22nd Century Group (XXII) Q1 2023 Earnings Call Transcript

22nd Century Group (XXII -5.26%)
Q1 2023 Earnings Call
May 09, 2023, 10:00 a.m. ET

Contents:

• Prepared Remarks
• Questions and Answers
• Call Participants

Prepared Remarks:

Operator

Welcome to 22nd Century Group first-quarter 2023 conference call and webcast. At this time, all participants have been placed in a listen-only mode. The floor will be open for questions following management's prepared remarks. [Operator instructions] It is now my pleasure to turn the call over to Matt Kreps, investor relations for 22nd Century.

Please begin.

Matt Kreps -- Investor Relations

Thanks, Brian, and good morning and welcome to 22nd Century's first-quarter earnings conference call. Joining me today are Jim Mish, CEO; Hugh Kinsman, CFO; and John Miller, president of our tobacco business. Earlier today, we issued a press release announcing our results for the first quarter 2023. The release, earnings presentation, and 10-Q are available in the Investor section of our website at xxiicentury.com.

We'll start today's call with prepared remarks from Jim, John, and Hugh before moving into a Q&A session with our analysts. Given the limited time for today's call and Q&A, we will again focus on commercial advancements driving revenues in our VLN tobacco and GVB hemp cannabis business units. If you have questions about our business not addressed on this call, you are welcome to email investor relations using my contact information provided in today's press release. On Slide 2, a few reminders for today's call.

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. Also 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 3.

Jim Mish -- Chief Executive Officer

Thanks, Matt, and good morning, everyone. We continue to execute our operational plan to grow the tobacco and hemp cannabis business and transform to cash positive in 2024. We recognize that there are many key questions from our shareholders that we will answer today. These include: clear guidance on revenues and how and when we get their; VLN distribution; and more important, store count and commercial sales; and hemp cannabis ingredient and distribution ramp up.

We also get a lot of questions about cost cutting. I can assure you that this is a constant part of our discipline to focus dollars only where it leads to our goal of operating profit. Just this quarter for example, my staff has been reduced by 30 %, and we have ongoing cost programs across the business. Now, this said, we will not cost cut our way to success.

We are a growth company. We're off to a great start this year on revenue in Q1. And once the business interruption insurance for Q1 is received here in Q2, it will result in a succeeding plan on revenue, gross profit, and operating results for the first quarter. I'm proud of this team and our continued execution of our plan that will drive growth, margin improvement, and operating performance.

Recall that we have been consistent that Q2 would be when we gain real traction on commercial sales of VLN based on the flag planning process and timing of our retailers. It's important to understand that the VLN rollout follows a detailed process, but it is happening at twice the speed of a typical tobacco product rollout. John will detail our aggressive commercial rollout of our FDA authorized VLN reduced nicotine cigarettes. This includes a highly anticipated launch covering thousands of stores across California, Texas, and Florida with the No.

1 USC store chain supported by national scale distribution providers. Additional new retail chains are already scheduling product launches planned for 2023 to ensure their position with us. In our hemp cannabis business, we're focused on growth initiatives to capitalize on our dominant market position in cannabinoid ingredients in our new sales and distribution services. We again reported record cannabinoid ingredient volumes and recently signed two transformational CDMO+D license agreements with industry leader Cookies and Old Pal.

Combined, these agreements are worth at least $140 million in sales over their three-year term with very attractive margins. And additional deals are well into the pipeline. We're also restoring our capacity lost in the Grass Valley fire. And while business interruption insurance will cover our margin impact in Q1 and Q2, we will see significant margin expansion in the second half of 2023 due to this restored capacity.

Combining these facts, our confidence in our growth outlook has us introducing our first revenue guidance, calling for full-year 2023 revenue of $105 million to $110 million. This represents a 69% to 77% increase from the $62 million in 2022. Achieving that goal plus execution on several cost cutting and margin improvement initiatives already in progress provides us a clear pathway to achieve cash positive operations from both businesses in 2024. Slide 4 provides a snapshot of this path.

