22nd Century Group, Inc. Q3 FY2022 Earnings Call

Welcome to the 22nd Century Group's Third Quarter 2022 Conference Call and Webcast. At this time, all participants have been placed in a listen-only mode and the floor will be opened for your questions following management's prepared remarks. It is now my pleasure to turn the floor over to your host Mei Kuo, Director of Communications and Investor Relations. Please begin.

Thank you, Rob. Good morning, and welcome to 22nd Century's third quarter earnings conference call. Joining me today are Jim Mish, our Chief Executive Officer; Hugh Kinsman, our Chief Financial Officer; and John Miller, President of our Tobacco Business. Earlier today, we issued a press release announcing our results for the third quarter 2022. The release, earnings presentation and 10-Q are available in the Investors section of our website at xxiicentury.com, under the Events subheading. We'll start today's call with prepared remarks from Jim, John and Hugh before moving into a Q&A session. As a reminder, those joining by webcast can submit questions through the online interface, which we may include during the Q&A section of today's call, time permitting. Some of the statements made today are forward-looking. Forward-looking statements are subject to risks, uncertainties and other factors that may cause actual results to differ materially from those contemplated by these statements. Additional information regarding these factors can be found in our annual, quarterly and other reports filed with the SEC. During today's call, we may discuss non-GAAP financial measures, including adjusted EBITDA, which we define as earnings before interest, taxes, depreciation and amortization as adjusted for certain noncash and nonoperating expenses. For more details on these measures, please refer to our press release issued earlier today. And with that, I'll turn the call over to Jim beginning from slide three.

Thanks, Mei. Good morning to everyone, and happy Election Day. I've spoken at a number of recent conferences, so I'm going to keep my opening comments brief, and we can get to the details quickly. I will say it's been an incredible few months since our last quarterly update, and there are more exciting topics to discuss than we can fit into our call today. We're going to focus our time on commercial activities of our rapidly expanding U.S. tobacco business and our global scale hemp/cannabis ingredients and CDMO business. I'm joined today by John Miller, President of the Tobacco Business Unit, and Hugh Kinsman, our CFO. First, since our last call, we have aggressively expanded our exceptional VLN pilot results by moving into a multistate commercial launch designed specifically to leverage our awareness, education and trial approach. We've advanced from our Chicago pilot to expanding across Illinois to our first statewide multi-partner launch in Colorado and now announced three additional statewide launches to complete the Four Corners region. This is just the beginning as we intend to grow our presence in now up to 18 states over the next 12 months and take a notable share in these markets. John will detail this more in a moment, but I can't be more excited about our prospects. We have an unstoppable expansion blueprint driven by consumer interest. We can reach a 1% share milestone quickly where we decide to go; we have a plan to cover over 50% of the addressable market within 12-months. Second, we have now integrated GVB Biopharma, a top-shelf ingredient and CDMO provider in the hemp/cannabis derived ingredient space. This has catapulted us into a fully commercialized and growing hemp/cannabis business with increasing margins, and we're moving quickly to complete certifications that will further differentiate our products and make us the dominant global supplier of hemp-derived ingredients. I'll come back to this detail after John. Finally, our financial results are driving long-term growth, margin expansion, operating leverage and cash generation. Our balance sheet is fully funded to support our existing business plans, and we're closely monitoring our investments to rapidly drive share, scale, and financial returns in our commercial pursuits. The chart on the slide illustrates the quickly developing revenue scale in our business that will ultimately drive us to cash-positive flows as we complete this carefully planned commercial launch and investments. With that, I'll let John dive into the incredible work he and his team are doing in the tobacco business. John?

