22ND CENTURY : Management's Discussion and Analysis of Financial Condition and Results of Operations (form 10-Q)

Forward Looking Statements

This Quarterly Report on Form 10-Q contains "forward-looking statements" that reflect, when made, the Company's expectations or beliefs concerning future events that involve risks and uncertainties. Forward-looking statements frequently are identified by the words "believe," "anticipate," "expect," "estimate," "intend," "project," "will be," "will continue," "will likely result," or other similar words and phrases. Similarly, statements herein that describe the Company's objectives, plans or goals also are forward-looking statements. Actual results could differ materially from those projected, implied or anticipated by the Company's forward-looking statements. Some of the factors that could cause actual results to differ include: our ability to monetize our intellectual property portfolio; our ability to achieve profitability; our ability to manage our growth effectively; the lack of implementation of the plan by the U.S. Food and Drug Administration ("FDA") to regulate nicotine content in cigarettes; our ability to obtain FDA authorization for our Modified Risk Tobacco Product; our ability to gain market acceptance for our products; our ability to prevail in litigation; and our ability to maintain our rights to our intellectual property and the impact of the outbreak of the coronavirus or another health pandemic or other global disaster on our business and operations. For a discussion of these and all other known risks and uncertainties that could cause actual results to differ from those contained in the forward-looking statements, see "Risk Factors" in the Company's Annual Report on Form 10-K for the year ended December 31, 2019, which is available on the SEC's website at www.sec.gov. All forward-looking statements are qualified in their entirety by this cautionary statement, and the Company undertakes no obligation to revise or update this Quarterly Report on Form 10-Q to reflect events or circumstances after the date hereof.

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.

Overview

We are a plant biotechnology company focused on technology that allows us to alter the level of nicotine and other nicotinic alkaloids in tobacco plants and the levels of cannabinoids in hemp/cannabis plants through genetic engineering and modern plant breeding techniques. Our mission in tobacco is to reduce the harm caused by smoking by introducing adult smokers to our proprietary, Very Low Nicotine Content ("VLNC") tobacco and cigarette products. Our mission in hemp/cannabis is to develop proprietary varieties of hemp with valuable cannabinoid profiles and other superior agronomic traits. We have a significant intellectual property portfolio of issued patents and patent applications relating to both tobacco and hemp/cannabis plants.

In tobacco, we have developed unique and proprietary bright and burley VLNC tobaccos that grow with at least 95% less nicotine than tobacco used in conventional cigarettes. In the year 2011, we developed our SPECTRUM® research cigarettes in collaboration with independent researchers and officials from the FDA, the National Institute on Drug Abuse ("NIDA"), which is part of the National Institutes of Health ("NIH"), the National Cancer Institute ("NCI"), and the Centers for Disease Control and Prevention ("CDC"). Since 2011, we have provided more than 28 million research cigarettes containing our proprietary VLNC tobacco for use in numerous independent clinical studies at many well-known study locations, with agencies of the United States federal government investing more than $125 million in such independent clinical studies. The results of these independent clinical studies have been published in peer-reviewed publications (including but not limited to the New England Journal of Medicine, the Journal of the American Medical Association, and many others) and demonstrate that our VLNC tobaccos have been associated with reductions in smoking, nicotine exposure, and nicotine dependence, with minimal evidence of nicotine withdrawal, compensatory smoking, or serious adverse events. A list of completed and published clinical studies using cigarettes made with our VLNC tobaccos is shown on our website at http://www.xxiicentury.com/published-clinical-studies/. A list of on-going clinical studies using our SPECTRUM® research cigarettes is shown on our website at http://www.xxiicentury.com/on-going-clinical-studies/. We do not incorporate third party studies or the information on our website into this Quarterly Report on Form 10-Q.

