22nd Century Group (NASDAQ:XXII) is a small, rather speculative company, but risk and reward go hand in hand here as it's also a company which has really crucial IP that could have a significant impact on the multi-billion dollar tobacco market.
This IP consists of 100+ patents (with new ones added regularly, like here, here and here) that enable the company to regulate the level of nicotine in tobacco, from very high to virtually zero. While there exist chemical ways to reduce nicotine levels, this affects taste, so XXII has a crucial advantage here, cemented by a research licensing deal with British American Tobacco (BTI). BAT can exchange this research license into a full commercial license and sub-license (revenues of which will be shared with 22nd Century).
A Seeking Alpha article appeared in which the author (The Geo Team) argued the shares were only worth 20 cents and it raised what at first sight seemed to be several interesting questions:
- Why doesn't the company sell Red Sun and Magic as a non (Master Settlement, MSA) participating member? (Geo Team mentions other small companies do this, without mentioning them by name).
- Earlier efforts to sell Red Sun and Magic haven't exactly been successful. At the minimum, it needs big expenditures in marketing.
- Why has XXII acquired NASCO to get MSA membership while it had its own application and the procedures are essentially the same (according to the article)?
- Earlier (2011) clinical trial failure of X22; why would they be successful this time around?
- Suspension of new clinical trials, what is the prospect of continuation?
- BAT's development plan doesn't include low nicotine cigarettes?
- What is the status of the license of the patents from North Carolina State University? Article puts these in doubt.
- The failure of Vector's Quest cigarettes based on the same patents isn't exactly reassuring. Is there a significant difference between Magic and Quest?
With the stock price tanking rapidly on the article, one doesn't have much time to think these through and often it is best to sell ASAP unless one is 100% certain. Why?
- Either the article raises at least some problems with the business, in which case selling turns out sensible;
- But even in case the article is nonsense, there will be enough people fearing it might contain something and it's likely selling will occur anyway. The selling might also be instigated as part of a more or less organized short campaign.
The only case in which selling isn't a good idea is when there is important news pending. As it happens, this turned out to be the case with 22nd Century even if the initial company reaction to the article wasn't particularly impressive. It didn't deal with all of the allegations, but only a few of these. However, the company did answer the most important one, question no. 7 above, apparently the licenses are safe and just renewed:
just today, 22nd Century signed a new license agreement with the same university that the author falsely alleges that the Company is in default with.
The company also answered question no. 5 in proclaiming that it has every intention of continuing the clinical trials for its smoking cessation product X-22.
It's unclear how this helped stabilize and reverse the stock price because at that time, rumors became rife that news was pending and the stock price retraced almost all the terrain lost. And news indeed came out. First up was a cooperation agreement with Smoker Friendly International (SFI) and 22nd Century's take-over target NASCO.
NASCO is going to manufacture SFI branded cigarettes as a contract manufacturer. The agreement also contained some other interesting stuff. Red Sun and Magic, brands from 22nd Century:
we expect hundreds of Smoker Friendly stores to carry RED SUN upon the brand becoming an MSA brand.
The missing link here was the so far elusive MSA membership (the Master Tobacco Settlement between tobacco companies and 46 states), but that followed in quick order. This is a big step. It allows the NASCO acquisition to close and 22nd Century to market and sell its own branded cigarettes, finally.
With a stroke, MSA membership rendered the questions no. 1 and 3 irrelevant, and question no. 2, whilst a legitimate concern, is also at least partly addressed by the new distribution deal with SFI. The story about the Quest brand from Vector is described on the 22nd Century website:
In 2006, Vector Tobacco sponsored a multi-center Phase II smoking-cessation clinical trial to evaluate the effectiveness of Quest® alone or in combination with nicotine replacement therapy (Becker et al. 2008). This trial was performed under Vector's Investigational New Drug Application (IND) filed with the FDA in 2004. After conveying that it intended to proceed with Phase III clinical trials, Vector Group Ltd. announced that Vector Tobacco was no longer pursuing FDA approval of its smoking cessation aid in development. Accordingly, 22nd Century's licenses to all affiliates of Vector Group Ltd. were terminated. Subsequently (in 2008) through binding arbitration, 22nd Century obtained rights to use and reference at the FDA all data in Vector's IND, including all results from the Phase II clinical trial, relating to cigarettes containing 22nd Century's proprietary tobacco. 22nd Century no longer has any type of relationship with Liggett Group or Vector Tobacco.
Quest was taken off the market in 2008 (not everybody was happy with this), and they didn't taste as bad as the short article made out they did.
Essentially, with MSA in the bag and the closing of the NASCO acquisition a formality and the first distribution deal in the bag, the foundations for a company with actual sales of its own products (rather than act as a contract manufacturer) are now in place.
It has one huge advantage and a couple of hurdles. The big advantage it has that it has a unique patent portfolio which enables it, alone, to vary genetically the level of nicotine in cigarettes from almost zero to normal or high, without affecting taste.
The hurdles to overcome are:
- To be able to brand these as modified risk (an application is supposedly to be made before the end of the year), or very low nicotine cigarettes on the packaging and in marketing campaigns
- To ramp up marketing and distribution.