Thanks, Jim, and good morning, everyone. It's an exciting time at 22nd Century as we rapidly work to bring a disruptive product to market. Our Chicago pilot with Circle K yielded exceptional results in a short timeframe, especially when compared to typical industry expectations for a new product launch. We explored various offers to encourage trial and repeat purchases, which has helped us refine our launch strategies for our multistate rollout. We are fully dedicated to our commercial efforts within the $80 billion U.S. retail tobacco market. Even capturing a small fraction of this market would significantly benefit 22nd Century and boost our revenue. Phase 3 involves not just expanding into new states but also bringing on partners for distribution, training, and support at various retail sites. This strategy allows us to efficiently manage overhead while providing extensive service for VLN's rollout. Some of our new partners have authorized VLN to access potentially hundreds or thousands of store locations and offer us accelerated opportunities in new states where these chains operate. Consequently, our retail launch efforts are becoming more efficient, faster, and productive through our partnership model. Now, regarding our current five states, they account for about 7% of the total U.S. retail cigarette market, approximately $5.7 billion at retail prices. Securing just a 1% share would translate to around 3.8 million packs of VLN annually. Additionally, three of these five states benefit from favorable MRTP excise tax structures, which will enhance the effectiveness of our launch programs aimed at adult consumers and our commercial partners. We started our collaboration with Circle K in Illinois, which has fully backed our mission. They've also supported our entry into Colorado, where we engaged Eagle Rock and Creager Mercantile to further distribute VLN across various retail channels. As new retail partners join us, they can also extend our reach into the four corner states where we're currently launching. For instance, Circle K has authorized VLN sales not just in Illinois and Colorado but also in all their stores in New Mexico. This marks the beginning of our rapid expansion of VLN availability, growth in market share, and revenue over the next year, aiming for distribution across 12 to 18 states. The U.S. cigarette market is quite concentrated, and we've adjusted our launch plans to leverage this. Entering just 18 states could give us access to over half of the total U.S. cigarette market, translating to more than $39 billion in sales. Our five current states include three that offer MRTP excise tax benefits. Furthermore, five other states have enacted MRTP tax programs with similar advantages, and additional states have proposed MRTP legislation. The MRTP states present compelling market opportunities that, when connected to neighboring states, allow us to create larger regional markets and enhance the effectiveness of our marketing and awareness initiatives. We will determine the states and order of expansion as we progress, but our approach will include distribution partnerships, awareness campaigns, and educational efforts in collaboration with retail partners committed to improving public health while growing our market share and revenue. I want to delve a bit deeper into how we can enhance the efficiency of our marketing investments by focusing on key market centers. For instance, in Colorado, where we are actively launching, the top 10 counties represent over 82% of the population and nearly 79% of the state's cigarette volume. By concentrating our marketing and consumer engagement efforts on just 11 counties, we can potentially reach 80% of the state's cigarette purchases while still allocating resources appropriately to the other counties. This strategy allows us to focus our marketing budget effectively to maximize returns on our launches. Our Chicago pilot showed that an FDA-authorized tobacco cigarette designed to help smokers reduce their intake is indeed newsworthy. We gained significant media coverage that informed adult smokers about VLN and its benefits. This trend continued in Colorado, with more than 15 segments focusing on VLN aired on local television news stations. With an adult population exceeding 13 million and a retail cigarette market valued over $3 billion, our initiative targets more than 7,000 key stores across various retail brands in the Four Corners region. We will establish both traditional and non-traditional partnerships to collaborate with us in our mission to reduce the harms of smoking. Where applicable, we will leverage favorable excise tax regulations to encourage market adoption and help our partners maximize the VLN opportunities. As we increase our volume, we also need to scale our tobacco cultivation and manufacturing capabilities. We've already announced a record planting season and a 25% increase in our manufacturing capacity to prepare for higher demand. Additionally, we are diversifying our growing locations to include the Southern Hemisphere and are continuously working to enhance our planting results. Our latest VLN 2.0 tobacco harvests showed a 30% yield improvement and better leaf quality, disease resistance, and reduced nutrient needs. Our leaf inventory is increasing rapidly, improving in quality as we ramp up production to meet market demand. This is especially critical, given the growing regulatory movements at both state and federal levels favoring reduced nicotine products. We have discussed the proposed federal ban on menthol products and the potential reduced nicotine content mandate, while state and local governments are taking proactive measures, as shown by eight states with MRTP-reduced excise tax statutes. We believe that our VLN Menthol King cigarettes could be the only combustible menthol option exempt from the menthol ban due to our MRTP authorization. Moreover, research indicates that a reduced nicotine mandate would assist smokers in quitting more easily or transitioning to less harmful products, as we currently hold the only product that meets this standard with supporting clinical data. 22nd Century's research cigarettes are fueling numerous independent studies that validate the public health benefits recognized by the FDA from implementing a nicotine standard. We believe it's only a matter of time regarding these developments, and we are ready to help smokers leverage these policy opportunities to significantly reduce their consumption. We are progressing swiftly and plan to maintain our accelerated rollout to ensure VLN reaches as many adult smokers as possible. Now, I'll hand it back to Jim for an update on our hemp and cannabis division.