In tobacco products, we've secured major national scale distribution agreements with the No. 1 and No. 2 distributors that expedite putting VLN into hundreds or even thousands of stores at a time across multiple states. This enables the launch we are working on now with thousands of C-stores in the three largest state markets and for us to expand our relationship with the No.

2 C-store and also opens up a massive funnel of more than 100 retail chains interested in VLN. Q2 is where the commercial sales and store count will take traction. And recall that we just need to hit an annualized run rate of 1.2 million VLN carton sales to generate positive cash flow in our tobacco business unit. In hemp cannabis, we continue to deliver record ingredient volumes as the dominant leader.

We're driving increased demand for our CDMO services and have now secured the first two exclusive fully verticalized sales and distribution agreements with major brands. Combining with several cost cutting and margin improvement programs, we're tracking to our goal of cash positive in the first half of 2024 in this business. So, I say with continued confidence and stay confident that we will deliver on the company's full potential and cash positive operations. With that, let me turn over to John to discuss our tobacco business activities in much more detail.

John?

John Miller -- President, Tobacco Business

Thank you, Jim, and good morning, everyone. We are rapidly scaling an incredibly disruptive product and on track to move quickly from 500 stores carrying to VLN to 5,000. And that's just to get things started. And while the path has certainly changed along the way and we'll definitely continue to evolve as we learn more about this incredible product, we are 100% committed to success.

Turning to Slide 6. It's important to appreciate that at this time last year, we were in less -- we were 30 days into our VLN pilot. We needed to confirm how best to take this exceptional product from FDA authorization to scalable distribution to full consumer acceptance. The cigarette category is ultra competitive.

National distribution is a multiphased, time-consuming, and complex product, and the adult smoker acceptance will be driven through sales and marketing actions that drive awareness, education, and trial. Early sales exceeded industry expectations and drove our continued market research activities and testing through the remainder of 2022. I came on board last May and, in the fall, began to hire our team of deeply experienced tobacco industry professionals to help in our mission to be the last cigarette adult smokers ever purchased. By December, we knew that there was an opportunity to make a major shift into national scale distributors with geo-focused retailers and the sales and marketing activities that will drive consumer acceptance.

We understood this process will require some time but would also greatly accelerate our launch capabilities for 2023. We have now done that. And our new launch plans for thousands of stores will be the proof that the time, patience, and incredible effort that has taken place behind the scenes these last few months was 100% worth it. Slide 7 explains why.

You've seen this map. What is different is that we now have the No. 1 and 2 national distributors signed up and shipping, allowing us to place VLN at thousands of stores within weeks. This is critical as the opportunities our teams have worked on for the past five months can take us from 500 stores to 5,000 stores in a single agreement.

And that's the start. This distribution has also opened up the floodgates, and retailers are scheduling product launches across the rest of 2023. This includes not just C-stores but also pharmacy, big box, club stores, and military sites, all drawn from more than 100 retail chains now at various stages in our sales pipeline. Support is growing fast.

For example, we have just been approved by the National Coalition of Franchise Associations behind one of our key retailers even before a launch. This gives VLN access to franchise owner groups covering more than 7,500 stores across the country. As another example of the benefit of taking the time to properly build the national distribution network, we expect to be rolling out VLN to several Marine Corps bases later this month. The bases are located in Southern California, Arizona, and North Carolina.

This provides an entry point to expanding with other branches of the armed forces domestically and internationally and supports a key Department of Defense initiative of helping our military personnel reduce smoking. These military facilities are all serviced through our new distribution agreements. Moving to Slide 8. Underpinning this phenomenal market access and acceleration, we have refined and enhanced our consumer marketing based on what we have learned, so we can maximize these incredible opportunities.

Our research last year helped us to understand how smokers are not just addicted to nicotine but also the act of smoking itself. Further, most current cessation tools only address the nicotine addiction and utilize negative messaging, which works against success by smokers. VLN offers a new tool and a positive optimistic approach to reducing smoking. We empower smokers to confidently and capably take control of their habit, break the nicotine addiction, and then move away from the behaviors as well.

