In preparing the discussion and analysis contained in this Item 2, we presume that persons reviewing this Item have read or have access to the discussion and analysis contained in our Annual Report on Form 10-K for the year ended December 31, 2008, filed with the Securities and Exchange Commission, or SEC, on March 16, 2009. In addition, persons reviewing this Report should read the discussion and analysis of our financial condition and results of operations in conjunction with our consolidated financial statements and related notes included elsewhere in this Report. The following results of operations include a discussion of the three and nine months ended September 30, 2009 as compared to the three and nine months ended September 30, 2008. Overview
We are a technology-oriented tobacco company with a mission to reduce toxins in tobacco leaf and tobacco smoke. We are primarily engaged in:
• the development, implementation and licensing of our proprietary 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, or TSNAs;

• the manufacture, sales, marketing and development of very low-TSNA dissolvable smokeless tobacco products that carry enhanced warnings beyond those required by the Surgeon General, including ARIVA® compressed powdered tobacco cigalett® pieces, or ARIVA®, and STONEWALL Hard Snuff®;

• the licensing of trademarks for certain of our cigarette brands that we discontinued manufacturing in 2007, consistent with our previously announced plan to transition from the sale of cigarettes to low-TSNA smokeless tobacco products; and

• the development of pharmaceutical products, particularly products that have a botanical, tobacco-based component, that are designed to treat tobacco dependence and a range of neurological conditions, including Alzheimer's disease, Parkinson's disease, schizophrenia and depression and related products such as nutraceuticals.

Our long-term focus is the research, development and licensing of technology for the production of very low-TSNA tobacco and related products, particularly dissolvable smokeless tobacco products, that expose adult tobacco users to substantially lower levels of toxins as compared to other smoked and smokeless tobacco products, tobacco-based pharmaceuticals and related products such as nutraceuticals. Our overall objective is to ultimately reduce the range of serious health hazards associated with the use of smoked and smokeless tobacco products and the reduction of harm from the use of tobacco products at all levels. We currently are focusing our efforts on the manufacture and sale of ARIVA® and STONEWALL Hard Snuff®, our dissolvable low-TSNA smokeless tobacco products, the development of tobacco-based pharmaceutical products, related products such as nutraceuticals and the continued refinement of our patented technology for the production of low-TSNA tobacco. In December 2008, we filed a new U.S. patent application for a variation of our patented curing technology that results in the production of cured tobacco that consistently contains virtually undetectable levels of any carcinogenic TSNAs. That patent is currently pending before the U.S. Patent and Trademark Office. Also, we are undertaking toxicity testing relating to a non-nicotine nutraceutical that is designed to be of value in minimizing nicotine cravings.
In 2007 we incorporated our Rock Creek subsidiary to pursue the development and regulatory approval of pharmaceutical products to treat tobacco addiction and a range of neurological conditions and potentially related products such as nutraceuticals. In 2009, Rock Creek has undertaken research relating to a non-nicotine nutraceutical designed to minimize nicotine cravings and a "relapse prevention product." In the past we deferred the initiation and continuation of certain research projects by Star Scientific because of the lack of working capital. Our ability to promote the sale of our low-TSNA dissolvable smokeless tobacco products and our ability to continue the research and development efforts of Star Scientific and the advancement of the research and development activities of Rock Creek will, in large part, depend on our available working capital, and our ability to procure funding for these initiatives, either through improved revenues or other funding initiatives. These initiatives also will depend on the successful outcome of our ongoing patent infringement litigation against R.J. Reynolds Tobacco Company, or RJR. In that litigation, a jury, following a trial that took place between May 18, 2009 and June 16, 2009, returned a verdict in favor of RJR, holding that there was no infringement of the two patents at issue in the case and that the patents were invalid due to anticipation, obviousness, indefiniteness and failure to disclose best mode. On July 7, 2009, we filed a motion with the United States District Court for the District of Maryland, or District Court, for Judgment as a Matter of Law or, in the Alternative, for a New Trial. That motion is currently pending. If the motion is not granted, we intend to appeal the jury verdict to the Federal Circuit Court of Appeals.

