Tuesday, July 24, 2018

22nd Century Group, Inc. - Smoke and Mirrors?

Smoke 'em if you've got 'em.

Overview:

22nd Century Group, Inc. is a plant biotechnology company focused on changing the level of nicotine and nicotinic alkaloids in tobacco plants and levels of cannabinoids in cannabis plants through genetic engineering and plant breeding. Its products include X-22, modified risk cigarettes, spectrum government research cigarettes, magic 0 and magic 2, moonlight, red sun, variable nicotine-level research cigarettes, and verfola. 
Founded: 2011
Number of Employees: 79
Headquarters: Clarence US
CEO: Henry Sicignano, III, MBA

Analysis Methodology

After doing some background research on XXII it became clear that the story I need to investigate is whether XXII is a credible company.  Some analysts outline XXII's promising future with their strong intellectual property and the good fortune to be in the business they'e in at this point in time.  Others present what appears to be a well researched tale of fraud and misdirection.
The objective of this article is to separate the hype and find the unembellished fact.  It will cover the following areas: financial analysis, patents, the FDA pronouncement, the market for very low nicotine (VLN) cigarettes, and the company's possible future.

Financial Analysis

The company's most recent quarter was positive but that is due to revaluing their investment in Anandia Laboratories to fair value (which was the correct treatment).  I looked at 10 quarters previous to this one and the company has not been profitable, even at the gross margin level.  In addition to the quarterly review, I looked at seven years of financial history and there hasn't been a profitable year yet.  It did have profitable gross margins in Y-4 and Y-6
This lack of gross margin profitability includes their most recent quarter, despite their claim they did have gross profit in Q1 2018 (see Note 1 and 2 in the Analysis Notes below).   The company did not include expenses in its cost of goods sold (depreciation and amortization) that rightfully should have been.  It was identified in the notes, but not everyone reads those so I found this treatment deceptive.    
This lack of profitable gross income is problematic.  It is unusual to have negative gross income because if you can't cover the expenses related to producing your product, what's the point in being in business?   To have a viable company, you have to have positive gross margin.  If not, the more sales you make the more money you lose.  
I checked to see if there was a positive trend in the gross margin.
Over the last four years the trend has been improving.

Cash

From an operating standpoint only, XXII burned over $12M dollars last fiscal year.  Their need for cash has been growing at an average rate of 23% per year (calculated over three years), again, looking only at the company's operational needs.  They ended fiscal 2017 with just under $63M and ended the most recent quarter with just over $59M, a change of -$3.2M.  Last year the company's cash changed -$2.8M in the same period.  
If we assume their operational burn stays at $12M per year and they don't have to make any capital expenditures (unlikely) they'll have enough money for approximately five years.

Patents

XXII claims to be the only company in the world able to grow tobacco plants with non-addictive levels of nicotine.  I'm skeptical of this claim.  A search on patents.google shows over 12,000 patents for "tobacco genetic modification to change nicotine levels"
Top five assignees are Pioneer Hi-Bred International, U.S. Smokeless Tobacco Company, Centocor, E.I. DuPont and MacGill University.
search with "22nd Century Limited LCC" as the assignee brings up 10 patents or applications.  One had to do with biomass utilization and one was related to cannabis, of the remaining eight, three were granted patent status and the balance were still in the application stage.




But there are two concerns more important than attempting to tear down their claim.  Firstly, a patent is only as good as your ability to defend it.  In my opinion they don't have the cash resources to take on a deep pocketed competitor in the courts.  And secondly, the lack of competition is not a good sign.  If this is such a good market why is no one else here?

The Recent FDA pronouncement





On the first page of their website, XXII says "FDA shines spotlight on 22nd Century's Technology".  I consider this an exaggeration.

A lot of XXII's recent story had to do the FDA's recent pronouncement made by Scott Gottlieb MD, the commissioner at the FDA.  He said the FDA is "looking at ways to reduce nicotine levels in cigarettes so that they are minimally or non-addictive, while not altering the nicotine content of noncombustible products such as e-cigarettes."  But no where in his speech does he mention XXII by name nor does he discuss or mention their technology (or anyone else's).

However, it is clear that the FDA wants cigarettes to move in the direction of a product that XXII could supply.  Their method is genetic engineering but there are other methods of creating VLN cigarettes and the FDA is keeping its options open.  But I won't deny the FDA statement is good news for XXII.  

