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SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
FORM 10-Q
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the quarterly period ended June 30, 2002
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from _____________ to ______________
Commission File Number: 0-15324
STAR SCIENTIFIC, INC.
(Exact Name of Registrant as Specified in its charter)
Delaware
(State of incorporation)
52-1402131
(IRS Employer Identification No.)
801 Liberty Way
Chester, VA 23836
(Address of Principal Executive Offices)
(804) 530-0535
(Registrant's telephone number, including area code)
- --------------------------------------------------------------------------------
Former Name, Former Address and Former Fiscal Year, if Changed Since Last Report
Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes |X| No |_|
At August 12, 2002, there were 59,719,480 shares outstanding of the Registrant's
common stock, par value $.0001 per share.
See notes to condensed consolidated financial statements.
1
Table of Contents
Page
----
PART I Item 1 - Financial Statements
Condensed Consolidated Balance Sheets as of June 30, 2002 (Unaudited)
and December 31, 2001 3
Condensed Consolidated Statements of Operations for the three and six months
ended June 30, 2002 and 2001 (Unaudited) 5
Condensed Consolidated Statement of Stockholders' Equity 6
Condensed Consolidated Statements of Cash Flows for the six months
ended June 30, 2002 and 2001 (Unaudited) 7
Notes to Condensed Consolidated Financial Statements 8
Item 2 - Management's Discussion and Analysis of Financial Condition and
Results of Operations 14
Item 3 - Quantitative and Qualitative Disclosure on Market Risk 20
PART II Item 1 - Legal Proceedings 21
Item 2 - Changes in Securities and Use of Proceeds 21
Item 6 - Exhibits and Reports on Form 8-K 22
Signatures
See notes to condensed consolidated financial statements.
2
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
ASSETS
June 30,
2002 December 31,
(Unaudited) 2001
---------- ------------
Current assets:
Cash and cash equivalents $ 1,035,435 $ 3,084,612
Accounts receivable, trade 12,229,251 3,188,412
Inventories 10,068,694 12,004,078
Prepaid expenses and other current assets 726,505 371,715
Refundable income tax 1,383,403 2,264,516
Deferred tax asset 76,000 50,000
----------- -----------
Total current assets 25,519,288 20,963,333
Property, plant and equipment, net 23,162,765 21,577,386
Idle equipment 2,071,000 2,071,800
Intangibles, net of accumulated amortization 1,048,321 985,585
Other assets 1,599,131 1,599,422
Deposits on property and equipment 2,997,360 3,697,214
MSA Escrow fund 33,582,285 28,444,280
----------- -----------
Total Assets $89,980,150 $79,339,020
=========== ===========
(Continued)
See notes to condensed consolidated financial statements.
3
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
LIABILITIES AND STOCKHOLDERS' EQUITY
June 30,
2002 December 31,
(Unaudited) 2001
-------------------- --------------------
Current liabilities:
Current maturities of long-term debt $ 2,137,010 $ 775,210
Accounts payable, trade 11,467,075 11,898,944
Current maturities of capital lease obligations 4,109,657 3,029,567
Federal excise taxes payable 5,824,749 1,841,637
Accrued expenses 1,116,126 1,888,789
---------- ------------
Total current liabilities 24,654,617 19,434,147
Notes payable, less current maturities 24,715,760 22,969,780
Capital Lease obligations 6,528,616 6,847,823
Line of credit 5,551,188 -
Deferred gain on sale-leaseback 520,399 457,867
Deferred tax liability 424,000 1,105,000
---------- ------------
Total liabilities 62,394,580 50,814,617
---------- ------------
Stockholders' equity:
Common stockA 5,972 5,974
Additional paid-in capital 14,838,040 14,665,456
Retained earnings 16,141,558 17,252,973
Notes receivable, officers (3,400,000) (3,400,000)
---------- ------------
Total stockholders' equity 27,585,570 28,524,403
---------- ------------
$89,980,150 $79,339,020
========== ============
A ($.0001 par value, 100,000,000 shares authorized, 59,741,460 shares issued
and outstanding in 2001; 59,719,480 shares issued and outstanding in 2002)
See notes to condensed consolidated financial statements.
4
STAR SCIENTIFIC, INC AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
Three Months Ended June 30, Six Months Ended June 30,
-------------------------------------- ------------------------------------
2002 2001 2002 2001
------------------ ---------------- ---------------- ------------------
Net sales $37,198,987 $43,660,976 $70,719,347 $ 81,035,581
Less:
Cost of goods sold 13,239,061 13,313,428 23,428,249 24,356,514
Excise taxes on products 17,074,457 18,472,737 31,810,535 34,872,949
----------- ----------- ------------ ------------
Gross profit 6,885,469 11,874,811 15,480,563 21,806,118
----------- ----------- ------------ ------------
Operating expenses:
Marketing and distribution 5,060,030 2,627,698 8,596,355 4,993,347
General and administrative 4,108,176 4,326,897 7,807,949 7,250,018
Research and development 345,755 538,940 565,056 1,127,205
----------- ----------- ------------ ------------
Total operating expenses 9,513,961 7,493,535 16,969,360 13,370,570
----------- ----------- ------------ ------------
Operating income (loss) (2,628,492) 4,381,276 (1,488,797) 8,435,548
Other income (expenses):
Interest income, net of interest expense (216,680) 304,674 (395,192) 253,395
Gain (loss) on disposal of assets 52,258 (159,152) 88,758 (159,152)
----------- ---------- ------------ -----------
Income (loss) from continuing operations before
income taxes (2,792,915) 4,526,798 (1,795,231) 8,529,791
Income tax (expense) benefit 1,155,500 (1,828,520) 707,000 (3,413,020)
----------- ---------- ----------- -----------
Net income (loss) $(1,637,415) $ 2,698,278 $(1,088,231) $ 5,116,771
=========== =========== =========== ============
Basic income (loss) per common share $ (.03) $ 0.05 $ (.02) $ 0.08
Diluted income (loss) per common share $ (.03) $ 0.05 $ (.02) $ 0.08
Weighted average shares outstanding, basic 59,737,229 59,741,481 59,739,333 59,741,481
=========== =========== =========== ============
Weighted average shares outstanding, diluted 59,737,229 60,756,529 59,739,333 60,756,529
=========== =========== =========== ============
See notes to condensed consolidated financial statements.
5
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
FOR THE SIX MONTHS ENDED JUNE 30, 2002
Common stock Additional
--------------------------------- Paid-In Retained
Shares Amount Capital Earnings
---------------- --------------- ---------------- ---------------
Balances, December 31, 2001 59,741,460 $ 5,974 $14,665,456 $17,252,973
Issuance of common stock options - - 178,082 -
Repurchase and retirement of treasury
shares (22,000) (2) (5,502) (23,184)
Net loss - - - (1,088,231)
---------- ------- ----------- -----------
Balances, June 30, 2002 59,719,460 $ 5,972 $14,838,036 $16,141,558
=== ==== ========== ======= =========== ===========
Notes
Receivable,
officers Total
---------------- -------------
Balances, December 31, 2001 $(3,400,000) $ 28,524,403
Issuance of common stock options - 178,082
Repurchase and retirement of treasury
shares - (28,688)
Net loss - (1,088,231)
----------- -------------
Balances, June 30, 2002 $(3,400,000) $ 27,585,566
=== ==== =========== =============
See notes to condensed consolidated financial statements.