Over the last several years, we have expended significant time and resources on our ongoing patent infringement litigation against RJR, the development of ARIVA® and STONEWALL Hard Snuff®, our low-TSNA dissolvable smokeless tobacco products, the license of low-TSNA products related to, and the technology behind, our StarCured® tobacco curing process, and the development efforts of Rock Creek. Our future success will largely depend on the successful results of these initiatives. The recurring losses generated primarily by our smokeless tobacco business continue to impose significant demands on our liquidity. Product licensing royalties and smokeless tobacco sales have been de minimis to date and, given the typical long lead time for federal approval of any pharmaceutical products, we do not expect that Rock Creek will generate any revenues from the sale of pharmaceutical products for the foreseeable future. Rather through Rock Creek we will focus on the research and development aspects of a range of pharmaceuticals, including tobacco-based drug products, and related products such as nutraceuticals, assuming we can generate sufficient working capital to support these activities.
Our future prospects are also dependent on the distribution and consumer acceptance of our low-TSNA dissolvable smokeless tobacco products and our ability to support the expansion of the market for these products as well as our continued development of new low-TSNA smokeless tobacco, independently and through alliances with other tobacco manufacturers. Our future results of operations are also dependent on our ability to begin generating significant revenues through royalties from the patented tobacco curing process to which we are the exclusive licensee. However, our ability to generate revenues through sales of our smokeless tobacco products and the licensing of such products will substantially be dependant upon a reversal of the recent jury verdict in favor of RJR in our ongoing patent litigation and ultimately the completion of that litigation in our favor.
We experienced net sales of approximately $0.6 million and an operating loss from continuing operations of approximately $(17.2) million during the nine months ended September 30, 2009. The recurring losses generated from our operating expenses continue to impose significant demands on our liquidity. As of September 30, 2009, we had net working capital (current assets less current liabilities) of approximately $12.9 million, which included approximately $17.5 million in cash and cash equivalents. Since January 1, 2009, through the exercise of an aggregate of 2,596,868 options and 7,647,592 warrants for our common stock, in each case for cash and the sale of 5,000,000 shares of our common stock and 5,000,000 warrants to purchase our common stock, our company has received proceeds of approximately $25.0 million. See note 6 of our financial statements for a complete discussion of these transactions. Absent the exercise of outstanding warrants and options for cash, a substantial improvement in revenues and/or royalties from smokeless tobacco products, we believe that it is likely that we will need to pursue additional sources of funds during the first quarter of 2010. However, depending upon market conditions and the price of the common stock, we may decide to seek additional funds before that date. Smokeless Tobacco. Net sales of our dissolvable smokeless tobacco products were $0.6 million for the nine months ended September 30, 2009 compared to $0.3 million for the same period in 2008. Net sales for the three months ended September 30, 2009 were $0.2 million as compared to $0.1 million for the same period in 2008. STONEWALL Hard Snuff® represented a majority of our hard tobacco sales during these periods. Our working capital constraints over the last several years have limited both the direct marketing of our dissolvable smokeless tobacco products and our research and development efforts, which we believe negatively impacted our efforts to increase consumer acceptance of those products. We continue to work to increase the distribution and consumer acceptance of low-TSNA smokeless tobacco products as well as the improvement of our existing very low-TSNA products, and the development of other smokeless tobacco products, independently and through alliances with other tobacco manufacturers. We are currently in the process of restructuring our smokeless tobacco operations to reduce costs while concentrating our effort on a more narrow geographical area and on sales to our established regional and national retail chain customers. We believe that this restructuring will better allow us to grow our smokeless tobacco business, while at the same time reducing costs associated with our sales efforts.
Development of Tobacco-based Pharmaceutical Products and a Non-nicotine Nutraceutical. In 2007, we incorporated our wholly owned subsidiary Rock Creek through which we intend to pursue a range of pharmaceutical products, including products that have a botanical, tobacco-based component, for the treatment of tobacco dependence, as well as products that would utilize certain MAO agents in tobacco to treat a range of neurological conditions, including Alzheimer's disease, Parkinson's disease, schizophrenia and depression and related products such as nutraceuticals. Rock Creek operates pursuant to a sublicense under our exclusive license with Regent Court Technologies, LLC, or Regent Court, which includes patents for producing tobacco with low TSNA levels. The sublicense also covers patents for the use of MAO inhibitors in tobacco to treat various neurological conditions. Through Rock Creek we also are continuing to explore the development of other pharmaceutical products with clinical claims, as well as a "relapse prevention product" to assist smokers during nicotine withdrawal, with the goal of higher "quit" rates for long-term smokers who have failed in their treatments with conventional nicotine replacement therapy, or NRT, smoking cessation products and related products such as nutraceuticals. We recently developed a prototype non-nicotine nutraceutical that is intended to lessen nicotine craving that we intend to market under the trademark CigRx™. We initiated two research studies relating to the non-nicotine nutraceutical in the first half of 2009 and began a further research study with a university-based hospital. We also conducted a study of our relapse prevention product during July 2009.