In hemp, we are developing proprietary hemp strains for use in new medicines and as important agricultural crops in the U.S. and elsewhere. Our current activities in the United States involve only work with legal hemp in compliance with U.S. federal and state laws. The hemp plant and the marijuana plant are both part of the same cannabis genus of plant, except that hemp has not more than 0.3% dry weight content of delta-9-tetrahydrocannabinol ("THC"). The federal Agricultural Improvement Act of 2018 (the "2018 Farm Bill") legalized hemp and cannabinoids extracted from hemp in the U.S., but such extracts remain subject to state laws and the regulation by other U.S. federal agencies, such as the FDA and the U.S. Department of Agriculture ("USDA"). The same plant, with a higher THC content is marijuana, which is legal under certain state laws, but which is currently not legal under U.S. federal law. The similarities between these plants can cause confusion. To reflect this difference in law, sometimes we refer to legal hemp and the legal hemp industry as hemp/cannabis to distinguish this as being separate and apart from marijuana/cannabis currently not legal under U.S. federal law. Our activities with legal hemp have sometimes been incorrectly perceived as us being involved in federally illegal marijuana. This is not the case. In the United States, we work only with legal hemp in compliance with federal and state laws.

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Additional information about our business and operations is contained in our Annual Report on Form 10-K for the year ended December 31, 2019.

COVID-19 Update

The COVID-19 pandemic has caused a disruption to our business and poses a risk to our future business, including the potential disruption or delays by third party providers of goods or services to our business, disruptions to our research and development activities and potential disruptions to our manufacturing facility. Our executive leadership team and staff are continuously monitoring this situation and its impacts on our business. Our corporate employees based in Williamsville, New York have been working remotely, in line with NY State mandates, with minimal disruption to normal business activities. However, our R&D Lab in Buffalo, New York has temporarily closed due to the same New York state orders. Our Research and Development work has been impacted by this temporary lab closure; however, we are continuing a significant portion of our genetic research in a manner consistent with government orders and safe business practices.

Our NASCO production facility in North Carolina remains open, as it has been classified as an essential business as it is part of the supply chain for grocery stores and convenience stores. During this time, we have seen a higher rate of time off among our production staff, and we have encouraged employees who need to stay home at this time to do so. At this time, we are still able to fulfill sales orders in a timely manner, while supporting the safety and well-being of our employees, and complying with all Local, State, and Federal orders. We have provided safety equipment, closed common areas, and encouraged appropriate physical distancing at our production facility. However, an outbreak at our production facility would cause us to temporarily cease our manufacturing operations.

We will continue to monitor the Local, State and Federal guidance regarding our business practices.

First Quarter 2020 and Recent Accomplishments and notable events:

The Company presented data to FDA's Tobacco Products Scientific Advisory Committee ("TPSAC") in support of our MRTP Application for our very low nicotine content tobacco cigarettes. The Company's MRTP Application requests a reduced exposure marketing authorization from the FDA to market the Company's very low nicotine content tobacco cigarettes in the U.S. under the proposed brand name of VLN®with product labeling and advertising claims stating that VLN® has 95% less nicotine than conventional cigarettes, among other claims related to reduced nicotine exposure. This meeting was the first time that TPSAC considered an MRTP Application for a modified exposure claim, and it was also TPSAC's first discussion of an application for a combustible tobacco product.

Subsequent to the end of the first quarter of 2020, the FDA announced May 18, 2020 as the deadline to submit comments on 22nd Century Group's MRTP Application. The imminent closing of the public comment period is another important milestone in the FDA's ongoing scientific review of the Company's MRTP Application.

Our reduced nicotine tobacco plant research continued with the successful completion of research field trials that validated new non-GMO (genetically modified organism) methodologies for reducing nicotine in the tobacco plant. As an alternative to older, genetic-engineering technologies that result in the creation of plants regulated as GMOs, the NCSU researchers used newer, non-CRISPR, non-GMO, gene editing technologies to consistently achieve reductions in nicotine levels by as much as 99%, when compared to a conventional tobacco plant. 22nd Century has earlier filed a patent application with the U.S. Patent and Trademark Office to secure intellectual property rights for this non-GMO genetic approach that achieves very low nicotine content (VLNC) levels in tobacco using non-GMO methodologies.