This is a critical distinction for VLN. You'll also notice that the ad sample captures those same strengths that set VLN apart, confidence, capability, freedom, and the lack of pressure from fear of failure. It's really an incredible opportunity to give the power back to adult smokers, so they -- they can succeed on their own terms. And turning to Slide 9.

As part of getting the word out about this incredible new tool to reduce smoking, we're going heavily digital with hyper targeted awareness campaigns designed to educate and encourage trial. We can be very precise with our placements reaching just our target audience or key influencers by utilizing videos, native, banner, and image ads. These and other dynamic engagements are designed to convey the VLN product position, value proposition, and reinforce brand credibility. One of the things we learned is that many smokers are absolutely interested in switching once they learn about VLN, an incredibly difficult feat with smokers who are among the most brand-loyal consumers.

It gives credence to how powerful VLN can be. Moving to Slide 10. We'll complement that engagement with the revamped brand site, testimonials, continued positive reinforcement and encouragement, plus local PR efforts to generate public awareness and proactive conversations about smoking harm reduction and highlighting a new tool that can help smokers reduce their smoking by still smoking until they naturally see a decline in their consumption. We're also looking to build and reach influencer communities.

In addition to macro social influencers and clinical leaders, it's also micro-influencers and peer-to-peer influence such as family members and friends of the smoker who can play an important role in education, awareness, and continued support along this journey. In Slide 11. So, can we do it? That's the key question. And the good news is that we not only have an incredible runway of exciting new relationships, market data, marketing campaigns, and retail stores, we also have a good predicate to demonstrate these channels can work.

Pinnacle is a new premium store brand designed to offer better value to smokers not yet ready to quit. It's also a great proof point that we put a new product into thousands of stores across more than 20 states and quickly gained share, which is exactly what we are doing with VLN. Pinnacle launched to the top five C-store chain with 1,700 locations rolling out in just weeks through one of our new distribution agreements. Early sales are robust even before the C-store began promotions, moving toward a run rate of several hundred thousand cartons per year.

This experience illustrates the path for VLN with more retailers, more stores, and a more differentiated story. In short, yes, we can launch with the No. 1 chain across thousands of stores in multiple states. All we need is the green light to go.

On Slide 12, we update several other initiatives and placed design to expand and improve our business results. Many of you are keeping close watch on our international efforts, which are moving forward. We've launched a test in Switzerland. The product has already shipped to our Swiss distributor, and the more than 200 targeted stores will receive VLN later this month.

In Japan, we have cleared all major regulatory hurdles and are preparing the shipment to our Japanese distributor to begin a test in approximately 200 stores in June. And our efforts in South Korea continue to move ahead. We learned a lot from the initial program. We've updated the packaging and product attributes to align closely with that market and will again be shipping mid summer for additional retail program.

Slide 13. On the operational front, we're taking actions to improve our margins and profit. This includes rotating out of lower margin filter cigar business and allocating greater production capacity to our growth markets in premium products like VLN and Pinnacle. Volumes have already increased ahead of retail placements as distribution centers prepare for their customer sales and replenishment orders.

You will start to see this activity in the Q2 results and growing thereafter. Turning to Slide 14. We have talked extensively about the benefit of federal regulation in both the U.S. and overseas and believe these policies are moving closer to reality.

We believe the first action is the FDA's proposed ban on menthol slated for final rule status in August. We believe that our VLN Menthol King cigarettes could be the only combustible menthol cigarette on the market exempt from federal menthol ban. Longer term, a federal-reduced nicotine content mandate, such as that adopted by New Zealand, would be even more effective in reducing the harms of smoking. We are excited about New Zealand's groundbreaking policy as, not only a great policy for their country, but as a template for other countries to pursue similar action.

We announced a seed growing program sufficient to supply the entire New Zealand cigarette market approximately 2 billion sticks. This shows that it's not only feasible but actually workable to scale up a full federal-reduced nicotine program in a relatively short period, a massive opportunity for a public health benefit. So, bringing it all together on Slide 15. We're rapidly accelerating toward our goal of achieving cash positive results in 2024.

