Short: Star Scientific, Inc. (STSI)

Stock Price                        $1.70
Market Cap                        $290M
Daily Volume                        1.6M shares
Rebate                                    -13%

Star Scientific is a long running stock promotion that I believe is on its last legs. Despite generating an average loss of about $25 million in every year of the past decade, STSI trades at a ridiculous valuation of 46x revenues.

For many years, STSI had been in the business of selling smokeless tobacco products. This was always a money-losing venture for STSI, and they exited in 2012. For the principals of STSI, I believe the real business has always been the selling of STSI stock. Over the past five years, the basic share count has expanded from 81 million to 146 million through the grant of options and warrants and equity sales. Management has done their best to monetize these equity grants by spinning one story after another from the stock promotion textbook. Since 2001, that story was a patent infringement lawsuit against RJR over processes to prevent the formation of TSNA (a supposed carcinogen) in tobacco products. They pumped the stock price to over $6 on this, but in late 2012 they settled with RJR for a mere $8.4 million.

STSI now calls itself a “technology-oriented company with a mission to promote maintenance of a healthy metabolism and lifestyle”. STSI is now selling a few new products:

* CigRX, a smoking-cessation neutraceutical;
* Anatabloc, an anatabine-based neutraceutical that purportedly reduces inflammation (anatabine is a natural substance derived from certain tobacco plants); and
* Anatabloc Facial Crème, a cosmetic product whose sales “to date … have been relatively low” (no kidding!)

The promotion tactic here is to identify huge addressable markets and claim to have a nonzero probability of capturing them:

The company has applied for patents “for therapeutic 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”

Anatabine has a roughly zero percent chance of treating any of these conditions effectively. A quick google search for Anatabine comes up with no peer-reviewed / independent studies, but rather a bunch of websites promoting Anatobloc; studies from the Roskamp Institute, an organization associated with STSI which receives a royalty from sales of Anatobloc; and blog posts by a Dr. John Faessel, who apparently is not a medical researcher, but a dentist with a proclivity for posting about STSI on Seeking Alpha. Even if Anatabine magically has some therapeutic value, it is a naturally-occurring substance which will not enjoy any real IP protection.

CigRX has a roughly zero percent chance of working as well. The company initially submitted it to the FDA for review in 1997. The company then mysteriously decided to halt the FDA submission process, claiming cost issues. Fast forward to 2010. CigRX is reintroduced as a “dietary supplement” by the company to forgo the FDA’s rigorous approval process. I was following STSI (then CIGX) in early 2011, a few months after the product launch. Web traffic to CigRX.com spiked at the launch before plummeting right back down to zero. Today, the traffic is so low that quantcast and compete do not even display it.

Anatabloc.com is also showing a similar pattern today: http://www.quantcast.com/anatabloc.com 

Shortly post-launch of CigRX, they were also promoting their facebook page, if I recall correctly through a press release. The funny thing is that if you compared the number of “likes” on the facebook page (around 50k) to their reported revenues at the time, assuming everyone paid near MSRP, they had probably only sold to a few hundred customers at the time, or about 1% of their number of “likes”.

Similarly, if you go on Amazon and read the reviews for Anatabloc and CigRX, they are suspicious to say the least. How likely is it that there are people out there who really need to buy CigRX and Anatabloc, and love them both so much that they go on Amazon to post 5-star reviews?

This is right in line with management’s history of putting out false and misleading statements. Here are a couple examples:

http://www.thestreet.com/story/11749416/1/star-scientific-takes-a-magical-mulligan-on-failed-study-results.html

http://www.thestreet.com/story/11820016/1/star-scientifics-made-up-misleading-relationship-with-johns-hopkins.html

Management self-dealing, Equity sales and DOJ investigation

One might wonder what an appropriate salary would be for a CEO of a company that consistently loses $25 million a year. For most of the past decade, STSI decided that the correct amount was $1 million/yr. In addition to that, STSI has spent millions for aircraft costs for the Jonnie Williams, the CEO – to an aircraft company owned by the CEO! And STSI’s patents? They are owned by an entity called Regent Court, licensed to STSI. I’m sure most of you have already guessed that the owner of Regent Court is none other than Jonnie Williams.

STSI has been a serial issuer of equity. Typically, the company has sold shares at the market price and thrown in warrants for free; effectively selling shares below market price. The company has sold at least 40 million shares since 2008 and has issued or repriced 40 million warrants. I estimated the value of these warrant issuances to have been worth around $80 million.

The massive share sales, by themselves, are a huge red flag, but incredibly some or all of these sales were to management and related parties to capture the warrant value / discount.

Buried in the company’s 10-K is this little gem:

“In late January and February of this year, our company, directors and others received subpoenas from the United States Attorney's Office for the Eastern District of Virginia seeking documents. Our present understanding is that the investigation is principally focused on transactions involving our company's securities including certain private placements and related party transactions since 2006. We are responding to the subpoenas and intend to cooperate fully with the investigation.”

It appears that the company’s numerous self-dealing transactions are finally amounting to some attention, interestingly, not from the SEC which doles out civil penalties, but from the DOJ.

Timing / Risks

The reason why STSI is a short now is (a) the RJR litigation is history; (b) borrow costs have come down from 50%+ to a more reasonable 13%; (c) DOJ investigation. They will have to actually deliver profits now to sustain the stock price, an outcome which I consider extremely unlikely. Keep in mind that revenues may continue to grow; neutraceuticals which don’t work may still sell. However, regardless of what happens to revenues, I consider it an impossibility for STSI to ever grow into its current valuation. There are the usual borrow risks as with any stock promotion, but as a liquid stock trading on NASDAQ these are somewhat mitigated.

Disclosure: We are short STSI, and may transact in STSI securities at any time without disclosure. Short selling is an inherently risky activity and should only be undertaken by investment professionals.