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SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
FORM 10-Q
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the quarterly period ended September 30, 2002
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from _____________ to ______________
Commission File Number: 0-15324
STAR SCIENTIFIC, INC.
(Exact Name of Registrant as Specified in its charter)
Delaware
(State of incorporation)
52-1402131
(IRS Employer Identification No.)
801 Liberty Way
Chester, VA 23836
(Address of Principal Executive Offices)
(804) 530-0535
(Registrant's telephone number, including area code)
- --------------------------------------------------------------------------------
Former Name, Former Address and Former Fiscal Year, if Changed Since Last Report
Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [_]
At November 4, 2002, there were 59,719,480 shares outstanding of the
Registrant's common stock, par value $.0001 per share.
See notes to condensed consolidated financial statements.
1
Table of Contents
Page
PART I Item 1 - Financial Statements
Condensed Consolidated Balance Sheets as of September 30, 2002 (Unaudited)
and December 31, 2001 3
Condensed Consolidated Statements of Operations for the three and nine months
ended September 30, 2002 and 2001 (Unaudited) 5
Condensed Consolidated Statement of Stockholders' Equity for the nine months ended
September 30, 2002 6
Condensed Consolidated Statements of Cash Flows for the nine months
ended September 30, 2002 and 2001 (Unaudited) 7
Notes to Condensed Consolidated Financial Statements 8
Item 2 - Management's Discussion and Analysis of Financial Condition and
Results of Operations 14
Item 3 - Quantitative and Qualitative Disclosure on Market Risk 22
Item 4 - Controls and Procedures 22
PART II Item 1 - Legal Proceedings 23
Item 2 - Changes in Securities and Use of Proceeds 24
Item 6 - Exhibits and Reports on Form 8-K 24
Signatures
See notes to condensed consolidated financial statements.
2
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
ASSETS
September 30, December 31,
2002 2001
(Unaudited)
-------------------- ---------------------
Current Assets:
Cash and cash equivalents $ 0 $ 3,084,612
Accounts receivable, trade 10,112,808 3,188,412
Inventories 16,329,523 12,004,078
Prepaid expenses and other current assets 1,505,102 371,715
Refundable income tax 1,927,981 2,264,516
Deferred tax asset 37,000 50,000
-------------------- --------------------
Total current assets 29,912,414 20,963,333
Property, plant and equipment, net 21,348,289 21,577,386
Idle equipment 2,071,000 2,071,800
Intangibles, net of accumulated amortization 1,057,611 985,585
Other assets 1,589,062 1,599,422
Deposits on property and equipment 2,997,360 3,697,214
MSA Escrow funds 33,582,285 28,444,280
-------------------- --------------------
Total Assets $ 92,558,021 $ 79,339,020
==================== ====================
(Continued)
See notes to condensed consolidated financial statements.
3
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
LIABILITIES AND STOCKHOLDERS' EQUITY
September 30, December 31,
2002 2001
(Unaudited)
-------------------- --------------------
Current liabilities:
Current maturities of long-term debt $ 0 $ 775,210
Accounts payable, trade 12,250,196 11,898,944
Current maturities of capital lease obligations 5,209,971 3,029,567
Federal excise taxes payable 1,843,606 1,841,637
Customer Deposits 5,199,003 0
Bank Overdraft 271,326 0
Accrued expenses 848,310 1,888,789
-------------------- --------------------
Total current liabilities 25,622,412 19,434,147
Notes payable, less current maturities 21,607,926 22,969,780
Capital lease obligations 8,147,498 6,847,823
Line of credit 7,434,291 -
Deferred gain on sale-leaseback 470,034 457,867
Deferred tax liability 1,205,000 1,105,000
-------------------- --------------------
Total liabilities 64,487,161 50,814,617
-------------------- --------------------
Stockholders' equity:
Common stock/A/ 5,972 5,974
Additional paid-in capital 14,942,251 14,665,456
Retained earnings 16,522,637 17,252,973
Notes receivable, officers (3,400,000) (3,400,000)
------------------- --------------------
Total stockholders' equity 28,070,860 28,524,403
-------------------- --------------------
$ 92,558,021 $ 79,339,020
==================== ====================
/A/($.0001 par value, 100,000,000 shares authorized, 59,741,460 shares issued
and outstanding in 2001; 59,719,480 shares issued and outstanding in 2002)
See notes to condensed consolidated financial statements.
4
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OR OPERATIONS
Three Months Ended September 30, Nine Months Ended September 30,
-------------------------------- ------------------------------
2002 2001 2002 2001
------------- ------------- ------------- -------------
Net sales $ 46,108,929 $ 57,478,381 $ 116,828,276 $ 138,513,962
Less:
Cost of goods sold 24,345,842 33,827,219 47,774,092 58,183,733
Excise taxes on products 13,392,211 14,148,608 45,202,746 49,021,557
------------- ------------- ------------- -------------
Gross profit 8,370,876 9,502,554 23,851,438 31,308,672
------------- ------------- ------------- -------------
Operating expenses:
Marketing and distribution 3,186,710 2,425,000 11,783,065 7,418,347
General and administrative 3,916,789 4,724,669 11,725,553 12,084,064
Research and development 305,930 1,531,644 870,986 2,658,849
------------- ------------- ------------- -------------
Total operating expenses 7,409,429 8,681,313 24,379,604 22,161,260
------------- ------------- ------------- -------------
Operating income (loss) 961,447 821,241 (528,166) 9,147,412
Other income (expenses):
Interest income, net of interest expense (305,274) 239,501 (700,466) 492,895
Gain (loss) on disposal of assets 44,724 2,529 133,482 (156,623)
------------- ------------- ------------- -------------
Income (loss) from continuing operations before
income taxes 700,897 1,063,271 (1,095,150) 9,483,684
Income tax (expense) benefit (319,000) (551,980) 388,000 (3,965,000)
------------- ------------- ------------- -------------
Net income (loss) $ 381,897 $ 511,291 ($ 707,150) $ 5,518,684
============= ============= ============= =============
Basic income (loss) per common share $ .01 $ .01 ($ .01) $ .09
Diluted income (loss) per common share $ .01 $ .01 ($ .01) $ .09
Weighted average shares outstanding, basic 59,737,229 59,741,481 59,739,333 59,741,481
============= ============= ============= =============
Weighted average shares outstanding, diluted 59,737,229 60,768,290 59,739,333 60,730,511
============= ============= ============= =============
See notes to condensed consolidated financial statements.
5
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2002
Additional Notes
Common stock Paid-In Retained Receivable,
---------------------------
Shares Amount Capital Earnings officers Total
------------- ------------ -------------- ------------- --------------- -------------
Balances, December 31, 2001 59,741,480 $ 5,974 $ 14,665,456 $ 17,252,973 ($ 3,400,000) $ 28,524,403
Issuance of common stock options - - 282,295 - - 282,295
Repurchase and retirement of treasury
shares (22,000) (2) (5,502) (23,184) - (28,688)
Net loss - - - (707,150) - (707,150)
------------- ------------ -------------- ------------ --------------- -------------
Balances, September 30, 2002 59,719,480 $ 5,972 $ 14,942,249 $ 16,522,639 ($ 3,400,000) $ 28,070,860
============= ============ ============== ============ =============== =============
See notes to condensed consolidated financial statements.
6
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
STATEMENTS OF CASH FLOWS
Nine Months Ended September 30,
2002 2001
------------ ------------
(Unaudited) (Unaudited)
Operating activities:
Net income (loss) ($ 707,150) $ 5,518,684
Adjustments to reconcile net income (loss) to net cash flows
from operating activities:
Depreciation and amortization 1,099,666 1,902,389
Increase (decrease) in deferred income taxes 100,000 745,000
Loss on fixed asset disposal 133,482 159,152
Royalty Revenues (non-cash) (1,300,000) (1,350,000)
Stock-based compensation expense 282,295 660,187
Increase (decrease) in cash resulting from changes in:
Current assets (12,033,693) (13,882,909)
Current liabilities 4,783,071 (1,436,141)
Other assets (5,771) (548,889)
------------ ------------
Net cash flows from (used in) operating activities (7,648,100) (8,232,527)
------------ ------------
Investing activities:
Purchases of property, plant and equipment (528,381) (1,230,062)
Proceeds from disposal of property and equipment 264,754 7,866,128
Patent costs incurred (83,500) (234,837)
Deposits on property and equipment - -
Advances to Officers - (600,000)
------------ ------------
Net cash flows from (used in) investing activities (347,127) 5,801,229
------------ ------------
Financing activities:
Proceeds from revolving line of credit 7,434,291 -
Proceeds from notes payable and capital leases 6,582,888 4,000,000
Cash paid to reacquire common stock (28,688) -
Payments on notes payable and capital leases (3,939,871) (2,849,052)
------------ ------------
Net cash flows from financing activities 10,048,620 1,150,948
------------ ------------
MSA Escrow fund (5,138,005) (14,694,504)
------------ ------------
Decrease in cash and cash equivalents (3,084,612) (15,974,854)
Cash and cash equivalents, beginning of period 3,084,612 16,746,599
------------ ------------
Cash and cash equivalents, end of period $ - $ 771,745
============ ============
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Cash paid during the year for:
Interest $ 729,628 $ 500,758
============ ============
Income taxes $ 428,800 $ 3,728,970
============ ============
See notes to condensed consolidated financial statements.
7
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
1. Accounting Policies:
The financial statements of Star Scientific, Inc. ("Star Scientific" or the
"Company") and notes thereto should be read in conjunction with the financial
statements and notes for the year ended December 31, 2001.
In the opinion of management, all adjustments (consisting only of normal
recurring accruals) necessary for a fair presentation of the results of
operations for the periods presented have been included. The results of
operations for the three and nine months ended September 30, 2002 and 2001 are
not necessarily indicative of the results for a full year.
Revenue Recognition - In connection with its leaf segment, the Company sells
very low-TSNA StarCured(TM) tobacco at a price equivalent to its purchase price.
The Company is the primary obligor to the farmers from whom the tobacco is
purchased and has general inventory risk. Due to these factors and others, the
Company has recorded StarCured(TM) tobacco sales at gross amounts.
Diluted weighted average shares outstanding for the nine months ended September
30, 2002, is the same as basic weighted average shares outstanding as the effect
of conversion of outstanding options and warrants would be anti-dilutive.
Diluted earnings per share for the other periods assumes conversion of
outstanding common stock options and warrants.
In 1999, the Company adopted the accounting provisions of Statement of Financial
Accounting Standards No. 123 - Accounting for Stock-Based Compensation ("FAS
123"), which requires the use of the fair-value based method to determine
compensation for all arrangements under which employees and others receive
shares of stock or equity instruments (warrants and options).
