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STSI > SEC Filings for STSI > Form 10-Q on 9-Nov-2012All Recent SEC Filings

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Form 10-Q for STAR SCIENTIFIC INC


9-Nov-2012

Quarterly Report


Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

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, filed with the SEC on March 15, 2012. 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, 2012 as compared to the three and nine months ended September 30, 2011.

Overview

We are a technology-oriented company with a mission to promote maintenance of a healthy metabolism and to reduce the harm associated with the use of tobacco at every level. Through our Rock Creek subsidiary, we have been engaged in:

· the manufacture, sale, marketing and development of non-nicotine nutraceutical, dietary supplements designed to promote the maintenance of a healthy metabolism: Anatabloc®, for anti-inflammatory support and CigRx®, our tobacco alternative;

· the manufacture, sale and marketing of a cosmetic facial cream designed to improve the appearance of the skin; and

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

We also have continued our prior efforts relating to:

· the development, implementation and licensing of the technology behind our proprietary StarCured® tobacco curing process, which substantially prevents the formation of carcinogenic toxins present in tobacco and tobacco smoke, primarily the tobacco-specific nitrosamines, or TSNAs;

· the manufacture, sales, marketing and/or development of very low-TSNA dissolvable smokeless tobacco products that carry enhanced warnings beyond those required by the Family Smoking Prevention and Tobacco Control Act, or FDA Tobacco Act, including ARIVA® compressed powdered tobacco cigalett® pieces and STONEWALL Hard Snuff®.

Since the incorporation of Rock Creek in 2007, we have been focused on utilizing certain alkaloids found in the tobacco plant and in other members of the Solanacea family of plants, such as potatoes, tomatoes and eggplants, initially to address issues related to the desire to smoke or use other tobacco products. More recently, we have been focusing on the anti-inflammatory aspects of one of those alkaloids, anatabine. We believe our research and development efforts relating to the anatabine alkaloid have positioned us to utilize our technology to develop a range of non-nicotine dietary supplements, cosmetic facial cream and related pharmaceutical products that could be beneficial in maintaining a healthy metabolism and in treating a variety of diseases and conditions.

Since the 1990s, we also have sought to develop processes and products that significantly reduce the levels of toxins, principally TSNAs, in tobacco compared to traditional smoked and smokeless tobacco products. Our development of technology for reducing TSNA levels led us to focus on the development of tobacco-based pharmaceutical products and the non-nicotine dietary supplements that we are pursuing through Rock Creek. Given our long-term focus on reducing the levels of toxins in tobacco and the harm associated with tobacco use, we believe our proprietary technology designed to reduce the harm associated with tobacco use enables us to cure tobacco and develop tobacco-based products with the lowest TSNA levels in the tobacco industry and that, as a result, we are uniquely positioned to pursue a range of very-low TSNA tobacco products and licensing opportunities related to such products and our underlying technology.

On September 21, 2012 our Company and RJR entered into a confidential settlement agreement of the RJR litigation matters. As part of settlement, the Company's remaining obligation to RJR for unsecured promissory notes with a principal balance of $3.4 million as of August 1, 2012 and accrued interest on the notes was satisfied and extinguished and the Company received a one-time payment of $5.0 million. In addition, the consolidated cases pending in the District Court of Maryland were dismissed with each party bearing their own costs and fees, which had the effect of extinguishing RJR's request of an award of costs in those cases in the amount $442,388.05 and its motion for an award of attorneys' fees of approximately $35.0 million against the Company. The benefit of the settlement to the Company consisted of $8.4 million in loan forgiveness and a cash payment, elimination of claimed court cost of approximately $0.4 million and the avoidance of potential attorneys' fees owing to RJR of approximately $35.0 million, totaling $43.8 million.

In considering the settlement, our company weighed the prospects for continued multi-year litigation, related appeals to the Federal Circuit Court of Appeals and the disruption of continued litigation, particularly given the shift in our focus to the dietary supplement portion of our business, and concluded that the resolution of the RJR litigation matters at this time was in the best interest of our company. While we have settled our ongoing litigation with RJR, we continue to pursue means of collecting royalties for our curing technology through licensing arrangements and through monitoring of the curing practices of industry participants other than RJR that may infringe on our tobacco curing patents which were affirmed by the United States Court of Appeals for the Federal Circuit.