I want to highlight another part of Dr. Gottlieb's speech:
"...the nicotine in cigarettes is not directly responsible for the cancer, lung disease, and heart disease that kill hundreds of thousands of Americans each year.  Yes, it got them all addicted and kept them addicted for the long term.  And it got most of them addicted when they were still teenagers.  But it's the other chemical compounds in tobacco, and in the smoke created by setting tobacco on fire, that directly and primarily cause the illness and death, not the nicotine."
He says that phrase "setting tobacco on fire" more than once.  It's clear that in his mind, the harm that comes from tobacco is released when it burns.  I would suggest that he is interested in the demise of cigarettes completely.  That cigarettes become pleasure-less.
Another  of XXII's claims is that their product retains its flavour despite being de-nicotinized.  Perhaps that isn't a feature the FDA is looking for.

Market for VLN cigarettes


Regardless of the speculation above, we do have to consider the future of a product where its greatest pleasure and it's most motivating reason to buy it - nicotine - has been removed and all that remains is a health risk.


There is a misconception held by some smokers that the risk in smoking is directly related to the amount of nicotine in the cigarette.  Policy makers are concerned this would lead to more, not less smoking.  This hypothesis was tested in a study conducted by Duke University in North Carolina. 


This is strong testament to the possibility XXII has an unusual product.  If it's working properly, people will eventually stop using it.  This in fact would probably be the FDA's goal in approving it.  Are cigarettes a dying technology, being replaced by something else that does the job (nicotine delivery) in a better, in this case less harmful way?  It appears so.

However, given the right support and promotion XXII could be profitable (assuming it overcomes its gross margin issues) for a period of time and the technology could be adopted in other areas of the world.  Eventually though, the music will stop so it is important that XXII sees a future beyond VLN cigarettes.

The Future of Cannabis

XXII has investments in cannabis which will undoubtedly be a growth industry. 

If XXII intends to be a long-term play this is where their future lies. Their focus seems to be around industrial hemp uses, rather than around non-THC cannabiniods for medical uses (although if anecdotal evidence holds any weight this will be a much bigger industry).

My Conclusion


I don't like deceit and their treatment of amortization and depreciation as an operating expense when it should have been a CGS was sly.  They've made more than their share of bombastic claims and I like a company that says less and does more.  

However, contrary to some of the bear analysts, I do think they are a legitimate company trying to accomplish something.  Unfortunately I question whether that is something worth doing because they cannot seem to earn a gross profit.  The more sales they make the more money they'll lose. 

I don't think their technology is a "slam-dunk" but based on their propaganda and the intentions of the FDA it could be a strong contender.  If they solve their gross profit issues, get all the permissions they need to market their product and the FDA goes forward with mandating non-addictive levels of nicotine in cigarettes their stock will pop, I don't doubt it.  But without a new business model to follow up on the success of their VLN cigarette, they will inevitably go into decline.  It is ironic that the FDA's mandate which is key to their success will also underwrite their eventual failure.

Will they have the foresight to see this and move quickly into a new business model?  Let's see how well they do accomplishing this first one.

Notes to the Analysis


Note 1. The Q1 earnings call transcript and the consolidated statement of operations filed with the SEC shows a gross profit in Q1. 

You'll notice that the cost of goods sold figure excludes amortization and depreciation. 

Amortization includes both patent and trademark costs.  It could be argued, but in my opinion patent costs are a cost of good sold because their patent is fundamental to what they manufacture. 

A more obvious situation is the depreciation of cigarette manufacturing equipment, which was included with office equipment, laboratory equipment and leasehold improvements as an operational expense.  The depreciation of cigarette manufacturing equipment is without question part of the cost of goods sold.  

I estimate the depreciate for Q1 on the cigarette manufacturing equipment to be $168,000 (see Note 2).  This alone wipes out the profit even without an estimate for the patent portion of the amortization.


NOTE 5. - MACHINERY AND EQUIPMENT

Machinery and equipment at March 31, 2018 and December 31, 2017 consisted of the following:

Useful LifeMarch 31,
2018
December 31,
2017
Cigarette manufacturing equipment3 - 10 years$4,427,251$4,302,299
Office furniture, fixtures and equipment5 years132,796110,499
Laboratory equipment5 years86,60932,193
Leasehold improvements6 years150,707106,429
4,797,3634,551,420
Less: accumulated depreciation1,359,9011,235,373
Machinery and equipment, net$3,437,462$3,316,047


Depreciation expense was $124,528 and $88,121 for the three months ended March 31, 2018 and 2017, respectively

Note 2. The half way point between 3 and 10 years equals 6.5 years.  Annual straight line depreciation on the December 31, 2017 balance is $661,892.  Three months is $165,473 (this is already enough to wipe out the profit).  Depreciation of the new equipment purchased in Q1 is ($4,427,251-4,302,299)/2/6.5/4= $2,403.  Total estimated depreciation for Q1 2018 on cigarette manufacturing equipment is $167,876.

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