On March 11, 2020, the Company announced in partnership with KeyGene that it has assembled, in just under three months, high-quality genome sequences of two hemp/cannabis lines and established a new proprietary hemp/cannabis bioinformatics platform. Both are believed to be among the highest quality, hemp/cannabis reference genomes in the world. The establishment of a comprehensive bioinformatics platform is the first step in building out the Company's hemp/cannabis knowledge foundation. Further work is underway to enhance the platform with additional plant lines. The Company has also made significant achievements in rapid cycle breeding and metabolomics with both high-CBD and oil-seed hemp/cannabis plant lines widely used in the hemp/cannabis industry.

The establishment of a comprehensive bioinformatic platform is the first step in building out the Company's hemp/cannabis knowledge foundation. Further research is underway to create a genomic map of all the genes present in both "Cherry" and "Blue Dream" plant lines.

The Company has also made achievements in rapid cycle breeding and trait integration in both "Cherry" and "Finola" plant lines. The Company and KeyGene remain focused on developing proprietary new hemp/cannabis plants with exceptional cannabinoid profiles for medical and therapeutic use.

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Results of Operations

Dollar Amounts in Thousands ($000's), except for per-share data

Three Months Ended March 31, 2020 Compared to Three Months Ended March 31, 2019

Revenue - Sale of products, net

                                        Quarter-to-Date
                                     March 31       March 31
                                         2020           2019
Sale of products, net               $   7,058     $    6,294
Dollar Change from Prior Year             764

Percentage Change from Prior Year 12.1 %

The increase in sales revenue was primarily the result of an increase in the sales of contract manufactured cigarettes in the amount of approximately $600, which was driven by a mix of increased unit sales and price increases. Sales of contract manufactured filtered cigars increased approximately $140 from the quarter ended March 31, 2019 and was also influenced by higher sales and unit price increases.

Cost of goods sold - Products / Gross profit (loss)

                                        Quarter-to-Date
                                     March 31       March 31
                                         2020           2019
Cost of goods sold                  $   6,771     $    6,397
Percent of Product Sales                 95.9 %        101.6 %
Dollar Change from Prior Year             374

Percentage Change from Prior Year 5.8 %

                                         Quarter-to-Date
                                     March 31        March 31
                                         2020            2019
Gross (loss) profit                 $     287      $     (103 )
Percent of Product Sales                  4.1 %          (1.6 %)
Dollar Change from Prior Year             390

Percentage Change from Prior Year n/a

For the three months ended March 31, 2020, the change to a Gross profit from a Gross loss for the comparable prior year period was driven by lower Cost of Goods sold as a percentage of revenue. Cost of goods sold declined to 95.9% of revenue from 101.6% of revenue. The improved gross margin was primarily the result of price increases during the first quarter of 2020, as well as lower labor and overhead costs per unit.

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Research and development expense

                                         Quarter-to-Date
                                     March 31        March 31
                                         2020            2019
Research and Development            $     960      $    2,451
Percent of Product Sales                 13.6 %          38.9 %
Dollar Change from Prior Year          (1,491 )
Percentage Change from Prior Year       (60.8 %)

Lower R&D expense for the three months ended March 31, 2020 was driven by a decrease of approximately $1,062 in expenses related to our MRTP Application filed in 2019, a $242 decrease in our R&D Personnel expense, a $158 decrease in our R&D Contract costs, and a $47 decrease in R&D-related Travel & Entertainment expenses compared to the three months ended March 31, 2019.

Sales, general and administrative expense

                                         Quarter-to-Date
                                      March 31       March 31
                                          2020           2019

Sales, general, and administrative $ 3,141 $ 2,474 Percent of Product Sales

                  44.5 %         39.3 %
Dollar Change from Prior Year              667

Percentage Change from Prior Year 27.0 %

The increase in Sales, general and administrative ("SG&A") expense during the three months ended March 31, 2020 was driven by a $408 increase in Personnel expenses, a $243 increase in Consulting & Professional services, and a $135 increase in Legal fees which were primarily related to our TPSAC meeting. These increased expenses were partially offset by a reduction in repairs and maintenance expenses of $48, and a reduction in public company expenses of $47. Public company expenses are comprised of expense related to our annual meeting, Board of Directors, SEC reporting, and public accounting services.