2. Obligations under Master Settlement Agreement - MSA Escrow Fund:
In November 1998, 46 states (the "Settling States") and several U.S. territories
entered into a settlement agreement (the "Master Settlement Agreement" or "MSA")
to resolve litigation that had been instituted against the major tobacco
manufacturers. The Company was not named as a defendant in any of the litigation
matters and chose not to become a participating manufacturer under the terms of
the Master Settlement Agreement. As a nonparticipating manufacturer, the Company
is required to satisfy certain purported escrow obligations under statutes which
the Master Settlement Agreement required participating states to pass, if they
were to receive the full benefits of the settlement. The so-called "level
playing field" statutes require nonparticipating manufacturers to fund escrow
accounts that could be used to satisfy judgments or settlements in lawsuits that
may at some future date be filed by the participating states against such
nonparticipating tobacco manufacturers. Under these statutes the Company is
obligated to place an amount equal to $1.88 per carton for 1999, $2.09 in 2000,
$2.72 for 2001 and 2002, $3.35 for 2003 through 2006 and $3.77 thereafter, in
escrow accounts for sales of cigarettes occurring in the prior year in each such
state after the effective date of each state specific statute. An inflation
adjustment is also added to these deposits at the higher of 3% or the Consumer
Price Index each year. Such escrowed funds will be available to satisfy
tobacco-related judgments or settlements, if any, in some states. If not used to
satisfy judgments or settlements, the funds will be returned to the Company 25
years after the applicable date of deposit on a rolling basis. Also, absent a
challenge to the state specific statutes or some accommodation as to the escrow
amounts, the failure to place the required amounts in escrow could result in
penalties to the Company and potential restrictions on its ability to sell
tobacco products within particular states. Since all of the MSA states have
passed the so-called "level playing field" statutes, the Company expects that a
material portion of its cigarette sales will continue to be subject to such
purported escrow obligations.
As of January 1, 2001, all forty-six MSA states had adopted model "level playing
field" statutes. As noted above, under these statutes, the Company is required
to place funds in escrow for each cigarette sold in a state that is a member of
the MSA. After funding escrow accounts for 2001 sales, the Company has deposited
a total of approximately $33,600,000 into escrow under protest. In addition to
the escrow deposits associated with the Company's direct customer sales, the
Company has, under protest, been required to make additional escrow deposits
related to sales of the Company's cigarettes subsequently made by the Company's
direct customers in other states ("indirect sales"). In 2001 and in the first
two quarters of 2002, the Company made approximately $4,500,000 in escrow
payments in connection with indirect sales that occurred in 1999, 2000 and 2001.
The Company has received demands for additional escrow payments after making its
escrow payments for 2001 and expects that it will continue to be subject to
additional escrow obligations related to indirect sales which occurred from 1999
through 2001. The Company is not presently able to estimate the total amount of
this obligation, which will depend on a number of factors including a
determination of the amount of indirect sales in particular states and a
determination of whether the Company is obligated to escrow funds for all
products it manufactured and sold, including product manufactured by Brown &
Williamson Tobacco Corporation ("B&W") under its contract manufacturing
agreement with the Company, or only product the Company manufactured at its
Petersburg, Virginia, facility. If the Company is only required to
8
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
make escrow payments for cigarettes it manufactured at its
Petersburg, Virginia, facility, it could have potential obligations to B&W for
additional costs which B&W incurred for producing cigarettes which it made under
the manufacturing agreement with the Company. Under either scenario, the amount
of any additional obligation would be material and may require the Company,
among other things, to raise additional funds to meet such obligations. All
funds placed in escrow continue to be an asset of the Company, and the Company
receives the interest income generated by the escrow deposits.
In addition to the "level playing field" statutes, a number of states have
recently enacted statutes that require nonparticipating manufacturers to certify
that they are in full compliance with the escrow requirements of the MSA as a
condition to being permitted to sell cigarette products in those states. While
the Company has recently focused its sales in the four states that were not part
of the MSA, these statutes could impact on its ability to sell cigarettes in the
MSA states, notwithstanding its substantial payments into escrow.
On December 15, 2000, the Company filed a lawsuit in the United States District
Court for the Eastern District of Virginia requesting that the court declare
both the MSA and Virginia's Qualifying Statute unconstitutional and, therefore,
invalid. The Company's complaint challenges the MSA on the grounds that it
violates the Interstate Compact Clause and the Commerce Clause of the
Constitution of the United States. It challenges the Qualifying Statute on the
grounds that it violates the Equal Protection, Due Process, Takings and Commerce
Clauses of the Constitution. On March 12, 2001, the District Court heard oral
argument on the Commonwealth's Motion to Dismiss, after both sides had exchanged
briefs on all the constitutional and related issues. On March 26, 2001, the
District Court dismissed the Company's complaint, but in its opinion, the
District Court did note that Star "must now suffer as a result of the bad faith
of previous market entrants." The District Court further noted that Star "has
never been accused of the fraudulent, collusive and intentionally dishonest
activities of the Big Four," "was not even in existence during the bulk of the
time that these activities were occurring," and has taken "every step to provide
complete disclosure about the harmful nature of its products." The District
Court also stated that the "financial burden on Star and others like it may
hamper efforts to develop new tobacco technologies." The Company promptly
appealed the District Court's ruling.
On January 22, 2002, the United States Court of Appeals for the Fourth Circuit
affirmed the decision of the District Court and later denied the Company's
request for rehearing. On May 20, 2002, the Company filed a Petition for a Writ
of Certiorari with the United States Supreme Court asking that Court to review
the case, given its continuing belief that the MSA and the Virginia Qualifying
Statute are constitutionally flawed. On October 7, 2002, the Supreme Court
denied the Petition for a Writ of Certiorari. The action by the Supreme Court
effectively ends the Company's constitutional challenge to the MSA.
On June 12, 2001, Star filed a second lawsuit challenging the MSA and Indiana's
Qualifying Statute in the United States District Court for the Southern District
of Indiana. That suit raised claims similar to those in the complaint in the
Commonwealth of Virginia. The Indiana lawsuit also raised the contention that
Star is not subject to any escrow obligation in Indiana because it has no
substantial nexus to the state, and Star moved for a preliminary injunction on
this issue. On August 20, 2001, the District Court issued a ruling denying the
motion for preliminary injunction and dismissing the substantial nexus claim. At
the same time, the court deferred ruling on the remainder of the claims pending
further development of the record and final disposition of the Company's
Virginia action, which had not yet been reviewed by the Supreme Court. Based on
the Supreme Court denial of the Company's Petition For a Writ of Certiorari, the
Company anticipates moving to dismiss this case.
In May 2002, the Company entered into negotiations with representatives of the
National Association of Attorneys General ("NAAG") regarding terms under which
Star could become a Subsequent Participating Member of the MSA and resolve all
currently contested issues relating to the MSA and state Qualifying Statutes,
including its constitutional challenge to the MSA. In connection with those
discussions, a Standstill Agreement was negotiated which provides that during
the standstill period, the Settling States that executed the Agreement would not
initiate any enforcement action against the Company relating to any claims for
additional escrow funding and the compliance with state Qualifying Statutes, and
the Company would not initiate any new actions against those Settling States.
The Standstill Agreement was executed by twenty-nine of the forty-six Settling
States and by Puerto Rico, and by its terms extended through July 23, 2002.
Although the Standstill Agreement has not been formally extended, the parties
have continued negotiations and neither the Settling States that signed the
Standstill Agreement nor the remaining Settling States have initiated any
enforcement action against the Company. The Company and NAAG are continuing the
negotiation of a comprehensive settlement. Should Star reach a settlement
agreement with the NAAG, it is anticipated that a settlement would result in a
resolution of all outstanding issues with the Settling States. Such a
comprehensive settlement may result in Star contributing some or all of its
escrow funds toward that settlement. Any such contributions will be charged as
an expense to the income statement in the period when paid, and could result in
a significant decrease in book value of the Company.
9
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
3. Liquidity and Capital Resources:
The Company has incurred approximately $0.7 million in losses during the first
nine months of operations, experienced an increase in working capital from $1.5
million to $4.3 million and negative cash flows during the period of $3.1
million.
During the third quarter, management addressed cash flow shortfalls by taking a
number of steps that will continue through the fourth quarter. These include: 1)
Cost-cutting measures designed to reduce cost of goods sold and overhead. For
example, during the first half of the third quarter of 2002, sales territories
were reevaluated and restructured. This resulted in a reduction of the Company's
sales force from approximately 90 sales persons who had been employed during the
second quarter of 2002 to approximately 75 sales persons. The full quarterly
impact of these changes will be felt during the fourth quarter. Further, while
maintaining the Company's commitment to explore various business alternatives
and ultimately shift its major focus to very low-TSNA smokeless tobacco
products, the Company, with respect to its cigarette business, has decided to
return to the production of more conventional discount cigarette products, in an
effort to ensure that such discount cigarettes are competitive in an expanding
4th tier of the marketplace. Accordingly, the Company plans to reduce, or
entirely replace, the current 24% StarCured(TM) tobacco content in its
MAINSTREET(R) brand, its most popular brand, with other less expensive low-TSNA
tobacco. The Company may also consider comparable reductions in StarCured(TM)
tobacco in its other three discount cigarette brands. The Company previously
decided to use a more costly carbon/acetate filter on all of its discount
cigarettes. The added benefit of the use of such filters has been questioned by
certain members of the public health advocacy community. Accordingly, the
Company has replaced carbon/acetate filters with more conventional acetate
filters that are standard in the industry. The Company anticipates that these
changes will not have any material adverse impact on the sales of discount
cigarettes by Star Tobacco. 2) Increasing margins for its discount cigarettes by
raising prices approximately $1.00 per carton as compared to the second quarter
of 2002. 3) Obtaining a cash advance from B&W ($900,000) to fund, in part,
short-term tobacco leaf segment working capital needs of approximately $2.5
million. This cash advance was repaid in early October 2002. 4) Undertaking
steps to refinance an existing operating lease into a capital lease which will
result in the release of approximately $1.2 million of cash collateral and
undertaking to enter into a lease for ARIVA(TM) manufacturing equipment totaling
approximately $1.2 million resulting in a release of approximately $500,000 in
deposits held by the equipment manufacturer. The Company anticipates completing
this refinancing and lease during the fourth quarter of 2002 or the first
quarter of 2003.
