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| STSI > SEC Filings for STSI > Form 10-Q on 9-Aug-2004 | All Recent SEC Filings |
9-Aug-2004
Quarterly Report
Overview
The following discussion provides an assessment of the Company's consolidated results of operations, capital resources, and liquidity and should be read together with the financial statements and related notes included elsewhere in this report and in the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2003.
The Company's prospects are dependent, in the near term, on its ability to improve the performance of its discount cigarette business and raise additional funds; and, in the longer term, on the distribution and consumer acceptance of its low-TSNA smokelesss tobacco products as well as the continued development of new low-TSNA smokeless tobacco products, independently and through alliances with other tobacco manufacturers, and on its ability to begin generating significant revenues through royalties on its patented tobacco curing process, including through success in its pending patent litigation against RJR.
Specifically, in order to support its intellectual property litigation and other operations, the Company will need to raise approximately $7 million in the near term, and additional funds over the next 12 months.
The Company has a working capital deficit of approximately $10.2 million and substantial cash needs over the near term, including:
funding of current operations in light of continued operating losses;
accounts payable of approximately $5.3 million of which, 50.7% is over 90 days old and another 14.5% is over 60 days old;
litigation costs, which are expected to increase as the Company approaches trial in the RJR case;
monthly payments of approximately $36,000 to B&W for interest on restructured accounts payable, increasing to combined principal and interest payments of $250,000 per month beginning in January 2005, subject to provisions for delayed principal repayment in the event of a successful test market by B&W of its hard tobacco product;
quarterly interest payments of $180,000, next due on September 25, 2004, payable on the $9 million convertible debenture issued to Manchester Securities in March 2004, as well as, beginning on March 25, 2005, quarterly principal payments of 25% of the outstanding principal amount of the debenture;
monthly operating lease payments of approximately $200,000; and
the Company's annual deposits into its MSA escrow accounts for 2004 sales due in April 2005. For 2003 sales, the Company's MSA escrow obligation was approximately $6.2 million. Given the expected level of sales in 2004 and continued emphasis on sales in the four non-MSA states, the Company anticipates the escrow obligation in April 2005 would be less than this amount.
In addition, there exist certain contingencies which could require the Company to make significant cash payments, including:
if the Company does not achieve an operating profit of at least $1.6 million during the third quarter of 2004, Manchester Securities would be entitled to require the Company to redeem its debenture in exchange for the $9 million principal amount and any accrued and unpaid interest. In addition, default rates of interest would apply if the Company was not able to redeem the debenture if called. Management does not expect to be able to achieve an operating profit of $1.6 million during the third quarter of 2004, but has initiated discussions with Manchester Securities regarding its agreements including a modification of its redemption rights. (See "Prospects for The Company's Operations" below);
the Company is challenging the Virginia Department of Taxation's sale and use tax assessment of $860,115 with respect to the Company's curing barns. An administrative proceeding relating to this challenge may be concluded before the end of the year;
the Company is currently subject to an IRS audit of its 2001 Federal income tax return and has submitted a Request for Private Letter Ruling in connection with deductions of the Company's payments into the MSA escrow accounts which resulted in approximately $13.9 million in income tax refunds received during 2002, 2003 and 2004. If it is ultimately determined that the Company's treatment of the payments into escrow is not a current deduction for tax purposes, it is expected that the Company's existing carryback claims net of operating loss deductions will be sufficient to offset any additional tax due for the years in question, given the extent of the Company's recent losses.
The Company's cigarette sales and associated gross profits have continued to decline, particularly when consideration is given to the Company's MSA escrow requirements. Increasing regulatory requirements in both MSA and non-MSA states, as well as increased pricing competition, have also impacted on the sales of discount cigarettes. Further, there are significant impediments to generating significant revenues from royalties or sales of its smokeless tobacco products in the near future. Accordingly, the Company's ability to continue operations depends on raising additional funds. Notwithstanding that Jonnie Williams, the Company's CEO and largest stockholder, has pledged to fund the Company's working capital needs through March 2005, the Company continues to have significant past due payables and cash needs that will need to be funded through Mr. Williams or from other sources.
The Company continues to pursue additional sources of new funds. However, there are significant limitations on its ability to raise new debt financing, including its agreements with Manchester Securities and B&W, as well as its current financial condition.