We are driving to exponentially increase VLN's availability. We're leveraging our new distribution agreements and an incredible pipeline of retail stores wanting to carry the product. These efforts are backed by a new consumer awareness, marketing, engagement, and influencer campaign designed to empower and affirm smokers, encouraging them to take control and achieve success. Our campaigns will support the adult consumer and positively reinforce their efforts.

And along the way, we are optimizing our operation to transition our capacity toward these better-margin growth opportunities, scale up VLN capacity, and generates results for our investment in the team driving the ramp. Success here drives scale, margin improvement, and, ultimately, cash positive results in 2024. With that I'll hand it back to Jim.

Jim Mish -- Chief Executive Officer

Thanks, John. That's really an incredible update and should give everyone listening a clear understanding of the massive amount of activity and line of sight to revenue in our VLN programs. I'm excited to say we're also seeing similar results in our hemp cannabis division. Starting on Slide 17.

GVB is the market leader in North America for the manufacturing of hemp derived active ingredients and finished products servicing the consumer packaged goods, nutraceutical, and pharmaceutical industries with a global footprint. Sales have ramped strongly, and we believe we'll continue to do so, driving to cash positive operations in the first half 24. This is driven by key actions in motion. First, we continue to set new records for ingredient volumes and sales delivered quarter after quarter.

Second, our new CDMO+ distribution model provides a complete vertically integrated solution between 22nd Century and brands. Third, our new extraction unit is online, and a new distillate unit is coming online in Q2, putting us on track to replace capacity and recover margins following the Grass Valley fire last November. And fourth, we're taking several other actions to both ramp up our volume capability and reduce costs to improve profitability such as new contract farming of our own hemp biomass. Moving to Slide 18.

We continue to set new records in ingredient delivery each quarter and don't see that trend slowing. This quarter, we delivered more than 68,000 kilograms of ingredient. This is four times what GVB delivered in the quarter a year ago, and we see continued growth ahead even beyond this exceptional number. This has placed us in a dominant position for North America and our deliberate decision to ensure we maintain all customer deliveries and volumes, even at a short-term cost to our margins, was absolutely the right path, especially when the first business interruption insurance is received in Q2 applicable to Q1 gross profit.

And I want to point out again that we're doing this without our in-house production facilities. So, as our own capacity comes back online, those margins will return to positive territory. We can further improve them through our internal optimization efforts already in motion. On Slide 19, we announced last week the second of our transformative CDMO+D agreements, now encompassing both industry leader Cookies and the well-known Old Pal brand.

These exclusive license agreements cover branded, hemp-derived cannabinoid consumer products and accessories. 22nd Century provides single-source integrated production sales and distribution, leveraging our industry-leading formulation ingredient and manufacturing infrastructure plus the company's turnkey sales and distribution platform for a complete go-to-market solution. The brands can then focus on customer engagement and marketing while we provide expansive access to mass market channels urgently seeking new high-margin products to meet growing consumer demand. I continue to think that the market has underappreciated this opportunity as we estimate the combined value of our two agreements signed today is potentially more than $140 million, a significant increase in revenue over the next three years from just the first of these opportunities.

On Slide 20, making those agreements possible is our industry-leading infrastructure. We believe that as our world-class extraction facility in Prineville scales, it will displace our third-party crude purchases in the market. Our new distillate facility in Prineville will be online this quarter with isolate production capacity to come in either late '23 or very early '24. Our new campus approach will increase total capacity, efficiency, and productivity, generating a better capability than our original facilities.

From there, our 40,000 square foot Las Vegas manufacturing site will leverage our VLN market sales and distribution teams for the new CDMO+D agreements. We've also opened these facilities in Europe and acquired RXP in the U.K. to create a strong footprint for landed ingredient sales in the higher-margin European market. And finally, Slide 21.

Bringing it all together, we are tracking to exciting growth in a clear path to cash positive operations in the first half of '24 for this business unit. We'll do that by a steady and dedicated focus on operating performance enhancement, internalizing and capturing margins across our growing volumes, plus the new CDMO+D business agreements that significantly scale up our revenue and enable us to capture a greater share of the margin chain. We're augmenting these immediate actions with developments for the future, including path to pharmaceutical sales, as new facilities come online and positioning for the future food and nutraceuticals market opportunity once FDA and Congress establishes the new regulatory pathway. But our success is not dependent on this.