Previously, the Company submitted to the IRS a request for a Private Letter
Ruling that would confirm the deductibility of funds placed in escrow under the
MSA. Based on the rationale set forth in its Letter Ruling request, the Company
took a deduction for escrow expenses in its IRS return for 2001, and sought a
refund for prior year payments. Subsequent to September 30, 2002, the Company
received $7.4 million in Federal and State refunds relating to such payments. If
the IRS determines that the Company's treatment of the payments into escrow is
not appropriate for tax purposes, then the Company, based upon advice from tax
counsel, expects it will challenge that determination in US Tax Court to seek a
final determination with respect to this issue. Ultimately, if the Company does
not prevail in its position, the funds would have to be returned. Even the
successful execution of the above action items and the receipt of the tax refund
cited above, may not provide sufficient funds to meet the Company's ongoing cash
needs, particularly given the Company's potential MSA funding requirements in
April 2003. The Company's liquidity needs for the next 12 months are very
difficult to estimate. Increased competition in the cigarette business, the
complexity of the issues relating to the negotiations with the NAAG, the
Company's obligations to make MSA escrow deposits, and the uncertainty regarding
consumer acceptance of ARIVA(TM), make it difficult for the Company to predict
with clarity its precise liquidity needs over specific time frames. The adequacy
of the Company's liquidity on both a short and long-term basis will depend upon
the effects on the Company and its business from many factors such as the terms
of a potential settlement with the NAAG, potential strategic choices for the
cigarette business, and the amount of capital required to execute the Company's
business objectives of broadly distributing and marketing ARIVA(TM), defending
its intellectual property, and other working capital needs. Thus, it is
anticipated the Company may need to raise additional funds and/or consider other
business options. The Company is currently not able to estimate the combined
impact of these events, however, there could be circumstances under which the
Company would be required to raise a substantial amount of capital. There can be
no guarantee that the Company will be able to raise capital, or that if it can
raise the capital, that the terms would be acceptable to the Company. The
Company's need to raise additional funds to meet its working capital and other
capital requirements will depend upon numerous factors, including the results of
its marketing and sales activities, the amount of any escrow obligations it may
be required to deposit to comply with the Master Settlement Agreement, the
success of the Company's anticipated very low-nitrosamine smokeless tobacco
products and the other factors described under "Factors That May Affect Future
Results" in the Company's Annual Report on Form 10-K for the fiscal year ended
December 31, 2001.
10
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
4. Long Term Debt:
Notes/capital leases payable at September 30, 2002 consist of the
following:
Notes payable, non-interest bearing until January 1, 2005. Interest
accrues beginning January 2005 at prime plus 1%, payable monthly.
Principal payable in 60 equal monthly installments commencing January
2005; collateralized by the Company's tobacco curing barns, leaf
tobacco inventory and intellectual property. /A/ 21,607,926
Loan balance on a $7.5 million revolving line of credit facility
secured by the Company's eligible accounts receivable; effective rate
of interest at stated rate of prime plus 0.5% through an initial term
ending in January 2005. 7,434,291
Promissory note, payable with effective interest of 10.04%,
collateralized by the Company's tobacco curing barns. 2,590,097
Capitalized lease obligations, payable with effective interest ranging
from 9.0 to 10.5%, in varying installments through 2005. 10,767,372
----------
42,399,686
Less current maturities of long term debt and capital lease obligations 5,209,971
---------
Notes payable and capital leases, less current maturities $37,189,715
===========
/A/ On April 25, 2001, the Company renegotiated these notes to provide for
maturities beginning in 2005. There are provisions in the note
restatements for reductions based on royalties from Brown & Williamson
Tobacco Corporation ("B&W") and other future performance by B&W under
the agreements entered into on April 25, 2001, including a 50%
reduction of debt if B&W conducts a successful test market of a hard
tobacco product and a 100% reduction of debt if B&W subsequently
markets a hard tobacco product in 15 states.
The annual maturities of notes payable and capital leases are as follows:
Year ending September 30,
-------------------------
2003 $5,209,971
2004 12,955,135
2005 4,253,640
2006 4,495,264
2007 4,321,584
Thereafter 11,164,092
----------
$42,399,686
==========
5. Income tax (benefit) expense consists of the following:
Nine months ending September 30,
2002 2001
---- ----
Current ($1,501,000) $3,220,000
Deferred 1,113,000 745,000
--------- -------
($388,000) $3,965,000
========= ==========
11
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
6. Segment information:
Segment of Business
-------------------
Three months ended September 30, 2002
-------------------------------------
Discount Cigarettes/
Smokeless Products Tobacco Leaf Consolidated
------------------ ------------ ------------
Revenue/A/ $30,169,668 $15,939,261 $46,108,929
Cost of sales and excise taxes 22,312,292 15,425,761 37,738,053
----------- ----------- -----------
Gross margin 7,857,376 513,500 8,370,876
----------- ----------- -----------
Research and development - 305,929 305,929
----------- ----------- -----------
Segment assets $55,347,836 $38,210,185 $93,558,021
=========== =========== ===========
Three months ended September 30, 2001
-------------------------------------
Discount Cigarettes/
Smokeless Products Tobacco Leaf Consolidated
------------------ ------------ ------------
Revenue/A/ $34,379,202 $23,099,179 $57,478,381
Cost of sales and excise taxes 25,057,734 22,918,093 47,975,827
----------- ----------- -----------
Gross margin 9,321,468 181,086 9,502,554
----------- ----------- -----------
Research and development - 1,531,644 1,531,644
----------- ----------- -----------
Segment assets $47,091,396 $33,022,083 $80,113,479
=========== =========== ===========
Nine months ended September 30, 2002
------------------------------------
Discount Cigarettes/
Smokeless Products Tobacco Leaf Consolidated
------------------ ------------ ------------
Revenue/A/ $100,889,015 $15,939,261 $116,828,276
Cost of sales and excise taxes 77,551,077 15,425,761 92,976,838
------------ ----------- ------------
Gross margin 23,337,938 513,500 23,851,438
------------ ----------- ------------
Research and development - 870,986 870,986
------------ ----------- ------------
Segment assets $ 55,347,836 $38,210,185 $ 93,558,021
============ =========== ============
Nine months ended September 30, 2001
------------------------------------
Discount Cigarettes/
Smokeless Products Tobacco Leaf Consolidated
------------------ ------------ ------------
Revenue/A/ $115,414,783 $23,099,179 $138,513,962
Cost of sales and excise taxes 83,989,219 23,216,071 107,205,290
------------ ----------- ------------
Gross margin 31,425,564 (116,892) 31,308,672
------------ ----------- ------------
Research and development - 2,658,849 2,658,849
------------ ----------- ------------
Segment assets $ 47,091,396 $33,022,083 $ 80,113,479
============ =========== ============
/A/ Note - Revenue for the tobacco leaf segment includes $1,300,000 in
2002 and $1,350,000 in 2001 in royalties earned on low-TSNA leaf
purchases other than StarCured(TM) tobacco by Brown & Williamson
Tobacco Corporation.
7. Litigation:
In May 2001, the Company filed a patent infringement action against R. J.
Reynolds Tobacco Company ("RJR") in the United States District Court for
Maryland, Southern Division to enforce the Company's rights under U.S. Patent
No. 6,202,649 (`649 Patent). On July 30, 2002, the Company filed a second patent
infringement lawsuit against RJR based on a new patent issued by the U.S. Patent
and Trademark Office on July 30, 2002 (Patent No. 6,425,401). The new patent is
a continuation of the `649 Patent, which is at issue in the first lawsuit
against RJR. Shortly after filing its second lawsuit, the Company filed a motion
to consolidate the two patent infringement lawsuits in the United States
District Court for Maryland. This motion was granted on August 26, 2002 and the
court thereafter set a fact discovery deadline of January 31, 2003. While a
trial date has not yet been set, the Company anticipates that the consolidated
lawsuits will proceed to trial before the end of 2003.
12
STAR SCIENTIFIC, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
On June 28, 2002, Philip Morris filed a declaratory judgment action against the
Company in the United States District Court for the Eastern District of
Virginia, Richmond Division. The Complaint sought a declaration of
non-infringement and patent invalidity and unenforceability with respect to the
`649 patent. On July 29, 2002, the Company filed a motion to dismiss that
lawsuit on the basis that no actionable controversy exists between the
companies. After full briefing and oral argument, the United States District
Court on September 11, 2002, dismissed Philip Morris' lawsuit. Philip Morris did
not appeal the decision by the District Court.
Since the introduction of ARIVA(TM), three citizen petitions have been filed
with the Food and Drug Administration ("FDA") seeking to have ARIVA(TM)
regulated as a food and/or a drug product under the Federal Food, Drug and
Cosmetic Act. On May 1, 2002 the Company, through counsel, filed responses to
two of these petitions, and on June 13, 2002, filed a response to the third
petition. The Company has also filed responses to other comments filed with the
FDA in certain of these dockets, including comments filed by certain State
Attorneys General. The Company's legal team is headed by former U.S. Solicitor
General Charles Fried, Esquire and by FDA attorneys from McDermott, Will &
Emery; Paul, Hastings, Janofsky & Walker LLP and Bergeson & Campbell, P.C. In
the responses counsel concluded that the petitions are factually flawed and
without merit, because ARIVA(TM) does not fit the definition of a food or a drug
under the Federal Food, Drug and Cosmetic Act. Furthermore, because ARIVA(TM) is
a smokeless tobacco product that is intended to provide tobacco satisfaction and
is licensed by the Bureau of Alcohol, Tobacco and Firearms of the Department of
the Treasury, the FDA lacks jurisdiction to regulate ARIVA(TM) based on the
March 21, 2000 decision of the Supreme Court in FDA v. Brown & Williamson
Tobacco Corporation, 529 U.S. 120 (2000). Despite the Company's position as
reflected in its responses, there is no certainty that the FDA would agree with
that position and not seek to assert jurisdiction over ARIVA(TM). By letter
dated July 17, 2002, the FDA stated that it was continuing to review the issues
raised in the first petition filed with the agency on December 18, 2001.
The Virginia Department of Taxation has asserted a Virginia Sales and Use Tax
assessment for the period January 1, 1999, through March 31, 2002, against the
Company with respect to its tobacco-curing barns in the amount of $860,115.06.
The Company has applied for a correction of the assessment and a total abatement
of the tax on the grounds that its barns are exempt from sales and use taxes
under the industrial use and processing exemption and/or the agricultural
exemption. The Company has not paid that assessment and is not required to do so
pending its appeal to the Department of Taxation. The Company has also
challenged the taxation of certain other property on the grounds that the
property is used directly in production activities at the Company's plant in
Chase City, Virginia. The Company has paid that assessment, in the amount of
$24,273.75, in full pending appeal. The administrative procedure for
consideration of the Company's application for correction of these assessments
is expected to be concluded by June 30, 2003.
There is other minor litigation in the ordinary course of business which the
Company is vigorously defending.
8. Commitments and Contingencies
The Company has entered in fee arrangements with counsel in several litigation
matters under which certain costs related to the litigation are being advanced
by counsel on behalf of the Company. These costs are the ultimate responsibility
of the Company and will be due at or before the conclusion of the litigation. It
is estimated that at the time these litigation matters are concluded, which
likely will not be before late 2003, the Company's portion of these costs will
be in excess of one million dollars; however, given the contingent nature and
the fact that a probability assessment of liability cannot be made at this time,
no accrual has been made for any potential liability at September 30, 2002.
Also, as part of its fee arrangement in these matters, the Company has agreed to
pay counsel a percentage of any damage award and a percentage of the resulting
payments the Company actually receives in the event that the litigation is
resolved in favor of the Company.