Licensing. We have an exclusive, worldwide license from Regent Court under 12 U.S. patents and 52 foreign patents as well as additional patents pending in the U.S. and foreign countries 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 involves the control of certain conditions in tobacco curing barns, and in certain applications, the use of 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 tobacco smoke. We recently filed a new U.S. patent application for a variation of our patented curing technology that results in the production of cured tobacco that consistently contains virtually undetectable levels of any carcinogenic TSNAs. We continue to pursue means of collecting royalties with respect to our patented curing technology, including through our patent infringement lawsuit against RJR. However, in that case a jury, after a trial that began in May 2009, returned a verdict on June 16, 2009 in favor of RJR holding that there was no infringement of the two patents at issue in the case and that the patents were invalid due to anticipation, obviousness, indefiniteness and failure to disclose best mode. On July 7, 2009, we filed a motion with the District Court for Judgment as a Matter of Law or, in the Alternative, for a New Trial and that motion is currently pending. If the motion is not granted, we intend to appeal the jury verdict to the Federal Circuit Court of Appeals. See Note 8 to our consolidated financial statements and "Part II - Item 1 - Legal Proceedings" included elsewhere in this Report for additional information concerning our lawsuit against RJR. While we believe licensing of our exclusive patent rights could potentially be a significant source of additional revenue for us, in addition to our ability to successfully commercialize any related products, the realization of this potential also will depend on our ability to successfully defend and enforce our patent rights, obtain a reversal of the jury verdict of invalidity in the RJR litigation and ultimately prevail in that litigation.
Impact of Legislation Relating to Smoked and Smokeless Tobacco Products. Over the last decade there have been significant new restrictions relating to the use and consumption of tobacco products generally and cigarettes, in particular. As a result tobacco manufactures, wholesalers and retailers are subject to significant and increasing state and federal regulation. On June 22, 2009, President Barack Obama signed into law the Family Smoking Prevention and Tobacco Control Act, or FDA Act. The FDA Act provides the U.S. Food and Drug Administration, or FDA, with broad authority over all tobacco products through a new division within the FDA (The Center for Tobacco Products). The FDA Act contains broad changes in the way tobacco products will be regulated, manufactured and sold, including expanded warnings on all tobacco products and restrictions on the manner in which tobacco products may be marketed. Many of the changes specified in the FDA Act will be implemented gradually over a period of six months to three years from enactment. Manufacturers will be required to register with the FDA within six months and new labeling requirements with expanded health warnings will become effective one year after the date of enactment. The FDA Act does permit companies to apply to have products designated as "modified risk tobacco products" and the Company has indicated its intention to seek such a designation in early 2010 for a smokeless tobacco product with extremely low TSNA levels. The FDA Act also contains provisions that eventually could be beneficial to us in marking our very-low TSNA smokeless tobacco products, such as those that would require a listing of various constituent elements and the publication of ingredients in all tobacco products with notations as to the harmfulness of those ingredients, but under the provisions of the FDA Act those types of labeling changes and comparative ingredient information will not be put into place for at least two years. In the interim, the FDA Act attempts to level the playing field for all tobacco products by restricting the types of claims and descriptions that can be made with respect to various components in tobacco products, including any claims relating to reduced levels of toxins or reduced risk, unless a product receives a designation as a "modified risk tobacco product." In addition to federal regulation, many states have and continue to seek to impose restrictions on tobacco use, including imposing limits on the type of flavorings that could be used for smoked as well as smokeless products. For example, in October 2009 New York City enacted legislation that limits the flavors for certain tobacco products, including smokeless tobacco to those with a taste or aroma of tobacco, menthol, mint or wintergreen.
Off-Balance Sheet Arrangements
None.
Critical Accounting Policies and Estimates Accounting principles generally accepted in the United States of America, or GAAP, require estimates and assumptions to be made that affect the reported amounts in our company's consolidated financial statements and accompanying notes. Some of these estimates require difficult, subjective and/or complex judgments about matters that are inherently uncertain and, as a result, actual results could differ from those estimates.