This is all upside. With that, I'll turn it over to Hugh to cover the financials. Hugh?

Hugh Kinsman -- Chief Financial Officer

Thank you, Jim, and good morning to everyone. Starting off on Slide 23 with first-quarter financial results. Net sales increased 144% quarter over quarter to 22 million reflecting the addition of GVB revenue. Net revenues are expected to increase steadily through 2023, driven by increased VLN sales, growing GVB bulk ingredient revenue, and new CDMO distribution agreements.

Gross profit is projected to improve significantly in Q2 2023, reflecting higher-margin product mix for tobacco business unit, as well as the return of production capabilities, the establishment of a farming programs, and new distribution agreements for hemp cannabis. Moving to Slide 24. Tobacco revenue for the first quarter remained relatively unchanged at 8.9 million, with gross profit decreasing to slightly to 18,000, reflecting the planned reallocation of production capacity toward a higher-margin product mix including VLN and conventional cigarettes. On Slide 25, hemp cannabis revenue for the first quarter grew 85% to 13 million from 7 million due to continued strong customer demand for bulk ingredient products.

Gross profit decreased to negative 1.2 million reflecting the impact of the Grass Valley fire. The gross profit won't improve immediately in Q2, reflecting our new extraction facility and the return of distillate capabilities. And gross profit will continue expanding throughout the year due to the new farming program and return of isolate production in Q4 2023. On Slide 26, you'll see a few key highlights from our balance sheet.

Of note, total assets of more than 124 million includes approximately 51 million of goodwill and tangibles from the GVB and RX Pharmatech acquisitions. The balance sheet includes 23.7 million in cash balances, including proceeds from recently completed $21 million senior debt facility. The new credit facility will fund increased working capital needs, reflecting significant growth in both VLN and the hemp cannabis business lines. And it should be noted, the company received insurance proceeds of 5 million from the Grass Valley Fire in Q1 this year, with additional proceeds of approximately 8 million for business interruption to be received beginning in Q2 2023.

Finally, Slide 27 reaffirms our revenue guidance for fiscal year 2023 of 105 million to 110 million. Both tobacco and hemp cannabis franchises are tracking to cash flow breakeven at fiscal year 2024, reflecting strong demand for VLN product and hemp cannabis bulk ingredients, as well as accelerated unit sales from our new distribution agreements. And with that, the operator will now open the call to any questions.

Questions & Answers:

Operator

Thank you. Ladies and gentlemen, we will now begin the question-and-answer session. [Operator instructions]. Please note, you are allowed to have one question and one follow-up then rejoin the queue.

One moment please for your first question. First question comes from Aaron Grey with Alliance Global Partners. Please go ahead.

Aaron Grey -- Alliance Global Partners -- Analyst

Hi, good morning, and thank you for the questions. So, first question for me just wanted to start off on VLN. So, if I see that it looks like you'll be transitioning to more revenue generation for them. Just to give more color, did the shelf resets have an impact there, and are you already in-place for that for your retailers happy with the shelf space that you're going to be expecting there? And then, in terms of the revenue growth, you'll be expecting from tobacco off of that 40.5 million base of last year.

Looks like based on the graph, it will be about in the low pictures or so. Is that -- how much of that is driven by VLN versus by the Pinnacle? Thank you.

John Miller -- President, Tobacco Business

Hey, good morning, Aaron. This is John. I can take the question on the shelf, or that we're going to be merchandising yet. Everyone that we're going to market with, we are worked into their sets.

We are part of the merchandising, and a lot of them have truly understood the story that we're putting out there about what our brand is about. And they want to help provide a solution to those 35 million smokers who want a solution. So, yes, this is all encompassed within the schematics. And again, talks about the process that I talked about, the extensive process, the complexity around it.

That involves, obviously, planograms, reset schematics. So, VLN will be part of those sets. And I guess Hugh could probably answer the revenue question.

