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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 10-K
(Mark One)
[X] ANNUAL REPORT UNDER SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF
1934
For the fiscal year ended December 31, 1999
[ ] TRANSITION REPORT UNDER 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)
Securities Registered under Section 12(g) of the Act:
COMMON STOCK, $.01 PAR VALUE
(Title of Class)
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
-- --
Indicate by check mark if disclosure of delinquent filers pursuant to item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy of information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ ]
The aggregate market value of the Registrant's voting stock held by
non-affiliates of the Registrant as of March 14, 2000 is approximately
$78,000,000. Shares of voting stock held by each executive officer and director
and by each person who owns 5% or more of the any voting stock have been
excluded in that such persons may be deemed affiliates of the Registrant. This
determination of affiliate status is not necessarily a conclusive determination
for other purposes.
Number of shares outstanding of each class of common equity as of March 14,
2000: 58,749,201 shares of Common Stock.
DOCUMENTS INCORPORATED BY REFERENCE: (To the Extent Indicated Herein)
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Note on Forward-Looking Statements
CERTAIN STATEMENTS IN THIS ANNUAL REPORT ON FORM 10-K, UNDER THE SECTIONS
"MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS," "BUSINESS" AND ELSEWHERE RELATE TO FUTURE EVENTS AND EXPECTATIONS
AND AS SUCH CONSTITUTE "FORWARD-LOOKING STATEMENTS," WITHIN THE MEANING OF THE
PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995. THE WORDS "BELIEVES,"
"ANTICIPATES," "PLANS," "EXPECTS," AND SIMILAR EXPRESSIONS IN THIS REPORT ARE
INTENDED TO IDENTIFY FORWARD-LOOKING STATEMENTS. SUCH FORWARD-LOOKING STATEMENTS
INVOLVE KNOWN AND UNKNOWN RISKS, UNCERTAINTIES, AND OTHER FACTORS WHICH MAY
CAUSE THE ACTUAL RESULTS, PERFORMANCE OR ACHIEVEMENTS OF THE COMPANY TO BE
MATERIALLY DIFFERENT FROM ANY FUTURE RESULTS, PERFORMANCE OR ACHIEVEMENTS
EXPRESSED OR IMPLIED BY SUCH FORWARD-LOOKING STATEMENTS AND TO VARY
SIGNIFICANTLY FROM REPORTING PERIOD TO REPORTING PERIOD. SUCH FACTORS INCLUDE,
AMONG OTHERS, THOSE LISTED IN "FACTORS THAT MAY AFFECT FUTURE RESULTS" UNDER
ITEM 1 BELOW AND OTHER FACTORS DETAILED FROM TIME TO TIME IN THE COMPANY'S OTHER
FILINGS WITH THE SECURITIES AND EXCHANGE COMMISSION.
PART I
Item 1. Business
GENERAL
We are engaged in: (1) the development of proprietary scientific
technology for the curing of tobacco so as to prevent, retard or significantly
reduce the formation of carcinogenic toxins present in tobacco and tobacco
smoke, primarily, the tobacco specific nitrosamines ("TSNAs"); (2) the
development of less harmful smoked tobacco products utilizing tobacco with very
low levels of TSNAs (measured in parts per billion) which has been cured using
the Company's proprietary StarCure(TM) process; (3) the manufacture and sale of
discount cigarettes, with activated charcoal filters; (4) the research and
development of tobacco cessation products; and (5) the development of smokeless
tobacco products utilizing tobacco with very low levels of TSNAs (measured in
parts per billion) which has been cured using the Company's proprietary
StarCure(TM) process.
Star Scientific Inc.'s ("Star" or the "Company") central focus is the
reduction of the range of serious health hazards associated with the use of
tobacco products. Accordingly, Star's primary corporate mission is to
demonstrate the commercial viability of less harmful tobacco products and to
encourage other tobacco manufacturers to utilize and/or license Star's
proprietary curing technology. (When used in this Report, Star Scientific, Inc.
and its wholly-owned subsidiary, Star Tobacco & Pharmaceuticals, Inc. are
sometimes individually and/or collectively referred to as "Star" or the
"Company".)
The Company has an exclusive worldwide license under patents and patents
pending relating to methods to prevent the formation of TSNAs in tobacco.
Certain TSNAs are generally regarded by cancer researchers as the most abundant
and potent carcinogens in tobacco and tobacco smoke.
The Company has pioneered the development of an economically feasible
curing (StarCure(TM)) process for preventing the formation of virtually all of
the carcinogenic TSNAs in tobacco. This, in turn, reduces these carcinogens in
secondhand smoke. Star's non-chemical StarCure(TM) curing process does not
affect the taste, color or nicotine content of tobacco.
Today, the Company's revenue generation is principally through its
wholly-owned subsidiary, Star Tobacco & Pharmaceuticals, Inc. ("ST&P"). ST&P's
predecessor, a closely held private company, was organized in 1990 and, until
1994, primarily was engaged in the business of manufacturing cigars and
cigarettes for others as a contract manufacturer. By late 1994, ST&P had
commenced development and commercialization of its own brands of discount
cigarettes using primarily Virginia flue-cured tobacco and competed principally
on the basis of price. At about that same time, ST&P commenced a program of
research and development relating to a range of potentially less harmful tobacco
products and tobacco cessation products wherein ST&P secured certain
Investigatory New Drug applications ("INDs") from the U. S. Food and Drug
Administration ("FDA") to commence human clinical testing. Shortly thereafter,
ST&P shifted its near-term research focus to a technological development phase
focused upon reducing
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the carcinogenic TSNAs in the tobacco leaf and tobacco smoke. In
February 1998, ST&P merged with Eye Technology, Inc., a publicly-held OTC
Bulletin Board company based in Minneapolis, Minnesota. While Eye Technology
technically was the surviving corporation, in effect, control of the surviving
corporation shifted to the former stockholders of ST&P and the management of
ST&P became the control management of the survivor in the merger. By December
30, 1998, the assets and liabilities that comprised the pre-merger business of
Eye Technology, Inc. had been sold or liquidated, and the stockholders of Eye
Technology voted to change its name to Star Scientific, Inc. The Company's
primary corporate focus from that time forward has centered upon the development
of reduced toxin, and potentially reduced risk, tobacco products, plus continued
focus upon the long term development of smoking cessation products either with a
joint venture partner or a corporate pharmaceutical partner.
Thereafter, in pursuance of the Company's focus to reduce the
carcinogenic TSNAs in the tobacco leaf and tobacco smoke, the Company obtained
the exclusive right to patents and patent applications which are now pending,
pertaining to various aspects of the tobacco leaf curing process which has been
named StarCure(TM). The proprietary StarCure(TM) process, to which the Company
has an exclusive license from Regent Court Technologies LLC (as discussed
herein), involves the use of specially designed curing barns and a microwave
curing process using specially designed industrial size microwave ovens
(operated presently from its Chase City, Virginia processing center). This
proprietary StarCure(TM) process virtually precludes and/or substantially
reduces the formation in the tobacco leaf of the carcinogenic TSNAs, which are
widely believed by medical and scientific experts to be among the most potent
and powerful cancer-causing toxins present in tobacco and in side stream tobacco
smoke. In 1999, the Company processed over 3.5 million pounds of very low-TSNA
flue-cured tobacco using the StarCure (TM) process, and believes that
this process is applicable to burley and other varieties of tobacco on a
broad-scale commercial basis.
The Company's long-term strategy is to aggressively increase and expand
its production capacity for its proprietary StarCure(TM) process to produce very
low-TSNA tobacco (carcinogenic NNKs and NNNs at less than 400 parts per
billion). Further, the Company is committed to continue to explore the
development of potentially less harmful smoked and smokeless tobacco products,
as well as the development of tobacco cessation products. The Company has
started the process of integrating its very low-TSNA StarCure(TM) tobacco into
its present discount cigarette brands. Star presently markets four brands,
namely, SPORT(R), MAINSTREET(R), VEGAS(R) and G-SMOKE(R) all of which now have
activated charcoal filters and contain approximately 3% of very low-TSNA
flue-cured tobacco because of limited availability of very low-TSNA tobacco at
this time. It is anticipated that in light of Star's projected increased
StarCure(TM) production during the year 2000, in excess of 20 million pounds of
very low-TSNA tobacco will be processed during this year's growing season. With
such increased production, Star expects to be able to totally phase into its
four brands all very low-TSNA flue-cured tobacco over the next 24 months,to
launch a new very low-TSNA cigarette brand that also will have activated
charcoal filters, and contemporaneously to fulfill its tobacco supply
commitments to Brown & Williamson Tobacco Corporation ("B&W"), the third largest
tobacco company in the United States. (See "Relationship with B&W".)
The Company has announced plans to launch before the end of the third
quarter of 2000, the first very low-TSNA cigarette. This cigarette, which will
have a new name chosen by late Spring 2000, will have an activated charcoal
filter. The Company's central focus will continue to be to be aimed at reducing
the health hazards associated with the use of smoked and smokeless tobacco
products. The Company fully accepts the evidence showing links between tobacco
smoking 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 1.1 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 are as
safe as technologically possible. The Company has now demonstrated that the
method it has developed for curing tobacco using its proprietary StarCure(TM)
process, can be scaled up to meet broad commercial needs in the United States
and abroad. The Company's new brand will be the first cigarette to be launched
in the United States which utilizes StarCure(TM) very low-TSNA flue-cured
tobacco, as well as burley tobacco selected for its low-TSNA content, and a
small portion of sun dried oriental tobacco. The Company's new brand will also
use an activated charcoal filter aimed at reducing the levels of certain vapor
phase toxins.
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PRODUCTS
Discount Cigarettes
Star currently manufactures and sells four brands of discount
cigarettes, MAINSTREET(R), SPORT(R), VEGAS(R) and G-SMOKE(R) (formerly
GUNSMOKE(TM)), through approximately 325 tobacco distributors throughout the
United States. The cigarettes are sold as discount brands. Star does not engage
in extensive advertising or marketing programs for its cigarette products, but
relies primarily upon price communications with distributors and, to a lesser
extent, on product appearance and taste in order to compete in the marketplace.
There were no export sales by the Company in 1999.
In an effort to implement Star's corporate mission to develop
potentially less harmful tobacco products, Star intends to phase its very
low-TSNA tobacco which has been cured through its proprietary StarCure(TM)
process into its discount cigarettes within the next 24 months. As of July 1,
1999, Star changed all of its filters to activated charcoal because of
recommendations from leading health advocates and respected research scientists
to the effect that activated charcoal filters reduce certain vapor phase toxins
in tobacco smoke. Star intends to continue to use activated charcoal filters in
all of its discount cigarettes, as well as in its new brand.
Processed Tobacco
In 1999, Star processed and sold over 3.5 million pounds of low-TSNA
flue-cured tobacco that had been cured using its proprietary StarCure(TM)
process. All of these sales were made to B&W, pursuant to Star's contractual
arrangements with B&W described elsewhere in this Report. These sales accounted
for approximately 10% of the Company's net sales in 1999. During 2000, Star
expects to process, sell and/or use for its own brands in excess of 20 million
pounds of very low-TSNA tobacco cured using the StarCure(TM) process. Star
expects that a minimum of 8 million pounds will be sold to B&W pursuant to its
Supply Agreement. The remaining portion will be integrated into Star's own
discount cigarette brands over the next 24 months and/or will be available for
sale to B&W or other cigarette manufacturers. The Company's long-term goal is to
derive an increasingly larger percentage of its revenues from sub-licensing its
StarCure(TM) process to major cigarette manufacturers.
Smokeless Tobacco Products Containing Very Low-TSNA Tobacco
Scientific research has shown that TSNAs may be the most significant
carcinogens in smokeless tobacco products commonly known as "chew", "dip" and
"snuff". Accordingly, in the year 2000 Star intends to devote substantial
resources toward the development of very low-TSNA smokeless tobacco products.
Star expects to undertake those projects in concert with a major tobacco company
as a strategic partner or licensee. No assurance can be given at this time that
such a product will be developed and successfully commercialized.
Tobacco-Flavored Chewing Gum and Lozenges and Chewing Gum Containing
Tobacco Extract
The Company is in current discussions with a major pharmaceutical
company to joint venture, partner and/or license its technology to produce
tobacco cessation products. Star has produced for pilot Phase I testing both a
chewing gum and a tobacco lozenge, each containing very low-TSNA tobacco, as
potential smoking cessation products. The gum/lozenge products contain nicotine,
as well as the MAO-inhibitor known to be present in tobacco. In anticipation of
a then pending legislative proposal to provide the FDA with new legislative
authority to regulate tobacco products, Star submitted and received approval of
an IND for the gum product from the FDA. Star commenced a Phase I Human Clinical
Trial in the second quarter of 1998 in order to demonstrate the safety of the
product for smoking cessation purposes. Star has developed lozenges which
contain tobacco extract. Star has not yet filed an IND application with the FDA
covering lozenges, and in the current regulatory environment it is unlikely to
do
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so. Neither the gum nor the lozenge may be sold in the United States as
pharmaceutical products unless and until the FDA has approved a New Drug
Application for such products. No assurances can be given when or if Star might
obtain such approvals or that, even if such approvals are obtained, whether
there will be significant revenues from the sale of either. Given the present
uncertain status of the FDA's authority to regulate tobacco products, it now
appears that to be sold as pharmaceutical products these tobacco-containing
cessation products would be required to undergo all of the preclinical and
clinical testing required of a new drug product. It seems unlikely at the
present time that undertaking such testing would produce an adequate return on
investment. Star continues to investigate and explore opportunities for these
products in Western and Eastern Europe, and in other countries where regulating
authorities appear to be more receptive to the development of reduced risk and
less hazardous tobacco products. Star has taken a public position, unanimously
supported by its Board of Directors, that it is in favor of comprehensive FDA
regulation of all tobacco products.
SALES AND MARKETING
Star's four brands of discount cigarettes are each sold in a variety of
sizes and styles, i.e., king size and 100s, soft pack and hinged box, regular
flavor and menthol, and full flavor, lights and ultra lights. Star utilizes its
own specified blend of tobaccos in each brand. The blend consists of Virginia
flue-cured, burley and oriental varieties of tobacco, which is typical of
American-style cigarettes.
Star uses stylized packaging designs for its four brands of discount
cigarettes. As is typical in the cigarette industry, Star utilizes different
colors, e.g., green for menthol and similar designs on its packaging to denote
different product styles. Star primarily conducts trade journal and direct mail
advertising to the industry and not advertising directed to consumers. Star does
provide to its distributor customers, for redistribution to retailers,
point-of-sale materials such as posters, pull signs, display racks as well as
counter top and floor displays. Also, Star produces marketing materials for use
by distributors and their direct sales force to promote Star cigarettes to their
retail customers.
It is Star's strategy to rely to a large degree upon distributors to
promote and sell Star's brands to retail customers. In 1999 Star sold its
discount cigarettes to a total of approximately 325 distributors located in 48
states. The distributors maintain state and, where applicable, municipal
government tobacco product licenses, apply state and/or local cigarette tax
stamps when needed, and resell the cigarettes to retailers. Star delivers its
products directly to distributors mainly by common carrier trucks. Star's
distributor customers primarily serve convenience stores, gas stations and other
outlets and stores. No one distributor accounted for more than 10% of Star's
revenues in 1999.
During 1999, Star experienced substantial sales growth. Star believes
that the price increases imposed upon the major cigarette manufacturers created
an increased demand for low-price cigarettes. In late 1999, Star initiated an
aggressive expansion of its marketing and sales organization to respond to its
anticipated increase in demand, not only for its present products, but for what
the Company believes will be a demand by knowledgeable smokers for products
which deliver less toxins, i.e. Star's new brand expected to be launched in the
third quarter. This growth began under the leadership of its Chief Executive
Officer, Mr. Jonnie R. Williams, and then under the leadership of its Vice
President of Sales and Marketing, Mr. David M. Dean and Mr. Sheldon Bogaz, Vice
President of Trade Operations. Mr. Dean, who came to Star with extensive health
care oriented marketing expertise, supervises a staff of eleven regional sales
representatives who direct a field sales force. By the end of 2000, Star plans
to increase its sales force to cover a greater number of distributors located
throughout the 48 contiguous states.
