTRUMresearch cigarettes during the year ended December 31, 2011 and delivered an additional 2.7 million SPECTRUM research cigarettes in July 2012.

Results of Operations

Year Ended December 31, 2012 Compared to Year Ended December 31, 2011

Revenue. In the year ended December 31, 2012, we realized revenue of $18,775, mainly from our research cigarette program, as compared to revenue of $788,601 in year ended December 31, 2011. As of December 31, 2012 we had an outstanding backorder of approximately $3,000 for our research cigarettes.

Other income. In the year ended December 31, 2011, we recognized other income of $223,540 from a therapeutic grant award we received in fourth quarter of 2010.

Costs of goods sold. In the year ended December 31, 2012, costs of goods sold were $67,967 which exceeded revenue by 262% since we provided RTI with certain SPECTRUM research cigarettes without charge mainly due to production delays. In the year ended December 31, 2011, costs of goods sold were $418,171 or 53% of revenue. Costs of goods sold in the year ended December 31, 2011 include inventories written off in the fourth quarter of 2011 of $178,670 due to changes in the Company's manufacturing plans that rendered these costs not recoverable.

Research and development expense. Research and development expense was $729,225 in the year ended December 31, 2012, a decrease of $1,368,755, or 65%, from $2,097,980 in the year ended December 31, 2011. This decrease is mainly the result of suspending our clinical trials for X-22 early in the first quarter of 2012. In the year ended December 31, 2011 approximately $1.6 million was for expenditures related to the filing of our Investigational New Drug Application and our Phase II-B clinical trials for X-22.

General and administrative expense. General and administrative expense was $2,205,450 in the year ended December 31, 2012, an increase of $419,907, or 24%, from $1,785,543 in the year ended December 31, 2011. The increase was mainly attributable to the $337,165 increase in equity based compensation costs for administrative personnel which were $662,601 in 2012 as compared to $325,436 in 2011. The remainder of the increase was due to costs associated with investor relations activities.

Sales and marketing costs. Sales and marketing costs were $61,876 in the year ended December 31, 2012, a decrease of $224,157, or 78%, from $286,033 in the year ended December 31, 2011. The costs in 2011 related to the domestic market introduction of RED SUN and MAGIC and included expenses related to product testing, product and packaging design, product branding, trade samples, trade shows and advertising. Early in 2012, we curtailed marketing of these brands in order to facilitate reaching an agreement to have these products produced by a participating manufacturer of the MSA and, as a result, sales and marketing costs in 2012 were reduced as compared to 2011.

Amortization and depreciation expense. Amortization and depreciation expense relates almost entirely to capitalized patent and trademark costs. Amortization and depreciation expense increased 10% in the year ended December 31, 2012 to $198,406, up from $179,953 in the year ended December 31, 2011. This increase of $18,453 is mainly due to our additional investment in patents and trademarks in 2011 of $98,191and in 2012 of $162,774.

Warrant liability change - net. In multiple private placements in 2012, 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 the total consideration received by an aggregate of $814,500 resulting in an immediate charge to expense for this amount. This charge was in addition to the loss of $1,183,543 resulting from the increase in the estimated fair value during the year ended December 31, 2012 of all warrants we have issued. The market adjustment recorded in the year ended December 31, 2011 was a gain of $2,511,750. The change in the fair value of the warrant liability has been caused mainly by the decrease of the price of our common stock.

Interest expense and amortization of debt discount and expense. Interest expense and amortization of debt discount and debt issuance costs increased in the year ended December 31, 2012 to $1,494,545 from $103,998 in the year ended December 31, 2011. This increase of $1,390,547 or 1,337% was primarily a result of the amortization of debt discount and debt issuance costs related to convertible notes issued on December 14, 2011 and August 9, 2012, which also includes charges to interest expense for the value of warrants in excess of the note payable converted, totaling approximately $31,000 related to the partial conversions of the December 14, 2011 convertible notes.

Net loss. We had a net loss in the year ended December 31, 2012 of $6,736,737 as compared to a net loss of $1,347,787 in the year ended December 31, 2011, as a result of the warrant liability change and an increase in interest expense and amortization of debt discount and expense as well as a reduction in revenues.

Liquidity and Capital Resources

Summary of Balances and Recent Sources and Uses

As of December 31, 2012, we had negative working capital of approximately $3.3 million as compared to negative working capital of approximately $1.9 million at December 31, 2011. The $1.4 million increase in negative working capital was primarily the result of $1.7 million of cash used in operations and $1.2 million of note discount amortization that resulted in an increase in the carrying value of the convertible notes, which were offset by approximately $1.5 million of proceeds from equity securities we issued during 2012.