Thanks, John. It's been an amazing third quarter for tobacco progress, and we're just getting started. And I just have to pause for a second and just repeat some magic words, unstoppable expansion blueprint driven by consumer interest. It's just an amazing progress that John and the team are making. Let's turn to slide 13 now as we focus for a few minutes on our commercial progress in hemp/cannabis. You've seen this slide before discussing how GVB completes our capabilities from the most fundamental elements of plant genetics and receptor science all the way through to white labeling products on the retail shelf for purchase. We stand alone in the world with this level of breadth of expertise. More importantly, GVB is already the world's largest hemp/cannabis ingredients merchant market supplier with the lowest cost, largest scale, and highest quality. This platform is a tremendous growth opportunity with minimal investment, a process that we are undertaking at a lightning pace. It all starts with the assets we acquired, a fully integrated manufacturing chain that slots right into our plant science platform. This starts with a world-class extraction facility in Prineville, Oregon that will start out at 5,000 kilos per month capacity and grow quickly with our investment program already underway with an expected output capacity of 15,000 kilos per month in 2023. As this facility scales, it will displace a majority of our third-party crude purchases in the market. We will then take that crude material into our 30,000 square foot crude refinement facility where we expect to see a substantial increase in gross margins as Prineville expands, producing global-leading quality cannabinoid isolates and distillates. From there, our 40,000 square foot manufacturing site will produce an extensive variety of white label products for our customers in the nutraceutical consumer products and pharmaceutical industries. The acquisition gives us a strong revenue position in hemp/cannabis, a growth platform as an industry leader and a pathway to increase our gross margin profile and accelerate our path to profitability in hemp/cannabis. Slide 15 brings it together to show how we take our hemp/cannabis business to the next level of global leadership. First, our Prineville crude extraction facility will enable us to buy biomass and produce our own crude rather than buying crude on the open market. This is a massive cost reduction and will enable us to quickly scale gross margin on our operations as this facility scales up. We are ultimately targeting a 50% increase in our gross margins from the current levels as a result of this relatively modest investment while also increasing scale and quality even further. Second, FDA is moving steadily towards establishing novel food product standards for the CBD industry in 2023, including both quality standards, key to certifications and daily recommendations for intake that will unlock a massive consumer goods and nutraceutical market. In addition to our leading role as the world's largest producer of these active ingredients, we are now acting to secure the product in the facility standards that will enable us to become the dominant supplier to these brands. This includes pharmaceutical-grade certifications for both of our facilities of core cannabinoid APIs. In other words, this puts us in the pole position in an exponentially growing global consumer market and also reinforces our CDMO capabilities where we have exciting news to come soon. Moving to slide 16. We target that by the end of the second quarter next year, we'll have a full Drug Master File audit complete giving pharmaceutical-grade certification enable us to supply cannabinoids into clinical pharmaceutical activities under the highest certifications in the world. It will also give us the edge as a leading global ingredient supplier. We believe that we can generate double-digit growth in this business, expand gross margins and take the business unit to cash positive in 2023, helping self-fund our growth efforts across our corporate platform. While a lot of attention is understandably focused on our rapidly expanding tobacco business, our hemp/cannabis products are also scaling fast and have tremendous opportunities for margin expansion and cash flow in the near term. So those are a lot of words, and I just want to summarize one more time because it's an exciting perspective in cannabis. We are already the world's largest merchant marketer of hemp/cannabis ingredients. We already have the lowest cost, largest scale, and highest purity. Now the new extraction unit only adds to these three differentiators and allows new certifications that lead to global dominance. And timing is perfect as the FDA advances to novel food regulations in 2023 that unleash a massive market opportunity. And with that, let me turn it over to Hugh to discuss the financials.