PURCHASING
During 1999, the majority of tobacco used in Star's cigarettes was
purchased from a recognized leaf dealer in "cut rag" form, meaning that the
tobacco has been cut, processed and flavored to Star's specifications, and is
ready when delivered to Star for the manufacturing process. The Company expects
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during 2000 and thereafter to purchase increasing amounts of the tobacco needed
for its business directly from tobacco farmers.
MANUFACTURING
All of the tobacco planned to be used by the Company in 2000 in the
production of its very low-TSNA tobacco either for sale to B&W and potentially
other parties, or for incorporation into Star's own cigarettes, or in the
development by Star of smokeless tobacco products, will be cured using Star's
proprietary StarCure(TM) process. The StarCure(TM) process utilizes specially
equipped curing barns and microwave technology. The specially designed curing
barns, which incorporate the StarCure(TM) processing technology, are
manufactured exclusively for Star by Powell Manufacturing Company of
Bennettsville, South Carolina ("Powell"). Powell is the largest manufacturer of
curing barns in the U.S. These specially designed barns are erected on site at
the tobacco farms which provide Star with its tobacco. Approximately 550 of
these barns have already been manufactured and delivered and contracts with
tobacco farmers for approximately 350 additional curing barns have either been
executed or are being finalized. Star anticipates that Powell will have provided
Star with over 1,000 such barns by the end of 2000. Financing for a majority of
these barns is provided by B&W (see "Relationship With B&W"). The Company's
StarCure(TM) very low-TSNA tobacco is also processed in specially designed
microwaves at its StarCure(TM) processing facility, a leased facility in Chase
City, Virginia. Star's processing facility in Chase City is presently undergoing
construction to substantially expand its capacity to process larger amounts of
very low-TSNA tobacco. Star anticipates that it will be able to produce in
excess of 20 million pounds of StarCure(TM) tobacco (both flue-cured and burley)
during the year 2000 growing season.
Star's cigarettes are manufactured at its facility in Petersburg,
Virginia and under contract. The tobacco is combined with filters and paper in a
"maker" which produces finished cigarettes, which in turn are placed in a
"packer" which provides packaging into standard 20-cigarette packs and ten-pack
cartons. Star believes its manufacturing facilities, plus the additional
manufacturing contract relationship now in place with B&W, will allow Star to
respond to its growing demand for the foreseeable future.
RELATIONSHIP WITH B&W
On October 12, 1999, the Company and B&W entered into the Supply
Agreement under which B&W agreed to purchase Star Cure(TM) tobacco. During the
third quarter and early fourth quarter of 1999, the Company produced and
delivered to B&W approximately 3.5 million pounds of very low-TSNA Star Cure(TM)
processed tobacco. This tobacco will be used to explore the production
feasibility and commercial acceptance of very low-TSNA cigarettes. In each of
the years 2000 and 2001, B&W is obligated to purchase from Star five million
pounds of Virginia flue-cured tobacco that has been cured using the Star
Cure(TM) process; and B&W has an option to purchase three million pounds of
burley tobacco cured using the same process. B&W also has the option to become
the exclusive purchaser of tobacco cured using the Star Cure(TM) process in each
of the years 2002 through 2004, if it purchases from the Company at least 30
million pounds of tobacco in each of those years. During the same period and
beyond that period if certain conditions are met, the Company has agreed to
provide sufficient quantities of tobacco cured using the Star Cure(TM) process
to meet the demands of B&W and all participating B&W affiliates, including
British American Tobacco PLC, the second largest tobacco company in the world.
Further, B&W has agreed to finance the Company's purchase of 600 of the
specially designed curing barns and, subject to certain preconditions, an
additional 400 such barns. In addition, B&W has agreed to collaborate with the
Company in the development of a new very low-TSNA cigarette and the possible
licensing of trademark rights to B&W in connection with the sale of this new
product.
Star in 1999 entered into a manufacturing agreement under which B&W has
agreed to manufacture cigarettes for Star. Also, Star has entered into an
agreement under which B&W is supplying leaf tobacco to Star for use in its
tobacco products.
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COMPETITION
Star's primary competition for conventional cigarettes is from the four
"majors," that is, Philip Morris, the brands of which accounted for
approximately 50% of all cigarette sales in the United States in 1999, R.J.
Reynolds, B&W and Lorillard, each of which has substantially greater financial
and operating resources than Star. Star also encounters significant competition
from several other smaller U.S. manufacturers of cigarettes, as well as
importers of cigarettes manufactured in foreign countries. Many of these
manufacturers and importers have substantially greater financial, manufacturing,
marketing and other resources than Star.
Star's current conventional smoked products compete principally on the
basis of price and possibly quality of product. Generally speaking, there are
three price categories of cigarettes in the United States, "premium," which
includes such brands as Marlboro(R) and Camel(R), "full-price," which includes
such brands as Doral(R) and GPC(R), and "discount," which as a group account for
only a small percentage (approximately 3%) of the U.S. cigarette market. Each of
Star's brands is priced in the discount category. Other competitive factors
include package design, taste and the amount of marketing support provided to
distributors and retailers. At the consumer level, brand loyalty also is a
significant factor.
Star is not aware of any other company which currently produces very
low-TSNA tobacco on a commercial basis, although one Swedish company, Swedish
Match, has worked with various varieties of tobacco under crop management
environments and other methods in an effort to maintain low-TSNAs in its
smokeless products. Star is not aware of any other company that now incorporates
very low-TSNA tobacco into their cigarettes or other tobacco products. B&W now
has in its possession approximately 3.5 million pounds of very low-TSNA tobacco,
but has not made a public announcement of when it will start using that tobacco
in its current products or in a new product. However, recent announcements by
several of the major tobacco companies indicate that certain of these companies
either have commenced exploration or intend to explore the production of
low-TSNA tobacco in the next few years and the incorporation of low-TSNA tobacco
into their cigarettes. Star believes that if it is successful in commercializing
its unique very low-TSNA cigarettes and/or in developing and commercializing
very low-TSNA smokeless tobacco, it is inevitable that many of the major tobacco
companies will follow its lead.
If the Company is successful in developing and commercializing smoking
reduction or cessation products, it will encounter stiff competition. Smoking
cessation products that are approved for sale in the United States by the FDA
are primarily nicotine delivery products (nicotine only) designed to wean the
patient from nicotine addiction over a period of time ranging from 30 days to
six weeks. Three products, Nicorette(R), a nicotine chewing gum, and Nicotrol(R)
and NicoDerm(R), both transdermal nicotine patches, constituted substantially
all of the U.S. pharmaceutical nicotine market in 1999. All of these products
are sold over-the-counter. Zyban(R), (bupropion), a prescription drug which
originally was developed and is still sold under another proprietary name as an
antidepressant was introduced to the market in 1997 and has been demonstrated to
be useful as a cessation product. Star understands that sales of Zyban(R) to
date have been substantial and that Zyban(R) is often prescribed by physicians
to be used in conjunction with nicotine delivery products.
Star's principal competitors in the cessation and reduction market
include Smith Kline Beecham, the McNeil Consumer Division of Johnson & Johnson,
Glaxo-Wellcome and Pharmacia-Upjohn, all of which have capital resources,
research and development staffs, facilities, experience in conducting clinical
trials and obtaining regulatory approvals, and experience in manufacturing and
marketing their products which are significantly greater than those of Star. In
addition, there are several companies developing new technologies aimed at
smoking cessation therapies. There also are a number of consumer products which
do not require FDA approval as therapeutic drug products but which nevertheless
are advertised as alternatives to smoking or as help in the reduction of
smoking. For example, at least one of
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the leading United States confectionery chewing gum manufacturers has advertised
its gum products as an alternative to cigarettes. There are also non-tobacco
cigarettes produced with fillers such as lettuce and herbs. In addition to the
use of consumable products for smoking cessation or reduction purposes, medical
practitioners and others have developed a variety of programs intended to assist
a person in withdrawing from nicotine dependence. Treatments used include
psychological counseling, hypnosis, group therapy and behavior modification
techniques. There can be no assurance that Star can overcome regulatory barriers
to marketing its tobacco-containing cessation products or that Star's
competitors will not succeed in developing technologies and products that are
more effective than Star's product candidates, that are less toxic than Star's
products or that would render Star's products obsolete or non-competitive.
GOVERNMENT REGULATION
The manufacture and sale of cigarettes and other tobacco products and of
pharmaceutical products are subject to extensive federal and state governmental
regulation in the United States and by comparable authorities in many foreign
countries. These national agencies and other federal, state and local entities
regulate, among other things, research and development activities and the
testing, manufacture, safety, effectiveness, labeling, storage, record keeping,
approval, advertising and promotion of Star's products.
There are multiple bills pending before the 106th Congress and in
several state legislatures which, if enacted, would significantly change the
United States tobacco industry. Some of these federal bills contain provisions
which would provide substantial federal government funds for smoking cessation
programs and products, as well as incentives to tobacco companies and others to
produce less harmful or reduced-risk tobacco products. Star is unable to predict
what effect, if any, these provisions, if enacted, would have on Star's
technology for very low-TSNA tobacco or the sale of Star's smoking cessation
products and/or reduced-risk tobacco products. The Company believes, however,
that any bill that requires manufacturers to reduce or disclose levels of TSNAs
in tobacco or tobacco smoke would be beneficial. Star announced on February 29,
at a press conference held at the Dirksen Senate Office Building, its support of
a bi-partisan tobacco labeling Bill (S. 2125) introduced by Senators Frank
Lautenberg (D. N.J.), Richard Lugar (R. IND.), Richard J. Durbin, (D. ILL.), and
Lincoln D. Chafee (R. R.I.). The Senate Bill, entitled the "Smoker's Right to
Know and Truth in Tobacco Labeling Act", would, if enacted, significantly
enhance the current tobacco package warning labels and require disclosure of
toxic ingredients and health affects. The Bill would require all manufacturers
to disclose cancer-causing agents, including carcinogenic TSNAs, as well as the
percentage of such carcinogens "relative to the average of such concentration of
such carcinogen in the sales weighted average of all cigarettes marketed in the
United States." If enacted, Star believes such mandated disclosure would be
beneficial to informed adult smokers, as well as the Company.
FDA Regulation
The FDA has promulgated regulations governing the sale and advertising
of tobacco products designed primarily to discourage the sale to, and
consumption by, adolescents and children. The authority of the FDA to promulgate
such regulations was challenged in the federal courts. A federal District Court
upheld the FDA's authority to promulgate such regulations but ruled that certain
of the regulations restricting advertising were invalid as violative of the
constitutional right of free speech. On appeal, the United States Court of
Appeals for the Fourth Circuit affirmed portions of the District Court opinion
that held the FDA could not regulate tobacco advertising and ruled that the
executive branch of the United States government, in particular the FDA, does
not have any authority to regulate tobacco products generally. The federal
government appealed the Appeals Court's ruling and the matter was heard by the
United States Supreme Court in late 1999.
On March 21, 2000, the Supreme Court in a five to four decision held
that the Congress has not given the FDA authority to regulate tobacco products
as customarily marketed. Given the decision by the
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Supreme Court it is unclear whether the 106th or 107th Congress will act to
grant such authority to the FDA, although legislation that would create such
authority has already been introduced in Congress.
Star believes that in the future reasoned FDA regulation will better
enable the Company to compete in its particular market niche. Accordingly, the
Company has publicly announced its support for comprehensive FDA regulation of
tobacco products. The Company has shared the results of its proprietary curing
process with the FDA. The Company believes that the commercial value of its
proprietary StarCure(TM) tobacco curing process will depend in part upon its
validation by the scientific, health care and public health communities. The
Company believes that well designed and carefully executed tests and clinical
trials with resulting data shared with the scientific and public health
communities would further its objective of attaining more general acceptance for
its unique proprietary StarCure(TM) technology.
Federal Trade Commission
The requirements for health warnings on cigarettes is governed by
the Federal Cigarette Labeling and Advertising Act ("Labeling Act"). The
Labeling Act imposes labeling and advertising requirements on the manufacturers,
packagers, and importers of cigarettes and requires any company wishing to sell
cigarettes within the United States to submit a plan to the Federal Trade
Commission explaining how it will comply with the warning label display
requirements. Star has submitted such plans in the past, and the Federal Trade
Commission has approved its labeling plans.
Bureau of Alcohol, Tobacco and Firearms
Manufacturers and importers of tobacco products are taxed pursuant
to regulations promulgated by the federal Bureau of Alcohol, Tobacco and
Firearms under authority of the Internal Revenue Code of 1986, as amended. The
Company's tobacco products are subject to tax under such regulations.
State and Municipal Laws
The sale of tobacco products is subject to taxation in all fifty
states. In addition, some states permit municipalities to impose an additional
sales tax, and many municipalities do so. The state and municipal taxes are
imposed upon wholesalers and/or retailers but not manufacturers, and therefore
Star has no liability for such taxes. Star is required by many states, however,
to report its shipments of cigarettes to distributors/retailers located within
their jurisdiction. Star is aware of at least two states, Massachusetts and
Minnesota, which have recently adopted laws and regulations regarding the
disclosure by manufacturers of certain chemical constituents in their products.
Star intends to fully comply with such laws and believes it will benefit from
such disclosure.
Master Tobacco Settlement Agreement
In November 1998, 46 states and several U.S. territories entered
into a settlement agreement (the "Master Settlement Agreement") to resolve
litigation that had been instituted by them 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 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. Absent a legal challenge to the state
specific statutes or an agreement with respect to the funding of the required
escrow accounts, the Company is obligated to place an amount equal to $1.88 per
carton for 1999, and increased amounts per carton for subsequent years ($2.09 in
2000, $2.72 in 2001-2002, $3.35 in 2003-2006 and $3.77 thereafter), in escrow
accounts,
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beginning April 2000 and annually thereafter, for sales of cigarettes occurring
in the prior year in each such state after the effective date of each state
specific statute. 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. Also, absent a challenge to the
state specific statutes or some accommodation as to the payment of the escrow
amounts, the failure to pay the required escrow could result in penalties to the
Company and potential restrictions on its ability to sell tobacco products
within particular states. The Company is continuing to assess its options with
respect to the state specific statutes, including a range of potential legal
challenges to the statutes and/or the Master Settlement Agreement under a
variety of legal theories, including unconstitutional taking of property.
As of January 1, 2000, thirty-seven states had adopted model "level
playing field" statutes and Star's purported obligations under those statutes is
approximately $10.6 million with respect to 1999 sales. The Company's Board of
Directors has authorized the Company to fund the escrow obligations for 1999
under protest and to prepare a draft complaint for consideration by the
Company's Board of Directors.
Virginia Incentive Rebates
In 1999, the Commonwealth of Virginia enacted legislation that
explicitly encourages the manufacture and sale of "products that reduce the
carcinogenic TSNA levels in tobacco products." That legislation, pursuant to
House Bill 2635 and Senate Bill 1165 (1999), provides that $2,000,000 shall be
made available to the Virginia Economic Development Partnership to provide for
economic development incentive rebates to assist Virginia companies that reduce
carcinogenic TSNA levels in tobacco products and pass a portion of that rebate
on to tobacco farmers. The Company believes that it is the only company in
Virginia that produced any very low-TSNA tobacco in Virginia during the 1999
growing season and, thus, the only company that could qualify for these rebates.
Canadian Proposed Regulations for Tobacco Packaging
The Canadian government in 1999 proposed new labeling regulations
that would require disclosure of the amount of selected toxic emissions and
constituents, including TSNAs, in tobacco products sold in Canada, as well as an
explanatory phrase regarding each such toxic substance. The proposed phrase
regarding TSNAs would require a warning, that "NITROSAMINES CAUSE CANCER. THEY
ARE THE MOST ACTIVE CANCER-CAUSING AGENTS IN TOBACCO." Star believes that, if
adopted, the proposed regulations, which would require such disclosure on
cigarette labels covering 60% of the top of the principal display panel, could
benefit the Company to the extent that Star or any future Star licensee markets
tobacco in Canada. Star is currently exploring opportunities for the use of its
very low-TSNA tobacco in Canada, either directly or through a license granted by
Star to one or more tobacco companies which market cigarettes in Canada.