Results of Operations
Our company's unaudited condensed consolidated results for the three and nine
month periods ended September 30, 2009 and 2008 are summarized in the following
table:

                                         Three Months Ended September 30,            Nine Months Ended September 30,
                                              2009                  2008                2009                  2008
                                                                         (Unaudited)
Net sales                              $          231,942       $    136,725      $         617,938       $     334,551
Cost of goods sold                                626,366            570,412              1,886,993           1,572,932
Federal excise tax and Department
of Agriculture payment                              5,814              1,827                 12,912               5,142

Gross loss                                       (400,238 )         (435,514 )           (1,281,967 )        (1,243,523 )

Total operating expenses                        4,530,500          3,883,049             15,755,591          14,724,120

Operating loss from continuing
operations                                     (4,902,452 )       (4,357,405 )          (17,159,402 )       (16,182,457 )

Net loss                               $       (4,902,452 )     $ (4,397,405 )    $     (17,159,402 )     $ (16,302,457 )

Basic and diluted net loss per
common share                           $            (0.05 )     $      (0.05 )    $           (0.17 )     $       (0.18 )

Basic and diluted weighted average
shares outstanding                            102,925,551         92,110,972            100,019,774          89,050,831

Three Months Ended September 30, 2009 Compared to Three Months Ended September 30, 2008
Net Sales. For the three months ended September 30, 2009, net sales (gross sales less cash discounts, product discounts and product return allowance) of our dissolvable tobacco were $231,942 compared to $136,725 during same period in 2008 reflecting slightly lower sales volumes during the three months ended September 30, 2009 than the same period in 2008. Lower spending on product promotion programs, price increases on our smokeless tobacco products effective January 1, 2009 and the introduction of our five-piece packs, contributed to the net sales increase.
Gross Profit (loss). Gross loss decreased $35,276 in the three months ended September 30, 2009 to $(400,238) from $(435,514) for the same period in 2008. The decrease loss during the period was primarily due to higher net sales of our dissolvable tobacco offset, in part, by higher dissolvable tobacco costs of goods sold due to factory relocation expenses.
Total Operating Expenses. Total operating expenses were approximately $4.5 million for the three months ended September 30, 2009, an increase of approximately $0.6 million, or 16.6%, from approximately $3.9 million for the same period in 2008. General and administrative expenses increased by approximately $0.2 million, and marketing and distribution costs decreased approximately $0.2 million. Research and development costs increased approximately $0.6 million.
Marketing and Distribution Expenses. Marketing and distribution expenses were approximately $0.5 million for the three months ended September 30, 2009, and were approximately $0.7 million for the comparable period in 2008. The $0.2 million decrease was due primarily to lower trade show attendance cost of $0.1 million and promotional materials usage cost of $0.1 million. General and Administrative Expenses. General and administrative expenses were approximately $3.3 million for the three months ended September 30, 2009, an increase of approximately $0.2 million, or 7.0%, from approximately $3.1 million for the same period in 2008. During the three months ended September 30, 2009, we had increased legal costs of $0.2 million primarily associated with the trial of our RJR patent infringement case which took place between May 18, 2009 and June 16, 2009 and the ongoing reexamination of the patents at issue in the RJR litigation by the U.S. Patent and Trademark Office, as well as increased executive travel expense of $0.3 million, partially offset by decreases in stock-based compensation expense of approximately $0.3 million.
Research and Development Expenses. During the three months ended September 30, 2009, we expended approximately $0.6 million on product development initiatives aimed at improving our low-TSNA smokeless tobacco products. We had de minimis spending in the comparable period in 2008. Also, in 2008 Rock Creek undertook an initial assessment of the applicability of low-TSNA tobacco and certain MAO agents in tobacco for pharmaceutical and related applications, such as in a non-nicotine nutraceutical. During the three months ended September 30, 2009, Rock Creek incurred approximately $0.5 million on these initiatives, including work on two research studies relating to our non-nicotine nutraceutical. Given our working capital constraints, our ability to continue the research efforts of Star Scientific and to advance the research and development activities of Rock Creek will depend on our ability to obtain funding for these initiatives through improved revenues from our smokeless tobacco sales or from other funding sources. It will also depend on the reversal of the jury verdict in favor of RJR in our ongoing patent litigation and ultimately completion of that litigation in our favor.
Interest Income and Expense. We had interest income of $48,071 and interest expense of $109,656 for the three months ended September 30, 2009, for a net interest expense of $61,585 during the period primarily related to interest on our RJR debt. For the same period in 2008, we had interest income of $139,688 and interest expense of $178,530, for a net interest expense of $38,842. The lower interest expense for the three months ended September 30, 2009 reflected lower prevailing interest rates and scheduled payments made against the principal of our outstanding long-term debt.