Hugh Kinsman -- Chief Financial Officer

Sure. Will do. Aaron, just to give you some guidance, we're -- significant portion of the incremental increases related to VLN. I'd say probably 60%, 70% of that, and the remainder is due to Pinnacle growth.

Aaron Grey -- Alliance Global Partners -- Analyst

OK, great. Thanks for that. It's really helpful. And then secondly for me, just in terms of the contracts that you have with Old Pal and Cookies, strong brands in the THC market now transitioning to some of the other cannabinoids.

So, as we think about the 140 million over three years, how do we think about the timing and the ramping of that and how it might impact the P&L? Wondering if I ask is because again kind of looking at that top-line guidance, it would imply hemp sales again in the low 50s, you guys did about 13 million. So, that kind of maintains that 1Q 2023 run rate. So, not sure if those some shipments that might have impacted the timing that benefited the quarter that might not repeat or how to think about that segment going forward? Thank you.

Hugh Kinsman -- Chief Financial Officer

Sure. I can take that. So, obviously, we recently signed the agreement there, and so the shipments will start in Q3 of this year. And it increases pretty rapidly.

So, the way to think of it is, I would say, the bulk ingredients are pacing along the lines like you said, it might even be a little higher quite frankly. And we'll start later on the contract revenue as we refine tune the production and supply chain cycle. And then, from there, ramp the business accordingly, especially with the incremental penetration in the retail stores. So, probably the way to think about it is, ramping slightly in Q3 starting to really ramp significantly on both contracts in Q4.

And then, I would say -- I wouldn't call it hitting a steady state because it looks like it'll continue ramping meaningfully throughout 2024 and probably hitting a steady state sometime and mid-2024 and ramping steadily. But, really, the big ramp will be in the next two to three quarters for each of those contracts.

Aaron Grey -- Alliance Global Partners -- Analyst

OK, great. Thanks. Appreciate the color, and I'll jump back in the queue.

Operator

Thank you. And next question, we have Vivien Azer with TD Cowen. Please go ahead.

Victor Ma -- Cowen and Company -- Analyst

Hi, good morning. This is Victor Ma on for Vivien Azer, and thank you for the questions. So, first off with the launch of Pinnacle, can you please comment on price positioning given the down trading we're seeing in U.S. cigarettes? Thank you.

Jim Mish -- Chief Executive Officer

Yeah. As we had discussed on the call, Pinnacle is a brand for one of our chains. And they're pricing it, I would say probably the best position to say like probably around Lucky Strike. It seems to be in terms of that, in terms of their pricing and strategy on that product, not super premium, certainly not worth tier.

But right around that position.

Victor Ma -- Cowen and Company -- Analyst

Great. Thank you. And then, can you provide an update on the VLN's launch in the States that you're getting ready for last quarter, namely Arizona, New Mexico, and Utah?

Jim Mish -- Chief Executive Officer

Correct. As we continue to roll the product out and continue to refine the plans, we have had the product in Illinois and Colorado. We continue to make progress in those states, certainly still on the radar moving forward with all of those. Specifically, those three states are part of the 18 priority states that we're going to continue to ramp.

And we are continuing to see, obviously, the retailer demand for that moving forward. Part of Aaron's question, really, it was very good because when you look at sort of some of the complexity around getting into the stores, it has been about timing. We are subject to resets, schematic changes planograms. All of that is part of the discussions we're having with these major retailers in those states.

It continues, and we feel we are on track to be exactly where we said we would be in those 18 states and probably a few others.

Victor Ma -- Cowen and Company -- Analyst

Great. Thank you. I'll hop back into the queue.

Jim Mish -- Chief Executive Officer

Thank you.

Operator

Next question, we have Alex Fuhrman with Craig-Hallum Capital. Please go ahead.

Alex Fuhrman -- Craig-Hallum Capital Group -- Analyst

Hey, guys. Thanks for taking my question. wanted to ask about, as you've expanded to more states, what have you seen in terms of the mix of menthol? And as you think about expanding to states that you have either statewide or local city bans on menthol, how is your marketing strategy going to be different?