RESEARCH AND DEVELOPMENT
In the mid-1990's, Star commenced research and development
activities based upon newly-conceived technology for the processing of tobacco
so as to preclude, eliminate or substantially reduce TSNAs to very low levels.
This technology is under exclusive license from a company in which the
technology's inventor and the Company's founder and current Chief Executive
Officer, Jonnie R. Williams, is part owner. (See "Patents, Trademarks and
Licenses.") TSNAs are generally recognized by health researchers to be among
the most potent and abundant carcinogens in tobacco and tobacco smoke. Star's
research and development activities have focused on: (1) perfecting and testing
its proprietary methods for processing tobacco: (2) developing products which
incorporate Star's specially-processed tobacco, including products for the
smoked and smokeless tobacco markets: (3) establishing a patent position; and
(4) developing relationships with tobacco farmers, as well as the tobacco
industry, with a view to the commercialization of Star's processes. Star's
research and development efforts culminated in the development of various
aspects of the StarCure(TM) process, with respect to which Star has exclusive
rights to patents as well as patent applications which are pending (see
"Patents, Trademarks and Licenses").
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Star has convened a Scientific Advisory Board of highly regarded physicians,
scientists, and public health experts to provide it with counsel on how best to
proceed forward in a variety of scientific and research oriented areas. The
Scientific Advisory Board is chaired ex officio by Dr. Jerome H. Jaffe, Star's
Medical and Scientific Director.
Proprietary Technology
The process of curing or drying tobacco so that it is suitable for
production into tobacco products begins immediately upon harvesting of the
tobacco leaf. The two principal varieties of tobacco leaf in the United States
are Virginia flue-cured tobacco and burley tobacco, both of which are typically
used in American-made cigarettes to produce what is referred to as an American
blend. Under conventional curing methods with Virginia flue-cured tobacco, the
leaves are hung in enclosed barns and are then exposed to gas-fired heat, while
with burley tobacco the leaves are hung in sheds to dry naturally. The curing
process for Virginia flue-cured tobacco takes approximately 5 to 7 days and for
burley tobacco a month, or more.
The Company's StarCure(TM) proprietary curing technology is
applicable to Virginia flue-cured tobacco and, the Company believes, to burley
tobacco, and most likely to other varieties widely used throughout the world
on a broad-scale commercial basis. Star's curing process essentially arrests
or eliminates microbial activity that normally occurs during curing, thereby
preventing the production of TSNAs. Star's curing technology does not, however,
alter or affect taste, color or the nicotine content of tobacco. The Company
makes no claim or representation that its StarCure(TM) proprietary curing
process reduces any harmful chemical constituents in tobacco and/or tobacco
smoke other than TSNAs. Additionally, the Company makes no claim that the
elimination of TSNAs reduces the risk of disease from smoking. Star has been
careful not to make any health claims, directly or indirectly, since there is
not yet clinical evidence to show that a reduction in these specific
carcinogens in tobacco will translate into a reduced health risk.
Star's proprietary curing technology has been licensed to Star in an
agreement which grants to Star certain exclusive worldwide rights with a right
of sublicense. See "Patents, Trademarks and Licenses" below. It is Star's
objective to achieve widespread acceptance of its proprietary tobacco curing
technology as a standard for the manufacture of potentially less harmful tobacco
products and as a basis for the use of low-TSNA tobacco in the production of
smoking cessation products.
Star conducted a pilot program during the 1998 U.S. tobacco harvest
season (July through October). The purposes of this program were: (1) to
continue to test and perfect Star's curing processes in quantities and under
conditions which would serve as a model for future operations; (2) to test
custom designed equipment; (3) to provide processed tobacco to major
manufacturers in quantities for testing and test market purposes; and (4) to
demonstrate the commercial feasibility of adoption of Star's processes for
widespread use in the production of tobacco products. The program was operated
from the Company's facility in Chase City, Virginia. The Company completed the
pilot program and believes it achieved the objectives described above. In 1999,
Star processed over 3.5 million pounds of very low-TSNA tobacco using the
StarCure(TM) process. As discussed above, Star expects to process over 20
million pounds of very low-TSNA tobacco during the 2000 growing season.
Development of Very Low-TSNA Cigarette
Star plans to market the first very low-TSNA cigarette to be sold in
the United States before the end of the third quarter of 2000. This cigarette
will use Virginia flue cured tobacco processed using the proprietary
StarCure(TM) process, as well as other tobaccos (burley and oriental) selected
for low-TSNA levels. It is anticipated that, compared to leading brands, their
cigarette will achieve up to a 90% reduction of the carcinogenic TSNAs in the
tobacco and more than an 80% reduction of TSNAs in tobacco smoke (measured by
the FTC method) with comparable tar and nicotine yields. Also, the product will
have an activated charcoal filter that, it is anticipated, will reduce certain
gas and vapor phase toxic substances.
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Prior Development of CigRx(TM)
In 1997 Star submitted a cigarette product that it called
"CigRx(TM)" to the FDA as a pharmaceutical product. The objective was to offer a
product to help patients who relapse after a trial of smoking cessation to
prepare for another cessation attempt while reducing exposure to TSNAs. Star is
not aware of any other company submitting a tobacco product for FDA clearance.
Star's strategy has since changed, and it will not seek FDA approval for
CigRx(TM) A Phase I study, under an FDA-reviewed protocol, was completed at the
Virginia Commonwealth University under the direction of Professor William Barr,
Director of the Center for Drug Studies. The study, involving male and female
subjects, was a cross-over study designed to test in vivo elimination or
reduction of TSNAs following the smoking of CigRx(TM) cigarettes compared to the
subjects' normally used cigarettes. These test cigarettes were made entirely
from flue-cured Virginia tobacco with no added flavorings. The average total
TSNA levels in the tobacco itself at the time of testing were about 100 parts
per billion, as compared to more than 3,000 parts per billion in popular brands.
As measured by the current Federal Trade Commission method, the CigRx(TM)
cigarettes used in the study delivered substantially less carbon monoxide (4.8
milligrams versus 12.2 milligrams) and about half as much tar (7.0 milligrams
versus 14.0 milligrams) compared to an average of the best selling full-flavored
cigarettes. The study contrasted Star's product with conventional brands in
terms of breath levels of carbon monoxide, blood levels of nicotine, and urinary
levels of TSNAs. On the CigRx(TM) product, blood nicotine levels were somewhat
higher and carbon monoxide was substantially lower. Urinary levels of TSNA (as
measured by NNAL) were analyzed by the American Health Foundation. The average
levels of NNAL and its metabolite after 9 days on the CigRx(TM) product were
reduced substantially, consistent with published data showing that TSNAs leave
the body slowly over 90 to 120 days.
PRODUCT LIABILITY
In the United States, there have been numerous and well-publicized
lawsuits against the largest manufacturers of cigarettes and other tobacco
products initiated by state and municipal governmental units, health care
providers and insurers, individuals (for themselves and on a class-action basis)
and by others. The legal theories underlying such lawsuits are varied, but are
generally based upon one or more of the following: (1) manufacturer defendants
have deceived consumers about the health risks associated with tobacco product
consumption; (2) such defendants knew or should have known about various harmful
ingredients of their products and failed to adequately warn consumers about the
potential harmful effects of those ingredients; and (3) such defendants knew of
the addictive attributes of nicotine and have purposefully manipulated their
product ingredients so as to enhance the delivery of nicotine.
Star believes that the risk of being named a defendant in a lawsuit
of the type described above is relatively low, and therefore the risk of
liability in any such lawsuit is relatively low, because Star: (1) has not at
any time advertised its tobacco products to consumers except for
point-of-purchase materials; (2) has conducted research on the chemical or other
constituents of its products only in the course of trying to reduce the delivery
of toxic materials; (3) has not "manipulated" the nicotine content or delivery
of its tobacco products; and (4) has stated unequivocally that smoking involves
a range of serious health risks, is addictive, and that smoked cigarettes
products can never be produced in a "safe" fashion. Moreover, Star's brands have
been sold for only a relatively short period of time, i.e., since 1994, and the
volume of sales has not been substantial in relation to the volume generated by
the larger manufacturers.
Star maintains product liability insurance which is limited to any
claims that tobacco products manufactured by or for Star contain any foreign
object. Such insurance does not cover health-related claims such as those that
have been made against the major manufacturers of tobacco products. Star does
not believe that such insurance currently can be obtained. A lawsuit against the
Company based upon claims not covered by its product liability insurance could
have a materially adverse effect upon the Company.
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PATENTS, TRADEMARKS AND LICENSES
License Agreement with Regent Court Technologies
Star is the licensee under a license agreement (the "License
Agreement") with the licensor, Regent Court Technologies LLC ("Regent Court"), a
limited liability company of which Jonnie R. Williams, the Company's founder and
Chief Executive Officer and Francis E. O'Donnell, Jr., M.D. are the sole
members. The License Agreement provides, among other things, for the grant of an
exclusive, worldwide, irrevocable license to Star, with the right to grant
sublicenses, to make, use and sell tobacco and products containing tobacco under
the licensor's patent rights and know-how relating to the processes for curing
tobacco so as to eliminate TSNAs or reduce them to insignificant levels, and to
develop products containing such tobacco, whether such patent rights and
know-how are now in existence or hereinafter developed. This license includes
inventions of Regent Court and its affiliates during the term of the License
Agreement relating to the production, treatment or curing of tobacco, or a
method of manufacturing a product containing tobacco, and of extracting one or
more substances from tobacco for the purpose of incorporating such substance or
substances in a product or products.
Star is obligated to pay to Regent Court a royalty of 2% on all net
sales of products by it and any affiliated sublicensees, and 6% on all fees and
royalties received by it from unaffiliated sublicensees, less any related
research and development costs incurred by Star. The License Agreement expires
with the expiration of the last of any applicable patents. Two U.S. patents have
been issued, and additional patent applications are pending in the United States
and in approximately 80 foreign jurisdictions. Star paid no royalties to the
licensor in 1999.
The License Agreement may be terminated by Star upon 30 days written
notice. The License Agreement may also be terminated by Regent Court (a) upon a
default in the payment of royalties or a failure to submit a correct accounting
continuing for at least 30 days after written notice, or (b) upon a material
breach of any other obligation of Star under the License Agreement continuing
for at least 60 days after written notice. A material breach may include a
sublicense of the Patent Rights (as defined in the License Agreement) without
obtaining a written agreement of the sublicensee to be obligated to Regent Court
under the License Agreement. Star is also obligated to provide Regent Court with
copies of all patent applications by it relating to the Patent Rights. For
purposes of determining materiality, a breach shall be deemed material if such
breach results in a loss of royalties exceeding $100,000.
The License Agreement obligates Star to prosecute and pay for U.S.
and foreign patent rights. The License Agreement contains other provisions
typically found in a patent license agreement, such as provisions governing
patent enforcement and the defense of any infringement claims against Star and
its sublicensees. The License Agreement further provides that any obligation or
liability related to patent infringement matters brought against Star will be
borne by Star. Star has agreed to indemnify and defend the licensor and its
affiliates against losses incurred in connection with Star's use, sale or other
disposition of any licensed product or the exercise of any rights under the
License Agreement. Regent Court has made no representations to Star in any
documents regarding the efficacy of the licensed technology.
Patents and Proprietary Rights
Under the License Agreement, Star has exclusive rights to two issued
patents and pending patent applications. The issued and pending patents cover
the current technology for reducing the level of TSNAs in tobacco. Corresponding
patent filings have been initiated in numerous foreign countries. There can be
no assurance that patents will issue from any of the pending applications, that
claims which may be allowed thereunder will be sufficient to protect the
intellectual property owned or licensed by Star, or that Star or Regent Court
has or will develop or obtain the rights to any additional products or processes
that are patentable. In addition, no assurance can be given that any patents
issued to or licensed by Star will not be challenged, invalidated, infringed or
circumvented, or that the rights granted thereunder will provide competitive
advantages to Star.
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SALE OF OPHTHALMIC BUSINESS
By the end of 1998, the Company sold its ophthalmic business. This
sale was viewed as necessary due to the poor results of such business and to
enable the Company to focus on its core business strengths. The purchaser
assumed most of the liabilities of the ophthalmic business. The purchaser
deposited into escrow 250,000 shares of the Company's common stock to secure the
payment of these liabilities.
EMPLOYEES
As of December 31, 1999, the Company had approximately 140 full-time
employees. From time to time, the Company engages temporary personnel to augment
its regular employee staff. The Company utilizes from time to time the services
of consultants, experts and independent contractors to provide key functions in
the scientific, medical, health care, legal, communications, financial and
related areas. The use of such outside consultants enables the Company to secure
expertise in a wide variety of areas that it might otherwise not be in a
position to secure or which it would otherwise be required to secure through
the hiring of additional Company-employed personnel at potentially greater cost
to the Company. Substantially all of the Company's research and development
efforts have been, and are expected to continue to be, conducted pursuant to
contractual arrangements with universities and scientific, medical and public
health consultants and investigators under the leadership of Dr. Jerome H.
Jaffe, the Company's Medical and Scientific Director, an internationally
recognized and respected neuropsychopharmacologist and addiction specialist. The
Company's success depends in large part on its ability to attract and retain
highly qualified scientific, technical, management, financial and marketing
personnel. Competition for such personnel is intense and there can be no
assurance that the Company will be able to attract and retain the personnel
necessary for the development and operation of its business. The loss of the
services of its key personnel or the termination of its contracts with
independent scientific and medical investigators could have a material and
adverse effect on the Company's business.
FACTORS THAT MAY AFFECT FUTURE RESULTS
We Are Dependent on the Domestic Tobacco Business
Substantially all of our revenues in 1999 were derived from sales in
the United States of our four brands of discount cigarettes, and sales of our
very low-TSNA tobacco . If the U.S. cigarette market continues to contract, we
may not have significant tobacco sales abroad or sales of other products to
offset these effects. This trend could adversely affect our sales volumes,
operating income and cash flows.
Competition From Other Cigarette Makers Could Adversely Affect Us
The cigarette industry is highly competitive. The majority of our
competitors have substantially greater financial, marketing, personnel and other
resources than we have. While we are not aware of any other company which
produces very low-TSNA tobacco for commercial use or incorporates very low-TSNA
tobacco into their cigarettes or other tobacco products, other major tobacco
companies will undoubtedly follow Star's lead. Additionally, our competitors may
also develop other less toxic tobacco products that can compete with our very
low-TSNA products.
Very Low-TSNA Tobacco May Not Be Accepted by the Marketplace
While we have produced and test marketed limited quantities of our
very low-TSNA cigarette and have been encouraged by the initial results, very
low-TSNA tobacco may not be accepted ultimately by adult smokers. Adult smokers
may decide not to purchase tobacco products made with very low-TSNA tobacco due
to taste or other preferences, particularly in light of Star's decision to
introduce its new very low-TSNA cigarette product with an activated charcoal
filter.
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The Cigarette Industry is Subject to Substantial and Increasing
Regulation and Taxation
Various federal, state and local laws limit the advertising, sale and
use of cigarettes, and these laws have proliferated in recent years. If this
trend continues, it may have material and adverse effects on our sales volumes,
operating income and cash flows. In addition, cigarettes are subject to
substantial and increasing excise taxes. The federal excise tax on cigarettes
will rise from $.24 per pack in 1999 to $.34 in 2000, and to $.39 in 2002.
President Clinton has proposed a further increase of $.55 per pack.
Additionally, state excise taxes range from $.025 per pack in Virginia to $.87
per pack in California. Increased excise taxes may result in declines in overall
sales volume. This result could adversely affect our operating income and cash
flows.
The FDA has promulgated regulations governing the sale and advertising
of tobacco products designed primarily to discourage the sale to, and
consumption by, adolescents and children. The authority of the FDA to promulgate
such regulations was challenged in the federal courts. On March 21, 2000, the
United States Supreme Court in a five to four decision held that the Congress
has not given the FDA authority to regulate tobacco products as customarily
marketed. Given the decision by the Supreme Court it is unclear whether the
106th or 107th Congress will act to grant such authority to the FDA, although
legislation that would create such authority has already been introduced in
Congress.