6
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
STATEMENT OF CASH FLOWS
Six Months Ended June 30,
2002 2001
------------------- --------------------
(Unaudited) (Unaudited)
Operating activities:
Net income (loss) $(1,088,231) $ 5,116,771
Adjustments to reconcile net income (loss) to net cash flows
from operating activities:
Depreciation and amortization 391,540 371,217
Increase (decrease) in Deferred income taxes (707,000) 920,000
Loss on fixed asset disposal 88,758 159,152
Stock-based compensation expense 178,086 252,878
Increase (decrease) in cash resulting from changes in:
Current assets (6,579,132) (2,583,724)
Current liabilities 2,778,579 (2,533,944)
Other assets 142,587 (548,731)
----------- -------------
Net cash flows from operating activities (4,794,813) 1,153,619
----------- -------------
Investing activities:
Purchases of property, plant and equipment (1,434,111) (1,887,962)
Proceeds from disposal of property and equipment (-) 1,874,984
Patent costs incurred (74,211) (172,115)
------------ --------------
Net cash used in investing activities (1,508,322) (185,093)
------------ --------------
Financing activities:
Proceeds from revolving line of credit 5,551,188 -
Proceeds from notes payable and capital leases 6,582,888 -
Cash paid to reacquire common stock (28,684) -
Payments on notes payable and capital leases (2,713,429) (1,935,364)
------------ --------------
Net cash flows from financing activities 9,391,963 (1,935,364)
------------ --------------
MSA Escrow fund (5,138,005) (13,340,011)
------------ --------------
Decrease in cash and cash equivalents (2,049,177) (14,306,849)
Cash and cash equivalents, beginning of period 3,084,612 16,746,599
------------ --------------
Cash and cash equivalents, end of period $ 1,035,435 $ 2,439,750
============ ==============
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Cash paid during the year for:
Interest $ 729,628 $ 500,758
============ ==============
Income taxes $ 428,800 $ 378,970
============ ==============
See notes to condensed consolidated financial statements.
7
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
1. Accounting Policies:
The financial statements of Star Scientific, Inc. ("Star Scientific" or the
"Company") and notes thereto should be read in conjunction with the financial
statements and notes for the year ended December 31, 2001.
In the opinion of management, all adjustments (consisting only of normal
recurring accruals) necessary for a fair presentation of the results of
operations for the periods presented have been included. The results of
operations for the three and six months ended June 30, 2002 and 2001 are not
necessarily indicative of the results for a full year.
Diluted weighted average shares outstanding is the same as basic weighted
average shares outstanding as the effect of conversion of outstanding options
and warrants would be anti-dilutive.
Earnings per share assumes conversion of outstanding common stock options and
warrants.
In 1999, the Company adopted the accounting provisions of Statement of Financial
Accounting Standards No. 123 - Accounting for Stock-Based Compensation ("FAS
123"), which requires the use of the fair-value based method to determine
compensation for all arrangements under which employees and others receive
shares of stock or equity instruments (warrants and options).
2. Obligations under Master Settlement Agreement- MSA Escrow Fund:
In November 1998, 46 states (the "Settling States") and several U.S. territories
entered into a settlement agreement (the "Master Settlement Agreement" or "MSA")
to resolve litigation that had been instituted against the major tobacco
manufacturers. The Company was not named as a defendant in any of the litigation
matters and chose not to become a participating manufacturer under the terms of
the Master Settlement Agreement. As a nonparticipating manufacturer, the Company
is required to satisfy certain purported escrow obligations under statutes which
the Master Settlement Agreement required participating states to pass, if they
were to receive the full benefits of the settlement. The so-called "level
playing field" statutes require nonparticipating manufacturers to fund escrow
accounts that could be used to satisfy judgments or settlements in lawsuits that
may at some future date be filed by the participating states against such
nonparticipating tobacco manufacturers. Under these statutes the Company is
obligated to place an amount equal to $1.88 per carton for 1999, $2.09 in 2000,
$2.72 for 2001 and 2002, $3.35 for 2003 through 2006 and $3.77 thereafter, in
escrow accounts for sales of cigarettes occurring in the prior year in each such
state after the effective date of each state specific statute. An inflation
adjustment is also added to these deposits at the higher of 3% or the Consumer
Price Index each year. Such escrowed funds will be available to satisfy
tobacco-related judgments or settlements, if any, in some states. If not used to
satisfy judgments or settlements, the funds will be returned to the Company 25
years after the applicable date of deposit on a rolling basis. Also, absent a
challenge to the state specific statutes or some accommodation as to the escrow
amounts, the failure to place the required amounts in escrow could result in
penalties to the Company and potential restrictions on its ability to sell
tobacco products within particular states. Since all of the MSA states have
passed the so-called "level playing field" statutes, the Company expects that a
material portion of its cigarette sales will continue to be subject to such
purported escrow obligations.
As of January 1, 2001, all forty-six MSA states had adopted model "level
playing field" statutes. As noted above, under these statutes, the Company is
required to place funds in escrow for each cigarette sold in a state that is a
member of the MSA. After funding escrow accounts for 2001 sales, the Company has
deposited a total of approximately $33,600,000 into escrow under protest. In
addition to the escrow deposits associated with the Company's direct customer
sales, the Company has, under protest, been required to make additional escrow
deposits related to sales of the Company's cigarettes subsequently made by the
Company's direct customers in other states ("indirect sales"). In 2001 and in
the first two quarters of 2002, the Company made approximately $4,500,000 in
escrow payments in connection with indirect sales that occurred in 1999, 2000
and 2001. The Company has received demands for additional escrow payments after
making its escrow payments for 2001 and expects that it will continue to be
subject to additional escrow obligations related to indirect sales which
occurred from 1999 through 2001. The Company is not presently able to estimate
the amount of this obligation. However, the amount of any required escrow could
be material and may require the Company to raise additional funds to meet such
purported escrow obligations. All funds placed in escrow continue to be an asset
of the Company, and the Company receives the interest income generated by the
escrow deposits, but this interest income is not sufficient to offset the
Company's cost of capital.
In addition to the "level playing field" statutes, a number of states have
recently enacted statutes that require nonparticipating manufacturers to certify
that they are in full compliance with the escrow requirements of the MSA as a
condition to being permitted to sell cigarette products in those states. While
the Company has recently focused its sales in the four states that were not part
of the
8
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
MSA, these statutes could impact on its ability to sell cigarettes in the MSA
states, notwithstanding its substantial payments into escrow.
After almost two years of negotiations with the National Association of
Attorneys General ("NAAG"), the Company concluded that the NAAG had little
interest in working with Star to come to a reasonable solution under which the
Company could become a participant in the MSA. Accordingly, on December 15,
2000, the Company filed a lawsuit in the United States District Court for the
Eastern District of Virginia requesting that the court declare both the MSA and
Virginia's Qualifying Statute unconstitutional and, therefore, invalid. The
Company's complaint challenges the MSA on the grounds that it violates the
Interstate Compact Clause and the Commerce Clause of the Constitution of the
United States. It challenges the Qualifying Statute on the grounds that it
violates the Equal Protection, Due Process, Takings and Commerce Clauses of the
Constitution. Neither Virginia Attorney General Kilgore nor any other state
attorney general has ever charged the Company with the tortuous and unlawful
conduct asserted against other cigarette manufacturers in lawsuits by various
states which led to the execution of the MSA. Despite the absence of any claim
against the Company, which is focused primarily on producing less toxic and
potentially less hazardous tobacco and tobacco products, the MSA and the
Qualifying Statute impose a severe burden on its research and development
activities.
On March 12, 2001, the District Court heard oral argument on the Commonwealth's
Motion to Dismiss, after both sides exchanged briefs on all the constitutional
and related issues. On March 26, 2001, the District Court dismissed the
Company's complaint, but in its opinion, the District Court did note that Star
"must now suffer as a result of the bad faith of previous market entrants." The
District Court further noted that Star "has never been accused of the
fraudulent, collusive and intentionally dishonest activities of the Big Four,"
"was not even in existence during the bulk of the time that these activities
were occurring," and has taken "every step to provide complete disclosure about
the harmful nature of its products." The District Court also stated that the
"financial burden on Star and others like it may hamper efforts to develop new
tobacco technologies." The Company promptly appealed the District Court's
ruling.
On January 22, 2002, the United States Court of Appeals for the Fourth Circuit
affirmed the decision of the District Court and later denied the Company's
request for rehearing. On May 20, 2002, the Company filed a Petition for a Writ
of Certiorari with the United States Supreme Court asking that Court to review
the case, given its continuing belief that the MSA and the Virginia Qualifying
Statute are constitutionally flawed. The Commonwealth filed an opposition brief
on July 23, 2002 and the Company filed a reply on August 1, 2002. It is
anticipated that the Supreme Court will decide whether to hear this case in late
September or early October.
On June 12, 2001, Star filed a second lawsuit challenging the MSA and Indiana's
Qualifying Statute in the United States District Court for the Southern District
of Indiana, which suit raised claims similar to those in the complaint in the
Commonwealth of Virginia. The Indiana lawsuit also raised the contention that
Star is not subject to any escrow obligation in Indiana because it has no
substantial nexus to the state, and Star moved for a preliminary injunction on
this issue. On August 20, 2001, the District Court issued a ruling denying the
motion for preliminary injunction and dismissing the substantial nexus claim. At
the same time, the court deferred ruling on the remainder of the claims pending
further development of the record and final disposition of the Company's
Virginia action, which is pending before the Supreme Court. The case has
remained inactive since that time.