Prospects for Our Operations

The recurring losses generated by our business continue to impose significant demands on our liquidity. We introduced Anatabloc®, our dietary supplement for anti-inflammatory support, in August 2011 through an interactive website and a customer service center. Rock Creek introduced Anatabloc® Facial Crème on September 10, 2012 and has been selling this product through its interactive website. Net sales of Anatabloc® and CigRx®, our dietary supplement products, were $4.1 million in the nine months ended September 30, 2012, which constituted approximately 91% of our net sales for the period, while Anatabloc® Facial Crème sales were $28 thousand through September 30, 2012.

In addition to the development of line extensions for our Anatabloc® dietary supplement and conducting or supervising clinical and preclinical studies to support the benefits of nutritional supplementation with Anatabloc®, Rock Creek is pursing the development of pharmaceutical products that would treat a range of neurological conditions, including Alzheimer's Disease, Parkinson's Disease, schizophrenia and depression. However, given the typical long lead time for approval by the Food and Drug Administration, or FDA, of pharmaceutical products, we do not expect that Rock Creek will generate any revenues for the foreseeable future from the sale of pharmaceutical products.

Given sales trends since the introduction of Anatabloc®, we believe the prospects for our operations in the near-term will depend on the distribution and consumer acceptance of our current Anatabloc® dietary supplement and extensions of our Anatabloc® product line. In addition, we intend to continue to explore the development of new dietary supplements and pharmaceutical products independently and/or through alliances with third-parties, including dietary supplement and pharmaceutical companies. Sales of our low-TSNA smokeless tobacco products and licensing revenue during the nine months ended September 30, 2012 were comparable to the same period in the prior year, but were de minimis in both periods. Given the recurring losses and low volume of sales for our dissolvable tobacco products, as well as our current focus on Anatabloc® and related dietary supplements and potentially pharmaceuticals, we are considering the future roll for this segment of our business at the same time that we continue to explore the licensing of our patented low-TSNA tobacco curing process and related technology of which we are the exclusive licensee.

We experienced net sales of approximately $4.5 million for the nine months ended September 30, 2012 and an operating loss of approximately $(19.8) million, excluding the miscellaneous income of $7.1 million from the resolution of the RJR litigation matters (see Note 6 of the Financial Statements and "Part II-Item
1. Legal Proceedings" included in this Report for further details related to the resolution of the RJR litigation matters). The recurring losses generated by our operations continue to impose significant demands on our company's liquidity. As of September 30, 2012, we had approximately $10.2 million of working capital, including approximately $9.5 million of cash and cash equivalents in current assets. Absent the exercise of outstanding warrants and options for cash or a substantial improvement in sales and revenues and/or royalties, we believe that the cash on hand at September 30, 2012 will support our operations into the first quarter 2013. Depending upon sales levels, market conditions and the price of our common stock, it may be necessary for us to seek additional funds.

Dietary Supplements and Development of Related Products. Anatabloc®, which is intended to provide anti-inflammatory support, is currently being sold through our interactive website, a customer service center and on a consignment basis through GNC, a retailer of dietary supplements. GNC initially sold Anatabloc® through its online store and, beginning in late March 2012, GNC began carrying Anatabloc® at its company-owned stores and franchised retail locations. Initially, marketing of Anatabloc® was directed toward physicians and other healthcare professionals. More recently we have been focusing our marketing efforts on athletes and other groups of individuals who regularly deal with issues relating to inflammation. Through Rock Creek we have also been developing extensions of our Anatabloc® product line. We introduced an unflavored version of Anatabloc® during the three months ended June 30, 2012 and introduced into the market Anatabloc® Facial Crème on September 10, 2012 as a cosmetic to improve the appearance of the skin. In 2009, Rock Creek developed a non-nicotine, non-tobacco nutraceutical, CigRx®, that is intended to temporarily reduce the desire to smoke. CigRx® is currently available through our interactive website and customer service center and at retail locations in the Richmond, Virginia metropolitan area, and the northeast and northwest regions of the United States. Further, through Rock Creek, we are exploring the development of other related nutraceutical products that may assist in stabilizing metabolism, pharmaceutical products with clinical claims, products that assist in the treatment of tobacco dependence, and a "relapse prevention product" to assist smokers during nicotine withdrawal, with the goal of higher quit rates. In addition, we are exploring the research and development of pharmaceuticals for a range of neurological conditions, including Alzheimer's disease, Parkinson's disease, schizophrenia and depression.