Accordingly, the Company is focusing on the potential for raising funds through the issuance of new common stock. The Company is filing with the Securities & Exchange Commission today a registration statement on Form S-3 with respect to an offering on a delayed basis in the future of up to $25 million in common stock. The Company is not currently soliciting offers with respect to its common stock, and will seek additional equity financing only after that registration statement is effective. The Company's ability to raise equity financing on terms acceptable to the Company will depend on a number of factors, including the performance of the Company's stock price in the coming months. Any equity financing will be dilutive to the Company's existing shareholders.
While the Company intends to raise funds though the issuance of stock, the Company's largest shareholder and CEO, Mr. Williams, and other members of senior management have expressed an intent to purchase up to 1 million shares of the Company's common stock in transactions that may include purchases on the open market, private acquisitions from third parties and purchases directly from the Company.
The Company's inability to raise substantial amounts of new funds from Mr. Williams or other sources over the next three to twelve months would have a material adverse effect on its ability to meet its working capital needs and continue operations.
Company Mission
Star Scientific, Inc. ("Star") and its wholly-owned subsidiary, Star Tobacco, Inc. ("ST", and together with Star, the "Company") are technology-oriented tobacco companies with a mission to reduce toxins in tobacco leaf and tobacco smoke. The Company is engaged in:
(1) the development, implementation and licensing of scientific technology for the curing of tobacco so as to substantially prevent the formation of carcinogenic toxins present in tobacco and tobacco smoke, primarily the tobacco-specific nitrosamines ("TSNAs");
(2) the manufacturing, sales, marketing and development of very low-nitrosamine smokeless tobacco products that also carry enhanced warnings beyond those required by the Surgeon General, including Stonewalldry snuff, ARIVA compressed powdered tobacco cigalett pieces, and STONEWALL Hard Snuff. The Company also manufacturers a very low-nitrosamine smokeless tobacco product (Interval) for B&W which is currently in test market; and
(3) the manufacture and sale of four discount cigarette brands, SPORT , MAINSTREET , VEGAS and G-SMOKE, which have historically generated the vast majority of the Company's revenues.
The Company has previously purchased very low-TSNA flue-cured tobacco, cured by farmers using the StarCured tobacco curing process, and resold this leaf tobacco to B&W. The Company has suspended these purchases and sales through at least the end of 2004.
Star Scientific's long-term focus continues to be the research, development and sale of products that expose adult tobacco users to lower levels of toxins. The Company's overall objective is to ultimately reduce the range of serious health hazards associated with the use of smoked and smokeless tobacco products. The Company fully accepts the evidence that links smoking tobacco with a variety of diseases and premature death and believes that it is highly unlikely that the health risks of smoked tobacco can be completely eliminated. Star believes it was the first company to state unequivocally that "there is no such thing as a safe cigarette", and to affix to the back of the package of its first premium low-TSNA product, Advance, a package "onsert" which contained not only scientifically verified comparative content data, but also additional health warnings. Nevertheless, in a world where an estimated 1.2 billion people smoke and use other conventional tobacco products, there is an urgent need to reduce the toxicity of tobacco products to the maximum extent possible, given available technology. Accordingly, the Company believes that it has a corporate responsibility to continue its research and development efforts to manufacture tobacco products in the least hazardous manner possible, given available technology, particularly through the StarCured tobacco curing process. While the Company because of cost-cutting efforts necessitated by its lack of available working capital has deferred certain research projects, it expects to renew those efforts in the second half of 2004, subject to the availability of funds, and is continuing to explore alternatives for completing certain of its research projects.
The Company believes it has the technology to reduce exposure to carcinogenic TSNAs, particularly the subgroups of nitrosamines commonly referred to as NNNs and NNKs, to the lowest possible levels and has demonstrated that its method for curing tobacco using the StarCured tobacco curing process can be scaled up to meet broad commercial needs in the United States and abroad. Given the fact that tobacco smoke contains over 4,000 constituents, 43 of which are known carcinogens, the Company's focus over the last several years has centered on the development and commercialization of very low-TSNA, non-fermented smokeless tobacco products that can be used as an alternative to cigarettes in situations where adult tobacco users either cannot or choose not to smoke. The Company expects that in the future its focus will continue to be on the development and sale of very low-TSNA non-fermented smokeless tobacco products, as well as on encouraging other tobacco manufacturers to sublicense the StarCured tobacco curing technology to produce very low-TSNA tobacco (with carcinogenic NNKs and NNNs that measure 200 parts per billion and below). The Company currently markets three very low-TSNA smokeless products: (1) ARIVA, a compressed powdered tobacco "cigalett"; (2) a dry snuff under the brand name Stonewall; and (3) STONEWALL Hard Snuff, a new, non-fermented, spit-free "hard tobacco" product for moist snuff users. The tobacco in each of the Company's smokeless products is 100% StarCured very low-TSNA tobacco. Previously, the Company had manufactured a low-TSNA moist snuff (Stonewall moist snuff). With the introduction of STONEWALL Hard Snuff, the Company has discontinued the manufacture of Stonewall moist snuff. To date, the Company's smokeless products have not generated significant revenues.