We Have Substantial Obligations Under State Laws Adopted Under the
Master Settlement Agreement
Absent a successful legal challenge to the statutes passed by various
states in connection with the Master Settlement Agreement, or an agreement with
the National Association of Attorneys General ("NAAG") with respect to the
funding of the required escrow accounts, in April of each year we would be
obligated to place an amount equal to $1.88 per carton for 1999, and increased
amounts per carton for subsequent years ($2.09 in 2000, $2.72 in 2001-2002,
$3.35 in 2003-2006 and $3.77 thereafter), in escrow accounts beginning April
2000 for sales of cigarettes occurring in the prior year in each such state
after the effective date of each state specific statute. The failure to pay such
required escrow amounts could result in penalties to us and potential
restrictions on our ability to sell tobacco products within particular states.
Because of the escrow payment requirement, a substantial portion of our net
income from operations will be unavailable for our use and the escrow amount
payable for each carton sold may exceed the cash flow generated by each carton
sold. This will adversely affect our ability to apply the capital generated from
our present cigarette sales toward the further scientific development of less
hazardous tobacco products and growth of our business. In addition, the escrow
obligations will impede our ability to distribute dividends to our stockholders.
Our Current Supply Contracts and Other Contracts with B&W May Not Be
Extended
We have entered into a Supply Agreement with B&W under which B&W agreed
to purchase StarCure(TM) tobacco in the period 2000-2001, with the right to
purchase tobacco from us on a long-term basis in later years. If B&W were to
stop purchasing our tobacco that has been cured using the StarCure(TM) process,
it could adversely affect our sales volumes, operating income and cash flows.
Additionally, we currently have other business relationships with B&W. B&W has
agreed to: (1) loan us the capital necessary to finance the purchase of up to
600 specially manufactured curing barns and potentially up to 1,000 curing
barns, (2) manufacture cigarettes for us and (3) supply tobacco to us. The
termination of any of these agreements could negatively affect our business
operations.
Lawsuits May Affect Our Profitability
We are not named as a defendant in any legal actions affecting the
tobacco industry, including proceedings and claims arising out of the sale,
distribution, manufacture, development, advertising, marketing and claimed
health effects of cigarettes. While we believe that the risk of being named a
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defendant in such a lawsuit is relatively low, we may be named as a defendant in
the future as there has been a noteworthy increase in the number of these cases
pending. Punitive damages, often in amounts ranging into the hundreds of
millions, or even billions of dollars, are specifically pleaded in a number of
these cases in addition to compensatory and other damages. Our inclusion in any
of these actions or any future action could have a material and adverse effect
on our financial condition.
We May Not Properly Manage Our Growth
If we are successful in maintaining and increasing market acceptance
for our products, we will be required to manage substantial volume from our
customers. To accommodate any such growth and compete effectively, we will be
required to attract, integrate, motivate and retain additional highly skilled
sales, technical and other employees. We face competition for these people. Our
ability to successfully manage such volume also will be dependent on our ability
to scale up our tobacco processing and production operations. There can be no
assurance that we can overcome the challenge of scaling our processing and
production operations or that our personnel, systems, procedures and controls
will be adequate to support our future operations. Any failure to implement and
improve our operational, financial and management systems or to attract,
integrate, motivate and retain additional employees required by future growth,
if any, could have a material and adverse effect on our business and prospects,
financial condition and results of operations.
We May Not Be Successful in Protecting Our Proprietary Rights
Our success in commercially exploiting our licensed tobacco curing
technology depends in large part on our ability to defend issued patents, to
obtain further patent protection for the technology in the United States and
other jurisdictions, and to operate without infringing upon the patents and
proprietary rights of others. Additionally, we must be able to obtain
appropriate licenses to patents or proprietary rights held by third parties if
infringement would otherwise occur, both in the United States and in foreign
countries.
Patent positions, including our patent positions (owned or licensed)
are uncertain and involve complex legal and factual questions for which
important legal principles are unresolved. Any conflicts resulting from third
party patent applications and patents could significantly reduce the coverage of
our patents and limit our ability to obtain meaningful patent protection. If
patents are issued to other companies that contain competitive or conflicting
claims, we may be required to obtain licenses to these patents or to develop or
obtain alternative technology. Such licensing agreements, if required, may be
unavailable on acceptable terms or at all. If such licenses are not obtained, we
could be delayed in or prevented from pursuing the development or
commercialization of our products.
Litigation which could result in substantial cost may also be
necessary to enforce any patents to which we have rights, or to determine the
scope, validity and unenforceability of other parties' proprietary rights which
may affect our rights. U.S. patents carry a presumption of validity and
generally can be invalidated only through clear and convincing evidence. We may
also have to participate in interference proceedings declared by the U.S. Patent
and Trademark Office to determine the priority of an invention, which could
result in substantial cost. There can be no assurance that our licensed patents
would be held valid by a court or administrative body or that an alleged
infringer would be found to be infringing. The mere uncertainty resulting from
the institution and continuation of any technology-related litigation or
interference proceeding could have a material and adverse effect on our business
and prospects.
We may also rely on unpatented trade secrets and know-how to
maintain our competitive position, which we seek to protect, in part, by
confidentiality agreements with employees, consultants, suppliers and others.
There can be no assurance that these agreements will not be breached or
terminated, that we will have adequate remedies for any breach, or that our
trade secrets will not otherwise become known or be independently discovered by
competitors.
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We Depend On Key Personnel
We depend upon the continued services of our senior management for our
continued success. The loss of either of the Company's Chief Executive Officer,
Mr. Jonnie R. Williams, or the Company's President and Chief Operating Officer,
Paul L. Perito, Esquire, could have a serious negative impact upon our business
and operating results. To minimize the present risk of the loss of either one of
these two senior executives, the Company has initiated a search for another
senior executive who would share some of the present responsibilities now
assumed by either Mr. Williams and/or Mr. Perito.
Management and Significant Stockholders Can Exercise Influence over the
Company
Based upon stock ownership as of March 14, 2000, our executive officers,
directors and their associates, own an aggregate of approximately 70% of our
outstanding shares. As a result, these persons acting together may have the
ability to control matters submitted to our shareholders for approval and to
control the management and affairs of the Company. This concentration of
ownership may have the effect of delaying or preventing a change in control of
the Company, impede a merger, consolidation, or takeover or other business
combination, or discourage a potential acquiror from attempting to obtain
control. This concentration of control could also have a negative effect on the
market price of our shares.
Pursuant to our Certificate of Incorporation and Bylaws, the Board of
Directors is divided into three classes. Members of each class serve for a
three-year term and until the election and qualification of their successors, or
their earlier resignation or removal. Because the Board is divided into classes,
only those directors in a single class may be changed in any one year.
Consequently, changing a majority of the Board generally would require two
years. A classified Board, which may be regarded as an "anti-takeover"
provision, may make it more difficult for our stockholders to change the
majority of directors and thus have the effect of maintaining continuity of
management.
Item 2. Properties
The Company's executive offices and manufacturing facilities have been
located in Petersburg, Virginia. The Company recently relocated its executive
offices to its Chester, Virginia facility and anticipates establishing an
additional executive/scientific office in Washington, D.C. within the next two
months. The Company owns the Petersburg facilities, which consist of a 50,000
square foot, four-story manufacturing building and an adjacent 6,000 square
foot, single-story office building. The Company leases a 10,000 square foot
warehouse in Petersburg, Virginia, about one mile from its manufacturing
facilities, pursuant to a month-to-month lease. The Company recently entered
into a five-year lease for a 45,000 square foot warehouse facility, including
7,000 square feet of office space in Chester, Virginia. The warehouse space is
used for storing and shipping cigarette products. The Company also leases a
single office at the Biotechnology Office Park of the Medical College of
Virginia in Richmond, Virginia, on a tenancy-at-will basis.
The Company leases seven acres of land and an approximately 50,000
square foot building thereon in Chase City, Virginia, that is used in processing
tobacco utilizing the Company's proprietary StarCure(TM) method to prevent the
formation of TSNAs. The existing facility is currently being expanded from
50,000 square feet to 100,000 square feet. The Company has recently entered into
a new ten-year lease for the Chase City property, which covers the expanded
facility and it has an option to purchase the property at any time during the
term of the lease.
The Company considers its facilities adequate for the purposes for which
they are used.
-16-
18
Item 3. Legal Proceedings
The Company is not involved in any material legal proceedings.
Item 4. Submission of Matters to a Vote of Security Holders
The 1999 annual meeting of stockholders of the Company (the "Meeting")
was held on December 10, 1999. At the Meeting, the stockholders voted upon a
number of proposals, each of which is summarized below, along with the votes
cast for and against each such proposal, votes withheld or abstaining therefrom
and broker non-votes.
ELECTION OF DIRECTORS. At the Meeting, the stockholders elected the
following persons to the Board of Directors of the Company until the date of the
annual stockholders meeting in the calendar year set forth opposite the name of
each such person:
NAME TERM VOTES FOR VOTES AGAINST ABSTAINING BROKER NON-VOTES
---- ---- --------- ------------- ---------- ----------------
Malcolm L. "Mac" Bailey 2002 49,599,919 0 203,315 0
Paul L. Perito, Esquire 2002 49,598,119 0 205,115 0
Elliott D. Prager, M.D. 2002 49,589,919 0 213,315 0
RATIFICATION OF ACCOUNTANTS. At the Meeting, the stockholders of the
Company voted on and ratified the appointment of Aidman, Piser & Company, P.A.
as independent accountants for 1999. 49,603,115 votes were cast for such
proposal, 7,405 votes were cast against or withheld, with 192,714 votes
abstaining and no broker non-votes.
-17-
19
PART II
Item 5. Market for Common Equity and Related Stockholder Matters
The Common Stock of the Company was traded in the over-the-counter market and
was quoted on the OTC Bulletin Board under the symbol "STSI." On March
21, 2000, the Common Stock of the Company commenced trading on the NASDAQ
National Market under the symbol "STSI." Set forth below are the high and low
bid prices (which reflect prices between dealers and do not include retail
markup, markdown or commission and may not represent actual transactions) for
each full quarterly period during 1998 and 1999, as reported by the National
Quotation Bureau. From time to time, during the periods indicated, trading
activity in the Company's stock was infrequent. No dividends have ever been
declared by the Company. As of December 31, 1999, there were approximately 649
record holders of the Company's Common Stock.
1999 High Bid Low Bid
-------- -------
First Quarter $2.1250 $1.6250
Second Quarter $3.6250 $1.5625
Third Quarter $5.1875 $3.1250
Fourth Quarter $8.5625 $5.0625
1998 High Bid Low Bid
-------- -------
First Quarter $5.9375 $0.0100
Second Quarter $5.6250 $3.0000
Third Quarter $3.5000 $1.4375
Fourth Quarter $3.5000 $1.3750
The closing price on March 21, 2000 was $6.625.
Item 6. Selected Financial Data
In thousands of dollars, except share and per share data for the Year
Ended December 31,
1999 1998 1997 1996 1995
- ------------------------------------------------------------------------------------------------------------------
(In Thousands except per share data)
Statement of Operations Data:
Net Sales $ 99,325 $ 19,445 $ 20,764 34,260 33,158
Cost of goods sold 31,878 7,669 10,033 16,150 16,340
Gross Profit 33,624 2,938 2,920 4,639 4,295
Operating income (loss) 17,078 (3,475) (1,986) (753) 10
Net income (loss) 11,515 (4,196) (1,986) (753) 10
Basic income (loss) per share 0.32 (0.42) (0.58) (0.22) 0.00
Diluted income (loss) per share 0.30 (0.42) (0.58) (0.22) 0.00
Weighted average shares outstanding 36,207 8,327 3,435 3,437 3,437
Balance Sheet Data:
Cash and cash equivalents 17,205 103 11 11 4
Property, Plant & equipment 10,974 1,704 2,416 2,767 3,187
Total assets 38,709 4,435 4,120 6,644 8,050
Long-term obligations 7,505 612 1,099 2,655 2,625
Stockholders' equity (deficit) 12,319 (639) (1,742) (838) 57
-18-
20
Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operation
The following discussion and analysis of operating results of the
Company and of the liquidity and capital resources of the Company at December
31, 1999 should be read in conjunction with the consolidated financial
statements of the Company and the notes thereto.
RESULTS OF OPERATIONS - FISCAL 1999 COMPARED TO FISCAL 1998
The following discussion and analysis of operating results of the
Company and of the liquidity and capital resources of the Company at December
31, 1999 should be read in conjunction with the consolidated financial
statements of the Company and the notes thereto.
During 1999, the Company's net sales increased to $99.3 million,
reflecting an increase of $79.9 million, or 411% over 1998 net sales. Net sales
in 1999 included $9.3 million in very low-TSNA tobacco sold to B&W, delivered
primarily in the third and fourth quarters of 1999. There were no such sales in
1998, except for minor leaf deliveries to major tobacco companies during the
development stage of the Company's very low-TSNA program.
Other than very low-TSNA tobacco sales made to B&W, substantially all of
the Company's revenues in 1999 have been derived from sales of its four brands
of "discount" cigarettes. The Company's shipment volume during 1999 increased
approximately 276% over 1998 to 2.6 billion units, reflecting a continued
upswing in sales of the Company's cigarettes as a result of growing the customer
base across the country, including the addition of several major retail chains.
Slight increases in product pricing also contributed to higher net sales.
During 1999, the Company's gross profit increased to $33.6 million,
reflecting an increase of $30.7 million over 1998, as increases in net sales of
$79.9 million were partially offset by increased costs of goods sold ($24.2
million) and increased excise taxes ($25.0 million). Increased costs of goods
sold were related to volume increases, and were partially offset by a decrease
in the average cost of tobacco purchased by the Company.
Marketing and distribution expenses totaled $6.3 million for 1999, an
increase of $5.1 million over 1998 which is in line with the increased sales
volume and reflects salary and incentive compensation payments to sales
personnel. The Company's marketing and distribution expenses are expected to
grow significantly during 2000 as the Company expands its commercialization
capabilities.
General and administrative expenses for 1999 totaled $9.9 million for
1999, an increase of $6.7 million partially attributable to operating costs for
the Company's Chase City facility. This facility processes the very low-TSNA
tobacco during the months of June through November. Chase City facility costs in
1998 were significantly lower, due to the experimental nature of the operation
at the time, and were classified in 1998 as research and development costs, in
keeping with the Company's mission at the time to develop the StarCure(TM)
process to a commercially feasible production level, which was accomplished in
1999. Other general and administrative costs are relatively flat when compared
to the comparable periods in 1998; however, there are some cost increases
associated with the higher sales volume, as well as increased legal and
consulting costs associated with the Company's fulfillment of its compliance
obligations as a publicly-held company, its legal and public health strategies
in the legislative, regulatory and executive agency arenas, its technical
recruitment efforts, expansion of its Scientific Advisory Board as well as the
costs of scientific consulting.
Research and development expenses were significantly higher in 1998
primarily as a result of costs incurred in this period specifically related to
the development of the Company's TSNA reduction technology. Research and
development expenses in 1999 consist primarily of costs incurred by the Company
for consulting services, professional fees and expenses in connection with the
Company's continuing research and development associated with scientific,
medical and health related matters.
-19-
21
Net interest income in 1999 reflects positively against net interest
expense in 1998, reflecting interest on higher 1999 cash balances generated by
the improved operating results.
Income tax expense reflects use of the Company's net operating loss
carryover from 1998, the benefit of which was previously reserved.
In 1998, the Company recorded charges to earnings for the discontinued
operations of the ophthalmic business and a loss on the disposal (sale) of such
business totaling $972,000. These charges resulted in a loss from discontinued
operations equal to ($0.12) per share. As a result of various settlements with
the Company's creditors, reached prior to the merger with Eye Technology in
February 1998, the Company also recorded an extraordinary gain of $252,000 in
1998 or $0.03 per share.