13
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
General
Star Scientific, Inc. ("Star") and its wholly-owned subsidiary, Star Tobacco,
Inc. ("ST" and together with Star, the "Company"), is a technology-oriented
tobacco company with a mission to reduce toxins in tobacco leaf and tobacco
smoke. The Company is engaged in: (1) the development and implementation of
scientific technology for the curing of StarCured(TM) tobacco so as to retard or
significantly reduce the formation of carcinogenic toxins present in tobacco and
tobacco smoke, primarily the tobacco specific nitrosamines ("TSNAs"); (2) the
sales, marketing and development of tobacco products that expose adult tobacco
users to substantially lower levels of carcinogenic toxins, namely TSNAs, and
that are sold with enhanced health warnings and comparative content information
so that adult tobacco consumers will have the option to make informed choices
about the use of tobacco products which pose a range of serious health risks
(the TSNA levels in the Company's smokeless tobacco products will continue to be
reduced to very low levels, measured in parts per billion, using the
StarCured(TM) tobacco curing process); (3) the sales, marketing and development
of very low-nitrosamine smokeless tobacco products which also carry enhanced
warnings beyond those required by the Surgeon General (in 2001, the Company
introduced three new smokeless products, Stonewall(TM) moist and dry snuffs, and
ARIVA(TM) compressed powdered tobacco cigalett(TM) pieces, and is currently
developing other smokeless tobacco products); (4) the manufacture and sale of
four discount cigarette brands; and (5) in the future, continued focus on
developing smoking cessation products if the Company can secure a joint venture
partner or corporate pharmaceutical partner with a significant regulatory
infrastructure.
During the third quarter of 2002, the Company's revenues were generated through
(i) the sale of discount cigarettes by ST, (ii) royalty revenues generated
through the sublicensing of the patented StarCured(TM) technology to B&W in
connection with B&W's purchases of low-TSNA tobacco other than StarCured(TM)
tobacco, (iii) the sale of StarCured(TM) tobacco to B&W, and (iv) the sale of
smokeless tobacco products.
Over the past two years, the Company has been engaged in the development of
smokeless tobacco products that could provide adult tobacco users with a viable
alternative to cigarettes in situations and environments when they can't smoke,
or when they would prefer not to smoke. This effort was encouraged by the
Company's Scientific Advisory Board and other independent scientific, medical,
and public health advisors who encouraged Star to accelerate the development of
smokeless products whose tobacco is 100% StarCured(TM) very low-TSNA tobacco,
because smokeless products have far fewer toxins than conventional cigarettes.
Cigarette smoke contains more than 4,000 chemical compounds, 43 of which are
known to be carcinogenic. A number of respected scientists and researchers
believe that the only major or significant toxins in smokeless tobacco are the
TSNAs, particularly the NNNs and NNKs. Accordingly, the Company expects to
increasingly focus in the future on a range of very-low TSNA smokeless tobacco
products.
As the Company increases its focus on the development and commercialization of
smokeless tobacco products, especially its flagship hard tobacco cigalett(TM)
pieces (ARIVA(TM)), the Company's central focus continues to be the research,
development and commercialization of products that reduce the range of serious
health hazards associated with the use of tobacco products. The Company fully
accepts the evidence showing links between smoking tobacco and a variety of
diseases and premature death and believes that it is unlikely that the health
risks of smoked tobacco can be completely eliminated. Nevertheless, in a world
where an estimated 1.2 billion people smoke and use other tobacco products,
there is an urgent need to reduce the toxicity of tobacco products to the
maximum extent possible using available technology. The Company believes that it
has a corporate responsibility to continue its research and development efforts
to manufacture tobacco products that contain the lowest levels of toxins as
technologically possible, although given the present limited state of the
research efforts of the Company and others in this area, the Company in
discussing its low-TSNA products has shared with adult consumers the fact that
there is not now sufficient evidence to demonstrate that reduced toxin delivery
can be quantified in terms of reduced health risk. Accordingly, the Company
makes no direct or indirect health claims for its smoked or smokeless tobacco
products.
On September 28, 2001, the Company introduced its first two very low-TSNA snuff
products (a moist and a dry snuff) under the brand name Stonewall(TM). On
November 14, 2001, Star introduced its flagship hard tobacco cigalett(TM) pieces
(ARIVA(TM)). ARIVA(TM) is a compressed powdered tobacco product designed to
dissolve completely in the mouth without leaving any residue. Sales of Star's
smokeless products were de minimus in 2001. In late January 2002, the Company
began expanded distribution of ARIVA(TM) in the United States. ARIVA(TM) is
being marketed nationwide by ST through its network of established tobacco
distributors and through new distributors with whom ST has not previously had a
relationship. In addition, the Company has sought to introduce ARIVA(TM) through
direct arrangements with several national retail chains and through national
distributors experienced with consumer products. Following the successful
limited test market of ARIVA(TM), Star decided it was appropriate to expand
distribution. By March 31, 2002, ARIVA(TM) had been placed in more than 12,000
convenience and retail stores. As of June 30, 2002 that had increased to 30,000
14
stores, and ARIVA(TM) now is available in more than 33,000 stores. In the third
quarter, the Company sold 16,540 cartons of ARIVA(TM) (10 packs equal one
carton), compared to 70,800 in the previous quarter and none in the third
quarter of 2001. The Company has been introducing ARIVA(TM) into distribution in
a wide variety of retail, convenience and tobacco departments of drug stores,
and a majority of the sales to date have been initial orders. In the third
quarter of 2002, the number of new locations increased by 3,000 sites. The
Company anticipates that future sales will be a combination of initial sales to
retail, convenience and tobacco departments of drug stores as well as re-orders
from existing customers. Overall, the sales of smokeless products continued to
represent a small portion of the Company's total sales. Despite the broad
distribution of ARIVA(TM), sales have been slower than expected, in part, due to
the lack of customer familiarity with ARIVA(TM). As a result, the time period
for generating significant revenue and cash flow from the introduction of
ARIVA(TM) will be longer than originally expected and it will take longer for
the smokeless products to support themselves on a stand-alone basis. During the
remainder of 2002, the Company anticipates continuing to expand the number of
stores in which ARIVA(TM) will be available, but cannot be sure that ARIVA(TM)
will be accepted into the national marketplace or produce sufficient revenues to
support the Company's initiative to focus primarily on smokeless tobacco
products. The acceptance of ARIVA(TM) has been impacted by a number of factors,
including, among others: (1) the fact that ARIVA(TM) requires a change in habit
by smokers, i.e. using a smokeless product rather than a smoked product; (2)
publicly stated opposition to ARIVA(TM) by certain Attorneys General and certain
public health advocacy groups which has appeared in various newspapers and FDA
filings; (3) required smokeless warning labels which may be unfamiliar to and/or
misunderstood by cigarette smokers; (4) the need to develop name brand
recognition with consumers; and (5) difficulty in obtaining capital required for
large scale consumer education and marketing. ARIVA(TM) can currently be found
in the following chain stores: CVS Pharmacies, Rite Aid Drug Stores, Albertsons,
and 7-Eleven franchises.
Notwithstanding the Company's increasing focus on low TSNA smokeless tobacco
products, in the third quarter of 2002, the Company's revenue continued to be
generated principally through the sale of discount cigarettes by ST, which
currently manufactures and sells four brands of discount cigarettes, SPORT(R),
MAINSTREET(R), VEGAS(R) and G-SMOKE(R). ST's cigarettes are sold through
approximately 260 tobacco distributors throughout the United States, although
the Company has sought to focus sales efforts in the states of Florida,
Minnesota, Mississippi and Texas. Sales of the Company's discount cigarettes
have continued to decline in MSA states as a result of the shift in focus to
non-MSA states and increased price in those states to take into account the
burden imposed by MSA escrow requirements. The Company also has faced
intensified pricing competition, particularly from foreign manufacturers in the
four non-MSA states in which it is currently focusing its sales efforts. Given
the current competitive environment in the sale of 4th tier discount cigarettes,
the Company's ongoing negotiations with the NAAG, its continued emphasis on
smokeless tobacco products, principally ARIVA(TM), and its continued focus on
its technology for producing very low-TSNA tobacco, the Company is evaluating a
number of strategic options relating to its cigarette manufacturing operations.
Further, while maintaining the Company's commitment to explore various business
alternatives and ultimately shift its major focus to very low-TSNA smokeless
tobacco products, the Company, with respect to its cigarette business, has
decided to return to the production of more conventional discount cigarette
products, in an effort to ensure that such discount cigarettes are competitive
in an expanding 4th tier of the marketplace. Accordingly, the Company plans to
reduce, or entirely replace, the current 24% StarCured(TM) tobacco content in
its MAINSTREET(R) brand, its most popular brand, with other less expensive
low-TSNA tobacco. The Company may also consider comparable reductions in
StarCured(TM) tobacco in its other three discount cigarette brands. The Company
previously decided to use a more costly carbon/acetate filter on all of its
discount cigarettes. The added benefit of the use of such filters has been
questioned by certain members of the public health advocacy community.
Accordingly, the Company has replaced carbon/acetate filters with more
conventional acetate filters that are standard in the industry. The Company
anticipates that these changes will not have any material adverse impact on the
sales of discount cigarettes by Star Tobacco.
During the third quarter of 2002, the Company recorded royalty revenue of $1.3
million out of an anticipated $1.5 million for this growing season attributed to
the purchase of low-TSNA tobacco by B&W other than StarCured(TM) tobacco. The
royalty payments are made in the form of a reduction of long-term debt in
accordance with the terms of a licensing agreement entered into with B&W on
April 25, 2001. Additional revenue during the third quarter of 2002 of
approximately $14.6 million was generated by the sale of approximately 7.5
million pounds of the Company's very low nitrosamine StarCured(TM) tobacco leaf
to B&W. As of September 30, 2002, the Company had received 10.8 million pounds
of StarCured(TM) tobacco in its Chase City, Virginia, facility, and had shipped
7.5 million pounds of StarCured(TM) tobacco to B&W. Revenues are not recognized
until the tobacco departs the Chase City facility. As of September 30, 2002, B&W
had prepaid $5.2 million for 4th quarter leaf sales.
During this growing season, the farmers growing StarCured(TM) tobacco in
Florida, Georgia and South Carolina delivered approximately 600,000 pounds of
StarCured(TM) tobacco to B&W tobacco receiving stations across the southeast.
Star did not recognize these StarCured(TM) tobacco deliveries to other receiving
stations as revenue, since B&W paid those farmers directly for the product and
Star did not assume inventory risk. During the 2002 growing season which
continued into early November, the Company processed
15
approximately 18.1 million pounds of StarCured(TM) tobacco at its Chase City,
Virginia, processing center.