John Miller -- President, Tobacco Business

Good question, Alex. When we saw at 2022 end, menthol still represented about 35% of the market. Obviously, when you have states like California and quite honestly, some of the other local brands, I think at the end of the last call, we talked about over 100 initiatives were in place in the states to ban menthol and flavors and things like that. Certainly, it's having an impact on the category.

In terms of mix for us, our menthol has always either been rate at the market level or maybe slightly higher, which is pretty normal, I think, for a new product like this. We're continuing to monitor it. We're continuing to work through it. And we certainly have put some things in place to try to position VLN as it should be, which is a solution for menthol smokers.

One of the biggest issues when you ban menthol is it doesn't mean menthol smokers stop smoking. 50% to 60% of those smokers just transition to another product. So, we're getting the case out in front of the legislative bodies who are looking at this and saying, why is VLN a solution, not only on the federal level, but we know it's also important on the state levels. So, again, working within these -- but even California, where we're definitely moving into.

They ban menthol, but obviously, there's still a need for the deal and solution.

Alex Fuhrman -- Craig-Hallum Capital Group -- Analyst

That's great. That's really helpful. Thank you. And then, can you comment on now that you've been in more state that have preferential tax treatment for VLN? Are you seeing any kind of a difference in velocity or profits for you or the retailers?

Jim Mish -- Chief Executive Officer

Well, we're definitely utilizing -- and it's different by state. It depends on the state on how the retailer wants to utilize how we position the product. Initially, in Colorado, we positioned it at par with Marlboro mainline. We started working with Circle K and Smoker-Friendly in Colorado and some different pricing strategies.

We're sometimes using that money now to get maybe a better initial introductory offer or something that to consumers. We're also testing some things in Chicago with Circle K to where we're actually getting the price with Circle K support about what does it look like in Chicago, if they would remove the tax against MRTP products and now getting a test going on that. We're actually -- it's giving us some ability to be flexible. It's giving us ability to try different things.

It's getting the message out, not only about the product but also about how do we get people to try it and repeat purchase, things like that.

Alex Fuhrman -- Craig-Hallum Capital Group -- Analyst

OK, great. That's really helpful. Thank you.

Operator

Thank you. Next question we have Brian Wright with ROTH MKM. [Operator instructions]

Brian Wright -- ROTH MKM -- Analyst

Thanks. Good morning. I wanted to understand a little bit more about the comments about the processing being -- did I hear that right on the distillate in the fourth quarter? So, I just wanted to understand how -- what's going to drive the incremental gross margin improvement in the GVB in the second and the third quarter? And what are those steps to be aware of?

Jim Mish -- Chief Executive Officer

I can take that one in queue and maybe chime in with the details. But thanks for the question, Brian. Yes, just to refresh everyone's memory, right now, we're purchasing and reselling both the distillate and isolate. The first big impact on margin improvement will come as now our new world-scale extraction unit is online and operating.

We'll continue to ramp that up. That makes a big impact on margin improvement. The rebuild of the distillate facility now moving very quickly in Prineville, comes online in Q2. That relieves any of the purchase resale we go internal again.

We continue to see margin improvement, dramatic margin improvement on top of that, especially now fed by our own extraction crude material. And then, we've been expediting, bringing the new isolate facility online. We had put a stake in the ground for Q1 of '24. We see pathways of pulling that forward, and we're executing on that.

It's not definitive yet, but I do think we have a good opportunity to get that fully operational by even the end of the year, which will further improve margins. The margin improvement is stacked as we get into even Q2 now with the extraction and distillate and then into Q4, Q1 on the isolate. In the meantime, for at least Q1 and Q2, the business interruption insurance heavily impacts the financials. It's a bit retroactive because the Q1 sales are covered by insurance that we're receiving now in Q2.

Brian Wright -- ROTH MKM -- Analyst

Great. Thank you. And then, just wanted to understand you had made some comments about some cost efficiencies and some reductions and just -- was that just your staff or were there broader kind of actions and just any quantifications on efficiencies there?