In May 2002, the Company entered into negotiations with representatives of the
NAAG regarding terms under which Star could become a Subsequent Participating
Member of the MSA and resolve all currently contested issues relating to the MSA
and state Qualifying Statutes, including its constitutional challenge to the
MSA. In connection with those discussions, a Standstill Agreement was negotiated
which provides that during the standstill period, the Settling States which
executed the Agreement would not initiate any enforcement action against the
Company relating to any claims for additional escrow funding and the compliance
with state Qualifying Statutes and the Company would not initiate any new
actions against those Settling States. The Standstill Agreement was executed by
twenty-nine of the forty-six Settling States and by Puerto Rico, and by its
terms extended through July 23, 2002. Although the Standstill Agreement has not
been formally extended, the parties have continued negotiations and neither the
Settling States which signed the Standstill Agreement nor the remaining Settling
States have initiated any enforcement action against the Company.
3. Liquidity and Capital Resources:
The Company has incurred approximately $1.1 million in losses during the first
six months of operations, experienced a decline in working capital from $1.5
million to $0.86 million and negative cash flows during the period of $2
million.
Management plans to address these cash flow shortfalls include: 1) cost-cutting
measures designed to reduce overhead. For example, during the first half of the
third quarter of 2002, sales territories were reevaluated and restructured. This
resulted in a reduction of the Company's sales force from approximately 90 sales
persons who had been employed during the second quarter of 2002 to
9
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
approximately 75 sales persons, 2) cash advances from Brown & Williamson
($900,000) to fund, in part, short-term tobacco leaf segment working capital
needs of approximately $2.5 million, and 3) refinancing of an existing operating
lease into a capital lease which will result in the release of approximately
$1.2 million of cash collateral and the entering into of a lease for ARIVA(TM)
manufacturing equipment totaling approximately $1.2 million resulting in a
release of approximately $500,000 in deposits held by the equipment
manufacturer. In addition, the Company has previously submitted to the IRS a
request for a letter ruling that, if granted, would result in significant
additional tax refunds to the Company. Even the successful execution of the
above action items may not provide sufficient funds to meet the Company's
ongoing cash needs, particularly given the Company's anticipated MSA funding
requirements in April 2003. The Company's liquidity needs for the next 12 months
are very difficult to estimate. Increased competition in the cigarette business,
the complexity of the issues relating to the negotiations with the NAAG, the
Company's obligations to make MSA escrow deposits, and the uncertainty regarding
consumer acceptance of ARIVA(TM), make it difficult for the Company to predict
with clarity its precise liquidity needs over specific timeframes. The adequacy
of the Company's liquidity on both a short and long-term basis will depend upon
the effects on the Company and its business from many factors such as our
ability to reach a settlement with the NAAG on terms reasonably acceptable to
the Company, our ability to operate profitably the cigarette business, either
inside or outside the MSA, other potential strategic choices for such business,
and the amount of capital required to execute the Company's business objectives
of rolling out ARIVA(TM), defending its intellectual property, and other working
capital needs. Thus, it is anticipated the Company will need to raise additional
funds. While the Company is currently not able to estimate the combined impact
of these events there could be circumstances under which the Company
would be required to raise a substantial amount of capital. There can be no
guarantee, however, that the Company will be able to raise capital, or that if
it can raise the capital, that the terms would be acceptable to the Company. The
Company's ability to raise additional funds to meet its working capital and
other capital requirements will be affected by the potential for profitably
operating the cigarette business, the prospects for the success of the Company's
very low-nitrosamine smokeless tobacco products, our substantial leverage, the
terms of our indebtedness and the other factors described under "Factors That
May Affect Future Results" in the Company's Annual Report on Form 10-K for the
fiscal year ended December 31, 2001.
4. Long Term Debt:
Notes/capital leases payable at June 30, 2002 consist of the following:
Note payable under a $13,200,000 credit facility restricted for the
purchase of tobacco curing barns; interest accrues beginning January
1, 2005 at the stated rate of prime plus 1%; principal payable in 60
equal monthly installments commencing January 2005; collateralized by
the Company's curing barns, leaf tobacco inventory and
intellectual property. A $6,957,928
Note payable, non-interest bearing until January 1, 2005. Interest accrues
beginning January 2005 at prime plus 1%, payable monthly. Principal
payable in 60 equal monthly installments commencing January 2005. A 11,000,000
Note payable, non-interest bearing until January 1, 2005. Interest
accrues beginning January 1, 2005 at the stated rate of prime plus
1%; principal payable in 60 equal monthly installments commencing January 2005. A 4,950,000
Loan balance on a $7.5 million revolving line of credit facility
secured by the Company's eligible accounts receivable; effective rate
of interest at stated rate of prime plus 0.5% through an initial term ending in January 2005. 5,551,188
Promissory note, payable with effective interest of 10.04%, collateralized by the
Company's tobacco curing barns. 2,838,086
Capitalized lease obligations, payable with effective interest ranging from 9.0
to 10.5%, in varying installments through 2005. 11,745,030
----------
43,042,231
Less current maturities of long term debt 6,246,667
---------
Notes payable, less current maturities $36,795,564
===========
10
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
A On April 25, 2001, the Company renegotiated these notes to provide for
maturities beginning in 2005. There are provisions in the note
restatements for reductions based on royalties from Brown & Williamson
Tobacco Corporation ("B&W") and other future performance by B&W under
the agreements entered into on April 25, 2001.
The annual maturities of long term debt are as follows:
Year ending June 30,
--------------------
2003 6,246,667
2004 5,480,253
2005 11,455,873
2006 4,707,847
2007 4,360,234
Thereafter 10,791,357
-----------
$43,042,231
===========
5. Income tax (benefit) expense consists of the following: Six months ending June 30,
2002 2001
-------- -------
Current $ (-) $864,500
Deferred (707,000) 720,000
---------- ----------
$ (707,000) $1,584,500
========== ==========
6. Segment information:
Segment of Business
-------------------
Three months ended June 30, 2002
--------------------------------
Discount Cigarettes/
Smokeless Products Tobacco Leaf Consolidated
------------------ ------------ ------------
Revenue $37,198,987 $ - $37,198,987
Cost of sales and excise taxes 30,313,518 - 30,313,518
----------- ------------- -----------
Gross margin 6,885,469 - 6,885,469
----------- ------------- -----------
Research and development - 345,755 345,755
- ------------- -----------
Segment assets $55,931,061 $32,667,076 $88,598,137
=========== ============= ===========
Three months ended June 30, 2001
--------------------------------
Discount Cigarettes/
Smokeless Products Tobacco Leaf Consolidated
------------------ ------------ ------------
Revenue $43,660,976 $ - $43,660,976
Cost of sales and excise taxes 31,635,850 150,315 31,786,165
---------- ------------- -----------
Gross margin 12,025,126 (150,315) 11,874,811
---------- ------------- -----------
Research and development - 538,940 538,940
- ------------- -----------
Segment assets $59,387,078 $11,795,499 $71,182,577
=========== ============= ===========
11
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Six months ended June 30, 2002
------------------------------
Discount Cigarettes/
Smokeless Products Tobacco Leaf Consolidated
------------------ ------------ ------------
Revenue $ 70,719,347 $ - $ 70,719,347
Cost of sales and excise taxes 55,238,784 - 55,238,784
------------ ------------
Gross margin 15,480,563 - 15,480,563
------------ -
Research and development - 565,056 565,056
- ----------- -----------
Segment assets $55,931,061 $32,667,076 $88,598,137
=========== =========== ===========
Six months ended June 30, 2001
Discount Cigarettes/
Smokeless Products Tobacco Leaf Consolidated
------------------ ------------ ------------
Revenue $81,035,581 $ - $81,035,581
Cost of sales and excise taxes 58,931,485 297,978 59,229,463
---------- ------------
Gross margin 22,104,096 (297,978) 21,806,118
---------- ----------- ------------
Research and development - 1,127,205 1,127,205
- ----------- ------------
Segment assets $59,387,078 $11,795,499 $ 71,182,577
=========== =========== ============
Note - Revenues for the tobacco leaf segment are only generated in the
third and fourth quarters of the year.