Net income of $11.5 million for 1999 compared favorably with a net loss
of ($4.2) million for 1998. In 1999, the Company had basic and diluted earnings
per share from continuing operations equal to $0.32 per share and $0.30,
respectively versus basic and diluted losses per share from continuing
operations of ($0.42) per share for 1998. In 1999, weighted average shares
outstanding were 36,207,390 versus 8,327,345 for 1998.
RESULTS OF OPERATIONS - FISCAL 1998 COMPARED TO FISCAL 1997
Net sales for 1998 of $19,445,000, consisting almost entirely of the
sale of branded cigarettes, were approximately equal to 1997 sales of
$20,763,000. Sales in 1997 included sales to Swisher (a long-time private brand
customer) of $3,872,000. There were no sales to Swisher in 1998. However, fourth
quarter 1998 sales of $8,666,000 compared favorably with the prior year's fourth
quarter sales of $3,613,553. In 1998, sales from contract manufacturing, i.e.
the manufacturing of products under brand names owned and marketed by others,
was $1,251,000, compared to $3,872,000 in 1997.
Cost of goods sold, as a percentage of net sales volume, was 39% in 1998
versus 48% in 1997. Profit margins on contract manufacturing are slightly higher
than the margins on branded cigarettes. In 1998, profit margins increased
because of December 1998 price increases on branded cigarettes, a factor that
affected positively the sales of the entire cigarette manufacturing industry.
Marketing and distribution expenses increased slightly from $1,111,000
in 1997 to $1,199,000 in 1998. Star did not incur any significant expense in
this category with respect to contract manufacturing customers; almost all of
such expense was incurred with respect to branded cigarettes
General and administrative expenses increased from $1,425,000 in 1997 to
$3,174,000 in 1998, primarily as a result of the legal, consulting and
accounting costs associated with the merger with Eye Technology and resulting
status as a publicly-held company, including the hiring of additional personnel.
Research and development expense represents primarily expenditures
related to the development of Star's proprietary StarCure(TM) technology for the
processing of tobacco so as to prevent, reduce an/or significantly decrease the
formation of carcinogenic TSNAs, as well as expenses for the development of the
tobacco-flavored, non-nicotine chewing gum which Star is no longer developing.
Star does not maintain its own research laboratories or other physical assets
for research and development; it is dependent upon the services of third parties
for these services. Similarly, it did not employ a scientific staff in 1997 or
1998 and instead relied upon scientific and medical consultants and third-party
service providers. Expenditures in this category include payments for such
consultants, contract research organizations, laboratory testing, research
grants, raw materials, equipment, legal and regulatory fees, including expenses
for the filing and prosecution of patents, and allocations of management
personnel and general and administrative expenses. This category includes
payments of $400,000 in 1998 and $565,000 in 1997, respectively, to Jonnie R.
Williams, the inventor of Star's proprietary technology for the processing of
tobacco.
-20-
22
Net interest expense was $238,000 in 1998 and $235,000 in 1997,
consisting primarily of interest incurred in connection with a bank revolving
line of credit, the borrowing levels of which were determined by levels of
accounts receivable and inventory. The Company had several injections of capital
during 1998, thereby reducing costs associated with borrowing.
The increased loss in 1998 can be attributed to several factors,
including the expenses associated with the public Company, and research and
development costs incurred. The Company has emphasized throughout the last
several years its commitment to develop less harmful tobacco products, and the
resources needed to continue that effort, while lower in 1998 than 1997,
resulted in the issuance of the first patent ever for the production of very
low-TSNA tobacco.
LIQUIDITY AND CAPITAL RESOURCES
Accounts receivable and accounts payable throughout 1999 were current
and the Company has normal industry terms with all of its suppliers, a situation
that did not exist in 1998. This favorable situation is primarily due to cash
generated by operating activities resulting primarily from higher net income in
1999 and a $6,000,000 non-refundable deposit from B&W in connection with the
Supply Agreement, which is to be applied toward B&W's year 2000 StarCure(TM)
tobacco purchase orders. In 1999, $20.8 million of cash was provided by
operating activities compared to $2.7 million of cash used in operating
activities in 1998.
During 1999, the Company incurred $10.0 million in capital expenditures,
virtually all of it as part of the StarCure(TM) barn production program with
Powell Manufacturing. B&W has agreed to loan the Company capital necessary to
finance the purchase of curing barns designed by the Company and specially
manufactured for the Company by Powell Manufacturing. Approximately 550 of these
barns have already been manufactured and delivered and contracts with tobacco
farmers for approximately 350 additional curing barns have either been executed
or are being finalized. At December 31, 1999, the Company has borrowed $7.2
million under the credit facility with B&W.
During January 2000, the Company negotiated a line of credit with a new
working capital lender, which is to be collateralized by accounts receivable
from its cigarette business, in the amount of $3 million.
In October 1999, the Company also received approximately $1.0 million in
proceeds from the exercise of a warrant to purchase 522,920 shares of the
Company's common stock. The Company currently has warrants outstanding to
purchase a total of 977,080 shares of common stock that are exercisable until
September 2000. All of such warrants have exercise prices of $2.00 per share. In
1998, the Company sold common and preferred stock in several private placements,
which generated net proceeds of approximately $4.7 million.
Under the Master Settlement Agreement, absent a successful legal
challenge to the state specific statutes or an agreement with the National
Association of Attorneys General with respect to the funding of the required
escrow accounts, the Company will be obligated to place an amount equal to $1.88
per carton for 1999, and increased amounts per carton for subsequent years, in
escrow accounts for sales of cigarettes occurring in each such state after the
effective date of each state specific statute. Such escrowed funds will be used
to fund tobacco-related litigation or settlements and if not so used, returned
to the Company after 25 years. The Company will be obligated to put into escrow
approximately $10.6 million in April 2000 for sales made in 1999. The funds
placed in escrow will continue to be an asset of the Company and the Company
will receive the interest income generated by the escrow deposit. However, these
escrow obligations will significantly impede the Company's ability to apply the
capital generated from its cigarette sales as it sees fit and the escrow amount
payable for each carton sold may exceed the cash flow generated by each carton
sold. Based on Star's projected increase in sales for future years, the Company
will have to pay significant sums into these escrow accounts to meet the Master
Settlement Agreement requirements.
-21-
23
The Company believes that its existing working capital, together with
anticipated earnings from its operations, will be sufficient to meet its
liquidity and capital requirements in the foreseeable future. The Company's
need, if any, to raise additional funds to meet its working capital and capital
requirements will depend upon numerous factors, including the results of its
marketing and sales activities, any escrow obligations it may be required to
comply with under the Master Settlement Agreement, the success of the Company's
new product development efforts and the other factors described under "Risk
Factors That May Affect Future Results."
YEAR 2000 ISSUES
The Company undertook an assessment of its information technology
systems relating to year 2000 issues at its Virginia facilities and contacted
major customers and vendors to assess their status. The assessment resulted in
the development of a plan to prepare Star for year 2000 readiness. The costs for
implementation of Star's plan were not material. Such costs were capitalized or
expensed as appropriate. No additional Year 2000 costs are anticipated. As of
the date of this filing, the Company has not experienced any disruption of its
operations due to Year 2000 issues.
Item 8. Financial Statements
This information is contained on Pages F-1 through F-24 hereof and is
incorporated into Part I of this report by reference.
Item 9. Changes in and Disagreements with Accountants and Financial Disclosure
The information required by this item with respect to the change in the
Company's principal independent accountants (1) from Price Waterhouse LLP to
Olsen, Thielen & Co., Ltd., effective March 5, 1998, has been previously
reported in the Company's Current Report on Form 8-K dated March 30, 1998, (2)
from Olsen, Thielen & Co., Ltd. to Keiter, Stephens, Hurst, Gary & Shreaves,
P.C., effective September 4, 1998, has been previously reported in the Company's
Current Report on Form 8-K/A dated September 16, 1998, and (3) from Keiter,
Stephens, Hurst, Gary & Shreaves, P.C. to Aidman, Piser & Company, P.A.,
effective January 15, 1999, has been previously reported in the Company's
Current Report on Form 8-K dated January 15, 1999.
PART III
Item 10. Directors and Executive Officers Compliance With Section 16(a) of the
Exchange Act
Information concerning directors and executive officers of the Company
and compliance with Section 16(a) of the Securities Exchange Act of 1934, as
amended, is included under the caption "Election of Directors" of the Proxy
Statement for the 2000 Annual Meeting of Stockholders and is incorporated herein
by reference.
Item 11. Executive Compensation
Information concerning executive compensation is included under the
caption "Executive Compensation" of the Proxy Statement for the 2000 Annual
Meeting of Stockholders and is incorporated herein by reference.
Item 12. Security Ownership of Certain Beneficial Owners and Management
Information concerning security ownership of certain beneficial owners
and management is included under the captions "Principal Stockholders" and
"Election of Directors" of the Proxy Statement for the 2000 Annual Meeting of
Stockholders and is incorporated herein by reference.
-22-
24
Item 13. Certain Relationships and Related Transactions
Information concerning transactions and other relationships, if any,
between the Company and its directors, officers or principal stockholders is
included under the caption "Certain Transactions" of the Proxy Statement for the
2000 Annual Meeting of Stockholders and is incorporated herein by reference.
ITEM 14. EXHIBITS AND REPORTS ON FORM 8-K
(a) EXHIBITS
NUMBER DESCRIPTION
- -------- ------------
2.01 Asset Purchase Agreement between Star Scientific, Inc., a
Delaware Corporation and Eyetech, LLC, a Minnesota Limited
Liability Company, by Robert J. Fitzsimmons, an individual
residing in St. Paul, Minnesota, dated December 30, 1998 (Form
8-K dated March 2, 1999)*
2.02 Escrow Agreement between Star Scientific, Inc., a Delaware
Corporation, Eyetech, LLC, a Minnesota Limited Liability
Company and Robert J. Fitzsimmons, an individual residing in
St. Paul, Minnesota, and Jonnie R. Williams and Vincent Ellis
as Escrow Agents, dated February 16, 1999, and effective
December 30, 1998 (Form 8-K dated March 2, 1999)*
3.01 Restated Certificate of Incorporation (Form 10-KSB for fiscal year
ended December 31, 1992)*
3.02 Certificate of Amendment of Restated Certificate of Incorporation,
dated March 25, 1993, and effective April 2, 1993 (Form 10-KSB for
fiscal year ended December 31, 1996)*
3.03 Certificate of Amendment of Restated Certificate of Incorporation,
dated March 25, 1993, and effective April 2, 1993 (Form 10-KSB for
fiscal year ended December 31, 1996)*
3.04 Certificate of Amendment of Certificate of Incorporation, dated
December 15, 1998 (Form 8-K dated January 15, 1999)*
3.05 Bylaws of the Company as Amended to Date (Form 10-KSB for fiscal
year ended December 31, 1992)*
10.18 Stock Exchange Agreement between the Company and the stockholders of
Star Tobacco and Pharmaceuticals, Inc., dated February 6, 1998 (Form
8-K dated February 19, 1998)*
10.19 License Agreement between Star Tobacco and Pharmaceuticals, Inc., as
Licensee and Regent Technologies, Jonnie R. Williams, and Francis
E. O'Donnell, J.R. , M.D., as Licensor, dated January 5, 1998 (Form
10-QSB for quarterly period ended March 31, 1998)*
10.21 Exclusive Supply Agreement between Star Tobacco and Pharmaceuticals,
Inc. and Amana Company, L.P., dated August 18, 1998 (Form 10-QSB for
quarterly period ended September 30, 1998)*
10.22 Purchase and Sale Agreement between Prometheus Pacific Growth Fund
LDC, a Cayman Island Limited Duration Company, and Eye Technology,
Inc., a Delaware Corporation, dated July 10, 1998 (Form 8-K dated
July 15, 1998)*
10.23 Amendment No. 1 to License Agreement between Regent Court
Technologies, Jonnie R. Williams, Francis E. O'Donnell, J.R., M.D.
and Star Tobacco and Pharmaceuticals, Inc., dated August 3, 1998
(Form 8-K dated September 11, 1998)*
10.24 1998 Stock Option Plan, as amended @
-23-
25
10.26 Executive Employment Agreement dated as of April 27, 1999 entered
into by the Company, Jonnie R. Williams and Paul L. Perito (Form
10-QSB for quarterly period ended June 30, 1999)* @
10.27 Qualified Stock Option Agreement dated as of April 27, 1999 between
the Company and Paul L. Perito (Form 10-QSB for quarterly period
ended June 30, 1999)* @
10.28 Executive Employment Agreement dated as of April 12, 1999 entered
into by the Company and James A. McNulty (Form 10-QSB for quarterly
period ended September 30, 1999)* @
10.29 Stock Option Agreement dated as of April 12, 1999 entered into by
the Company and James A. McNulty (Form 10-QSB for quarterly period
ended September 30, 1999)* @
10.30 Restricted Stock Award Agreement dated as of April 12, 1999 entered
into by the Company and James A. McNulty (Form 10-QSB for quarterly
period ended September 30, 1999)* @
10.31 Amended and Restated Manufacture and License Agreement between the
Company and Powell Manufacturing Company, Inc., dated October 12, 1999 #
10.32 Agreement between the Company and Brown & Williamson Tobacco
Corporation, dated October 12, 1999 #
10.33 Loan Agreement between the Company and Brown & Williamson Tobacco
Corporation, dated October 12, 1999 #
10.34 Security Agreement between the Company and Brown & Williamson
Tobacco Corporation, dated December 16, 1999 #
10.35 Supply Agreement between Star Tobacco & Pharmaceuticals, Inc. and
Brown & Williamson Tobacco Corporation, dated January 1, 2000 #
10.36 Cigarette Manufacturing Agreement between Star Tobacco &
Pharmaceuticals, Inc. and Brown & Williamson Tobacco Corporation,
dated January 1, 2000 #
10.37 Loan and Security Agreement between Star Tobacco & Pharmaceuticals,
Inc. and Finova Capital Corporation, dated January 20, 2000
10.38 Lease and Purchase Option Contract between the Company and the
Industrial Development Authority of the Town of Chase City,
Virginia, dated March 10, 2000.
10.39 Form of Director Indemnification Agreement
10.40 Form of Officer Indemnification Agreement
16.01 Response Letter from Price Waterhouse LLP, dated April 10, 1998
(Form 8-K/A dated April 10, 1998)*
16.02 Response Letter from Olsen, Thielen & Co., Ltd, dated September 15,
1998 (Form 8-K/A dated September 16, 1998)*
16.03 Response Letter from Keiter, Stephens, Hurst, Gary & Shreaves, dated
January 20, 1999 (Form 8-K dated January 15, 1999)*
21 Subsidiaries of the Company (Form 10-KSB for the fiscal year ended
December 31, 1998)*
23 Consent of Independent Public Accountants
24 Powers of Attorney, executed by certain officers of the
Registrant and the individual members of the Board of
Directors, authorizing such officers of the Registrant to file
amendments to this Report, are located on the signature page of
this Report
-24-
26
27 Financial Data Schedule
*These items are hereby incorporated by reference from the exhibits of
the filing or report indicated (Commission File No. 0-15324) and are hereby made
a part of this Report
# Confidential treatment requested as to certain portions.
@ This exhibit is a management contract or compensatory plan required to
be filed as an exhibit to this Form 10-K pursuant to Item 14(c).
(b) REPORTS ON FORM 8-K
None
-25-
27
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this Report to be signed on
its behalf by the undersigned, thereunto duly authorized in Virginia on the ___
day of March, 2000.
STAR SCIENTIFIC, INC.
By: /s/ JONNIE R. WILLIAMS
---------------------------------------------
Jonnie R. Williams
Chief Executive Officer
POWER OF ATTORNEY
KNOW ALL MEN BY THESE PRESENTS, that each person whose signature appears
below constitutes and appoints Jonnie R. Williams and Paul L. Perito, Esquire,
or either of them, his attorney-in-fact, each with the power of substitution,
for him in any and all capacities, to sign any amendments to this Report, and to
file the same, with exhibits thereto and other documents in connection
therewith, with the Securities and Exchange Commission, hereby ratifying and
confirming all that each of said attorneys-in-fact, or his substitute or
substitutes, may do or cause to be done by virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934,
this Report has been signed by the following persons in the capacities
indicated.