Thank you, Jim, and good morning to everyone. Starting off on Slide 18 with third quarter financial results. Net sales increased by 149% quarter-over-quarter to $19.4 million, which reflects the addition of a full quarter of GVB revenue and record tobacco CMO manufacturing sales. We continue to experience significant customer demand for tobacco and hemp/cannabis products, including higher CMO cigarette volume from new customers in addition to the acceleration of VLN product sales. Gross profit increased slightly quarter-over-quarter to $619,000 as improved gross margin from CMO manufacturing was offset by lower margin from hemp/cannabis sales, reflecting certain nonrecurring charges, and I'll explain gross profit further on slides 19 and 20. Moving to slide 19, tobacco revenue for the third quarter increased to a record $11.5 million from $7.8 million, an increase of 48%. Gross profit margin on tobacco sales increased to 5.5% through a combination of strong unit sales growth and improved product mix from higher-margin CMO and VLN cigarette sales. We expect continued gross profit margin expansion to be achieved with the accelerated launch of VLN. Moving to Slide 20 for hemp/cannabis, which reflects a full quarter of GVB's operations, revenue grew 25% to $7.8 million for the third quarter. This revenue growth reflects an increase in unit sales of over 80% due to strong demand for the company's premium quality built ingredients. And excluding certain nonrecurring charges and the impact of purchase price accounting, GVB's pro forma gross margin was 8.1% in the third quarter. GVB's gross profit margin is typically 15% to 20% and will expand as the company becomes more vertically integrated with the addition of the new Prineville, Oregon extraction facility in 2023. Slide 21 illustrates the updated third-quarter GVB acquisition purchase price accounting in more detail. As the footnote from our third-quarter Form 10-Q explains, the allocation reflects estimated fair values as of the date of the acquisition, which is determined using significant estimates and assumptions. We have substantially completed the valuation procedures required to allocate the purchase price in areas such as property and equipment, intangible assets, deferred taxes, and goodwill. However, further changes may occur in the future, which did material. And last for me, on slide 22, you'll see a few key highlights from our balance sheet. Notably, the total assets of more than $140 million includes the $44 million of goodwill and intangibles from the GVB acquisition. The strength of our balance sheet, including a quarter-end cash balance of $44 million, will support our near-term strategic initiatives, primarily the accelerated launch of VLN. I know that many of you are focused on our cash position and how we're using it to continue our steady progress toward profitability. The company is selectively deploying capital to accelerate the launch of VLN, expand tobacco manufacturing operations, invest in GVB's production capacity, and increase inventory levels to meet growing demand for both hemp/cannabis and tobacco products. 22nd Century's cash requirements are anticipated to decrease, reflecting higher sales volume for VLN products through fiscal 2023 and continued organic growth of GVB's operations. In fact, GVB's on pace to becoming a cash-generating business in 2023, due to the investments we are now making to meet market demand. And as a result, the company has adequate liquidity from the current balance sheet to complete its strategic initiatives. And with that, I'll pass you back to Jim.