Rock Creek also has been involved in human (clinical) trials evaluating the impact of supplementation with anatabine citrate on an inflammatory marker called c-reactive protein, or CRP, (which is believed to be an indicator of coronary heart disease), on Hashimoto's autoimmune thyroiditis, in individuals with mild to moderate Alzheimer's disease and in pre-clinical (non-human) studies assessing the impact of supplementation with anatabine and anatabine citrate on a variety of inflammatory related conditions. An interim look at the results of the Hashimoto's Autoimmune Thyroid Study was undertaken in August 2012 which supported completion of the study protocol and the Company anticipates that the study will be completed and results analyzed during the fourth quarter. Rock Creek also recently reported on an interim look at the CRP study results. That interim look showed that 61% of diabetic subjects (11 of 18) taking metformin (the most common drug prescribed for diabetics) had a CRP reduction, as did 38% of the general trial population not taking metformin (31 of 81). Overall, 42 of 99 subjects (42%) subjects had a decrease in CRP after one month of anatabine supplementation. The Alzheimer's study that is being sponsored by Rock Creek and conducted at the Roskamp Institute is ongoing and began enrolling subjects at the end of August. As of November 8, 2012, thirty-seven subjects have been screened and twenty-two subjects enrolled in the study. The Roskamp Institute will be funding most of the cost associated with the ongoing Alzheimer's study.

We anticipate that research and development costs will decrease on a going forward basis as we continue to focus on the evaluation of data relating to the CRP study and as we complete the protocol regimen for the Hashimoto's thyroiditis study. We also anticipate the analysis of results relating to the Hashimoto's thyroiditis study in December.

Work continues with our research partner the Roskamp Institute on the preparation of a drug development plan for a prescription product based on a version of anatabine citrate.

Low-TSNA Dissolvable Smokeless Tobacco. Net sales were $0.3 million in the nine months ended September 30, 2012 and $0.4 million for the nine months ended September 30, 2011. During each of these periods, STONEWALL Hard Snuff® represented a majority of our dissolvable tobacco sales. Since the reorganization of Star Tobacco's sales force in late 2009, we have been concentrating sales efforts for our dissolvable tobacco products in the Richmond, Virginia metropolitan area and with established regional and national retail chain customers.

"Modified risk tobacco products." In 2010 we filed applications with the FDA to have a version of our low-TSNA products (Ariva-BDL™ and Stonewall-BDL™) designated by the FDA as "modified risk tobacco products" and we filed a similar application for a Stonewall Moist-BDL™, a traditional moist snuff product, in February 2011. In March 2011, the FDA issued a decision holding that it currently does not have jurisdiction over the Ariva-BDL™ and Stonewall-BDL™ products. In August 2011, we voluntarily withdrew our application for our Stonewall Moist-BDL™ product and we are not actively pursuing that application or the marketing of our ARIVA-BDL or STONEWALL-BDL products.

Licensing and Intellectual Property. In 2011 and in 2010 we filed five non-provisional U.S. patent applications relating to our dietary supplement products, uses of the products and product formulations. These included two applications for therapeutic treatment methods involving the administrations of anatabine, its isomers, and any derivatives thereof; an application relating to the administration of anatabine, or an isomer or salt thereof, for treating chronic inflammation that may be associated with disorders such as thyroiditis, cancer, arthritis, Alzheimer's disease, and multiple sclerosis; an application for an anatabine and yerba mate formulation; and an application for a relapse prevention product. We also filed provisional patent applications relating to our Anatabloc® formulation, for a new tobacco product and for an enriched form of tobacco, and in 2012 we filed utility applications covering each of those provisional applications. In June 2012 the United States Patent and Trademark Office, or PTO, issued a patent to Rock Creek for an improved method of synthesizing anatabine that facilitates large scale commercial production of high purity anatabine. Also, on August 14, 2012 the PTO issued a patent to Rock Creek for an anatabine and yerba mate composition and uses of the composition in assisting in weight loss and curbing the urge for tobacco. We also received a design patent for our 20-piece dispenser utilized for our Anatabloc® and CigRx® products in 2011 from an application that was filed in 2010. Further, in April 2012 the PTO issued a patent for a variant of our patented curing technology that results in the production of cured tobacco that contains virtually undetectable levels of carcinogenic TSNAs as measured by prevailing standards. We also have six pending international applications that relate to inflammation-mediated disorders, our anatabine and yerba mate formulation, the Anatabloc® formulation, a relapse prevention product and the administration of anatabine, its isomers and any derivatives thereof generally, and also for autism and seizure indications.