Over the last several years, the Company has expended significant effort and money on the development of its very low-TSNA tobacco and smokeless tobacco products, its patent infringement lawsuits against RJR, and sales of smokeless products. While product licensing royalties and smokeless tobacco sales were de minimis during 2003 and the first six months of 2004, the Company will continue its development and sales of smokeless tobacco products and product licensing efforts. The Company continues to seek additional sales outlets for its smokeless products.
Prospects for Company Operations
Discount Cigarettes. Since 2000, the Company's discount cigarette business has experienced a significant decline in sales, partly caused by intensified pricing competition from foreign manufacturers. In addition, a substantial portion of the Company's gross profits on cigarette sales must be paid into escrow in April of each year to meet the Company's obligations under the MSA. ST's cigarettes are sold through approximately 177 tobacco distributors throughout the United States, although the Company has sought to focus sales efforts in the states of Florida, Minnesota, Mississippi and Texas, where it does not incur escrow obligations under the MSA.
During the second quarter of 2004, the number of cigarettes sold as well as the price of cigarettes declined compared with the second quarter of 2003. In addition, the termination of the proposed sale of the cigarette business to North Atlantic Trading Company, Inc. ("NATC") in July 2003 resulted in a significant disruption of the Company's cigarette business, particularly in Texas where a number of senior sales managers left the Company shortly after the termination of the NATC transaction was announced. Since the termination of the NATC purchase agreement, the Company has taken a number of steps to address these negative trends, including the implementation of a promotional program at the retail level and a separate wholesale pricing promotion, which were terminated in June 2004, as well as the successful restructuring of the senior sales management team in Texas. The Company has also sought to offset lower sales by manufacturing its cigarettes at its own facility and using less expensive tobacco and filters in its discount cigarettes.
Despite the Company's efforts to reenergize cigarette sales, shipments in the second quarter of 2004 fell to approximately 66.5 truckloads of cigarettes. This compares to 70.5 truckloads in the second quarter of 2003 and 73.6 truckloads in the first quarter of 2004. The truckload sales continue to reflect pricing competition in the non-MSA states and pressures on the cigarette industry in general. The decrease in truckload sales and lower carton sales prices resulted in substantially reduced cigarette revenues for the second quarter of 2004. To mitigate these trends, over the past year the Company has been reducing its cost-of-goods sold. Also, in the second quarter as the Company reduced its retail and wholesale promotional discounts and, as prices firmed up in the latter half of the second quarter of 2004, the gross profit per month increased correspondingly. Gross profits were $534,540 in April, $941,419 in May and $1,178,897 in June.
Notwithstanding the decreasing revenue associated with its discount cigarette business, the Company will continue to focus its principal efforts on the sale of discount cigarettes in the four non-MSA states for the foreseeable future. At the same time, the Company will continue to evaluate the prospects for its cigarette business in general and, in particular, sales in MSA states given the additional regulatory and MSA burdens of operating in those states.
Smokeless Tobacco. Sales of Star's smokeless products continue to be de minimis and it will take significantly greater sales of smokeless products for this business segment to operate at breakeven levels. STONEWALL Hard Snuff now represents a majority of Star's hard tobacco sales and accounts for the increase in sales of smokeless products from the second quarter of 2003. The Company continues to seek to increase the distribution and consumer acceptance of low-TSNA smokeless tobacco products as well as the continued development of other smokeless tobacco products, independently and through alliances with other tobacco manufacturers. While the Company's marketing of its smokeless products has been curtailed due to its working capital constraints, the Company expects to increase its efforts to broadly market smokeless products once its liquidity needs have been resolved.