Thank you. It's an exciting time for 22nd Century as we accelerate our U.S. VLN launch with major national convenience store and pharmacy chains featuring our VLN products. Our successful pilot has exceeded our internal expectations, and the market opportunity is significant; even a small share could be transformative for us, as John and I have discussed at recent conferences. With the proposed menthol ban progressing as expected and state actions ahead of federal policies, there has never been a better time for a disruptive reduced nicotine content product. We are prepared to advance not only our tobacco innovations but also our hemp and cannabis products, along with the new GVB platform that has now fully integrated and doubled our revenues, enhancing our path to profitability. We have established the framework and foundation, and we are now executing our business fundamentals to move to the next phase of our strategy and maximize the full potential of 22nd Century. Operator, please open the call for questions.

Thank you. At this time, we’ll be conducting a question-and-answer session. Our first question comes from the line of Vivien Azer. Please proceed with your question.

Hi, good morning. Lots of great detail on your aspirations to further expand VLN. Jim, you noted a target for 12 to 18 states over the next 12 months, obviously, a reasonably wide range in terms of incremental volume penetration to as high as 53% at the upper end of that. What are going to be some of the key factors that form whether you hit 12 states as opposed to 18? Thanks.

Vivien, I'll let John share his thoughts on this as well, but I'll provide my perspective first. A few weeks ago, we were aiming for 12 to 15 states; that figure has now increased to include three additional states, pushing us over the 50% mark. This change is primarily influenced by the supply chain. We want to ensure that we don't overextend ourselves in relation to supply chain capacity, taking into account growth cycles and the timing for shelf availability. This is the main factor driving our plans. We intend to progress as quickly as possible towards the full goal of 18 states, while ensuring that we consider our entire supply chain, including the agricultural side, to avoid any stock-out issues when we launch. I'll ask John to provide his input on this as well.

Yes. Thanks, Jim, and good morning, Vivien. Good question too about how do we come to the 12 to 18 states. There's no doubt that there's certainly analytical work that's been done on choosing the 18 states. And really, as Jim has been very transparent in the past, changing the conversation to what we're trying to achieve through these states. What have we taken from the pilot? What have we learned? How do we then implement that in a very pragmatic geographical approach to the business? The 12 to 18 states that you saw on the map that we showed represent about 53% of the total cigarette market. And in the beginning, or I should say maybe last call, there were a lot of questions about a national launch and how do we get nationally. Our team was internally working on exactly what does that mean to have the sort of scope, scale, and presence to make an impact in the market. And this is where we've begun, right? You started in Illinois, you moved to Colorado; the Four Corners approach gives access East to West, North, again, expanding through the pilot program in the Midwest, understanding the opportunities in the Southeast, taking advantage of MRTP taxes in Connecticut and potentially in the Tri-State area. So it's a very pragmatic approach of how we get to meaningful levels in the best way possible doing the analysis and research that shows this is where the opportunities are, this is where the consumers are, and these are our partners who can get us there. I hope that answers your question.

Yes, it sure does. That's really helpful. And so, as we kind of think about modeling the tobacco opportunity on a go-forward basis, clearly, there are going to be two components to revenue realization: One is selling into new states; and then the other being repeat in quasi-legacy states, albeit nascent where it does seem like you have plans to bring on incremental points of sale to deepen your penetration geographically as well? Do you think that the sequential growth that we saw in terms of absolute revenues between 2Q and 3Q is a good framework to keep in mind as we model the opportunity going forward at least over the next, call it, three to five quarters?

Hugh, that would be.

Yes, I'll take that. Hi, good morning, Vivien, very good question. I think part of it we had a big step-up because we had a full quarter, this quarter for GVB revenue. So I think when you're thinking in terms of modeling, let's just take tobacco operations. Some of that was just a significant increase in our CMO manufacturing. We expect to have that continue going forward. But VLN sales will start rolling into the velocity of the VLN sales will start to accelerate going into the end of this year, this fiscal period, and then go starting in Q1 2023. So for purposes of modeling, keeping a kind of the growth rate incremental quarter-over-quarter, which would be steady, if you will, which would be comprised of CMO revenue. And then I would start layering on some incremental growth for VLN as we continue to accelerate the rollout strategy.

That's super helpful. Thank you so much.

Thank you.