We are the exclusive licensee under a License Agreement with Regent Court, which grants us exclusive worldwide rights to and a right of sublicense for the StarCured® process, related patents covering the production of low-TSNA dissolvable smokeless tobacco products and the use of certain MAO agents in treating neurological conditions. For additional information related to our proprietary curing process, see "Item 1. Business - Our Patents, Trademarks and Licenses" in our Annual Report. Two of the patents under our license with Regent Court that relate to our method for producing low-TSNA tobacco have been the subject of our ongoing lawsuits against RJR that were settled as part of the agreement entered into with RJR on September 21, 2012. See "Part II-- Item 1. Legal Proceedings." of this Report and Note 6 of the Financial Statements for further details of the resolution of the RJR litigation matters. While we have settled our ongoing litigation with RJR, we continue to pursue means of collecting royalties for our curing technology through licensing arrangements and through monitoring of the curing practices of industry participants other than RJR. While licensing of our exclusive patent rights is a potential source of additional revenue for us, full realization of this potential will depend on our ability to successfully defend and enforce our patent rights.

Federal Regulations of Dietary Supplements and Drug Products. Under the Food, Drug and Cosmetic Act, the FDA has authority for reviewing and approving any new drug product prior to its introduction into commerce. The FDA approval process involves, among other things, successfully completing clinical trials under an Investigational New Drug Application and obtaining a premarket approval after filing a New Drug Application, or NDA. The NDA process requires a company to prove the safety and efficacy of a new drug product to the FDA's satisfaction. The Dietary Supplement Health Education Act, or DSHEA, provides the FDA with authority over the production and marketing of dietary supplements. In certain cases DSHEA also requires notification to the FDA before a company begins to market a dietary supplement. DSHEA does not require prior approval by the FDA for the introduction of dietary supplements into the market, but does require that such products comply with the requirements of DSHEA prior to and after their introduction into commerce. See "Item 1. Business- Government Regulation" of our Annual Report for more information relating to governmental regulation of dietary supplements and new drug products.

Federal and State Legislation Relating to Cigarettes and Smokeless Tobacco Products. The manufacture and sale of cigarettes and other tobacco products are subject to extensive federal governmental regulation in the United States and by comparable authorities in many foreign countries. Under the FDA Tobacco Act, the Center for Tobacco Products within the FDA has broad authority over the manufacturing, sale and distribution of cigarettes and smokeless tobacco products, including expanded control over the introduction of new tobacco products, warnings that must be included on all tobacco products and the manner in which tobacco products may be marketed and sold. The FDA also has announced that it intends to issue a proposed regulation relating to its authority over products other than cigarettes, smokeless tobacco and snuff that meet the definition of "tobacco products" under the FDA Tobacco Act, which could impact on our modified risk products over which the FDA previously concluded it does not have jurisdiction. See "Item 1. Business- Government Regulation" in our Annual Report for more information relating to governmental regulation of tobacco products.

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. See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations - Critical Accounting Policies and Estimates" in our Annual Report for more information. There have been no material changes to our critical accounting policies and estimates since the filing of our Annual Report.

Results of Operations



Our company's unaudited condensed consolidated results for the three and nine
month periods ended September 30, 2012 and 2011 are summarized in the following
table:



                                                      Three Months Ended September 30,               Nine Months Ended September 30,
                                                        2012                    2011                  2012                    2011
$ and shares in thousands except per share data                                         (Unaudited)
Net sales                                         $           1,748       $             401     $           4,508       $             819
Cost of goods sold                                            1,574                   1,571                 3,561                   2,544
Federal excise tax and Department of
Agriculture payment                                               3                       3                     8                       8
Gross profit (loss)                                             171                  (1,173 )                 939                  (1,733 )
Total operating expenses                                      6,897                   5,341                20,752                  15,743
Operating loss                                               (6,726 )                (6,514 )             (19,813 )               (17,476 )
Miscellaneous income                                          7,101                       -                 7,101                      (5 )
Net profit (loss)                                 $             366       $          (6,565 )   $         (12,801 )     $         (17,647 )

Three Months ended September 30, 2012 Compared to Three Months Ended September 30, 2011

Net Sales. For the three months ended September 30, 2012, net sales (gross sales less cash discounts, product discounts and product return allowance) were $1.7 million compared to $0.4 million during same period in 2011. Our Anatabloc® and CigRx® dietary supplements contributed $1.6 million of total revenue in the three months ended September 30, 2012 and $0.3 million in the same period in 2011. Our dissolvable tobacco net sales were $0.1 million during each of the three months ended September 30, 2012 and 2011.