The company has seasoned tobacco men on board and viral marketing can circumvent the limitations. It's also important to realize that these restrictions don't necessarily hold abroad and XXII is actively pursuing joint venture opportunities in Asia. Lest we forget, earlier in the year the company announced this:
22nd Century Group, Inc. (NYSE MKT:XXII) today announced that its subsidiary, Goodrich Tobacco Company LLC, signed a letter of intent with Orion, a cigarette manufacturer based in Poland, to contract manufacture the Company's proprietary tobacco products to be distributed in the European Union.
So the company is actively pursuing other markets besides the US and it does have a rather unique selling point, even if it's not always allowed to mention it.
Smoke cessation aid X-22
Another rather interesting question is whether low (or very low, essentially zero) nicotine cigarettes are actually helping (alone or in combination with other products) people to stop or reduce smoking. There is some fear, highlighted in the short article, that now nicotine cigarettes could actually lead to increased smoking (as one needs to smoke more to get the same nicotine fix).
The helpful newsletter 'How To Find Big Stocks' (HTFBS) pointed out the following article describing a trial at the University of Waterloo in Canada involving the three versions of Quest cigarettes (stepwise decreasing the nicotine level to essentially zero):
The scientists found that the smokers taking part did not change the number of cigarettes they smoked or the number of inhalations they took during each of the four weeks.
What is also not widely appreciated is that the FDA has a mandate to reduce nicotine levels in cigarettes to negligible amounts following the 2009 Family Smoking Prevention and Tobacco Control Act. Whether it will use this mandate remains to be seen, but if more evidence emerges that low nicotine cigarettes help people quit smoking, they very well might.
HTFBS also pointed out that no FDA approval is needed to sell 22nd Century's X-22 as a smoking cessation product. It does need FDA approval for a doctor to prescribe it as a smoking cessation product (so that health insurance pays for it). This is a subtle, but important distinction nevertheless, as it doesn't stop consumers from buying X-22 if they think this low nicotine cigarette helps them quit smoking.
Do Very Low Nicotine (VLN) cigarettes help people to quit smoking?
A very important question as a yes is likely to unlock a tremendous amount of value from 22nd Century Group, as it will:
- Enable the company to market its various brands as reduced risk and/or VLN cigarettes, making its competitive advantage explicit;
- Allow the company to sell its X-22 smoking cessation product as a prescription solution, increasing its potential market;
- Increase the likelihood that the FDA will use its regulatory powers to mandate lower nicotine levels in cigarettes.
Needless to say, the latter especially would be enormously lucrative for 22nd Century. So what does the evidence say? Well, here is what the company's own website argues:
There have been numerous studies on very low nicotine (VLN) cigarettes. VLN cigarettes for smoking cessation have increased quit rates in all independent studies, whether VLN cigarettes were used alone or concurrently with nicotine replacement therapy (NRT), including the following 4 clinical trials (2019 total subjects)
However, the outcome of two clinical trials mentioned on the same page are less promising. The second, despite being completed, doesn't mention results (we assume this is the failed test Geo Team mentioned) while the first does.
The most notable from these is that the combination of VLN cigarettes and a 21mg nicotine patch led to a significantly higher relapse time (7.6 weeks, on average) compared to patch or the VLN cigarettes on their own (2.1 and 2.6 weeks).
Risk
Like most small caps, this one also faces a number of risks:
- Jury is still out and probably will be for quite some time on clinical trials and favorable changes in the regulatory environment and there is no guarantee that this will happen
- Its cigarettes, now that it can produce and sell them under the MSA agreement, might not sell as well as hoped
- Further license payments (there is another $7M from BAT waiting, upon the meeting of certain milestones) are not guaranteed and the company might have to go to the markets for funding.
- Between now and 2018 there is considerable dilution (up to 10M shares) from outstanding warrants
Against those risks stands the company's unique intellectual property. The company is alone in having multiple patents on genetic variation of nicotine levels in tobacco, and it seems that over time these unique capabilities will increasingly matter. After all, the basic truth is that nicotine, while not harmful, is the main component of tobacco products that makes them so addictive.
Conclusion
What remains from all this is that XXII is the king of low nicotine cigarettes. How much this is worth depends on whether and to what extent authorities around the world are satisfied enough to enable the company to market its cigarettes as low nicotine and/or reduced risk, and whether health insurance companies will be allowed to reimburse X-22 users.
For that to happen in the US, we probably need some conclusive evidence from clinical trials to show that low (or essentially zero) nicotine cigarettes do not lead to increased smoking and can (alone or in combination with other tools like nicotine patches) help people to quit smoking.
Needless to say, even better would be if authorities (like the FDA) will move in to mandate lower nicotine levels in cigarettes. This would give 22nd Century Group a near unassailable position in a market worth hundreds of billions.
What's not in doubt is that even without the above, after the just received MSA membership, it can now sell its low nicotine cigarettes. The company can also sell its X-22 smoking cessation aid in the US, but not as a subscription product. There are other places in the world where regulation isn't as strict and 22nd Century Group can exploit its advantage a bit more openly, or others do it for them by licensing its technology.
Selling cigarettes is rather lucrative business and the market is enormous. That's also something to keep in mind.