Our next question comes from Aaron Grey with Alliance Global Partners. Please proceed with your question.

Hi, good morning. Thank you for the questions and the detail. I have a question about VLN. As you expand into new markets, particularly in Chicago and Illinois, you had a strong partnership with Circle K for displays and shelf placement. I’d like to know how you plan to replicate that success in other states like Colorado, where Circle K will also be present. Specifically, how will you ensure similar shelf placement and displays at retail to achieve the same 1% plus market share you reached in Chicago and other areas? Thank you.

Thank you, Aaron, for your question. It's a great starting point to discuss the current retail environment. In Colorado, we have a program with Circle K that closely resembles what we implemented in Illinois. Additionally, as I mentioned earlier, we have expanded our partnership with Circle K into New Mexico. This strategy involves applying the insights gained from our pilot programs and broadening them across various stores. In Colorado, our approach with Circle K largely mirrors our success in Illinois, and we are directly applying those lessons in New Mexico. We focus on what we refer to as trial education awareness, which is crucial in guiding retailers through the process of trial and adoption. When retailers comprehend our approach, including the distinctions between VLN and traditional cigarettes, and see the results of our testing alongside our market introduction, it becomes clear and logical to them.

Great. Thanks for that. That's really helpful color. I'm glad to hear that retailers have been receptive. So second question, we want to talk about GVB a bit. Now that it's been under the company umbrella for a bit, we go back to when the acquisition was made, you guys talked about revenues being $48 million for the year 2022, gross margins of 44%. Obviously, if you look at the filings, it looks like year-to-date had it been closed January 1, you're at $23 million, so below that mark on the sales. And you talked about the gross margins 15% to 20%. Last quarter, you had mentioned 20% to 25%. So just at the high level, I want to maybe take some learnings, maybe there's some more noise from the acquisition once you got under the hood than you had previously expected. So I would love to get more color in terms of how you see the acquisition now a couple of months post-acquiring it versus maybe some thoughts you had initially? Thanks.

Yes, I can begin, and then Hugh can add his insights. Overall, post-acquisition, things are aligning with our expectations and even exceeding them. We anticipated the usual integration challenges in Q3, which we experienced. This involved a coordinated effort across various functions, especially in commercial operations. We expected a potentially slower Q3 in terms of volume, followed by a stronger recovery in Q4 and into 2023, which is precisely what we are seeing. This applies to both our ingredient offerings and cannabinoids, as well as the CDMO sector, which was just starting to develop when we completed the acquisition in May. The integration process is progressing well. Having overcome the challenges of Q3, we are now seeing positive momentum on both the ingredient and CDMO fronts. As previously stated, the key to unlocking the CBD market lies in the U.S., while Europe awaits the FDA's safety guidelines for CBD. This will not only enhance the U.S. consumer product landscape by addressing safety and quality but will likely influence the larger European market due to its population size. Everything is unfolding as we anticipated. We dedicated additional time to the integration in Q3, but by Q4, we are returning to our desired momentum. We boast excellent ingredients and CDMO capabilities supported by an energized team, which has solidified our foundation. Hugh, is there anything you would like to add from the financial perspective?

Yes, I completely agree, Jim. I think it's important to mention that just the backlog for the demand we have for specialty ingredients is significant going forward. So that should compel revenue growth in addition to some of our white-label contracts which should be coming along in fiscal 2023. And with that and the Prineville extraction facility coming online will be continued margin expansion as well.

Great to hear that. Helpful detail and I’ll jump back into the queue.

Our next question comes from Brian Wright with Roth Capital Partners. Please proceed with your question.

Thanks. Good morning. I wanted to start by discussing the VLN map with the 18 states. In the press release, you mentioned focusing on the favorable MRTP states, but you also considered the importance of adjacency factors. Texas particularly stands out to me. I'd like to know how you're prioritizing these states and your thoughts on this analysis.

John, do you want to cover that?

I'm sorry, Brian, my phone cut out for a second. Did you say that Texas was highlighted in red?