7. 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). This case is now proceeding in discovery with a
discovery deadline of September 30, 2002. 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, which is at issue in the
first lawsuit against RJR. The lawsuit was filed in the United States District
Court for Maryland and the Company expects that the case will be consolidated
with its earlier lawsuit against RJR filed in the same Court.
On June 28, 2002, Philip Morris filed a declaratory judgment action against the
Company in the United States District Court for the Eastern District of
Virginia, Richmond Division. The Complaint seeks a declaration of
non-infringement and patent invalidity and unenforceability with respect to the
`649 patent. On July 29, 2002, the Company filed a motion to dismiss that
lawsuit. That motion is currently pending.
Since the introduction of ARIVA(TM), three citizen petitions have been filed
with the Food and Drug Administration ("FDA") seeking to have ARIVA(TM)
regulated as a food and/or a drug product. On May 1, 2002 the Company, through
counsel, filed responses to two of these petitions, and on June 13, 2002, filed
a response to the third petition. The Company also filed responses to other
comments filed with the FDA in certain of these dockets, including coments filed
by certain State Attorneys General. The Company's legal team is headed by former
U.S. Solicitor General Charles Fried, Esquire and by FDA attorneys from
McDermott, Will & Emery; Paul, Hastings, Janofsky & Walker LLP and Bergeson &
Campbell, P.C. In the responses counsel concluded that the petitions are
factually flawed and without merit, because ARIVA(TM) does not fit the
definition of a food or a drug under the Federal Food, Drug and Cosmetic Act.
Furthermore, because ARIVA(TM) is a smokeless tobacco product that is intended
to provide tobacco satisfaction, the FDA lacks authority to regulate ARIVA(TM)
based on the March 21, 2000 decision of the Supreme Court in FDA v. Brown &
Williamson Tobacco Corporation, 529 U.S. 120 (2000). Despite the Company's
position as reflected in its responses, there is no certainty that the FDA would
agree with that position and not seek to assert jurisdiction over ARIVA(TM).
The Virginia Department of Taxation has asserted a Virginia Sales and Use Tax
assessment for the period January 1, 1999, through March 31, 2002, against the
Company with respect to its tobacco-curing barns in the amount of $860,115.06.
The Company has applied for a correction of the assessment and a total abatement
of the tax on the grounds that its barns are exempt from sales and use taxes
under the industrial use and processing exemption and/or the agricultural
exemption. The Company has not paid that assessment and is not required to do so
pending its appeal to the Department of Taxation. The Company has also
challenged the taxation of certain other property on the grounds that the
property is used directly in production activities at the Company's processing
facility in Chase City,
12
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Virginia. The Company has paid that assessment, in the amount of $24,273.75, in
full pending appeal. The administrative procedure for consideration of the
Company's application for correction of these assessments is expected to be
concluded by December 31, 2002.
There is other minor litigation in the ordinary course of business which the
Company is vigorously defending.
13
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
General
Star Scientific, Inc. ("Star") and its wholly-owned subsidiary, Star Tobacco,
Inc. ("ST" and together with Star, the "Company"), is a technology-oriented
tobacco company with a mission to reduce toxins in tobacco leaf and tobacco
smoke. The Company is engaged in: (1) the development and implementation of
scientific technology for the curing of StarCured(TM) tobacco so as to retard or
significantly reduce the formation of carcinogenic toxins present in tobacco and
tobacco smoke, primarily the tobacco specific nitrosamines ("TSNAs"); (2) the
sales, marketing and development of tobacco products that expose adult tobacco
users to substantially lower levels of carcinogenic toxins, namely TSNAs, that
are sold with enhanced health warnings and comparative content information so
that adult tobacco consumers will have the option to make informed choices about
the use of tobacco products which pose a range of serious health risks (the TSNA
levels in the Company's tobacco products will continue to be reduced to very low
levels, measured in parts per billion, using the StarCured(TM) tobacco curing
process); (3) the sales, marketing and development of very low-nitrosamine
smokeless tobacco products which also carry enhanced warnings beyond those
required by the Surgeon General (in 2001, the Company introduced three new
smokeless products, Stonewall(TM) moist and dry snuffs, and ARIVA(TM) compressed
powdered tobacco cigalett(TM) pieces); (4) the manufacture and sale of four
discount cigarette brands which currently contain 24% very low-TSNA
StarCured(TM) tobacco; and (5) in the future continued focus on developing
smoking cessation products if the Company can secure a joint venture partner or
corporate pharmaceutical partner with a significant regulatory infrastructure.
Over the past two years, the Company has been engaged in the development of
smokeless tobacco products that could provide adult tobacco users with a viable
alternative to cigarettes in situations and environments when they can't smoke
or when they would prefer not to smoke. This effort was encouraged by the
Company's Scientific Advisory Board and other independent scientific, medical,
and public health advisors who encouraged Star to accelerate the development of
smokeless products whose tobacco is 100% StarCured(TM) low-TSNA tobacco, because
smokeless products have far fewer toxins than conventional cigarettes. Cigarette
smoke contains more than 4,000 chemical compounds, 43 of which are known to be
carcinogenic. A number of respected scientists and researchers believe that the
only major or significant toxins in smokeless tobacco are the TSNAs,
particularly the NNNs and NNKs. Accordingly, the Company expects in the future
to increasingly focus on smokeless tobacco products.
As the Company increases its focus on the development and commercialization of
smokeless tobacco products, especially its flagship hard tobacco cigalett(TM)
pieces (ARIVA(TM)), the Company's central focus continues to be the research,
development and commercialization of products that contain less toxins and
potentially may reduce the range of serious health hazards associated with the
use of tobacco products. The Company fully accepts the evidence showing links
between smoking tobacco and a variety of diseases and premature death and
believes that it is unlikely that the health risks of smoked tobacco can be
completely eliminated. Nevertheless, in a world where an estimated 1.2 billion
people smoke and use other tobacco products, there is an urgent need to reduce
the toxicity of tobacco products to the maximum extent possible using available
technology. The Company believes that it has a corporate responsibility to
continue to expand its research and development efforts to manufacture tobacco
products that contain the lowest levels of toxins as technologically possible,
although given the present limited state of the research efforts of the Company
and others in this area, the Company in discussing its low-TSNA products has
shared with adult consumers the fact that there is not now sufficient evidence
to demonstrate that reduced toxin delivery can be quantified in terms of reduced
health risk.
On September 28, 2001, the Company introduced its first two very low-TSNA snuff
products (a moist and a dry snuff) under the brand name Stonewall(TM). On
November 14, 2001, Star introduced its flagship hard tobacco cigalett(TM) pieces
(ARIVA(TM)). ARIVA(TM) is a compressed powdered tobacco product designed to
dissolve completely in the mouth without leaving any residue. Sales of Star's
smokeless products were de minimus in 2001. During January 2002, ARIVA(TM) was
launched nationally in the United States. ARIVA(TM) is being marketed nationwide
by ST through its network of established tobacco distributors and through new
distributors with whom ST has not previously had a relationship. In addition,
the Company has sought to introduce ARIVA(TM) through direct arrangements with
several national retail chains and through national distributors experienced
with consumer products. Following the successful limited test market of
ARIVA(TM), Star decided it was appropriate to expand distribution. By March 31,
2002, ARIVA(TM) had been placed in more than 12,000 convenience and retail
stores and by June 30, 2002, that number had increased to more than 30,000
stores. In the second quarter, the Company sold 70,800 cartons of ARIVA(TM) (10
packs equals one carton). Overall, the sales of smokeless products continued to
represent a small portion of the Company's total sales, consistent with the
introduction of those products into test markets beginning the fall of 2001. To
date, the sales of ARIVA(TM) have been slower than expected. As a result, the
time period for generating significant revenue and cash flow from the
introduction of ARIVA(TM) will take longer than expected and therefore, it will
take longer for the smokeless products to support themselves on a stand-alone
basis. During the remainder of 2002, the Company anticipates continuing to
expand the number of stores in which its smokeless tobacco products will be
available, but
14
cannot be sure that its smokeless tobacco products will be accepted into the
national marketplace or produce sufficient revenues to support the Company's
initiative to focus primarily on smokeless tobacco products.