Licensing. The Company has an exclusive, worldwide license from Regent Court Technologies, LLC under eleven patents issued and patents pending relating to methods to substantially prevent the formation of TSNAs in tobacco including the StarCured tobacco curing process and the production of very low-TSNA tobacco products. The StarCured tobacco curing process, as discussed herein, involves the control of certain conditions in tobacco curing barns, and in certain applications, uses microwave and/or electronic beam technology. The StarCured process substantially prevents the formation in the tobacco leaf of the carcinogenic TSNAs, which are widely believed by medical and scientific experts to be among the most abundant and powerful cancer-causing toxins present in tobacco and in tobacco smoke. The Company continues to pursue means of collecting royalties with respect to this curing technology, including through arrangements described below and its patent infringement lawsuits against RJR, as described in greater detail in Part II, Item 1 "Legal Proceedings" below.
Pursuant to the Hard Tobacco Agreement entered into with B&W in April 2001, B&W will forgive one-half of Star's then-outstanding indebtedness to B&W if B&W determines that its test market of a hard tobacco products is successful, and all of the remaining debt if and when it introduces a hard tobacco product into distribution in retail locations in 15 states. On December 15, 2003, B&W began to test market in Louisville, Kentucky a hard tobacco product named Interval which the Company manufacturers at its facility in Chase City, Virginia. B&W is in the process of initiating a further large-scale test market this summer and product for
that test market has already been shipped to B&W by Star. However, there can be no assurances that this test market will be deemed successful or extended into additional states. The Company has had de minimis revenues from royalties on the sale of Interval by B&W.
In the second quarter of 2004, Star entered into an agreement with another tobacco manufacturer for the licensing of low-TSNA hard tobacco. Under that agreement, it is anticipated that the manufacturer will conduct an initial assessment of a hard tobacco product and follow up with a subsequent test market. The Company does not anticipate receiving any royalties under that agreement for the foreseeable future. To enable Star to pursue this agreement, and potentially other licensing of hard tobacco products, B&W agreed to waive its ten-year right to be the exclusive purchaser of hard tobacco from Star (subject to Star's own rights) in return for concessions on the April 21, 2001 Hard Tobacco Agreement and a 3-month extension of the date on which it would begin once again to pay royalties under the April 25, 2001 Other Low-TSNA Tobacco Royalty Agreement, once a royalty rate is established with one of the other three largest tobacco manufacturers.
Impact of the MSA. The Company continues to experience negative cash flow from operations, particularly when its significant escrow obligations arising under the MSA are taken into account. The Company has deposited into escrow a net amount of approximately $33.0 million for sales of cigarettes in MSA states during the period 1999-2003, including approximately $6.2 million which the Company deposited into these accounts in April 2004 based on 2003 sales. To minimize the impact of these MSA obligations on the Company's liquidity, the Company has attempted to focus its cigarette sales primarily in the four non-MSA states where it is not required to make deposits into escrow and has enhanced its efforts to prevent its cigarettes intended for the non-MSA states from being diverted into MSA states. However, as described in "Liquidity and Capital Resources" below, in the near term the Company will continue to be required to make substantial MSA escrow deposits. Given the Company's focus on sales in the non-MSA states, its declining cigarette volume to date in 2004, and the fact that the per carton obligation in 2004 is comparable to 2003, it is anticipated that the escrow obligations for 2004 sales would be somewhat less than the $6.2 million paid in April 2004.
New State Legislation Impacting Sales of Discount Cigarettes
Minnesota, one of the four non-MSA states in which Star increasingly has focused its sales of discount cigarettes, passed a statute which took effect on July 1, 2003, requiring distributors in the state to pay an additional $0.35 per-pack fee on cigarettes purchased from manufacturers like Star that have not entered into a separate settlement with the state. Because the statute impacts on all non-participating manufacturers, its effect has tended to be uniform among these manufacturers. The statute has provided an advantage to Vector Group, whose subsidiary Liggett Group manufactures and sells several discount brands that compete with brands of non-participating manufacturers, including those sold by Star. Vector had previously settled with the State of Minnesota, and after passage of the statute reached a separate agreement on payments that it would have to make each year under its prior settlement.
In Florida and Mississippi, two of the other non-MSA states, bills were introduced in the 2004 legislative sessions that would have imposed an additional user fee on non-participating manufacturers at a rate of $0.50 and $0.40 per pack, respectively, on cigarettes sold by companies that have not entered into separate settlement agreements with those states. Neither Florida nor Mississippi enacted such legislation during their respective 2004 legislative sessions, which have concluded. In Texas, a special thirty-day session of the legislature was convened in April to address deficits in statewide school funding. One proposal that has been offered as part of a funding formula is a $0.50 per-pack fee on cigarettes sold by manufacturers that had not previously settled with Texas. The special session was concluded without any resolution of the funding dispute, and the matter is currently being considered by working groups of state legislators. It is unclear whether a further special session will be convened to address these issues. The next regular legislative session will be convened in January 2005.
