Tobacco Documents Online

SI~.CURITIFS AND EXCHANGE COMMISSION Washington, D.C, 20549 Form 10-K ANNUAl, REPORT PURSUANT 10 SFXgTION 13 OR 15(d) OF Till,; SECURn'IES EXCIIANGE A~-~T OFi1934 I,br tile Fiscal "ll.ar F.nded June 30, 1985 Conlmission File No. 2-88812 ADVAN CED TOBACCO PRODUCTS, INC. (ExacI name of reglstnmt as sp0clfied in it~ charter) Slate 6f l~xas (Slate or other jurisdiction of ilIcorl~rallon Or orgarlizatiort) 121 Interparg Boulevard, Suite 108 San Antonio, Texas 78216 (Addlc~ of principal e×ccutivc offic©s) (Zip Code) R¢~istranI's telephone number, including area code: (512) 496-9994 74-2285214 (I.RS F.nzployer Identification NO,) SeCurities registered pursuant to Seclioa 12(h] of the Act: Nolle Se, euritics registered pursuant to Section 12(g) of the Act: Oanlrnon ~qtoek, $~1 par ~lue Warrants to purcha'.e (k',nunon Stock (Tglc of Class) Indicateh'c c, cktuark'~het er heregIsra t(1) a~l'~eda re|~r..req redttabe fiedb~'Se¢ on 5 or IS(d) of file S~urilies Exchange A¢I of 1934 d~lring Ihe preceding 12 month~ tar for such sllorter periled ~hal tile regi~iraul was requh'ed to file such relmrts], and (2) has been subjecl It~ ~ueh filing requir~ment~ for the 1~1 90 days "~, ~ No • As ol Augtl'~t 30, 1985 the aggregate irlarket ~afiie of the voling stock held b) na~l-affiliates of {he rel~i~trant ~a~ appr(~xfomleiy $51,9791922. A'; of 8epl~nlhel¸ 20, ] 98S, tile nlllnher of outslanding shares tff (!t ~nlllloll ~loek, sg.gl par value fol¸ ~,~1~ II nt'ed lobacco I'r~duct~ ~ras 7,083,890.

ITEM ]. Bug]nest. Advanced Tobacco Products, Part I Inc., the Company, has developed a smoke-free tobacco product (the "FAVOR Smoke-Free Cigarettedr) w has the appearance and feel and provideE a sensation sJmi]ar to a conventional C~garette, but which delivers nicot±ne satlsfactJon to the user by inhalation of nicotine vapor in a manner not requiring the combustion of tobacco. The Company intends to market FAVOR as a pleasurable nicotin p~oduct and not as a product intended to discourage or reduce smoking or to hav~ therapeutic benefits. The Company believes me users of the smoke-free cigarette will be smokers of conventional cigarettes who wish to enjoy the inhalation of nicotine in smoki restricted environments. Development of the smoke-free cigarette was commenced in 1977 by Mr. J. P. Ray, President of the Company. During 1978 and 1979 medical tests were performed regarding the nicotine delivered by the smo~e-free cigarette. In 1978 MI. Ray applied for a United States patent and a number of foleiqn patents intended to cover the technology underlylilg the smoke-free clgarette. A United States patent relating to the FAVOR Smoke-Free Cigarette was issued on August 18, 1981 and e/even foreign patents were subsequently issued (four ad- ditional foreign patents are pendlng). The Company was formed in April, 1983, under the name S. A. Vend, inc., which was c~anged to Advanced Tobacco Pioduets, Inc. in January, ]984. On September ]9, ]983, the -2-

Company entered into an agreement with NCC Group, Ltd., a p~*tne~ship formed by Mr. Ray in August, 1982 to finance the development and testing of the smoke-free cigarette, under which the Company has acquired the technology relating to the smoke-free cigarette and other nicotine products and the United States and foreign patents and patent applications relating to such technology. Unless the context requires other- wise, all references to the "Company" include NCC ~ Ltd. Group, Mr. Ray and other previous owners of the patents and technology acqulred by the Company through NCC Group, Ltd. During thd period since inception the Company's activities have consisted o~ product development, development of manufacturing capacity, clinical and consumer testing, and the development of promotional and advertising plans. During the period from inception in April, 1983, through June 30, 1985, the Company had an accumulated net loss of $I,818,130. The Company does not anticipate that it will have significant sales until after September of 1985 when the initial co~ercial introduction of its smoke-free cigarette will occur. Furthermore, the Company antlcipates that its operations could result in decreases in its cash for at least the next 12 months. GENERAL DESCRIPTION OF THE PRODUCT The FAVOR Smoke-Free Cigarette consists essentially of an active surface contalning a nicotlne solution blended with carriers and f]avorants inserted within a small tube having the shape, weight and size of a conventional cigarette. When the user draws air through the smoke-free c/gazette a small amount of nicotine vapor is emitted into the air inhaled by the user. The smoke-free -3-