Yes, as far as like, it's so close to the Four Corner States, and it's a big state. I know it's not MRTP, but it just kind of seems like that would be a high next priority.

If you examine the map with the 18 states, the light green states indicate the MRTP states, while the dark green states represent our priority states, with Texas being one of them. The purpose of the map is to distinguish between MRTP states and our priority states. Texas is clearly a priority, being the leading cigarette state in the country, presenting a significant opportunity as we focus on the MRTP states. There are eight MRTP states, and we are looking to build a regional market around them. In the Southwest, we consider Texas and the Four Corners region, while in the Southeast, North Carolina and Florida, which ranks third for cigarette consumption, create a connection. Additionally, both Georgia and Texas initiated MRTP legislation last year, which could present opportunities if it passes soon. The Midwest includes Kentucky and Michigan as MRTP states near Illinois, an area with a high concentration of adult smokers. I hope that clarifies things for you, Brian.

Great. Yes, it does. Thank you so much. If I could have just one follow-up. On the GVB side, I wanted to understand more about the Drug Master File submission to the FDA. Is there a timeline for that, and could you provide some details about the process and what it entails?

Yes, I can handle that, Brian. Yes, the submission we're scheduling for Q1, that does two things for us: first, it opens up the door to supply ethical into the ethical pharmaceutical industry for clinical trials and no one can do that at the moment with naturally derived products. So that opens up that space. And it also then establishes really the highest level of quality, obviously, the lowest level of impurities to our isolate. And that really sets the stage to keeping up with the FDA's movement on the novel food safety standards. The first thing they'll do is establish an upper threshold. Nobody knows for sure exactly what that's going to be, but I've heard numbers anywhere from 25 milligrams per day up to 100 milligrams per day, that would service the nutraceutical market. That's the first thing that they'll do in '23. Right behind that, they will establish the highest quality specifications, and they'll be looking to what's plausible in the marketplace and looking for people to work with them, which we already are to establish those quality purity guidelines and also specifically what impurities are in there and the stabilization of it. So we'll derive advantage off of that via the DMF filing at the same time. So it really helps us on pharmaceuticals; that simultaneously helps us on novel food, meaning food, beverage, and nutraceutical products. And as I said, we've heard very strongly that the FDA has really taken the lead on a global basis to establish these specifications and more than likely, the external European markets, Asian markets, Canadian markets will look to them to establish similar guidelines and expand and reboot in essence, the CPG market. So that's the timing, and that's really the value to us right along with our mission, which is we want to have the absolute lowest cost, the absolute largest scale and continue to push the absolute highest levels of certification and certainly, pharma-grade CBD and other cannabinoids is where you need to go and the DMF is part of that process.

Great. Thank you so much.

Sure.

Our next question comes from Jim McIlree with Dawson James. Please proceed with your question.

Yes, thank you and good morning. Just wanted to follow-up on a question Vivien was asking about the contract manufacturing revenues in Q3. Do I understand this correctly that the quarter-to-quarter change in tobacco revenues of about $1.5 million was mostly contract revenue?

Yes, Jim, that's correct.

Thank you. Hugh, you mentioned a gross margin of 15% to 20% for GVB. I want to clarify if you are indicating that this margin is on a normal basis without considering the new manufacturing plants coming online. Is that accurate? So, we should expect to see this 15% to 20% starting in Q4, and as these additional plants begin operations, there should be a rise as we move through 2023. Is that the correct perspective?

That's exactly right, Jim. I mean, 15%, 20% is our typical gross margin, especially just in a steady state. That percentage will start to increase over time as we layer on the fully integrated Prineville facility. So those will be the right assumptions going forward.

Great. And then my last question is on operating expenses for the quarter. In the Q, I talked about accelerated stock comp accounting for an additional $1.9 million and then strategic consulting accounting for an additional $1.7 million. How transitory or permanent are both of those expense levels when we're looking at Q4 and 2023?

