Likely, everyone will know a story that kicked a stock into hyposphere, only to fall into dust later. The respective companies either did not recover anymore or went entirely bust. They all share one commonality: a nice story that catches the interest of especially retail investors. But where there is excessive greed without the support of fundamentals, the fall from grace is just around the corner. Here’s an example that was set to disrupt an undisruptable industry: tobacco.

Summary and key takeaways from today’s Weekly
– Great stories can make for a great stock return, but without fundamental support, the risk for a disaster is higher.
– Never buy a stock just for its story – always check the financials.
– Even a good idea can run out of cash, leaving shareholders holding the bag.

The basic story of tobacco is well-known and thus quickly told.

Smoking rates have been falling since around the 1950s. Depending on the country, they are hovering somewhere around or even below 20%. In Sweden for example they are even deep in the single-digits only, however, the people there prefer alternatives in the form of snus or other orally consumed tobacco / nicotine products.

Let’s just say that traditional cigarette smoking is on the decline.

As this was and still is the case volume-wise, the stocks of tobacco companies should have also experienced a slowdown in their businesses.

We know that it came the other way around.

With the banning of ads and making the entire business pretty unattractive, regulators created a heavy moat around the incumbents, keeping new competition out of the game. But there was the addictive effect of smoking that made customers come back. The remaining companies invested only what was necessary, cut costs to a minimum and focussed on selling the same standardized product forever.

Paired with regular rounds of price hikes, sales and margins increased. Taking the dividends and counting buybacks on top, tobacco was either the best or one of the best performing sectors over the last decades, depending on which timeframe you look.

For decades this formula worked (until recently).

My longer-time readers will know that I am skeptical about this trend to continue, as with every lost customer the pace of the price hikes must increase disproportionately – just to keep sales stable.

This is exactly the same logic as if your stocks dropped: 50% down and you need a gain of 100% just to break even. Apply this to the situation tobacco companies are in. Theoretically, the last smoker would need to pay billions for the last pack which is questionable to happen.

You can read more about Altria (ISIN: US02209S1033, Ticker: MO) and Philip Morris (ISIN: US7181721090, Ticker: PM) here and here in my older articles.

Over the last years, an emerging biotech company came to the surface that had the aim of not less than to disrupt the entire tobacco sector in the US.

How so? Two points.

US regulators have been watching flavored cigs, especially menthol, for a while with a federal ban still looming. Massachusetts and California already did that (see here). Unfortunately, this is a big part of the business for British-American Tobacco (ISIN: GB0002875804, Ticker: BATS) – this paired with the high debt load are the reasons why my members have not received a report about BAT. Too risky.

Besides the menthol topic, also nicotine has get caught in the crossfire.

Wouldn’t it be great to have cigarettes containing nicotine only in a non-addictive quantity? The big advantage would be that smokers could still enjoy their ritual. An exclusive recipe plus the permission to sell them legally? Makes for a compelling investment case, doesn’t it?

Indeed this was the story of 22nd Century Group (ISIN: US90137F2020, Ticker: XXII). The company had a very nice story and received the permission to bring their packs to the market. First sales already started and expansion plans were presented.

I have been following this for years. However, it seems as if this becomes a bent butt.

My focus is on avoiding risks, looking for fundamentally sound stock ideas.

The average total return of my best stock ideas is +11.7%, beating the S&P500 and the iShares MSCI World ETF.

^{as per 22 November 2023 market close}

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Shortly before the finish line…

Note: 22nd Century Group has become a heavily fluctuating penny stock. I am writing about it only to discuss its former case and development to stress that fundamentals must support a story. Promises without supportive financials in most cases are going to fail. This example is no exception.

Basically, the story of 22nd Century Group is a bit more complex, so I have to break it down and focus on the for me essential part, as the envisioned tobacco revolution was a potential game changer.

I must admit, the story sounded really good.

The problem was: weak fundamentals and financing fell short and broke the neck of the company as you will see later in this weekly.

Don’t be confused by the shown return of almost 1,000% over the maximum range.

Make no mistake about it, over the last five years and even over the last twelve months the loss is over 98%…

This alone likely tells it all.

At the peak of optimism, the market cap was even close to a billion USD.

Now it is less than 10 mn. USD and I seriously think that a bankruptcy is more likely than a successful turnaround.

22nd is a biotech company which has been researching and testing cigarettes that contain low levels of nicotine for over a decade. These are said to be non-addictive and the company even was allowed by the FDA to use the claim “helps you smoke less”.

This cannot be done without much effort behind it and without any validity.

22nd Century Group promised to keep the same or at least a familiar taste and the same habit of putting the hand to the mouth which they saw as the main reason why quitting smoking by using cessation products or abruptly over night were tough or even next to impossible for the majority of those who tried.

Management explained their research showed that quitting smoking is often perceived as a negative thing which makes it even harder to accomplish. This observation, the addiction not only to nicotine, but also to the act of smoking itself, became a crucial pillar of 22nd’s marketing efforts.

The secret behind these new type of cigarettes, called VLN (very low nicotine) was a proprietarily cultivated tobacco plant, first as a GMO version and later also as a GMO-free next generation.

That’s why they see themselves as a biotech and not as a traditional tobacco company.

Interestingly, no competitor has ever discussed this topic.

I have never heard or read about Altria, Philip Morris, BAT or Imperial Brands (ISIN: GB0004544929, Ticker: IMB) even mentioning this as an opportunity for the future of their businesses. And PM sees the issue in the combustion process, while 22nd Century focusses on lowering the nicotine content, but keeps the combustion.