cigarette includes a plastic tube, a porous plastic element which contains the nicotine and flavorlng and is wrapped with conventlonal cigarette t~pping paper. The nicotine solution used Jn the smoke-free olgarette is blended wlth flavorants for the purpose of approximating the flavors of leading brands of "regular", "menthol", and "light" conventional cigarettes. These flavorants are available to the Company from suppliers of flavorants to the eonventlonal cigarette industry. The nicotine inhaled from the smoke-free cigarette is not derived from the combustion of tobacco as is the case with a conventional cigarette; the user inhales none of the carbon monoxide or tars produced by tobacco combustion which the United States S~rgeon General has determined may cause cancer and increase the risk of heart disease. In addition, use of the smoke-free cigarette does not expose the user or others to the smoke and the related odor associated with the use of conventional cigarettes and, as a result, may be enjoyed where conventional cigarette smoking is prohlbited or ~s socially unacceptable. The Company intends to market the sMoke-free cigarette as a pleasurable nicotine product and not as a product intended to discourage or reduce smoking or to have therapeutic benefits. The Company believes that the Surgeon General's determination that cigarette smoking ls dangerous to smokers' health and the legal and social trend toward the protection of non-smokers from the effects of cigarette smoke have created a market for a product that delivers nlcotine in a form and manner similar to that enjoyed by smokers of conventional • cigarettes while avoiding the principal negative effects of cigarette smoking. -4~

Th~ Company is not aware of any currently available product which provides the conventional cigarette smoker with a means of enjoying the inhalation of nicotine in circumstances in which conventional cigarette smoking is illegal or socially unacceptable. Consequently, the Company believes that its smoke-free cigarette is a unique alternative for conventional cigarette smokers who desire nicotlne inhalation pleasure without negative social consequences or legal restrictions. The Company intends to initially offer the smoke-free cigarettes in packs of six at a retail price approximately the same as, or slightly less than, a pack of twenty conventional cigarettes. Each pack of six smoke-free cigarettes will have a nicotine delivery capacity intended to satisfy the average smoker of conventional cigarettes for an entire day. Because the nicotine delivery capacity of a smoke-free cig- arette is determined primarily by the amount of nicotine it contains, a single smoke-free cigarette can be manufactured with the nicotine delivery capacity of several cigars or conventional clgarettes. However, because the smoke-free cigarette Is more efficient as a means of nlcotlne delivery than are cigars and conventional cig- arettes, a smoke-free cigarette can be manufactured to deliver an amount of nicotine equivalent to several conventional cigarettes or cigars while containlng only an amount of nicotine comparable to that contained in a single cigarette of some brands of conventional cigarettes and less than Js contained in most cigars. The Company expects initially to manufacture the smoke-free cigarette in a form such that each normal "puff" on a FAVOR Smoke-Free Cigarette will deliver an amount of vaporlzed nicotine which1 the Company believes is within a range of amounts of nicotine delivered by a normal puff on -5-

MARKETING The Company believes that most users of the smoke-free cigarette w±ll be current smokers of conventional cigarettes who wish to reduce their health concerns el to enjoy nicotine in environments where smoking is ferbidden el w~en others may De offended by conventional cigarrette smoke and odor• The number of conventional cigarette smokers who will pur- chase and use the smoke-free cigarette on a sustained basis, however, cannot be reliably estimated. Nevertheless, the Company believes that lts profitability will not require a large percentage penetration of the conventional c~garette market because an independent study indicates % that in 1982 there~were approximately 56 million American smokers smoklng approximately 633 billion conventional cigarettes at a retail cost of approximately $23.4 ballion ( and that in 1981 more than four trillion conventional cigarettes were manufactured worldwide]. EGC Assoelates, Inc., an independent market research firm retained by lhe Company, completed a study of consumer acceptance of the smoke-free cigarette involving shopping mall intercept interviews in Los Angeles, Chicago, San Antonio, Oklahoma City and Columbus, Ohio. Of the 550 cagarette smokers interviewed after sampling the smoke-free cigarette, 44% indicated they would be "very likely" to purchase the smoke-free cigarette on a trial basls if it were available, 30% indicated they would be "somewhat likely" to do so, and 26% indicated that it was not too likely" that they would purchase the smoke-free cigarette on a trial basis. Of those interviewed, 12% indicated they would be willing to pay mole for "a days worth" of the smoke-free cigarette than for a pack of conventional cigarettes, 46% indicated they would pay the same -6-

amount, 41% indiGated they would pay slightly less than such amount, and 5% did hot know what they would pay. The study attempted to measure only the initial interest of consumers in the smoke-free cigarette and may not be indicative of a level of sustained acceptance of the smoke-free cigarette in the markets tested or in other markets. During 1985 the Company employed Moskow~tz & Jaoobs of valhalla, N.Y. Mr. Howard Moskowitz is a recognized authority on taste and sensory perception. Mr. Moskowitz conducted sever~l Focus Group Studies to define the taste for the Regular, Menthol, and Light smoke-free cigarettes. He also studled the purchase intent and his findings paralleled those of the original EGC study. The Company h~s developed its advertising and promotion plan with the assistance of an advertising and promotion firm. During 1984 & 1985 the Company continued consumer testing in order to further develop £ts advertislng and promotion program. Th~ introductlo~ of the smoke-free cigarettes to the retail market in selected major Texas cities will beg~n in September 1985 and then expand its market throughout the United States and selected Foreign countries consistent with its production and marketing capacity and results of its initial marketing. The Company anticipates two significant marketlng advantages not enjoyed by its conventional cigarette competitors. These are television and the uniqueness of its product. Television is believed to be the most cost-effec[ive means of mass consumer advertising for this product. Second, the Company believes that the introduction of its smoke-free clgarettes will require less promotion and advertising than is the ease in the introduction of new conventional cigarette brands or smokeless tobacco products because zhe FAVOR Smoke-Free Cigarette is a novel form of nicotine dellvery and therefore more likely to benefit from comsumer -7-