Cash demands on operations

In 2012 and 2011, we operated at a loss and operating activities consumed more than $5.2 million in cash during this two year period. Cash on hand at December 31, 2012 of $188 was insufficient to fund operations and meet our obligations as they come due in 2013. The Company has suspended clinical trials for X-22 and is seeking licensing agreements for its products with both domestic and international businesses. At December 31, 2012, the Company had current assets of $1,281,305 and current liabilities of $4,602,948.

On January 11, 2013, the Company closed a private placement and realized net proceeds of approximately $2.125 million. From January 1, 2013 through February 6, 2013, the Convertible Notes with a carrying value at December 31, 2012 of approximately $1.41 million were converted into common stock and warrants. While both these steps significantly improved the Company's financial position; we will need additional capital or one or more licensing arrangements for our technology and products in order to meet cash requirements to fund operations and meet our obligations during 2013. Excluding contract growing of our proprietary tobacco with farmers and extraordinary expenses such as clinical trials and factory setup costs, our monthly cash expenditures are approximately $100,000. In the event the Company does not enter into an out-licensing agreement with a third party in 2013, approximately $1.6 million of additional capital is required through 2013, which includes paying approximately $1 million of obligations that will become due in 2013. The Company expects its cigarette factory start up costs to require an additional $250,000 of capital. It plans to lease a portion of the machinery required. There can be no assurance that the Company will be able to raise sufficient capital or obtain a licensing agreement.

Other than the R&D agreement at UVA, the Company has no other substantial third-party R&D commitments requiring funding. The Company may carry out a minimal amount of R&D in 2013, not to exceed $100,000, for additional field trials of plants from our seed lots that resulted from our R&D at NCSU, NRC, NAIST and UVA. Upon the required funding, we expect to carry out exposure studies for our Modified Risk cigarette candidates and will carry out additional clinical trials for X-22 if Hercules Pharmaceuticals, our subsidiary, identifies a joint venture partner willing to fund these trials.

The ability to complete additional equity or debt financings on acceptable terms will depend on a number of factors, including the general performance of the capital markets, the Company's progress in the manufacture, distribution and sale of its products, licensing of its technology, products and tobacco, and results on independent smoking cessation clinical trials utilizing the Company's products. In addition, our ability to complete additional debt and equity financings is limited by covenants related to our Series A-1 Preferred Stock, unless weissue securities to an entity in a business synergistic to ours. Failure to license the Company's technology, products and tobacco or to raise sufficient capital would significantly increase the risk that we would be unable to continue operations. To the extent that we raise additional funds through collaboration and licensing arrangements, it may be necessary to relinquish some rights to our technology, tobacco or products or grant licenses on terms that are not favorable to us.

Net Cash used in Operating Activities.

In the year ended December 31, 2012, $1,764,445 of cash was used in operating activities compared to $3,449,430 of cash used in operating activities in the year ended December 31, 2011. This decreased use of cash of $1,684,985 was mainly due to the decrease of clinical trial expenses in 2012 as compared to 2011 and less cash was used in paying down debt in 2012 as compared to 2011.

Net Cash used in Investing Activities.

In the year ended December 31, 2012, we used $162,774 of cash related to third party costs incurred for patents and trademarks and the acquisition of office furniture and fixtures as compared to $607,297 used in the year ended December 31, 2011. This decrease was attributable to our payment, in 2011, of $500,000 towards outstanding patent costs charges that were deferred in prior periods.

Net Cash From Financing Activities.

During the year ended December 31, 2012, we generated $1,675,158 from our financing activities mainly as a result of the $1,467,500 proceeds from the May and November 2012 private placements, the $210,000 proceeds from the August 9, 2012 convertible notes, $4,136 in advances from officers and $56,000 in proceeds from the issuance of short term secured notes, partially offset by payments on borrowings of $41,000 and net payments to a related party of $21,478. During the year ended December 31, 2011, we generated net cash of $4,308,666 from our financing activities; we received approximately $3,293,789 in net cash proceeds from the private placement that closed on January 25, 2011, and approximately $1.7 million from the issuance of the December 14, 2011 Convertible Notes and $215,000 from the issuance of notes; these receipts were partially offset by the payments on borrowings of a $443,276, payment of debt issuance costs of $23,500, $10,914 in net advances to officers and net payments to a related party of a related party $22,433.

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.

Revenue Recognition

We recognize revenue at the point the product is shipped to a customer and title . . .

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