Results of Operations
The Company's unaudited condensed consolidated results for the periods ended
September 30, 2002 and 2001 are summarized in the following table:
Three Months Ended September 30, Nine Months Ended September 30,
2002 2001 2002 2001
---- ---- ---- ----
Net sales $46,108,929 $57,478,381 $116,828,276 $138,513,962
----------- ----------- ------------ ------------
Cost of goods sold 24,345,842 33,827,219 47,774,092 58,183,733
Excise taxes on products 13,392,211 14,148,608 45,202,746 49,021,557
----------- ----------- ------------ ------------
Gross profit 8,370,876 9,502,554 23,851,438 31,308,672
Total operating expenses 7,409,429 8,681,313 24,379,604 22,161,251
----------- ----------- ------------ ------------
Operating income (loss) 961,447 821,241 (528,166) 9,147,412
----------- ----------- ------------ ------------
Net income (loss) $ 381,897 $ 511,291 ($707,150) $ ,518,684
=========== =========== ============ ============
Basic income (loss) per common share:
Net income (loss) $ 0.01 $ 0.01 ($0.01) $ 0.09
Diluted income (loss) per common share:
Net income (loss) $ 0.01 $ 0.01 ($0.01) $ 0.09
Weighted average shares outstanding 59,719,480 59,741,481 59,732,626 59,741,481
Diluted weighted average shares outstanding 59,880,684 60,768,290 60,333,555 60,730,511
THIRD QUARTER 2002 COMPARED WITH THIRD QUARTER 2001
During the third quarter of 2002, the Company's consolidated net sales decreased
$11.4 million or 19.8% to $46.1 million, from $57.5 million, for the third
quarter of 2001. As discussed below, due to timing of shipments of StarCured(TM)
tobacco to B&W, sales of tobacco leaf were lower in the third quarter of 2002
than the third quarter of 2001. In addition, cigarette sales declined primarily
due to concentrating sales and marketing efforts into a smaller and increasingly
price-sensitive geographic region, namely Texas, Florida, Mississippi and
Minnesota, and the Company's focus on the introduction and market penetration of
its very low-TSNA smokeless tobacco products, which were introduced in the fall
of 2001. The Company sold approximately 714 million cigarettes during the third
quarter of 2002, compared with sales of approximately 856 million cigarettes
during the third quarter of 2001, representing a decrease of approximately 17%.
The decrease in sales volume was offset in part by an increase in the sales
price charged by the Company and by the sale of its smokeless tobacco products.
Leaf tobacco revenues are seasonal in nature, and only occur during the third
and fourth quarters. Additional revenue of $14.6 million during the third
quarter of 2002 was generated by the sale of approximately 7.5 million pounds of
the Company's very low nitrosamine StarCured(TM) tobacco leaf to B&W. As of
September 30, 2002, the Company had received 10.8 million pounds of
StarCured(TM) tobacco in its Chase City facility, and had shipped 7.5 million
pounds of StarCured(TM) tobacco to B&W. Revenues are not recognized until the
tobacco departs the Chase City, Virginia, facility. As of September 30, 2002,
B&W had prepaid $5.2 million for 4th quarter leaf sales. During the third
quarter of 2001, revenue of $21.7 million was generated by the sale of
approximately 11.2 million pounds of StarCured(TM) tobacco leaf to B&W. The
revenues in 2001 were higher because in 2002 less tobacco was shipped to B&W
during the 3rd quarter. During the 2002 growing season which continued into
early November, the Company processed approximately 18.1 million pounds of
StarCured(TM) tobacco at its Chase City, Virginia, processing center. During the
third quarter of 2002, the Company recorded royalty revenue of $1.3 million out
of $1.5 million for this growing season attributed to the purchase of low-TSNA
tobacco by B&W other than StarCured(TM) tobacco. During the third quarter of
2001, the Company recorded royalty revenue of $1.35 million out of a total of
$1.5 million for the 2001 growing season. The royalty payments are made in the
form of a reduction of long-term debt in accordance with the terms of a
licensing agreement entered into with B&W on April 25, 2001. During the third
quarter of 2002, the Company earned de minimus royalties paid by B&W on sales of
its ADVANCE(R) low-TSNA cigarette, which B&W continues to test
16
market in Indianapolis, Indiana.
Gross profit in the third quarter of 2002 was $8.4 million, approximately 11.9%
lower than the $9.5 million gross profit in the third quarter of 2001. Sales
price increases in the third quarter were offset by lower sales volume and an
increase in manufacturing costs, including increased contract prices for
cigarettes made by B&W given the lower level of production under the Company's
contract manufacturing agreement. The Company's federal excise tax expense for
third quarter 2002 was $13.4 million, a decrease of $0.8 million from 3rd
quarter of 2001, despite a 14.7% increase in the federal excise tax from $3.40
per carton to $3.90 per carton which became effective on January 1, 2002.
Total operating expenses decreased to $7.4 million for the third quarter of 2002
from $8.7 million for the third quarter of 2001. Approximately $0.5 million of
this amount is related to the promotion and product introduction of ARIVA(TM).
Marketing and distribution expenses, on a consolidated basis, totaled $3.2
million for the third quarter of 2002, an increase of $0.8 million over the
comparable 2001 period. This reflected increased distribution expense associated
with the introduction of ARIVA(TM) in major chain stores which previously had
not been Company customers. At the end of the first quarter of 2002, Star's
smokeless products were in approximately 12,000 convenience and retail stores,
and by the end of the second and third quarters of 2002, the number of
convenience and retail stores carrying Star's smokeless products had increased
to more than 30,000 and 33,000, respectively.
General and administrative expenses, on a consolidated basis, totaled $3.9
million for the third quarter of 2002, a decrease of $0.8 million over the
comparable 2001 period. This decrease was attributable in part due to a decrease
in legal and consulting expenses which were $0.5 million less during the third
quarter of 2002 compared to the third quarter of 2001. Legal expenses during the
third quarter related primarily to the Company's pending lawsuit against R.J.
Reynolds for patent infringement, which is in active discovery in the United
States District Court for the District of Maryland. Also, there were additional
costs related to the Company's constitutional challenge to the MSA, responses to
the Citizen Petitions filed with the FDA concerning ARIVA(TM), and for
scientific, legal, medical and public health consultants and advisors who are
assisting senior management in bringing the Company's new very low-TSNA
smokeless tobacco products to market. While general and administrative expenses
were lower in the third quarter of 2002 than they were in the third quarter of
2001, the Company anticipates increases in its general and administrative costs
in the coming months in connection with its patent infringement lawsuits and
other legal matters described above.
Research and development costs in the third quarter of 2002 were approximately
$0.3 million compared to $1.5 million during the third quarter of 2001. These
decreased costs reflect that the Company launched its new smokeless tobacco
products, ARIVA(TM) and STONEWALL(TM) moist and dry snuff, into test markets
during late 2001. Pre-launch R&D expenses were significantly higher than post
launch R&D costs, thus accounting for the decrease in R&D costs during the third
quarter of 2002 compared to the third quarter of 2001. The Company continues its
focus on the research and development on products that have reduced levels of
toxins, primarily TSNAs, and that potentially may reduce exposure to toxins
related to the range of serious health hazards associated with the use of
conventional smoked and smokeless tobacco products. The Company has initiated
and is in the process of designing several additional scientific studies to
determine, among other things, whether a reduction in TSNAs can be equated with
a reduction in health risk. These studies are conducted through independent
laboratories and universities.
The Company had interest expense of $490,000 and interest income of $185,000,
for a net interest expense of $305,000 in the third quarter of 2002. This
compares to net interest income of $240,000 during the third quarter of 2001.
The higher interest expense in the third quarter of 2002 resulted from capital
lease obligations entered into in late 2001 and the first quarter of 2002, as
well as interest charges from the Company's line of credit facility, which line
was utilized, in part, to finance the MSA Escrow obligation in April 2002 and
for general working capital requirements. This interest expense was partially
offset by interest income generated by the Company's deposits in its MSA Escrow
Fund. The Company receives for its own account the current interest on the
amounts in escrow, but this interest income is not sufficient to offset the
Company's cost of capital.
The Company had income tax expense of $0.3 million for the third quarter of 2002
as compared to an income tax expense of $0.5 million for the third quarter of
2001. This decrease is directly attributable to the change in pre-tax income
during the respective periods.
The Company had consolidated net income of $0.4 million for third quarter 2002
compared with consolidated net income of $0.5 million reported in the comparable
2001 period. The net income reflected higher margins on decreased cigarette
sales and the recognition of revenue for smokeless products which were being
sold during the third quarter of 2002 but which were still under development at
substantial cost during the same period in 2001. In the third quarter 2002, the
Company had basic and diluted earnings per share of $0.01 compared to comparable
period basic and diluted per share earnings of $0.01 in the same period in 2001.
17
FIRST NINE MONTHS 2002 COMPARED WITH FIRST NINE MONTHS 2001
During the first nine months of 2002, the Company's consolidated net sales
decreased $21.7 million or 15.7% to $116.8 million, from $138.5 million for the
first nine months of 2001. The decrease in sales was primarily due to
concentrating sales and marketing efforts into a smaller and increasingly
price-sensitive geographic region, namely Texas, Florida, Mississippi and
Minnesota, and the Company's focus on the introduction and market penetration of
its very low-TSNA smokeless tobacco products, which were introduced in the fall
of 2001. The Company sold approximately 2.7 billion cigarettes during the first
nine months of 2002, compared with sales of approximately 3.3 billion cigarettes
during the first nine months of 2001, representing a decrease of approximately
18%. The decrease in sales volume was offset in part by an increase during the
third quarter in the sales price charged by the Company and by the sale of its
smokeless tobacco products.
During the third quarter of 2002, the Company recorded royalty revenue of $1.3
million out of an anticipated $1.5 million for this growing season attributed to
the purchase of low-TSNA tobacco by B&W other than StarCured(TM) tobacco. The
royalty payments are made in the form of a reduction of long-term debt in
accordance with the terms of a licensing agreement entered into with B&W on
April 25, 2001. Royalty revenue during the third quarter of 2001 was $1.35
million out of a total of $1.5 million for the 2001 growing season. Additional
revenue of $14.6 million during the third quarter of 2002 was generated by the
sale of approximately 7.5 million pounds of the Company's very low nitrosamine
StarCured(TM) tobacco leaf to B&W. As of September 30, 2002, the Company had
received 10.8 million pounds of StarCured(TM) tobacco in its Chase City,
Virginia, facility, and shipped 7.5 million pounds of StarCured(TM) tobacco to
B&W. Revenues are not recognized until the tobacco departs the Chase City
facility. As of September 30, 2002, B&W had prepaid $5.2 million for 4/th/
quarter leaf sales. During the third quarter of 2001, revenue of $21.7 million
was generated by the sale of approximately 11.2 million pounds of StarCured(TM)
tobacco leaf to B&W. The revenues in 2001 were higher because in 2002 less
tobacco was shipped to B&W during the 3/rd/ quarter. Leaf tobacco revenues are
seasonal in nature, and occur during the third and fourth quarters. During the
first nine months of 2002, the Company earned de minimus royalties paid by B&W
on sales of its ADVANCE(R) low-TSNA cigarette, which B&W continues to test
market in Indianapolis, Indiana.