Depreciation expense



                                        Quarter-to-Date
                                     March 31       March 31
                                         2020           2019
Depreciation                        $     156      $     135
Percent of Product Sales                  2.2 %          2.1 %
Dollar Change from Prior Year              21

Percentage Change from Prior Year 15.6 %

The increase in Depreciation expense was primarily due to additional Machinery and Equipment acquisitions during 2019, which primarily supported the build-out of our VLN tobacco processing capabilities.

Amortization expense



                                        Quarter-to-Date
                                     March 31       March 31
                                         2020           2019
Amortization                        $     172      $     216
Percent of Product Sales                  2.4 %          3.4 %
Dollar Change from Prior Year             (44 )

Percentage Change from Prior Year (20.4 %)

Amortization expense relates to amortization taken on capitalized patent costs and license fees. The decrease was primarily due to amortization expense on a lower patent base which resulted from one-time impairment charges of $1,142 incurred during the quarter ended September 30, 2019.

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Unrealized (loss) gain on investment

                                            Quarter-to-Date
                                        March 31        March 31
                                            2020            2019

Unrealized (loss) gain on investment $ (445 ) $ 2,974 Percent of Product Sales

                    (6.3 %)         47.3 %
Dollar Change from Prior Year             (3,419 )
Percentage Change from Prior Year            n/a

The warrants to purchase 973,971 shares of Aurora common stock are considered an equity security and are recorded at fair value. We recorded the fair value of the stock warrants of $228 at March 31, 2020, using the Black-Scholes pricing model, and recorded an unrealized loss on the warrants in the amount of $445 for the three months ended March 31, 2020.

Gain on the sale of machinery and equipment

                                                   Quarter-to-Date
                                               March 31        March 31
                                                   2020            2019

Gain on the sale of machinery and equipment $ 0 $ 87 Percent of Product Sales

                            0.0 %           1.4 %
Dollar Change from Prior Year                       (87 )
Percentage Change from Prior Year                   n/a




We did not realize any gains on the sale of Machinery and equipment during the
three months ended March 31, 2020. During the three months ended March 31, 2019,
we sold a piece of machinery and equipment no longer required in our factory
operations in North Carolina and recorded a gain on the sale in the amount of
$87.



Interest income, net

                                        Quarter-to-Date
                                      March 31      March 31
                                          2020          2019
Interest Income, net                $      612     $     272
Percent of Product Sales                   8.7 %         4.3 %
Dollar Change from Prior Year              340

Percentage Change from Prior Year 125.0 %

Interest income, net (interest income less investment fees) of $612 is made up of approximately $209 interest accreted on our convertible note and preferred stock investment in Panacea, interest income accrued on the convertible note receivable of approximately $172, and net interest income earned on our short-term investment account of approximately $231.

Interest expense



                                         Quarter-to-Date
                                     March 31        March 31
                                         2020            2019
Interest Expense                    $     (12 )    $      (11 )
Percent of Product Sales                 (0.2 %)         (0.2 %)
Dollar Change from Prior Year              (1 )

Percentage Change from Prior Year 9.1 %

Interest expense was in line with the expense for the same quarter during prior
year. Interest expense was derived from the accretion of interest on notes
payable to NCSU and the University of Kentucky and interest accretion on accrued
severance.



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Net loss



                                        Quarter-to-Date
                                     March 31       March 31
                                         2020           2019
Net Loss                            $  (4,028 )    $  (2,073 )
Percent of Product Sales                (57.1 %)       (32.9 %)
Dollar Change from Prior Year          (1,955 )
Percentage Change from Prior Year        94.3 %

The increase in net loss for the three months ended March 31, 2020 compared to the comparable period during the prior year was primarily the result of an unrealized gain of $2,974 on our Aurora warrants during the three months ended March 31, 2019, which turned to an unrealized loss of $445 for the three months ended March 31, 2020. This was partially offset by an increase in gross profit, lower total operating expenses, and the interest income associated with our convertible note and preferred stock investment in Panacea.