Notwithstanding the Company's increasing focus on smokeless tobacco products, in
the second quarter of 2002, the Company's revenue continued to be generated
principally through the sale of discount cigarettes by ST, which currently
manufactures and sells four brands of discount cigarettes, SPORT(R),
MAINSTREET(R), VEGAS(R) and G-SMOKE(R). ST's cigarettes are sold through
approximately 260 tobacco distributors throughout the United States, although
the Company has sought to focus sales efforts in the states of Florida,
Minnesota, Mississippi and Texas. Sales of the Company's discount cigarettes
have continued to decline in MSA states as a result of the increased price in
those states to take into account the burden imposed by MSA escrow requirements
and the Company has faced intensified pricing competition particularly from
foreign manufacturers in the four non-MSA states in which it is currently
focusing its sales efforts. Given the current competitive environment regarding
the sale of discount cigarettes, the Company's ongoing negotiations with the
NAAG, its continued emphasis on smokeless tobacco products, principally
ARIVA(TM) and its continued focus on its technology for producing very low-TSNA
tobacco, the Company is evaluating a number of strategic options relating to its
cigarette manufacturing operations.
In the second quarter, there were no sales of tobacco leaf as tobacco leaf sales
are seasonal in nature and occur in the third and fourth quarters each year.
Results of Operations
The Company's unaudited condensed consolidated results for the periods ended
June 30, 2002 and 2001 are summarized in the following table:
Three Months Ended June 30, Six Months Ended June 30,
2002 2001 2002 2001
---- ---- ---- ----
Net sales $37,198,987 $43,660,976 $70,719,347 $81,035,581
----------- ----------- ----------- -----------
Cost of goods sold 13,239,061 13,313,428 23,428,249 24,356,514
Excise taxes on products 17,074,457 18,472,737 31,810,535 34,872,949
---------- ----------- ----------- -----------
Gross profit 6,885,469 11,874,811 15,480,563 21,806,118
Total operating expenses 9,513,961 7,493,535 16,969,360 13,370,570
--------- ----------- ----------- -----------
Operating income (loss) (2,628,492) 4,381,276 (1,488,797) 8,435,548
----------- ----------- ----------- ----------
Net income (loss) $(1,637,415) $2,698,278 $(1,088,231) $5,116,771
============ =========== =========== ==========
Basic income (loss) per common share:
Net income (loss) ($0.03) $0.05 ($0.02) $0.08
Diluted income (loss) per common share:
Net income (loss) ($0.03) $0.05 ($0.02) $0.08
Weighted average shares outstanding 59,737,229 59,741,481 59,739,333 59,741,481
Diluted weighted average shares outstanding 59,737,229 60,756,529 59,739,333 60,756,529
SECOND QUARTER 2002 COMPARED WITH SECOND QUARTER 2001
During the second quarter of 2002, the Company's consolidated net sales
decreased $6.5 million or 14.8% to $37.2 million, from $43.7 million, for the
second quarter of 2001. The decrease in sales was primarily due to concentrating
sales and marketing efforts into a smaller and increasingly price-sensitive
geographic region, namely Texas, Florida, Mississippi and Minnesota, and the
Company's focus on the introduction and market penetration of its very low-TSNA
smokeless tobacco products, which were introduced in the fall of 2001. The
Company sold approximately 879 million cigarettes during the second quarter of
2002, compared with sales of approximately 1.10 billion cigarettes during the
second quarter of 2001, representing a decrease of approximately 20.2%. The
decrease in sales volume was offset in part by an increase in the sales price
charged by the Company and by the sale of its smokeless tobacco products.
15
There were no leaf tobacco revenues during the second quarter of 2002, as leaf
tobacco revenues are seasonal in nature, and occur during the third and fourth
quarters. During the second quarter of 2002, the Company earned de minimis
royalties paid by B&W on sales of its ADVANCE(R) low-TSNA cigarette, which B&W
continues to test market in Indianapolis, Indiana.
Gross profit in the second quarter of 2002 was $6.9 million, approximately 42%
lower than the $11.9 million gross profit in the second quarter of 2001. Sales
price increases were partially offset by an increase in manufacturing costs,
including increased contract prices for cigarettes made by B&W given the lower
level of production under the Company's Contract Manufacturing Agreement with
B&W. The Company's federal excise tax expense for second quarter 2002 was $17.1
million, a decrease of $1.4 million from the second quarter of 2001, despite a
12.8% increase in the federal excise tax from $3.40 per carton to $3.90 per
carton which became effective on January 1, 2002.
Total operating expenses increased to $9.5 million for the second quarter of
2002 from $7.5 million for the second quarter of 2001 principally due to the
sales and marketing efforts associated with the market introduction of ARIVA(TM)
and STONEWALL(TM). Approximately $2.1 million of this amount is related to the
promotion and product introduction of ARIVA(TM) in Florida, Minnesota,
Mississippi and Texas, and to a lesser extent, in Virginia, where the Company's
sales force is concentrated. Marketing and distribution expenses, on a
consolidated basis, totaled $5.1 million for the second quarter of 2002, an
increase of $2.5 million over the comparable 2001 period. This reflected a
larger sales force of approximately 90 employees and increased distribution
expenses resulting from the introduction of the Company's new smokeless
products, including additional costs related to the introduction of ARIVA(TM) in
major chain stores which previously had not been Company customers. At the end
of the first quarter of 2002, Star's smokeless products were in approximately
12,000 retail stores, and by the end of the second quarter of 2002, the number
of retail stores carrying Star's smokeless products had increased to more than
30,000 retail stores.
General and administrative expenses, on a consolidated basis, totaled $4.1
million for the second quarter of 2002, a decrease of $0.2 million over the
comparable 2001 period. This decrease was attributable primarily to legal
expenses which were $0.3 million less during the second quarter of 2002 compared
to the second quarter of 2001. Such legal expenses related to the Company's
pending lawsuit against R.J. Reynolds for patent infringement, which is in
active discovery in the United States District Court for the District of
Maryland. Also, there have been additional costs related to the Company's
constitutional challenge to the MSA, responses to the Citizen Petitions filed
with the FDA concerning ARIVA(TM), and for scientific, legal, medical and public
health consultants and advisors who are assisting senior management in bringing
the Company's new very low-TSNA smokeless tobacco products to market. While
general and administrative expenses were lower in the second quarter of 2002
than they were in the second quarter of 2001, the Company anticipates increases
in its general and administrative costs in the coming months in connection with
its patent infringement lawsuits and other legal matters described above.
Research and development costs in the second quarter of 2002 were approximately
$346,000 compared to $539,000 during the second quarter of 2001. These decreased
costs reflect the Company's decreased product development costs related to its
new smokeless tobacco products, ARIVA(TM) and STONEWALL(TM) moist and dry snuff,
which were released into test markets during late 2001. The Company continues
its focus on the research and development on products that have reduced levels
of toxins and that potentially may reduce the range of serious health hazards
associated with the use of smoked and smokeless tobacco products. The Company
has initiated and is in the process of designing several additional scientific
studies to determine, among other things, whether a reduction in TSNAs can be
equated with a reduction in health risk. The Company conducts these studies
through independent laboratories and universities.
The Company had interest expense of $408,000 and interest income of $190,000,
for a net interest expense of $217,000 in the second quarter of 2002. This
compares to net interest income of $305,000 during the second quarter of 2001.
The higher interest expense in the second quarter of 2002 resulted from capital
lease obligations entered into in late 2001 and the first quarter of 2002, as
well as interest charges from the Company's line of credit facility, which was
utilized, in part, to finance the MSA Escrow obligation in April 2002 and for
general working capital requirements. This interest expense was partially offset
by interest income generated by the Company's deposits in its MSA Escrow Fund.
The Company receives for its own account the current interest on the amounts in
escrow, but this interest income is not sufficient to offset the Company's cost
of capital. Given the increase in the Company's indebtedness during late 2001
and the first quarter of 2002, the Company's interest expense will remain
substantially higher than historical levels.
The Company's income tax benefit for the second quarter of 2002 was $1.2 million
as compared to an income tax expense of $1.8 million for the second quarter of
2001. This decrease was due to the Company's pre-tax loss during the second
quarter of 2002.