Signature Title Date
--------- ----- ----
/s/ JONNIE R. WILLIAMS
- ---------------------------------------------- Chief Executive Officer and Director March __, 2000
Jonnie R. Williams (Principal Executive Officer)
/s/ PAUL L. PERITO, ESQUIRE
- ---------------------------------------------- Chief Operating Officer, President and Director March __, 2000
Paul L. Perito, Esquire
/s/ JAMES A. MCNULTY
- ---------------------------------------------- Chief Financial Officer March __, 2000
James A. McNulty (Principal Financial and Accounting Officer)
/s/ ROBERT J. DELORENZO, M.D. Ph.D., M.P.H.
- ---------------------------------------------- Chairman of the Board March __, 2000
Robert J. DeLorenzo, M.D.,
Ph.D., M.P.H.
/s/ MALCOLM L. BAILEY
- ---------------------------------------------- Director March __, 2000
Malcolm L. Bailey
/s/ MARK W. JOHNSON
- ---------------------------------------------- Director March __, 2000
Mark W. Johnson
/s/ ELLIOT D. PRAGER, M.D.
- ---------------------------------------------- Director March __, 2000
Elliot D. Prager, M.D.
/s/ LEO S. TONKIN, ESQUIRE
- ---------------------------------------------- Director March __, 2000
Leo S. Tonkin, Esquire
-26-
28
STAR SCIENTIFIC, INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
PAGE
----
Report of Independent Public Accountants................................................ F-2
Consolidated Balance Sheets............................................................. F-3
Consolidated Statements of Operations................................................... F-4
Consolidated Statements of Stockholders' Equity......................................... F-5
Consolidated Statements of Cash Flows................................................... F-7
Notes to Consolidated Financial Statements.............................................. F-9
F-1
29
Independent Auditors' Report
To the Board of Directors and Stockholders of
Star Scientific, Inc. and Subsidiaries
Petersburg, Virginia
We have audited the accompanying consolidated balance sheets of Star Scientific,
Inc. and Subsidiaries as of December 31, 1999 and 1998 and the related
consolidated statements of operations, stockholders' equity, and cash flows for
the years then ended. These financial statements are the responsibility of the
Company's management. Our responsibility is to express an opinion on these
financial statements based on our audits. The financial statements of Star
Scientific, Inc. and Subsidiaries for the year ended December 31, 1997 were
audited by other auditors whose report dated March 24, 1998, expressed an
unqualified opinion on those statements.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
As discussed in Note 13, the Company elected not to join in the Master
Settlement Agreement ("MSA") among forty-six states, several U.S. territories
and a number of tobacco manufacturers, as a Subsequent Participating
Manufacturer. As a result thereof, the Company is required to annually
contribute funds into escrow under statutes which the MSA required participating
states to pass if they were to receive the full benefits of the settlement. Such
escrowed funds will be used to pay tobacco-related litigation and, if not used,
returned to the Company in twenty-five years. The Company's 1999 escrow
obligation must be funded by April 2000 and this escrow funding obligation is
expected to increase in future years.
In our opinion, the consolidated 1999 and 1998 financial statements referred to
above present fairly, in all material respects, the consolidated financial
position of Star Scientific, Inc. and Subsidiaries as of December 31, 1999 and
1998 and the consolidated results of their operations and their cash flows for
the years then ended in conformity with generally accepted accounting
principles.
/s/ Aidman, Piser & Company, P.A.
February 9, 2000
Tampa, Florida
F-2
30
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
DECEMBER 31, 1999 AND 1998
ASSETS
1999 1998
--------------------- --------------------
Current assets:
Cash and cash equivalents $ 17,205,248 $ 102,695
Accounts receivable trade,
net of allowance for
doubtful accounts (1999,
$225,870; 1998, $95,636) 3,599,965 1,497,457
Inventories 3,570,609 636,456
Prepaid expenses and other current
assets 338,790 265,672
Deferred tax asset 2,303,000 -
--------------------- --------------------
Total current assets 27,017,612 2,502,280
Property, plant and equipment, net 10,974,029 1,704,569
Intangibles, net of accumulated
amortization, (1999, $205,217;
1998, $162,045) 338,043 135,928
Other assets 296,263 92,379
Deferred tax asset 83,000 -
--------------------- --------------------
$ 38,708,947 $ 4,435,156
===================== ====================
LIABILITIES AND STOCKHOLDERS' EQUITY
1999 1998
--------------------- --------------------
Current liabilities:
Current maturities of notes payable $ 275,000 $ 379,082
Accounts payable, trade 3,492,755 2,516,658
Federal excise taxes payable 1,476,524 876,875
Accrued expenses 1,442,521 646,115
Income taxes payable 6,198,000 -
Customer deposit 6,000,000 -
--------------------- --------------------
Total current liabilities 18,884,800 4,418,730
Notes payable, less current
maturities 7,504,679 611,584
--------------------- --------------------
Total liabilities 26,389,479 5,030,314
--------------------- --------------------
Commitments and contingencies - -
Redeemable preferred stock
(Class A, convertible, 250
shares issued and outstanding in 1998,
at liquidation value) - 44,000
--------------------- --------------------
Stockholders' equity (deficit):
Common stock(A) 587,493 98,198
Preferred stock(B) - 143
Additional paid-in capital 10,631,875 6,668,392
Retained earnings (accumulated
deficit) 4,187,906 ( 7,326,724)
Unearned compensation - ( 79,167)
Notes receivable, officers ( 3,087,806) -
--------------------- ---------------------
Total stockholders' equity (deficit) 12,319,468 ( 639,158)
--------------------- ---------------------
$ 38,708,947 4,435,156
===================== =====================
(A) ($.01 par value, 100,000,000 shares authorized, 58,749,200 and 9,819,740
shares issued and outstanding 1999 and 1998, respectively)
(B) (Series B, convertible; $.01 par value 15,000 shares authorized, 14,084
shares issued and outstanding in 1998)
See notes to consolidated financial statements.
F-3
31
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
FOR THE YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997
1999 1998 1997
------------------ ------------------- -----------------
Net sales $ 99,324,789 $ 19,445,491 $ 20,763,856
Less:
Cost of goods sold 31,878,879 7,669,428 10,033,330
Excise taxes on products 33,821,112 8,837,868 7,810,720
------------------ ------------------- -----------------
Gross profit 33,624,798 2,938,195 2,919,806
------------------ ------------------- -----------------
Operating expenses:
Marketing and distribution 6,253,265 1,198,757 1,111,420
General and administrative 9,899,165 3,173,991 1,425,299
Research and development 535,782 1,377,657 2,134,656
------------------ ------------------- -----------------
Total operating expenses 16,688,212 5,750,405 4,671,375
------------------ ------------------- -----------------
Operating income (loss) 16,936,586 ( 2,812,210) ( 1,751,569)
------------------ ------------------- -----------------
Other income (expenses):
Interest income 227,648 17,167 21,073
Interest expense ( 85,604) ( 255,113) ( 256,001)
Loss on disposal of assets - ( 425,316) -
------------------ ------------------- -----------------
142,044 ( 663,262) ( 234,928)
------------------ ------------------- -----------------
Income (loss) from continuing operations
before income taxes 17,078,630 ( 3,475,472) ( 1,986,497)
Income tax expense 5,564,000 - -
------------------ ------------------- -----------------
Income (loss) from continuing operations 11,514,630 ( 3,475,472) ( 1,986,497)
Discontinued operations:
Loss from discontinued operations
(no applicable income taxes) - ( 751,080) -
Loss on disposal of business segment
(no applicable income taxes) - ( 221,290) -
------------------ ------------------- -----------------
Income (loss) before extraordinary item 11,514,630 ( 4,447,842) ( 1,986,497)
Extraordinary gain from extinguishment
of debt (no applicable income taxes) - 251,767
------------------ ------------------- -----------------
Net income (loss) $ 11,514,630 ($ 4,196,075) ($ 1,986,497)
================== =================== ==================
Basic income (loss) per common share:
Continuing operations $ .32 ($ .42) ($ .58)
Discontinued operations - ( .12) -
Extraordinary gain - .03 -
------------------ ------------------- -----------------
Net income (loss) $ .32 ($ .51) ($ .58)
================== =================== ==================
Diluted income (loss) per share $ .30 ($ .51) ($ .58)
================== =================== ==================
Weighted average shares outstanding basic 36,207,390 8,327,345 3,435,190
================== =================== ==================
Weighted average shares outstanding diluted 38,765,251 8,327,345 3,435,190
================== =================== ==================
Pro forma presentation applicable to conversion
from S Corporation to C Corporation:
Net loss before pro forma income tax
expense ($ 1,986,497)
Pro forma income tax expense -
------------------
Pro forma net loss ($ 1,986,487)
==================
Pro forma basic loss per share ($ .58)
==================
See notes to consolidated financial statements.
F-4
32
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
FOR THE YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997
Preferred Stock
---------------------
Series B Common Stock
--------------------- ----------------------- Additional
Paid-In
Shares Amount Shares Amount Capital
------------- -------- ---------- ---------- ----------------
Balances, January 1997 - $ - 200 $ 383,557 $ 16,320
Collection of notes receivable
Conversion of debt to equity 923,499
Capital contribution 64,788
Net loss for the year
Distributions ------------- -------- ---------- ---------- ----------------
Balances,December 31, 1997 - - 200 383,557 1,004,607
Conversion of debt to equity 1,402,550 14,026 483,623
Reverse merger and reorganization 3,434,990 ( 349,205) ( 117,577)
Stock issued pursuant to merger 13,831 138 ( 138)
Mandatory redeemable preferred
stock converted to common 232,000 2,320 229,680
Increase of Series A Preferred
Stock to Redemption value ( 19,000)
Exchange of preferred stock for
common 305 3 ( 3)
Shares gifted to company and
retired ( 1,144) ( 11) 11
Issuance of common stock pursuant to
private placements 763 8 4,400,000 44,000 3,905,992
Issuance of preferred stock pursuant
to private placements 304 3 999,997
Stock issuance costs ( 220,000)
Stock issued for current and future
services 25 2 350,000 3,500 401,200
Net loss for the year
------------- -------- ---------- ---------- ----------------
Balances, December 31, 1998 14,084 143 9,819,740 98,198 6,668,392
------------- -------- ---------- ---------- ----------------
Retained Earnings Treasury Stock Unearned
(Accumulated ----------------------- Compen- Notes
Deficit) Shares Amount sation Receivable
----------------------- ------------ ---------- ------------- --------------
Balances, January 1, 1997 ($ 988,004) - $ - $ - ($ 250,000)
Collection of notes receivable 250,000
Conversion of debt to equity
Capital contribution
Net loss for the year ( 1,986,497)
Distributions ( 156,148)
--------------------- ------------ ---------- ------------- --------------
Balances,December 31, 1997 ( 3,130,649) - - - -
Conversion of debt to equity
Reverse merger and reorganization
Stock issued pursuant to merger
Mandatory redeemable preferred ( 1,000,000)
stock converted to common
Increase of Series A Preferred
Stock to Redemption value
Exchange of preferred stock for
common
Shares gifted to company and
retired
Issuance of common stock pursuant to
private placements 1,000,000
Issuance of preferred stock pursuant
to private placements
Stock issuance costs
Stock issued for current and future
services ( 79,167)
Net loss for the year ( 4,196,075)
--------------------- ------------ ---------- ------------- --------------
Balances, December 31, 1998 ( 7,326,724) - - ( 79,167) -
--------------------- ------------ ---------- ------------- --------------
Total
------------------
Balances, January 1, 1997 ($ 838,127)
Collection of notes receivable 250,000
Conversion of debt to equity 923,499
Capital contribution 64,788
Net loss for the year ( 1,986,497)
Distributions ( 156,148)
--------------------
Balances,December 31, 1997 ( 1,742,485)
Conversion of debt to equity 497,649
Reverse merger and reorganization ( 466,782)
Stock issued pursuant to merger -
Mandatory redeemable preferred
stock converted to common 232,000
Increase of Series A Preferred
Stock to Redemption value ( 19,000)
Exchange of preferred stock for
common -
Shares gifted to company and
retired -
Issuance of common stock pursuant to
private placements 3,950,000
Issuance of preferred stock pursuant
to private placements 1,000,000
Stock issuance costs ( 220,000)
Stock issued for current and future
services 325,535
Net loss for the year ( 4,196,075)
--------------------
Balances, December 31, 1998 ( 639,168)
--------------------
See notes to consolidated financial statements
F-5
33
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (CONTINUED)
FOR THE YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997
Preferred Stock
----------------------
Series B Common Stock Additional
---------------------- -------------------------- Paid-In
Shares Amount Shares Amount Capital
--------- -------- ------------- ----------- ------------------
Balances, December 31, 1998 -
carried forward 14,084 143 9,819,740 98,198 6,668,392
Conversion of preferred
stock to common ( 14,084) ( 143) 46,127,500 462,175 ( 462,032)
Amortization of unearned
stock - based compensation
Mandatory redeemable
preferred stock converted
to common 20,000 200 43,800
Issuance of stock 2,000,000 20,000 1,980,000
Stock issued for services 39,000 390 97,405
Issuance of common stock to
charitable organizations 130,000 1,300 767,342
Common stock options and
stock purchase rights issued 536,278
Warrants exercised 522,920 5,229 1,040,691
Stock issuance costs
associated with
warrants ( 40,000)
Note receivable issued
Net income
========= =========== ============= ================= ====================
Balances, December 31, 1999 - $ - 58,749,200 $ 587,493 $10,631,875
========= =========== ============= ================= ====================
Retained Earnings Treasury Stock Unearned
(Accumulated -------------------------- Compen- Notes
Deficit) Shares Amount sation Receivable Total
------------------ ------------- ------------ --------------- -------------- -------------
Balances, December 31, 1998 -
carried forward ( 7,326,724) - - ( 79,167) - ( 639,158)
Conversion of preferred
stock to common -
Amortization of unearned
stock - based compensation 79,167 79,167
Mandatory redeemable
preferred stock converted
to common 44,000
Issuance of stock ( 2,000,000) -
Stock issued for services 97,795
Issuance of common stock to
charitable organizations 768,642
Common stock options and
stock purchase rights
issued 536,278
Warrants exercised 1,045,920
Stock issuance costs
associated with warrants ( 40,000)
Note receivable issued ( 1,087,806) ( 1,087,806)
Net income 11,514,630 11,514,630
Balances, December 31, 1999 4,187,906 - $ - $ - ($ 3,087,806) $ 12.319.468
================== ============= ============ =============== ============== =============
See notes to consolidated financial statements
F-6
34
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997
1999 1998 1997
---------------- ---------------- --------------
Operating activities:
Net income (loss) $ 11,514,630 ($ 4,196,075) ($ 1,986,497)
Adjustments to reconcile net income
(loss) to net cash provided by
(used in) operating activities:
Depreciation 745,205 359,135 355,292
Amortization of intangibles and
other non-cash charges 38,546 637,478 68,385
Deferred income taxes ( 2,386,000) - -
Loss on fixed asset disposal - 425,316 -
Stock-based compensation expense 1,481,882 325,535 -
Extraordinary gain on
extinguishment of debt - ( 251,767) -
Increase (decrease) in cash resulting
from changes in:
Accounts receivable, trade ( 2,102,508) ( 722,289) 540,248
Accounts receivable, other 68,271 ( 68,271) -
Inventories ( 2,934,153) ( 31,064) 1,011,439
Prepaid expenses and other
current assets ( 168,786) ( 164,137) 24,324
Accounts payable 976,097 ( 57,582) 458,300
Federal excise taxes payable 599,649 517,092 ( 178,086)
Income taxes payable 6,198,000 - -
Accrued expenses 796,406 561,007 ( 52,093)
Customer deposit 6,000,000 - -
---------------- ---------------- --------------
Net cash provided by (used in) operating
activities 20,827,239 ( 2,665,622) 241,312
---------------- ---------------- --------------
Investing activities:
Collections of notes receivable 17,213 1,915 19,045
Purchases of property, plant and equipment ( 10,014,665) ( 454,888) (3,530)
Proceeds from disposal of property
and equipment - 175,000 -
Purchases of intangible assets ( 240,681) ( 48,815) -
Deposits on property and equipment (193,700) - -
Note receivable from stockholder (1,087,806) - -
Net cash provided by (used in)
investing activities ( 11,519,639) ( 326,788) 15,515
---------------- ---------------- --------------
See notes to consolidated financial statements.