Gross Profit (loss). We had a gross profit of $0.2 million for the three months ended September 30, 2012 compared to a gross loss of $(1.1) million for the same period in 2011, an improvement of $1.3 million. Increased sales of our dietary supplements contributed $0.7 million and a reduction of inventory write offs of $0.7 million contributed to our improved gross profit, while we experienced increased losses of $(0.2) million in connection with the sale of our dissolvable tobacco products.

Total Operating Expenses. Total operating expenses were approximately $6.9 million for the three months ended September 30, 2012, an increase of approximately $1.5 million, or 29.1%, from approximately $5.3 million for the same period in 2011. This change was attributable to increases in general and administrative expenses of approximately $0.1 million, increased marketing and distribution costs of approximately $1.0 million, and an increase in research and development costs of approximately $0.4 million.

Marketing and Distribution Expenses. Marketing and distribution expenses were approximately $1.8 million for the three months ended September 30, 2012, an increase of approximately $1.0 million, or 121.1%, from approximately $0.8 million for the same period in 2011. The increase in marketing expense was directly attributable to the expanded promotion of our Anatabloc® dietary supplement that was introduced into the market on August 30, 2011. Dissolvable tobacco marketing expense was approximately the same during the three months ended September 30, 2012 and 2011, as we continued to limit the marketing for our dissolvable tobacco products to a more narrow geographical area and to certain national distributors.

General and Administrative Expenses. General and administrative expenses were approximately $3.6 million for the three months ended September 30, 2012, an increase of approximately $0.1 million, or 4.5%, from approximately $3.5 million for the same period in 2011. For the three months ended September 30, 2012, we had an increase in legal costs of approximately $0.1 million in connection with our continuing efforts to protect and expand the patented technology relating to our dietary supplements and our RJR litigation, as compared to the same period in the prior year.

Research and Development Expenses. We expended approximately $1.5 million on research and development costs in the three months ended September 30, 2012 compared to approximately $1.1 million in the comparable period in 2011. The research and development costs in both the three months ended September 30, 2012 and 2011 related to our ongoing clinical (human) trials and pre-clinical (non-human) studies involving our Anatabloc® product or the principal dietary ingredient in the product. In addition, our research in the three months ended September 30, 2012 included costs related to the development and testing of our Anatabloc® Facial Crème, prior to its introduction into the market on September 10, 2012, as well as payment of royalties of 5% of Anatabloc® sales to an affiliate of the Roskamp Institute under the Research and Royalty Agreement entered into with that entity in 2010.

Interest Income and Expense. We had interest income of $4 thousand and interest expense of $13 thousand for the three months ended September 30, 2012, for a net interest expense of $9 thousand during the current period. For the same period in 2011, we had interest income of $12 thousand and interest expense of $63 thousand, for a net interest expense of $51 thousand. The lower interest expense for the three months ended September 30, 2012 reflected the lower outstanding balance due to the scheduled principal payments on our outstanding debt and the extinguishment of our RJR long-term debt obligation pursuant to the term of the September 21, 2012 settlement agreement with RJR (see "Part II-Item 1. Legal Proceedings" and Note 6 of the Financial Statements included in this Report for further details of the resolution of the RJR litigation matters). The lower interest income during the three months ended September 30, 2012 reflected lower average cash balances.

Miscellaneous Income. We had Miscellaneous Income for the three months ended September 30, 2012 in the net amount of $7.1 million, in connection with the resolution of the RJR litigation matters. This consisted of the satisfaction and extinguishment of unsecured promissory notes in the amount of $3.4 million as of August 1, 2012 that has been payable to RJR following its combination with B&W in 2004 and a separate cash payment of $5.0 million for a total amount of $8.4 million and an offset of $1.3 million in connection with a contingent fee arrangement with counsel relating to this litigation, although we anticipate negotiating the final amount of any fees payable (see Note 9 of the Financial Statements in this Report for more details relating to Miscellaneous Income).

Net Loss.We had net income of approximately $0.4 million for the three months ended September 30, 2012 compared to a net loss of approximately $(6.6) million . . .

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