The Company had a consolidated net loss of $1.6 million for second quarter 2002
compared with consolidated net income of $2.7 million reported in the comparable
2001 period, as a result of decreased cigarette sales plus the costs associated
with the introduction of the Company's smokeless tobacco products. In the second
quarter 2002, the Company had a basic and diluted loss per share of
16
$0.03 compared to comparable period basic and diluted per share earnings of
$0.05 in 2001. This decrease in earnings per share reflects the net loss for the
second quarter of 2002.
FIRST SIX MONTHS 2002 COMPARED WITH FIRST SIX MONTHS 2001
During the first six months of 2002, the Company's consolidated net sales
decreased $10.3 million or 12.7% to $70.7 million, from $81.0 million for the
first six months of 2001. The decrease in sales was primarily due to
concentrating sales and marketing efforts into a smaller and increasingly
price-sensitive geographic region, namely Texas, Florida, Mississippi and
Minnesota, and the Company's focus on the introduction and market penetration of
its very low-TSNA smokeless tobacco products, which were introduced in the fall
of 2001. The Company sold approximately 1.65 billion cigarettes during the first
six months of 2002, compared with sales of approximately 2.03 billion cigarettes
during the first six months of 2001, representing a decrease of approximately
18.7%. The decrease in sales volume was offset in part by an increase in the
sales price charged by the Company and by the sale of its smokeless tobacco
products.
There were no leaf tobacco revenues during either the first or second quarters
of 2001 or 2002, as leaf tobacco revenues are seasonal in nature, and occur
during the third and fourth quarters. During the first six months of 2002, the
Company earned de minimis royalties paid by B&W on sales of its ADVANCE(R)
low-TSNA cigarette, which B&W continues to test market in Indianapolis, Indiana.
Gross profit in the first six months of 2002 was $15.5 million, approximately
29% lower than the $21.8 million gross profit in the first six months of 2001.
Sales price increases were partially offset by an increase in manufacturing
costs, including increased contract prices for cigarettes made by B&W given the
lower level of production under the Company's Contract Manufacturing Agreement
with B&W. The Company's federal excise tax expense for the first six months of
2002 was $31.8 million, a decrease of $3.0 million from the $34.9 million of
federal excise tax paid for the first six months of 2001, despite a 12.8%
increase in the federal excise tax from $3.40 per carton to $3.90 per carton
which became effective on January 1, 2002. The decrease in federal excise taxes
paid is explained by the decrease in sales volume even after taking into account
the increase in the excise tax per carton paid.
Total operating expenses increased to $17.0 million for the first six months of
2002 from $13.4 million for the first six months of 2001 principally due to the
sales and marketing efforts associated with the market introduction of ARIVA(TM)
and STONEWALL(TM). Approximately $4.0 million of this amount is related to the
promotion and product introduction of ARIVA(TM) in Florida, Minnesota,
Mississippi and Texas, and to a lesser extent, in Virginia, where the Company's
sales force is concentrated. Marketing and distribution expenses, on a
consolidated basis, totaled $8.6 million for the first six months of 2002, an
increase of $3.6 million over the comparable 2001 period. This reflected a
larger sales force of approximately 90 employees and increased distribution
expenses resulting from the introduction of the Company's new smokeless
products, including additional costs related to the introduction of ARIVA(TM) in
major chain stores which previously had not been Company customers. During the
first six months of 2002, Star's smokeless products were in more than 30,000
retail stores.
General and administrative expenses, on a consolidated basis, totaled $7.8
million for the first six months of 2002, an increase of $0.6 million over the
comparable 2001 period. This increase was attributable primarily to expenses
related to the Company's pending lawsuit against R.J. Reynolds for patent
infringement, which is in active discovery in the United States District Court
for the District of Maryland. Also, there have been additional costs related to
the Company's constitutional challenge to the MSA, responses to the Citizen
Petitions filed with the FDA concerning ARIVA(TM), and for scientific, legal,
medical and public health consultants and advisors who are assisting senior
management in bringing the Company's new very low-TSNA smokeless tobacco
products to market. While general and administrative expenses were lower in the
second quarter of 2002 than they were in the second quarter of 2001, the Company
anticipates increases in its general and administrative costs in the coming
months in connection with its patent infringement lawsuits and other legal
matters described above.
Research and development expenses were $565,000 during the first six months of
2002, a decrease of 49.9% from $1.1 million for the first
17
six months of 2001. These decreased costs reflect the Company's decreased
product development costs related to its new smokeless tobacco products,
ARIVA(TM) and STONEWALL(TM) moist and dry snuff, which were released into test
markets in late 2001. The Company continues its focus on the research and
development on products that have reduced levels of toxins and that potentially
may reduce the range of serious health hazards associated with the use of smoked
and smokeless tobacco products. The Company has initiated and is in the process
of designing several additional scientific studies to determine, among other
things, whether a reduction in TSNAs can be equated with a reduction in health
risk. The Company conducts these studies through independent laboratories and
universities.
The Company had interest expense of $729,000 and interest income of $334,000,
for a net interest expense of $395,000 during the first six months of 2002. This
compares to net interest income of $253,000 during the first six months of 2001.
The higher interest expense in the first six months of 2002 resulted from
capital lease obligations entered into in late 2001 and the first quarter of
2002, as well as interest charges from the Company's line of credit facility,
which was utilized, in part, to finance the MSA Escrow obligation in April 2002
and for general working capital requirements. This interest expense was
partially offset by interest income generated by the Company's deposits in its
MSA Escrow Fund. The Company receives for its own account the current interest
on the amounts in escrow, but this interest income is not sufficient to offset
the Company's cost of capital. Given the increase in the Company's indebtedness
during late 2001 and the first quarter of 2002, the Company's interest expense
will remain substantially higher than historical levels.
An income tax credit of $707,000 for the first six months of 2002 reflects the
pre-tax loss of $1.8 million versus income tax incurred for the first six months
of 2001 of $3.4 million on pretax profit of $8.5 million.
Consolidated net loss for the first six months of 2001 was $1.1 million,
compared with net income of $5.1 million for the comparable 2001 period. In the
first six months of 2002, the Company had a basic and diluted loss of $0.02 per
share versus basic and diluted earnings per share of $0.08 in the first six
months of 2001.
Liquidity and Capital Resources
In the first six months of 2002, $4.8 million of cash was used to support
operating activities. This compared to a positive net cash flow of $1.2 million
during the first six months of 2001. The increase in cash used in operations
during the first six months of 2002 was primarily due to an increase of $5.5
million in accounts receivable from customers and additional costs related to
the introduction of ARIVA(TM) on a national basis during the same six month
period. This increase in accounts receivable resulted primarily from a timing
difference in sales. An increase in federal excise tax occurred on 1 January
2002, and wholesalers attempted to minimize the amount of inventory on hand as
of that date to avoid paying a "floor tax" of 50 cents per carton, since the
federal excise tax increased from $3.40 per carton to $3.90 per carton on that
day. Thus, receivables were uncharacteristically low as of December 31, 2001,
and had increased to more normal end of quarter levels by June 30, 2002.
Further, receivables have increased as a result of longer duration payment terms
granted to smokeless tobacco distributors. There were approximately $700,000 of
receivables from smokeless tobacco distributors as of June 30, 2002.
During the second quarter of 2002, the Company had deposits for equipment orders
and cash in restricted accounts collateralizing lease obligations in the
aggregate amount of approximately $2.7 million. The Company intends to complete
a leasing transaction in the third or fourth quarter of 2002 for equipment
required to manufacture ARIVA(TM) totaling approximately $1.2 million, which
will release approximately $0.5 million in equipment order deposits. Further,
the Company intends during the third or fourth quarter of 2002 to refinance or
renegotiate an operating lease and convert it to a capital lease which will
result in the release of approximately $1.2 million in cash from a restricted
account. Previously, the Company entered into loans and/or lease agreements
collateralized by a substantial portion of the Company's assets. As a result,
the ability of the Company to generate additional funds through additional loans
or leases collateralized by its assets is limited.
The Company and ST each have granted B&W a first priority security interest
under the B&W credit facility in their respective intellectual property as
collateral, and have each guaranteed the payment of the other's obligations.
Also, the B&W credit facility is collateralized by the Company's curing barns
and leaf tobacco inventory.