Gross profit in the first nine months of 2002 was $23.9 million, approximately
23.8% lower than the $31.3 million gross profit in the first nine months of
2001. Sales price increases were partially offset by an increase in
manufacturing costs, including increased contract prices for cigarettes made by
B&W given the lower level of production under the contract manufacturing
agreement. The Company's federal excise tax expense for the first nine months of
2002 was $45.2 million, a decrease of $3.8 million from the $49.0 million of
federal excise tax paid for the first nine months of 2001, despite a 14.7%
increase in the federal excise tax from $3.40 per carton to $3.90 per carton
which became effective on January 1, 2002. The decrease in federal excise taxes
paid is explained by the decrease in sales volume even after taking into account
the increase in the excise tax per carton paid.
Total operating expenses increased to $24.4 million for the first nine months of
2002 from $22.2 million for the first nine months of 2001 principally due to the
sales and marketing efforts associated with the market introduction of ARIVA(TM)
and STONEWALL(TM). Approximately $2.5 million of this amount is related to the
promotion and product introduction of ARIVA(TM) in Florida, Minnesota,
Mississippi and Texas, and to a lesser extent, in Virginia, where the Company's
sales force is concentrated. Marketing and distribution expenses, on a
consolidated basis, totaled $12.0 million for the first nine months of 2002, an
increase of $4.6 million over the comparable 2001 period. This reflected a
larger sales force of approximately 90 employees through the second quarter and
part of third quarter (during the third quarter, the Company reduced its sales
force to approximately 75 employees) and increased distribution expenses
resulting from the introduction of the Company's new smokeless products,
including additional costs related to the introduction of ARIVA(TM) in major
chain stores which previously had not been Company customers. By the end of the
first nine months of 2002, Star's smokeless products were in approximately
33,000 convenience and retail stores.
General and administrative expenses, on a consolidated basis, totaled $11.8
million for the first nine months of 2002, a decrease of $0.4 million over the
comparable 2001 period. This decrease was attributable primarily to a reduction
in legal and consulting expenses which were $0.9 million less during the first
nine months of 2002 compared to the comparable 2001 period. Legal expenses
during this period primarily related to the Company's pending lawsuit against
R.J. Reynolds for patent infringement, which is in active discovery in the
United States District Court for the District of Maryland. Also, there have been
additional costs related to the Company's constitutional challenge to the MSA,
responses to the Citizen Petitions filed with the FDA concerning ARIVA(TM), and
for scientific, legal, medical and public health consultants and advisors who
are assisting senior management in bringing the Company's new very low-TSNA
smokeless tobacco products to market. While general and administrative expenses
were lower in the first nine months of 2002 than they were in the first nine
months of 2001, the Company anticipates, despite its cost-cutting efforts
described below, increases in its general and administrative costs in the coming
months in connection with its patent infringement lawsuits and other legal
matters described above.
18
Research and development expenses were $0.9 million during the first nine months
of 2002, a decrease of 67% from $2.7 million for the first nine months of 2001.
These decreased costs reflect the Company's decreased product development costs
related to its new smokeless tobacco products, ARIVA(TM) and STONEWALL(TM) moist
and dry snuff, which were released into test markets in late 2001. The Company
continues its focus on the research and development of products that have
reduced levels of toxins, primarily TSNAs, and that potentially may reduce
exposure to toxins related to the range of serious health hazards associated
with the use of conventional smoked and smokeless tobacco products. The Company
has initiated and is in the process of designing several additional scientific
studies to determine, among other things, whether a reduction in TSNAs can be
equated with a reduction in health risk. These studies are conducted through
independent laboratories and universities.
The Company had interest expense of $1.2 million and interest income of $0.5
million, for a net interest expense of $0.7 million during the first nine months
of 2002. This compares to net interest income of $0.5 million during the first
nine months of 2001. The higher interest expense in the first nine months of
2002 resulted from capital lease obligations entered into in late 2001 and the
first quarter of 2002, as well as interest charges from the Company's line of
credit facility, which line was utilized, in part, to finance the MSA Escrow
obligation in April 2002 and for general working capital requirements. This
interest expense was partially offset by interest income generated by the
Company's deposits in its MSA Escrow Fund. The Company receives for its own
account the current interest on the amounts in escrow, but this interest income
is not sufficient to offset the Company's cost of capital. Given the increase in
the Company's indebtedness during late 2001 and the first quarter of 2002,
interest expense will remain substantially higher than historical levels.
An income tax benefit of $0.4 million for the first nine months of 2002 reflects
the pre-tax loss of $1.1 million versus income tax incurred for the first nine
months of 2001 of $4.0 million on pretax profit of $9.5 million.
Consolidated net loss for the first nine months of 2002 was $0.7 million,
compared with net income of $5.5 million for the comparable 2001 period. In the
first nine months of 2002, the Company had a basic and diluted loss of $0.01 per
share versus basic and diluted earnings per share of $0.09 in the first nine
months of 2001.
Liquidity and Capital Resources
In the first nine months of 2002, $7.6 million of cash was used to support
operating activities. This compared to negative cash used in operating
activities of $8.2 million during the first nine months of 2001. The increase in
cash used in operations during the first nine months of 2002 was primarily due
to an increase of $6.9 million in accounts receivable from customers and
additional costs related to the introduction of ARIVA(TM) on a national basis
during the same nine month period. This increase in accounts receivable resulted
primarily from a timing difference in sales. An increase in federal excise tax
occurred on 1 January 2002, and wholesalers attempted to minimize the amount of
inventory on hand as of that date to avoid paying a "floor tax" of 50 cents per
carton, since the federal excise tax increased from $3.40 per carton to $3.90
per carton on that day. Thus, receivables were uncharacteristically low as of
December 31, 2001, and had increased to more normal end of quarter levels during
2002. Further, receivables have increased as a result of longer duration payment
terms granted to smokeless tobacco distributors. There was a decrease of $0.3
million of refundable income taxes and there were approximately $0.5 million of
receivables from smokeless tobacco distributors as of September 30, 2002.
During the third quarter of 2002, the Company had deposits for equipment orders
and cash in restricted accounts collateralizing certain obligations in the
amount of approximately $2.7 million. The Company intends to complete a leasing
transaction in the fourth quarter of 2002 or first quarter of 2003 for equipment
required to manufacture ARIVA(TM) totaling approximately $1.2 million, which
will release approximately $0.5 million in equipment order deposits. Further,
the Company during the fourth quarter of 2002 or first quarter of 2003 intends
to refinance or renegotiate an operating lease and convert it to a capital lease
which will result in the release of approximately $1.2 million in cash from a
restricted account. Previously, the Company entered into loans and/or lease
agreements collateralized by a substantial portion of the Company's assets. As a
result, the ability of the Company to generate additional funds through
additional loans or leases collateralized by its assets is limited.
The Company and ST each have granted B&W a first priority security interest
under the B&W credit facility in their respective intellectual property as
collateral, and have each guaranteed the payment of the other's obligations. The
B&W credit facility is collateralized by the Company's curing barns, leaf
tobacco inventory and intellectual property, and principal is repaid beginning
on January 1, 2005 in equal monthly installments for 60 months. The B&W credit
facility bears no interest until January 2005.
In December 2001, the Company purchased approximately $5 million of
StarCured(TM) tobacco from B&W for use in its cigarette and smokeless tobacco
operations. The Company recognizes this obligation by showing the remaining
balance of the $3.5 million liability on its balance sheet, and a corresponding
tobacco inventory asset as the inventory has not yet been fully utilized in
cigarette and smokeless tobacco production.
19
The Company has a working capital line of credit, which is collateralized by
under-30 day accounts receivable from its cigarette business, in the amount of
$7.5 million. The Company can borrow up to 80% of its receivables and had $7.4
million of borrowings under this credit facility at September 30, 2002 at an
interest rate of Prime plus 0.5% which was an effective rate of approximately
5.25% during the third quarter of 2002. This line of credit matures in 2005.
Subsequent to September 30, 2002, the Company received $7.4 million in Federal
and State refunds. If the IRS determines that the Company's treatment of the
payments into escrow is not appropriate for tax purposes, then the Company,
based upon advice it has received from tax counsel, expects it will challenge
that determination in US Tax Court to seek a final determination with respect to
this issue. Ultimately, if the Company does not prevail in its position, the
funds would have to be returned. While general and administrative costs were
lower in the third quarter, the Company anticipates increases in its general and
administrative costs in the coming months in connection with the patent
infringement lawsuits and other legal matters.
As of September 30, 2002, the Company, on behalf of ST, had deposited into
escrow approximately $33.6 million to fund ST's net escrow obligations under the
MSA for sales in 1999, 2000 and 2001. Based on the increased escrow amount per
carton, and ST's sales in MSA states in future years, the Company will have to
pay significant sums into these escrow accounts to meet MSA requirements for
sales in later years. If not used to satisfy judgments or settlements, the funds
will be returned to the Company 25 years after the applicable date of deposit on
a rolling basis. In addition to the escrow deposits associated with the
Company's direct sales, the Company has, under protest, been required to make
additional escrow deposits related to sales of the Company's cigarettes
subsequently made by the Company's direct customers into other states ("indirect
sales"). In 2001 and in the first and second quarters of 2002, the Company made
approximately $4,500,000 in escrow payments in connection with indirect sales
that occurred in 1999, 2000 and 2001. The Company has received demands for
additional escrow payments for indirect sales which occurred in 2001, and
expects that it will continue to be subject to further additional escrow
obligations related to indirect sales which occurred from 1999-2001. In April
2003, the Company will be required to make escrow payments for all sales into
MSA states which occurred during 2002. It is anticipated that the Settling
States may make additional demands for indirect sales made during 2002 and Star
may be subject to additional escrow obligations for such sales. For the past
three years, the amount of MSA escrow funds which the Company has been required
to deposit has exceeded the Company's net income and its cash generated by
operations. Accordingly, the Company has been required to meet its MSA escrow
deposit obligations from sources other than operating income. To the extent that
the amounts the Company is required to deposit into the MSA escrow exceed
available cash flow from operations and other sources of liquidity, the Company
will be required to raise additional outside capital to make these payments.
In May 2002, the Company entered into negotiations with representatives of the
NAAG regarding terms under which Star could become a Subsequent Participating
Member of the MSA and resolve all currently contested issues relating to the
MSA, including all issues relating to claims under State Qualifying Statutes and
the Company's constitutional challenge to the MSA. In connection with those
discussions, a Standstill Agreement was negotiated which provides that during
the standstill period, the Settling States that executed the Agreement would not
initiate any enforcement action against the Company relating to claims for
additional escrow funding and compliance with state Qualifying Statutes, and the
Company would not initiate any new actions against the Settling States. The
Standstill Agreement was executed by twenty-nine of the forty-six Settling
States and Puerto Rico, and by its terms extended through July 23, 2002.