Passage of statutes in the non-MSA states that impose fees on manufacturers would be expected to impact on all such manufactures equally, but would make discount cigarettes more expensive and lessen the competitive price advantage they currently enjoy compared to generic and premium brand cigarettes. In addition, there are numerous recently enacted statutes and legislative initiatives in MSA states that could further impact the Company's ability to compete in these states. The Company has determined to cease sales in certain states in response to some of these developments.
Michigan, an MSA state, passed a fee statute in January 2004 that requires the payment of a $0.35 per-pack fee on cigarettes sold by non-participating manufacturers, which must be paid in advance, and is based on an estimate of projected sales by the state's Department of Revenue. This fee is in addition to the MSA requirement that non-participating manufacturers deposit funds into escrow for each cigarette sold in an MSA state. Given the cost burden of making both the escrow payments and fee payments, Star has advised the Department of Revenue that it will not sell its cigarette brands in Michigan in the future. In March 2004, Utah, another MSA state, also passed legislation assessing a $.35 per-pack fee on cigarettes sold by non-participating manufacturers. However, this statute has little impact on Star since the company has had virtually no sales in Utah during the past several years. Similarly, in Alaska, another state in which the Company has virtually no sales, a bill has been signed by the Governor that would impose an additional per-pack fee on cigarette sales by non-participating manufacturers.
Similar legislation imposing a fee on cigarettes sold by non-participating manufacturers has been introduced and is pending in the state legislatures in California, Kentucky, Illinois, Kansas, Louisiana, Missouri, New Hampshire and Tennessee, and it is anticipated that other MSA states will introduce similar legislation. Similar legislation was introduced but not enacted in Indiana this year. The impact of these new statutes in the MSA states would be expected to negatively impact on sales in these states by all non-participating manufacturers, including Star. However, as previously noted, Star has sought to focus its cigarette sales in recent years in the four non-MSA states.
On June 28, 2004, regulations went into effect in New York requiring that cigarettes sold in that state meet certain fire safety standards. As discussed in its Annual Report on Form 10-K for the year ended December 31, 2003, the Company decided it would not be economically feasible to develop a separate type of cigarette for sale in New York and has not attempted to become certified under the new regulations. As a result, the Company does not anticipate having sales of cigarettes in New York State in the future. Bills relating to fire safety standards have been introduced in several other states and in Congress. The Company will monitor these legislative initiatives as they move forward and reassess its position on this issue as appropriate.
RJR Litigation
In May 2001, the Company filed a patent infringement action against R. J. Reynolds Tobacco Company ("RJR") in the United States District Court for Maryland, Southern Division to enforce the Company's rights under U.S. Patent No. 6,202,649 (`649 Patent), which claims a process for substantially preventing the formation of TSNAs in tobacco. On July 30, 2002, the Company filed a second patent infringement lawsuit against RJR based on a new patent issued by the U.S. Patent and Trademark Office on July 30, 2002 (Patent No. 6,425,401). The new patent is a continuation of the `649 Patent, and on August 27, 2002 the two suits were consolidated.
In April 2003, after the conclusion of discovery, the parties filed a number of dispositive Motions for Summary Judgment. On March 31, 2004 and June 24, 2004, the Court issued rulings denying all of RJR's Summary Judgment Motions and granted in part, and denied in part, Star's motion for Summary Judgment. Judge Williams ruling on the Summary Judgment Motions clears the way for the Court to establish a trial date. At the conclusion of a hearing on the Summary Judgment Motions in August 2003, Judge Williams indicated that if the case were to proceed to trial that the Court would endeavor to set a trial date within four months of its rulings on the Summary Judgment Motions. By letter dated June 30, 2004, Star Scientific requested that the Court set a trial date or schedule a status conference to set a trial date.
The lawsuit against RJR is consistent with Star Scientific's announced policy of protecting the intellectual property to which it is the exclusive licensee under its license arrangement with Regent Court Technologies.
Merger of B&W and RJR
On July 28, 2004, the shareholders of RJR Tobacco Company approved the previously announced plan to combine its operations with British American Tobacco PLC's U.S. tobacco operations (including those of its wholly owned . . .
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