curiosity and word-of-mouth publicity. The Company believes that such publicity is likely to occur due to the continuing publicity regarding the health risks of smoking and legal restrletlons on smoking in public places, publicity surrounding the recent introduction of Dew Chemical Co~pany of its N~oorette nicotine chewing gum~ and publicity normally associated wlth newly introduced novel consumer products. The Company's strategy of area by area introduction of the smoke-free cigarette is intended to help control its adve~tisihg and promotional cost by allowing the Company to concentrate its initlal advertising in select key markets in order to initiate its anticipated word-of-mouth advantage. The Company p~ans to introduce its smoke-free c~garette through a multi-media advertising program emphasizing television advertising, but also including magazine, newspaper and outdoor billboard advertising. This program has been developed by the Company with the assistahce of its advertising agency, The Richards Group, Inc. of Dallas. The Company's strategy will be to dlstribute its smoke-free cigarettes through the same retail outlets through which conventional cigarettes are sold. The Company anticipates selling directly to supermarkets, drug stores, and tobacco wholesalers through brokers. The Company expects that tobacco who]esalels will re-distribute the smoke-free cigarettes to restaurants. newsstands and other retailers of tobacco products. The Company does not anticlpate any significant delay or difficulties in establishing Satis- factory distribution relationships because the Company believes, based on management's experience with the introductlon of other consumer products, that demand by brokers and tobacco wholesalers for now consumer product is sufficient to facilitate the wholesale and retail distrlbution of the anticipated quantltJes o~ the smoke-free cigarette. -8-

COMPETITION The Company believes that its principal competitors will be manufacturers of conventional cigarettes, Most, if not all, of which have financial, promotional, advertising, manufacturing and other resources substantially in excess of the Company's• The Company's ability to finance promotional activities is small when compared with such large and experienced competltors. However, because the smoke-free cigarette is a novel concept in the ~eligery of nicotine satisfaction, the Company believes that the promotional and adver- tls~ng costs required to introduce its product will be substantially less than the cgsts normally incurred in the introduction of a conventional cig~ette brand into the highly competitive conventional cigarette market. The Company believes the use of television advertislng will also provide the Company with a competitive advantage over conventional cigarette manufacturers who are pro- hibited by the Federal Cigarette Labeling and Advertising Act from advertising conventional cigarette products on television. Further, since the Company anticipates that the direct man~fact~rlng costs of a pack of smoke-free cigarettes wlll be no greater than a pack of conventional cigarettes with less nicotine delivery capacity, the Company anticipates that it will be able to offer a substantial cost per unit advantage to the consumer, if necessary, for competitive purposes, because of the heavy tax component of the retail price of conventional cigarettes. The Company intends, however, initially to sell packs of six FAVOR Smoke-Free Cigarettes at approximately the same factory price as most packs of 20 conventional cigarettes• • In addltion to other factors, the Company anticipates that it wlll enjoy a direct manufacturing cost advantage over manufacturers of -9-

conv~ntial is less complicated, resulting in a smaller skilled labor among manufacturing personnel handling and storage of tobacco will not be olgarettcs because the Company's manufacturing equipment percentage of and because costly required. The Company believes that the smoke-free cigarette is competitive with conven- tional cigarettes because the smoke-free cigarette can often be used in situations in which smoking conve~tional cigarettes is undesirable or prohibited. In addition, although th4 Company does not clmim that the smoke-free cigarette possesses any t~erapeutio benefits, the public may percelve the smoke-free cigarette to be less harmful than conventional cigarettes. In addition kS manufacturers of conventional cigarettes, the Company will be competing w~th manufacturers of conventional smokeless tobacco products such as chewing tobacco add snuff, and of alternative nicotine delivery products such as Dew Chemical Company's Nicorette nicotine chewing gum, many, ~f not all, of which also have financial, promotional, advertising, manufacturing and other resources far greater than those of the Company. The Company may also experience substantial competition from manu- facturers of future nicotine delivery products similar to the smoKe-free cigarettes unless the Company is able successfully to assert patent infringement actions with respect to such products. MANUFACTURING While the smoke-free cigarette resembles a conventional cigarette, it consists of a plastic tube, a plastic element, with which the nieotiDe has been impregnated, and conventional cigarette tipplng paper. The individual units are then hermetically pouched in a barrier ~10-