Jim Mish -- Chief Executive Officer

Yeah. It's more of a constant process across all the functions, all the business units -- both business units we're looking for every opportunity to control our costs in a very disciplined manner and making every attempt to make sure every dollar goes toward our single goal, which is operating profitability. It cuts into every function, it cuts into every location, and it takes many different forms, whether it's an attritional loss that we're not backfilling. We're taking proactive measures on the SG&A basis or on capex programs, etc.

Every dollar spent is under very high scrutiny for both myself and Hugh and John and others, they are functional leaders, whether it's innovation, etc. We're looking for every way to control our costs. We know there's not an endless stream of capital out there, especially in today's market. And our intent is to drive this toward operating profit with no further dilution.

It's an all hands review on a weekly basis to make sure every dollar is being maximized.

Brian Wright -- ROTH MKM -- Analyst

Great. Thanks. And then, just one last one if I could. The VLN sales by the end of the year are going to be pretty significant as far as the overall tobacco business.

And just like -- have you thought about like timing as far as when you think you'll start officially breaking out those sales?

Hugh Kinsman -- Chief Financial Officer

Yeah. I think that's probably a very good question, Brian. I think we'd prefer to kind of get it into a little bit more of a steady state to such a significant incremental ramp for VLN over the next two to three quarters sequentially. So, probably, there's thought that we probably would start breaking out separately sometime Q3, Q2, Q3 next year.

Brian Wright -- ROTH MKM -- Analyst

OK, great. Thank you so much.

Operator

[Operator instructions]. Next question, we have Jim McIlree with Dawson James. Please go ahead.

Jim McIlree -- Dawson James Securities -- Analyst

Yeah. Thank you, and good morning. In Q1, you did 68,000 kilograms of bulk ingredients. Once you get all of your reconstruction and construction plans completed, what will be the bulk ingredient capacity relative to the Q1 levels? Are you just replacing what you've been buying online? Or is it going to be replacing and adding?

Hugh Kinsman -- Chief Financial Officer

Yeah. I can take that, Jim. We'll have capacity once we have all of our disciplined capabilities, including, obviously, the crude extraction capability online. And of course, a lot of it's incremental, we can always keep layering on incremental capacity going forward, but we'll have a capacity to produce that first quarter and probably five times as much if we wanted to on a run rate basis.

Jim McIlree -- Dawson James Securities -- Analyst

OK. That's helpful. Thank you. And can you help me understand what gross margin you think you will exit 2023 and 2024 at for both the hemp and the tobacco business?

Hugh Kinsman -- Chief Financial Officer

Yeah. I'd say for hemp tobacco 2023, so much of it's weighted toward the back end as far as margin expansion for the reasons that Jim had mentioned, but that probably is somewhere in the high single digits. Again, if you were to take fourth quarter and run rate that it'd be much higher going at 2024, it would be maybe because it would have a full-year benefit of return of all of our function capacity. Not to mention the farming program, which caps our per unit, raw material costs, which is significant. Solidly in the 20% and possibly moving toward 30%.

And then, back of 2023, again, because of ramping up VLN and it's happening mostly in the second half of the year as Q2 and the second half of the year. We're going to see that plus the fact that we have Pinnacle and other tobacco products that are higher margin than, say, just the site of cigars, that margin will steadily expand to heading to 20%. And then, it's going to be much higher than that going in 2024 as the weighted average. The majority of the weighted average sales are going to be geared toward VLN.

Jim McIlree -- Dawson James Securities -- Analyst

Understood. Great. Thank you.

Operator

Thank you. Ladies and gentlemen, this concludes your conference call for today. [Operator signoff]

Duration: 0 minutes

Call participants:

Matt Kreps -- Investor Relations

Jim Mish -- Chief Executive Officer

John Miller -- President, Tobacco Business

Hugh Kinsman -- Chief Financial Officer

Aaron Grey -- Alliance Global Partners -- Analyst

Victor Ma -- Cowen and Company -- Analyst

Alex Fuhrman -- Craig-Hallum Capital Group -- Analyst

Brian Wright -- ROTH MKM -- Analyst

Jim McIlree -- Dawson James Securities -- Analyst

More XXII analysis

All earnings call transcripts