The stock compensation comprises mostly one-time expenses related to the acceleration of payment for reorganization. While consulting expenses may not reach that level, there will still be some ongoing costs due to the way we are developing our IP portfolio moving forward.

So the strategic consulting is mostly on the IP side, and I assumed it was for the DLM rollout; it's mostly IP is what you're saying?

Yes. It's mostly IP, but there is some of that consulting really to VLN, but it's definitely related to our IP development for our receptor science and plant genetics.

Got it. Got it. All right, fantastic. That’s it from me. Thanks a lot.

Thank you.

Our next question is from Alex Fuhrman with Craig-Hallum. Please proceed with your question.

Hey, thanks very much for taking my question. I'm curious, now that you've been in a couple of different states that have different tax treatments for your VLN product? Has there been a clear indication of which kind of ways of passing on that pricing have the biggest impact, whether that's just a bigger margin for the retailer or passing that savings on to the consumer. I'm curious if you've had enough experience in different jurisdictions to really have a sense of is that helping to move the needle for demand or how that's playing out?

Yes, that was a good question. We closely examined the retail pricing for VLN. During the pilot, we observed various price points, especially in Cook County and the City of Chicago, where some stores had three different tax stamps on the packs. We conducted research to determine the appropriate retail pricing for launching VLN. We discovered that consumers weren't necessarily seeking bargains; they were willing to pay prices similar to top-tier brands like Marlboro or Camel. While consumers appreciate offers, we integrated this into our trade marketing strategy. In MRTP states, we can utilize tax savings for marketing purposes to enhance awareness, education, and trial. For instance, in Colorado, the price is $6.50 per carton, and for those wanting to reduce their dependence on traditional cigarettes, the difference is just $0.65. When consumers understand and are aware of VLN, it drives trial and repeat purchases. We have an effective trade marketing program in Colorado, collaborating with sophisticated retailers like Circle K and Smoker Friendly, which operates primarily as a discount tobacco channel. Their systems enable us to implement promotions and adjusted carton prices in various areas. Therefore, the MRTP's influence is part of a comprehensive program that ultimately benefits consumers, trade partners, and everyone involved in delivering VLN to consumers. I hope that answers your question.

It certainly does. That's very helpful. I would like to ask about the VLN 2.0 tobacco. It appears you're experiencing a lot of success with that crop. Will the majority of VLN cigarettes in the future use this VLN 2.0? Can you discuss whether it's primarily focused on improved taste and texture or on better yields and reduced costs? I would love to hear more about the success you're having with this second-generation product.

Sure. I can address specific aspects of this. We're seeing that VLN 2.0 is contributing to our brand's sustainability. Calvin Treat, our Chief Science Officer, along with our teams, has done an exceptional job developing a more sustainable product. As I mentioned in my opening remarks, this product offers better yields, requires fewer nutrients, and improves as our experience in growing it increases. It will certainly be part of our product lineup, enhancing sustainability and disease resistance. There is substantial science behind how this will benefit the product. Jim, if you have anything to add, feel free. Overall, it will lead to a more sustainable and superior product.

Yes. The only thing I can add is that we aim for year-round growing in both the Northern and Southern Hemispheres, which we are achieving with all the varietals where we hold intellectual property and can blend as needed. The initial feedback on the product is already very positive. This approach provides us with flexibility in our supply chain and for future product development as well. That's essentially the main driving force behind this initiative.

Hey, that’s really helpful. Thank you very much.

Sure.

We've reached the end of the question-and-answer session. I'd now like to turn the call back over to James Mish for closing remarks.

Thank you, and thanks again to everyone for joining us today. All I'll say is please stay tuned shortly for our next updates as we continue to expand our VLN launch in the U.S. and move ahead on our cannabinoid opportunities utilizing the GVB platform. You'll be hearing from us very soon and I look forward to talking to you all next quarter as well. Thank you and have a great day.

This concludes today's conference and webcast. You may disconnect your lines at this time, and we thank you for your participation.