F-7
35
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)
FOR THE YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997
1999 1998 1997
------------ ------------- -------------
Financing activities:
Payments on line of credit, net - ( 1,095,801) (266,334)
Proceeds from notes payable 7,172,000 - 300,000
Payments on notes payable ( 382,967) ( 550,023) ( 198,788)
Proceeds from sale of stock 1,045,920 4,950,000 64,788
Stockholder distributions - - ( 156,148)
Stock offering costs paid ( 40,000) ( 220,000) -
------------- -------------- -------------
Net cash provided by (used in)
financing activities 7,794,953 3,084,176 ( 256,482)
------------- -------------- -------------
Increase in cash and cash
equivalents 17,102,553 91,766 345
Cash and cash equivalents,
beginning of year 102,695 10,929 10,584
------------- -------------- -------------
Cash and cash equivalents,
end of year $ 17,205,248 $ 102,695 $ 10,929
============= ============== =============
Supplemental disclosure of cash
flow information:
Cash paid during the year for:
Interest $ 123,119 $ 254,713 $ 230,370
============= ============== =============
Income taxes $ 1,752,000 $ - $ -
============= ============== =============
Supplemental schedule of non-cash
investing and financing activities:
Repayment of related party note
payable with related party
note receivable $ 759,489
=============
Conversion of debt to equity $ 497,649 $ 923,499
============== =============
Conversion of redeemable preferred
stock to equity $ 44,000 $ 232,000
============= ==============
Notes payable reduced by proceeds
from equipment sale $ 255,000
==============
Acquisition (reverse merger):
Fair value of assets acquired $ 1,237,238
Liabilities assumed ( 2,001,688)
--------------
Excess assigned to goodwill $ 764,450
==============
See notes to consolidated financial statements.
F-8
36
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:
Organization and basis of presentation:
Star Scientific, Inc. and Subsidiaries was formerly known as Eye
Technology, Inc. and Subsidiaries (the "Company"). In December 1998,
the Company changed its name to Star Scientific, Inc.
On February 6, 1998, the Company and its subsidiaries, entered into a
stock exchange agreement with the stockholders of Star Tobacco and
Pharmaceuticals, Inc. ("Star"), a privately owned corporation. Under
the agreement, Star stockholders exchanged all of their common stock
for 13,831 shares of Series B Preferred Stock, par value $.01 per
share. When converted, this stock would equal 46,127,500 shares of
common stock, or approximately 90% of the outstanding common stock of
the Company and its subsidiaries as of the conversion date.
Accounting Principles Board Opinion No. 16 states that presumptive
evidence of the acquiring corporation in combinations effected by an
exchange of stock is obtained by identifying the former common
stockholder interest of a combining company which either retains or
receives the larger portion of the voting rights in the combined
corporation. That corporation should be treated as the acquirer unless
other evidence clearly indicates that another corporation is the
acquirer. As the former stockholders of Star hold the larger portion of
the voting rights of the combined corporation, the transaction has been
recorded as a reverse acquisition with Star as the accounting acquirer.
In a reverse acquisition, the accounting acquirer is treated as the
surviving entity, even though the registrant's legal existence does not
change. The accounting acquirer treats the merger as a purchase
acquisition. As a result, the merger has been recorded using the
historical cost basis for the assets and liabilities of Star, as
adjusted, and the estimated fair value of the Company's and its
subsidiaries assets and liabilities. The excess of the Company's and
its subsidiaries' liabilities assumed over assets acquired amounted to
$764,450 and was assigned to goodwill which was being amortized over
five years on a straight line basis (see Note 2 for disposal of this
business segment).
The accompanying consolidated financial statements include the accounts
of Star, and the Company and its Subsidiaries. All intercompany
accounts and transactions have been eliminated. The results of
operations of the Company are included in the accompanying consolidated
financial statements from the date of acquisition.
F-9
37
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED):
Organization and basis of presentation:
The following summarized pro forma information assumes the acquisition
had occurred as of January 1, 1997.
1998 1997
------------ --------------
Net sales $ 20,134,099 $ 22,097,287
Operating loss ($ 3,299,669) ($ 2,252,324)
Net loss ($ 4,209,784) ($ 2,316,688)
Loss per share:
Basic and diluted ($ .51) ($ .67)
Nature of business:
Star has been engaged since 1991 in the manufacture and sale of tobacco
products. Since 1994, Star has engaged in extensive research and
development activities relating to (1) the development of proprietary
scientific technology for the curing of tobacco so as to prevent or
retard the formation of certain toxic carcinogens present in tobacco
and tobacco smoke, namely, the tobacco specific nitrosamines, (2) the
development of less harmful tobacco products which have been cured
pursuant to licensed patented technology and (3) the development of
tobacco-smoking cessation products. The Company is also engaged in the
manufacture and sale of discount cigarettes, without additives, and
with activated charcoal filters. Through the year ended December 31,
1998, the Company had not yet marketed or received any revenues from
products developed from its research and development activities.
During 1997, Star had sales to one customer which represented
approximately 19% of net sales. There were no sales to this customer in
1999 or 1998. During 1999, Star had purchases from a major domestic
tobacco company which represented 21% of cost of sales. The Company
also borrowed $7,172,000 from this same company to finance property,
plant and equipment acquisitions in 1999. (See Notes 5 and 6)
Advertising Costs:
Advertising costs are expensed as incurred and are included in
marketing and distribution expenses. For the years ended December 31,
1999, 1998 and 1997, advertising costs were $36,000, $38,000 and
$60,000, respectively.
F-10
38
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED):
Use of estimates:
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates
and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the
date of the financial statements and the reported amounts of income and
expenses during the reporting period. Actual results could differ from
those estimates.
Cash equivalents:
For purposes of the statement of cash flows, the Company classifies all
highly liquid investments with an original maturity of three months or
less as cash equivalents.
Fair value of financial instruments:
Financial instruments consist of cash, cash equivalents, short-term
trade receivables and short-term trade payables for which the current
carrying amounts approximate fair value. Additionally, the borrowing
rates currently available to the Company approximate the rates for debt
agreements with similar terms and average maturities.
Inventories:
Inventories are valued at the lower of cost or market. Cost is
determined on the first-in, first-out (FIFO) method.
Property, plant and equipment:
Property, plant and equipment are recorded at cost. Depreciation is
determined using the straight-line method over the estimated useful
lives of three to seven years for office equipment and machinery and
equipment and thirty-nine years for buildings and improvements.
Intangibles:
Intangibles consist primarily of licensing costs, trademarks and
packaging design costs. Intangibles are amortized by the straight-line
method over a period of 15 years for trademarks 17 years for licensing
costs and 5 years for packaging design costs.
F-11
39
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED):
Income taxes:
Star was an S Corporation from August 1, 1991 through February 6, 1998
for federal income tax purposes. Accordingly, the taxable income or
loss of Star had been "passed-through" to its stockholders, and they
have been subject to the tax on any income earned by the Company. As a
result of the change in ownership discussed in Note 1, Star was no
longer eligible for S corporation status and became a C Corporation
effective February 6, 1998. As a C corporation, Star is responsible
for income taxes payable resulting from earnings subsequent to February
6, 1998. Additionally, under the provisions of Financial Accounting
Standards Board ("FASB") Statement No. 109, Accounting for Income
Taxes, deferred tax assets and liabilities are recorded based on the
difference between the financial statement and tax bases of assets and
liabilities using currently enacted tax rates.
Credit risk:
Financial instruments which potentially subject the Company to
concentrations of credit risk consist principally of cash and cash
equivalents and accounts receivable.
The Company maintains its cash and cash equivalents balances in 5
financial institutions, including approximately $64,000 in one foreign
bank. Each of the balances in the domestic banks are insured by the
Federal Deposit Insurance Corporation up to $100,000.
Trade accounts receivable result from sales of tobacco products to its
various customers throughout the United States. Credit is extended to
customers after an evaluation for credit worthiness; however, the
Company does not require collateral or other security from customers.
Employee stock-based compensation:
During 1999, the Company adopted the accounting and disclosure
provisions of Financial Accounting Standard No. 123 -- Accounting for
Stock-Based Compensation ("FAS 123"), which requires 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). There were no stock-based
compensation transactions with employees in 1998 or 1997 that would
have been subject to the accounting or disclosure provisions of FAS
123.
F-12
40
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED):
Research and development costs:
Research and development costs are charged to expense when incurred.
Segment reporting:
During 1999, the Company commenced operations in a new business segment
and as a result, adopted the Statement of Financial Accounting
Standards Number 131, "Disclosures about Segments of an Enterprise and
Related Information". Statement No. 131 establishes standards for
reporting information about operating segments in annual financials
statements. Operating segments are defined as components of an
enterprise about which separate financial information is available that
is evaluated on a regular basis by the chief operating decision maker
or decision making group, in deciding how to allocate resources to an
individual segment and in assessing performance of the segment. The
Company has identified these segments based on the nature of business
conducted by each. The identifiable segments at December 31, 1999 are
1) the manufacture and sale of discount cigarettes to wholesalers, and
2) the sale of tobacco cured utilizing its proprietary technology. This
second segment also includes costs incurred in the research and
development of methods of manufacturing a less harmful tobacco product.
Net income (loss) per common share:
In 1997, the Financial Accounting Standards Board ("FASB") issued SFAS
No. 128, Earnings Per Share. SFAS No. 128 replaced the previously
reported primary and fully diluted earnings per share with basic and
diluted earnings per share. Unlike primary earnings per share, basic
earnings per share excludes any dilutive effects of options, warrants
and convertible securities.
Basic earnings per share is computed using the weighted-average number
of common shares outstanding during the period. Diluted earnings per
share is computed using the weighted-average number of common shares
and potential common shares outstanding during the period. Potential
common shares are excluded from the computation if their effect is
antidilutive.
Basic income (loss) per common share was computed using the
weighted-average number of common shares outstanding. Potential common
shares outstanding were excluded in 1998 and 1997, as their effect was
antidilutive.
Diluted earnings per share was computed assuming conversion of all
potentially dilutive stock options and warrants.
F-13
41
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997
2. DISCONTINUED OPERATIONS:
On December 30, 1998, the Company completed the sale of its ophthalmic
and intraocular business. As a result thereof, the Company has recorded
an after tax loss on the disposal of $221,290. Results of operations of
the discontinued business segment have been classified as discontinued
operations from the date of the Eye Technology, Inc. acquisition in
February 1998 through December 31, 1998.
Net sales and loss from discontinued operations are as follows for
1998:
Net sales $629,715
--------
Operating losses $751,080
--------
Income taxes -
--------
Loss from discontinued operations $751,080
--------
Loss on disposal $221,290
--------
3. INVENTORIES:
Inventories consist of the following:
1999 1998
---------- -----------
Raw materials $ 623,692 $ 329,238
Packaging materials 781,448 262,467
Finished goods 2,165,469 44,751
---------- ----------
$3,570,609 $ 636,456
========== ==========
4. PROPERTY, PLANT AND EQUIPMENT:
Property, plant and equipment consists of the
following: 1999 1998
----------- -----------
Land $ 172,572 $ 172,572
Buildings and improvements 340,139 269,484
Tobacco curing barns 8,661,312 -
Machinery and equipment 3,202,577 2,180,653
Office and sales equipment 586,087 312,649
----------- -----------
12,962,687 2,935,358
Less accumulated depreciation 1,988,658 1,230,789
----------- -----------
$10,974,029 $ 1,704,569
=========== ===========
F-14
42
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997
5. CUSTOMER DEPOSIT AND LONG-TERM SUPPLY AGREEMENT:
During October 1999, the Company entered into an agreement with a major
domestic tobacco company ("customer"), whereby that customer will, subject
to certain conditions, purchase quantities of the Company's low
nitrosamine tobacco leaf (StarCure(TM) tobacco) and evaluate the potential
for that tobacco in the marketplace. In that regard, the customer has made
a $6,000,000 non-refundable deposit to the Company toward its purchase of
tobacco in 2000. Additionally, the customer has agreed to finance the
purchase/construction of tobacco curing barns which will assist the
Company in its production of low nitrosamine tobacco products to be
marketed by the Company, the customer and others in the industry (see Note
6 regarding financing provided through December 31, 1999). Tobacco leaf
sales under this agreement during 1999 were approximately $9,300,000. In
each of the years 2000 and 2001, the customer is obligated to purchase
five million pounds of Virginia flue-cured tobacco that has been cured
using the StarCure(TM) process, and the customer has an option to purchase
three million pounds of burley tobacco cured using the same process. The
customer also has the option to become the exclusive purchaser of tobacco
cured using the StarCure(TM) process in each of the years 2002 through
2004, if it purchases at least thirty million pounds of tobacco in each of
those years. If the customer were to stop purchasing flue-cured tobacco
that has been cured using the StarCure(TM) process after the year 2001,
the Company's sales volume, operating income and cash flows could be
negatively effected.
6. NOTES PAYABLE:
Notes payable consists of the following:
1999 1998
---------- -----------
Note payable under a $13,200,000 credit facility restricted for the
purchase of tobacco curing barns; interest accrues at prime plus 1%
commencing December 2000-payable monthly thereafter; principal
payable in 60 equal monthly installments commencing September 2004;
collateralized by the Company's curing barns and leaf tobacco
inventory. $ 7,172,000 $ -
Note payable, bank, due in monthly installments of $3,111,
including interest at prime plus 1%, through 2001; secured by real
property and guaranteed by certain stockholders. 259,343 275,393
F-15
43
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997
6. NOTES PAYABLE (CONTINUED):
Term note payable, finance company, due in monthly installments of
$21,047, including interest at 10.15% through September 2001;
secured by manufacturing equipment. 172,469 362,247
Term note payable, finance company, due in monthly installments of
$7,262, including interest at 9.31% through October 2001; secured
by manufacturing equipment. 146,356 216,292
Other 29,514 136,734
----------- --------------
7,779,679 990,666
Less current maturities 275,000 379,082
----------- --------------
$ 7,504,679 $ 611,584
=========== ==============
The annual maturities of notes payable are as follows:
Year ending December 31
-------------------------
2000 275,000
2001 332,679
2005 7,172,000
-----------
$ 7,779,679
===========
7. STOCKHOLDERS' EQUITY:
Preferred stock:
Class A:
The Company has authorized 4,000 shares of $.01 par value Class A
Convertible Redeemable preferred stock. Each share of the Preferred
Stock is convertible into 80 shares of common stock of the Company at
the option of the holder and has voting rights equal to the number of
common shares issuable if converted. The Preferred Stock has the right
to share in dividends declared on the Company's common stock and has
certain liquidation preferences. The carrying value of the Preferred
Stock at December 31, 1998 reflected an additional acceleration premium
as the Company has raised funds in excess of defined amounts. At
December 31, 1999 all Class A preferred shares had been converted to
common.
F-16
44
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997
7. STOCKHOLDERS' EQUITY (CONTINUED):
Series B:
During the year ended December 31, 1998, the Company authorized 15,000
shares of $.01 par value Series B Preferred Stock. The stock is
convertible into common stock at the holders' option prior to December
31, 2002 at 3,280 shares of common for each share of Series B
Preferred. Holders of Series B Preferred Stock are entitled to 500
votes for each share held. During 1999, holders of all of the 14,084
shares of Series B Preferred Stock converted their shares to common.