Although the Standstill Agreement has not been formally extended, the parties
have continued negotiations and neither the Settling States that signed the
Standstill Agreement nor the remaining Settling States have initiated any
enforcement action against the Company. Should Star reach a settlement agreement
with the NAAG, it is anticipated that a settlement would result in a resolution
of all outstanding issues with the Settling States. Such a comprehensive
settlement may result in Star contributing some or all of its escrow funds
toward that settlement. Any such contributions will be charged as an expense to
the income statement in the period when paid, and could result in a significant
decrease in book value of the Company. In the event the Company does not reach a
settlement agreement with the representatives of the NAAG, it is anticipated
that the states will promptly move forward on their demands that the Company
make additional escrow deposits to cover indirect sales claimed for the period
1999-2001. Failure to deposit required MSA escrow payments could result in
significant penalties to the Company and potential restrictions on selling
tobacco products in particular states. The Company is not presently able to
estimate the total amount of this obligation which will depend on a number of
factors including a determination of the amount of indirect sales in particular
states, and a determination of whether the Company is obligated to escrow funds
for all products it manufactured and sold, including product manufactured by B&W
under its contract manufacturing agreement with the Company, or only product the
Company manufactured at its Petersburg, Virginia, facility. If the Company is
only required to make escrow payments for cigarettes it manufactured at its
Petersburg, Virginia, facility, it could have potential obligations to B&W for
additional costs which B&W incurred for producing cigarettes which it made under
the manufacturing agreement with the Company. Under either scenario, the amount
of any additional obligation would be material and may require the Company to
raise additional funds to meet such obligations. All funds placed in escrow
continue to be an asset of the Company, and the Company receives the interest
income generated by the escrow deposits.
20
The Company has incurred approximately $0.7 million in losses during the first
nine months of operations, experienced an increase in working capital from $1.5
million to $5.3 million and negative cash flows during the period of $3.1
million.
Currently, the Company is not generating sufficient cash to fund its operations
and anticipated cash requirements. The Company recognizes that in order to
protect and defend its intellectual property, additional capital will need to be
spent in connection with its ongoing patent litigation matters. Additional
capital will be required for other litigation matters described herein. Further,
in order to continue to market and develop ARIVA(TM) additional capital will be
needed for sales, marketing and promotion. Given the current cash shortfalls,
the Company will need to generate or raise from outside sources a substantial
amount of additional cash to meet its obligations and to support its ongoing
operations and activities. Failure to raise additional capital may inhibit the
efforts described above and impede or prevent the Company from recognizing the
market potential for ARIVA(TM).
During the third quarter, management addressed cash flow shortfalls by taking a
number of steps that will continue through the fourth quarter. These include: 1)
Cost-cutting measures designed to reduce cost of goods sold and overhead. For
example, during the first half of the third quarter of 2002, sales territories
were reevaluated and restructured. This resulted in a reduction of the Company's
sales force from approximately 90 sales persons who had been employed during the
second quarter of 2002 to approximately 75 sales persons. The full quarterly
impact of these changes will be felt during the fourth quarter. Further, while
maintaining the Company's commitment to explore various business alternatives
and ultimately shift its major focus to very low-TSNA smokeless tobacco
products, the Company, with respect to its cigarette business, has decided to
return to the production of more conventional discount cigarette products, in an
effort to ensure that such discount cigarettes are competitive in an expanding
4th tier of the marketplace. Accordingly, the Company plans to reduce, or
entirely replace, the current 24% StarCured(TM) tobacco content in its
MAINSTREET(R) brand, its most popular brand, with other less expensive low-TSNA
tobacco. The Company may also consider comparable reductions in StarCured(TM)
tobacco in its other three discount cigarette brands. The Company previously
decided to use a more costly carbon/acetate filter on all of its discount
cigarettes. The added benefit of the use of such filters has been questioned by
certain members of the public health advocacy community. Accordingly, the
Company has replaced carbon/acetate filters with more conventional acetate
filters that are standard in the industry. The Company anticipates that these
changes will not have any material adverse impact on the sales of discount
cigarettes by Star Tobacco. 2) Increasing margins for its discount cigarettes by
raising prices approximately $1.00 per carton as compared to the second quarter
of 2002. 3) Obtaining a cash advance from B&W ($900,000) to fund, in part,
short-term tobacco leaf segment working capital needs of approximately $2.5
million. This cash advance was repaid in early October 2002. 4) Undertaking
steps to refinance an existing operating lease into a capital lease which will
result in the release of approximately $1.2 million of cash collateral and
undertaking to enter into a lease for ARIVA(TM) manufacturing equipment totaling
approximately $1.2 million resulting in a release of approximately $500,000 in
deposits held by the equipment manufacturer. The Company anticipates completing
this refinancing and lease during the fourth quarter of 2002 or the first
quarter of 2003.
Previously, the Company submitted to the IRS a request for a Private Letter
Ruling that would confirm the deductibility of funds placed in escrow under the
MSA. Based on the rationale set forth in its Letter Ruling request, the Company
took a deduction for escrow expenses in its IRS return for 2001, and sought a
refund for prior year payments. Subsequent to September 30, 2002, the Company
received $7.4 million in Federal and State refunds relating to such payments. If
the IRS determines that the Company's treatment of the payments into escrow is
not appropriate for tax purposes, then the Company, based upon advice from tax
counsel, expects it will challenge that determination in US Tax Court to seek a
final determination with respect to this issue. Ultimately, if the Company does
not prevail in its position, the funds would have to be returned. Even the
successful execution of the above action items and the receipt of the tax refund
cited above, may not provide sufficient funds to meet the Company's ongoing cash
needs, particularly given the Company's potential MSA funding requirements in
April 2003. The Company's liquidity needs for the next 12 months are very
difficult to estimate. Increased competition in the cigarette business, the
complexity of the issues relating to the negotiations with the NAAG, the
Company's obligations to make MSA escrow deposits, and the uncertainty regarding
consumer acceptance of ARIVA(TM), make it difficult for the Company to predict
with clarity its precise liquidity needs over specific time frames. The Company
is not generating sufficient cash from operations to fund its operations and
anticipated cash requirements. The adequacy of the Company's liquidity on both a
short and long-term basis will depend upon the effects on the Company and its
business from many factors such as the terms of a potential settlement with the
NAAG, potential strategic choices for the cigarette business, and the amount of
capital required to execute the Company's business objectives of broadly
distributing and marketing ARIVA(TM), defending its intellectual property, and
other working capital needs. Thus, it is anticipated the Company may need to
raise additional funds and/or consider other business options. The Company is
currently not able to estimate the combined impact of these events, however,
there could be circumstances under which the Company would be required to raise
a substantial amount of capital. There can be no guarantee that the Company will
be able to raise capital, or that if it can raise the capital, that the terms
would be acceptable to the Company. The Company's need to raise additional funds
to meet its working capital and other capital requirements will depend upon
numerous factors, including the results of its marketing and sales activities,
the amount of any escrow obligations it may be required to
21
deposit to comply with the Master Settlement Agreement, the success of the
Company's anticipated very low-nitrosamine smokeless tobacco products and the
other factors described under "Factors That May Affect Future Results" in the
Company's Annual Report on Form 10-K for the fiscal year ended December 31,
2001.
The foregoing discussion of the results of operations and financial condition of
the Company should be read in conjunction with the Company's condensed
consolidated financial statements and related notes included elsewhere in this
Report.
Item 3. Qualitative and Quantitative Disclosures About Market Risk
The Company has not entered into any transactions using derivative financial
instruments or derivative commodity instruments and believes that its exposure
to market risk associated with other financial instruments (such as investments
and borrowings) and interest rate risk is not material.
While a majority of the Company's debt facilities and leases are at fixed
interest rates, some borrowings, including the Company's line of credit and some
of the Company's leases are at variable rates and, as a result, the Company is
subject to interest rate exposure. In addition, the Company's investments in the
MSA-related escrow accounts are short-term very high quality investments.
Consequently, the income generated by these investments is subject to
fluctuation with changes in interest rates.
The Company receives for its own account the current interest on the amounts in
escrow, but this interest income is not sufficient to offset the Company's cost
of capital.
Note on Forward-Looking Statements
THIS REPORT ON FORM 10-Q CONTAINS CERTAIN FORWARD-LOOKING STATEMENTS WITHIN THE
MEANING OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995. THE COMPANY HAS
TRIED, WHENEVER POSSIBLE, TO IDENTIFY THESE FORWARD-LOOKING STATEMENTS USING
WORDS SUCH AS "ANTICIPATES", "BELIEVES", "ESTIMATES", "EXPECTS", "PLANS",
"INTENDS" AND SIMILAR EXPRESSIONS. THESE STATEMENTS REFLECT THE COMPANY'S
CURRENT BELIEFS AND ARE BASED UPON INFORMATION CURRENTLY AVAILABLE TO IT.
ACCORDINGLY, SUCH FORWARD-LOOKING STATEMENTS INVOLVE KNOWN AND UNKNOWN RISKS,
UNCERTAINTIES AND OTHER FACTORS WHICH COULD CAUSE THE COMPANY'S ACTUAL RESULTS,
PERFORMANCE OR ACHIEVEMENTS TO DIFFER MATERIALLY FROM THOSE EXPRESSED IN, OR
IMPLIED BY, SUCH STATEMENTS. THESE RISKS, UNCERTAINTIES AND CONTINGENCIES
INCLUDE, WITHOUT LIMITATION, THE CHALLENGES INHERENT IN NEW PRODUCT DEVELOPMENT
INITIATIVES PARTICULARLY IN THE SMOKELESS TOBACCO AREA, THE UNCERTAINTIES
INHERENT IN THE PROGRESS OF SCIENTIFIC RESEARCH, THE COMPANY'S ABILITY TO RAISE
THE CAPITAL NECESSARY TO GROW ITS BUSINESS, POTENTIAL DISPUTES CONCERNING THE
COMPANY'S INTELLECTUAL PROPERTY, RISKS ASSOCIATED WITH LITIGATION REGARDING SUCH
INTELLECTUAL PROPERTY, POTENTIAL DELAYS IN OBTAINING ANY NECESSARY GOVERNMENT
APPROVALS OF THE COMPANY'S LOW-TSNA TOBACCO PRODUCTS, MARKET ACCEPTANCE OF THE
COMPANY'S NEW SMOKELESS TOBACCO PRODUCTS, COMPETITION FROM COMPANIES WITH
GREATER RESOURCES THAN THE COMPANY, THE COMPANY'S DECISION NOT TO JOIN THE
MASTER SETTLEMENT AGREEMENT ("MSA") AND ITS DECISION TO CHALLENGE THE
CONSTITUTIONALITY OF THE MSA, THE EFFECT OF STATE STATUTES ADOPTED UNDER THE MSA
AND ANY SUBSEQUENT MODIFICATION OF THE MSA, THE COMPANY'S DEPENDENCE ON KEY
EMPLOYEES AND ON ITS STRATEGIC RELATIONSHIPS WITH BROWN & WILLIAMSON TOBACCO
CORPORATION. THE IMPACT OF POTENTIAL LITIGATION, IF INITIATED AGAINST OR BY
INDIVIDUAL STATES THAT HAVE ADOPTED THE MSA, COULD BE MATERIALLY ADVERSE TO THE
COMPANY.