B&W is holding $5 million of Star Cured(TM) tobacco for use by the Company. The
Company has a liability of $5 million associated with that inventory as shown in
accounts payable.
The Company has a working capital line of credit, which is collateralized by
accounts receivable from its cigarette business, in the amount of $7.5 million.
The Company had $5.6 million of borrowings under this credit facility at June
30, 2002 at an interest rate of Prime plus 0.5% which was an effective rate of
approximately 5.25% during the second quarter of 2002.
As of June 30, 2002, the Company, on behalf of ST, had deposited into escrow
approximately $33.6 million to fund ST's net purported escrow obligations under
the MSA for sales in 1999, 2000 and 2001. Based on the increased escrow amount
per carton, and ST's sales in MSA states in future years, the Company will have
to pay significant sums into these escrow accounts to meet MSA requirements for
sales in later years. If not used to satisfy judgments or settlements, the funds
will be returned to the Company 25 years after the applicable date of deposit on
a rolling basis. In addition to the escrow deposits associated with the
Company's direct sales, the Company has, under protest, been required to make
additional escrow deposits related to sales of the Company's cigarettes
subsequently made by the Company's direct customers into other states ("indirect
sales"). In 2001 and in the first and second quarters
18
of 2002, the Company made approximately $4,500,000 in escrow payments in
connection with indirect sales that occurred in 1999, 2000 and 2001. The Company
has received demands for additional escrow payments for indirect sales which
occurred in 2001, and expects that it will continue to be subject to further
additional escrow obligations related to indirect sales which occurred from
1999-2001. In April 2003, the Company will be required to make escrow payments
for sales into MSA states which occurred during 2002. It is anticipated that the
Settling States may make additional demands for indirect sales made during 2002
and Star may be subject to additional escrow obligations for such sales. For the
past three years, the amount of MSA escrow funds which the Company has been
required to deposit has exceeded the Company's net income. Accordingly, the
Company has been required to meet part of its MSA escrow deposit obligations
from sources other than operating income. To the extent that the amounts the
Company is required in the future to deposit into the MSA escrow exceed
available cash flow from operations and other sources of liquidity, the Company
will be required to raise additional outside capital to make these payments.
In May 2002, the Company entered into negotiations with representatives of the
NAAG regarding terms under which Star could become a Subsequent Participating
Member of the MSA and resolve all currently contested issues relating to the
MSA, including all issues relating to claims under State Qualifying Statutes and
the Company's constitutional challenge to the MSA. In connection with those
discussions, a Standstill Agreement was negotiated which provides that during
the standstill period, the Settling States which executed the Agreement would
not initiate any enforcement action against the Company relating to claims for
additional escrow funding and compliance with state Qualifying Statutes and the
Company would not initiate any new actions against the Settling States. The
Standstill Agreement was executed by twenty-nine of the forty-six Settling
States and Puerto Rico, and by its terms extended through July 23, 2002.
Although the Standstill Agreement has not been formally extended, the parties
have continued negotiations and neither the Settling States which signed the
Standstill Agreement nor the remaining Settling States have initiated any
enforcement action against the Company. Should Star become a Subsequent
Participating Manufacturer in the MSA, it is anticipated that a settlement would
result in a resolution of all outstanding issues with the Settling States. Such
a settlement may result in Star contributing some or all of its escrow funds to
the Settling States as MSA payments. Any such contributions will be charged as
an expense to the income statement in the period when paid, and could result in
a significant decrease in book value of the Company. In the event the Company
does not reach a settlement agreement with the NAAG, it is anticipated that the
Settling States will move forward on their demands that the Company make
additional escrow deposits to cover indirect sales claimed for the period
1999-2001.
The Company has incurred approximately $1.1 million in losses during the first
six months of operations, experienced a decline in working capital from $1.5
million to $0.86 million and negative cash flows during the period of $2
million.
Currently, the Company is not generating sufficient cash to fund its operations
and anticipated cash requirements. The Company recognizes that, in order to
protect and defend its intellectual property, additional capital will need to be
spent in connection with its ongoing patent litigation matters. In addition,
further capital will be required for other litigation matters described herein.
Further, in order to continue to market and develop ARIVA(TM) additional capital
will be needed for sales, marketing and promotion. Given the current cash
shortfalls, the Company will need to generate or raise from outside sources a
substantial amount of additional cash to meet its obligations and to support its
ongoing operations and activities. Failure to raise additional capital may
inhibit the efforts described above and impede or prevent the Company from
recognizing the market potential for ARIVA(TM).
Management plans to address these cash flow shortfalls include: 1) cost-cutting
measures designed to reduce overhead. For example, during the first half of the
third quarter of 2002, sales territories were reevaluated and restructured. This
resulted in a reduction of the Company's sales force from approximately 90 sales
persons who had been employed during the second quarter of 2002 to approximately
75 sales persons, 2) cash advances from Brown & Williamson ($900,000) to fund,
in part, short-term tobacco leaf segment working capital needs of approximately
$2.5 million, and 3) refinancing of an existing operating lease into a capital
lease which will result in the release of approximately $1.2 million of cash
collateral and the entering into of a lease for ARIVA(TM) manufacturing
equipment totaling approximately $1.2 million resulting in a release of
approximately $500,000 in deposits held by the equipment manufacturer. In
addition, the Company has previously submitted to the IRS a request for a letter
ruling that, if granted, would result in significant additional tax refunds to
the Company. Even the successful execution of the above action items may not
provide sufficient funds to meet the Company's ongoing cash needs, particularly
given the Company's anticipated MSA funding requirements in April 2003. The
Company's liquidity needs for the next 12 months are very difficult to estimate.
Increased competition in the cigarette business, the complexity of the issues
relating to the negotiations with the NAAG, the Company's obligations to make
MSA escrow deposits, and the uncertainty regarding consumer acceptance of
ARIVA(TM), make it difficult for the Company to predict with clarity its precise
liquidity needs over specific time frames. The adequacy of the Company's
liquidity on both a short and long-term basis will depend upon the effects on
the Company and its business from many factors such as our ability to reach a
settlement with the NAAG on terms reasonably acceptable to the Company, our
ability to operate profitably the cigarette business, either inside or outside
the MSA, other potential strategic choices for such business and the amount of
capital required to execute the Company's business objectives of rolling out
ARIVA(TM), defending its intellectual property, and other working capital needs.
Thus, it is anticipated the Company will need to raise additional funds. While
the Company is currently not able to estimate the combined impact of these
events there could be circumstances under which the Company would be
required to raise a substantial amount of capital. There can be no guarantee,
however, that the Company will be able to raise capital, or that if it can raise
the capital, that the terms would be acceptable to the Company. The Company's
ability to raise additional funds to meet its
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working capital and other capital requirements will be effected by numerous
factors, including the potential for profitably operating the cigarette
business, the prospects for the success of the Company's very low-nitrosamine
smokeless tobacco products, our substantial leverage, the terms of our
indebtedness and the other factors described under "Factors That May Affect
Future Results" in the Company's Annual Report on Form 10-K for the fiscal year
ended December 31, 2001.
The foregoing discussion of the results of operations and financial condition of
the Company should be read in conjunction with the Company's condensed
consolidated financial statements and related notes included elsewhere in this
Report.
Item 3. Qualitative and Quantitative Disclosures About Market Risk
The Company has not entered into any transactions using derivative financial
instruments or derivative commodity instruments and believes that its exposure
to market risk associated with other financial instruments (such as investments
and borrowings) and interest rate risk is not material.
While a majority of the Company's debt facilities and leases are at fixed
interest rates, some borrowings, including the Company's line of credit and some
of the Company's leases are at variable rates and, as a result, the Company is
subject to interest rate exposure. In addition, the Company's investments in the
MSA-related escrow accounts are short-term very high quality investments.
Consequently, the income generated by these investments is subject to
fluctuation with changes in interest rates. The interest received from these
escrow accounts is not sufficient to offset the Company's cost of capital.
Note on Forward-Looking Statements
THIS REPORT ON FORM 10-Q CONTAINS CERTAIN FORWARD-LOOKING STATEMENTS WITHIN THE
MEANING OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995. THE COMPANY HAS
TRIED, WHENEVER POSSIBLE, TO IDENTIFY THESE FORWARD-LOOKING STATEMENTS USING
WORDS SUCH AS "ANTICIPATES", "BELIEVES", "ESTIMATES", "EXPECTS", "PLANS",
"INTENDS" AND SIMILAR EXPRESSIONS. THESE STATEMENTS REFLECT THE COMPANY'S
CURRENT BELIEFS AND ARE BASED UPON INFORMATION CURRENTLY AVAILABLE TO IT.