Common stock warrants:
Common stock warrants issued, redeemed and outstanding during the year
ended December 31, 1999 and 1998 are as follows:
Issued in 1998 in connection with private placement of stock,
exercise price of $2 per share, expiring September 2000 1,500,000
----------------
Warrants issued and outstanding at December 31, 1998 1,500,000
Warrants exercised in 1999 ( 522,920)
----------------
Warrants issued and outstanding at
December 31, 1999, expiring September
2000 (remaining contractual life .75 years) 977,080
================
Stock option plan:
In 1998, the Company adopted the 1998 Stock Option Plan (the "Plan")
which provides for grants of options to those officers, key employees,
directors and consultants whose substantial contributions are essential
to the continued growth and success of the Company. The Plan provides
for grants of both qualified and non-qualified stock options to
purchase up to 4,000,000 shares at a purchase price equal to the fair
market value on the date of grant in the case of qualified options
granted to employees. The Company amended the Plan on April 12, 1999.
There were no options outstanding as of December 31, 1998. During 1999,
3,258,406 options were granted with a weighted average exercise price
of $2.17 per share. No options were exercised or forfeited in 1999.
F-17
45
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997
7. STOCKHOLDERS' EQUITY (CONTINUED):
The following table summarizes information for options outstanding and
exercisable at December 31, 1999 all of which were granted in 1999.
Options Outstanding Options Exercisable
----------------------------------------------- -------------------------------
Range of Weighted Avg. Weighted Avg. Weighted Avg.
Prices Number Remaining Life Exercise Price Number Exercise Price
------------- --------- -------------- --------------- ---------- ---------------
$ 1.00-2.00 2,500,000 9.71 yrs. $ 1.79 2,000,000 $ 1.74
$ 2.01-3.00 500,000 9.79 yrs. $ 3.00 - $ -
$ 3.01-4.00 175,000 9.52 yrs. $ 3.34 175,000 $ 3.34
$ 4.01-5.00 50,000 9.33 yrs. $ 4.13 50,000 $ 4.13
$ 5.01-8.56 33,406 9.92 yrs. $ 8.56 33,406 $ 8.56
--------- -------------- --------------- ---------- ---------------
$ 1.00-8.56 3,258,406 9.71 yrs. $ 2.17 2,258,406 $ 2.02
========== ============== =============== ========== ===============
The weighted average grant-date fair value of options granted during
1999 was $2.07 per share ($2.00 per share for those issued whose
exercise price was different from the market price of the stock at
date of grant).
In addition to stock options, the Company granted a stock purchase
right to acquire 2,000,000 shares of common stock at $1.00 per share.
This stock purchase right was accounted for as an option (see Note 13)
and had a grant-date fair value of $48,400.
The fair value of options and the stock purchase right granted in 1999
were estimated on the date of grant using the Black-Scholes option
pricing model with the following weighted average assumptions:
Expected life of options 1.25 years
Risk free interest rate 5.03%
Expected volatility 39%
Expected dividend yield 0%
Total compensation cost recognized in 1999 for all stock-based employee
compensation awards was $265,618.
F-18
46
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997
8. EARNINGS PER SHARE:
The following table sets forth the computation of basic and diluted
earnings per share for the years ended December 31,
1999 1998 1997
--------------- -------------- ---------------
Net income (loss)
$ 11,514,630 ($ 4,196,075) ($ 1,986,497)
=============== ============== ===============
Denominator for basic earnings per
share-weighted average shares 36,207,390 8,327,345 3,435,190
Effect of dilutive securities:
Warrants outstanding 729,621 - -
Stock options outstanding 1,828,240 - -
--------------- -------------- ---------------
Denominator for diluted earnings
per share- weighted average shares
adjusted for dilutive securities 38,765,251 8,327,345 3,435,190
=============== ============== ===============
Earnings (loss) per common share $ .32 ($ .51) ($ .58)
=============== ============== ===============
Earnings (loss) per common share-
diluted $ .30 ($ .51) ($ .58)
=============== ============== ===============
9. INCOME TAXES:
Net deferred tax assets and liabilities consist of the following:
1999 1998
------------------------ --------------------
Deferred tax assets:
Non-refundable deposit taxable currently $ 2,280,000 -
Net operating loss carryforwards (subject
to annual limitation) 423,000 2,000,000
Other 43,000 -
------------------------ -------------------
2,746,000 2,000,000
------------------------ -------------------
Deferred tax liabilities:
Differing bases in property, plant and
equipment for tax and financial reporting
purposes ( 360,000) ( 200,000)
------------------------ --------------------
2,386,000 1,800,000
Less valuation allowance - ( 1,800,000)
------------------------ --------------------
$ 2,386,000 $ -
======================== ====================
Net deferred tax assets are reflected in the accompanying 1999 balance
sheet as follows:
Current asset $ 2,303,000
Non-current asset 83,000
-------------------
$ 2,386,000
===================
F-19
47
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997
9. INCOME TAXES (CONTINUED):
Income tax expense consists of the following:
1999 1998 1997
------------------ ----------------- -------------
Current:
Federal $ 6,114,000 $ - -
State 1,250,000 - -
------------------ ----------------- --------------
7,364,000 - -
Deferred ( 586,000) ( 1,325,000) -
Increase (decrease) in valuation
allowance(a) ( 1,800,000) 1,325,000 -
------------------ ----------------- --------------
$ 5,564,000 $ - -
=================== ================= ==============
(a)During 1999, the Company reevaluated the deferred tax asset
valuation allowance based on the Company's current operations and
determined that it is more likely than not that these deferred tax
assets will be recoverable and, as such, has decreased the previously
recorded valuation allowance.
The provision for income tax expense (income tax benefit) varies from
that which would be expected based upon applying the statutory federal
rate to pre-tax accounting income (loss) as follows:
1999 1998 1997
---------------- ---------------- --------------
Statutory federal rate 34% ( 34%) ( 34%)
Non-deductible compensation
for stock options and grants 4 -
Other 3 - -
Non-deductible officer
compensation 4 - -
Change in deferred tax
asset valuation allowance ( 12) 34 34
---------------- ---------------- --------------
33% - % - %
================ ================ =============
At December 31, 1999 the Company had a net operating loss carryforward
of approximately $1,100,000, which expires from 2003 through 2009.
F-20
48
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997
10. RELATED PARTY TRANSACTIONS:
The Company has entered into certain transactions with companies and
trusts that are owned by members of management and stockholders. The
following is a summary of the significant related party transactions
for the years ended December 31, 1999, 1998 and 1997.
1999 1998 1997
---------------- --------------- ------------
Management fee expense $ - $ - $ 565,000
Business travel - aircraft expense $ 442,238 185,544 238,750
Loan repayments $ - 200,000 -
Legal fees (d) $ 940,000 $ - $ -
Advance to officers (a) (b) $ 1,143,134 - -
Note receivable, officer
(See Note 13-Employment
Agreement) $ 2,000,000 $ - $ -
Interest receivable on stock note
receivable officer (c) $ 94,889 $ - $ -
Tobacco purchases from/commissions
paid to organization controlled by an
officer/director $ 627,577 $ 59,429 $ -
Tobacco sales to an organization
controlled by an officer/director $ 578,683 $ 165,347 $ -
(a) $55,328 of which is unsecured and included in prepaid expenses
and other current assets in the accompanying 1999 balance sheet.
(b) Includes a $1,087,806 unsecured note receivable due from officer,
bearing interest at 5.66% due December 31, 2000.
(c) Included in prepaid expenses and other current assets in the
accompanying 1999 balance sheet.
(d) In 1999, the Company paid $940,000 to Paul, Hastings, Janofsky &
Walker LLP with respect to various legal matters. An executive
officer of the Company is senior counsel and a former partner of
this firm.
Effective January 1, 1998, Star entered into a license agreement with
the principal stockholder wherein Star has the exclusive world-wide
rights to produce and sell tobacco products with low-TSNA (tobacco
specific nitrosamines) tobacco. In connection with this agreement, Star
is obligated to pay royalties equal to 2% of all product sales (less
certain costs) and 6% of any royalty income earned from sublicensing
(less certain costs). There were no royalties due under this agreement
for 1999 or 1998.
F-21
49
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997
11. EMPLOYEE BENEFIT PLAN:
The Company is the sponsor of a defined contribution retirement plan
under Section 401(k) of the Internal Revenue Code. The plan covers all
employees who meet certain eligibility and participation requirements.
Participants may contribute up to 15% of their annual compensation. The
Company may make an annual discretionary contribution (approximately
$44,000 in 1999 and no contribution in 1998 or 1997).
12. SEGMENT REPORTING:
As discussed in Note 1, the Company adopted FAS No. 131, "Disclosures
about Segments of an Enterprise and Related Information". The Company's
reportable segments are strategic business units that offer different
products and have separate management teams. These segments are 1) the
manufacture and sale of discount cigarettes and 2) the sale of tobacco
cured using licensed technology, which commenced in 1999. Financial
information by business segment is as follows:
Leaf Discount
Tobacco Cigarettes Consolidated
---------------- ------------------- ---------------------
Sales $ 9,845,516 $ 89,479,273 $ 99,324,789
---------------- ------------------- ---------------------
Cost of sales 6,565,901 25,312,978 31,878,879
---------------- ------------------- ---------------------
Depreciation 407,011 338,194 745,205
---------------- ------------------- ---------------------
Research and development 535,782 - 535,782
---------------- ------------------- ---------------------
Property and equipment 9,107,039 1,866,990 10,974,029
---------------- ------------------- ---------------------
Capital expenditures 9,150,000 864,665 10,014,665
---------------- ------------------- ---------------------
F-22
50
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997
13. COMMITMENTS AND CONTINGENT LIABILITIES:
Obligations under master settlement agreement:
In November 1998, 46 states and several U.S. territories entered into a
settlement agreement to resolve litigation that had been instituted by
them 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 ("MSA"). As a nonparticipating manufacturer, the Company
would be required to satisfy certain escrow obligations under statutes
which the MSA 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 judgements of settlements
in lawsuits filed by the participating states against such
nonparticipating tobacco manufacturers. Absent a legal challenge to the
state specific statutes or an agreement with respect to the funding of
the required escrow accounts, the Company is obligated to place an
amount equal to $1.88 per carton sold in 1999, and increased amounts
per carton for subsequent years, in escrow accounts beginning April
2000 for sales of cigarettes occurring in each such state after the
effective date of each state specific statute. The Company's escrow
funding requirement in April 2000 for 1999 sales is approximately
$10,600,000 and is expected to increase in future years. Such escrowed
funds will be used to fund tobacco-related litigation or settlements
and if not so used, returned to the Company after 25 years (the Company
will, however, receive interest earnings on the invested escrowed
amounts). Also, absent a challenge to the state-specific statutes or
some accommodation as to the payment of the escrow amounts, the failure
to pay the required escrow could result in penalties to the Company and
potential restrictions on its ability to sell tobacco products within
particular states. The Company has the resources to meet its April 2000
escrow funding obligation and expects it will be able to do so in
future years. However, the degree to which these escrow requirements
negatively impact the Company's liquidity position in future years is
not presently determinable. Notwithstanding, the Company is continuing
to assess its options with respect to the state specific statutes,
including a variety of legal challenges to the statutes and/or MSA.
F-23
51
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997
13. COMMITMENTS AND CONTINGENT LIABILITIES (CONTINUED):
Leases:
The Company leases its office and warehouse facilities and various
vehicles and operating equipment under non-cancelable operating leases.
The following represents the future minimum rental payments required
under operating leases that have initial or remaining non-cancelable
lease terms in excess of one year as of December 31, 1999.
Year ending December 31, Amount
------------------------ ---------------
2000 $ 99,024
2001 76,736
2002 74,948
2003 74,948
2004 74,948
Thereafter 256,073
---------------
$ 656,677
===============
Rent expense for all operating leases amounted to approximately
$153,000, $107,000, and $170,000 for the years ended December 31, 1999,
1998 and 1997, respectively.
Employment Agreement:
During April 1999, the Company entered into an employment agreement
with an Executive Officer (the "officer"), which expires June 15, 2002.
In addition to a $600,000 base salary as of December 31, 1999, the
agreement provides for a minimum annual performance bonus of $250,000.
Compensation expense pursuant to this agreement in 1999 was
approximately $860,000.
F-24
52
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 1999, 1998 AND 1997
13. COMMITMENTS AND CONTINGENT LIABILITIES (CONTINUED):
Employment Agreement (continued):
The agreement also granted the officer the right to purchase 2,000,000
shares of the Company's common stock at $1 per share, and the Company
agreed to finance the purchase with interest due annually at 7% and all
principal due July 2005. The stock purchase occurred in 1999, and the
related $2,000,000 note receivable is presented as a reduction of
stockholders' equity in the accompanying 1999 balance sheet. Since the
note is non-recourse with respect to accrued unpaid interest and 85% of
the principal, this stock purchase right has been accounted for as an
option. The Company has recognized interest income of approximately
$90,000 during 1999 in connection with the note. In connection with the
aforementioned agreement, the officer was also granted qualified stock
options to purchase 1,000,000 shares of stock at $1 - 11/16 per share,
the price of the Company's common stock on the date of grant. Such
options vested immediately.
14. SUBSEQUENT EVENT:
During January 2000 the Company obtained a $3,000,000 revolving line of
credit. Borrowings under the line of credit are limited to 80% of
eligible accounts receivable, as defined, and bear interest at a rate
linked to the prime rate. The agreement places restrictions on new debt
and the Company's ability to further pledge its assets and stipulates a
minimum fixed charge coverage ratio, as defined. Borrowings under the
line of credit are secured by substantially all assets not otherwise
pledged.
During January 2000 the Company also entered into a long-term lease
arrangement for warehouse and office space. Future minimum rental
payments adjusted for amounts required under this agreement are as
follows:
Year ending Amount
----------------- ------------------
December 31, 2000 $ 293,887
2001 271,599
2002 269,811
2003 281,273
2004 281,273
Thereafter 897,973
------------------
$ 2,295,816
==================
F-25
53
STAR SCIENTIFIC, INC. AND SUBSIDIAIRIES
Schedule II
Valuation and qualifying accounts.
- ----------------------------------------------------------------------------------------------------------------------------------
Col. A Col. B Col. C Col. D Col. E
- ----------------------------------------------------------------------------------------------------------------------------------
Description Balance at Additions Deductions - Balance at
December 31, Beginning of Describe End of Period
1999, 1998 Period
and 1997
- ----------------------------------------------------------------------------------------------------------------------------------
(1) (2)
Charged Charged
to to
Costs Other
and Accounts-
Expenses Described
- ----------------------------------------------------------------------------------------------------------------------------------
For the year
ended
December 31,
1999:
- ----------------------------------------------------------------------------------------------------------------------------------
- ----------------------------------------------------------------------------------------------------------------------------------
Allowance
for cash
discounts
and returns $ 76,600 $ 102,770 $ - $ - $ 179,370
- ----------------------------------------------------------------------------------------------------------------------------------
- ----------------------------------------------------------------------------------------------------------------------------------
Allowance
for Recovery
uncollectible
accounts $ 46,436 $ 65,536 $ - $ 27,400 $ 46,500
- ----------------------------------------------------------------------------------------------------------------------------------
- ----------------------------------------------------------------------------------------------------------------------------------
For the year
ended
December 31,
1998:
- ----------------------------------------------------------------------------------------------------------------------------------
- ----------------------------------------------------------------------------------------------------------------------------------
Allowance Change in
for cash estimate
discounts
and returns $ 167,091 $ - $ - $ 90,491 $ 76,600
- ----------------------------------------------------------------------------------------------------------------------------------
- ----------------------------------------------------------------------------------------------------------------------------------
Allowance
for
uncollectible
accounts $ - $ 46,436 $ - $ - $ 46,436
- ----------------------------------------------------------------------------------------------------------------------------------
- ----------------------------------------------------------------------------------------------------------------------------------
For the year
ended
December 31,
1997:
- ----------------------------------------------------------------------------------------------------------------------------------
- ----------------------------------------------------------------------------------------------------------------------------------
Allowance
for cash
discounts
and returns $ 122,940 $ 44,151 $ - $ - $ 167,091
- ----------------------------------------------------------------------------------------------------------------------------------
- ----------------------------------------------------------------------------------------------------------------------------------
Allowance
for
uncollectible
accounts $ - $ - $ - $ - $ -
- ----------------------------------------------------------------------------------------------------------------------------------