Income Tax Expense. During the nine months ended September 30, 2008, we recognized approximately $120,000 of interest expense associated with uncertain tax positions. We received a favorable notification from the IRS in December 2008 that the uncertain position had been resolved and, as such, we derecognized our position of recording this income tax expense as of the period ended December 31, 2008.
Net Loss. We had a net loss of approximately $4.9 million for the three months ended September 30, 2009 compared to a net loss of approximately $4.4 million for the same period in 2008. The increase of $0.5 million during the three months ended September 30, 2009 was primarily related to the increased research and development expense during the period.
For each of the three months ended September 30, 2009 and September 30, 2008, we had a basic and diluted loss per share of $(0.05).
Nine Months Ended September 30, 2009 Compared to Nine Months Ended September 30, 2008
Net Sales. For the nine months ended September 30, 2009, net sales (gross sales less cash discounts, product discounts and product return allowance) of our dissolvable tobacco were $617,939 compared to $334,551 during same period in 2008 reflecting higher sales volumes during the nine months ended September 30, 2009 than the same period in 2008. In addition, lower coupon cost, higher product pricing and the introduction of our five-piece packs which have a higher price than our traditional 20-piece box partially impacted the sales volumes during the nine months ended September 30, 2009.
Gross Loss. Gross loss increased by $38,444 during the nine months ended September 30, 2009 to $1,281,967 from $1,243,523 for the same period in 2008, primarily as a result of higher net sales being offset by a $305,840 write down of packaging materials as a result of packaging changes and disposal of obsolete materials and one time factory relocation expenses.
Total Operating Expenses. Total operating expenses were approximately $15.7 million for the nine months ended September 30, 2009, an increase of approximately $1.0 million, or 7.0%, from approximately $14.7 million for the same period in 2008. General and administrative expenses increased by approximately $0.6 million, and marketing and distribution costs decreased by approximately $0.9 million. Research and development costs increased approximately $1.3 million.
Marketing and Distribution Expenses. Marketing and distribution expenses were approximately $1.9 million for the nine months ended September 30, 2009, a decrease of approximately $0.9 million, or 32.8%, from approximately $2.8 million for the same period in 2008. This decrease reflected a reduction of $0.7 million in promotional consultant costs and a decrease of $0.2 million in retail coupon issuance costs.
General and Administrative Expenses. General and administrative expenses were approximately $12.5 million for the nine months ended September 30, 2009, an increase of approximately $0.7 million, or 5.2%, from approximately $11.8 million for the same period in 2008. During the nine months ended September 30, 2009, we had increased legal costs of $3.8 million primarily associated with the jury trial in our RJR patent infringement case, which took place between May 18, 2009 and June 16, 2009, the ongoing reexamination of the patents at issue in the RJR litigation by the U.S. Patent and Trademark Office and the review of regulatory issues relating to our new product development efforts, partially offset by reductions in stock-based compensation expense of approximately $2.7 million, executive travel expense of $0.2 million and other expenses that totaled $0.3 million.
Research and Development Expenses. During the nine months ended September 30, 2009, we expended approximately $1.4 million on product development initiatives aimed at improving our low-TSNA smokeless tobacco products. We had de minimis spending in the comparable period in 2008. Also, in 2008 Rock Creek undertook an initial assessment of the applicability of low-TSNA tobacco and certain MAO agents in tobacco for pharmaceutical and related applications, such as in a non-nicotine nutraceutical. During the nine months ended September 30, 2009, Rock Creek incurred approximately $1.2 million on these initiatives, including work on two research studies relating to our non-nicotine nutraceutical. Given our working capital constraints, our ability to continue the research efforts of Star Scientific and to advance the research and development activities of Rock . . .