This entire undertaking did not generate meaningful sales until recently when in late 2021 the FDA gave the marketing permission.

Before, a few sales came from manufacturing cigars for customers, however, with very low gross margins and sometimes even negative figures which was strange to me.

Later on in 2022, 22nd Century Group acquired a cannabis company with the name GVB Biopharma (see here) which later was put into a single segment with a genetically modified hop business.

From here on, I am only writing about the low-nicotine tobacco segment as I have never viewed the rest as interesting.

After the FDA permission, 22nd Century started the production and its first sales of the promising new tobacco product. Due to its little size and weak finances, the strategy was to first start with a so called pilot program and later on to expand into other states.

The first target was Chicago, one of the biggest US cities and one with high enough smoking rates according to the management. Later, other cities and entire states like Colorado, Florida, Texas, New Mexico, California or Utah were chosen for a launch.

22nd Century Group announced several cooperations with convenience stores like Circle K as their distribution partners.

I saw a five-minute video on YouTube on a regional channel where they reported about the launch of the novelty.

At least one cannot say that these were completely empty promises, as 22nd’s products indeed made it into the shelves for the public to be bought and consumed.

Besides a “normal” version, also a menthol version was introduced where 22nd Century was expecting that the FDA would not ban them in case of a ban of menthol cigarettes (see here).

If you look at the comments below this video, they were a mix of hopeful, thankful and all in all on the positive side.

Some people even wrote about their own experiences with VLNs.

Frequently, 22nd Century was pitching their story with

• a likely coming ban of menthol cigarettes with the hope that smokers would then switch to their menthol version of VLNs as the only game in town
• people who want to but cannot stop smoking, would try VLNs and stay with them to at least reduce smoking with the possibility to abandon it later (22nd would cannibalize itself with this, but that’s another topic…)

At least, this did sound plausible and not completely unrealistic.

Indeed, this has been a topic, not only in the USA, but also in New Zealand (see here) or recently in the UK (see here), where not only menthol, but even cigarette smoking altogether (respectively the sale of cigs to people below a certain age) where implemented or are about to be implemented to dry out smoking entirely.

It was not just a claim from 22nd’s management.

You can find on the official FDA website similar statements.

BAT shareholders, you should at the minimum be aware of this risk.

As this whole story was somewhat exciting to watch and the market entry also done, it is understandable that the stock ripped higher in hope of a success story. It doubled from the official FDA announcement till its subsequent peak and even 5x-ed from just a month before this crucial event.

You can also see below that sales on a quarterly basis ticked up after the launch.

After a period of twelve months in the market, management was speaking about “exceptional early sales” and “consumer interest exceeding all industry exceptions”.

This is from June 2023, i.e. relatively fresh.

But here is what did not work out.

The project was too big to be executed, meaning 22nd lacked the financial firepower to do the marketing, but also pre-produce enough packs for a fast rollout.

Profitability was never there and the initial goal of the management was to become cash flow positive somewhere towards the end of 2024. Effectively, they needed money for at least two full calendar years to pre-finance the launch, to only then maybe harvest their planted seeds.

Cash on hand quickly dried out (negative columns = net cash):

Every new dip shows you where fresh cash was raised.

Now, they have net debt and at high interest rates and no profitably, this door is shut.

You can see below how they diluted their shareholders. In late 2018, the share count stood at 8.3 mn. shares. Until the market launch, i.e. late-2021 to Q1 2022, not much happened. Since then, share count first almost doubled with several equity issuances in just a year towards 15 mn.

As the share price was tanking already, every new capital raise was diluting shareholders even more.

The last raise in Q3 2023 was hefty with a dilution of more than 30% on top.

But the bad news did not end as there is still not enough cash.

After 30 September 2023, another raise came, diluting shareholders by another 50% immediately via new shares and on top another 66% / 100% (20 mn. in relation to 20 mn., respectively 30 mn. after the new share issuance) via warrants.

Since then, the stock is down another more than 50%.

The 5 mn. USD they raised is peanuts. How do you want even keep unprofitable operations alive with 5 mn. USD, not to mention that they raised them to pay down some debt so that this cash was not even available for marketing.

In between, 22nd Century had to do a so called reverse split which is the opposite of a stock split. In the former case, share count gets reduced and the price rises in the same proportion, while the latter is exactly the other way around.

Usually, strong companies with high share prices do stock splits, while penny stocks do reverse splits (not always, as General Electric (ISIN: US3696043013, Ticker: GE) also did a reverse 1–8 split (see here) ).

In the case of 22nd Century, the reverse split was done, because it became a penny stock and this is against NASDAQ listing rules. Since the reverse split which was a 1–15, the stock fell from around 15 USD post split again into penny stock territory as you can see above.

I want to close this overview with the recent earnings announcement where management had to admit that demand – which in June was strongly above expectations – suddenly dropped off due to “an unknown brand to the target market” which is okay for a company with a young product, but also due to the financial hardship:

It is disappointing to see revenue growth having come to a halt on a quarterly basis and that even gross profit (i.e. after material costs) is still negative.

With this, I think the odds for a turnaround are realistically nonexistent, not to mention that we are dealing here with a micro cap penny stock.

With the exception of some hardcore gamblers, no one will buy this stock. Recently raised cash was used to pay down debt, but there’s not enough to finance operations. Without growth and even negative gross margins, we can set the timer for a bankruptcy filing.

Of course there is the chance for a takeover and a quick buck. But I would not count on that.

Conclusion

Great stories can make for a great stock return, but without fundamental support, the risk for a disaster is higher.

Never buy a stock just for its story – always check the financials.

Even a good idea can run out of cash, leaving shareholders holding the bag.

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