ACCORDINGLY, SUCH FORWARD-LOOKING STATEMENTS INVOLVE KNOWN AND UNKNOWN RISKS,
UNCERTAINTIES AND OTHER FACTORS WHICH COULD CAUSE THE COMPANY'S ACTUAL RESULTS,
PERFORMANCE OR ACHIEVEMENTS TO DIFFER MATERIALLY FROM THOSE EXPRESSED IN, OR
IMPLIED BY, SUCH STATEMENTS. THESE RISKS, UNCERTAINTIES AND CONTINGENCIES
INCLUDE, WITHOUT LIMITATION, THE CHALLENGES INHERENT IN NEW PRODUCT DEVELOPMENT
INITIATIVES PARTICULARLY IN THE SMOKELESS TOBACCO AREA, THE UNCERTAINTIES
INHERENT IN THE PROGRESS OF SCIENTIFIC RESEARCH, THE COMPANY'S ABILITY TO RAISE
THE CAPITAL NECESSARY TO GROW ITS BUSINESS, POTENTIAL DISPUTES CONCERNING THE
COMPANY'S INTELLECTUAL PROPERTY, RISKS ASSOCIATED WITH LITIGATION REGARDING SUCH
INTELLECTUAL PROPERTY, POTENTIAL DELAYS IN OBTAINING ANY NECESSARY GOVERNMENT
APPROVALS OF THE COMPANY'S LOW-TSNA TOBACCO PRODUCTS, MARKET ACCEPTANCE OF THE
COMPANY'S NEW SMOKELESS TOBACCO PRODUCTS, COMPETITION FROM COMPANIES WITH
GREATER RESOURCES THAN THE COMPANY, THE COMPANY'S DECISION NOT TO JOIN THE
MASTER SETTLEMENT AGREEMENT ("MSA") AND ITS DECISION TO CHALLENGE THE
CONSTITUTIONALITY OF THE MSA, THE EFFECT OF STATE STATUTES ADOPTED UNDER THE MSA
AND ANY SUBSEQUENT MODIFICATION OF THE MSA, THE COMPANY'S DEPENDENCE ON KEY
EMPLOYEES AND ON ITS STRATEGIC RELATIONSHIPS WITH BROWN & WILLIAMSON TOBACCO
CORPORATION. THE IMPACT OF POTENTIAL LITIGATION, IF INITIATED AGAINST OR BY
INDIVIDUAL STATES THAT HAVE ADOPTED THE MSA, COULD BE MATERIALLY ADVERSE TO THE
COMPANY.
SEE ADDITIONAL DISCUSSION UNDER "FACTORS THAT MAY AFFECT FUTURE RESULTS" IN THE
COMPANY'S ANNUAL REPORT ON FORM 10-K FOR THE YEAR ENDED DECEMBER 31, 2001, AND
OTHER FACTORS DETAILED FROM TIME TO TIME IN THE COMPANY'S OTHER FILINGS WITH THE
SECURITIES AND EXCHANGE COMMISSION. THE COMPANY UNDERTAKES NO OBLIGATION TO
UPDATE OR ADVISE UPON ANY SUCH FORWA RD-LOOKING STATEMENTS TO REFLECT EVENTS OR
CIRCUMSTANCES AFTER THE DATE OF THIS PRESS RELEASE OR TO REFLECT THE OCCURRENCE
OF UNANTICIPATED EVENTS.
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PART II - OTHER INFORMATION
Item 1. Legal Proceedings
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). This case is now proceeding in discovery with a
discovery deadline of September 30, 2002. 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, which is at issue in the
first lawsuit against RJR. The lawsuit was filed in the United States District
Court for Maryland and the Company expects that the case will be consolidated
with its earlier lawsuit against RJR filed in the same Court.
On June 28, 2002, Philip Morris filed a declaratory judgment action against the
Company in the United States District Court for the Eastern District of
Virginia, Richmond Division. The Complaint seeks a declaration of
non-infringement and patent invalidity and unenforceability with respect to the
`649 patent. On July 29, 2002, the Company filed a motion to dismiss that
lawsuit. That motion is currently pending.
Since the introduction of ARIVA(TM), three citizen petitions have been filed
with the Food and Drug Administration ("FDA") seeking to have ARIVA(TM)
regulated as a food and/or a drug product. On May 1, 2002 the Company, through
counsel, filed responses to two of these petitions, and on June 13, 2002, filed
a response to the third petition. The Company also filed responses to other
comments filed with the FDA in certain of these dockets, including comments
filed by certain State Attorneys General. The Company's legal team is headed by
former U.S. Solicitor General Charles Fried, Esquire and by FDA attorneys from
McDermott, Will & Emery; Paul, Hastings, Janofsky & Walker LLP and Bergeson &
Campbell, P.C. In the responses counsel concluded that the petitions are
factually flawed and without merit, because ARIVA(TM) does not fit the
definition of a food or a drug under the Federal Food, Drug and Cosmetic Act.
Furthermore, because ARIVA(TM) is a smokeless tobacco product that is intended
to provide tobacco satisfaction, the FDA lacks authority to regulate ARIVA(TM)
based on the March 21, 2000 decision of the Supreme Court in FDA v. Brown &
Williamson Tobacco Corporation, 529 U.S. 120 (2000). Despite the Company's
position as reflected in its responses, there is no certainty that the FDA would
agree with that position and not seek to assert jurisdiction over ARIVA(TM).
The Virginia Department of Taxation has asserted a Virginia Sales and Use Tax
assessment for the period January 1, 1999, through March 31, 2002, against the
Company with respect to its tobacco-curing barns in the amount of $860,115.06.
The Company has applied for a correction of the assessment and a total abatement
of the tax on the grounds that its barns are exempt from sales and use taxes
under the industrial use and processing exemption and/or the agricultural
exemption. The Company has not paid that assessment and is not required to do so
pending its appeal to the Department of Taxation. The Company has also
challenged the taxation of certain other property on the grounds that the
property is used directly in production activities at the Company's processing
facility in Chase City, Virginia. The Company has paid that assessment, in the
amount of $24,273.75, in full pending appeal. The administrative procedure for
consideration of the Company's application for correction of these assessments
is expected to be concluded by December 31, 2002.
There is other minor litigation in the ordinary course of business which the
Company is vigorously defending.
Item 2. Changes in Securities and Use of Proceeds.
In the second quarter of 2002, Star granted its directors, officers, employees
and consultants (the "Purchaser Class") options to purchase Star's Common Stock
as described below. All options described below were granted under the Star
Scientific, Inc. 1998 Stock Option Plan or the Star Scientific, Inc. 2000 Equity
Incentive Plan. On each of the dates set forth below, the options described were
offered to one or more members of the Purchaser Class in a private offering in
accordance with Section 4(2) of the Securities Act of 1933, as amended.
Date of Grant Exercise Price Options Granted
(per share)
---------------------- ------------------------------ ------------------------
04/13/02 $2.11 25,000
---------------------- ------------------------------ ------------------------
05/31/02 $1.12 200,000
---------------------- ------------------------------ ------------------------
06/14/02 $1.17 100,000
---------------------- ------------------------------ ------------------------
06/09/02 $1.24 25,000
---------------------- ------------------------------ ------------------------
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Item 6. Exhibits and Reports on Form 8-K.
(a) Exhibits
Number Description
10.1 Contract with The Industrial Development Authority of Mecklenburg County,
Virginia and The Industrial Development Authority of the Town of Chase
City, Virginia, for a 10-year lease and option to purchase an
approximately 91,000 square foot building at 89 Duckworth Road.
(b) Reports on Form 8-K
No reports on Form 8-K were filed during the period covered by this report.
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SIGNATURES
In accordance with Section 13 or 15(d) of the Exchange Act, the registrant
caused this report to be signed on its behalf by the undersigned, thereunto duly
authorized.
STAR SCIENTIFIC, INC.
Date: August 14, 2002 /s/ Christopher G. Miller
-------------------------
Authorized Signatory and
Chief Financial Officer
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