Other comprehensive income (loss)

                                         Quarter-to-Date
                                     March 31        March 31
                                         2020            2019

Other comprehensive income (loss) $ (193 ) $ 163 Percent of Product Sales

                 (2.7 %)          2.6 %
Dollar Change from Prior Year            (356 )

Percentage Change from Prior Year n/a

We maintain an account for short-term investment securities that are classified as available-for-sale securities and consist of money market funds, and corporate bonds with maturities greater than three months at the time of acquisition. Unrealized gains and losses on short-term investment securities (the adjustment to fair value) are recorded as Other comprehensive income or loss. We recorded an unrealized loss on short-term investment securities in the amount of $196 and recorded a reclassification of losses to net loss in the amount of $3, resulting in other comprehensive loss of $193 for the three months ended March 31, 2020. For the three months ended March 31, 2019, we recorded an unrealized gain on short-term investment securities of $147 and recorded a reclassification of losses to net loss in the amount of $16, resulting in other comprehensive income of $163.

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Liquidity and Capital Resources

                                                           Quarter-to-Date
                                                        March 31      March 31
                                                            2020          2019
Net cash used in operating activities                  $  (4,662 )      (4,681 )
Net cash provided by investing activities                  4,896         4,666
Net cash used in financing activities                          0             0
Net increase (decrease) in cash and cash equivalents         234           (15 )
Cash and cash equivalents - beginning of period              485           605
Cash and cash equivalents - end of period              $     719           590
Short-term investment securities                          33,274        38,477




Working Capital

As of March 31, 2020, we had working capital of approximately $33,460 compared to working capital of approximately $36,962 at December 31, 2019, a decrease of $3,502. This decrease in working capital was primarily due to a decrease in net current assets of approximately $4,248 and was offset by a decrease in net current liabilities of approximately $746. Cash, cash equivalents and short-term investment securities decreased by approximately $4,969 and the remaining net current assets increased by approximately $719. We used approximately $4,662 of cash in operating activities during the three months ended March 31, 2020.

We must successfully execute our business plan to increase revenue and profitability in order to achieve positive cash flows from operations to sustain adequate liquidity without requiring additional funds from capital raises and other external sources to meet minimum operating requirements.

 Cash demands on operations

We had cash and cash equivalents and short-term investment securities at March 31, 2020 of $33,993. We believe this amount of cash and cash equivalents and short-term investment securities will be adequate to sustain normal operations and meet all current obligations as they come due. During the three months ended March 31, 2020, we experienced an operating loss of approximately $4,028 (including approximately $477 in expenses relating to our MRTP Application) and used cash in operations of approximately $4,662. Excluding discretionary expenses relating to certain R&D, modified risk tobacco products, and certain nonrecurring operating expenses, our monthly cash expenditures are approximately $1,200. The Company will continue to incur consulting and legal expenses as the MRTP Application continues through the FDA review process.

Net cash used in operating activities

The decrease in use of cash in operations was due to a decrease in the cash portion of the net loss in the amount of $1,336, which was mostly offset by an increase in cash used for working capital components related to operations in the amount of $1,355 for the three months ended March 31, 2020 as compared to the three months ended March 31, 2019.

Net cash provided by investing activities

The increase in cash provided by investing activities was primarily the result of an increase in net cash provided from transactions relating to our short-term investment account in the amount of $375 and an increase in cash flows related to acquisitions of Machinery and equipment of $81. These increased cash inflows were partially offset by a decrease in cash flows (cash outflow) of $96 related to acquisitions of patents and trademarks, and a decrease in proceeds from the sale of Machinery and equipment in the amount of $166 in during the first quarter of 2020 as compared to the first quarter of 2019.

Net cash used in financing activities

We did not use any cash in financing activities during the three months ended March 31,2020, nor did we use any cash in financing activities during the three months ended March 31, 2019.

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Critical Accounting Policies and Estimates

There have been no material changes to the information set forth in our Annual Report on Form 10-K for the year ended December 31, 2019.

Inflation

Inflation did not have a material effect on our operating results for the three months ended March 31, 2020 and 2019, respectively.

Off-Balance Sheet Arrangements

We do not have any off-balance sheet arrangements as defined by Item 303(a)(4) of Regulation S-K.

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