SEE ADDITIONAL DISCUSSION UNDER "FACTORS THAT MAY AFFECT FUTURE RESULTS" IN THE
COMPANY'S ANNUAL REPORT ON FORM 10-K FOR THE YEAR ENDED DECEMBER 31, 2001, AND
OTHER FACTORS DETAILED FROM TIME TO TIME IN THE COMPANY'S OTHER FILINGS WITH THE
SECURITIES AND EXCHANGE COMMISSION. THE COMPANY UNDERTAKES NO OBLIGATION TO
UPDATE OR ADVISE UPON ANY SUCH FORWARD-LOOKING STATEMENTS TO REFLECT EVENTS OR
CIRCUMSTANCES AFTER THE DATE OF THIS PRESS RELEASE OR TO REFLECT THE OCCURRENCE
OF UNANTICIPATED EVENTS.
Item 4. Controls and Procedures
22
The Company maintains disclosure controls and procedures that are designed to
ensure that information required to be disclosed in the Company's Exchange Act
reports is recorded, processed, summarized and reported within the time periods
specified in the SEC's rules and forms, and that such information is accumulated
and communicated to the Company's management, including its Chief Executive
Officer and Chief Financial Officer, as appropriate, to allow timely decisions
regarding required disclosure based closely on the definition of "disclosure
controls and procedures" in Rule 13a-14(c). In designing and evaluating the
disclosure controls and procedures, management recognized that any controls and
procedures, no matter how well designed and operated, can provide only
reasonable assurance of achieving the desired control objectives, and management
necessarily was required to apply its judgment in evaluating the cost-benefit
relationship of possible controls and procedures.
Within 90 days prior to the date of this report, the Company carried out an
evaluation, under the supervision and with the participation of the Company's
management, including the Company's Chief Executive Officer and the Company's
Chief Financial Officer, of the effectiveness of the design and operation of the
Company's disclosure controls and procedures. Based on the foregoing, the
Company's Chief Executive Officer and Chief Financial Officer concluded that the
Company's disclosure controls and procedures are effective.
There have been no significant changes in the Company's internal controls or in
other factors that could significantly affect the internal controls subsequent
to the date the Company completed its evaluation.
PART II - OTHER INFORMATION
Item 1. Legal Proceedings
In May 2001, the Company filed a patent infringement action against R. J.
Reynolds Tobacco Company ("RJR") in the United States District Court for
Maryland, Southern Division to enforce the Company's rights under U.S. Patent
No. 6,202,649 (`649 Patent). On July 30, 2002, the Company filed a second patent
infringement lawsuit against RJR based on a new patent issued by the U.S. Patent
and Trademark Office on July 30, 2002 (Patent No. 6,425,401). The new patent is
a continuation of the `649 Patent, which is at issue in the first lawsuit
against RJR. Shortly after filing its second lawsuit, the Company filed a motion
to consolidate the two patent infringement lawsuits in the United States
District Court for Maryland. This motion was granted on August 26, 2002 and the
court thereafter set a fact discovery deadline of January 31, 2003. While a
trial date has not yet been set, the Company anticipates that the consolidated
lawsuits will proceed to trial before the end of 2003.
On June 28, 2002, Philip Morris filed a declaratory judgment action against the
Company in the United States District Court for the Eastern District of
Virginia, Richmond Division. The Complaint sought a declaration of
non-infringement and patent invalidity and unenforceability with respect to the
'649 patent. On July 29, 2002, the Company filed a motion to dismiss that
lawsuit on the basis that no actionable controversy exists between the
companies. After full briefing and oral argument, the United States District
Court on September 11, 2002, dismissed Philip Morris' lawsuit. Philip Morris did
not appeal the decision by the District Court.
Since the introduction of ARIVA(TM), three citizen petitions have been filed
with the Food and Drug Administration ("FDA") seeking to have ARIVA(TM)
regulated as a food and/or a drug product under the Federal Food, Drug and
Cosmetic Act. On May 1, 2002 the Company, through counsel, filed responses to
two of these petitions, and on June 13, 2002, filed a response to the third
petition. The Company also filed responses to other comments filed with the FDA
in certain of these dockets, including comments filed by certain State Attorneys
General. The Company's legal team is headed by former U.S. Solicitor General
Charles Fried, Esquire and by FDA attorneys from McDermott, Will & Emery; Paul,
Hastings, Janofsky & Walker LLP and Bergeson & Campbell, P.C. In the responses
counsel concluded that the petitions are factually flawed and without merit,
because ARIVA(TM) does not fit the definition of a food or a drug under the
Federal Food, Drug and Cosmetic Act. Furthermore, because ARIVA(TM) is a
smokeless tobacco product that is intended to provide tobacco satisfaction and
is licensed by the Bureau of Alcohol, Tobacco and Firearms of the Department of
the Treasury, the FDA lacks jurisdiction to regulate ARIVA(TM) based on the
March 21, 2000 decision of the Supreme Court in FDA v. Brown & Williamson
Tobacco Corporation, 529 U.S. 120 (2000). Despite the Company's position as
reflected in its responses, there is no certainty that the FDA would agree with
that position and not seek to assert jurisdiction over ARIVA(TM). By letter
dated July 17, 2002, the FDA stated that it was continuing to review the issues
raised in the first petition filed with the agency on December 18, 2001.
The Virginia Department of Taxation has asserted a Virginia Sales and Use Tax
assessment for the period January 1, 1999, through March 31, 2002, against the
Company with respect to its tobacco-curing barns in the amount of $860,115.06.
The Company has applied for a correction of the assessment and a total abatement
of the tax on the grounds that its barns are exempt from sales and use taxes
under the industrial use and processing exemption and/or the agricultural
exemption. The Company has not paid that assessment
23
and is not required to do so pending its appeal to the Department of Taxation.
The Company has also challenged the taxation of certain other property on the
grounds that the property is used directly in production activities at the
Company's plant in Chase City, Virginia. The Company has paid that assessment,
in the amount of $24,273.75, in full pending appeal. The administrative
procedure for consideration of the Company's application for correction of these
assessments is expected to be concluded by June 30, 2003.
There is other minor litigation in the ordinary course of business which the
Company is vigorously defending.
Item 2. Changes in Securities and Use of Proceeds.
In the third quarter of 2002, Star granted its directors, officers, employees
and consultants (the "Purchaser Class") options to purchase Star's Common Stock
as described below. All options described below were granted under the Star
Scientific, Inc. 1998 Stock Option Plan or the Star Scientific, Inc. 2000 Equity
Incentive Plan. On each of the dates set forth below, the options described were
offered to one or more members of the Purchaser Class in a private offering in
accordance with Section 4(2) of the Securities Act of 1933, as amended.
---------------------------------------------------------------------------------
Date of Grant Exercise Price Options Granted
(per share)
---------------------------------------------------------------------------------
08/29/02 $1.48 20,000
---------------------------------------------------------------------------------
Item 6. Exhibits and Reports on Form 8-K.
(a) Exhibits
Number Description
10.1 Amended and Restated Employment Agreement for Paul L. Perito, Esq.
dated as of June 14, 2002.
10.2 Allonge, dated as of June 14, 2002, by and between the Company and Paul
L, Perito, Esq.
10.3 First Modification Agreement to Amended and Restated Employment
Agreement for Paul L. Perito, Esq. dated as of November 1, 2002.
(b) Reports on Form 8-K
No reports on Form 8-K were filed during the period covered by this report.
SIGNATURES
In accordance with Section 13 or 15(d) of the Exchange Act, the registrant
caused this report to be signed on its behalf by the undersigned, thereunto duly
authorized.
STAR SCIENTIFIC, INC.
Date: November 14, 2002 /s/ Christopher G. Miller
-------------------------
Authorized Signatory and
Chief Financial Officer
24
CERTIFICATIONS
I, Jonnie R. Williams, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Star Scientific,
Inc.;
2. Based on my knowledge, this quarterly report does not contain any
untrue statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances
under which such statements were made, not misleading with respect to
the period covered by this quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and
cash flows of the registrant as of, and for, the periods presented in
this quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and
we have:
a. designed such disclosure controls and procedures to ensure
that material information relating to the registrant,
including its consolidated subsidiaries, is made known to us
by others within those entities, particularly during the
period in which this quarterly report is being prepared;
b. evaluated the effectiveness of the registrant's disclosure
controls and procedures as of a date within 90 days prior to
the filing date of this quarterly report (the "Evaluation
Date"); and
c. presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based
on our evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based
on our most recent evaluation, to the registrant's auditors and the
audit committee of registrant's board of directors (or persons
performing the equivalent function):
a. all significant deficiencies in the design or operation of
internal controls which could adversely affect the
registrant's ability to record, process, summarize and report
financial data and have identified for the registrant's
auditors any material weaknesses in internal controls; and
b. any fraud, whether or not material, that involves management
or other employees who have a significant role in the
registrant's internal controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in
internal controls or in other factors that could significantly affect
internal controls subsequent to the date of our most recent evaluation,
including any corrective actions with regard to significant
deficiencies and material weaknesses.
Date: November 14, 2002
/s/ Jonnie R. Williams
Jonnie R. Williams
Chief Executive Officer
25
I, Christopher G. Miller, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Star Scientific,
Inc.;
2. Based on my knowledge, this quarterly report does not contain any
untrue statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances
under which such statements were made, not misleading with respect to
the period covered by this quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and
cash flows of the registrant as of, and for, the periods presented in
this quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and
we have:
a. designed such disclosure controls and procedures to ensure
that material information relating to the registrant,
including its consolidated subsidiaries, is made known to us
by others within those entities, particularly during the
period in which this quarterly report is being prepared;
b. evaluated the effectiveness of the registrant's disclosure
controls and procedures as of a date within 90 days prior to
the filing date of this quarterly report (the "Evaluation
Date"); and
c. presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based
on our evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based
on our most recent evaluation, to the registrant's auditors and the
audit committee of registrant's board of directors (or persons
performing the equivalent function):
a. all significant deficiencies in the design or operation of
internal controls which could adversely affect the
registrant's ability to record, process, summarize and report
financial data and have identified for the registrant's
auditors any material weaknesses in internal controls; and
b. any fraud, whether or not material, that involves management
or other employees who have a significant role in the
registrant's internal controls; and
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in
internal controls or in other factors that could significantly affect
internal controls subsequent to the date of our most recent evaluation,
including any corrective actions with regard to significant
deficiencies and material weaknesses.
Date: November 14, 2002
/s/ Christopher G. Miller
Christopher G. Miller
Chief Financial Officer
26